Products/Variable Contracts
Limited Representative Exam
Series 6
9th Edition
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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.
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Contents
1 Securities Markets, Investment Securities,
and Economic Factors 1
1.1
What Is a Security? 3
1.3
1.2
Equity Securities 6
Common Stock Tracking
Equity Securities Preferred
Stock American Depositary
Receipts Rights and
Warrants Options
Debt Securities 30
Characteristics of Bonds
Bond Yields U.S. Government
and Agency Securities
Municipal Bonds Corporate
Bonds Tracking Corporate
Bonds The Money Market
1.4
Economic Factors 66
Gross Domestic Product
(GDP) Economic Policy
iii
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iv
Contents
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2.7
2.8
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Contents
3.2 Qualification
Examinations179
3.9
Registered Representatives
Registered Principals
Ineligibility and Disqualifications
Examinations
3.3
3.5
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3.12
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vi
Contents
5.2
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vii
Contents
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6.2
Calculations 375
Glossary 377
Index 407
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Introduction
INTRODUCTION
Thank you for choosing this exam preparation system for your educational needs and welcome to the Series 6 License Exam Manual. This manual has applied adult learning principles
to give you the tools youll need to pass your exam on the first attempt.
ix
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Introduction
% of Exam
22
22%
47
47%
21
21%
10
10%
When you complete your exam, you will receive a printout that identifies your performance in each area.
TA K E N O T E
EXAMPLE
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Each Test Topic Alert reviews content that is especially likely to appear on the
exam.
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Introduction
QUICK QUIZ
xi
Quick Quizzes are a quick interactive review of what you just read. These ensure
you understand and retain the material.
Coordinating with the LEM, the SecuritiesProTM QBank includes a large number of
questions that are similar in style and content to those you will encounter on the exam. You
may use it to generate tests by a specific unit or combination of units. The QBank also allows
you to create Weighted Mock Exams that mimic your test. There is no limit to 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 indicators of potential actual exam scoresthe 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 & Content Updates link
Dont forget to monitor your Exam-tips & Content Updates (located on your homepage).
When rules and regulations change, or when we want to share new information regarding your
exam, its posted there.
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xii
Introduction
Topic
each unit as you go. Carefully review all rationales. Use the reference number to locate additional or related information on the test topic in your LEM if needed (23 hours per Unit).
Do not become too overwhelmed or bogged down in any one unit. You dont want to lose
sight of the finish line because youre having trouble with one hurdle. Keep moving forward. Its 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 in the License Exam Manual and their
Unit Tests, using the Securities Pro 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 (about 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.
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Introduction
xiii
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 (about 2 hours per exam).
We recommend taking the Practice Exam prior to a scheduled class and the Mastery Exam
afterward.
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 skillsand improve your scoreby
learning a few test-taking techniques:
Read the full question
Avoid jumping to conclusionswatch 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
Beware of changing answers
Pace yourself
Each of these pointers is explained below, including examples that show how to use them
to improve your performance on the exam.
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xiv
Introduction
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Introduction
xv
Use of a calculator
For the most part, there are only a few questions that will require the use of a calculator.
Any math will be simple math; add, subtract, multiply, and divide. We recommend using a
calculator for math. You may ask for a calculator or ask if you can use your own. If using your
own, only simple math functions are allowed (add, subtract, multiply, and divide).
Pace yourself
Some people will finish the exam early and some do not have time to finish all the questions. Watch the time carefully (your time remaining will be displayed on your computer
screen) and pace yourself through the exam.
Do not waste time by dwelling on a question if you simply 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. Make sure that you have time to read all 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
Prometric secure website at www.prometric.com. You may also use www.prometric.com 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.
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xvi
Introduction
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1
Securities Markets,
Investment Securities,
and Economic Factors
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OBJECTIVES
When you have completed this Unit, you should be able to:
explain the basic features of common stock and other equity securities;
recognize the types of preferred stock and their unique features;
recognize the basic features of corporate, federal, agency, and municipal bonds as well
as other debt securities;
demonstrate the relationship of yields;
list and describe common money market instruments;
identify the four phases and key characteristics of the business cycle;
describe fundamental economic policies;
distinguish the four major interest rates in the United States;
assess currency exchange rates and their effects on importers and exporters.
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1. 1 WHAT IS A SECURITY?
A security constitutes an investment of money, in a common enterprise, with the expectation of profits to be derived primarily from the efforts of a person other than the investor. A
security may represent either an ownership (equity) interest in a company or a creditor relationship (through a debt obligation) with a company. Equity is most commonly represented by the
various forms of stock. Debt is most commonly represented by bonds and notes. Instruments
that give enhanced access to securities, such as rights, warrants, and options, are also considered
equity securities.
1. 1. 1
1. 1. 2
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1. 1. 3
1. 1. 3. 2 Broker
(1) A broker includes: an individual or a firm that charges a fee or commission for executing buy and sell orders submitted by another individual or firm; (2) the role of a brokerage
firm when it acts as an agent for a customer and charges the customer a commission for its
services; and (3) any person engaged in the business of effecting transactions in securities for
the accounts of others that is not a bank.
1. 1. 3. 3 Customer
A customer is any individual, person, partnership, corporation, or legal entity that is not a
broker, dealer, or municipal securities dealerthat is, the public.
1. 1. 3. 4 Dealer
(1) A dealer includes: the role of a brokerage firm when it acts as a principal in a particular trade. A firm acts as a dealer when it buys or sells a security for its own account and at its
own risk, then charges the customer a markup or markdown; and (2) any person engaged in
the business of buying and selling securities for their own account, either directly or through
a broker, that is not a bank.
1. 1. 3. 5 Member
A member of FINRA is any individual, partnership, corporation, or legal entity admitted
to membership in FINRA.
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1. 1. 3. 6 Security
Under the Securities Exchange Act of 1934, any note, stock, bond, investment contract,
variable annuity, profit-sharing or partnership agreement, certificate of deposit, option on a
security, or other instrument of investment is commonly known as a security.
1. 1. 3. 8 Prospectus
Generally, the term prospectus means any prospectus, notice, circular, advertisement,
letter, or communication, written or by radio or television, which offers any security for sale
or confirms the sale of any security. There are several types of prospectuses defined throughout
the license exam manual.
1. 1. 4
Liabilities
Net worth
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Dealer
Associated person
Member
Broker
Security
Equity
Debt
Assets
Liabilities
Net worth
Self-Regulatory Organization
(SRO)
Broker
Dealer
Associated person
Customer
Primary offering
Secondary transaction
FINRA
1. 2 EQUITY SECURITIES
This section discusses the following equity securities:
Common stock
Preferred stock
Related equity securities
Corporations may issue two types of stock: common stock and preferred stock. When
speaking of stock, people generally refer to common stock.
1. 2. 1
COMMON STOCK
A company issues common stock as its primary means of raising capital. All corporations
issue common stock. Investors who buy the stock buy a share of ownership in the companys
net worth. Whatever a business owns (its assets) less its creditors claims (its liabilities) belongs
to the business owners (its stockholders).
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TA K E N O T E
Each share of common stock entitles its owner to a portion of the companys profits, distributed, usually quarterly, as dividends, and an equal vote on directors and other important
matters. Most corporations are organized in such a way that their common stockholders regularly vote for and elect candidates to a board of directors to oversee the companys business. By
electing a board of directors, stockholders have some say in the companys management but
are not involved with the day-to-day details of its operations.
Common stock can be classified in four ways: authorized, issued, treasury, and
outstanding.
1. 2. 1. 1 Authorized Stock
As part of its original charter, a corporation receives authorization from the state to issue,
or sell, a specific number of shares of stock. Often, a company sells only a portion of the
authorized shares, raising enough capital for its foreseeable needs. The company may sell the
remaining authorized shares in the future or use them for other purposes. Should the company
decide to sell more shares than are authorized, it must amend its charter through a stockholder
vote that approves more shares.
1. 2. 1. 2 Issued Stock
Once authorized, issued stock can be distributed to investors. As already stated, when a
corporation issues or sells fewer shares than the total number authorized, it normally reserves
the unissued shares for future needs, including:
raising new capital for expansion;
paying stock dividends;
providing stock purchase plans for employees or stock options for corporate officers;
investors converting convertible bonds or convertible preferred stock to common stock; or
satisfying the exercise of outstanding stock purchase warrants.
Authorized but unissued stock does not carry the rights and privileges of issued shares
(such as voting rights and the right to receive dividends) and is not considered in determining
a companys total capitalization.
1. 2. 1. 3 Treasury Stock
Treasury stock is stock a corporation has issued and subsequently repurchased from the
public. The corporation can hold this stock indefinitely or can reissue or retire it. A corporation could reissue its treasury stock to fund employee bonus plans, distribute it to stockholders
as a stock dividend or, under certain circumstances, redistribute it to the public in an additional offering. Treasury stock does not carry the rights of outstanding common shares, such as
voting rights and the right to receive dividends.
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Treasury stock:
was outstanding stock before it was repurchased by the issuer;
has no voting rights;
does not receive dividends; and
can be reissued or retired.
A corporation buys back its stock for reasons that include:
increase earnings per share;
have an inventory of stock available to distribute as stock options, fund an
employee pension plan, etc.; or
use for future acquisitions.
1. 2. 1. 4 Outstanding Stock
Outstanding stock includes any shares that a company has issued but has not repurchasedthat is, investor-owned stock.
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1. 2. 1. 5. 2 Book Value
A stocks book value per share is a measure of how much a common stockholder could
expect to receive for each share if the corporation were liquidated. Most commonly used by
fundamental analysts, the book value per share is the difference between the historical value of
a corporations tangible assets and liabilities, divided by the number of shares outstanding. The
book value per share can (and usually does) differ substantially from a stocks market value.
1. 2. 1. 5. 3 Par Value
For investors, a common stocks par value is meaningless. It is an arbitrary value the company gives the stock in its articles of incorporation, and it has no effect on the stocks market
price. If a stock has been assigned a par value for accounting purposes, such as $1 or $.01, it is
usually printed on the face of the stock certificate.
When the corporation sells stock, the money received exceeding par value is recorded on
the corporate balance sheet as capital in excess of par, also known as paid-in surplus, capital
surplus, or paid-in capital.
The three methods of common stock valuation do not result in the same amount.
Outstanding stock
Authorized stock
Book value
Par value
1. 2. 1. 6. 1 Voting Rights
Common stockholders exercise control of a corporation by electing a board of directors
and by voting at annual meetings on important corporate policy matters, such as:
issuance of convertible securities or additional common stock;
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10
Shareholders do not vote on anything that has to do with dividends, such as when they
are declared and how much they will be. Shareholders do vote on stock splits, membership on
the Board of Directors, and issuance of additional securities like common stock and convertible bonds.
Calculating the Number of Votes. A stockholder can cast one vote for each share of
stock owned for each item on the ballot. Depending on the companys bylaws and applicable
state laws, a stockholder may have a statutory or cumulative vote.
Statutory voting allows a stockholder to cast one vote per share owned for each item on
a ballot, such as seats on the board of directors. A board candidate needs a simple majority to
be elected.
Cumulative voting allows stockholders to allocate their votes in any manner they choose.
Cumulative voting may be advantageous for small shareholders by giving them a greater opportunity to offset the votes of large shareholders by combining all their shares on a single seat.
EXAMPLE
An investor owns 100 shares of stock in the ABC Company. An election of the
board of directors is coming up, and several candidates are running to fill three seats.
The investor thus has a total of 300 votes100 for each seat. Under statutory voting,
he would allocate 100 votes to each of the three candidates he prefers. Under cumulative voting, he could, if he wished, allocate all 300 of his votes to a single candidate
for just one of the seats.
Proxies. Most stockholders find it difficult to attend the annual stockholders meeting
and so vote on company matters by means of a proxy, a form of absentee ballot. Once returned to the company, a proxy is cancelled if the stockholder attends the meeting, authorizes
a subsequent proxy, or dies.
1. 2. 1. 6. 2 Preemptive Rights
When a corporation raises capital through the sale of additional common stock, it may
be required by law or its corporate charter to offer the securities to its common stockholders
before the general public; this is known as an antidilution provision. Stockholders then have
a preemptive right to buy enough newly issued shares to maintain their proportionate ownership in the corporation.
TA K E N O T E
EXAMPLE
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11
1. 2. 1. 6. 3 Limited Liability
Stockholders cannot lose more than the amount they have paid for a corporations
stock. Limited liability protects stockholders from having to pay a corporations debts in
bankruptcy.
Limited liability means a shareholder of common stock cannot lose more than
what was investeda shareholder can lose the original value of his stock only. Another way to refer to limited liability is to state that common stock is non-assessable.
You may see the term assessable common stock on your exam; there is no such thing
as assessable common stock in todays marketplace.
1. 2. 1. 8. 1 Growth
An increase in the market price of shares is called capital appreciation. Historically, owning
common stock, with its associated capital appreciation, has provided investors with high real
returns compared to other types of investments.
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12
TA K E N O T E
When an investor sells a security for more than it was purchased for, the profit is
defined as a capital gain; if money is lost on the sale, the loss is defined as a capital
loss. If the investor does not sell the stock, the investor has an unrealized gain (or
loss). Capital gains are taxable only when they are realized.
1. 2. 1. 8. 2 Income
Many corporations pay regular quarterly cash dividends to stockholders based upon the
companys earnings. A companys dividends may increase over time as profitability increases.
Dividends, which can be a significant source of income for investors, are another reason many
people invest in stocks.
TA K E N O T E
EXAMPLE
A company that earns $1 per share may elect to pay a portion of those earnings
to shareholders in dividends. As earnings increase over time, the company may
increase its dividend as well. Investors who receive dividends must generally pay
15% dividend tax. (Until recently, investors paid ordinary income taxes on dividend
income.) The IRS makes no exceptions for individuals, but corporations receive a 70%
exclusion on dividend income.
Ten years ago, an investor bought 100 shares of ABC Corp. for $20 per share,
for a total investment of $2,000. At the time, the companys business was profitable,
earning $3 per share of which it paid $1 per share in dividends to shareholders and
reinvested the rest in growing the business. Ten years later, after moderate but consistent growth, the company earns $12 per share and pays $4 in dividends per share.
The stock price has consistently increased with the earnings growth and now sells for
$80 per share ($8,000 total value for our investors 100 shares). The investor has had
to pay income taxes each of the past 10 years on the dividend income he received but
will only have to pay capital gain taxes if he sells the stock. If he sold the stock now,
his taxable capital gain would be $60 per share ($80 current value $20 original cost
= $60 capital gain).
1. 2. 1. 9. 1 Market Risk
The chance that a stock will decline in price at a time that the investor needs the money
is a risk of owning common stock. The tendency for securities to move with the market is market risk. When the market is rising, stocks have a tendency to increase in value. Conversely,
most stocks tend to fall with declines in the overall market. Often, a move in the market is
prefaced by some change in the economic environment such as was the case in 2008.
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A long investors losses are limited to his total investment in a stock. A short sellers losses
are theoretically unlimited because there is no limit to how high a stocks price may climb
before an investor can close his position by purchasing the stock he originally sold.
1. 2. 1. 9. 2 Business Risk
Business risk, or the level of risk of the specific business, includes the speculative nature
of the business, the management of the business, the philosophy of the business, and so on.
Different types of businesses will have different levels of risk. For instance, searching for oil is
generally riskier than operating a grocery store.
However, each has unique risks associated with that type of business. Business risk can
also be thought of as the uncertainty of operating income. Utility companies have relatively
stable and predictable income streams and, therefore, have lower business risk. Because cyclical companies, such as auto manufacturers, have business risk unsteady or fluctuating operating income levels, they have higher business risk. Business risk relates to the activities of the
company.
1. 2. 1. 9. 3 Decreased or No Income
Another risk of stock ownership is the possibility of dividend income decreasing or ceasing
entirely if the company has business reverses.
TA K E N O T E
Common shareholders are last in line when a corporations assets are liquidated,
so common stock is often referred to as a junior security.
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Corporate bonds
Common stock
Preferred stock
Mortgage bonds
I and II
I and III
II and III
III and IV
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14
dividends
growth
guaranteed income
voting rights
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No assurance of return
Lower priority of income payment
No voting rights
Less inflation protection
I and II
I and III
II and IV
III and IV
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15
1. 2. 2
40
Stock
ABC Corp
Yld
%
Div
.75
PE
Ratio
Sales
100s
High
Low
Last
Chg
12
3329
78
71
73
- 1.50
EXPLANATORY NOTES
High-Low: High-low numbers are the highest and lowest prices for the stock in the last 52 weeks, not
including yesterdays trading.
Stock: Stocks are listed alphabetically, by the companys full name (not by its abbreviation). Company
names that are made up of initials appear at the beginning of the letters list.
Div: Current annual dividend rate paid on stock, based on the latest quarterly or semiannual
declaration, unless otherwise footnoted.
PE Ratio: Closing price of the stock divided by the companys earnings per share for the latest
12-month period reported. No P/E shown for stocks with no profit or for preferred stocks.
Last: The price at which the stock was trading when the exchange closed for the day.
Chg: The loss or gain for the day, compared with previous sessions closing price. No change at the
close is indicated by ... mark.
pf: Preferred stock. Dividends paid to preferred shareholders take precedence over those on common
stock. rt: Rights. wi: When and if issued. Stock may be authorized but not yet issued; it may be a new
issue; or it may have been split. wt: Warrant. The right to buy a set number of shares at a specific price
and until a certain date. x: Ex-dividend, meaning the seller of the stock, not the buyer, receives the
latest declared dividend. z: Sales total is given in full, not in hundreds.
* This sample comprises formats, styles, and abbreviations from a variety of currently available
sources and has been created for educational purposes.
TA K E N O T E
EXAMPLE
TA K E N O T E
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The exam may ask you to determine the cost of a round lot of stock in whole
dollars from its quoted price.
If ABC corporation common stock is purchased at its trading day low, how much
does an investor pay for a round lot? For the price of a round lot, multiply the trading
day low price of $71 by 100.
$71 x 100 = $7,100
Calculators are available at the test center, but do not expect a lot of math.
Typically, the entire exam has fewer than five calculations.
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16
1. 2. 2. 1 Exchange-Listed Stocks
In order to trade on an exchange, a security must meet the listing requirements of the
exchange such as maintaining a certain price and trading activity. These listed securities will
then trade on the exchange.
The model exchange for your exam is the NYSE; however, it is not the only exchange.
There are several regional exchanges in the U.S. but you dont need to know them by name
for your exam. Exchanges have physical locations and are considered an auction market; there
is a trading floor where buyers and sellers compete for trades.
In addition to trading on exchanges, listed securities may also trade over-the-counter
(OTC) (in the third market, discussed later).
1. 2. 2. 1. 1 Nasdaq
Nasdaq stands for National Association of Securities Dealers Automated Quotation
system. Nasdaq is an electronic stock market and it originated in 1971. Nasdaq does not have
a physical trading floor that brings together buyers and sellers; it is an automated computerized
information system that provides price and inventory information for market makers of
securities traded over-the-counter (OTC).
1. 2. 2. 1. 2 Nasdaq Markets
Nasdaq stocks that dont meet the listing requirements of an exchange or choose not to
trade OTC are unlisted securities. Most securities that trade are unlisted.
1. 2. 2. 1. 3 Non-Nasdaq
Thousands of securities trade in the OTC market that are not part of Nasdaq. These
securities are termed non-Nasdaq securities and trade on the over-the-counter bulletin board
(OTCBB) or the Pink Sheets and tend to be the most speculative of all equity securities.
TA K E N O T E
1. 2. 3
OTC Markets Group, Inc., formerly known as Pink OTC Markets, Inc., operates
OTC Link, an electronic quotation system that displays quotes from broker/dealers for
many OTC securities. These quotes at one time were printed on pink sheets of paper
and distributed to broker/dealers. Though Pink Sheets dont exist today, the term is
still referred to when discussing unlisted, non-Nasdaq securities.
PREFERRED STOCK
Preferred stock is an equity security because it represents ownership in the corporation. However, it does not normally offer the appreciation potential associated with common
stock.
Like a bond, a preferred stock is issued with a fixed (stated) rate of return. In the case of the
preferred stock, it is a dividend rather than interest that is being paid. As such, these securities
are generally purchased for income. Although the dividend of most preferred stocks is fixed,
some are issued with a variable dividend payout known as adjustable rate preferred stock. Like
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17
other fixed income assets such as bonds, preferred stock prices tend to move inversely with
interest rates. Most preferred stock is nonvoting and maintains no preemptive rights.
Although preferred stock does not typically have the same growth potential as common
stock, preferred stockholders generally have two advantages over common stockholders.
When the board of directors declares dividends, owners of preferred stock must receive
their stated dividend in full before common stockholders may be paid a dividend.
If a corporation goes bankrupt, preferred stockholders have a priority claim over common
stockholders on the assets remaining after creditors have been paid.
Because of these features, preferred stock appeals to investors seeking income and safety.
TA K E N O T E
Preferred stock has preference over common stock in payment of dividends and
in claim to assets in the event the issuing corporation goes bankrupt.
Fixed Rate of Return. A preferred stocks fixed dividend is a key attraction for incomeoriented investors. Normally, a preferred stock is identified by its annual dividend payment
stated as a percentage of its par value, which is usually $100 on the Series 6 exam. (A preferred stocks par value is meaningful to the investor, unlike that of common stock.) A preferred stock with a par value of $100 that pays $6 in annual dividends is known as a 6%
preferred. The dividend of preferred stock with par value other than $100 is stated in a dollar
amount, such as a $6 preferred.
The stated rate of dividend payment causes the price of preferred stock to act like the price
of a bond: prices and interest rates have an inverse relationship. In addition to the following
example, inverse relationship is presented later in this Unit under debt securities.
EXAMPLE
Consider a 6% preferred. If interest rates are at 8% and you want to sell your
preferred, you will have to sell at a discounted price. Why would a buyer pay full
value for an investment that is not paying a competitive market rate? But if interest
rates fall to 5%, the 6% preferred will trade at a premium. Because it is offering a
stream of income above the current market rate, it will command a higher price.
Limited Ownership Privileges. Except for rare instances, preferred stock does not have
Preferred stock represents ownership in a company like common stock, but its
price is sensitive to interest ratesjust like the price of a bond.
ferred stock, unlike bonds, has no preset date at which it matures and no scheduled redemption date or maturity value.
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1. 2. 3. 1. 1 Straight (Noncumulative)
Straight preferred has no special features beyond the stated dividend payment. Missed
dividends are not paid to the holder. The years stated dividend must be paid on straight preferred if any dividend is to be paid to common shareholders.
TA K E N O T E
1. 2. 3. 1. 2 Cumulative Preferred
Buyers of preferred stock expect fixed dividend payments. The directors of a company in
financial difficulty can reduce or suspend dividend payments to both common and preferred
stockholders. With cumulative preferred, any dividends in arrears must be paid prior to paying
a common dividend.
TA K E N O T E
EXAMPLE
RST Corp. has both common stock and cumulative preferred stock outstanding. Its preferred stock has a stated dividend rate of 5% (par value $100). Because of
financial difficulties, no dividend was paid on the preferred stock last year or the year
before. If RST wishes to declare a common stock dividend this year, RST is required to
first pay how much in dividends to the cumulative preferred shareholders?
RST must pay missed dividends to cumulative preferred (as well as the current
dividend) before dividends are paid on common stock. RST must pay $5 for the year
before last, $5 for last year, and $5 for this year, for a total of $15.
For noncumulative preferred stock outstanding, the answer would have been
$5. Only the current year dividend would need payment before common because
noncumulative preferred is not entitled to dividends in arrears.
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1. 2. 3. 1. 3 Convertible Preferred
A preferred stock is convertible if the owner can exchange each preferred share for shares
of common stock. The price at which the investor can convert is a preset amount and is noted
on the stock certificate. Because the value of a convertible preferred stock is linked to the
value of the issuers common stock, the convertible preferreds price fluctuates in line with the
common.
Convertible preferred is often issued with a lower stated dividend rate than nonconvertible preferred because the investor may have the opportunity to convert to common shares
and enjoy capital gains. In addition, the conversion of preferred stock into shares of common
increases the total number of common shares outstanding, which decreases earnings per common share and may decrease the common stocks market value. When the underlying common stock has the same value as the convertible preferred, it is said to be at its parityprice.
EXAMPLE
XYZ Companys convertible preferred stock, with a par value of $100 and a
conversion price of $20, can be exchanged for five shares of XYZ common stock
($100 $20 = 5). This is true, no matter what the current market value of either the
preferred or the common stock. Thus, if an investor bought the preferred for $100
per share and the common stock rises in price eventually to more than $20 per share,
the preferred stockholder could make a capital gain from converting.
1. 2. 3. 1. 4 Participating Preferred
In addition to fixed dividends, participating preferred stock offers owners a share of corporate profits that remain after all dividends and interest due other securities are paid. The
percentage to which participating preferred stock participates is noted on the stock certificate.
Before the participating dividend can be paid, a common dividend must be declared.
EXAMPLE
1. 2. 3. 1. 5 Callable Preferred
Corporations often issue callable, or redeemable, preferred, which a company can buy
back from investors at a stated price after a specified date. The right to call the stock allows the
company to replace a relatively high fixed dividend obligation with a lower one.
When a corporation calls a preferred stock, dividend payments and conversion rights
cease on the call date. In return for the call privilege, the corporation usually pays a premium
exceeding the stocks par value at the call, such as $103 for a $100 par value stock.
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TA K E N O T E
Callable preferred stock is unique because of the risk that the issuer may buy it
back and end dividend payments. Because of this risk, callable preferred has a higher
stated rate of dividend payment than straight, noncallable preferred.
Issuers are likely to call securities when interest rates are falling. Like anyone, an
issuer would prefer to pay a lower rate for money. Issuers call securities with high
rates and replace them with securities that have lower fixed rate obligations.
1. 2. 3. 1. 6 Adjustable-Rate Preferred
Some preferred stocks are issued with adjustable, or variable, dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bill and
money market rates, and can be adjusted as often as semiannually.
Participating
Straight
Cumulative
Callable
Answer: D. When the stock is called, dividend payments are no longer made. To
compensate for that possibility, the issuer must pay a higher dividend.
2. Which of the following would you expect to have the higher stated rate?
A. Straight
B. Cumulative
Answer: A. Cumulative preferred is safer, and there is always a risk-reward tradeoff. Because straight preferred has no special features, it will pay a higher stated
rate of dividend.
1. Which of the following types of preferred stock is most influenced by the price of
an issuers common stock?
A.
B.
C.
D.
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Participating
Straight
Convertible
Callable
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2. Which of the following types of preferred stock might pay a dividend that is
higher than that printed on the certificate?
I.
II.
III.
IV.
A.
B.
C.
D.
Straight preferred
Cumulative preferred
Participating preferred
Callable preferred
I and III
I and IV
II and III
II and IV
3. In which of the following ways does preferred stock differ from common stock as
an investment?
A.
B.
C.
D.
Lower dividends
Greater sensitivity to interest rate fluctuation
Lower priority of dividend payment
Greater voting rights
TA K E N O T E
Cash Dividends. Cash dividends are normally distributed by check if an investor holds
the stock certificate or are automatically deposited to a brokerage account if the shares are
held in street namethat is, held in a brokerage account in the firms name to facilitate
payments and delivery. Dividends are usually paid quarterly and taxed as dividend income
in the year they are received.
Stock Dividends. If a company must use its cash for business purposes rather than to pay
cash dividends, its board of directors may declare a stock dividend. This is typical of many
growth companies that invest their cash resources in research and development. Under
these circumstances, the company issues shares of its common stock as a dividend to its
current stockholders. A stocks market price per share declines after a stock dividend, but
the companys total market value remains the same.
Stock Splits. A company will sometimes change the number of outstanding shares by
means of a stock split. The total value of the outstanding stock must be the same before and
after the split. Thus if theXYZ Corporation did a 2for-1 stock split, an investor who owned
100 XYZ shares worth $20 per share before the splitwould own 200 shares worth $10 per
share after the split. If the company did a 1-for-2 reverse split, an investor with 100 shares
worth $20 per share before the split would own 50 shares worth $40 per share after the split.
Note that although the individual share value changes as a result of a split, the total value of
the stock remains the same. Since they change the trading characteristics of a stock, shareholder approval must be obtained for stock splits.
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TA K E N O T E
Stock dividends, unlike cash dividends, are not taxed when received. There are
no tax consequences incurred until the investor chooses to liquidate the shares and
realize the gains or losses.
EXAMPLE
RST stock has a current market value of $50. Total dividends paid during the year
were $5. What is the dividend yield? The solution is found by dividing $5 by $50. The
yield is 10%.
Be alert for a slightly tricky approach to this question. The question might state
that RST has a current market value of $50. The most recent quarterly dividend paid
was $1.25. What is the dividend yield?
The solution is found by annualizing the quarterly dividend (multiplying by 4)
first. $1.25 4 = $5. $5 $50 = a 10% dividend yieldremember to use annual
dividends in calculating yield.
You may see a question that asks about the priority of dividend payments made
by a corporation. The order of payment is as follows:
1. Dividends in arrears paid to cumulative shares
2. Stated dividends paid to all preferred shares
3. Common dividend
EXAMPLE
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A common stock purchased for $20 with an annual dividend of $1 is sold after
one year for $24. The total return on the investment is $5, $1 in dividends plus $4 in
capital appreciation. The total return, then, is 25% ($5 $20 = 25%).
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1. 2. 3. 3 Transferability of Ownership
The ease with which stocks and other securities can be bought and sold contributes to
the smooth operation of the securities markets. When an investor buys or sells a security, the
exchange of money and ownership requires little or no additional action on the investors
part.
EXAMPLE
An investor who buys 100 shares of ABC, Inc., would receive one certificate for
100shares.
Stock certificates identify the companys name, number of shares, and investors name,
among other things. Each certificate is printed with the securitys CUSIP number (an identification or tracking number).
1. 2. 3. 3. 2 Negotiability
Shares of stock are negotiable; that is, a stockholder can give, transfer, assign, or sell shares
the stockholder owns with few or no restrictions.
100
Preemptive right
Current yield
Quarterly
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1. 2. 4
TA K E N O T E
ADRs allow domestic investors to buy foreign securities moreeasily. Many investors include foreign issues in their portfolios for diversification.
The following question identifies nearly all of the testable points on ADRs:
Which of the following statements about ADRs is TRUE?
A. Owners of ADRs have premptive rights.
B. ADRs allow foreign investors to buy domestic issues of stock.
C. Owners of ADRs receive dividends in foreign currency.
D. ADR owners are subject to currency risk.
nswer: D. Owners of ADRs face currency risk. The exchange rate between the
A
foreign currency of the ADR issuer and the U.S. dollar causes the dividend payment to rise and fall in dollar value. Owners of ADRs have no preemptive rights.
ADRs allow domestic investors to purchase foreign issues, not the reverse. ADR
owners receive dividends in dollars.
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1. 2. 5
Dividends
Capital gains or losses
Both dividends and capital gains or losses
Neither dividends nor capital gains or losses
1. 2. 5. 1 Rights
Preemptive rights allow existing stockholders to maintain their proportionate ownership
in a company by buying newly issued shares before the company offers them to the general
public. A rights offering allows stockholders to purchase common stock below the current
market price. The rights are valued separately from the stock and trade in the secondary market during the subscription period. A stockholder who owns rights may:
exercise the rights to buy stock by sending the rights certificates and a check for the
required amount to the rights agent;
sell the rights and profit from their market value (rights certificates are negotiable securities); or
let the rights expire and lose their value.
1. 2. 5. 1. 2 Characteristics of Rights
Once a rights offering has been issued, the rights may be bought or sold in the secondary
market just as stock is bought and sold. If the holder of a right does not sell it, the holder may
exercise it to buy the stock specified in the right or let it expire.
Subscription Right Certificate. A subscription right is a certificate representing a shortterm (typically 30 to 45 days) privilege to buy additional shares of a corporation. One right is
issued for each common stock share held by the investor.
Terms of the Offering. The terms of a rights offering are stipulated on the subscription
right certificates mailed to stockholders. The terms describe how many new shares a stockholder may buy, price, the date new stock will be issued, and a final date for exercising the
rights. The stock is often offered to rights holders at a discount.
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Standby Underwriting. If the current stockholders do not subscribe to all the additional
stock, the issuer may offer unsold shares to a broker/dealer in a standby underwriting. A
standby underwriting is done on a firm commitment basis, meaning the broker/dealer or underwriter buys all unsold shares from the issuer and then resells them to the general public.
1. 2. 5. 2 Warrants
A warrant is a certificate granting its owner the right to buy securities from the issuer at a
specified price, normally higher than the market price when issued. Unlike a right, a warrant is
usually a long-term instrument, giving the investor the choice of buying shares at a later date
at the exercise price.
1. 2. 5. 2. 1 Origination of Warrants
Warrants are usually offered to the public as sweeteners (inducements) in connection with
other securities, such as debentures or preferred stock, to make the securities more attractive;
such offerings may be bundled as units.
Warrants may be detachable or nondetachable from other securities. If detachable, they trade
in the secondary market in line with the common stocks price. When first issued, a warrants
exercise price is set well above the stocks market price. If the stocks current market price
increases, the owner can exercise the warrant and buy the stock at the exercise price or sell
the warrant in the market.
Comparison of Rights and Warrants
Rights
Short term
Long term
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Warrants
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1. 2. 6
OPTIONS
An option is a contract that gives the buyer a right to do something with an underlying
security over time, usually nine months. The right will be to buy or sell the underlying security
at a stated price; the seller of the contract is obligated to fulfill the terms of the contract if it
is exercised.
An option is also a type of derivative because the value of the contract is primarily based
on the value of the underlying security. Buying and selling option contracts can expose investors to elevated and even unlimited financial risk, therefore, before an investor can open an
options trading account, it must be determined to be suitable for the investor. An options
disclosure document must be delivered prior to opening the account. This document is mostly
educational in nature and reviews basic options terminology, definitions, and risks.
The buyer is the owner of the contract and the seller is often referred to as the writer of
the contract.
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Each stock option contract covers 100 shares (a round lot) of stock which may be exercised (bought in the case of a call, sold in the case of a put), at a specific price, called the strike
price, before a specific date, called the expiration date. In general, the maximum life of an
option is nine months. This makes them longer term than stock rights but shorter than warrants. An options cost is called the premium. Premiums are quoted in dollars per share.
EXAMPLE
1. 2. 6. 1. 1 Exercise Prices
An options exercise or strike price is the price at which the option owner is entitled to
buy or sell the underlying security and the price at which the option seller has agreed to sell
or buy the security.
1. 2. 6. 1. 2 Leverage or Income
Option contracts provide purchasers with leverage: a relatively small cash outlay allows an
investor to control an investment that would otherwise require a much larger sum. If a stock
is currently $20 per share, 100 shares would cost $2,000, but a call on 100 shares might cost
only $200 to $300.
As the seller of an option contract, there is one main objective: Income.
The writer sells the contract, collects the premium, and hopes the contract expires so they
can keep the premium.
TA K E N O T E
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In a call: the buyer of the call has the right to buy; the seller of the call has the
obligation to sell.
In a put: the buyer of the put has the right to sell; the seller of the put has the
obligation to buy.
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The exam will have very few questions about options. You should be well prepared if you know the information in the following table.
Buy
Sell
Call
Right to buy
Bullish
Obligation to sell
Bearish
Put
Right to sell
Bearish
Obligation to buy
Bullish
Call buyer
Call writer
Put buyer
Put writer
I and III
I and IV
II and III
II and IV
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Call buyer
Call writer
Put buyer
Put writer
I and III
I and IV
II and III
II and IV
Terms and Concepts Checklist
Common stock
Par value
Authorized
Issued
Treasury
Outstanding
Current market value
(CMV)
Book value
Exchange listed
OTC
Fixed income
Straight preferred
Cumulative preferred
Callable preferred
Convertible preferred
Participating
preferred
Adjustable rate
preferred
Statutory voting
Cumulative voting
Preferred stock
ADR
(Preemptive) rights
Warrant
Option contracts
Bull, bullish
Leverage
Bear, bearish
Cash dividends
Dividend yield
Stock dividends
Growth
Investment risk
Return on investment
Exercise price or strike
price
Long or short call
Long or short put
Expiration date
1. 3 DEBT SECURITIES
So far, we have been discussing equity securities, those that confer actual ownership in a
company upon its holder. These securities, as we have seen, take the form of common and preferred stock. A second major form of security, debt securities, can be issued not only by corporations, but by federal, state, or local governmental bodies as well. Corporate debt instruments
can be secured or unsecured. Secured bonds are backed by some form of collateral, discussed
later. A debt instrument issued by a state or local government takes the form of a municipal
bond or note. A debt instrument issued by the federal Treasury takes the form of a Treasury
bill, note, or bond. A debt instrument issued to fund a government-sponsored enterprise takes
the form of an agency issue.
Bonds, whether issued by corporations, municipalities, the U.S. government, or its agencies, are debt securities. As the borrower, the issuer promises to repay the debt on a specified
date and to pay interest on the loan amount.
Because the interest rate the investor receives is set when the bond is issued, it is a fixedincome security. Individual bonds usually have a par (principal or face) value of $1,000.
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1. 3. 1
31
CHARACTERISTICS OF BONDS
As creditors, bondholders receive preferential treatment over common and preferred
stockholders if a corporation files for bankruptcy. Because creditor claims are settled before the
claims of stockholders, bonds are considered senior securities. Therefore, stockholder interests
are subordinate to those of bondholders.
1. 3. 1. 1 Issuers
Corporations issue bonds to raise working capital or funds for capital expenditures such as
plant construction or equipment and other major purchases. Corporate bonds are commonly
referred to as funded debt. Funded debt is any long-term debt payable in five years or more.
The federal government is the nations largest borrower and the most secure credit risk.
Treasury bills (maturities of 52 weeks or less), notes (2- to 10year maturities), and bonds
(greater than 10-year maturities) are backed by the full faith and credit of the government and
its unlimited taxing powers.
Municipal securities are the debt obligations of state and local governments and their
agencies. Most are issued to raise capital to finance public works or construction projects that
benefit the general public.
TA K E N O T E
Generally, bonds issued by the federal government have the lowest default risk,
followed by agency issues of the federal government, municipal bonds, then corporate bonds. Because corporate bonds are the riskiest, they provide the highest potential income to investors.
1. 3. 1. 2. 1 The Trustee
The Trust Indenture Act of 1939 requires a corporation to appoint a trusteeusually a
commercial bank or trust companyfor its bonds. The trustee ensures compliance with the
covenants of the indenture and acts on behalf of the bondholders if the issuer defaults.
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Exemptions. Federal and municipal governments are exempt from the Trust Indenture
Act provisions, although municipal revenue bonds are typically issued with a trust indenture
to make them more marketable.
1. 3. 1. 3 Interest
Both the interest rate an issuer pays its bondholders and the timing of payments are set
when a bond is issued. The interest rate, or coupon, is calculated from the bonds par value.
Par value, also known as face value, is normally $1,000 per bond, meaning each bond is sold
for $1,000 at issue and will be redeemed for $1,000 when it matures. Interest on a bond accrues
daily and is paid in semiannual installments over the life of the bond.
1. 3. 1. 4 Maturities
On the maturity date, the loan principal is repaid to the investor. Each bond has its own
maturity date. The most common maturities fall in the five- to 30-year range.
1. 3. 1. 5 Bond Certificates
1. 3. 1. 6 Registration of Bonds
Bonds are registered to record ownership should a certificate be lost or stolen. Tracking a
bonds ownership through its registration has been common in the United States only since
the early 1970s.
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1. 3. 1. 6. 2 Registered Bonds
Registered bonds may be issued as fully registered or registered as to principal only.
Fully Registered. When bonds are registered as to both principal and interest, the transfer
agent maintains a list of bondholders and updates this list as bond ownership changes. Interest payments are automatically sent to bondholders of record. The transfer agent transfers
a registered bond whenever a bond is sold by cancelling the sellers certificate and issuing a
new one in the buyers name. Today, if a bond is issued with a certificate, it will be fully registered.
Registered as to Principal Only. Principal-only registered bonds have the owners name
printed on the certificate, but the coupons are in bearer form.
When bonds registered as to principal only are sold, the names of the new owners are
recorded (in order) on the bond certificates and on the issuers registration record. Like bearer
bonds, bonds registered as to principal only are no longer issued.
1. 3. 1. 6. 3 Book-Entry Bonds
Book-entry bond owners do not receive certificates. Rather, the transfer agent maintains
the securitys ownership records. The names of buyers of both registered and book-entry bonds
are recorded (registered), but the book-entry bond owner does not receive a certificatethe
registered bond owner does. The trade confirmation serves as evidence of book-entry bond
ownership. All U.S. government and municipal bonds are available only in book-entry form.
Bonds issued today must be fully registered or book-entry, not bearer or registered as to principal only bondsthe issuer must have the name of the investor
entitled to both principal and interest payments on its ownership list.
Remember that bonds are senior to stock, meaning they must be paid first. Thus, bond
interest must be paid before dividends may be paid. Similarly, just as preferred stock is senior
to common stock, secured bonds are senior to unsecured bonds (debentures), which are in turn
senior to subordinated debt. The general order thus described may be illustrated with the other
obligations of a company by means of the priority of payment upon liquidation.
1. 3. 1. 7 Liquidation Priority
In the event a company goes bankrupt, the hierarchy of claims on the companys assets
are as follows.
1. Unpaid wages
2. IRS, state, and county (taxes)
3. Secured debt (bonds and mortgages)
4. Unsecured bonds (debentures) and general creditors of the issuer
5. Subordinated debt
6. Preferred stockholders
7. Common stockholders
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1. 3. 1. 8 Pricing
Once issued, bonds are bought and sold in the secondary market at prices determined by
market conditions.
Means . . .
Or . . .
92
92% of
$1,000
$ 920.00
931/8
931/8% of $1,000
$ 931.25
941/4
941/4% of $1,000
$ 942.50
953/8
953/8% of $1,000
$ 953.75
961/2
961/2% of $1,000
$ 965.00
975/8
975/8% of $1,000
$ 976.25
983/4
983/4% of $1,000
$ 987.50
997/8
997/8% of $1,000
$ 998.75
100
100% of
$1,000
$1,000.00
105
105% of
$1,000
$1,050.00
Bond price changes are quoted in newspapers in points. One point is 1% of $1,000 (or
$10), and point is $2.50. The minimum variation for most corporate bond quotes is
(.125%, or $1.25).
Example:
Bid Ask
98 98
The term basis point may be used on your exam. A basis point is of 1%. 100basis
points equals 1%. Therefore 75 basis points is .75%, 50 basis points is .50%, and soon.
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TA K E N O T E
35
It is important to remember that one bond point is equal to $10 and one stock
point is equal to $1. For example, when a bond is selling at a 2% premium, it is selling
at 102% of par, or $1,020 (2 points over par).
Just like preferred stock, bond prices are inversely affected by interest rates. As
interest rates fall, bond prices rise; as interest rates rise, bond prices fall. This inverse
relationship affects all debt securities.
Long-term bond prices fluctuate more than short-term bond prices because the
longer length of time to maturity magnifies price movement. The risk of rising interest rates reducing the value of fixed income investments such as preferred stock or
bonds is called interest rate risk.
Price
sole proprietorships
the U.S. government
municipalities
corporations
2. Which of the following entities are exempt from the Trust Indenture Act of 1939?
I.
II.
III.
IV.
A.
B.
C.
D.
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the premium
the discount
the amount owed
the overage
Moodys
Interpretation
Aaa
AA
Aa
BBB
Baa
Ba
Caa
TA K E N O T E
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You might be asked to choose the bond with the highest rating. Ratings are like
report cardsthe more As up front, the better.
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EXAMPLE
1. 3. 1. 11 Liquidity
Liquidity is the ease with which a bond or any other security can be sold. Many factors
determine a bonds liquidity, including:
quality;
rating;
maturity;
call features;
coupon rate and current market value;
issuer; and
existence of a sinking fund (an account to insure payment of principal).
TA K E N O T E
The terms liquidity and marketability are synonymous. Know that either term
refers to how quickly a security can be converted into cash.
1. 3. 1. 12 Maturity
The longer the term to maturity, the greater the risk to bondholders. Bonds with longer terms to maturity experience greater fluctuation in price, or volatility, than short-term
bonds.
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1. 3. 1. 13 Debt Retirement
The schedule of interest and principal payments due on a bond issue is known as the debt
service.
1. 3. 1. 13. 1 Redemption
When a bonds principal is repaid, the bond is redeemed. Redemption usually occurs on
the maturity date. When redeemed at maturity, the redemption equals the last semi-annual
interest payment plus the principal of the bond.
EXAMPLE
The redemption amount for a 6%, $1,000 par corporate bond equals the last
semi-annual interest payment of $30, plus the principal of $1,000, for a total amount
due of $1,030.
Sinking Fund. To facilitate the retirement of its bonds, a corporate or municipal issuer
sometimes establishes a sinking fund operated by the bonds trustee. The trust indenture
often requires a sinking fund, which can be usedto call bonds, redeem bonds at maturity, or
buy back bonds in the open market.
To establish a sinking fund, the issuer deposits cash in an account with the trustee.
Because a sinking fund makes money available for redeeming bonds, it can aid the bonds
price stability.
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If a bond issues trust indenture does not include a call provision, the issuer can buy bonds
in the open market, a practice known as tendering, to retire a portion of its debt.
Call Protection. Bonds are called when general interest rates are lower than they were
when the bonds were issued. Investors, therefore, are faced with having to replace a relatively
high fixed-income investment with one that pays less; this is known as call risk.
A newly issued bond normally has a call protection period of five or 10years to provide
some safety to investors. During this period, the issuer may not call any of its bonds. When
the call protection period expires, the issuer may call any or all of the bonds, usually at a premium. A call protection feature is an advantage to bondholders in periods of declining interest
rates.
Callable bonds generally have slightly higher coupons than comparable noncallable bonds
because of the increased risk to investors.
Bonds are typically called when interest rates are declining. Consider the issuers
side: would you want to pay more interest for the use of money than you need
to?
2. Investors who purchase callable bonds face what types of investment risk?
Call risk is the risk that the bonds will be called and the investor will lose the
stream of income from the bond. Remember that bonds dont pay interest after
they have been called. The call feature also causes reinvestment risk. If interest
rates are down when the call takes place, what likelihood does the investor have
of reinvesting the principal received at a comparable rate?
Answer: A. Investors want to lock in the highest possible rate of interest for the
longest period of time. During the call protection period the issuer may not call
the bonds away.
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TA K E N O T E
Call protection
Premium
Debt service
Sinking fund
1. Account established so that an issuer has the money to redeem its bonds
2. Contractual promise stating that the bond issue is not callable for a certain
period of time
3. The schedule of interest and principal payments due on a bond issue
4. Difference between the higher price paid for a bond and the bonds face
amount at issue
5. Which of the following AA rated corporate bonds would be expected to have the
lowest market price?
A.
B.
C.
D.
1. 3. 2
BOND YIELDS
A bonds yield expresses the cash interest payments in relation to the bonds value. Yield
is determined by the issuers credit quality, prevailing interest rates, time to maturity, and call
features. Bonds can be quoted and traded in terms of their yield as well as their price, expressed
as a percentage of par dollar amount.
1. 3. 2. 1 Comparing Yields
Because bonds most frequently trade for prices other than par, the price discount or premium from par is taken into consideration when calculating a bonds overall yield. Many
investors judge the value of a bond by comparing various yields. You can look at a bonds yield
in several ways.
1. 3. 2. 1. 1 Nominal Yield
A bonds nominal yield, is set at issuance and printed on the face of the bond.
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Nominal yield is a fixed percentage of the bonds par value and is also known as the coupon or stated yield.
EXAMPLE
TA K E N O T E
Recognize that different names exist for a bonds nominal yield. It can be called
the coupon rate, the fixed rate, or the stated rate of the bond. The nominal rate of
interest will always be paid to the bondholder, regardless of whether the bonds price
changes.
1. 3. 2. 1. 2 Current Yield
Current yield (CY) measures a bonds annual interest relative to its market price, as shown
in the following equation:
Annual interest market price = current yield
Bond prices and yields move in opposite directions: as a bonds price rises, its yield declines,
and vice versa. When a bond trades at a discount, its current yield increases; when it trades at
a premium, its current yield decreases.
*
*
EXAMPLE
EXAMPLE
What is the current yield of a 6% bond trading for $1,200? Find the solution as
follows: $60 $1,200 = 5%. This bond is trading at a premium. Price is up, so the
yield is down. The current yield (5%) is less than the nominal yield (6%) when bonds
are trading at a premium.
The diagram below is effective in helping master the relationships in bond yields.
Be sure to understand the inverse relationship between price and yield.
YTM
Premium
Par
Discount
Coupon
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1. 3. 2. 1. 3 Yield to Maturity
A bonds yield to maturity (YTM) reflects the annualized return of the bond if held to
maturity and is the most comprehensive measure for comparison of bond yields. In calculating
yield to maturity, the bondholder takes into account the difference between the price paid for
a bond and par value.
If the bonds price is less than par, the discount amount increases the return (if held to
maturity). If the bonds price is greater than par, the premium amount decreases the return (if
held to maturity).
Follow the lines on the chart to identify these concepts:
1. When bonds are at par, coupon and current yield are equal. (The point of intersection on the CY line is neither higher nor lower than the coupon on the line
that represents par.)
2. When bonds are at a premium, the CY is less than the coupon. (The point of
intersection on the CY line is below the coupon on the line that represents premium.)
3. When bonds are at a discount, the CY is greater than the nominal yield. (The
point of intersection on the CY line is above the coupon on the line that represents discount.)
You can also compare a bonds yield to maturity to its coupon and current yield.
TA K E N O T E
When a bond is trading at a premium, its YTM is less than its current yield. The
point of intersection on the YTM line is below the current yield on the line that represents premium. Use the chart to keep these important relationships in mind. When
you take the Series 6 exam, draw this chart for reference on a piece of scratch paper.
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1. 3. 2. 2. 3 Municipal Issues
Generally, the next level of safety is in securities issued by municipalities. General obligation bonds (GOs), backed by the taxing power of the issuer, are usually safer than revenue
bonds. Revenue bonds are backed by revenues from the facility financed by the bond issue.
1. 3. 2. 2. 4 Corporate Debt
Corporate debt securities cover the spectrum from very safe (AAA corporates) to very risky
(junk bonds, also known as speculative, or high-yield bonds). Corporate bonds are backed, in
varying degrees, by the issuing corporation.
Usually, these securities are ranked from safe to risky, as follows:
1. Secured bonds
2. Debentures
3. Subordinated debentures
4. Income (adjustment) bonds
However, these rankings serve only as a general guideline.
TA K E N O T E
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Nominal yield
Investment grade
Book entry
Current yield
Yield to maturity
1. A new bond contains a provision that it cannot be called for 5 years after the
date of issuance. This call protection would be most valuable to a recent purchaser of the bond if interest rates are
A.
B.
C.
D.
falling
rising
stable
fluctuating
bought it at a discount
bought it at a premium
sold it at a discount
sold it at a premium
I and III
I and IV
II and III
II and IV
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6. When interest rates are falling or rising, the price fluctuations of which of the following will be the greatest?
A.
B.
C.
D.
1. 3. 3
Short-term bonds
Long-term bonds
Money market instruments
Common stock
EXAMPLE
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An investor buys a T-bill for 975 ($975) and receives $1,000 when the bill matures in six months. The $25 difference ($1,000 $975) is the investors return.
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Maturities. Treasury bills are issued and mature in 4, 13, 26, or 52 weeks.
Treasury bill maturities are expressed in weeks, or one year in the case of the 52week bill.
Pricing. Once they are issued, T-bill bid and ask quotes in the secondary market are
stated in terms of the annualized interest rates that the discount from par value will yield.
EXAMPLE
Bid
Ask
12/15
5.00
4.90
T-bills are quoted on a yield basis and sold at a discount from par. They are zerocoupon securities. The bid reflects the yield buyers want to receive. The ask reflects
the yield sellers are willing to accept.
The exam will not require you to calculate the bid and ask prices of T-bills.
Because T-bills are quoted in yield, a T-bill quote has a bid higher than its ask,
which is the reverse of bid-ask relationships for other instruments.
EXAMPLE
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A Bid of
98.01
Means
98 /32% of $1,000
Or
$980.3125
98.02
982/32% of $1,000
$980.6250
98.03
98 /32% of $1,000
$980.9375
98.10
9810/32% of $1,000
$983.1250
98.11
9811/32% of $1,000
$983.4375
98.12
98 /32% of $1,000
$983.7500
12
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before maturity. The Treasury department must give bondholders four months notice before
calling the bonds.
Marketable Government Securities: T-bills, T-notes, and T-bonds
Pricing
Form
T-bill
Type
4 to 52 weeks; short
term
Maturity
Issued at discount;
priced on discount basis
Book entry
T-note
Two to 10 years;
intermediate-term
Priced at percentage
ofpar
Book entry
T-bond
Priced at percentage
ofpar
Book entry
1. 3. 3. 1. 5 Treasury STRIPS
The Treasury Department designates certain Treasury issues as suitable for stripping. These
securities are known as STRIPS (Separate Trading of Registered Interest and Principal of
Securities). STRIPS are a type of zero coupon created from U.S. Treasury notes and bonds
when the Treasury sells separate receipts against the principal and coupon payments. The
securities underlying Treasury STRIPS are the U.S. governments direct obligation.
STRIPS are not issued or sold directly to investors. STRIPS can be purchased and held
only through financial institutions and government securities brokers and dealers.
The minimum face amount needed to strip a fixed-principal note or bond is $100 and any
par amount to be stripped above $100 must be in a multiple of $100.
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TA K E N O T E
As of January 1, 2012, paper savings bonds are no longer sold at financial institutions. This action supports the Treasurys goal to increase the number of electronic
transactions with citizens and businesses. In other words, savings bonds may only be
purchased directly through the Treasury, specifically the Treasurys Website
www.TreasuryDirect.gov.
Series EE bonds are sold at face value starting at a minimum of $25, in increments as
small as a penny. An investor could purchase a $40.54 EE bond. EE bonds earn a fixed rate
of interest, credited monthly and paid at redemption. The maximum amount an investor can
purchase in one calendar year is $10,000.
The tax on accrued interest can be paid annually or deferred until the bonds mature.
If an investor redeems EE Bonds in the first five years, he will forfeit the three most recent
months interest. If an investor redeems them after five years, she wont be penalized.
Series HH bonds are no longer issued as of September 1, 2004; however, billions of dollars of them are still outstanding. HH bonds are considered current-income securities and pay
a fixed rate of interest every six months until maturity or redemption, whichever comes first.
Maturity is 10 years with an additional 10-year extension during which interest continues to
be paid.
Interest is reportable for tax purposes in the year it is earned.
Series I bonds are a low-risk, liquid savings product designed to protect investors from
inflation risk. I bonds may be purchased electronically or paper I bonds may be purchased via
an investors IRS tax refund.
Electronic I bonds are sold at face value starting at a minimum of $25, to the penny. An
investor could purchase a $40.54 I bond. The maximum purchase in one calendar year is
$10,000.
Paper I bonds are sold at face value in denominations of $50, $75, $100, $200, $500,
$1,000, and $5,000, with $5,000 being the maximum purchase in one calendar year.
I bonds have an annual interest rate that reflects the combined effects of a fixed rate and
a semiannual inflation rate. Interest is added to the bond monthly and is paid when the bond
is redeemed.
The tax on accrued interest can be paid annually or deferred until the bonds mature.
1. 3. 3. 3 Agency Issues
Certain federal government agencies and agency-like organizations issue debt securities
to finance public sector operations. The following will review mortgage-backed issues of the
Government National Mortgage Association, the Federal Home Loan Mortgage Corporation,
and the Federal National Mortgage Association.
Mortgage-backed securities use pools of mortgages as collateral for the issuance of securities. They represent an ownership interest in mortgage loans made by financial institutions to
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finance the purchasers of homes or other real estate. As the homeowners pay off the mortgages,
investors receive interest and principal payments.
Agency and agency-like securities have higher yields than direct obligations of the federal
government but lower yields than corporate debt securities. They are considered very safe
when it comes to default risk and are actively traded in the secondary market.
Interest on these issues is taxed at the federal, state, and local level.
1. 3. 3. 3. 1 G
overnment National Mortgage Association (GNMA, or commonly
known as Ginnie Mae)
Ginnie Mae is a government-owned corporation within the Department of Housing and
Urban Development. Ginnie Maes are guaranteed by the full faith and credit of the U.S.
government.
GNMA buys Federal Housing Administration (FHA) and Veterans Administration
(VA) mortgages and auctions them to private lenders, who pool the mortgages to create passthrough certificates for sale to investor. Thus, monthly interest and principal payments from
the pool of mortgages pass through to investors.
TA K E N O T E
Unlike a traditional bond that pays interest every six months and returns an
investors principal in one lump sum at maturity, Ginnie Maes pay interest and return
a portion of principal to investors each month.
With virtually no default risk, the primary risk in Ginnie Maes has to do with changes in
interest rates in general. If interest rates fall, homeowners tend to pay off their mortgages early,
which accelerates the certificate maturities. If interest rates rise, certificates may mature more
slowly.
GNMAs are issued in minimum denominations of $25,000. Because few mortgages last
the full term, yield quotes are based on a 12-year prepayment assumption (i.e., that a mortgage
balance will be prepaid in full after 12 years of normally scheduled payments).
1. 3. 3. 4 Agency-Like Organizations
Government-sponsored enterprises (GSEs) such as Federal Home Loan Mortgage
Corporation (FHLMC, also known as Freddie Mac), or Federal National Mortgage Association
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(FNMA, also known as Fannie Mae), are chartered by acts of Congress but owned by stockholders. The U.S. government does not officially back these; however, many investors understand they carry an implied government backing.
TA K E N O T E
TA K E N O T E
Ginnie Mae is the only agency that is backed by the U.S. government. Freddie
Mac, Fannie Mae, and other agencies are backed by their own issuing authority and
are considered moral obligations of the U.S. government. On September 7, 2008,
the Federal Housing Finance Agency (FHFA) established a conservatorship for Fannie
Mae and Freddie Mac. As the conservator, the FHFA has taken over the assets and
assumed all the powers of shareholders, directors, and officers. It may take any necessary action to restore the firms to a sound and solvent condition. The conservatorship
will end when the FHFA finds that a safe and solvent condition has been restored.
For test purposes, you should consider agency issues (in general) to be second
only to issues of the U.S. government in terms of saftey from default.
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distribution schedule established when the CMO was created. One CMO may be entitled to
receive a certain amount of principal from the pool before all the others.
CMOs are issued by private sector financing corporations and are often backed by GNMA,
FNMA and FHLMC pass-through securities.
TA K E N O T E
You could see the term asset-backed security (ABS) on your exam. An ABS is
essentially the same thing as a mortgage-backed security, except that the securities
backing it are assets such as leases, loans, receivables, credit card debt, royalties and
so forth. In other words, an ABS is not backed by mortgage-based securities.
1. 3. 3. 5. 1 CMO Characteristics
Because mortgages back CMOs, they are considered relatively safe. However, their susceptibility to interest rate movements and the resulting changes in the mortgage repayment rate
mean CMOs carry several risks.
The rate of principal repayment varies.
If interest rates fall and homeowner refinancing increases, principal is received sooner than
anticipated, and fewer interest payments are made. This is known as prepayment risk.
If interest rates rise and refinancing declines, the CMO investor may have to hold his
investment longer than anticipated, although he does receive more interest payments.
This is known as extension risk.
Yields. CMOs yield more than Treasury securities and normally pay investors interest and
principal monthly. Principal repayments are made in $1,000 increments to investors in one
tranche before any principal is repaid to the next tranche.
Taxation. Interest from CMOs is subject to federal, state, and local taxes.
Liquidity. An active secondary market exists for CMOs, but the market for CMOs with
more complex characteristics may be limited or nonexistent. Certain tranches of a given
CMO may be riskier than others, and some CMOs or certain tranches carry the risk that
repayment of principal may take longer than anticipated (called extension risk).
Denominations. CMOs are issued in $1,000 denominations.
Suitability. Some varieties of CMOs may be particularly unsuitable for small or unsophis-
ticated investors because of their complexity and risks. Customers may be required to sign a
suitability statement before buying high-risk classes.
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Treasury bill
GNMA pass-through certificate
Collateralized mortgage obligation
Separate Trading of Registered Interest and Principal of Securities (STRIPS)
mortgages
real estate
municipal taxes
full faith and credit of U.S. government
1. 3. 4
FNMA
CMO
GNMA
SLMA
MUNICIPAL BONDS
A bond issued by a form of government other than the federal government or agency of
the federal government is a municipal bond. Municipal bond issuers include states, counties,
cities, townships, villages, school districts, and transportation authorities.
Municipal bonds (securities) are generally considered very safe; only U.S. government and
U.S. government agency securities are safer in terms of default risk. Of course, the degree of
safety varies among issues and among municipalities.
Municipal bonds pay interest semiannually. The interest payment schedule is set when the
bonds are issued.
1. 3. 4. 1 Tax Benefits
The federal government, with some exceptions, does not tax the interest from debt obligations of municipalities, but any capital gains from municipal transactions are taxable. This
tax-advantaged status of municipal bonds allows municipalities to pay lower interest rates on
their bond issues.
Municipal securities are more appropriate for investors in high tax brackets than those
in low tax brackets because the amount of tax savings for high tax-bracket investors is larger.
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EXAMPLE
Two investors, one in a 15% tax bracket and one in a 30% tax bracket, consider
purchasing a new municipal bond with a 7% coupon at par. Comparable corporate
bonds are currently being issued at 8.5%.
The investor in the 15% tax bracket would receive a tax-equivalent yield of
8.2%. To calculate this, divide 7% by (100% minus his tax rate of 15%), or 7%
divided by 85% (.85), which equals 8.2%. The municipal bond would not be a good
choice for this investor because he could get a higher rate of return by investing in
corporates.
If the investor chooses a corporate bond paying $85 a year, he would pay taxes
of $12.75 per bond ($85 15%), leaving him with $72.25 after taxes, which is more
than the $70.00 he would get from the municipal bond.
The investor in the 30% tax bracket would receive a tax-equivalent yield of 10%
(7% divided by 100% minus his 30% tax rate, or 7% divided by 70% = 10%). He
would receive a higher after-tax yield from the municipal bond.
If the investor chooses a corporate bond paying $85 a year, he would pay taxes
of $25.50 ($85 30%), leaving him with $59.50 after taxes, which is less than
$70.00 taxfree.
The most important point about municipal debt is that interest earned on these
securities is exempt from federal taxation. They are most suitable for high tax-bracket
investors and generally unsuitable for investors in low tax brackets or within retirement plans.
Note that interest may also be tax-exempt at the state and local level if the bond
holder is a resident of the state in which the bond is issued.
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1. 3. 4. 2. 1 Sources of Funds
GO bonds issued by states are backed by income taxes, license fees, and sales taxes. GO
bonds issued by towns, cities, and counties are backed by property taxes, license fees, fines, and
other sources of funds to the municipality. School and park districts may issue municipal bonds
backed by property taxes.
Because GOs are backed by a municipalitys taxing power, voter approval is required prior
to issue.
1. 3. 4. 3 Revenue Bonds
Revenue bonds can be used to finance any municipal facility that generates enough income
to support its operations and debt service. A feasibility study will be completed to ensure the
facility can generate the money needed. Because taxes are not being levied to a specific group
of taxpayers to support the bond, voter approval is not required prior to issue.
1. 3. 4. 3. 1 Sources of Revenue
The interest and principal payments of revenue bonds are payable to bondholders only
from the specific earnings and net lease payments of revenue-producing facilities such as:
utilities (water, sewer, electric);
housing;
transportation (airports, toll roads);
education (college dorms, student loans);
health (hospitals, retirement centers); and
industrial (industrial development, pollution control).
Debt service payments do not come from general or real estate taxes and are not backed by
the full faith and credit of the municipality.
1. 3. 4. 4 Legal Opinion
Attached to every bond certificate (unless the bond is specifically stamped ex-legal) is a
legal opinion written and signed by the bond counsel, an attorney specializing in tax-exempt
bond offerings. The legal opinion states that the issue conforms with applicable laws, the state
constitution, and that the interest is tax free at the federal level.
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True or False?
1. Municipal securities are issued by federal and state governments.
2. Capital gains from the profitable sale of municipal securities are not
exempt from taxation.
3. Municipal revenue bonds are generally backed by taxes collected by the
municipality.
4. The interest on IDRs is typically taxable at the federal level.
5. Bonds issued by school, road, and park districts are examples of GOs.
6. Municipals generally pay less interest than corporate issuers.
1. 3. 5
CORPORATE BONDS
Corporate bonds are issued to raise working capital or capital for expenditures such as
plant construction and equipment purchases.
1. 3. 5. 1. 1 Secured Bonds
A bond is secured when the issuer has identified specific assets as collateral for interest and
principal payments. A trustee holds the title to the assets that secure the bond. In a default,
the bondholder can lay claim to the collateral.
Mortgage Bonds. Mortgage bonds have real property (real estate) pledged as collateral.
While mortgage bonds, in general, are considered relatively safe, individual bonds are only as
secure as the assets that secure them and are rated accordingly. In this manner, their safety is
similar to a home mortgageif the property value is sufficient to support the loan, the bond
is safer than one where property values have fallen.
Collateral Trust Bonds. Collateral trust bonds are usually issued by corporations that own
securities of other companies as investments. A corporation issues bonds secured by a pledge
of those securities as collateral. The trust indenture usually contains a covenant requiring
that a trustee hold the pledged securities. Collateral trust bonds may be backed by one or
more of the following securities:
stocks and bonds of partially or wholly owned subsidiaries (or even the companys own
stock);
another companys stocks and bonds;
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Equipment Trust Certificates. Railroads, airlines, trucking companies, and oil companies
use equipment trust certificates (or equipment notes and bonds) to finance the purchase of
capital equipment. Title to the newly acquired equipment is held in trust, usually by a bank,
until all certificates have been paid in full. Because the certificates normally mature before
the equipment wears out, the amount borrowed is generally less than the full value of the
property securing the certificates.
TA K E N O T E
Holders of secured bonds do not have a specific claim on any of the other assets
of the corporation in a liquidation.
1. 3. 5. 1. 3 Unsecured Bonds
Unsecured bonds have no specific collateral backing and are classified as either debentures or subordinated debentures.
Debentures. Debentures are backed by the general credit of the issuing corporation, and
a debenture owner is considered a general creditor of the company. Debentures are junior to
secured bonds and senior to subordinated debentures and preferred and common stock in the
priority of claims on corporate assets.
Subordinated Debentures. The claims of subordinated debenture owners are junior to
the claims of all creditors. Subordinated debentures generally offer higher income than either
straight debentures or secured bonds due to their subordination, therefore riskier, status, and
they often have conversion features. Subordinated debentures are often subject to the lower
ratings that classify them as high-yield or junk bonds.
1. 3. 5. 1. 4 Guaranteed Bonds
Guaranteed bonds are backed by a company other than the issuer, such as a parent company. This effectively increases the issues safety because someone other than the issuer is
guaranteeing timely payment of interest and principal. It is not uncommon to find municipal
bonds that carry insurance as the guarantee.
1. 3. 5. 1. 5 Income Bonds
Income bonds, also known as adjustment bonds, are used when a company is reorganizing
and coming out of bankruptcy. Income bonds pay interest only if the corporation has enough
income to meet the interest payment and the board of directors declares a payment. Because
missed interest payments do not accumulate for future payment, these bonds are not suitable
investments for customers seeking income.
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1. 3. 5. 1. 6 Zero-Coupon Bonds
Bonds are normally issued as fixed-income securities. Zero-coupon bonds are debt obligations that do not make regular interest payments. Instead, zeros are issued at a deep discount
from their face value. The difference between the discounted purchase price and the full face
value at maturity is the return (accreted interest) the investor receives. The price of a zerocoupon bond reflects the general interest rate climate for similar maturities.
Zero-coupon bonds are issued by corporations, municipalities, and the U.S.Treasury
and may be created by broker/dealers from other types of securities.
Advantages and Disadvantages of Zero-Coupon Bonds. A zero-coupon bond requires a
relatively small investmentperhaps $100 to $200 per bondand matures at $1,000. They
offer investors a way to speculate on interest rate moves. Because they sell at deep discounts
and offer no cash interest payments to the holder, zeros are substantially more volatile than
traditional bonds; their prices fluctuate widely with changes in interest rates. Moreover, the
longer the time to maturity, the greater the volatility. When interest rates change, a zeros
price changes much more as a percentage of its market value than an ordinary bonds price.
Taxation of Zero-Coupon Bonds. Although zeros pay no regular interest income, an in-
vestor who owns taxable (government or corporate) zeros owes income tax each year on the
amount by which the bonds have accreted, just as if the investor had received it in cash. The
income tax is due regardless of the direction of the market price. Because the annual interest
is not prorated in equal amounts, the bond issuer must send each investor an Internal Revenue Service (IRS) Form 1099 annually showing the amount of interest subject to taxation.
TA K E N O T E
EXAMPLE
When a bond doesnt pay interest, it is said to trade flat. Zero-coupon bonds,
income (adjustment) bonds, and any bond in default is considered to trade flat.
If asked which security has no reinvestment risk, look for a zero. This is because
there are no semiannual interest payments to reinvest. Also, buying azero is the only
way to lock in a rate of return.
When the exam asks you to select an investment that provides for a certain dollar amount in the future, zeros are a good choice because investors know they will
receive the face amount at maturity.
A suitability question asks what you would recommend to a couple who wishes
to have $100,000 available in a college education fund in 10 years. Choose a zero
coupon.
1. 3. 5. 2 Convertible Bonds
Convertible bonds are corporate bonds that may be exchanged for a fixed number of
shares of the issuing companys common stock. Because they areconvertible into common
stock, convertible bonds pay lower interest rates than nonconvertible bonds and often trade in
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line with price movements of the common stock. They are bonds with fixed interest payments
and maturity dates, soconvertible bonds are less volatile than common stock. Issuers add convertible features to bonds or preferred stock to make these issues more marketable.
1. 3. 5. 2. 1 Considerations
From the issuers perspective, when a bond is convertible, it is more marketable to the public and, as such, can be issued with a lower coupon than bonds without this privilege. Investors
will buy a bond with a lower coupon because of the bonds convertibility. The lower coupon
reduces the cost of debt for the issuer and is a big advantage for the issuer; however, for investors looking for income, convertible bonds may not be appropriate.
On the other hand, convertible bonds offer the safety of the fixed-income market and the
potential appreciation of the equity market, providing investors with several advantages.
As a debt security, a convertible debenture pays interest at a fixed rate and is redeemable
for its face value at maturity, provided the debenture is not converted. As a rule, interest
income is higher and surer than dividend income on the underlying common stock. Similarly, convertible preferred stock usually pays a higher dividend than does common stock.
If a corporation experiences financial difficulties, convertible bondholders have priority
over common stockholders in the event of a corporate liquidation.
In theory, a convertible debentures market price tends to be more stable during market
declines than the underlying common stocks price. Current yields of other competitive
debt securities support the debentures value in the marketplace.
Because convertibles can be exchanged for common stock, their market price tends to
move upward if the stock price moves up. For this reason, convertible securities are more
volatile in price during times of steady interest rates than are other fixed-income securities.
Conversion of a senior security into common stock is not considered a purchase and a sale
for tax purposes. Thus, the investor incurs no tax liability on the conversion transaction.
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EXAMPLE
RST convertible bond has a conversion price of $50. If the bond has a current
market value of $1,200, what is the parity price of the underlying common stock?
Par value: $1,000
Conversion price: $50
Current market value (CMV) of the bond: $1,200
Calculate parity price of the common stock.
Step one: Calculate the conversion ratio:
$1,000 $50 = 20 shares of common stock
Step two: Divide the CMV by the conversion ratio to determine the parity value
of the common stock:
$1,200 20 = $60
If the stock is trading at $60, the value of the equity position (20 x $60 = $1,200)
is equal to the CMV of the bond ($1,200). Parity exists.
EXAMPLE
RST convertible bond has a conversion price of $50. If the current market value
of the underlying common stock is $40, what is the parity price of the bond?
Par value: $1,000
Conversion price: $50
Current market value (CMV) of common stock: $40
Calculate the parity price of the bond.
S tep one: Calculate the conversion ratio: $1,000 / $50 = 20 shares of common
stock.
S tep two: Multiply the CMV of common stock by the conversion ratio to determine
parity of the bond:
$40 x 20 = $800
If the stock is trading at $40, the value of the equity position ($40 x 20 = $800) is
equal to the CMV of the bond ($800). Parity exists.
1. 3. 5. 2. 3 Antidilution Provision
An antidilution provision gives the owner of convertible securities such as a convertible
preferred stock or bond, the right of the owner to maintain the same conversion ratio in the
event of a stock split or stock dividend. For example, if a convertible bond may be exchanged
for 50 shares of common stock and there is a 2-for-1 stock split, the same convertible bond can
be exchanged for 100 shares. This provision keeps the investor whole.
1. 3. 5. 3
Duration
Duration is another useful tool in bond calculations; it is a measure of the amount of time
a bond will take to pay for itself. Each interest payment is taken to be part of a discounted cash
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flow, so there is more to the calculation than simply adding up the interest payments. For the
Series 6, remember that duration is often used to assess the sensitivity of a bond in response
to interest rate changesthe longer the duration, the greater the sensitivity, and thus greater
interest rate risk in an environment of changing interest rates. Remember also that the duration of an interest-paying bond is always shorter than the time to its maturity because the
interest payments can be reinvested and earn additional interest. By way of comparison, the
duration of a zero-coupon bond is always equal to the time to its maturity because there is only
one paymentthe one made when the bond matures.
True or False?
1. Corporate bonds are quoted in points and 1/8s.
2. T-bills are short-term obligations.
3. T-bonds pay interest quarterly.
4. STRIPS are zero-coupon bonds issued by the Treasury.
5. STRIPS are backed directly by the Treasury.
1. 3. 6
Bonds
AlaP 9s 2019
AlldC zr 22
18
10
100 3/4
91 1/2
100 5/8
91 1/8
100 3/4
91 1/2
Net
Chg
+1/4
1/8
EXPLANATORY NOTES
Yield is current yield. cld: Called. cv: Convertible bond. dc: Deep
discount. f: Dealt in flat. m: Matured bonds, negotiability impaired by
maturity. na: No accrual. r: Registered. zr: Zero coupon. vi: In
bankruptcy or receivership or being reorganized.
This sample comprises formats, styles, and abbreviations from a variety of
currently available sources and has been created for educational purposes.
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EXAMPLE
Alabama Power 9s 2019 (AlaP): The description of its 9s 2019 bond indicates
the bond pays 9% interest and matures in the year 2019. The current yield is given
as 8.9%, which indicates the bond is selling at a premium. The Vol (volume, or
sales) column states how many bonds traded the previous day (the day being reported). In this case, 18 bonds, or $18,000 par value, were traded in Alabama Power
9s 2019 on Tuesday, January 8, 2013 (this is Wednesdays newspaper showing the
trading for the previous day).
The next three columns explain the high, low, and closing prices for the day.
For AlaP, the high was 100, the low was 10058, and the bonds closed at (last
trade) 100. Net change (the last column) refers to how much the bonds closing
price was up or down from the previous days close. AlaP 9s of 2019 closed up of
a point, or $2.50. AlaP closed the previous day (Monday, January 7) at 100.
(100 ).
Note that the Allied Chemical (AlldC) zr bonds have ellipses in the current yield column;
these are zero-coupon bonds that do not pay interest.
You might be asked to determine the price of a bond from a bond quote; 1bond
point = $10. If the bonds quote is 105, its price is $1,050.
If a bond is quoted at 9758, find its price in three steps:
1. 97 10 = $970
2. 5/8 = .625 10 = $6.25
3. $970 + $6.25 = $976.25
Zero-coupon bonds
Parity
Guaranteed bonds
Subordinated debenture
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$93
$500
$930
$2,500
11. Which of the following statements regarding convertible bonds is NOT true?
A. Coupon rates are usually higher than nonconvertible bond rates of the same
issuer.
B. Convertible bondholders are creditors of the corporation.
C. Coupon rates are usually lower than nonconvertible bond rates of the same
issuer.
D. If the underlying common stock should decline sharply, the bonds will sell at
a price based on their inherent value as bonds, disregarding the convertible
feature.
12. A bond is convertible to common stock at $20 per share. If the market value of
the bond is $800, what is the parity price of the stock?
A.
B.
C.
D.
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$12
$16
$25
$40
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1. 3. 7
2
8
12
20
TA K E N O T E
The money market is the source for short-term financing, while the capital
market is the source for medium- to long-term financing. Money market funds are
short-term, liquid debt obligations.
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1. 3. 7. 1. 3 Commercial Paper
Corporations issue short-term, unsecured commercial paper, or promissory notes, to raise
cash to finance accounts receivable and seasonal inventory overages. Commercial paper interest rates are lower than bank loan rates. Commercial paper maturities range from one to 270
days, although most mature within 90days. Commercial paper is issued at a discount from face
value.
Typically, companies with excellent credit ratings issue commercial paper. The primary
buyers of commercial paper are money market funds, commercial banks, pension funds, insurance companies, corporations, and nongovernmental agencies.
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Issued by banks
Minimum face value of $100,000
Mature in one year or less
Unsecured
Interest bearing
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Treasury bills
municipal notes
commercial paper
newly issued Treasury bonds
90
180
270
360
4. Commercial paper is
A.
B.
C.
D.
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Eurodollars
Bankers acceptances
ADRs
Commercial paper
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Bond
Par, premium,
discount
Coupon yield
Current yield
Yield to maturity
Inverse relationship
Agency issues
Redemption
Refunding
Duration
T-bills, T-notes,
Tbonds
STRIPS
Municipal bond
GO bond
Revenue bond
Sinking Fund
Trustee
Secured bond
Mortgage bond
Collateral trust
certificate
Equipment trust
certificate
Note
Fixed income security
Debenture
Subordinated debenture
Zero coupon bond
Convertible bond
Conversion price
Conversion ratio
Conversion parity
Senior, junior security
IDR, IDB
Legal opinion
Money market
Bankers acceptance
Commercial paper
Negotiable CD
Interest
Maturity
Liquidation priority
Income bond
Bond rating
Liquidity
Call
Call protection
Call premium
Coupon
Fully registered
egistered as to
R
principal only
Book entry
GNMA
Agency-like
organization
FNMA
FHLMC
CMO
1. 4 ECONOMIC FACTORS
Economics is the study of supply and demand. When people want to buy an item that is in
short supply, the items price rises. When people do not want an item that is in plentiful supply, the price declines. This simple notionthe foundation of all economic studyis true for
bread, cars, clothes, stocks, bonds, and money. Economic activity reflects the overall health of
a countrys economy. Economists attempt to measure and predict the economys cycles and the
effect on various industries and corporations.
The economic climate has an enormous effect on the condition of individual companies and the securities markets. A companys earnings and business prospects, business cycles,
changes in the money supply, Federal Reserve Board (FRB) actions, and a host of complex
international factors affect securities prices and trading.
1. 4. 1
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1. 4. 1. 1 Price Levels
When comparing the economic output of one period with that of another, analysts must
account for changes in the relative prices of products that have occurred during the intervening time. Economists adjust GDP figures to constant dollars rather than compare actual dollars. This allows economists and others who use GDP figures to compare the actual purchasing
power of the dollars instead of the dollars themselves.
1. 4. 1. 3 Inflation
Inflation is a general, continual increase in prices at the consumer level. Another way
of stating this is a persistent decline in the purchasing power of money. In other words, your
dollars wont purchase as much this year as they did last year, and things will cost more next
year. Mild inflation can encourage economic growth because gradually increasing prices tend
to stimulate business investments. High inflation reduces the buying power of a dollar and
hurts the economy. Gold prices usually rise during periods of high inflation. Increased inflation
drives up interest rates of fixed-income securities, which drives down bond prices. Decreases in
the inflation rate have the opposite effect: as inflation declines, bond yields decline and prices
rise.
If . . .
inflation
increases
And . . .
Then . . .
Thus . . .
inflation
interest rates bond prices bond yields
decreases go down
go up
go down
1. 4. 1. 3. 1 Deflation
Though rare, deflation is a general decline in prices. Deflation usually occurs during severe
recessions when unemployment is on the rise.
1. 4. 1. 4 Business Cycles
Periods of economic expansion are historically followed by periods of economic contraction in a pattern called the business cycle. Business cycles go through four stages:
Expansion
Peak
Contraction (decline)
Trough (and then the cycle repeats)
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Expansion is characterized by increased business activityincreasing sales, manufacturing, and wagesthroughout the economy. For a variety of reasons, an economy can grow for
only so long, and will reach its upper limit, or peak. When business activity declines from its
peak, the economy is contracting.
Recessions occur when the GDP declines for six consecutive months (two quarters).
When business activity stops declining and levels off, it is known as a trough. According to
the U.S. Commerce Department, the economy is in a depression when a decline in real output of goods and services (the GDP) lasts for six consecutive quarters.
TA K E N O T E
Know the order of the four phases of the business cycle: expansion, peak,
contraction, trough.
Inflation causes purchasing power risk. Todays dollars can buy fewer goods tomorrow. A constant dollar adjustment must be made to compare dollars from year to
year that have been affected by inflation.
Expansion
Contraction
Trough
In the normal course of events, some industries or corporations prosper as others fail. So
to determine the economys overall direction, economists consider many aspects of business
activity.
Expansions are characterized by:
increases in industrial production;
bullish (rising) stock markets;
rising property values;
increased consumer demand for goods and services;
increasing GDP; and
low unemployment.
Downturns in the business cycle tend to be characterized by:
rising numbers of bankruptcies and bond defaults;
higher consumer debt;
bearish (falling) stock markets;
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Recession
Inflation
Economics
CPI
Trough
1. 4. 2
ECONOMIC POLICY
The Federal Reserve Board (the Fed) conducts monetary policy by influencing the money
supply, which in turn affects interest rates and the economy. The President and Congress
implement fiscal policy by influencing the economy through Congresss powers to tax and
spend.
1. 4. 2. 1 Monetary Policy
Most people think of money as cash in their pockets. Economists take a much broader
view and include loans, credit, and an assortment of other liquid instruments. To a monetarist,
the rate of expansion or contraction of the money supply is the most important element in
determining economic health. The Federal Reserve Board determines monetary policy.
Because the FRB determines how much money is available for businesses and consumers
to spend, its decisions are critical to the U.S. economy. The FRB affects the money supply
through its use of three policy tools:
changes in reserve requirements;
changes in the discount rate (on loans to member banks); and
open-market operations (buying and selling Treasury securities).
1. 4. 2. 1. 1 Reserve Requirements
Commercial banks must deposit a certain percentage of their depositors money with the
Federal Reserve. This is known as the reserve requirement. All money deposited by commercial banks at Federal Reserve Banks, including money exceeding the reserve requirement, are
called federal funds.
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When the Fed raises the reserve requirement, banks must deposit more funds with the Fed
and, thus, have less money to lend, which drives up interest rates and contracts the economy.
Reducing the reserve requirement has the opposite effect.
Even a small change in the reserve requirement impacts so much money that reserve
requirements are rarely changed. When a small change in reserve requirements has an exaggerated result in terms of the money supply, it is known as a multiplier effect.
To compensate for shortfalls in its reserve requirement, a bank may borrow excess reserves
(federal funds) from another member bank. The interest rate banks charge each other for such
loans is called the federal funds rate.
The federal funds rate fluctuates daily and is, therefore, the most volatile interest rate in
the economy. A rising rate usually indicates that member banks are more reluctant to lend
their funds and, therefore, want a higher rate of interest in return. A higher rate usually results
from a shortage of funds to lend and probably indicates that deposits, in general, are shrinking.
A falling federal funds rate usually means that the lending banks are in competition to loan
money and are trying to make their own loans more attractive by lowering their rates. A lower
rate often results from an excess of deposits.
1. 4. 2. 1. 2 Discount Rate
Banks can also borrow money directly from the Fed at its discount rate, the interest rate
the Fed charges its members for short-term loans. The discount rate is the only interest rate set
by the Fed. (The Fed targets the federal funds rate and sets the discount rate.) Lowering the
discount rate reduces the cost of money to banks, which increases the demand for loans and
expands the economy. Raising the discount rate increases the cost of money and reduces the
demand for loans and contracts the economy.
1. 4. 2. 1. 3 Open-Market Operations
The Fed buys and sells U.S. government securities in the open market to expand and contract the money supply. The Federal Open Market Committee (FOMC) was created to direct
the FRBs open market operations. When the FOMC buys securities, it increases the supply of
money in the banking system, and when it sells securities, it decreases the supply of money in
the banking system.
When the Fed wants to expand (or loosen) the money supply, it buys securities from banks.
The banks receive direct credit in their reserve accounts. The increase of reserves allows banks
to make more loans and effectively lowers interest rates. Thus, by buying securities, the Fed
pumps money into the banking system, expanding the money supply.
When the Fed wants to contract (or tighten) the money supply, it sells securities to banks.
Each sale is charged against a banks reserve balance. This reduces the banks ability to lend
money, which tightens credit and effectively raises interest rates. By selling securities, the Fed
pulls money out of the system, contracting the money supply.
When the Fed buys securities, bank excess reserves go up; when the Fed sells securities,
bank excess reserves go down. When the Fed buys, it expands the money supply; when the
Fed sells, it contracts the money supply. Because most of these transactions involve next-day
payment, the effects on the money supply are immediate, making open market operations the
Feds most efficient and frequently used tool.
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When it comes to monetary policy, moving reserve requirements is the least used
tool and Federal Open Market Committee Operations is the most frequently used
tool.
1. 4. 2. 2 Fiscal Policy
Fiscal policy refers to legislative decisions of Congress and the President, which basically
involves the ability to tax and spend and can include increases or decreases in:
federal spending;
money raised through taxation; and
federal budget deficits or surpluses.
Fiscal policy is based on the assumption that the government can influence the levels of
unemployment and inflation by adjusting overall demand for goods and services.
If an expanding economy results in inflationary pressure, fiscal policy would dictate increasing taxes and/or reducing government spending in order to reduce inflation by contracting the
economy (money is tight resulting in less demand for goods and services).
On the other hand, in a contracting economy, unemployment rises and, in order to get
people back to work, fiscal policy would dictate reducing taxes and/or increasing government
spending in order to reduce unemployment by expanding the economy (discretionary income
increases, improving the demand for goods and services and, therefore, more people are hired
to meet demand).
Ideally, monetary and fiscal policies work together in a fluctuating economy to keep inflation and unemployment lowif only it were so simple!
1. 4. 2. 4 Interest Rates
The cost of doing business is closely linked to the cost of money; the cost of money is
reflected in interest rates. The money supply, general economic conditions, and inflation levels within the economy determine the level of interest rates. Major U.S. interest rates include
the following:
Federal funds rateInterest rate charged on reserves traded among member banks for
overnight use in amounts of $1 million or more; changes daily in response to the borrowing banks needs. This is considered the most volatile of all money rates, not because it
changes drastically, but because it changes every day.
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Prime rateBase rate on corporate loans at large U.S. money center commercial banks;
the prime rate changes when banks react to changes in FRB policy
Discount rateCharge on loans to depository institutions set by the Federal Reserve
Bank (FRB) in New York
Broker call loan rateCharge on loans to broker/dealers with stock as collateral (as in
margin accounts for their clients)
LIBORLondon InterBank Offered Rate is the average interest rate charged when banks
in the London interbank market borrow unsecured funds from each other. The LIBOR
rates are generally accepted as the internationally recognized benchmark for short-term
loans.
1. 4. 2. 5. 1 Balance of Payments
The flow of money between the United States and other countries is known as the balance of payments. The balance of payments may be a surplus (more money flowing into the
country than out) or a deficit (more money flowing out of the country than in). A deficit may
occur when interest rates in another country are high as money flows to where it will earn the
highest return.
The largest component of the balance of payments is the balance of tradethe export
and import of merchandise. On the U.S. credit side are sales of American products to foreign
countries. On the debit side are U.S. purchases of foreign goods that cause U.S. dollars to flow
out of the country. When debits exceed credits, a deficit in the balance of payments occurs;
when credits exceed debits, a surplus exists.
TA K E N O T E
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Importers like their own currency to be strong (or, similarly, foreign currencies to
be weak). Exporters like their own currency to be weak (or, similarly, foreign currencies to be strong).
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Monetary Policy:
Policy of the Federal Reserve Board (FRB)
Discount rate
Reserve requirement (multiplier effect)
Open market operations (most frequently used)
Fiscal Policy:
Actions of Congress and the President
Government spending and taxation
1. When the FOMC purchases T-bills in the open market, which of the following
scenarios are likely to occur?
I.
II.
III.
IV.
A.
B.
C.
D.
2. Which of the following situations could cause a fall in the value of the U.S. dollar
in relation to the Japanese yen?
I.
II.
III.
IV.
A.
B.
C.
D.
3. To tighten credit during inflationary periods, the Federal Reserve Board can take
any of the following actions EXCEPT
A.
B.
C.
D.
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the daily average rate charged by the largest money center banks
the daily rate charged by Federal Reserve member banks
the weekly average rate charged by the largest money center banks
the weekly average rate charged by Federal Reserve member banks
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Discount rate
Federal funds rate
Prime rate
LIBOR
Terms and Concepts Checklist
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GDP
Business cycle
Expansion, peak, contraction, trough
CPI
Inflation
Fiscal policy
Monetary policy
Balance of payments
Currency exchange rates
FRB
Reserve requirement
Discount rate
FOMC
Open market operations
Federal funds rate
Broker call loan rate
Prime rate
Constant dollar adjustment
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75
U N I T
T E S T
6. The Federal Open Market Committee is concerned with rising inflation. To counteract this
concern the FOMC should
A. increase the reserve requirement
B. sell U.S. Treasury securities in the open
market
C. increase the federal funds rate
D. increase the discount rate
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13. Which of the following are characteristics of general obligation (GO) municipal bonds?
I. They are backed by the revenue generated
from the facility that was built with the
proceeds of the bond issue.
II. Interest paid is tax free at the federal level.
III. They are issued by agencies of the federal
government.
IV. They are backed by the taxing power of the
issuing municipality.
A. I and III
B. I and IV
C. II and III
D. II and IV
14. A convertible corporate bond that has an 8%
coupon yielding 7.1% is available but may be
called some time this year. Which feature of this
bond would probably be least attractive to your
client?
A. Convertibility
B. Coupon yield
C. Current yield
D. Near-term call
15. All of the following statements about preferred
stock and bonds are true EXCEPT
A. they are both debt instruments
B. they both have a fixed rate of return
C. they are both senior to common stock at the
dissolution of a corporation
D. the prices of both are directly influenced by
interest rates
16. If the economy experiences an increasing GDP, it
is said to be in
A. an expansion
B. a peak
C. a decline
D. a trough
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77
17. Which of the following statements regarding Ginnie Maes are TRUE?
I. They are not taxable at the state level.
II. They are directly backed by the federal
treasury.
III. The minimum certificate at issue is $1,000.
IV. Investors receive a monthly check
representing both interest and a return of
principal.
A. I and III
B. I and IV
C. II and III
D. II and IV
18. The best time for an investor seeking returns to
purchase long-term, fixed-interest-rate bonds is
when
A. long-term interest rates are low and beginning
to rise
B. long-term interest rates are high and
beginning to decline
C. short-term interest rates are high and
beginning to decline
D. short-term interest rates are low and beginning
to rise
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A N S W E R S
A N D
R A T I O N A L E S
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Q U I C K
Q U I Z
A N S W E R S
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81
4. C.
3. B.
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82
1. B.
2. A.
3. B.
1. D.
4. C.
2. A.
5. B.
3. B.
6. A.
4. C.
7. C.
8. E.
9. A.
12. B.
1. F.
10. D.
11. C.
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2
Product Information:
Investment Company
Securities and Variable
Contracts
nvestment company products may offer a diversified portfolio of securities, professional management, and reduced transaction costs. Because
of these attractive features, they are very popular with investors. Mutual
funds, one form of investment company, currently manage trillions of dollars
for investors.
Insurance companies also offer products, known as variable contracts,
which are classified as securities. Variable annuities are a popular retirement
instrument that may invest in mutual funds or may invest directly in
individual securities for the purpose of funding a customers retirement.
Variable life insurance permits a customer to assume some of the investment
risk inherent in insurance coverage in order to obtain inflation protection
for his contracts death benefit.
The Series 6 exam will include 2025 questions on the topics covered in
thisUnit.
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OBJECTIVES
When you have completed this Unit, you should be able to:
list the three types of investment companies defined by the Investment Company Act of
1940;
distinguish the characteristics of open- and closed-end management companies;
summarize how investment companies and investment company securities register;
classify five significant roles involved in the management of an investment company;
describe disclosure documents distributed to investors of mutual fund shares;
summarize various types of mutual funds and investment objectives;
identify pricing and costs associated with mutual funds;
explain mutual fund accumulation plans, including contractual plans, and mutual fund
withdrawal plans;
list characteristics of annuities;
explain the phases of the annuity contract; and
differentiate the features of traditional whole life, variable life, and universal variable life
policies.
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87
2. 1. 1
2. 1. 2
Face Amount
Certificate
Company (FAC)
Management
Investment
Company
Unit
Investment
Trust (UIT)
Fixed UIT
Open-End
(Mutual Fund)
Diversified
Nondiversified
Nonfixed UIT
Closed-End
Diversified
Nondiversified
The Investment Company Act of 1940 classifies investment companies into three broad
types: face-amount certificate companies (FACs), unit investment trusts (UITs), and management investment companies.
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88
You will see no more than one or two questions involving face-amount certificate
companies on the Series 6 exam. Face-amount certificate companies:
are classified as investment companies;
pay a fixed rate of return; and
do not trade in the secondary market but are redeemed by the issuer.
UIT managers create a portfolio of debt or equity securities designed to meet the companys objectives. They then sell redeemable interests, also known as units or shares of
beneficial interest, in their portfolio of securities. Each share is an undivided interest in the
entire underlying portfolio. Because UITs are not managed, all proceeds must be distributed
when any securities in the portfolio are liquidated.
A UIT may be fixed or nonfixed. A debt fixed UIT typically purchases a portfolio of bonds
and terminates when the bonds in the portfolio mature. An equity fixed UIT purchases a portfolio
of stocks and, because stocks dont have a maturity date, terminates at a pre-determined date. A
nonfixed UIT purchases shares of an underlying mutual fund. Shares of fixed and nonfixed UITs
do not trade on exchanges or over-the-counter. If an investor wishes to sell his interest in a UIT, it
is redeemable through the issuer.
TA K E N O T E
A UIT is very similar to a mutual fundup to a point. Both fixed UITs and mutual
funds are comprised of a pool of securities in which investors own a proportionate
share. The most significant difference between UITs and mutual funds is that mutual
funds actively trade their portfolios and a portfolio manager gets paid a fee to meet
the objectives of the fund.
UIT portfolios usually are not traded; they are fixed trusts. The advantage to the
investor is that they own a diversified interest but do not pay a management feethe
biggest expense of mutual fund ownership. The downside is that the UIT portfolio is
not traded in response to market conditions.
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UITs are investment companies as defined under the Investment Company Act
of1940.
UIT shares (units) are not traded in the secondary market; they must be redeemed
by the trust.
UITs are not actively managed; there is no board of directors or investment
adviser.
EXAMPLE
TA K E N O T E
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The ABC New York Municipal Bond Fund, a closed end fund, issued 25 million
shares of stock priced at $20 per share, raising a total of $500 million. When all of the
shares were sold, the fund closed to new investors. The fund manager then invested
the proceeds of the offering in tax-exempt bonds issued by the state of New York.
Although the shares have a net asset value of about $20 per share, an investor that
decides to sell may receive more or less than that on the secondary market.
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An open-end investment company (mutual fund) only issues one class of security and
thats common stock. It does not specify the exact number of shares it intends to issue but
registers an open offering with the SEC. In other words, mutual funds conduct a continuous
primary offering of common stock. You should understand that mutual funds can purchase
common stock, preferred stock, and bonds for their investment portfolios, but as an investor
that invests in the ABC Bond Fund, or any mutual fund, one purchases common stock of the
fund. With this registration type they can raise an unlimited amount of investment capital
by continuously issuing new shares. Conversely, when investors want to sell their holdings in
a mutual fund, the fund itself redeems those shares. Mutual fund shares do not trade in the
secondary market.
The shares an open-end investment company sells are redeemable securities. When an
investor sells shares back to the fund, the fund sends the investor money for the investors
proportionate share of the funds net assets. Therefore, a mutual funds capital shrinks when
investors redeem shares but so does the number of outstanding shares; the value of each share
does not fall as a result of the redemption.
Comparison of Open-End and Closed-End Investment Companies
Open-End
Unlimited; continuous offering of
shares
Issues
Shares
Full or fractional
Full only
Pricing
Shareholder Rights
Ex-Date
Set by BOD
Set by SRO
TA K E N O T E
TA K E N O T E
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Closed-End
Capitalization
The ex-date, also known as the ex-dividend date, is the first day one can trade
for a security and not be entitled to receive a dividend distribution previously declared
by the issuer. (Covered in Unit 3)
You are likely to see three to four questions on the Series 6 exam that require
understanding the features of a closed-end company. Think in terms of what would
be true for any corporate security and examine the following chart.
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Like corporations:
FINRA
2. 1. 2. 4. 1 Diversified
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 funds total assets must be invested in securities issued by companies
other than the investment company itself or its affiliates.
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no more than 5% of the funds total assets are invested in the securities of any one
issuer, and
no more than 10% of the outstanding voting securities of any one issuer is owned (by
the 75%).
!
!
Remember, for testing purposes, the 5% and 10% limitations are part of the
75% invested. There are no conditions attached to the remaining 25%.
If a security represents 5% or less of the funds total assets at the time of purchase and thereafter exceeds 5% due to capital appreciation, no action is required in
order to maintain a diversified status.
2. 1. 2. 4. 2 Nondiversified
A nondiversified investment company does not meet the 75-5-10 test. An investment
company that specializes in one 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 stocks, technology stocks, or South American stocks; these are known as
specialized funds or sector funds. Sector funds must have at least 25% of assets invested in
a particular sector of the economy or geographic area. A sector fund can still be diversified,
provided it meets the 75-5-10 test.
2. 1. 3
2. 1. 3. 1 Hedge Funds
Many companies rely on one of the exceptions from the definition of investment company. These companies are commonly known as private investment companies. Some private
investment companies are commonly known as hedge funds.
Hedge funds are a type of equity security with similarities to a mutual fund. One difference
is that the hedge fund does not currently have to register with the SEC. Hedge funds typically have high minimum initial investment requirements and are only available to accredited
investors (discussed in Unit 3). Such funds are free to adopt far riskier investment policies than
those available to ordinary mutual funds, such as arbitrage strategies and massive short positions during bearish markets. An important consideration for investors to understand about
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hedge funds is their lack of liquidity; they often have several restrictions when an investor
wants to redeem their investment. Hedge funds are indirectly available to ordinary investors
through mutual funds called funds of hedge funds.
A fund of hedge funds will have restrictions on redemption because the investment in the
underlying hedge funds have restrictions on redemption.
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TA K E N O T E
1. Which of the following are covered under the Investment Company Act of 1940?
I.
II.
III.
IV.
A.
B.
C.
D.
All broker/dealers
Municipal bond brokers
Open-end management companies
Closed-end management companies
I and II
I and III
II and IV
III and IV
Open-end company
Closed-end company
Unit investment trust
Mutual fund
3. Which of the following statements regarding the 75-5-10 test of diversified management companies are TRUE?
I.
II.
III.
IV.
A.
B.
C.
D.
They may own no more than 5% of the voting stock of a single company.
No more than 5% of their assets are invested in any one company.
They may own no more than 10% of the voting stock of any one company.
If they own more than 25% of a target company, they do not vote the stock.
I and II
I and III
II and III
III and IV
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5. Which of the following statements are TRUE regarding open-end, but not closedend, investment companies?
I. They may make continuous offerings of shares provided the original registration statement and prospectus are periodically updated.
II. They may be listed on registered national exchanges.
III. They do not redeem their shares.
IV. They may issue only common stock.
A.
B.
C.
D.
I and II
I and IV
II and III
III and IV
Investment company
Face amount certificate company
Unit investment trust
Fixed trust
Management company
Open-end investment company
Closed-end investment company
Direct participation programs
Real estate investment trusts
Unit, share
Continuous primary offering
Public offering price
Exchange traded fund (ETF)
Hedge fund
Funds of hedge funds
75-5-10 test
Diversified
Nondiversified
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If the investment company does not have at least $100,000 in net assets, it may still register
a public offering with the SEC if it can meet these requirements within 90 days of registration.
The company must clearly define an investment objective under which it plans to operate. Once defined, the objective may be changed only by a majority vote of the companys
outstanding shares.
2. 2. 1
reports to shareholders must include a balance sheet, list and value of securities owned
and a statement of income.
TA K E N O T E
In filing for registration, an investment company must identify the overall investment
intentions of the fund as well as background information on affiliated persons, officers, and
directors.
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they are trading in the secondary market, closed-end funds need not be sold
with a prospectus.
Financial information in a prospectus may be no more than 16 months old.
TA K E N O T E
2. 2. 1. 3 Open-End Companies
The Investment Company Act of 1940 requires open-end companies to:
issue no more than one class of security; and
maintain a minimum asset-to-debt ratio of 300%.
Because open-end investment companies may issue only redeemable common stock,
they may borrow from banks provided their asset-to-debt ratio is not less than 3:1that is,
debt coverage by assets of at least 300%, or no more than one-third of assets from borrowed
money.
TA K E N O T E
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Mutual funds may borrow money from banks but not from investors. When borrowing money from the bank, the fund must have at least $3 of total assets for every
$1 borrowed.
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2. 2. 2
Be cautious of questions that ask about the asset-to-debt ratio described above.
If a question specifically asks about the asset-to-debt ratio, the answer to the question is 3:1, or 300%. But, if it asks about the debt-to-asset ratio, the correct answer
would be 1:3, or 33 1/3%.
2. 2. 3
RESTRICTIONS ON OPERATIONS
2. 2. 3. 1 Investment Practices
The SEC prohibits a mutual fund from engaging in the following activities unless the fund
meets stringent disclosure and financial requirements:
Purchasing securities on margin
Selling securities short
Selling uncovered call options
Participating in joint investment or trading accounts
The fund must specifically disclose these activities, and the extent to which it plans to
engage in these activities, in its prospectus.
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TA K E N O T E
Short selling is a securities industry practice that involves selling shares that are
not owned. Investors borrow shares from the broker/dealer by putting up collateral
in a margin account. The borrowed shares are sold with the hope that their market
price will fall. If the market price does fall, the short seller can buy back the borrowed
shares at a lower price to repay the broker/dealer. The difference in the price at
which the shares are sold and the lower price at which they are bought to repay the
broker/dealer is the investors profit. But if the price goes up, the potential for loss is
unlimited.
Investors usually buy low, then sell high for a profit; a short sale involves the
same steps in a different order. In a short sale, investors borrow and sell high, then
buy back low.
The exam may ask which mutual fund trading activities may be prohibited by the
SEC. The correct answer choices include margin account trading, short selling, joint
account trading, and naked (uncovered) options trading strategies. Covered option
transactions are permissible, but naked strategies are considered too risky.
diversified);
changing sales load policy (e.g., from a no-load fund to a load fund);
changing the nature of the business (e.g., ceasing business as an investment company);
changing investment policy (e.g., from income to growth or from bonds to small capital-
In addition to the right to vote on these items, shareholders retain all rights that stockholders normally possess.
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When answering questions, discern between shares voting and shareholders voting in mutual fund matters. A majority vote of the outstanding shares is required to
approve such actions as sales load or investment company objectives changes, not a
majority vote of shareholders.
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True or False?
1. Mutual funds are generally prohibited from using covered options strategies.
2. A majority vote of the outstanding shareholders is required to change the
investment objectives of a mutual fund.
3. Mutual fund shares may be purchased on margin but may not be used as
collateral in margin accounts.
4. Open-end companies must have at least $100,000 of net assets before
they may operate as an investment company.
5. Mutual funds are required to file registration statements with the SEC
before shares are sold to the public.
6. Mutual funds make continuous secondary offerings of securities.
7. Open-end investment companies must maintain a 3:1 debt-to-asset ratio.
8. Closed-end companies are generally considered mutual funds.
Terms and Concepts Checklist
Prospectus
Registration statement, N1A
prospectus, summary prospectus
Statement of additional
information (SAI)
Affiliated person
Shareholder voting rights
Purchase on margin
Short sale
2. 3. 1
BOARD OF DIRECTORS
Like publicly owned corporations in general, a management investment company has a
CEO, a team of officers, and a board of directors (BOD) to serve the interests of its investors.
The officers and directors deal with policy and administrative matters. They do not manage
the investment portfolio. As with other types of corporations, the shareholders of an investment company elect the BOD to make decisions and oversee operations.
A management investment companys board of directors pulls together the different parts
of a mutual fund. The BOD:
defines the type of funds to offer (e.g., growth, income, sector);
defines the funds objective; and
approves/hires the transfer agent, custodian, and investment adviser.
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Board of Directors
Handles administrative
matters
Elected by shareholders
Paid a stipend for
service
Underwriter
Transfer Agent
Customer service
Redeems shares
Paid from fund income
Custodian
Safekeeper of funds
and securities
Paid from fund income
Investment Advisor
Trades the portfolio
Adheres to portfolio
objectives
Paid from fund income
Fee is largest fund
expense
The Investment Company Act of 1940 restricts who may sit on an investment companys board of directors. At least 40% of the directors must be independent or noninterested
persons. Noninterested persons are only connected with the investment company in their
capacity as director. A noninterested person is not connected with the investment companys
investment adviser, transfer agent, or custodian bank. This means that no more than 60% of
the board members may be interested persons, including attorneys on retainer, accountants,
and any persons employed in similar capacities with the company. A shareholder who owns
5% or more of the investment company shares is interested.
Also, no individual who has been convicted of a felony of any type or a misdemeanor
involving the securities industry may serve on a BOD, nor may anyone who has been either
temporarily or permanently barred from acting as an underwriter, a broker, a dealer, or an
investment company by any court.
TA K E N O T E
2. 3. 2
Investment companies may never borrow or lend money with the board of directors or any other interested or affiliated person.
INVESTMENT ADVISER
An investment companys BOD contracts with an investment adviser or portfolio manager to invest the cash and securities in the funds portfolio, implement investment strategy,
and manage the portfolios day-to-day trading. Advisers must adhere to the objectives stated
in the funds prospectus and may not transfer the responsibility of portfolio management to
anyone else.
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The investment adviser earns a management fee, which is paid from the funds income.
This fee is typically a set annual percentage of the portfolio asset value. In addition, an investment adviser who consistently outperforms a specified market performance benchmark can
usually earn an incentive bonus.
An investment company may not contract with an investment adviser who has been
convicted of a felony unless the SEC has granted an exemption. In addition, an investment
company may not lend money to its investment adviser.
2. 3. 3
CUSTODIAN
To protect investor assets, the Investment Company Act of 1940 requires each investment
company to place its securities in the custody of a registered custodian, invariably a bank, but
some broker/dealers qualify. The bank or broker/dealer performs an important safekeeping role
as custodian of the companys securities and cash and receives a fee for its services. Often, the
custodian handles most of the investment companys clerical functions.
The custodian may, with the consent of the investment company, deposit the securities
it is entrusted to hold in one of the systems for the central handling of securities established
by FINRA. These systems make it easier to transfer securities. Once securities are placed in
the system, most transfers can be accomplished with a simple bookkeeping entry rather than
physical delivery of the securities.
Once an investment company designates a custodian and transfers its assets into the custodians safekeeping, the custodian must:
keep the investment companys assets physically segregated at all times;
allow withdrawal of assets only under SEC rules; and
restrict access to the account to certain officers and employees of the investment com-
pany.
TA K E N O T E
Investment companies must maintain a surety bond for all persons who have access to monies or securities.
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The custodian:
is generally a commercial bank;
is the safekeeper of the assets of the fund;
maintains asset records;
periodically audits the funds assets to assure that they are properly accounted for;
and
is paid a fee from the income of the fund.
2. 3. 4
The transfer agent may be the fund custodian or a separate service company. The fund
pays the transfer agent a fee for its services.
2. 3. 5
UNDERWRITER
A mutual funds underwriter, often called the sponsor or distributor, is appointed by the
board of directors and receives a fee for selling and marketing the fund shares to the public.
The open-end investment company sells its shares to the underwriter at the current NAV, but
only as the underwriter needs the shares to fill customer orders.
The underwriter is prohibited from maintaining an inventory of open-end company
shares. The underwriter is compensated only by a sales charge levied when the shares are sold
or redeemed. The underwriter may not be an expense to the fund.
In general, a mutual fund may not act as its own distributor or underwriter. However, there
is an exception to this rule for no-load funds. In other words, a no-load fund may sell shares
directly to the public without an underwriter.
Fund underwriters:
are also called the sponsors or distributors;
must be FINRA member firms;
may not inventory mutual fund shares;
are compensated only from the sales charge;
use compensation to pay for advertising and other selling expenses; and
may never be treated as an expense to the fund.
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TA K E N O T E
2. 3. 6
All parties that work together in the operation of a mutual fund are paid from the
income of the fund except the underwriter. The underwriters compensation comes
from sales charges.
2. 3. 6. 1 Prospectus (Statutory)
This is the full and fair disclosure document that provides a prospective investor with the
material information needed to make a fully informed investment decision. If using a statutory prospectus to solicit a sale, it must be distributed to an investor before or during the
solicitation. The front of a mutual fund prospectus must contain key information to appear
in plain English in a standardized order. Information in this clear and concise format includes
the funds objective, investment policies, sales charges, management expenses, and services
offered. It also discloses one-, five-, and 10-year performance histories, or performance over the
life of the fund, whichever is shorter.
If a fund has been in existence for eight years, it will show performance for one,
five, and eight years; if it has been in existence for four years, it will show one and
four years.
The delivery of sales literature is a solicitation of sale and must be accompanied or
preceded by the delivery of a prospectus.
A prospectus may not be altered in any way, which means no highlighting or
writing in any prospectus.
2. 3. 6. 2 Summary Prospectus
Under SEC Rule 498, a fund may provide a summary prospectus to investors that may
include an application investors can use to buy the funds shares.
The summary prospectus is a standardized summary of key information in the funds statutory (full) prospectus. Investors who receive the summary have the option of either purchasing
fund shares using the application found therein or requesting a statutory prospectus.
An investor who purchases fund shares on the basis of the summary prospectus
must receive a copy of the statutory prospectus no later than the confirmation of the
sale.
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Purpose
Contains
Presented
Summary
Prospectus
Rule 498
Short form that
may be used to
make the sale
Summary of key
information in the
prospectus
Prospectus
(statutory)
Sale document
Statement of
Additional
Information
SAI
More data for the
investor
Additional details
about the fund not
necessary for the
prospectus
2. 3. 6. 4 Financial Reports
The Investment Company Act of 1940 requires that shareholders receive financial reports
at least semiannually. One of these must be an audited annual report. The reports must
contain:
the investment companys balance sheet;
a valuation of all securities in the investment companys portfolio as of the date of the
balance sheet (a portfolio list);
the investment companys income statement;
a complete statement of all compensation paid to the board of directors and to the advisory board; and
a statement of the total dollar amount of securities purchased and sold during the
period.
In addition, the company must send a copy of its balance sheet to any shareholder who
requests one in writing between semiannual reports.
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2. 3. 6. 5 Additional Disclosures
The SEC requires the fund to include the following in its prospectus or annual reports:
A discussion of factors and strategies that materially affected its performance during its
most recently completed fiscal year
A line graph comparing its performance to that of an appropriate broadbased securities
market index
The name(s) and title(s) of the person(s) primarily responsible for the fund portfolios
day-to-day management
TA K E N O T E
Keep the financial reports of the fund and shareholder account statements
separate. The fund must distribute financial reports to shareholders semiannually. The
annual report must be audited; semiannual reports may be unaudited.
Account statements are typically sent monthly to shareholders with active accounts, quarterly to inactive accounts.
monthly
quarterly
semiannually
annually
the custodian
the transfer agent
her registered representative
the investment adviser
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Board of directors
Interested persons
Noninterested persons
Financial reports
Disclosures
Investment adviser
Custodian
Transfer agent
Underwriter, sponsor, distributor
N1-A prospectus
Statement of additional
information (SAI)
2. 4. 1
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stockholders, such as the right to vote for changes in the BOD, approval of
the investment adviser, changes in the funds investment objective, changes
in sales charges, and liquidation of the fund.
New mutual funds being formed today must offer reinvestment of dividends
methods at redemption.
Funds may offer reinstatement provisions that allow investors who withdraw
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True or False?
1. Mutual fund shareholders own a divided interest in the funds portfolio.
2. A mutual fund shareholders account value fluctuates proportionately
with the mutual funds portfolio value.
3. The transfer agent holds the mutual funds assets for safekeeping.
4. Mutual funds issue only one class of common stock.
5. The reinstatement provision allows reinvestment of withdrawn funds
within 60 days at no load.
6. To open an account, most funds require a minimum investment.
7. Mutual fund shareholders are allowed to vote on the frequency of dividend distributions.
2. 4. 2
EXAMPLE
The ABC fund has total assets of $100 million and $5 million in liabilities. If it has
10million shares outstanding, what is its NAV per share?
Net Assets: $100 million $5 million = $95 million, and
NAV: $95 million 10 million shares outstanding = $9.50 per share.
The NAV of a fund share is the amount the investor receives upon redemption. It must
be calculated at least once per business day. A typical fund calculates its NAV at 4:00 pm
ET every business day, since that is when the New York Stock Exchange closes. The price
the customer receives is the next NAV calculated after receipt of his redemption request.
This practice is known as forward pricing; we always have to wait until the next available
calculation to determine the value of shares redeemed or, for that matter, the number of shares
purchased.
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The purchase price of a fund share is called the public offering price, or POP. For the class
of fund shares known as front-end loaded shares, it is simply the NAV plus the sales charge.
The sales charge is paid as compensation for marketing the shares. As we will see, sales charges
can be levied at the time of purchase (front-end load), at the time of redemption (back-end
load), or there can simply be no sales charge (no-load), meaning that shares are purchased at
NAV.
TA K E N O T E
It is extremely rare that a mutual fund share price is a round number such as $10;
virtually all mutual fund shares are priced in fractions such as $10.7653. Therefore,
when purchasing mutual funds, investors dont indicate the number of shares they
wish to purchase but rather the dollar amount they wish to purchase.
EXAMPLE
Mr. Jones writes a check to purchase $10,000 of the ABC mutual fund. After
entering the order, the next available POP is $10.7653. Mr. Jones buys 928.91048
shares of the ABC mutual fund.
$10,000 $10.7653 = 928.91048 shares purchased
2. 4. 2. 1 Changes in NAV
The NAV can change daily because of changes in the market value of a funds portfolio.
Any of the events in the following chart may change a funds NAV per share.
Changes in NAV
Increases
Decreases
Liabilities decline
Liabilities increase
Under which of the following circumstances does NAV per share decrease?
I.
II.
III.
IV.
The correct choices are I and II. NAV per share decreases when the portfolio securities decline in value or when an income distribution is made from the portfolio to
the shareholders. NAV does not change when shares are issued or redeemed. When
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shares are purchased, new money paid to the fund is offset by a greater number of
shares outstanding; when shares are redeemed, the decrease in portfolio assets is
offset by a decrease in shares outstanding.
2. 4. 3
SALES CHARGES
FINRA prohibits its members from assessing sales charges in excess of 8.5% of the POP
on customers mutual fund purchases. Mutual funds are free to charge lower rates and most do,
provided they specify those rates in the prospectus.
TA K E N O T E
A mutual funds maximum sales charge is based on the POPnot the NAV. The
maximum load for mutual fund shares is 8.5% of the POP.
Most funds today charge somewhat lower sales loads. 5 to 6% is a typical maximum load for equity funds; 4 to 5% is a typical maximum load for bond funds.
2. 4. 3. 1 Closed-End Funds
After the initial public offering, closed-end funds do not have a sales charge embedded
in the share price. In the secondary market, an investor pays a brokerage commission (in an
agency transaction) or pays a markup or markdown (in a principal transaction). Closed-end
funds may trade at a premium (above) or discount (below) relative to their NAV.
2. 4. 3. 2 Open-End Funds
All sales commissions and expenses for an open-end fund are embedded in the POP or
other fees. Sales expenses include commissions for the managing underwriter, dealers, brokers,
and registered representatives, as well as all advertising and sales literature expenses. Mutual
fund distributors use different methods to collect the fees for the sale of shares and one to
compensate reps on an ongoing basis (trailer commissions):
Front-end loads (difference between POP and NAV)
Back-end loads (contingent deferred sales loads)
Level loads (asset-based feesprovide trail commissions to the registered representative
servicing the account)
2. 4. 3. 2. 1 Front-End Loads
Shares sold with a front-end load are called Class A shares. Front-end sales loads are
the charges included in a funds public offering price. The charges are added to the NAV at
the time an investor buys shares. Front-end loads are the most common way of paying for the
distribution services a funds underwriter and broker/dealers provide.
EXAMPLE
An investor deposits $10,000 with a mutual fund that has a 5% front-end load.
The 5% load amounts to $500, which is deducted from the invested amount. In this
example, $9,500 is invested in the funds portfolio on the investors behalf.
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2. 4. 3. 2. 2 Back-End Loads
Shares sold with a back-end load are called Class B shares. A back-end sales load (contingent deferred sales charge or CDSC) or redemption fee is charged if and when an investor
redeems mutual fund shares. The sales load, a declining percentage charge that is reduced
annually (e.g., 6% the first year, 5% the second, 4% the third, etc.), is applied to the proceeds
of any shares sold in that year. The back-end load is usually structured to drop to zero after an
extended holding period, such as six or seven years. The sales load schedule is specified in a
funds prospectus.
TA K E N O T E
With a back-end load, when an investor deposits $10,000 in a mutual fund, the
full $10,000 is invested in the portfolio on the investors behalf. The sales load is deducted only if the investor withdraws the money before the CDSC expires. This type
of sales charge is intended to discourage frequent trading in mutual fund accounts.
2. 4. 3. 2. 3 Level Loads
Class C shares typically have a one year, 1% CDSC, a .75% 12b-1 fee (discussed below),
and a .25% shareholder services fee. Because these fees are relatively high and never go away,
C shares are commonly referred to as having a level load. Class C shares are appropriate for
investors that have short time horizons as they become quite expensive to own if investing for
more than four to five years.
voting securities, the board of directors, and those directors who are noninterested persons.
Thereafter, the plan, together with any related agreements, is reapproved at least annually
by a vote of the board of directors of the company and of the directors who are not interested
persons of the company and have no direct or indirect financial interest in the operation of
the 12b-1 plan or in any related agreements.
Termination. The 12b-1 plan may be terminated at any time by a majority vote of the
noninterested directors OR a majority vote of outstanding voting securities.
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Misuse of No-Load Terminology. A fund that has a deferred sales charge or an asset-based
12b-1 fee of more than .25% of average net assets may not be described as a no-load fund. To
do so violates the Conduct Rules; the violation is not alleviated by disclosures in the funds
prospectus.
Expect several questions about 12b-1 fees and know the following points.
12b-1 fees are charged and reviewed quarterly.
To implement 12b-1 fees approval requires three votes: a majority of the
outstanding voting securities, the full board, and the noninterested members
of the board.
Renewal (done annually) requires two votes: a majority of the total board
may not charge more than .25% of average net assets for 12b-1 fees.
The maximum allowable 12b-1 charge under FINRA rules is .75% (75 basis
points).
FINRA does permit an additional .25% charge for shareholder services
(25basis points), but that is treated separate from the 12b-1 charge.
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If the dollar amount of the NAV and the sales charge percent are specified, the formula to
determine POP is to divide the NAV by 100% minus the sales charge percentage.
NAV ($10)
= POP ($10.50)
100% sales charge percentage (4.8%)
Because of the sales charge, loaded funds should be recommended for long-term investing.
EXAMPLE
NAV = $20 and POP = $21.00. What is the sales charge percentage?
The sales charge percentage is calculated by finding the sales charge amount
($21.00 $20.00) and dividing by the POP. Remember, sales charge is a percentage
of the POP, not the NAV.
$1.00 $21.00 = 4.8% (when rounded)
Assume a NAV of $20 and a sales charge of 5%. What is the POP?
POP is found by dividing the NAV by 100% minus the sales charge percentage.
$20 .95 = $21.05
In determining the POP when provided with the NAV, the answer has to be more
than the NAV. If such a question has only one choice with a higher POP than the
NAV, the correct answer should be immediately apparent.
You may be given two quotes using NAV and POP and be asked to identify each
as either closed-end or open-end funds. Remember this!
Closed-end
NAV can equal POP
NAV may be greater than POP
NAV may be less than POP
If the spread between NAV and POP is greater than 8.5%, it must be closed-end.
Open-end
NAV can equal POP
NAV can never be greater than POP
NAV may be less than POP
The spread between NAV and POP must be 8.5% or less.
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EXAMPLE
2. 4. 3. 3. 1 No-Load Funds
As the name implies, this means that the fund does not charge any type of sales load.
However, not every type of shareholder fee is a sales load. No-loads may charge fees that are
not sales loads. For example, a no-load fund is permitted to charge purchase fees, account fees,
exchange fees, and redemption fees, none of which is considered to be a sales load. (Although
a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not
considered to be a sales load.) In addition, under FINRA rules, a fund is permitted to pay its
annual operating expenses and still call itself no-load. However, the combined amount of the
funds 12b-1 fees or separate shareholder service fees cannot exceed 0.25% of the funds average annual net assets.
True or False?
1. 12b-1 fees are levied quarterly and renewed annually.
2. An open-end funds NAV may not be less than its POP.
3. A back-end load is often called a CDSC.
4. 12b-1 fees may not exceed .25% of average net assets.
5. Closed-end funds generally have higher yields than open-end funds.
2. 4. 4
INVESTMENT OBJECTIVES
Once a mutual fund defines its objective, the portfolio is invested to meet it. The objective
must be clearly stated in the mutual funds prospectus and may only be changed by a majority
vote of the funds outstanding shares.
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Name Rule. The name rule was really instituted to prevent abuse, such as the
ABC Government Bond Fund having only half of its assets in U.S. Government bonds,
but the implication is that it carries the minimal credit risk of Treasury Bonds. This
name rule requires a registered investment company with a name suggesting that the
company focuses on a particular type of investment such as stocks, bonds, federal or
municipal debt (e.g., ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Bond Fund) invest at least 80% of its assets in the type of security indicated by
its name. A small-cap, mid-cap, or large-cap fund seeking maximum flexibility with
respect to its investments would be free to select a name that does not connote a
particular investment emphasis.
2. 4. 4. 1 Stock Funds
Common stock is normally found in the portfolio of any mutual fund that has growth as a
primary or secondary objective. Bonds, preferred stock, and blue-chip stocks are typically used
to provide income to mutual funds with income objectives.
2. 4. 4. 1. 1 Growth/Value Funds
Growth funds invest in stocks of companies whose businesses are growing rapidly. Growth
companies tend to reinvest all or most of their profits for research and development rather than
pay dividends. Growth funds are focused on generating capital gains rather than income.
Blue-chip or conservative growth funds invest in established and more recognized companies to achieve growth with less risk. Generally these funds own shares of companies with
fairly large market capitalization. Market cap, as it is usually referred to, is the total number
of shares of common stock outstanding multiplied by the current market value per share. For
example, a listed company with 300 million shares outstanding where the share price is $50
would have a market cap of $15 billion and would be considered a large-cap stock. Funds
investing in stocks like this are sometimes called large-cap funds (their portfolio consists of
companies with a market capitalization of more than $10 billion).
Aggressive growth funds are sometimes called performance funds. These funds are willing
to take greater risk to maximize capital appreciation. Some of these funds invest in newer companies with relatively small capitalization (less than $2 billion capitalization) and are referred
to as small-cap funds. Mid-cap funds are somewhat less aggressive and have in their portfolios
shares of companies with a market capitalization of between $2 and $10 billion.
Investment style in growth funds can also be weighted toward capitalization, where companies are expected to continue to perform well in business and their stock to continue to grow
in price, versus valuation, where undervalued companies are expected to perform better than
the reports indicate, and thus their stock to increase in price. Value funds focus on companies
whose stocks are currently undervalued (earnings potential is not reflected in the stock price).
As a result, the dividend yields tend to be higher than growth funds.
2. 4. 4. 1. 2 Income Funds
An income fund stresses current income over growth. The funds objective may be accomplished by investing in the stocks of companies with long histories of dividend payments, such
as utility company stocks, blue-chip stocks, and preferred stocks.
Option income funds invest in securities on which options can be written and earn premium income from writing options. They may also earn capital gains from trading options at
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a profit. These funds seek to increase total return by adding income generated by the options
to appreciation on the securities held in the portfolio.
2. 4. 4. 1. 6 Blend/Core Funds
Blend/core funds are stock funds with a portfolio comprised of a number of different
classes of stock. Such a fund might include both blue-chip stocks and high-risk/high-potential
return growth stocks or both growth stocks and value stocks. The purpose is to allow investors to diversify their equity holdings and maximize their growth returns while owning just a
single stock fund. Customers, however, must understand that diversification is just one of a
number of risk management strategies and that blend/core funds share the risks common to
other equity funds.
TA K E N O T E
Value funds are considered more conservative than growth or blend/core funds.
2. 4. 4. 1. 7 Index Funds
Index funds invest in securities to mirror a market index, such as the S&P 500. An index
fund buys and sells securities in a manner that mirrors the composition of the selected index.
The funds performance tracks the underlying indexs performance. Turnover of securities in
an index funds portfolio is minimal. As a result, an index fund generally has lower management costs than other types of funds.
TA K E N O T E
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TA K E N O T E
2. 4. 4. 2 Balanced Funds
Balanced funds, also known as hybrid funds, invest in stocks for appreciation and bonds
for income. In a balanced fund, different types of securities are purchased according to a formula the manager may adjust to reflect market conditions.
EXAMPLE
A balanced funds portfolio might contain 60% stocks and 40% bonds.
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EXAMPLE
A fund may have 60% of its investments in stock, 20% in bonds, and the
remaining 20% in cash. If the stock market is expected to do well, the adviser may
switch from cash and bonds to stock. The result may be a portfolio of 80% in stock,
10% in bonds, and 10% in cash. Conversely, if the stock market is expected to decline, the fund may invest heavily in cash and sell stocks.
2. 4. 4. 4 Bond Funds
Bond funds have income as their main investment objective. Some funds invest solely
in investment-grade corporate bonds. Others, seeking enhanced safety, invest only in government issues. Still others pursue capital appreciation by investing in lower-rated bonds for
higher yields.
2. 4. 4. 5 Funds of Funds
A fund of funds is a type of mutual fund that invests solely in other mutual funds. These
funds strategies and objectives necessarily reflect the strategies of the underlying mutual funds
that make up their portfolios, and they can be pure growth, pure income, or a mixture of two
or more objectives. They are not to be confused with funds of hedge funds.
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TA K E N O T E
Though extremely rare, it is possible for investors to lose money in a money market mutual fund.
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2. 4. 4. 6. 2 Beta
One characteristic of note for money market funds is their low beta coefficient. Beta is a
means of measuring the volatility of a security or portfolio in comparison with the market as
a whole. A beta coefficient of 1.0 indicates a securitys price will move in direct correlation
with the market. A beta greater than 1.0 indicates a security is more volatile than the market,
and a beta less than 1.0 indicates that a security will be less volatile than the market.
Remembering the money market fund portfolio restrictions discussed previously, such as
the limitation to invest in short term, minimal risk securities, and the ability to peg the NAV
at $1 per share, it becomes apparent that no correlation exists between the movements of the
market and the share prices of money market funds.
TA K E N O T E
For suitability questions on the exam, first determine the customers primary
objective. In general, the following basic rules apply.
Investor Objective
Recommendation
Growth
Aggressive growth/speculation
Income
Tax-free income
High-yield income
Equity income
Liquidity
Stock portfolio
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Investors seeking safety of principal with high liquidity should consider a money market
fund.
Investors who wish to invest in a portfolio that mirrors the performance of the stock market should consider an index fund.
2. 4. 4. 8 Strategies
Whether an individual investor or a portfolio manager, many things influence the types
of securities purchased and sold including personal preferences, market factors, and goals and
objectives.
EXAMPLE
2. 4. 4. 8. 2 Defensive Strategies
Defensive investment strategies are often implemented during economic decline. Investors
may want to invest in securities of industries that tend to perform well in a contracting economy such as the:
utility industry;
food industry;
clothing industry; and
drug industry.
Defensive strategies may also include the purchase of high quality debt during a volatile
market.
2. 4. 4. 8. 3 Aggressive Strategies
Aggressive investment strategies attempt to maximize investment returns by assuming
higher risks. Such strategies include selecting highly volatile stocks, buying securities on margin, and using put and call option strategies.
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2. 4. 4. 8. 4 Balanced Strategies
Most investors adopt a combination of aggressive and defensive strategies when making
decisions about the securities in their portfolios. A balanced, or mixed, portfolio holds securities of many types.
Balanced fund
Aggressive growth fund
Specialized fund
Blue-chip stock fund
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2. 4. 5
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125
2. 4. 5. 1 Performance
Securities law requires that each fund disclose the average annual total returns for one-,
five-, and 10-year periods, or since inception if less than 10years. Performance must reflect full
sales loads with no discounts. The managers track record in keeping with the funds objectives
in the prospectus is also important.
Fund quotations of average annual return must be for one-, five-, and 10-year
periods, or as long as the fund has operated.
2. 4. 5. 2 Costs
Sales loads, management fees, and operating expenses reduce investor returns because
they reduce the amount of money available for investment.
2. 4. 5. 2. 1 Sales Loads
Historically, mutual funds have charged front-end loads of up to 8.5% of the money
invested. This percentage compensates a sales force. Many low-load funds charge between
2% and 5%. Other funds may charge a back-end load when funds are withdrawn. Some funds
charge ongoing fees under Section 12b1 of the Investment Company Act of 1940. These
funds deduct annual fees to pay for marketing and distribution costs. Sales loads will be covered in detail later in this unit.
2. 4. 5. 2. 2 Expense Ratio
A funds expense ratio relates the management fees and operating expenses to the funds
net assets. All mutual funds, load and no-load, have expense ratios. The expense ratio is calculated by dividing a funds expenses by its average net assets. An expense ratio of 1% means
that the fund charges $1 per year for every $100 invested. Typically, aggressive funds and international funds have higher expense ratios.
Stock funds generally have expense ratios between 1% and 1.5% of a funds average net
assets. For bond funds, the ratio is typically between .5% and 1%.
You may be asked about the factors included in calculating a mutual funds
expense ratio. The BOD stipend, investment adviser fee, custodian fee, transfer agent
fee, 12b-1 fee, and legal and accounting expenses are all included. The sales load is
not. The formula for the computation of a mutual funds expense ratio is:
Fund expenses average net assets = expense ratio
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EXAMPLE
$1 million expenses
$100 million average net assets
TA K E N O T E
= 1% expense ratio
The funds expense ratio is found in the prospectus and measures the efficiency
of its management. The largest part of the expense ratio is the investment advisory
fee.
2. 4. 5. 3 Taxation
Mutual fund investors pay taxes on any dividends or capital gains the fund distributes.
Even if the investor elects to reinvest some or all of the distribution, the total amount is taxable in the year earned by the fund. There will be a more detailed discussion on mutual fund
taxation in the next Unit.
2. 4. 5. 4 Portfolio Turnover
The costs of buying and selling securities, including commissions or markups and markdowns, are reflected in the portfolio turnover ratio. It is not uncommon for an aggressive
growth fund to reflect an annual turnover rate of 100% or more. A 100% turnover rate means
the fund replaces its portfolio annually. If the fund achieves superior returns, the strategy is
working; if not, the strategy is subjecting investors to undue costs.
The portfolio turnover rate reflects a funds holding period. If a fund has a turnover rate of
100%, it holds its securities, on average, for less than one year. Therefore, all gains are likely
to be short-term and subject to the maximum tax rate; a portfolio with a turnover rate of 25%
has an average holding period of four years and gains are likely taxed at the long-term rate.
2. 4. 5. 5 Services Offered
Investors should always weigh the cost of services provided against the value of the services to the investor.
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Sales charge
Blend/core fund
alue, or special
V
situation fund
fund
POP
Front end load
Growth fund
Income fund
Specialized, sector
Shares outstanding
NAV
Stock fund
Global fund
Quantitative risk
management
Preservation of capital
Defensive strategy
Aggressive strategy
Balanced strategy
Fractional share
Form 1099
Fund of funds
Fund of hedge funds
Money market fund
Performance factors
Sales load
Expense ratio
Taxation
Portfolio turnover
Services offered
2. 5. 1
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2. 5. 1. 1 Accumulation Plans
Mutual funds have a number of arrangements to implement an investment program.
A voluntary accumulation plan allows a customer to deposit regular periodic investments
on a voluntary basis (minimum amounts found in the prospectus). The plan is designed to help
the customer form regular investment habits while still offering some flexibility.
Voluntary accumulation plans may require a minimum initial purchase andminimum
additional purchase amounts. Many funds offer automatic withdrawal from customer checking
accounts to simplify contributions. If a customer misses a payment, the fund does not penalize
him because the plan is voluntary. The customer may discontinue the plan at any time.
TA K E N O T E
In a voluntary accumulation plan, once the account has been opened, contribution and frequency are very flexible.
Dollar Cost Averaging. One method of purchasing mutual fund shares is called dollar cost
averaging, where a person invests identical amounts at regular intervals. This form of investing allows the individual to purchase more shares when prices are low and fewer shares when
prices are high. In a fluctuating market and over a period of time, the average cost per share is
lower than the average price of the shares. However, dollar cost averaging does not guarantee
profits in a declining market because prices may continue to decline for some time. In this case,
the investor buys more shares of a sinking investment.
EXAMPLE
The following illustrates how average price and average cost may vary with dollar
cost averaging:
Month
Amount Invested
No. of Shares
January
$600
$20
30
February
$600
$24
25
March
$600
$30
20
April
$600
$40
15
Total
$2,400
$114
90
The average price per share is the sum of the prices paid divided by the number
of investments: $114 / 4 = $28.50.
The average cost per share is total amount spent divided by the number of shares
purchased: $2,400 / 90 = $26.67.
In this case, the average cost is $1.83 per share less than the average price.
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TA K E N O T E
129
Dollar cost averaging neither guarantees profit nor protects from loss. It merely
results in a lower cost per share than the average price per share.
2. 5. 1. 2 Contractual Plans
Until recently, periodic payment plans for investment in mutual funds could be purchased
from unit investment trusts known as contractual plan companies. These plans are no longer
sold, but many existing plans are still in effect and can still be the subject of test questions. In
marketing a contract, the sales person supplied the investor with two prospectuses: that of the
contractual plan company itself and that of the mutual fund that the company would purchase
for the investor. The investor would then enter into a nonbinding agreement to make periodic
payments to the plan company (typically monthly payments) for a specific period (typically 10
or 20 years) to be invested in a particular mutual fund. The plan company would, in turn, enter
into a binding agreement to purchase the shares whenever a payment was received.
Plan companies, as investment companies, were not FINRA members and had to pay
POP for their shares. Because they had their own marketing and sales requirements, they were
allowed to make the shares available to the investor at a 9% sales charge, calculated over the
projected life of the contract.
Plan completion insurance. Contractual plans were often sold on military bases with an
option to purchase plan completion insurance (decreasing term life insurance) in the event
the participant died prior to completion of the contract. However, insurance proceeds are
paid to the contractual plan (custodian), not a named beneficiary. The effect of this was that
the plan was immediately paid up (similar to a mortgage life insurance policy paying off the
entire mortgage) and the specified beneficiary(s) of the plan received a fully paid-up plan.
Contractual plan sales charges. Some plan companies were organized under the Invest-
ment Company Act of 1940. They are known as 1940 companies and also as front-end load
companies because of the way they collect their sales charge. They may collect up to 50% of
any given payment as a sales charge and may continue doing so until the equivalent of up to
9% of the total projected payments has been collected. Once the full sales charge has been
collected, further payments are wholly invested.
Other plan companies were organized under the Investment Company Act Amendments
of 1970, which amended paragraph 27(h) of the 1940 Act. They are known as 1970 companies and also as spread-load companies because of the way they collect their sales charge. They
may collect up to 20% of any given payment as a sales charge, but the average collected over
any 4-year period may not exceed 16%. They may continue to collect sales charges according
to this formula until up to 9% of the total projected payments has been collected. Once the
total sales charge has been collected, further payments are wholly invested.
Contractual plan reimbursements. Investors in contractual plans must be given a 45-day
free-look period to withdraw from the plan. The plan company had 60 days to post a letter
to the investor, called a 45-day free-look letter, which explained how contractual plans
worked and gave the investor 45 days from the posting of the letter to withdraw from his
plan. Both types of plans reimbursed the investor with all sales charges so far collected, plus
the NAV of the mutual fund shares so far purchased if the investor decided to withdraw from
his plan within the 45-day free-look period.
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130
1970 Companies
(spread load, 27(h))
Plan termination, 0 to 45
days
!
Q
Feedback tells us that the most testable information for contractual plans are the
sales charge percentages (see the following Quick Quiz).
20
50
16
9
1. Maximum sales charge that may be withdrawn in any one year for a
front-end load plan
2. Maximum average sales charge that may be withdrawn over any four
year period with a spread-load plan
3. Maximum sales charge that may be withdrawn in any one year for a
spread-load plan
4. Maximum sales charge percentage over the life of any contractual plan
2. 5. 1. 3 Withdrawal Plans
In addition to lump-sum withdrawals where customers sell all of their shares, mutual funds
offer systematic withdrawal plans (normally a free service). Most mutual funds require a customers account to be worth a minimum amount of money before a withdrawal plan may
begin. Additionally, most funds discourage continued investment once withdrawals start.
Not all mutual funds offer withdrawal plans, but those that do may offer plans that include
the following.
2. 5. 1. 3. 1 Fixed-Dollar Plan
A customer may request the periodic withdrawal of a fixed-dollar amount. Thus, the fund
liquidates enough shares each period to send that sum. The amount of money liquidated can
be more or less than the account earnings during the period. The amount of each check is
known. How long the checks will last is determined by the performance of the fund and is,
therefore, unknown.
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2. 5. 1. 3. 3 Fixed-Time Plan
Under a fixed-time withdrawal plan, customers liquidate their holdings over a fixed period
of time such as 10 years (120 months). How long the checks will last is known. The amount of
each check is determined by the performance of the fund and is, therefore, unknown.
TA K E N O T E
Mutual fund withdrawal plans are not guaranteed in any way. Charts and tables
regarding withdrawal plans must be cleared by the SEC before use.
1. Under which of the following circumstances will dollar cost averaging result in an
average cost per share that is lower than the average price per share?
I.
II.
III.
IV.
A.
B.
C.
D.
2. All of the following statements regarding dollar cost averaging are true EXCEPT
A.
B.
C.
D.
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132
4. An investor has requested a withdrawal plan from his mutual fund and currently
receives $600 per month. This is an example of what type of plan?
A.
B.
C.
D.
Contractual
Fixed-share periodic withdrawal
Fixed-dollar periodic withdrawal
Fixed-percentage withdrawal
Terms and Concepts Checklist
Accumulation plan
Periodic payment plan
Dollar cost averaging
Withdrawal plan
Fixed dollar plan
Fixed time plan
Fixed percentage, fixed share plan
Contractual plan
Front-end load plan
Spread load plan
45-day free-look period
45-day free-look letter
Terms of withdrawal
Refund, partial refund, of sales charge
NEWSPAPER QUOTES
Investment company prices, like those for individual securities, are quoted daily in the
financial press. However, because various methods are used to calculate sales charges, the
financial press provides several footnotes to explain the type of sales charge a mutual fund
issuer uses. A registered representative must understand the presentation and meaning of the
footnotes associated with investment company quotes so that he can accurately describe the
quotes to the investing public.
Most newspapers carry daily quotes of the NAVs and offer prices for major mutual funds.
A mutual funds NAV is its bid price. The offer price (also called the public offering price or
POP) is the ask price; it is the NAV plus the maximum sales charge, if any. The NAV Chg
column reflects the change in NAV from the previous days quote.
EXAMPLE
In the figure, look at the family of funds called The Jefferson Funds. The Jefferson
Growth Fund is a part of this group; its NAV, offering price, and the change in its NAV
per share are listed. As stated previously, when a difference exists between the NAV
and the offering price, the fund is a load fund. A no-load fund is usually identified by
the letters NL in the Offer Price column.
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133
Offer
Price
NAV
Chg
4.80
5.04 + .02
6.87
7.21 + .02
10.28 10.79 + .01
11.62 12.20
.04
NAV
FastTrak Funds
App
CapAp
Grwth
Offer
Price
NAV
Chg
13.79 14.44
.01
22.13 23.17 + .15
18.33 19.24
.10
e: Ex-distribution. f: Previous days quote. s: Stock split or div. x: Ex-dividend. NL: No load.
p: Distribution costs apply, 12b-1 plan. r: Redemption charge may apply.
* This sample comprises formats, styles, and abbreviations from a variety of currently
available sources and has been created for educational purposes.
The final column shows the change in a shares NAV since the last trading date.
A plus (+) indicates an upward move and minus () indicates a downward turn. From
this information, you can calculate any mutual funds sales charge.
Find the FastTrak group of funds in the Mutual Fund Quotations. The first entry
isApp.
The sales charge formula:
Public offering price NAV = sales charge
$14. 44 $13.79 = $.65
Remember, to calculate the sales charge percentage, use the following formula:
Sales charge public offering price = sales charge percentage
$.65 $14.44 = 4.5%
You can also watch the movements of the funds share value.
2. 6. 2
INVESTMENT SERVICES
Stock guides such as Standard & Poors include summaries of mutual funds for the year.
The graphic on this page shows a portion of a table adapted from a Standard & Poors Stock
Guide; you can use it to evaluate mutual funds.
To the right of the third fund listed on the table, Alliance Fund, the following information
is listed:
Principal objective of the fund: G means Alliance is a growth fund. Other objectives
might be income, return on capital, and stability; they are listed in the footnotes below
the table.
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134
FUND
Alliance Fund
Total
Net Cash &
at Dec 31
Prin
Assets Equiv
Obj Type (MILS) (MILS) 2011 2012 2013
G
948.2
19.0
5.2
+29.5 +8.9
$10,000
Invested
Price
Max 12-31-03
Record2013
Sales
Now
Chg % Worth
High
Low
Min
Unit
$250
5.5
24,661
9.67
6.96
10.00
Principal Objective: G-Growth; I-Income; R-Return on Capital; S-Stability; E-Objectives treated Equally; P-Preservation of Capital; Listed in order
of importance. Type: B-Balanced; BD-Bond; C-Common; CV-Conv Bond and Prefd Stock; FL-Flexible; GB-Long-term Govt; GL-Global; H-Hedge;
L-Leverage; P-Preferred; PM-Precious Metals; O-Options; SP-Specialized; TF-Tax Free; ST-Short-term investments
Type of fund: Alliance Fund is a C or common stock fund. Other types of funds are
FLflexible
Hhedge
Lleverage
Ppreferred
SPspecialized
TFtax free
Total net assets lists total net assets at market value (assets minus liabilities). Alliance
Fund has total net assets of $948.2 million.
Cash and equivalents includes cash and receivables, short-term government securities,
and other money market instruments less current liabilities. Cash and equivalents are part
of the total net assets.
Percentage change in net assets per share: these columns show a funds performance over
a specific periodin this case, from the previous December 31. For instance, on December
31, 2012, Alliance Fund had a 29.5% increase in NAV per share since December 31,
2011.
Minimum unit is the minimum initial purchase of shares (Alliance Fund= $250).
Maximum sales charge: Alliance Fund charges 5.5%. If a fund is a no-load fund, it levies
no sales charge.
Current worth of $10,000 invested December 31, 2003, provides a gauge of a funds
performance over several years. In this case, $10,000 invested in Alliance Fund on December 31, 2003, would have more than doubled, growing to $24,661.
Price record: from these columns, you can learn a shares percentage of appreciation from
its low price of the year. To determine the percentage, subtract the low price from the latest NAV per share, then divide the difference by the low price. For instance, during 2013,
Alliance Fund sold at a low of 6.96. If on the current date, its NAV per share was 9.45, the
appreciation would be computed as follows:
NAV
Low
9.45
6.96
2.49
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135
A.
B.
C.
D.
E.
POP
NAV
CN
CV
G
Newspaper quotes
Investment services
Withdrawal plans
Withdrawal plan disclosures
2. 7 ANNUITY PLANS
An annuity is an insurance contract designed to provide retirement income. The term
annuity refers to a stream of payments guaranteed for some period of timefor the life of the
annuitant, until the annuitant reaches a certain age, or for a specific number of years. The
actual amount to be paid out may or may not be guaranteed, but the stream of payments itself
is. Because an annuity can provide an income for the rest of someones life, the contract has
a mortality guarantee. When you think about a retirees greatest fear, it is typically outliving
her income. This product can take away that fear.
2. 7. 1
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136
TA K E N O T E
Annuities discussed in this section are non-qualified; that is, they are funded with
after-tax dollars, the money grows tax-deferred, and only the earnings are taxed at
distribution.
2. 7. 1. 1 Fixed Annuities
In a fixed annuity, investors pay premiums to the insurance company that are invested in
the companys general account. The insurance company is then obligated to pay a guaranteed
amount of payout (typically monthly) tothe annuitant based on how much was paid in.
Note that the insurer guarantees a rate of return and, therefore, bears the investment risk.
Because the insurer is the one at risk, this product is not a security. An insurance license is
required to sell fixed annuities, but a securities license is not.
Purchasing power risk (inflation risk) is a significant risk associated with fixed annuities.
The fixed payment that the annuitant receives loses buying power over time due to inflation.
EXAMPLE
2. 7. 1. 1. 1 Index Annuity
In an effort to overcome the purchasing power risk of fixed annuities, but without the
market risk of a variable annuity, the industry developed the index annuity.
Index annuities are currently popular among investors seeking market participation but
with a guarantee against loss. Unlike a traditional fixed annuity, an index annuity credits
interest to the owners account, using a formula based on the performance of a particular stock
index, such as the S&P 500. If the index does well, the annuitant is credited with a specified
percentage of the growth of the indextypically 80% or 90% of the growth. This is known as
the participation rate. If the index does poorly, the annuitant may receive a guaranteed minimum interest rate such as 1% or 2%.
To give you an idea of how an index annuity might work, consider a participation rate of
80% and a minimum guarantee of 1%. If the index shows growth of 9% during the measurement period, the annuitant would be credited with 7.2% growth (80% of 9%). If the index
performed at 9%, the annuitant would receive the minimum guarantee of 1%.
In addition to the participation rate, there is usually a cap rate. A typical cap might be
12%. This means that if the index annuity was pegged to the S&P 500 and that index increased
30% during the year, your gain would be capped at 12%. One other negative characteristic of
these products is that they tend to have longer surrender charge periods (as long as 15 years)
than other annuities, especially if there is a front-end bonus.
TA K E N O T E
The only license required in order to sell index annuities is an insurance license.
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2. 7. 1. 2 Variable Annuities
Insurance companies introduced the variable annuity as an opportunity to keep pace with
inflation. For this potential advantage, the investor assumes the investment risk rather than
the insurance company. Because the investor takes on this risk, the product is considered a
security. It must be sold with a prospectus by individuals who are both insurance licensed and
securities licensed.
The premium payments for variable annuities are invested in the separate account of the
insurer. The separate account is comprised of various subaccounts that behave like mutual
funds (we just cant call them mutual funds). These accounts will have a variety of investment
objectives to choose from such as growth, income, and growth and income. The returns in the
separate account are not guaranteed and therefore a loss of principal is possible.
As with all recommendations, suitability of any purchase is number one. However, in
light of the large number of cases involving variable annuities where there was failure to
supervise egregious unethical behavior, FINRA Rule 2330 evolved. This rule applies to
recommended purchases and 1035 exchanges (discussed later) of deferred variable annuities
(NOT immediate) and recommended initial subaccount allocations.
The representative and a principal of the firm must 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,
potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59,
mortality and expense fees,
investment advisory fees,
potential charges for and features of riders,
the insurance and investment components of deferred variable annuities, and
market risk
In addition, the firm must inquire to the customer as to whether the customer has had an
exchange of a variable annuity at another broker-dealer within the last 36 months.
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Variable Annuity
after-tax dollars
after-tax dollars
Portfolio of:
fixed income
securities and real estate
Who assumes
investment risk?
Insurer
Annuitant
Is it a security?
No
Yes
Rate of return:
guaranteed
depends on performance
of separate account
Administrative expenses:
fixed
fixed
Yes
Yes
Monthly payments:
constant
No
Regulation?
Subject to insurance
regulation
Although annuitants of variable annuities can choose a guaranteed monthly income for
life, the amount of monthly income received is dependent on the performance of the separate account. Monthly income either increases or decreases, as determined by the separate
accounts performance.
Investors may purchase a combination annuity to receive the advantages of both the fixed
and variable annuities. In a combination annuity, the investor contributes to both the general
and separate accounts, which provides for guaranteed payments as well as inflation protection.
Whenever you see the term variable, as in variable annuity or variable life (discussed later), two licenses are required for the sale; an insurance license and a securities license. Suitability must be determined and a prospectus must be delivered prior
to or with solicitation of the sale.
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Fixed Annuity
Combination Annuity
Variable Annuity
Payments to Separate
Accounts
Payments to General
Account
Open-End Investment
Company
UIT
Pricing:
Share value:
Regulated by:
Mutual Fund
NAV calculated once per
business day
Depends on performance
of fund
Act of 1933, Act of 1934,
Investment Company Act
of 1940, Investment Advisers Act of 1940
Portfolio manager
Variable Annuity
Unit value calculated once
per business day
Depends on performance
of separate account
Act of 1933, Act of 1934,
Investment Company
Act of 1940, Investment
Advisers Act of 1940
Separate account manager
If the investment manager of an insurance company is responsible for selecting the securities to be held in the separate account, the separate account is directly managed and must be
registered under the Investment Company Act of 1940 as an open-end management investment company. However, if the investment manager of the insurance company passes the
portfolio management responsibility to another party, the separate account is indirectly managed and must be registered as a unit investment trust under the Investment Company Act
of1940.
Although there are many similarities between mutual funds and variable annuities, there
are two extremely significant features that differentiate the products: a variable annuity offers
the advantage of guaranteed lifetime income (unlike mutual funds) and the earnings on dollars invested into a variable annuity accumulate tax deferred.
Mutual funds periodically distribute dividends and capital gains, and all of these distributions are typically taxable in the year of receipt, whether reinvested or taken in cash. Such
distributions are never paid directly to owners of annuities; instead, they increase the value
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of units in the separate account. Tax liability is postponed until withdrawals take place. This
feature of tax-deferred growth has established the annuity as a popular product for retirement
accumulation.
TA K E N O T E
Owners of mutual funds and variable annuities have voting rights. They get to
vote on major decisions like changes in investment objectives and investment advisers. They do not get to vote on day-to-day activities like deciding what securities to
buy or sell within a portfolio.
1. Which of the following represent the rights of an investor who has purchased a
variable annuity?
I.
II.
III.
IV.
A.
B.
C.
D.
2. Which of the following are TRUE for both variable annuities and mutual funds?
I. They contain managed portfolios.
II. An owners account value typically passes to his estate at the time of the
owners death.
III. They are regulated by the Investment Company Act of 1940.
IV. All investment income and realized capital gains are taxable to the owner in
the year they are generated.
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
3. Which of the following most significantly affects the value of annuity units in a
variable annuity?
A.
B.
C.
D.
4. Variable annuity salespeople must register with all of the following EXCEPT
A.
B.
C.
D.
SEC
state banking commission
FINRA
state insurance department
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a rate of return
a fixed mortality expense
a fixed administrative expense
a fixed investment risk
I and III
I and IV
II and III
II and IV
2. 7. 2
PURCHASING ANNUITIES
Insurance companies offer a number of purchase arrangements for annuities. The various
purchasing plans are discussed below. Aggregate fees include not only sales charges on the
front-end, but also those levied upon surrender, commonly referred to as Conditional Deferred
Sales Loads, or CDSL. In many cases, there is no load to purchase, but if surrender, other
than through annuitization, occurs during the early years of the contract, the charges can be
significant.
An investor is offered a number of options when purchasing an annuity. Payments to the
insurance company can be made either with a single lump-sum payment or periodically on a
monthly, quarterly, or annual basis.
A single premium deferred annuity is purchased with a lump sum, but payment of benefits is delayed until a later date selected by the annuitant.
A periodic payment deferred annuity allows investments over time. Benefit payments for
this type of annuity are always deferred until a later date selected by the annuitant.
An immediate annuity is purchased with a lump sum, and the payout of benefits usually
commences within 60 days.
2. 7. 2. 1 Bonus Annuities
Direct financial benefits are sometimes offered with annuities, called bonus annuities.
These benefits include enhancement of the buyers premium, with the insurance company
contributing an additional 35% to the premium payment. This comes with a cost, of course,
in the form of higher fees and expenses, and longer surrender periods than the typical 710
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years of standard contracts. Recommendations to customers must include the additional costs
as well as the benefits of the bonuses and enhancements.
2. 7. 2. 2 Sale Charges
Although there are no stated maximum sales charges on variable annuities, the SEC has
charged FINRA with the responsibility of ensuring that they are fair and reasonable. As a
practical matter, most annuities, both fixed and variable, are sold with little or no sales charge.
Instead, there is a surrender charge (think CDSC or CDSL) for early termination. This surrender period is longer for bonus annuities and generally the longest for index annuities.
2. 7. 3
ACCUMULATION STAGE
The variable annuity has two distinct phases. The growth phase is its accumulation phase,
while the payout phase is its annuity phase. A contract owners interest in the separate account
is known as either accumulation units or annuity units depending on the contract phase.
Both accumulation units and annuity units vary in value based on the separate accounts
performance.
When the annuitant decides to begin receiving payments from the annuity, he may choose
to annuitize the contract. Although not required, if annuitized, the owner enters into a contractual obligation with the insurance company for the systematic distribution of the asset.
Once annuitized, the money will be distributed per the payout option chosen (discussed later).
At that point, the accumulation units purchased over time will be converted into a fixed number of annuity units. This becomes one of the factors used to calculate the payout each month
during retirement.
Annuitization
Accumulation phase
----------------->
Annuity phase
Accumulation units
----------------->
Annuity units
2. 7. 4
As mentioned earlier in our comparison chart with mutual funds, accumulation unit values are computed daily on a forward pricing basis. As you will soon see,
annuity unit values are computed monthly based on actual performance versus the
assumed interest rate.
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The value of an annuity unit and the annuitants subsequent monthly income will vary,
depending on separate account performance as compared to the AIR. To determine whether
the monthly payment will increase, decrease, or stay the same as the previous month, the following rules apply.
If separate account performance is greater than the AIR, next months payment is more
than this months.
If separate account performance is equal to the AIR, next months payment stays the same
as this months.
If separate account performance is less than the AIR, next months payment is less than
this months.
EXAMPLE
Assume an AIR of 4% and that the actuaries have determined the first payment
to be $1,000.
Month 2s separate account performance is 6%, greater than AIR, so the next
check goes up.
Month 3s separate account performance is 4%, right at AIR. The next check
received equals the last check received.
Month 4s separate account performance is 3%, which is below AIR, therefore
the next check received will be less than the last check received.
Month 5s separate account performance is 3% again, which, although the same
as month 4s, is still below AIR. The next check is, therefore, less than that of the last.
Month 6s separate account performance is not shown, but if separate account
performance is above the AIR of 4%, the next check will be more than $950; if it is
below the AIR of 4%, the next check will be less than $950.
AIR = 4%
Month 1
$1,000
Month 2
6%
4%
3%
3%
$1,100
$1,100
$1,000
$950
TA K E N O T E
Above AIR
Increases
Same as AIR
Below AIR
Decreases
Consider this: if AIR is 4% and the separate account always returns 4%, the
check would never change!
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I and III
I and IV
II and III
II and IV
cost base is the total amount he has invested. He will be liable for income tax on the growth
plus a 10% penalty on the growth if he is under the age of 59.
Death of annuitant. If the annuitant dies during the accumulation period, the death
benefit takes effect. His beneficiary is guaranteed either the total value of the annuity or the
total amount invested, whichever is greater, and is liable for income tax on any growth.
Annuitization. If the annuitant wishes to receive scheduled payments for life, he may
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Life Annuity/Straight Life. If an annuitant selects the life income option, the insurance
company will pay the annuitant for life. When the annuitant dies, there are no continuing
payments to a beneficiary. Money remaining in the account reverts to the insurer. Because
there is no beneficiary during the annuitization, this represents the largest monthly check
an annuitant could receive for the rest of their life. (The insurance company has no further
obligation at death.)
TA K E N O T E
The life annuity probably would not have been a good choice if the annuitant
died after receiving only one months payment. With the life income option, all
money accumulated that was not paid out at the time of the annuitants death would
belong to the insurer.
The following options are a little less risky because they allow for payments to a beneficiary.
Life Annuity With Period Certain. To guarantee that a minimum number of payments are
made even if the annuitant dies, the life with period certain option can be chosen. The contract will specifically allow the choice of a period of 10 or 20 years, for instance. The length
of the period certain is a choice that is made when a payout option is selected. The annuitant
is guaranteed monthly income for life with this option, but if death occurs within the period certain, a named beneficiary receives payments for the remainder of the period. Because
there is a named beneficiary for the period certain, the size of this check will be smaller than
a straight life option. (The insurance company is obligated to pay the named beneficiary an
income if death occurs during the period certain.)
TA K E N O T E
To illustrate the life annuity with period certain option, assume a client selects a
life annuity with a 10-year period certain. If the annuitant lives to be 150 years old,
annuity payments are still made by the insurer. But, if the annuitant dies after receiving payments for two years, the beneficiary will receive payments for eight more
years.
Joint Life With Last Survivor Annuity. The joint life with last survivor option guarantees
payments over two lives. It is often used for spouses. Because the insurance company is obligated to pay a check over two lifetimes, this check is considered to be smaller than a life with
period certain option.
EXAMPLE
If the husband were to die first, the wife would continue to receive payments as
long as she lives. If the wife were to die first, the husband would receive payments as
long as he lives. Typically the payment amount is reduced for the survivor.
Unit Refund Option. If the annuitant chooses this option, a minimum number of payments are made upon retirement. If value remains in the account after the death of the annuitant, it is payable in a lump sum to the annuitants beneficiary. This option may be added
as a rider to one of the others.
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TA K E N O T E
The unit refund option is the only lifetime annuitization option that guarantees
all of the money in the contract will be distributed. If unit refund is chosen for a
$100,000 contract, the insurance company guarantees that a minimum of $100,000
will be distributed and also guarantees a monthly check for life. Therefore, more than
$100,000 may be distributed, but never less.
Unit refund is sometimes offered as a rider.
For test purposes, this option represents the smallest check a person could receive
for the rest of his life.
There is a risk-reward trade-off with these payout options. The exam is likely to
look at payout options in questions similar to the following.
Which of the following annuity options typically pays the largest monthly
income?
A.
B.
C.
D.
Life only
Joint life with last survivor
Life with 10-year period certain
Contingent deferred option
Answer: A. Life only: there is no beneficiary with this option, so that payments
cease with death and money remaining reverts to the insurer.
This question illustrates an important exam-taking principle. The term in D, contingent deferred is a distraction; it refers to surrender charges that may apply when
not annuitizing.
EXAMPLE
I.
II.
III.
IV.
A.
B.
C.
D.
Rank the following annuity options in ascending order from smallest to largest
monthly income:
Life only
Unit refund
Joint and last survivor
Life with 10 year period certain
I, IV, III, II
II, III, IV, I
II, IV, III, I
III, II, I, IV
Answer: B.
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Accumulation unit
Joint with last survivor annuity
Deferred annuity
Monthly payment
2. 7. 5
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Variable annuity contracts are insurance company products that invest in a portfolio of
securities via their separate account. If someone has a low risk tolerance or is wary of the
stock market, a VA is not likely a very suitable recommendation for that individual.
Maximum contributions to all other retirement savings vehicles available to an individual
should be made before a VA is considered a suitable recommendation. In other words, they
are best considered supplements to retirement income one can already anticipate like pensions and IRA or 401(k) distributions.
Terms and Concepts Checklist
Annuity plan
Fixed annuity
Equity-indexed
annuity
Variable annuity
Combination annuity
Bonus annuity
Payout options
Annuity stage
Annuity unit
AIR
Life only, straight life
Life with period
certain
Payout factors
Accumulation stage
Accumulation unit
Unit refund
Purchasing power risk
General account
Separate account
Direct management
Indirect management
Immediate annuity
Single premium
deferred annuity
Periodic payment
deferred annuity
Voting rights
2. 8 LIFE INSURANCE
Life insurance provides a death benefit to a named beneficiary in the event of an insureds
premature death. There are many variations of life insurance which serve different needs. We
will review three types of permanent life policies and focus on those that are also considered
securities. Permanent life insurance is designed to last until at least age 100 or the death of the
insured, whichever occurs first. These policies also accrue cash value that may be borrowed for
living needs. An insurance license is required to sell life insurance.
The premium for life insurance is calculated according to the policyowners health, age,
and sex as well as the policys face amount at issue.
2. 8. 1
2. 8. 1. 1 Cash Values
The cash value of whole life and other permanent policies represents a savings element
for the policyholder. Cash values grow tax-deferred and may be accessed via loan privileges
prior to age 59 without penalty, while living (discussed later). The cash value of whole life
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increases each year the policy is kept in force. In traditional whole life insurance, the insurance
company invests premiums received in the insurance companys general assets. General assets
are used to cover current and future obligations of the insurance company and are conservative investments such as government bonds, investment grade corporate bonds, real estate,
and mortgage loans. By investing conservatively, the insurance company is able to guarantee
the cash value of the policy.
2. 8. 2
TA K E N O T E
A variable life insurance policy has a minimum death benefit, the premiums necessary to fund this part of the death benefit are held in the insurers general account.
Any policy benefit that is guaranteed is invested in the insurers general account.
Any premium above what is necessary to pay for the minimum death benefit is
invested in the separate account. This portion of the premium is subject to investment
risk and, therefore, variable life insurance is also defined as a security. As long as
premiums are paid, the policy remains in force even if the separate accounts lose
money every year.
Once the premium has been determined and the expenses have been deducted, the net
premium is invested in a separate account the policyowner selects.
Universal variable life insurance (UVL) is a type of variable life insurance with flexible
premiums (and an adjustable death benefit). Premiums are invested only in separate accounts
and cash values are not guaranteed, nor is there a guaranteed minimum death benefit. Premiums
may be increased or decreased over time but the policy must maintain a minimum cash value
to pay for expenses or the policy will lapse. The death benefit may be adjusted after issue but
if increasing the death benefit, proof of insurability will be required.
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Whole Life
Universal Variable
Life(UVL)
Scheduled premium
Scheduled premium
Flexible premium
No guaranteed minimum
death benefit but does
have an adjustable death
benefit
Premiums to separate
account
If a UVL policy is funded properly, there is a death benefit but, technically, if the
insurance company knows neither when the next premium is coming nor how much
that premium will be, it cant guarantee a minimum death benefit.
If cumulative premium payments exceed certain amounts specified in the Internal
Revenue Code, the life insurance policy will become a Modified Endowment Contract (MEC). Once defined as a MEC, the status cannot be reversed and cash value
removed from the policy (in excess of premiums paid) in the form of loans, partial
surrenders, or withdrawals, are subject to ordinary income tax and a 10% penalty
(if done prior to the insured reaching age 59). Distributions from MECs use LIFO
(Last-In-First-Out) accounting which means any cash value in excess of premiums
paid are distributed first.
TA K E N O T E
Any insurance product that includes the word variable requires both an insurance
license and securities license in order to sell it.
2. 8. 3
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Deductions from the gross premium normally reduce the amount of money invested in the
separate account. Charges deducted from the gross premium include:
the administrative fee;
the sales load; and
state premium taxes.
The administrative fee is normally a one-time charge to cover the cost of processing the
application.
2. 8. 4
TA K E N O T E
The exam may ask you which charges are deducted from the grosspremium and
which are deducted from the separate account (the net premium). Remember the
acronym P.A.S.S. to make it simple. The charges deducted from the gross premium
include the following:
Premium
Administrative fee
Sales load
State premium taxes
Any other charges; such as cost of insurance, expense risk fees, and investment management fees, are deducted from the separate account.
2. 8. 5
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benefit. Should the separate account returns be less than the AIR, the contracts death benefit
will decrease; however, it will never fall below the amount guaranteed at issue.
TA K E N O T E
2. 8. 6
The variable death benefit is adjusted annually. If there have been several months
of negative performance, therefore, they must be offset by equivalent positive performance before the variable death benefit can be adjusted upward.
HYPOTHETICAL ILLUSTRATIONS
The policyowners cash values reflect the investments held in the separate account. The
individual policys cash value must be calculated at least monthly.
The cash value, like the death benefit, may increase or decrease depending on the separate
accounts performance. If performance has been negative, the cash value may decrease to zero,
even if the contract has been in force for several years.
When illustrating hypothetical returns for variable life insurance cash value, the maximum
gross return is 12% provided a 0% return is also illustrated.
For scheduled premium policies, cash value may be accessed through surrendering the
policy or taking a loan.
TA K E N O T E
The AIR has no effect on cash value accumulation in a variable life policy. The
cash value will grow whenever the separate account has positive performance. The
AIR, however, does affect the death benefit. Just remember the rules for variable annuities. The rules for the death benefits are analogous.
If the separate account performance for the year is greater than the AIR, the
You may see a question that asks about the frequency of certain calculations associated with variable life insurance policies. Know that:
death benefits are calculated annually;
cash value is calculated monthly; and
unit values are calculated daily.
2. 8. 7
LOANS
Like traditional WL, a VL contract allows the insured to borrow against the cash value
that has accumulated in the contract. Loans are not considered constructive receipt of income
and therefore are received income tax free. However, certain restrictions exist. Usually, the
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insured may only borrow a percentage of the cash value. The minimum percentage that must
be made available is 75% after the policy has been in force for three years. There is no scheduled repayment of a loan. However, if the death benefit becomes payable and a loan is outstanding, the loan amount is deducted from the death benefit before payment. The interest
rate charged is stated in the policy. If an outstanding loan reduces cash value to a negative
amount, the insured has 31 days to deposit enough into his account to make it positive. If he
fails to do so, the insurance company will terminate the contract. If this happens, the loan, of
course, need not be repaid.
cash value, the policyowner must make payment to the insurer within 31
days.
If the insured dies with a loan outstanding, the death benefit is reduced by
2. 8. 8
CONTRACT EXCHANGE
During the early stage of ownership, a policyowner has the right to exchange a VL contract for a traditional fixed-benefit WL contract. The length of time this exchange privilege is
in effect varies from company to company, but under no circumstances may the period be less
than 24 months (federal law).
The exchange is allowed without evidence of insurability. If a contract is exchanged, the
new WL policy has the same contract date and death benefit as the minimum guaranteed in
the VL contract. The premiums equal the amounts guaranteed in the new WL contract (as if
it were the original contract).
Two testable facts about the contract exchange provision are as follows.
The contract exchange provision must be available for a minimum of two
years.
No medical underwriting (evidence of insurability) is required for the
exchange.
2. 8. 9
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2. 8. 9. 1 Sales Charges
The sales charges on a fixed-premium VL contract may not exceed 9% of the payments
to be made over the life of the contract. The contracts life, for purposes of this charge, is a
maximum of 20 years. For those of you familiar with life insurance compensation, the effect of
this is that renewal commissions are earned up to the 20th anniversary of policy issue.
2. 8. 9. 2 Refund Provisions
The insurer must extend a free-look period to the policyowner for 45 days from the execution of the application or for 10 days from the time the owner receives the policy, whichever
is longer. During the free-look period, the policyowner may terminate the policy and receive
all payments made.
The refund provisions extend for two years from issuance of the policy. If, within the
two-year period, the policyowner terminates participation in the contract, the insurer must
refund the contracts cash value (the value calculated after the insurer receives the redemption notice) plus all sales charges deducted in excess of 30% in the first year of the contract
and 10% in the second year. After the two-year period has lapsed, only the cash value need be
refunded; the insurer retains all sales charges.
Several testable facts about sales charges and refunds are as follows.
Because variable life is considered a contractual plan, the maximum sales
for the first year, the refund is sales charges in excess of 30% of the premiums paid plus the cash value;
for the second year, the refund is sales charges in excess of 10% of the premium paid plus the cash value; and
thereafter, the policyowner has access to the cash value only.
2. 8. 10 VOTING RIGHTS
Contract holders receive one vote per $100 of cash value funded by the separate account.
As with other investment company securities, changes in investment objectives and other
important matters may be accomplished only by a majority vote of the separate accounts
outstanding shares or by order of the state insurance commissioner. Contract holders must be
given the right to vote on matters concerning separate account personnel at the first meeting
of contract holders within one year of beginning operations.
Do not confuse the voting rights of variable annuities and variable life. Variable
annuities and mutual funds are the same: one vote per unit (share). Variable life is one
vote per $100 of cash value (fractional votes are allowed).
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2. 8. 11 LIFE SETTLEMENTS
Selling a life insurance policy (or the right to receive the death benefit) to an entity other
than the insurance company that issued the policy is a transaction known as a life settlement
(they used to be called viaticals). When the sale involves a variable life insurance policy, variable life settlements are securities transactions that are subject to the federal securities laws
and all applicable FINRA rules. In particular, the regulators are concerned about suitability
and disclosure.
When a life insurance policy is sold, the buyer is acquiring a financial interest in the
insureds death. In addition to paying a lump sum for the policy, the buyer agrees to pay any
additional premiums that might be required to support the cost of the policy for as long as the
insured lives. In exchange, the buyer will receive the death benefit when upon the insureds
death.
Because the secondary market for life insurance is not developed in the way it is for other
securities, FINRA is concerned about the level of commissions and clients receiving a fair
price for their policies. One requirement is that your firm should receive bids from multiple
sources. As a result, if you had an exclusive arrangement to market all of your life settlement
policies through one source, FINRA would consider that to be a violation of their rules.
As a relatively new product, training is critical, so FINRA requires that any person engaging in this activity or supervising those who do, must be adequately trained and that training
be documented.
Match each of the following numbers with the best description below.
A.
B.
C.
D.
75
24
9
10
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2. 8. 12. 3 Annuity
The beneficiary may opt to either place the proceeds into a deferred annuity or take an
immediate annuity with a choice of any of the annuity payout options.
Choose W for whole life, V for variable life, and U for universal variable life.
More than one may apply to each choice.
1. Features a stated premium
2. Always has some guaranteed death benefit
3. Features a guaranteed cash value
4. Cash value not guaranteed
5. Policy loans available
6. Has flexible premiums
Terms and Concepts Checklist
Whole life
Variable life (VL)
Universal variable life (UVL)
Fixed premium, scheduled premium
Flexible premium
Deductions from separate account
Mortality risk fee, guarantee
Expense risk fee, guarantee
Investment management fee
Policy loans
Sales charges
Voting rights
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U N I T
157
T E S T
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19. Which of the following statements regarding dollar cost averaging is TRUE?
A. It is effective if smaller dollar purchases are
made when the market prices rise.
B. When the market fluctuates, it will result in a
lower average cost per share.
C. It will protect investors from losses in a falling
market.
D. It is most effective when the market remains
constant.
20. Your customer invests $200 monthly in a mutual
fund. His daughter plans to enter college soon, and
he would like to send her $100 monthly. Which
of the following actions should you recommend
tohim?
A. Invest $100 monthly into the mutual fund and
send his daughter $100 monthly.
B. Invest $200 monthly into the mutual fund and
send all dividends to his daughter.
C. Invest $200 monthly into the mutual fund and
redeem shares when needed.
D. Begin a systematic withdrawal program of
$100 monthly.
21. An annuitant received payments until his death
from a nonqualified variable annuity. At his death,
his wife received a lump sum payment from the
annuity. This example illustrates which type of
annuity?
A. Straight life
B. Cash balance
C. Joint and last survivor
D. Unit refund
22. A customer owns a universal variable life insurance policy and has been notified by the insurance
company that any cash value in excess of premiums paid removed from the policy are subject to
ordinary income tax and a 10% penalty (if done
prior to the insured reaching age 59). Which of
the following best defines his policy?
A. The policy is paid-up.
B. The policy is a modified endowment contract.
C. No more premiums can be paid.
D. The policy has endowed.
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A N S W E R S
A N D
R A T I O N A L E S
161
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Q U I C K
Q U I Z
A N S W E R S
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6. T.
1. T.
2. F.
3. T.
4. F.
5. F.
Quick Quiz 2.G
1. D.
2. B.
3. A.
4. C.
5. D.
6. A.
7. B.
8. C.
9. C.
10. D.
11. B.
2. T.
12. A.
13. C.
4. T.
14. D.
15. A.
16. B.
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17. C.
18. D.
19. B.
20. A.
Quick Quiz 2.H
1. B.
2. C.
3. A.
4. D.
Quick Quiz 2.I
1. B. Dollar cost averaging benefits the investor
if the same amount is invested on a regular
basis over a substantial period of time, during
which the price of the stock fluctuates. A
constant dollar plan (Choice IV) is one in
which the investor maintains a constant
dollar value of securities in the investment
portfolio.
2. B. Dollar cost averaging is available to both
small and large investors.
3. D. Mutual fund withdrawal plans are not
guaranteed. Because principal values
fluctuate, investors may not have sufficient
income for their entire lives.
4. C. If the investor receives $600 a month, the
dollar amount of the withdrawal is fixed;
therefore, this must be a fixed-dollar plan.
Quick Quiz 2.J
1 D.
2. E.
3. A.
4. B.
5. C.
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1. D.
167
2. A.
3. B.
4. C.
Quick Quiz 2.O
1. W, V.
2. W, V.
3. W.
4. V, U.
5. W, V, U.
6. U.
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3
Securities and Tax
Regulations
ince the Great Depression, the securities industry has been closely
regulated in the interest of protecting the investor. The processes of
issuing securities and trading them once issued are subject to careful
regulatory procedures. It is recognized that investing money is inherently
risky, so laws cannot require that risk be eliminated; rather, the laws require
that the investor receive enough information to be able to assess the risk
accurately and be able to make sound investment decisions.
Since tax law and securities law are, for the present, indissolubly
connected, the registered representative must also be able to inform his
customer of the tax consequences of his investment decisions, whether
they involve individual securities, investment company securities, or the
contracts governing variable annuities or variable life insurance, which are
funded by securities.
The Series 6 exam will include 2025 questions on the topics covered in
thisUnit.
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OBJECTIVES
When you have completed this Unit, you should be able to:
interpret FINRA rules and regulations;
explain the process of issuing securities and the federal laws associated with issuing;
distinguish the various trading markets and terminology for securities;
recall the process of mutual fund distributions and taxation;
illustrate how variable contracts are taxed;
identify and summarize nonqualified and qualified retirement plans;
define ERISA guidelines; and
summarize federal laws designed to protect the buying public (SIPC, ITSFEA,
Regulation SP).
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3. 1. 1
promote the investment banking and securities business, standardize principles and practices, promote high standards of commercial honor, and encourage the observance of federal and state securities laws;
provide a medium for communication among its members and between its members, the
government, and other agencies;
adopt, administer, and enforce the Conduct Rules and rules designed to prevent fraudulent
and manipulative practices, as well as to promote just and equitable principles of trade;
investigate and adjust grievances between the public and members, as well as between
members.
DISTRICTS
FINRA divides the United States into districts to facilitate its operation. Each district
elects a district committee to administer the rules. Within each district, the Department of
Enforcement (Enforcement) handles trade practice violations. The executive committee,
made up of members of the board of governors, manages the organizations national affairs.
3. 1. 2
TERMS OF MEMBERSHIP
Application for FINRA membership includes the applying firms specific agreement to:
comply with federal securities laws;
comply with FINRAs rules and regulations; and
pay dues, assessments, and other charges in the manner and amounts fixed by FINRA.
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3. 1. 3
TA K E N O T E
EXAMPLE
Neither FINRA nor the SEC will approve the way a representative or firm
conducts business. To suggest otherwise is prohibited.
FINRA Registered
Representative
Note that the large, bold print used to identify FINRA affiliation could mislead
the recipient of this business card into thinking that John Doe is actually associated
with FINRA. FINRAs name may not be more prominent than the name of the
representatives firm.
3. 1. 4
FINRA RULES
FINRA policies fall into four sets of rules and codes by which the OTC market and New
York Stock Exchange members are regulated.
Conduct RulesSet out fair and ethical trade practices that member firms and their representatives must follow when dealing with the public.
Uniform Practice CodeEstablished the Uniform Trade Practices, including settlement,
good delivery, ex-dates, confirmations, and other guidelines for broker/dealers when they
do business with other member broker/dealer firms.
Code of ProcedureDescribes how FINRA hears and handles member violations of the
Conduct Rules.
Code of Arbitration ProcedureGoverns the resolution of disagreements and claims
between members, registered representatives, and the public; it addresses monetary
claims.
3. 1. 5
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3. 1. 5. 1 Broker/Dealer Registration
Any broker/dealer registered with the SEC may apply for membership in FINRA. Any
person who effects transactions in securities as a broker, a dealer, or an investment bank also
may register with FINRA, as may municipal bond firms. Application for FINRA membership,
done on Form BD, carries the applying firms specific agreement to:
establish and maintain written supervisory procedures and supervise the activities of each
registered representative, registered principal, and other associated person that is reasonably designed to achieve compliance with applicable federal securities laws and regulations, and with applicable FINRA Rules.
pay dues, assessments, and other charges in the manner and amounts fixed by the association.
A membership application is made to FINRAs office in the district in which the applying
firm has its home office. If a district committee passes on the firms qualifications, the firm can
be accepted into FINRA membership.
3. 1. 5. 2 Office Registration
A member firm must identify and register at least one Office of Supervisory Jurisdiction
(OSJ). The significance of an OSJ is that the office is responsible for the activities of registered
representatives and associated persons not only housed in that office but also within other
offices within that region. OSJs must be managed by at least one resident principal.
Each location where securities transactions are conducted regularly is defined as a branch
office. Branch offices are not required to maintain a resident principal. A properly qualified
registered representative may act as a branch manager. All branch offices must be identified
and registered with FINRA.
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TA K E N O T E
Any changes to this information require filing an amended form with the CRD (central registration depository) no later than 30 days after the member becomes aware of these
changes.
Qualifications Investigated. Before submitting an application to enroll a person with
FINRA as a registered representative, a member firm must certify that it has investigated the
persons business reputation, character, education, qualifications, and experience, and that
the candidates credentials are in order.
If, during its routine review of the U-4, FINRA discovers that any portion of the U-4
information submitted, especially relating to personal history and past disciplinary or law
enforcement encounters, is misleading or omits material information, disciplinary action may
be taken resulting in a bar to the individual. In addition, the principal signing on the application may be liable as well.
Rule 17f-2, the Fingerprint Rule, requires that every person who deals with securities
certificates, records, or money must have their fingerprints taken and filed.
Failure to Register Personnel. A member firms failure to register an employee who performs any of the functions of a registered representative will lead to disciplinary action.
TA K E N O T E
Member firms are in violation when unregistered sales assistants accept orders
from customers.
3. 1. 5. 4 Exemptions
Certain people are not required to register with FINRA as associated persons or are exempt
from having to pass a qualification exam.
3. 1. 5. 4. 1 Foreign Associates
Foreign associates, noncitizens who conduct business outside the United States, must be
registered with FINRA but are exempt from having to pass a qualification exam.
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TA K E N O T E
The former employer is not required to provide a copy to the new employing
member firm. The new firm must get a copy from either the CRD or from its new
employee. The new employee, if asked, must provide a copy within two business days
of the request.
An individual may not transact business as a registered representative unless associated with a broker/dealer. A representatives license is no longer effective upon
leaving the firm.
3. 1. 5. 5. 2 Continuing Commissions
An individual must be registered to sell securities. A registered representative who leaves
a member firmupon retirement, for instancemay continue to receive commissions on
business placed while employed. The most common example of business where commissions
continue to come in after the departure of the registered representative is ongoing investment
in mutual funds or variable annuities. However, the representative must have a contract to
this effect before leaving the firm. If a contract exists, the deceased representatives heirs may
receive continuing commissions on business the representative placed.
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TA K E N O T E
Notification must include the individuals name and the nature of the action.
The rules also require the reporting of any case where an associated person is indicted,
or convicted of, or pleads guilty to, or pleads no contest to, any felony; or any misdemeanor
that involves the purchase or sale of any security, the taking of a false oath, the making of a
false report, bribery, perjury, burglary, larceny, theft, robbery, extortion, forgery, counterfeiting,
fraudulent concealment, embezzlement, fraudulent conversion, or misappropriation of funds,
or securities, or a conspiracy to commit any of these offenses, or substantially equivalent activity in a domestic, military, or foreign court. A member firm also must notify FINRA of significant disciplinary action the firm itself has taken against an associated person. In particular, any
action that involves a suspension, termination, withholding of commissions, or a fine in excess
of $2,500 would have to be reported.
3. 1. 5. 5. 4 Terminations
Once an associated person ends employment with a member firm, registration with that
firm ceases 30 calendar days from the date FINRA receives written notice from the employing
member. FINRA and the SEC maintain jurisdiction over terminated persons for two years.
Terminating Representatives Under Investigation. If a registered representative or another
associated person is under investigation for federal securities law violations or has disciplinary action pending against him from any SRO, a member firm may not terminate its business
relationship with the person until the investigation or disciplinary action is resolved.
TA K E N O T E
If a registered person is without a broker/dealer for more than two years, their
registration is canceled. If a person with a canceled registration want back in, the
person must start from the beginning by passing a qualification exam (again).
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One particular concern that FINRA has voiced is when the clients at the former broker/
dealer have been sold proprietary products and the new broker/dealer cannot become the firm
of record and receive commissions. Under this circumstance, FINRA has warned its members
to be cautious about newly hired registered representatives liquidating those positions and
reinvesting the proceeds into securities where the firm has a selling agreement. This could be
considered switching solely for the purposes of generating commissions.
3. 1. 5. 5. 6 Broker-dealer Records
The SEC requires broker-dealers to make and keep for prescribed periods, and furnish copies thereof, such records in the public interest; for the protection of investors and the industry.
Broker-dealers may store required records in electronic form. Electronic records must be preserved exclusively in a non-rewriteable and non-erasable format for their required retention
period.
TA K E N O T E
3. 1. 5. 6 State Registration
In addition to registering with FINRA, registered representatives and broker/dealers
must register with the state securities Administrator in each state in which they intend to do
business.
3. 1. 6
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BrokerCheck is a free tool to help investors research the professional backgrounds of current and former FINRA-registered brokerage firms and representatives, as well as investment
adviser firms and representatives. It should be the first resource investors turn to when choosing whether to do business or continue to do business with a particular firm or individual.
Through BrokerCheck, investors can:
search for information about brokers and brokerage firms,
search for information about investment adviser firms and representatives,
obtain online background reports, if available, and
link to additional resources such as educational tools for investors.
The information about brokers and brokerage firms made available through BrokerCheck
is derived from the Central Registration Depository (CRD), the securities industry online
registration and licensing database.
TA K E N O T E
The U-4 and U-5 must be filed with FINRAs CRD electronically.
True or False?
1. The wife of a deceased representative may continue to receive commissions based on a verbal agreement with the former employer.
2. A foreign representative of a foreign broker/dealer is not required to register with FINRA if it engages in business with a U.S. citizen.
3. A member firm is required to investigate the background and character of
any person it may hire.
4. A firm that terminates a registered representative must file a U-5form.
5. If a representative is registered with FINRA, state registration is not
necessary.
6. A member firms clerical staff must register with FINRA.
7. Broker/dealers may not use the phrase member of FINRA on any sales
literature they prepare.
8. If notified by FINRA that tape recording of conversations is required,
recordings must be maintained for three years.
Quick Quiz answers can be found at the end of the Unit.
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FINRA
District
Firm registration
Form BD
Dues
Assessments, fees, charges
Associated persons
Individual registration
Form U-4
Exemptions from registration
Terminations
Form U-5
Conduct Rules
Code of Procedure
Code of Arbitration Procedure
Uniform Practice Code
OSJ
Supervisory, nonsupervisory branch
17f-2, the fingerprint rule
Disciplinary action
Continuing commissions
CRD
Foreign associates
State registration
3. 2 QUALIFICATION EXAMINATIONS
To become a registered representative or principal, an individual must pass the appropriate
licensing examination(s).
FINRA considers all of its Qualification Examinations to be highly confidential. The
removal from an examination center, reproduction, disclosure, receipt from or passing to any
person, or use for study purposes of any portion of such Qualification Examination, whether
of a present or past series, or any other use which would compromise the effectiveness of the
Examinations and the use in any manner and at any time of the questions or answers to the
Examinations are prohibited and are deemed to be a violation. An applicant cannot receive
assistance while taking the examination. Each applicant shall certify to the Board that no
assistance was given to or received by him or her during the examination.
3. 2. 1
REGISTERED REPRESENTATIVES
All associated persons engaged in the investment banking and securities business, whether
licensed as principals or as registered representatives, are technically referred to as registered
representatives, including:
an assistant officer who does not function as a principal;
individuals who supervise, solicit, or conduct business in securities; and
individuals who train people to supervise, solicit, or conduct business in securities.
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TA K E N O T E
TA K E N O T E
Individuals who hold Series 6 licenses are permitted to sell investment company
products, which include unit investment trusts, face-amount certificates, open-end
company shares, and primary offerings of closed-end company shares. Registered
representatives with a Series 6 license, who also hold an insurance license, may also
sell variable contracts.
EXAMPLE
face-amount certificates
aggressive growth mutual fund shares
closed-end company shares in the secondary market
unit investment trusts
TA K E N O T E
A Series 6 representative may not transact business in REITs (real estate investment trust units), limited partnerships, or DPPs (direct participation programs).
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REGISTERED PRINCIPALS
Anyone who manages or supervises any part of a members investment banking or securities business must be registered as a principal. This includes people involved solely in training
associated persons. Principals must review every customer order, all customer correspondence,
and the handling of all customer complaints. Unless the member firm is a sole proprietorship,
it must employ at least two registered principals.
TA K E N O T E
For FINRAs purposes, customer includes any person other than a broker/dealer
with whom the member has engaged, or has sought to engage, in securities activities,
and complaint includes any written grievance by a customer involving the member
or person associated with a member. All complaints received by the registered representative must promptly be transmitted to the supervising principal. Furthermore,
complaint records must be kept for four years.
Dont be surprised if you see the exam ask about a complaint letter addressed to
the registered representatives home address. In that case, the rule is the samebring
it into the office and submit it to the proper supervisory person.
3. 2. 3
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3. 2. 3. 1 Statutory Disqualification
Disciplinary sanctions by the SEC, another SRO, a foreign financial regulator, or a foreign
equivalent of an SRO can be cause for statutory disqualification (SD) of FINRA membership.
Individuals applying for registration as an associated person will be rejected if they:
have been or are expelled or suspended from membership or participation in any other
SRO or from the foreign equivalent of an SRO;
are under an SEC order or an order of a foreign financial regulator denying, suspending, or
revoking registration, or barring them from association with a broker/dealer; or
have been found to be the cause of another broker/dealer or associated person being
expelled or suspended by another SRO, the SEC, or a foreign equivalent of an SRO.
3. 2. 3. 2 Continuing Education
All registered representatives are subject to continuing education requirements and must
periodically complete a regulatory element and a firm element.
3. 2. 3. 2. 1 Regulatory Element
The regulatory element of the continuing education requirement must be completed
within 120 days of a persons second registration anniversary and every three years thereafter. It requires participation in an exercise involving industry regulation and ethics in dealing with customers. Registered representatives who fail to complete the required regulatory
element have their registrations become inactive and may not conduct business activities.
Registrations that remain inactive for two years are terminated.
3. 2. 3. 2. 2 Firm Element
Any registered representative who has direct contact with customers in the sale of securities, and their principals, are subject to the firm element requirement on an annual basis.
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Member firms must design a written training program that is interactive and covers the following topics:
Regulatory requirements that apply to business performed by the representative
Suitability and ethical sales practices
Overall investment features and related risk factors
3. 2. 4
EXAMINATIONS
Qualification for any registration generally requires passing the appropriate examination.
In extreme cases, FINRA has been known to waive the exam requirement (but dont count
on it).
3. 2. 4. 1 Retakes
If the applicant is not successful on his first or second attempt, there is a 30-day waiting
period before the exam may be retaken. After the third (and subsequent) attempts, the waiting
period is 180 days.
3. 2. 4. 2 Valid Period
The registration is valid during anytime in which the registered person serves in the appropriate function for a member. Once registration is terminated, either voluntary or involuntary,
there is a two-year period during which reassociation will not require retaking the exam. But,
once that two-year period has passed, even by just one day, re-examination is necessary.
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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 placed on hold beginning on
the date the person enters active military service and will end 90 days after that persons
completion of active service (FINRA must be notified upon return). If the person does not
re-register with a member within 90 days after completion of service, the standard two-year
clock starts ticking.
30
26
10
2
Code of Procedure
Code of Arbitration Procedure
Uniform Practice Code
FINRA Membership
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Qualification examination
Series 6
Limited securities representative
Series 26
Investment company principal
Statutory disqualification
Annual compliance review
Series 7
3. 3 ISSUING SECURITIES
In general, securities are bought either as new issues from a corporation, municipality, or
the federal government, or in the secondary market as trades between investors. This section
introduces the market for newly issued securities and the role an investment bank (underwriter) plays in various types of offerings.
3. 3. 1
INVESTMENT BANKING
A business or municipal government that plans to issue securities usually works with an
investment bank (a securities broker/dealer that specializes in underwriting new issues). An
investment banks functions may include:
advising corporations on the best ways to raise long-term capital;
raising capital for issuers by distributing new securities;
buying securities from issuers and reselling them to the public;
distributing large blocks of stock to the public and to institutions; and
helping issuers comply with securities laws.
TA K E N O T E
Investment bankers help issuers raise money through the sale of securities. They
do not loan money. They are sometimes also called underwriters. All underwriters of
corporate securities must be FINRA member firms.
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3. 3. 1. 1. 1 The Issuer
The issuer, or the party selling the securities to raise money, must do the following:
File an S-1 Registration Statement with the SEC. This document requires that the issuer
supply sufficient information about the security and the corporation and its officers to
allow an investor to make a sound investment decision. When the SEC reviews this document, during what is known as the 20-day cooling-off period, they look for sufficiency of
investment information rather than accuracy, though upon completion of the review, they
do not guarantee adequacy of the prospectus.
File a registration statement with the states in which it intends to sell securities (also
known as blue-skying the issue).
Negotiate the securities price and the amount of the spread with the underwriter.
3. 3. 1. 1. 2 The Underwriter
The underwriter assists with the registration and distribution of the new security and may
advise the corporate issuer on the best way to raise capital.
Underwriting Compensation, also known as the Spread. The price at which underwriters buy stock from issuers always differs from the price at which they offer the shares to the
public. The price the issuer receives is known as the underwriting proceeds, and the price
investors pay is the public offering price. The underwriting spread, the difference between
the two prices, consists of the:
managers fee, for negotiating the deal and managing the underwriting and distribution
process;
underwriting fee, for assuming the risk of buying securities from the issuer without assurance that the securities can be resold; and
selling concession, for placing the securities with investors.
TA K E N O T E
The largest part of the underwriting spread is the selling concession; the smallest
is the management fee.
3. 3. 1. 2 Types of Offerings
A new stock offering is identified by who is selling the securities as well as by whether the
company is already publicly traded.
3. 3. 1. 2. 1 Primary Offering
In a primary offering, the underwriting proceeds go to the issuing corporation. The corporation increases its capitalization by selling stocks or bonds, in either new or additional
issues.
New issuesThe new issue market is comprised of companies that are raising capital from
the public for the first time in an initial public offering (IPO).
Additional issuesThe additional issue market is made up of new securities being offered
to the public by companies that are currently publicly traded.
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3. 3. 2
3. 3. 2. 1 Firm Commitment
The firm commitment is the most commonly used type of underwriting contract. Under
its terms the underwriter(s) (investment bank(s)) commit to buy the securities from the issuer
and resell them to the public. The underwriters assume the financial risk of incurring losses in
the event they are unable to distribute all the shares to the public.
A firm commitment underwriting can be either a negotiated underwriting contract or a
competitive bid arrangement. Negotiated underwriting contracts are used in most corporate
issues. The issuer selects an underwriter and they negotiate the conditions of the underwriting
contract. A competitive bid arrangement is the standard for new issue offering in the municipal securities market. The underwriting contract is awarded to the underwriter who presents
the most competitive bid, or lowest net interest cost, to the issuer. Sales begin on the effective
date of the offering.
TA K E N O T E
In a firm commitment underwriting, the managing underwriter takes on the financial risk because he purchases the securities from the issuer. Because he purchases
and resells the shares, he is acting in a principal capacity.
The managing underwriter may share the risk with other broker/dealers by forming a syndicate. It may also form selling groups with some of the 5,000+ broker/
dealers registered with FINRA. Syndicates may contract with selling groups but only
on a best efforts basis (see the following). Selling groups never take on any liability for
the underwriting.
3. 3. 2. 2 Best Efforts
In a best efforts arrangement, the underwriter acts as agent for the issuing corporation.
The deal is contingent on the underwriters ability to sell shares to the public. In a best efforts
underwriting, the underwriter sells as much as possible, without financial liability for what
remains unsold. The underwriter is acting in an agency capacity with no financial risk.
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A.
B.
C.
D.
E.
Best efforts
Investment banker
Standby
Firm commitment
Spread
Issuer
Investment banker
Underwriter
Primary offering, IPO
Secondary offering
Split offering
Sale by prospectus
Negotiated contract
Competitive bid
Firm commitment
Principal capacity
Best efforts
Agency capacity
Standby underwriting
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189
TA K E N O T E
Nonexempt means must register with the SEC under the Securities Act of
1933. Think of corporate issues as nonexempt.
Exempt means not required to register with the SEC. Think of government
securities and municipals as exempt.
Listed below are the most important provisions of the Securities Act of 1933.
Issuers of nonexempt securities must file registration statements with the SEC.
Prospectuses must be provided to all purchasers of new, nonexempt issues for full and fair
disclosure.
Fraudulent activity in connection with underwriting and issuing of all securities is prohibited.
Criminal penalties are assessed for fraud in the underwriting and sale of new issues.
TA K E N O T E
If a question on the exam discusses the new issue market or primary market,
or any activity associated with the sale of new issues, the regulation involved is the
Securities Act of1933.
The Securities Act of 1933 is associated with:
new issues;
underwriting;
registration statement;
prospectuses; and
primary market.
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3. 4. 2
REGISTRATION OF SECURITIES
3. 4. 2. 1 Federal Registration
The Securities Act of 1933 requires new issues of corporate securities to be registered with
the SEC. The corporate issuer does so by filing a registration statement. Most of the registration statement becomes the prospectus.
TA K E N O T E
Think of the Securities Act of 1933 as the Paper Act because of the registration
statement and prospectus. It will remind you of the paperwork requirements for full
and fair disclosure.
3. 4. 2. 2 State Registration
State securities laws, also called blue-sky laws, require state registration of securities, broker/dealers, and registered representatives. An issuer or investment banker may blue-sky an
issue by one of the following methods.
QualificationThe issuer files with the state, independent of federal registration, and
must meet all state requirements.
CoordinationThe issuer registers simultaneously with the state and the SEC. Both registrations become effective on the same date.
Notice FilingSecurities listed on the major exchanges and on Nasdaq, as well as
investment companies registered under the Investment Company Act of 1940 are known
as federal covered securities. State registration is not required, but most states require the
filing of a notice that the issuer intends to offer its securities for sale in that state and the
state may assess a filing fee.
The Securities Act of 1933 regulates all of the following activities EXCEPT
A.
B.
C.
D.
Answer: B. The Securities Act of 1933 regulates federal registration of new issues
with the SEC. The Uniform Securities Act regulates the registration of securities at
the state level. Registering at the state level is called blue-skying the issue.
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Effective dateoffering
period may begin
Cooling-off period
Red Herring. The red herring (preliminary prospectus) is used to gauge investor reac-
tions and gather indications of interest. A registered representative may discuss the issue
with prospects during the cooling-off period and provide them with preliminary information
through the red herring. It must carry a legend, printed in red, that declares that a registration statement has been filed with the SEC but is not yet effective. The final offering price
and underwriting spread are not included in the red herring.
Allowable Activity During the Cooling-off Period
May:
May not:
SEC rules prohibit the sale of public offering securities without a prospectus, which means
that no sales are allowed until the final prospectus is available.
Tombstone Advertisements. During the cooling-off period, sales of the security and related activities are prohibited. Nonbinding indications of interest may be gathered with a
preliminary prospectus. In addition, tombstone advertisements are allowed to be published.
These announcements, typically published after the offering has been cleared for sale, offer
information to investors. However, they do not offer the securities for sale. Issuers are not
required to publish tombstones but they may appear either before or after the effective date
of the sale.
TA K E N O T E
name of issuer
type of security
underwriter
price
effective date of sale
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The Final Prospectus (Effective Prospectus, Statutory Prospectus). When the registration
statement becomes effective, the issuer amends the preliminary prospectus and adds
information, including the final offering price and the underwriting spread for the final
prospectus. Registered representatives may then take orders from those customers who
indicated interest in buying during the cooling-off period.
A copy of the final prospectus must precede or accompany all sales confirmations. However,
if the prospectus has been filed with the SEC and is available through its Website, access to the
prospectus equals delivery of the prospectus.
The prospectus must include:
selling discounts;
a description of management;
an SEC review.
SEC Disclaimer. The SEC reviews the prospectus to ensure that it contains the necessary
material facts, but it does not guarantee the disclosures accuracy. Furthermore, the SEC does
not approve the issue but simply clears it for distribution. Implying that the SEC has approved the issue violates federal law. Finally, the SEC does not pass judgment on the issues
investment merit.
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The front of every prospectus must contain a clearly printed SEC disclaimer specifying the
limits of the SECs review procedures. A typical SEC disclaimer clause reads as follows:
These securities have not been approved or disapproved by the Securities and Exchange
Commission or by any State Securities Commission nor has the Securities and Exchange Commission or any State Securities Commission passed upon the accuracy or adequacy of this
prospectus. Any representation to the contrary is a criminal offense.
The information supplied to the SEC becomes public once a registration statement is filed.
1. ABC, Inc., will be offering $8 million of its common stock in its home state and in
three other states. For the offering to be cleared for sale by the SEC, ABC must
file
A.
B.
C.
D.
an offering circular
a standard registration statement
a letter of notification
nothing
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5. If the SEC has cleared an issue, which of the following statements is TRUE?
A.
B.
C.
D.
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The following securities are exempt from the Securities Act of 1933:
Commercial papermaturity less than 270 days
Bankers acceptancesmaturity less than 270 days
Securities acquired in private placementsrestricted stock
3. 4. 2. 5. 1 Private Placements
In addition to the above exemptions, Regulation D under the Securities Act of 1933
allows the offer and sale of securities to accredited investors without registration under the act.
These transactions are called private placements.
Under SEC Rule 506, there are two ways to approach the exemption:
the company cannot use general solicitation or advertising to market the securities and
limits the number of non-accredited investors to 35; or
the company can advertise as long as they sell exclusively to accredited investors. (There
are heightened verification rules regarding the accredited investor if advertising.)
Under SEC Rule 501, an accredited investor can be
(1) an insider at the issuer,
(2) a professional, sophisticated, or institutional investor, or
(3) an individual who meets one of two criteria: at least $1 million net worth (excluding
the net value of their primary residence) or at least $200,000 in adjusted gross income
(AGI) for the last two years with good prospects of reaching that level in the current
year ($300,000 if the investor is a married couple).
Note that assets held jointly with another person who is not the purchasers spouse may be
included in the calculation for net worth, but only to the extent of percentage of ownership.
TA K E N O T E
3. 4. 3
Just because an investor is accredited does not automatically qualify them for
investing in a private placement or any other investment for that matter. Suitability
must be determined prior to all recommendations.
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The definition of immediate family includes a persons parents, mother-in-law or fatherin-law, spouse, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law,
and children, and any other individual to whom the person provides material support.
Under this rule, before selling a new common stock issue to an account, firms are required
to obtain a written representation from the account owner that the account is eligible to
purchase the new issue, in other words, that the purchaser is not a restricted person. All representations must be obtained within the 12-month period before the sale of the new issue.
The rule does not apply to sales to and purchases by the following accounts or persons,
whether directly or through accounts in which such persons have a beneficial interest:
an investment company registered under the Investment Company Act of 1940 (but the
rule does apply to the portfolio manager);
an insurance company general, separate, or investment account, provided that the account
is funded by premiums from 1,000 or more policyholders, or, if a general account, the
insurance company has 1,000 or more policyholders (but the rule does apply to the portfolio manager); and
a publicly traded entity (other than a broker/dealer or an affiliate of a broker/dealer) that
is listed on a national securities exchange,
is traded on Nasdaq, or
is a foreign issuer whose securities meet the quantitative designation criteria for listing
on a national securities exchange or trading on Nasdaq.
EXAMPLE
According to FINRA Rule 5130, who of the following would NOT be required to be
treated as a restricted person?
A. The manager of a New York Stock Exchange member firm
B. A trust officer at a large commercial bank
C. A registered representative employed by a limited securities broker/dealer whose
sales are confined to mutual funds
D. The portfolio manager for the GHI Special Situations Fund
Answer: C. This rule deals with the sale of initial public offerings (IPOs). Under the
rule, most individuals and firms in the securities business are considered restricted
persons. Those individuals with the power to control portfolio investments are
generally placed into that category as well. Specifically excluded are those firms
and their employees whose only securities activity consists of the sale of investment
company products and variable contracts of insurance companies.
Terms and Concepts Checklist
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SEC disclaimer
Restricted person
Exemptions from FINRA Rule 5130
Blue-sky laws
Coordination
Notice filing
Qualification
3. 5 TRADING SECURITIES
Stock and bond trades take place on exchanges and through a nationwide network of
broker/dealers known as the over-the-counter market. The terminology of trading securities is
discussed below.
3. 5. 1
SECURITIES MARKETS
The market in which securities are bought and sold is known as the secondary market, as
opposed to the primary market for new issues. All securities transactions take place in one of
two trading markets. These two markets consist of the exchanges where prices are established
by auction and the over-the-counter market, where prices are established by negotiation.
3. 5. 1. 1 Exchange Market
The exchange market consists of the national exchanges, such as the New York Stock
Exchange (NYSE), and various regional exchanges. The NYSE is the model exchange for
your exam. The regional exchanges list stocks and bonds of local interest in their areas. The
national exchanges list securities of national trading interest, and on a typical day, billions of
shares change hands on their floors.
Each stock exchange requires companies to meet certain criteria before it will allow their
stock to be listed for trading on an exchange.
3. 5. 1. 2 Trading Location
Exchange markets, such as the NYSE, have central marketplaces and trading floor
facilities.
3. 5. 1. 3 Pricing System
Although the vast majority of trades at exchanges take place electronically, youll want
to be aware that exchanges also operate as double-auction markets. Floor brokers compete
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among themselves to execute trades at prices most favorable to the public. If you see the term
auction market, think exchange.
3. 5. 1. 4 Price Dynamics
When a floor broker representing a buyer executes a trade by taking stock at a current offer
price higher than the last sale, a plus tick occurs (market up); when a selling broker accepts a
current bid price below the last sale price, a minus tick occurs (market down).
3. 5. 1. 5 Over-the-Counter Market
The OTC market is an interdealer market in which unlisted securities (securities not
listed on any exchange) trade.
In the OTC market, securities dealers across the country are connected by computer and
telephone. Thousands of securities are traded OTC, including stocks, bonds, and all municipal
and U.S. government securities. Historically, the criteria a company needed to meet to have
its stock traded in the OTC market were rather loose. In recent years, however, the quality of
companies that trade OTC has improved substantially with some of the best known companies in the world traded there.
3. 5. 1. 7 Fourth Market
The fourth market is a market for institutional investors in which large blocks of stock,
both listed and unlisted, trade in privately negotiated transactions unassisted by broker/dealers.
The networks used for these transactions are called Electronic Communications Networks
(ECNs).
TA K E N O T E
When a trade is made in the fourth market, the party on the other side is invariably an institution, such as an investment company, insurance company, large employee benefit plan, or bank.
Exchanges are the only auction markets. All of the other marketsthe OTC,
third, and fourth marketsare negotiated.
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3. 5. 1. 8 Location
No central marketplace facilitates OTC trading. Trading occurs over the phone and computer networks and in trading rooms across the country.
3. 5. 1. 9 Pricing System
The OTC market works through an interdealer network. Registered market makers compete among themselves to post the best bid and ask prices. The OTC market is a negotiated
market.
3. 5. 1. 10 Price Dynamics
When a market maker raises its bid price to attract sellers, the stock price rises; when a
market maker lowers its ask price to attract buyers, the stock price declines.
3. 5. 2
3. 5. 2. 1 Brokers
Brokers act in an agency (or agent) capacity by arranging trades for clients and charging
a commission. When acting as a broker, the firm does not buy or sell shares; it simply arranges
trades between buyers and sellers.
Remember ABC. Agency (or agent) transactions are broker transactions and they
make commissions.
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3. 5. 2. 2 Dealers
Dealers, or principals, buy and sell securities for their own accounts, often called position
trading. When selling from their inventories, dealers charge their clients markups rather than
commissions. A markup is the difference between the current interdealer offering price and
the actual price charged the client. When a price to a client includes a dealers markup, it is
called the net price.
TA K E N O T E
If youre uncertain about the role of dealers in the securities market place, try
thinking of them as car dealers. If you were a car dealer, you would maintain an
inventory of cars. If someone bought a car from you, you wouldnt sell it at the
wholesale price, but would mark up the price for profit. If someone wanted to sell
you their used car, you wouldnt offer top dollar. Instead, you would mark down the
price so you could later make a profit. Securities dealers hold inventories of securities
and buy and sell from inventory. They profit on transactions by charging markups and
markdowns.
3. 5. 2. 3 Filling an Order
A broker/dealer may fill a customers order to buy securities in any of the following ways.
The broker may act as the clients agent by finding a seller of the securities and arranging
a trade either OTC or on an exchange.
The dealer may buy the securities from a market maker, mark up the price and resell them
to the client.
If it has the securities in its own inventory, the dealer may sell the shares to the client,
with a markup, from that inventory.
Dealer
Charges a commission
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Must disclose its role to the client Must disclose its role to the client, but
and the amount of its commission not necessarily the amount or source of
the markup or markdown (except for
Nasdaq trades)
TA K E N O T E
All firms can act in one of two capacities in a customer transaction. If the firm
acts as agent, it is the broker between the buying and selling parties. Agents receive
commissions for transactions they perform, and commissions must be disclosed on
confirmations.
If the firm acts as a dealer and transacts business for/from its inventory, it acts in
a principal capacity and is compensated by a markup or markdown.
Confirmations do not disclose markups or markdowns (except for Nasdaq trades).
A firm is never allowed to act as both agent and principal in a single transaction.
True or False?
1. A broker/dealer may act as an agent or as a dealer in a transaction.
2. The definition of a restricted person under FINRA Rule 5130 includes close
friends of restricted persons.
3. The exchange market is where listed securities trade.
4. OTC securities prices are established through negotiation.
5. Both commissions and markups/markdowns must be disclosed to the
customer.
3. 5. 3
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3. 5. 3. 1. 1 Trade Confirmations
A confirmation is a document that confirms a trade, its settlement date, and the money due
from or owed to the customer. For each transaction, a customer must be sent or given a written
confirmation of the trade at or before the completion of the transaction, the settlement date.
The confirmation may be sent electronically, if agreed to. A registered representative receives
a copy of a customers confirmation and checks its accuracy against the order ticket.
Trade confirmations must be maintained by the firm for three years.
Customer Confirmation
Confirmation of your order:
Order
No.
Description
Price
Amount
Inter.
or Tax
Reg.
Fee
Commission
Odd-lot Diff.
Trade Date
Account No.
AE No.
AE Name
Net Amount
Settlement
Customer Name/Address:
Payment for securities bought and delivery of securities sold are due promptly and in any event on or before
the end of payment period in order to comply with federal Regulation T and to avoid interest or premium charges.
EXAMPLE
If a trade occurs on a Tuesday (trade date), it settles regular way on Friday. If the
trade is on a Thursday, it settles the following Tuesday.
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If the seller delivers before the settlement date, the buyer may either accept the security
or refuse it without prejudice.
US government note and bond transactions settle regular way the next business day.
When investors purchase mutual funds with an application order, there really is no settlement
because the check is attached to the application form.
Cash Settlement. Cash settlement, or same day settlement, requires delivery of securities
from the seller and payment from the buyer on the same day a trade is executed. Stock or
bonds sold for cash settlement must be available on the spot for delivery to the buyer.
Cash trade settlement occurs no later than 2:30 pm ET if the trade is executed before 2:00
pm. If the trade occurs after 2:00 pm, settlement is due within 30 minutes. Keep in mind that
cash settlement is not an entitlement and must be requested of the broker/dealer. On your
exam, always assume regular-way settlement unless the question states otherwise.
Government
Securities
Cash
Regular way
Regulation T Payment. Regulation T specifies the date customers are required to pay for
purchase transactions. Under Regulation T, payment is due two business days after settlement. Therefore, on a regular way trade, customer payment is due five business days after the
trade date.
TA K E N O T E
Under regular way settlement, payment is requested three business days after
the trade. Under Regulation T, payment is due two business days later, which is five
business days after the trade. Regulation T payment is sometimes referred to as settlement plus two (S+2).
Extensions. If a buyer cannot pay for a trade within the time limit prescribed under
Regulation T, the broker/dealer may request an extension from its designated examining
authority (DEA) before the deadline. DEAs include FINRA and the various exchanges.
If the customer cannot pay by the end of the extension or the extension request is denied,
the broker/dealer sells the securities in a close-out transaction. After the closeout, the account
is frozen for 90 days. A frozen account must have sufficient cash before a buy transaction may
be executed.
The broker/dealer has the option of ignoring amounts that do not exceed $1,000 without
violating Regulation T requirements.
TA K E N O T E
Consider the relationship between regular way settlement and Regulation T payment this way: because brokerage firms must comply with industry trade practices
and settle those trades on the third day, they request their customers to settle within
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that time period as well. However, if the customer does not settle by then, there is,
in essence, a two-day grace period under Regulation T giving the firm time to correct
the problem and, if necessary, request an extension.
Any question about settlement date will always be referring to the Uniform Practice Code (same-day for cash; T+3 for regular way). Final time for payment comes
under Regulation T.
$1,000
Third business day after the trade
S+2
90 calendar days
Same day
3. 5. 3. 2 Dividend Department
The dividend department collects and distributes cash dividends for equity securities. In
addition to processing cash dividends, the department handles registered bond interest payments, stock dividends, stock splits, rights offerings, warrants, and any special distributions to
a corporations stockholders or bondholders.
3. 5. 3. 2. 1 Transfer Agent
Dividends are actually disbursed, on the payable date, by a party known as the transfer
agent. The corporation itself may have the transfer agent on its payroll, or the transfer agent
may be a bank or trust company that keeps track of the stockholders and disburses dividends
when declared.
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Ex-Date (Ex-Dividend Date). For corporate securities and closed-end funds, the SRO posts
an ex-date on the basis of the dividend record date. The ex-date is two business days before
the record date. Because most trades settle regular waythree business days after the trade
datea customer must purchase the stock three business days before the record date to qualify for the dividend.
For mutual funds, the BOD posts an ex-date on the basis of the dividend record date. The
ex-date is typically the day after the record date.
TA K E N O T E
An investor does not own a corporate stock until settlement date, three business
days after the trade date.
On the ex-date, the securitys opening price drops to compensate for the fact that customers who buy the stock that day or later do not qualify for the dividend. Trades executed the
regular way on or after the ex-date do not settle until after the record date.
A customer who buys the security before the ex-date receives the dividend but pays a
higher price for the stock. The customer who buys the stock on or after the ex-date does not
receive the dividend but pays a lower price for the stock.
Dividend Record Date. The stockholders of record, as of the record date receive the divi-
dend distribution.
Payable Date. Two or three weeks after the record date, the dividend disbursing agent
sends dividend checks to all stockholders whose names appeared on the books as of the record
date.
TA K E N O T E
TA K E N O T E
The acronym DERP will help you remember the order in which the dates involving corporate dividend distributions occur.
The Declaration takes place first; the Payment of the dividend is actually the last
step in the process. The dividend is paid to owners on the date of Record. The corporations board of directors determines the declaration, record and payable dates. The
ex-date is determined by the SRO.
Most of the questions on your exam regarding dividend dates are based on the
corporate information you see here. However, should you be asked a question regarding dividend dates and mutual funds, remember that the board of directors sets all the
dates, and the ex-dividend date is typically the day after the record date.
June
Sun Mon Tue Wed Thu
Record Date
Series_6_Unit_3.indd 205
Fri
Sat
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
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Will an investor who purchases stock on Friday, June 16, receive the dividend?
The investor would receive the dividend because regular way settlement takes
place three business days after the trade. Monday, Tuesday, and Wednesday are the
three business days that must be counted. The investor settles on Wednesday, June
21, which means he owns the stock on the record date and is entitled to the dividend,
which is paid on the payable date.
What if the transaction had taken place on Monday, June 19?
Counting the three business days required, regular way settlement would take
place on Thursday, June 22. The investor would own the stock on the business day
after the record datetoo late to receive the dividend.
This example illustrates that June 19 is the first day the investor buys the stock
without the dividend (the ex-date) when the record date is June 21. An investor must
buy the stock before the ex-date to get the dividend. The seller receives the dividend
if the transaction takes place on or after the ex-date.
June
Sun Mon Tue Wed Thu
Declaration Date
Ex-date
Record Date
Fri
Sat
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
Payable Date
The ex-date is two business days before the record date in transactions executed
with regular way settlement.
Consider an investor who purchases the stock on Wednesday, June 21, in a cash
settlement transaction. Because the settlement takes place the same day, the investor
receives the dividend and owns the stock on the record date of June 21.
As you will learn in the next Unit, mutual fund ex-dates are typically the business
day after the record date.
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We have prepared this chart to help you remember the sequence. Just as a refresher, weve started with Trade Date and Settlement date, and then we list DERP.
Event
Definition
Trade date
Settlement date
Declaration date
Record date
Payable date
Trade date
Settlement date
Ex-date
Declaration Date
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Exchanges, first
market
Specialist
OTC, second market
Market maker
Third market
Fourth market
Trade date
Customer
confirmation
Dividend payment
Auction market
Negotiated market
Broker, agent
Commission
Transfer agent
Markup, markdown
Cash settlement
Declaration date
Ex-dividend date
Record date
Payable date
Dealer, principal
Broker/dealer
Position trading
Regulation T payment
Regular way
settlement
Extension
Frozen account
ules of good
R
delivery
TA K E N O T E
Like the Securities Act of 1933, key words help identify the Securities Exchange
Act of 1934.
Consider the Securities Exchange Act of 1934 as the People and Places Act: it regulates
all persons involved in trading securities on behalf of customers and the markets, (exchanges),
where that trading takes place.
Although certain securities are exempt from the registration requirements of the Securities
Act of 1933, no security is exempt from the antifraud provisions of the Securities Exchange
Act of 1934.
This statement means that certain securities are exempt from registration and prospectus requirements, but you may not use fraud in the trading of any security, exempt or
nonexempt.
3. 6. 1
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The Securities Exchange Act of 1934 requires exchange members, broker/dealers that
trade securities OTC and on exchanges, and individuals who make securities trades for the
public to be registered with the SEC.
Determine whether each phrase below describes the Act of 1933 or 1934.
1. Prohibits fraud in the primary markets
2. Requires registration of broker/dealers
3. Created the SEC
4. Requires nonexempt issuers to file registration statements
5. Prohibits fraudulent trading practices
6. The Paper Act
7. Regulates underwriting activity
8. Regulates extension of credit by brokerage firms
9. Regulates client accounts
10. The People and Places Act
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pany must file annual audited reports informing the SEC of its financial status and providing
other information.
Regulation of Broker/Dealers. Broker/dealers must comply with SEC rules and regulations when conducting business. A broker/dealer that does not comply is subject to:
censure;
suspension of its registration (or one of its associated persons license to do business);
revocation of registration; or
a fine.
Although a broker/dealer must register with the SEC, the broker/dealer may not claim
that this registration in any way implies that the Commission has passed upon or approved
the broker/dealers financial standing, business, or conduct. Any such claim or statement is a
misrepresentation.
The Maloney Act. Originally an amendment to the Securities Exchange Act of 1934,
the Maloney Act of 1938 gave the SEC authority to delegate authority to the existing exchanges and to create other self-regulatory organizations (SROs) to regulate the securities
industry as needed. This led to the creation of the National Association of Securities Dealers (NASD). Since 1938, the SEC has also created the Municipal Securities Rule-making
Board (MSRB), the Chicago Board Options Exchange (CBOE), and other SROs. In July
of 2007, the NASD and New York Stock Exchange Regulation, Inc. merged to form the
Financial Industry Regulatory Authority (FINRA).
SROs, including FINRA, the MSRB, CBOE, and the other exchanges, must register with
the SEC. Although they make rules for their member firms, they are not themselves federal
agencies but are merely clubs for broker/dealers to belong to and are subject to regulation by
the SEC.
Fingerprinting (Rule 17f-2). Registered broker/dealers must have fingerprint records made
for all of their employees, directors, officers, and partners and must submit those fingerprint
cards to the U.S. attorney general for identification and processing. Broker/dealer employees
(typically clerical) are exempt from the fingerprinting requirement if they:
are not involved in securities sales;
do not handle or have access to cash or securities or to the books and records of original
entry relating to money and securities; and
do not supervise other employees engaged in these activities.
3. 6. 1. 2 Regulation of Credit
The Securities Exchange Act of 1934 authorized the Federal Reserve Board (FRB) to
regulate margin accounts, the credit extended for the purchase of securities. Within FRB jurisdiction are:
Regulation T, which regulates the extension of credit to customers by broker/dealers;
and
Regulation U, which regulates the extension of credit to customers for the purpose of
purchasing securities by banks and other lenders.
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3. 6. 1. 2. 1 Margin Accounts
In a long margin account, an investor may use some cash and some credit to purchase
securities. An investor can purchase more securities with some cash and some credit than by
using cash only. A margin account, therefore, is a leveraged account. The term margin refers
to the minimum amount of cash or other marginable securities a customer must deposit to buy
securities.
The Securities Exchange Act of 1934 prohibits the extension of credit for the purchase of
securities that are deemed to be part of a new issue until that issue has come to rest for 30
days. Mutual fund shares may be used as collateral for a loan as long as they have been held for
30 days. The effect of this is that, although mutual fund shares may be used as collateral in a
margin account, they may never be purchased on margin.
TA K E N O T E
3. 6. 2
Mutual funds arent the only security that cant be purchased on margin; option
contracts cant be purchased on margin either. (Investors cant use a loan to purchase
mutual funds or option contracts.)
3. 6. 2. 1 Exclusions
TA K E N O T E
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TA K E N O T E
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 and would need to register as such.
EXAMPLE
TA K E N O T E
An investment adviser managing less than $100 million in assets must register
with the state(s).
Under SEC regulations, advisers managing at least $100 million, but not quite
$110 million, have the option to register with either the state(s) or the SEC. If managing $110 million or more, the investment adviser must register at the federal level
with the SEC.
Federal registered investment advisers are exempt from state registration. While exempt
from state registration, these investment advisers may still be required to pay state filing fees
and give notice.
State Administrators are responsible for overseeing the business activities of all investment advisers that conduct business within the state and for enforcing the antifraud provisions
under state law.
TA K E N O T E
SEC release IA-1092 expanded the definition of investment adviser to include financial planners, pension consultants, investment counselors, and investment advisory
services. Anyone who receives a fee for investment advising must register.
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3. 7. 1
TAXATION
3. 7. 1. 1 Income
Most monies received by an individual are subject to income tax. This includes salaries,
bonuses, commissions, gratuities, dividends, and interest. The current tax system includes
brackets. The tax bracket is defined as the percent tax due on the next dollar the individual
will receive. This is referred to as your marginal income tax bracket.
Sometimes, income may be subject to the Alternative Minimum Tax. This requires
income from certain specified tax preference items to be taxed if income exceeds an indexed
maximum. Its purpose is to ensure that wealthy persons and corporations pay at least some
tax.
Receipts from selling something for more (or less) than was originally paid for it fall under
the capital gains tax. If there was a gain, tax must be paid on it. If there was a loss, it can be
used to offset gains and income.
3. 7. 2
3. 7. 2. 1 Dividend Distributions
A mutual fund may pay dividends to each shareholder in much the same way corporations
pay dividends to stockholders. The Investment Company Act of 1940 requires a written statement to accompany dividend payments by management companies. Every written statement
made by or on behalf of a management company shall be made on a separate paper and shall
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clearly indicate what portion of the payment per share is made from. Mutual fund dividends
are typically paid from the mutual funds net investment income, usually on a quarterly basis.
Net investment income (NII) includes gross investment incomedividend and interest
income from securities held in the portfoliominus operating expenses. Advertising and sales
expenses are not included in a funds operating expenses when calculating net investment
income, but management fees, custodian bank charges, legal and accounting fees, and transfer
agent costs are included. Dividends from net investment income are taxed as ordinary income
to shareholders.
Net investment income = dividends + interest expenses of the fund
You may see a question on the exam that asks for this calculation and gives a list
of items to exclude or include in the calculation. Remember D + I E and it will be
easy to remember which items to include. Note that capital gains are NOT a part of
NII.
TA K E N O T E
A bond fund does not pay interest to investors! Investors buy common stock of
the bond fund and, therefore, will receive a dividend if declared. Interest paid in the
form of a dividend is taxed as interest.
EXAMPLE
Triple taxation?
GEM Fund owns shares of Mountain Brewing Co. First, Mountain Brewing is
taxed on its earnings before it pays a dividend. Then, GEM Fund pays tax on the
amount of the dividend it receives. Finally, the investor pays income tax on the distri
bution from the fund.
Triple taxation of investment income may be avoided if the mutual fund qualifies under
Subchapter M of the Internal Revenue Code (IRC). If a mutual fund acts as a conduit (pipeline) for the distribution of net investment income, the fund may qualify as a regulated investment company (RIC) subject to tax only on the amount of investment income the fund
retains. The investment income distributed to shareholders escapes taxation at the mutual
fund level.
To avoid taxation under Subchapter M, a fund must distribute at least 90% of its net investment income to shareholders. The fund then pays taxes only on the undistributed amount.
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*
*
EXAMPLE
EXAMPLE
If a fund distributes 89%, it must pay taxes on 100% of net investment income.
What are the tax consequences to a fund that distributes 98% of its net investment income? In this situation, the fund does not pay taxes on the 98% that is
distributed; it pays taxes only on the 2% of retained earnings.
TA K E N O T E
Long-term capital gain distributions may be made no more than once per year.
Any gains distribution from a mutual fund is long term. A short-term gain is identified,
distributed, and taxed as a dividend distribution, taxed at ordinary income tax rates.
Long-term capital gain: Holding period of more than one year, taxed as a capital
gain, which is (generally) lower than ordinary income tax rates for an investor.
Short-term capital gain: Holding period of one year or less, taxed at ordinary
income tax rates for an investor.
TA K E N O T E
The exam is fond of asking a question like this: An investor purchases shares of a
mutual fund. Three months later, the fund has a long-term capital gains distribution.
This would be taxed to the investor as ______. And, the answer is long-term capital
gain. Why? It makes no difference how long the investor held the fund shares, this
is a distribution of the funds long-term gains being passed through to the investor.
However, when the investor sells his shares, then the holding period of those shares is
important for determining long-term or short-term status.
The terms realized gains and unrealized gains can be confusing. Think of an
unrealized gain as a paper profit and realized gain as actual profit made.
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EXAMPLE
If you had purchased a house for $150,000 and its value had appreciated to
$200,000, you would experience an unrealized gain of $50,000. You would have no
taxes to pay on these paper profits. If you had sold the house, the $50,000 would be
taxable to you as a capital gain. The gain resulting from a sale is known as a realized
gain. Unrealized profits are not taxable; realized profits are taxable as capital gains.
A mutual fund portfolio that has increased in value has unrealized profits; these
are not taxable to investors. But, when the fund sells appreciated portfolio securities, it has realized profits. These profits are distributed as capital gains to shareholders. Shareholders can take these capital gain distributions in cash or reinvest them to
purchase additional shares. In either case, these distributions are taxable as capital
gains to shareholders.
3. 7. 2. 4 Reinvestment of Distributions
Dividends and capital gains are distributed in cash. However, a shareholder may elect to
reinvest distributions in additional mutual fund shares. The automatic reinvestment of distributions is similar to compounding interest. The reinvested distributions purchase additional
shares, which may earn dividends or gains distributions.
A mutual fund that is being formed today must offer the reinvestment of dividends and
capital gains back into the fund without a sales charge (at NAV). This means that investors
are able to buy new shares without a sales loada significant advantage that results in faster
growth to the investor.
TA K E N O T E
Just as with dividend distributions, whether capital gains are taken in cash or
reinvested, they are currently taxable to the shareholder. Dividends will be reported as
qualified (taxed at a lower rate) or nonqualified (taxed as ordinary income).
Any short-term capital gain is distributed as a nonqualified dividend.
It is the shareholders responsibility to report all dividends and long-term capital
gains distributions to the IRS and state tax agency.
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True or False?
1. A portfolios unrealized gains are taxable to mutual fund shareholders.
2. Capital gains distributions are typically paid quarterly.
3. Mutual fund capital gains distributions are taxable to shareholders as
short-term capital gains.
4. Mutual funds pay dividends to shareholders from net investment income.
5. IRC Subchapter M requires a fund to distribute a minimum of 90% of
itsnet investment income to avoid taxation as a corporation on what it
distributes.
6. Funds that comply with IRC Subchapter M are considered registered
investment companies.
7. Reinvested dividend distributions are not currently taxable to
shareholders.
8. Form 1099 classifies mutual fund distributions to shareholders.
EXAMPLE
ABC mutual fund distributed dividends of $1 and capital gains of $1 in the past
year. The current NAV of ABC shares is $19.50 and the POP is $20. What is the current yield of ABC shares? The correct answer is 5%.
Mutual fund yield is found exactly like the current yield on common stock:
Annual dividend
POP
The annual dividends of $1 divided by the POP of $20 equals current yield of
5%. Never include capital gains in the calculation of current yield.
The calculation of total return assumes the reinvestment of both dividends and
capital gains.
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3. 7. 2. 4. 3 Ex-Dividend Date
Unlike the ex-dividend date for corporate securities, the ex-dividend date for mutual funds
is set by the board of directors. Normally, the ex-dividend date for mutual funds is the day after
the record date.
3. 7. 2. 4. 4 Selling Dividends
If an investor buys fund shares just before the ex-dividend date, the investor will receive
the dividend, pay tax on the distribution, and see his share price reduced by the amount of
the dividend. A registered representative may not encourage investors to purchase fund shares
before a distribution because of this tax liability. Doing so is selling dividends, a violation of
FINRA rules.
TA K E N O T E
TA K E N O T E
To find the cost basis of mutual fund shares, add the price paid and all reinvested
distributions. These distributions become part of the cost basis because they have
already been taxed.
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EXAMPLE
219
An investor bought shares for $10 and redeemed them for $15. The investor had
reinvested dividend distributions of $1 per share and capital gains of $.50. What was
the investors cost basis and capital gain?
The cost basis is found by adding the initial share cost and the reinvested distributions ($10 + 1 + .50 = $11.50 cost basis). The capital gain is found by subtracting the
cost basis from the sales proceeds ($15 cost basis of $11.50 = capital gain of $3.50
per share).
If the shares had been sold for $11.00 instead, the investor would have experienced a capital loss of $.50 because the cost basis of $11.50 was $.50 greater than
the sales proceeds of $11.00.
EXAMPLE
Capital Losses
$20,000
$30,000
The investor experiences a net capital loss of $10,000. Of this loss, $3,000 can be
used to reduce the investors ordinary income in the current tax year. The remaining
$7,000 net capital loss may be carried forward indefinitely, and $3,000 per year can
be used as a deduction until the full amount is used up.
3. 7. 2. 6 Accounting Methods
An investor who decides to liquidate shares determines the cost base by electing one of
three accounting methods: first in, first out (FIFO); share identification; or average basis. If
the investor fails to choose, the IRS assumes the investor liquidates shares on a FIFO basis.
3. 7. 2. 6. 2 Share Identification
When using the share identification accounting method, the investor keeps track of the
cost of each share purchased and uses this information when deciding which shares to liquidate. He then liquidates the shares that provide the desired tax benefits.
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EXAMPLE
3. 7. 2. 7. 1 Withholding Tax
If an investor neglects or fails to include their tax ID number (Social Security number)
when purchasing mutual fund shares, the fund must withhold a designated percentage (set by
the IRS) of the distributions to the investor as a withholding tax.
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EXAMPLE
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3. 7. 2. 7. 3 Dividend Exclusions
Corporations that invest in other companies stock may deduct 70% of dividends received
from taxable income. No similar exclusion exists for individual investors.
Capital gains
distributions:
3. 7. 2. 7. 6 Wash Sales
Capital losses may not be used to offset gains or income if the investor sells a security at a
loss and purchases the same or a substantially identical security within 30 days before or after
the trade date. The sale at a loss and the repurchase within this period is a wash sale.
The rule disallows the loss or tax benefit from selling a security and repurchasing the security or one substantially identical to it in this manner. The term substantially identical refers to
any other security with the same investment performance likelihood as the one being sold.
Examples are:
securities convertible into the one being sold;
warrants to purchase the security being sold;
rights to purchase the security being sold; and
call options to purchase the security being sold.
31st
SELL
31st
30 Days
LOSS
30 Days
OK
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TA K E N O T E
The wash sale rule covers 30 days before and after the trade date. Including the
trade date, this is a total time period of 61 days.
FINRA
The exchange where it trades
SEC
Board of directors of the fund
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3. Your client owns shares in an open-end investment company. The shares are currently quoted at $10 bid and $10.80 ask. Within the past 12 months, the investment company has distributed capital gains of $1.20 per share and dividends of
$.60per share. What is the current yield on your clients shares?
A.
B.
C.
D.
1.8%
5.0%
5.6%
6.0%
4. Which of the following factors would be used in calculating the tax due on a
capital gains distribution by a mutual fund?
I.
II.
III.
IV.
A.
B.
C.
D.
Average basis
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3. 8. 1
TAXATION OF ANNUITIES
Nonqualified individual annuities are purchased with after-tax dollars and money grows
tax-deferred. Payments into the account, therefore, comprise the cost basis and are not taxed
or penalized when distributed. There are four ways to distribute money from an annuity: lump
sum distribution, death, random withdrawals, and annuitization. In any event, only the earnings are taxed. Any taxes due are based on ordinary income tax rates, never capital gains rates.
Random withdrawals are taxed using last in, first out (LIFO) accounting. Accumulation
and earnings are distributed first and taxed as ordinary income, plus a 10% penalty if the annuitant is not yet 59. The 10% penalty is waived in the event of death or annuitization. Once
all earnings have been distributed, the remaining cost basis is distributed income tax free.
EXAMPLE
Typically, during the first 710 years of an annuity, if withdrawals take place,
earnings will be subject to taxes (plus a 10% penalty if under age 59), but in addition, the insurance company may levy a surrender charge on the distribution. Similar
to a contingent deferred sales charge, the surrender charge is reduced the longer the
policy is owned until it completely disappears. Where is this information found for
variable annuities? In the prospectus!
A good way to understand taxation of annuity withdrawals is to remember that with random withdrawals, the money representing the growth in the account must be taken out first,
whether the annuitant is over the age of 59 or not.
When annuitizing an annuity, the policyowner enters into a contractual obligation for the
systematic distribution of the asset. When annuitized, taxes are calculated using an exclusion
ratio. The amount of each payment considered a return of cost basis is determined by dividing
the annuity owners cost basis by her expected return (based on life expectancy).
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EXAMPLE
225
You will not be asked to calculate the amount of each annuity payment that is
taxable or nontaxable; however, you may be asked a question similar to the following.
The amount of each months annuity payment that is considered by the IRS as a
return of cost basis is determined by which of the following calculations?
A.
B.
C.
D.
LIFO
FIFO
Cost basis divided by life expectancy
Income averaging
Answer: C. The calculation that is made to identify the portion of each months
income that is a return of the after-tax dollars invested (the investors cost basis)
is:
Annuity owners cost basis annuitants life expectancy
EXAMPLE
earnings
total account value
If the investor makes a random withdrawal of $60,000, what are the tax
consequences?
Remember that LIFO appliesthe IRS wants tax revenue as early as possible.
Those earnings that accumulated tax deferred are now fully taxable. The investor
must pay ordinary income taxes on the first $50,000 withdrawn because that is
the amount of earnings. And, if the investor is under age 59, an extra 10% early
withdrawal tax applies. The remaining $10,000 is a return of the cost basis and is not
taxed or penalized.
Any answer choice that mentions capital gains taxation on annuities or retirement
plans is wrong. There is only ordinary income tax on distributions from annuities and
retirement plans.
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1. A customer buys a nonqualified variable annuity at age 60. Before the contract is
annuitized, she withdraws some of her funds. What are the consequences?
A. 10% penalty plus payment of ordinary income on all funds withdrawn
B. 10% penalty plus payment of ordinary income on all funds withdrawn in
excess of basis
C. Capital gains tax on earnings in excess of basis
D. Ordinary income tax on earnings in excess of basis
2. Distributions from both an IRA and a variable annuity are subject to which of the
following forms of taxation?
A.
B.
C.
D.
3. Joe, who is 42, is investing in a nonqualified variable annuity. This year, the securities in his separate account experience capital gains of $4,000. What tax must
he pay on the gains this year?
A.
B.
C.
D.
0%
10%
25%
50%
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2. After the death of the annuitant, beneficiaries under a life and 15-year period
certain option are subject to
A. capital gains taxation on the total amount of payments received
B. ordinary income taxation on the total amount of payments received, plus a
10% withdrawal penalty if the annuitant was under the age of 59
C. ordinary income taxation on the amount of the payment that exceeds the
cost basis
D. tax-free payout of all remaining annuity benefits
Answer: C. Payments from the annuity to the beneficiary through a period
certain option are taxed in the same way as all other annuity payments: benefits
over the amount of the cost basis are taxable as ordinary income. However, no
10% penalty applies in this situation.
3. 8. 2
TA K E N O T E
The 1035 provisions apply only to taxation. The insurance company itself may
impose surrender charges if a contract or policy is exchanged under the 1035 provisions. Therefore, the suitability of 1035 exchanges is always looked at very carefully.
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FINRA is concerned about Section 1035 abuses where the registered representative emphasizes the tax-free nature of the exchange without pointing out possible
disadvantages. Those include:
possible surrender charges on the old policy;
a new surrender charge period on the new policy; and
possible loss of a higher death benefit that existed on the old policy.
True or False?
1. Policy death benefits are taxable as income to beneficiaries.
2. Policy death benefits are excluded from the estate of the deceased
policyowner.
3. The cost basis of an insurance policy is equal to the premiums paid.
4. A 1035 exchange from an insurance policy to an annuity is not permitted.
5. A 1035 exchange can be made between fixed and variable policies.
6. When a policy is surrendered, any earnings in excess of the cost basis are
subject to taxation as capital gains.
7. The amount withdrawn for a policy loan is not taxable to the
policyholder.
Terms and Concepts Checklist
Exclusion ratio
1035 Exchange
Life expectancy
3. 9 RETIREMENT PLANNING
An important goal for many investors is to provide themselves with retirement income.
Many individuals accomplish this through corporate retirement plans, others set up their own
plans, and some have both individual and corporate retirement plans.
There are two basic types of retirement plans in the United States: qualified and
nonqualified. Generally speaking, qualified plans allow pretax contributions to be made, while
nonqualified plans are funded with after-tax money. Both plans can allow money to grow tax
deferred until needed. There are exceptions to these basic characteristics.
Contribution limits for qualified retirement plans vary and are adjusted from time to time.
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3. 9. 1
Nonqualified Plans
Plan is a trust
3. 9. 1. 1 Types of Plans
Deferred compensation and payroll deduction programs are two types of nonqualified
retirement plans. Both plans may be used to favor certain employees (typically executives)
because nondiscrimination rules are not applicable to nonqualified plans.
TA K E N O T E
When a plan is nondiscriminatory, all persons that meet certain criteria must be
eligible to participate. In a discriminatory plan, the employer may choose to provide
benefits to certain employees but exclude others.
A nonqualified deferred compensation plan is a contractual agreement between a company and an employee in which the employee agrees to defer receipt of current income in
favor of payout at retirement; therefore, contributions have not been taxed. Money grows taxdeferred and all distributions will be taxed as ordinary income. It is assumed that the employee
will be in a lower tax bracket at retirement age. These plans are not available to outside board
members as they are not employees for retirement planning purposes.
Deferred compensation plans may be somewhat risky because the employee covered by the
plan has no right to plan benefits if the business fails. In this situation, the employee becomes
a general creditor of the firm. Covered employees may also forfeit benefits if they leave the
firm before retirement. When the benefit is payable at the employees retirement, it is taxable
as ordinary income to the employee. The employer now deducts the benefits as a business
expense. These types of plans are often offered to highly compensated, older employees who
are close to retirement.
Payroll deduction plans allow employees to authorize their employer to deduct a specified
amount for retirement savings from their paychecks. The money is deducted after taxes are
paid and may be invested in any number of retirement vehicles at the employees option.
Section 457 plans are nonqualified retirement plans set up by state and local governments
and tax-exempt employers for their employees. They function as deferred compensation plans
in which earnings grow tax deferred and all withdrawals are taxed at the time of distribution.
Employees may defer up to 100% of their compensation, up to an indexed contribution limit.
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a trust
a conservatorship
an administratorship
a beneficial ownership
3. 9. 2
TA K E N O T E
Taxpayers age 50 and older may contribute an additional amount to their IRAs.
This is known as a catch-up contribution ($1,000 in 2014).
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3. 9. 2. 0. 1 Contributions
Between January 1 and April 15 (the last legal filing date), contributions and adjustments
may be made to an IRA for both the current year and the previous year. Contributions of
earned income may continue until age 70. Contributions are fully deductible, regardless of
income, if the investor is not covered by a qualified employer plan or, in the case of a defined
benefit plan, is ineligible for coverage. If covered or, in the case of a defined benefit plan,
eligible for coverage, contributions are only deductible if the taxpayers AGI (adjusted gross
income) falls within established income guidelines (and those amounts are not tested).
Excess contributions are subject to a 6% penalty. The excess contribution penalty can be
avoided by removing the excess contribution (and any earnings) prior to the legal filing date.
Certain investments are not permitted for funding IRAs, including:
collectibles (e.g., antiques, gems, rare coins, works of art, stamps);
life insurance contracts; and
municipal bonds (which are considered inappropriate because the benefit of their tax-free
interest is lost within a retirement plan).
Certain investment practices are also considered inappropriate. Those that are not permitted within IRAs or any other retirement plan include:
margin account trading;
short sales of stock; or
uncovered call options.
Covered call writing is permissible because it does not increase risk.
TA K E N O T E
Although life insurance is not allowed within IRAs, other life insurance company
products, such as annuities, are. Annuities are frequently used as funding vehicles for
IRAs. Following is a partial list of which investments are appropriate for IRAs:
Stocks and bonds
Mutual funds (other than municipal bond funds)
Unit investment trusts (UITs)
Government securities
US government-issued gold and silver coins
3. 9. 2. 0. 2 Distributions
Distributions may begin without penalty after age 59 and required minimum distributions (RMDs) must begin by April 1 of the year after the individual turns 70. Distributions
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before age 59 are subject to a 10% penalty as well as regular income tax. The 10% penalty is
not applied in the event of:
death;
disability;
purchase of a principal residence by a first-time homebuyer (up to $10,000);
education expenses for the taxpayer, a spouse, child, or grandchild;
medical premiums for unemployed individuals;
medical expenses in excess of defined AGI limits; and
Rule 72t: substantially equal periodic payments.
If RMDs do not begin by April 1 of the year after the individual turns 70, a 50% insufficient distribution penalty applies. It is applicable to the amount that should have been
withdrawn based on IRS life expectancy tables. Ordinary income taxes also apply to the full
amount.
3. 9. 2. 0. 3 Inheriting an IRA
The rules on the treatment of an inherited IRA depend on whether the beneficiary is
the spouse or is some other relative (or nonrelative) of the deceased. Another factor is if the
deceased had already begun taking RMDs. This issue is very technical, and we will only cover
points that might be tested.
3. 9. 2. 0. 4 Spousal Beneficiary
When the beneficiary is the spouse, there are two choices that can be made:
Do a spousal rollover, meaning the amount of the inheritance is rolled over into the
spouses own IRA
Continue to own the IRA as the beneficiary
When doing a spousal rollover, this is treated, logically, as your own with all of the normal
rules applying (withdrawal ages, RMDs, and so forth). That means that if the spouse is younger
than 59, any distributions prior to then will be subject to the 10% penalty (unless meeting
the exceptions).
If, however, the spouse elects to continue the account as the beneficiary, then there is no
10% penalty for withdrawals prior to age 59. Thats the good news. The bad news is that
RMDs (from a traditional IRA or SEP IRA) must begin when the deceased would have had to
take them, a disappointment if the survivor is the younger partner. However, the RMDs will be
computed based on the beneficiarys age, not that of the deceased. Also, if it is a Roth IRA and
the account hasnt been open for at least five years, any withdrawal of earnings will be subject
to income tax but not the 10% penalty.
3. 9. 2. 0. 5 Non-Spouse Beneficiary
When you inherit an IRA as a nonspouse beneficiary, the account works much like a typical IRA, with the following important exceptions.
Unlike when a spouse inherits an IRA, a nonspouse may not rollover the IRA into their
own account.
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Just as with the spouse continuing the IRA as beneficiary, there is ordinary income tax, of
course, but the 10% penalty does not apply to any distributions.
Just as with the spouse continuing the IRA as beneficiary, if the account were a Roth IRA
and it had not been opened for the five-year minimum, any earnings distributed will be
subject to ordinary income tax but not the 10% penalty.
RMDs must commence the year after the death of the account owner. However, the payout will be based on the beneficiarys life expectancy. This can be very attractive when the
IRA is left to a grandchild because it allows for the stretching of the distributions over a
very long period.
A nonspouse beneficiary may elect to distribute the entire amount over a five-year period.
Interestingly, the IRS does not require the payments to be made with any designated
frequency. That is, you can take a portion the first year because you can use some cash,
nothing for the next three years, and the balance in the fifth year.
TA K E N O T E
An employee leaves work and the company must distribute the balance of his
401(k) plan. If the proceeds are made payable to the employee, a 20% withholding
applies. If the proceeds are sent to another plan trustee, there is no withholding. The
20% withholding only occurs on distributions from an employers qualified plan made
directly to the plan participant.
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3. 9. 2. 2 Roth IRAs
Created in 1997, Roth IRAs allow the same contribution amounts as traditional IRAs.
The maximum contribution is 100% of earned income up to an indexed maximum. Both the
catch-up provision for those age 50 or older and spousal Roth IRAs are available. Earnings
accumulate tax deferred.
Unlike traditional IRAs:
contributions are nondeductible (after-tax)
contributions can be made to a Roth IRA beyond the age of 70
withdrawals from a Roth IRA need not begin at age 70
if the contributor has too much adjusted gross income, they may not contribute (number
not testable).
The owner of a Roth IRA can withdraw contributions at any time without tax or penalty.
If initial contributions to the Roth IRA are less than five years before withdrawal, no
matter at what age, earnings withdrawn will trigger ordinary income taxes plus a 10% penalty.
Prior to age 59, if account is held five years, contributions and earnings may be withdrawn tax free in the case of death, disability, or first-time home purchase (up to $10,000).
Other than for these exceptions, for the withdraw of earnings from a Roth IRA to be tax- and
penalty-free, the owner must be over 59 years-old and initial contributions must also have
been made five years before the date funds are withdrawn.
The biggest advantage of Roth IRAs is that distributions (including earnings) that satisfy
holding period requirements are income tax free.
TA K E N O T E
A person may maintain both a traditional IRA and a Roth IRA. However, the
contributions must be allocated so no more than 100% of earned income up to the
indexed maximum (plus catch-up, if eligible) is exceeded.
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Contributions may be made by any person, provided the total contribution per child does
not exceed $2,000 in one year. Earnings grow tax deferred and distributions are tax free as
long as the funds are distributed prior to the beneficiarys 30th birthday and used for qualified
education expenses.
TA K E N O T E
Just as with Roth IRAs, there is an AGI limit beyond which contributions may not
be made. It will not be necessary to know that limit, only know that one exists.
Assume questions are about traditional IRAs unless they specifically state Roth or
Education. Some key points to remember about these newer IRAs follow:
Roth IRA
Contributions may be made after age 70.
Catch-up contribution per year available beginning at age 50.
Contributions are not tax deductible.
Any qualified distribution from a Roth IRA is free from federal income
taxes. Qualified Roth IRA distributions must satisfy two requirements. First,
the distribution must be made after the five-tax-year period beginning
with the first tax year for which a contribution was made to any Roth IRA
established for the individual. Second, the distribution has to be made on or
after the date the individual turns 59 (realizing that there are exceptions to
the age requirement, but not the five years, in the case of death, disability, or
first time home purchase up to $10,000).
Distributions are not required to begin at age 70.
No 10% early distribution penalty for death, disability, and first-time home
purchase.
Coverdell Education Savings Accounts (CESAs)
Contribution limit is $2,000 per year per child under age 18.
Contributions may be made by persons other than parents; total for one
child is still $2,000.
Contributions must cease after the childs 18th birthday.
Contributions are not tax deductible.
Distributions are tax free if taken before age 30 and used for education
expenses.
Under most circumstances, if the money is not used for education or the
money is distributed after age 30, earnings are subject to ordinary income
tax plus a 10% penalty.
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TA K E N O T E
Because 529s are state sponsored, individual states have their own version of the
plan. The test does not expect you to have knowledge of specific state plans, only
characteristics of the plan in general.
3. 9. 2. 6 Money-Purchase Plans
Money-purchase plans are the simplest of the qualified defined contribution plans. Any
employer that meets funding requirements may offer such a plan. The employer simply contributes a specified fraction of the employees compensation up to an indexed maximum.
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2. A 50-year-old individual wants to withdraw funds from her IRA. The withdrawal
will be taxed as
A.
B.
C.
D.
ordinary income
ordinary income plus a 10% penalty
capital gains
capital gains plus a 10% penalty
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7. Which of the following is TRUE of both traditional IRAs and Roth IRAs?
A.
B.
C.
D.
8. What is the maximum amount that may be invested in an Education IRA in one
year?
A.
B.
C.
D.
3. 9. 3
SELF-EMPLOYED PLANS
Retirement plans for self-employed people were formerly referred to as Keogh plans after
the law that first allowed unincorporated businesses to sponsor retirement plans. Since the law
no longer distinguishes between corporate and other plan sponsors, the term is seldom used.
However, you may still see it on your exam.
The one-participant 401(k) plan isnt a new type of 401(k) plan. Its a traditional 401(k)
plan covering a business owner with no employees, or that person and his or her spouse.
Keogh plans are qualified plans intended for self-employed persons and owner-employees
of unincorporated businesses or professional practices who file Schedule C, such as doctors or
lawyers.
3. 9. 3. 1 Contributions
In order to make a tax-deductible contribution to a Keogh plan, there must be a gross profit
(no profit, no contribution). Participants may contribute as much as 25% of net earnings from
self-employment (not including contributions for yourself), up to an indexed maximum. As
with IRAs, a person may make contributions to a Keogh until age 70. In addition, employers
must make contributions into the plans of their eligible employees in an amount equal to their
own postcontribution percentage.
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Eligible employees must be allowed to participate in Keogh plans. ERISA eligibility rules
apply. Employees are eligible if they:
Self-employed doctor
Analyst who makes extra money giving speeches outside regular work
Individual with a full-time job who has income from freelancing
Corporate executive who receives $5,000 in stock options from his
corporation
I and II
I and III
I, II and III
III and IV
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3. 9. 4
403(b) PLANS
403(b) plans are a form of tax-sheltered annuity (TSA) available to employees of the
following organizations:
public educational institutions (403(b) institutions);
private schools;
tax-exempt organizations (501(c)(3) organizations); and
religious organizations.
In general, the clergy and employees of charitable institutions, private hospitals, colleges
and universities, elementary and secondary schools, and zoos and museums are eligible to
participate if they are at least 21 and have completed one year of service. The 403(b) plans
are funded by elective employee deferrals. The employee may contribute up to an indexed
maximum. The deferred amount is excluded from the employees gross income and earnings
accumulate tax free until distribution. A written salary reduction agreement must be executed
between the employer and the employee. Employer contributions may also be made. As with
other qualified plans, a 10% penalty is applied to distributions before age 59.
The IRS created the 403(b) in 1958 and at the time contributors were limited to investment choices offered by insurance companies. In 1974 Congress added a paragraph which
allowed employees to set up retirement plans directly with mutual fund companies. These
plans are titled 403(b)(7) plans, but are usually, and correctly so, referred to as a type of
403(b) plan.
3. 9. 5
A student may not participate in a 403(b) because the plan is only available
to employees.
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TA K E N O T E
All defined benefit and defined contribution plans, other than profit-sharing
plans, require an annual contribution. Employers may skip contributions to profitsharing plans in unprofitable years.
401(k) plans, the most popular form of defined contribution retirement plan, allow the
employee to elect to contribute a specific percentage of salary to a retirement account.
Contributions are excluded from the employees gross income and accumulate tax deferred.
Employers may make matching contributions up to a specified percentage of the employees contributions. Additionally, 401(k) plans permit certain hardship withdrawals.
Roth 401(k) plans are a relatively new plan option. Roth 401(k) plans are now available
as a plan option. A Roth 401(k), like a Roth IRA, requires after-tax contributions but
allows tax-free withdrawals, provided the plan owner is at least 59though unlike a
Roth IRA, there are no income limitations on who may have such a plan. Like a 401(k),
it allows the employer to make matching contributions, but the employers contributions
must be made into a traditional 401(k) account. The employee, who would thus have two
401(k) accounts, may make contributions into either, but may not transfer money from
one to the other once it has been deposited. In contrast to a Roth IRA, the account owner
must begin withdrawals by the age of 70 (unless still workingsee Required Beginning
Date in the following topic).
Corporate Retirement Plans
Benefit amount:
Contribution:
Assumes investment risk:
Plan favors:
Defined Benefit
fixed
amount varies
sponsor
older key employees
Defined Contribution
varies
amount fixed
participant
younger employees
(more time to
accumulate funds)
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Profit-sharing plan
Qualified plan
Deferred compensation plan
Rollover
Defined contribution plan
3. 9. 6
3. 9. 6. 1 Participation
This identifies eligibility rules for employees. All employees must be covered if they are 21
years or older and have performed one year of full-time service, which ERISA defines as 1,000
hours or more.
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3. 9. 6. 2 Funding
Funds contributed to the plan must be segregated from other corporate assets. Plan trustees
must administer and invest the assets prudently and in the best interest of all participants. IRS
contribution limits must be observed.
3. 9. 6. 3 Vesting
Vesting defines when an employer contribution to a plan becomes the employees money,
such as an employer matching contribution to a 401(k) plan. ERISA limits how long the vesting schedule can last before the employee is fully vested. Note that an employee is always fully
vested in her own contributions to a plan.
3. 9. 6. 4 Communication
The plan document must be in writing, and employees must be given annual statements
of account and updates of plan benefits.
3. 9. 6. 5 Nondiscrimination
All eligible employees must be treated impartially through a uniformly applied formula.
3. 9. 6. 6 Beneficiaries
Beneficiaries must be named to receive an employees benefits at death.
You may see a question that asks for the type of plans that ERISA regulates.
ERISA applies to private sector plans (corporate) only. It does not apply to plans for
federal or state government workers (public sector plans).
Vesting
Funding
Nondiscrimination
Reporting and disclosure
2. Which of the following determines the amount paid into a defined contribution
plan?
A.
B.
C.
D.
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US government workers
only public entities, such as the city of New York
only private organizations, such as Exxon
both public and private organizations
Terms and Concepts Checklist
Nonqualified plan
Individual plan
Qualified plan
Contribution limit
SEP
SIMPLE
Keogh plan
TSA, 403(b), 501(c)(3)
401(k) plan
Self-employed 401(k)
Roth 401(k)
Vesting
Ineligible investments
Beneficiary
Payroll deduction plan
Deferred compensation plan
Discrimination rule
Nondiscrimination
Section 457 plan
IRA
Roth IRA
Spousal contribution
overdell Educational Savings
C
Account (CESA)
Rollover, transfer
Section 529 plan
ERISA
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3. 10
SECURITIES INVESTOR PROTECTION CORPORATION
(SIPC)
After many brokerage firm defaults in the 1960s, the Securities Investor Protection Act was
passed in 1970 to protect customers from broker/dealer failure or insolvency. This act intensified broker/dealer financial requirements and created the Securities Investor Protection
Corporation (SIPC).
SIPC is an independent nonprofit corporation that collects annual assessments from broker/
dealers. These assessments create a general insurance fund for customer claims from broker/dealer
failure. All broker/dealers that are registered with the SEC must be SIPC members except for:
broker/dealers handling only mutual funds or unit trusts;
broker/dealers handling only variable annuities or insurance; and
investment advisers.
Firms that fail to pay their SIPC assessments may not engage in the brokerage business.
TA K E N O T E
SIPC protects customers from the risk of broker/dealer bankruptcy only. It does
not protect them from market risk or unwise investments.
EXAMPLE
Account Registration
Type of Account
Coverage
cash account
margin account
joint account
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The firm itself, its investment accounts, and its officers are not covered under the Act.
Also, anything that is not cash or a security is not covered.
TA K E N O T E
SIPC coverage is per separate customer, not per account. Cash and margin accounts are combined for SIPC coverage purposes.
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3. 11
247
TA K E N O T E
Even a slip of the tongue by a corporate insider could create liability under these
rules. The SEC has a greatly broadened scope of authority for investigating and prosecuting the abuse of inside information.
3. 11. 2 PENALTIES
If the SEC determines that a violation has occurred, civil penalties of up to the greater of
$1 million or 300% of profits made or losses avoided may be levied. Violators may also face
criminal penalties of up to 20 years in prison.
The trader also has potential liability to other traderscalled contemporaneous traders
who may have suffered loss because of his insider trading.
If the SEC convicts a person of insider trading after receiving a tip from someone, that tipster may be entitled to a bounty of as much as 30% of the penalty
collected.
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2. A client has a special cash account with stock valued at $460,000 and $40,000 in
cash. The same client also has a joint account with a spouse with securities valued at
$200,000 and $260,000 in cash. What is the SIPC coverage for this clients accounts?
A.
B.
C.
D.
$460,000 for the special cash account, $200,000 for the joint account
$500,000 for the special cash account, $450,000 for the joint account
$500,000 for the special cash account, $460,000 for the joint account
A total of $1 million for both accounts
3. SIPC uses which of the following to determine the value of customer claims when
a broker/dealer becomes insolvent?
A.
B.
C.
D.
4. Regarding the civil penalties that may be imposed for insider trading violations
under the Securities Exchange Act of 1934, which of the following statements is
NOT true?
A. A civil penalty may be imposed only on a person who is registered under a
securities act.
B. The violation for which a penalty may be imposed is defined as buying or
selling securities while in possession of material, nonpublic information.
C. The SEC may ask a court to impose a penalty of up to 3 times the loss
avoided or profit gained on an illegal transaction.
D. Improper supervision may cause a broker/dealer firm to be liable to pay a
penalty if one of its representatives commits an insider trading violation.
5. For purposes of insider trading, who of the following are insiders?
I.
II.
III.
IV.
A.
B.
C.
D.
Insider trading
Tipper and tippee
Insider information
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3. 12
249
REGULATION S-P
Regulation S-P, adopted by the SEC, derives from the privacy rules under the Gramm
Leach-Bliley Act, wherein Congress stated that each financial institution has a responsibility
to protect the privacy of its customers nonpublic personal information (NPI).
NPI is personally identifiable financial information such as information obtained on an
application for a product or service that is not publicly available. (Examples include social
security number; drivers license number, account number, and security codes.)
Regulation S-P requires firms to maintain adequate safeguards to protect customer information from unauthorized access or use. In addition, a financial institution may not disclose
nonpublic personal information to a nonaffiliated third party unless proper disclosures are made.
3. 12. 1 DISCLOSURES
Disclosure of a firms policies and procedures regarding customer privacy must be made no
later than when the customer relationship is established, generally at the time a new customer
opens an account. The customer must receive an updated notice containing the same information at least annually.
Guidelines include:
financial institutions must clearly and conspicuously disclose to the consumer, in writing
or in electronic form or other form permitted that such information may be disclosed to a
third party;
the consumer must be given the opportunity, before any information is initially disclosed,
to direct that information not be disclosed to a third party; and
the consumer is given an explanation of how to opt out of the sharing of information.
TA K E N O T E
Regulation S-P
Disclosures
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U N I T
T E S T
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252
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253
24. Which of the following is protected by the Securities Investor Protection Corporation (SIPC)?
A. Broker/dealer failure
B. Fraudulent transaction
C. Issuer default
D. Market risk
25. According to the participation provisions of
the Employee Retirement Income Security Act
(ERISA), which of the following circumstances
would allow an employee to participate in his
companys qualified retirement plan?
I. The employee is 20 years old.
II. The employee has a management position.
III. The employee has been with the company for
three years.
IV. The employee works part time, five hours each
week.
A. II and III.
B. I and III.
C. I and IV.
D. II and IV.
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A N S W E R S
A N D
R A T I O N A L E S
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255
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256
Q U I C K
Q U I Z
A N S W E R S
1. B.
2. A.
3. E.
4. C. or D. Standby is a type of firm commitment!
5. C.
Quick Quiz 3.D
1. Y.
3. N.
4. N.
8. T.
6. N.
1. D.
2. B.
3. A.
4. C.
5. A.
6. C.
7. B.
8. D.
2. Y.
5. Y.
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1. 1933
2. 1934
3. 1934
4. 1933
5. 1934
6. 1933
3. T.
7. 1933
8. 1934
9. 1934
10. 1934
Quick Quiz 3.J
1. F. Unrealized gains, or paper profits, are not
taxable to investors.
2. F. Capital gains distributions may not be made
more than once a year.
3. F. Mutual fund gains distributions are all
long-term. Mutual fund short-term gains are
distributed as dividends.
4. T.
5. T.
6. F. Funds that comply with IRC Subchapter
M are considered regulated investment
companies.
7. F. Dividend distributions, whether taken in
cash or reinvested, are taxable as ordinary
income to shareholders.
8. T.
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1. F.
2. F.
3. T.
4. F.
5. T.
6. F.
7. T.
Quick Quiz 3.N
1. A. A deferred compensation plan is considered
nonqualified because there are no tax benefits
associated with contributions. An executive,
in effect, simply agrees to a lower level of
compensation in exchange for a promise of
retirement benefits.
2. A. All corporate pension and profit-sharing
plans must be set up under a trust agreement.
A plans trustee has fiduciary responsibility
for the plan.
3. B. Deferred compensation plans may be
offered to select employees. However, board
members are not considered employees.
4. C. Because the annuitant has no cost basis, all
payments are considered ordinary income.
In a nonqualified annuity, contributions are
made with after-tax dollars, which establish
the annuitants basis. Annuity payments from
a nonqualified annuity are treated as ordinary
income to the extent that they exceed the
cost basis.
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260
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4
Marketing, Prospecting,
and Sales Presentations
261
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OBJECTIVES
When you have completed this Unit, you should be able to:
define the three types of communications with the public;
summarize other types of communication;
distinguish general communication standards;
state characteristics of communications regarding variable contracts;
know the methods of marketing mutual fund shares; and
explain the redemption of mutual fund shares.
262
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263
TA K E N O T E
In the spring of 2012, the SEC passed FINRA Rule 2210 governing communications with the public. The new rule makes drastic changes to the classifications and
definitions that once existed. If you happen to be familiar with the way it used to
be regarding communications with the public, youll need to relearn the terms and
definitions in place today.
TA K E N O T E
General securities principals (Series 24) may review and/or approve communications for all securities except options. Limited securities principals (Series 26) may only
review and/or approve communications for investment company products.
4. 1. 1
INSTITUTIONAL COMMUNICATIONS
Institutional communication is any written communication that is distributed or made
available only to institutional investors but does not include a member firms internal communications. Keep in mind that when regulators talk about written communication, they always
include electronic communication (e-comm), too.
Lets take a look at some examples of institutional investors:
Member firm or registered person
Bank
S & L
Insurance company
Registered investment company
Investment adviser
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Any entity with $50 million or more of total assets, including natural persons.
Governmental entity
Employee benefit plan that meets the requirements of Section 403(b) or Section 457 and
Note that 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 available to a person who is
not an institutional investor, the communication must be treated as a retail communication
until the member reasonably concludes the improper practice has ceased.
This definition is important because any account that isnt an institutional account is a
retail account.
Each member shall 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 associated persons by an appropriately qualified, registered principal. Such procedures
must be reasonably designed to ensure that institutional communications comply with applicable standards. When such 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 associated persons as to the firms procedures governing institutional communications,
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.
4. 1. 2
RETAIL COMMUNICATION
Retail communication is defined by FINRA as any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any
30 calendar-day period. What would commonly be thought of as advertisements and sales
literature generally fall under this definition.
What is a retail investor? Any personother than an institutional investorregardless of
whether the person has an account with the firm is considered a retail investor.
An appropriately qualified registered principal of the member must approve each retail
communication before the earlier of its use or filing with FINRAs 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 FINRAs Advertising Department and has received a letter from the department stating that it appears to be consistent with applicable standards;
and
the member using it in reliance upon the letter has not materially altered it and will use it
in a manner that is consistent with the conditions of the departments letter.
The requirement of prior principal approval generally will not apply with regard to what
is posted to an online interactive electronic forum or any retail communication that does not
make any financial or investment recommendation or otherwise promote a product or service
of the member.
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FINRA may also grant an exception from the approval rule for good cause.
Notwithstanding any other exception, an appropriately qualified registered principal of
the member must approve each retail communication before the earlier of its use or filing with
FINRA.
4. 1. 3
Please note that the term retail customer refers to any customer, existing or prospective, that does not fit into the definition of institutional client.
CORRESPONDENCE
Correspondence is written or electronic communication that is distributed or made available to 25 or fewer retail investors within any 30 calendar-day period.
Similar to what was discussed earlier for institutional communications, each member shall
also establish written procedures that are appropriate to its business, size, structure, and customers for the review of incoming and outgoing correspondence with the public, including
procedures to review incoming correspondence directed to registered representatives to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with firm procedures. Procedures may allow for either pre- or
post-review of correspondence by a principal. When pre-review is not required, the firm must
include a provision for the education and training of associated persons as to the firms procedures governing correspondence, 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.
4. 1. 4
OTHER COMMUNICATIONS
In addition to the three kinds of communications with the public, there are several other
types of communications you should be aware of.
4. 1. 4. 1 Public Appearance
Public appearance is participation in a seminar, Webinar, forum (including an interactive
electronic forum such as a chat room), radio or television interview, 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. Therefore,
pre-approval of a principal may be required but is not mandated. Such procedures must provide for the education and training of associated persons who make public appearances as to
the firms 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 communications audience, content, and use.
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If an associated person recommends a security in a public appearance, the associated person must have a reasonable basis for the recommendation. The associated person also must
disclose any conflicts of interest that may exist, such as a financial interest in any security
being recommended.
4. 1. 4. 3 Research Reports
A research report is a document prepared by an analyst or strategist, typically as a part of a
research team for an investment bank or broker/dealer. The report may focus on an individual
stock or sector of the economy and generally, but not always, will recommend buying, selling,
or holding an investment.
FINRA has established rules designed to improve the objectivity of research reports and
provide investors with more useful and reliable information when making investment decisions. Members must take steps to ensure that all research reports reflect an analysts 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 analysts actual views regarding a subject company, FINRA considers such action
fraudulent.
To ensure the investing public receives objective information from the media and publications, the rule requires the following.
Firms must clearly explain their rating systems, use rating terms according to their plain
meaning, note the percentage of all ratings they have assigned to each category (e.g., buy/
sell/hold), and document the percentage of investment banking clients in each category.
Analysts compensation may not be tied to the firms investment banking revenues.
Analysts must disclose in their research reports and public appearances whether they
or any member of their households have a financial interest in the subject security and
whether their employer firms owned 1% or more of any class of a subject companys equity
securities at the close of the previous month.
Research reports must disclose whether, 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 company that is the subject of a research report. They must also disclose whether 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.
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TA K E N O T E
267
of current ratings
Notices of ratings or price target changes
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TA K E N O T E
Regulations are clear; firms must have established procedures to maintain, review,
and supervise communications transmitted via blogs, email, instant messaging, texts,
Twitter, Facebook, and whatever new communication forum is coming our way.
Recently a firm and some representatives were fined when it was discovered that reps
had used outside electronic sources for securities related business. In other words, no
supervision, no review, no record of the communication! FINRA does not look kindly
on that.
2. Billboard
3. Television interview
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TA K E N O T E
Firms must have available for sale the type of security or service they advertise.
For example, a brokerage firm is not permitted to advertise no-load mutual funds if it
does not sell them.
There is a specific SEC rule permitting registered investment companies to use what is
known as an omitting prospectus. SEC Rule 482 describes mutual fund tombstone advertisements. Tombstone advertisements are used to advertise mutual funds (i.e. in newspapers and
magazines). Since technically this a prospectus, these advertisements are subject to the same
liabilities as any other prospectus as well as the antifraud provisions of the federal securities
laws.
To comply with this rule, an omitting prospectus must meet the following criteria.
The advertisement must state conspicuously from whom a prospectus may be obtained.
The advertisement must urge investors to read the prospectus carefully before investing.
Any past performance data, such as yields or return, that is quoted in the advertisements
must be accompanied by appropriate disclaimer and disclosures of load, if any.
The advertisement may not be used to purchase the shares (purchase may be made only
via an application found in a statutory or summary prospectus).
If the advertisement shows performance, it must show (other than a money market fund)
average annual total returns (after taxes on distributions) and average annual total returns
(after taxes on distributions and redemptions) for one-, five-, and 10-year periods.
The advertisement may include information, the substance of which is not included in the
statutory prospectus.
Funds may describe investment policies and objectives, services, principal officers, year
of incorporation, and aggregate net asset value if the advertisement includes the following
legend:
For more complete information about (funds name), including charges and expenses, send
for a prospectus from (name and address). Read it carefully before you invest or send money.
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TA K E N O T E
4. 1. 5
EXAMPLE
4. 1. 5. 1 Recommendations
In making a recommendation in a communication, whether labeled as such or not, a
member must have a reasonable basis for the recommendation.
4. 1. 5. 1. 1 Disclosure Requirements
Proposals and written presentations that include specific recommendations must have reasonable basis to support the recommendations, and the member firm must provide it in the
proposal or other document or offer to furnish it upon request.
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EXAMPLE
If a recommendation includes a stock purchase, the firm must provide the stocks
current price.
rectly, to past specific recommendations of the member that were or would have been profitable to any person; provided, however, that a retail communication or correspondence may
set out or offer to furnish a list of all recommendations as to the same type, kind, grade, or
classification of securities made by the member within the immediately preceding period of
not less than one year, if the communication or list:
states the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell, or hold), the market price at that time, the price
at which the recommendation was to be acted upon, and the market price of each such
security as of the most recent practicable date; and
contains the following cautionary legend, which must appear prominently within the communication or list, It should not be assumed that recommendations made in the future
will be profitable or will equal the performance of the securities in this list.
TA K E N O T E
These guidelines do not apply to any communication that meets the definition
of research report nor do they apply to any communication that recommends only
registered investment companies or variable insurance products, provided there is a
reasonable basis for the recommendation.
Time. The time span covered in the list of recommendations must run through consecutive periods, without skipping periods in an attempt to hide particular recommendations or
negative price performance data.
Costs and Member Involvement. All recommendations to customers must disclose:
all transaction costs;
whether the firm intends to buy or sell any of the recommended security for its own
account;
whether the firm is a market maker in the recommended security at the time the advertisement or sales literature was published;
whether the firm or its officers or partners own options, rights, or warrants to buy the recommended security;
whether officers or employees of the firm are directors of the company being recommended;
and
whether the firm managed or co-managed a public offering of the recommended security
or any other of the same issuers securities during the past 12 months.
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4. 1. 5. 1. 2 Recommending Funds
When recommending mutual funds to clients as investments and when using public communication developed for those investments, a broker/dealer should:
use charts or graphs showing a funds performance over a period of time long enough to
reflect variations in value under different market conditions, generally a period of at least
10 years;
reveal the source of the graphics;
separate dividends from capital gains when making statements about a funds cash
returns;
not state that a mutual fund is similar to or safer than any other type of security;
reveal a funds highest sales charge, even if the client appears to qualify for a breakpoint;
and
not make a fraudulent or misleading statement or omit facts.
4. 1. 5. 1. 3 Prohibitions
In addition to meeting certain information requirements, the firm making the recommendation must not:
imply that any guarantees accompany the recommendation;
compare the recommended security to dissimilar products;
make fraudulent or misleading statements about the recommended security;
make any predictions about the recommended securitys future performance or potential;
or
make statements of advantages without stating risks.
Communication of recommendations must contain the date the material was first published or distributed and the name of the member, person, or firm that prepared the material.
If information in the material is not current, this fact must be stated.
4. 1. 5. 1. 4 P
ayments Involving Publications that Influence the Market Price of
a Security
Unless a communication is a clearly paid advertisement, a research report or discloses the
receipt of compensation, no member shall give or receive anything of value for a communication that may or will have an effect upon the market price of any security.
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Rule 498 also requires that a legend appear on the cover page that refers to the summary nature of the prospectus and the availability of the funds statutory prospectus. The legend must provide a toll-free number to request paper delivery of the prospectus or a Website
where one may be downloaded. The summary must provide specific information in a particular
sequence. Following is a list of required disclosures:
Risk/Return Summary: Investments, Risks, and Performance
Risk/Return Summary: Fee Table
Investment Objectives, Principal Investment Strategies, Related Risks, and Disclosure of
Portfolio Holdings
Management, Organization, and Capital Structure
Shareholder Information
Distribution Arrangements
Financial Highlights Information
TA K E N O T E
These mutual fund disclosure documents, such as a statutory prospectus, summary prospectus, or statement of additional information, are not prepared by member
firms (they are prepared by the issuer) and as such are not subject to approval by a
principal.
4. 1. 5. 4 Testimonials
If any testimonial in a communication concerns a technical aspect of investing, the person
making the testimonial must have the knowledge and experience to form a valid opinion.
Retail communications or correspondence providing any testimonial concerning the
investment advice or investment performance of a member or its products must prominently
disclose the following:
The fact that the testimonial may not be representative of the experience of other customers.
The fact that the testimonial is no guarantee of future performance or success.
If more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial.
EXAMPLE
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4. 1. 5. 7 Hedge Clauses
A member may use no hedge clause, caveat, or disclaimer if it is misleading or inconsistent
with the context of the material.
TA K E N O T E
Any members Website that mentions FINRA membership must have a hyperlink
to the FINRA Website.
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EXAMPLE
Interest income on certain municipal securities is exempt from federal tax but is
subject to state and local taxes. Capital gains on municipal securities are taxable.
4. 1. 5. 12 Comparisons
If a member makes comparisons, the purpose of the comparisons must be clear and provide
a balanced presentation, including material differences between the subjects of comparison
(e.g., investment objectives, sales and management fees, liquidity, safety, guarantees or insurance, fluctuation of principal and return, tax features, and similar factors).
When comparing a taxable investment to a tax-deferred investment, an illustration must
use identical investment amounts and identical assumed gross rates of return, not to exceed
10%. In addition, only actual federal income tax rates can be used.
EXAMPLE
It would be misleading to compare bond fund performance with stock fund performance without disclosing that stock funds are historically more volatile.
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4. 1. 5. 14 Recruitment Advertising
Companies that advertise to attract new registered representatives are regulated by the
same Conduct Rules that cover companies advertising investment products. The advertisements must be truthful, informative, and fair in representing the opportunities in the industry
and must not contain exaggerated or unwarranted claims.
The advertisements may not emphasize the salaries of top-paid salespeople without revealing that they are not representative, and the advertisements may not contain any other statements that may be misleading or fraudulent.
Broker/dealers are permitted, in this one instance, to run blind advertisementsthat is,
advertisements that do not list a companys name.
TA K E N O T E
4. 1. 5. 14. 1 Interviews
Once a company starts interviewing potential employees, it is the principals responsibility
to see that both the industry and the job opportunity are honestly represented. Any discussions of the business must present both the upside and the downside of the position and should
not misrepresent the average employees compensation.
True or False?
1. It is permissible to omit facts in retail communications.
2. Testimonials in investment company advertising are prohibited.
3. Firms are not allowed to offer free services.
4. The price of the recommended security must always be disclosed at the
time the recommendation is made.
5. A recommendation showing past performance must include all recommendations made of similar securities within the past 6 months.
4. 1. 6
PERFORMANCE DATA
Investment companies frequently choose to advertise measures of performance, such as
return on investment or total return. When mutual funds, variable annuities, and unit investment trusts use such performance data, additional requirements apply under SEC Rule 482.
Performance data must be current. The rule assumes that data to the most recent calendar
quarter is current.
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TA K E N O T E
Keep in mind that bond funds dont pay interest, they pay dividends from net investment income (NII). Therefore, total return is calculated the same for funds holding
equity and/or debt securities.
4. 1. 6. 3 Past Performance
An advertisement containing performance data must clearly state that what is shown is
past performance and that investment returns and principal values fluctuate. The advertisement must further state that an investor who redeems shares may receive more or less than the
original cost. Money market funds are not required to state the risks of principal fluctuation.
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4. 1. 7
True or False?
1. All outgoing customer correspondence that does not contain any sales or
product recommendation must be reviewed by a principal.
TA K E N O T E
Outgoing electronic securities business correspondence is subject to the threeyear requirement as well. One way to accomplish this is to require a copy of all emails
to go to a central mailbox for review and recordkeeping.
4. 1. 7. 1 Filing Requirements
When a firm becomes registered with FINRA, during the first year of operation, FINRA
will require the member to file any retail communication that is published or used in any electronic or other public media, including any generally accessible Website, newspaper, magazine
or other periodical, radio, television, telephone or audio recording, video display, signs or billboards, motion pictures, or telephone directories (other than routine listings) with FINRA at
least 10 business days before first use (pre-filing).
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279
After the first year of registration, a member firm, sometimes referred to as established, may
file within 10 business days of first use (post-filing) retail communications relating to investment companies (including mutual funds, variable contracts, and UITs).
Whether a first year firm or not, retail communications for investment companies
(including mutual funds, variable contracts, and UITs) 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 with FINRA at least 10 business days before first use
(pre-filing).
If the ranking or comparison is generally published or is the creation of an independent entity (e.g., Lipper or Morningstar), the usual filing rules for filing will apply
(i.e., within 10 business days of first use [post-filing]).
4. 1. 7. 1. 1 Spot Checks
Each members retail communications are subject to routine spot checks. Members must
comply with written requests for such material by FINRA. Material filed previously with
FINRA under this rule need not be resubmitted.
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TA K E N O T E
True or False?
3. New firms are required to file all retail communications with FINRAs
advertising department 10 days before use.
4. 1. 7. 2 Summary of Regulations
The following summarizes FINRA regulations regarding communications with the
public.
A principal must approve all retail communications before use.
All retail communications must be kept in a separate file for a minimum of three years.
For each filing with FINRA, the member must provide the actual or anticipated date of
first use, the name and title of the registered principal who approved the advertisement or
sales literature, and the date on which the approval was given.
The member must file most retail communications concerning registered investment companies (including mutual funds, variable contracts, and UITs) within 10 business days of
first use. An exception exists for custom rankings and/or bond volatility ratings which
must be filed 10 business days before first use.
First-year members must file their retail communications at least 10 business days before
use.
Institutional sales literature is subject to review by a principal, whereas IPRs require
approval by a principal. These items are not filed with FINRA.
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True or False
3. Independently prepared reprints (IPRs) must be pre-approved by a principal and are not required to be filed with FINRA.
Before or After? Identify whether the following communications must be filed 10 days
before (B) or 10 days after (A) first use.
4. 1. 8
7. Literature 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
4. 1. 8. 1 Product Communications
All communications must clearly describe the product as either variable life or a variable
annuity, as applicable. Proprietary names may be used in addition to these descriptions. There
may be no implication that the product being offered or its underlying account is a mutual
fund.
4. 1. 8. 2 Liquidity
Because variable life insurance and variable annuities frequently involve substantial
charges and/or tax penalties for early withdrawal, there may be no representation or implication that these are short-term, liquid investments. Any statement about the ease of liquidation
of these products must be accompanied by the negative impact of factors such as contingent
deferred sales loads, tax penalties, and impact on cash value and death benefits.
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4. 1. 8. 3 Guarantees
Although insurance products contain a number of specific guarantees, the relative safety
of the product from these guarantees may not be overemphasized as it depends on the claimspaying ability of the insurance company. There may be no representation or implication that a
guarantee applies to the investment return or principal value of the separate account. Also, it
may not be represented or implied that an insurance companys financial ratings apply to the
separate account.
Although the rating firms weve mentioned before (Standard and Poors and Moodys
Investor Service) offer ratings on the financial health of insurance companies, the primary
source used by almost everyone in the industry is A.M. Best. An A or A+ rating from them
signifies substantial ability to meet their claim obligations.
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In essence, this passage states that an act is unlawful if the SEC says it is, and enforcement
of the intent of the act is not to be limited by the letter of the law.
4. 1. 8. 7. 1 Statute of Limitations
Under state statutes, any client may sue for damages if he believes that a broker/dealer
used any form of manipulative or deceptive practices in the sale of securities. The client must
bring the lawsuit within three years of the manipulative act and within two years of discovery
of the manipulation or deception, whichever occurs first.
4. 1. 9
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284
Under the TCPA of 1991, consumers, businesses, and state authorities may sue telemarketers who violate the act. Consumers may sue telemarketers in state court to prohibit further
violations or to recover monetary damages for each violation.
TA K E N O T E
EXAMPLE
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.
I and II
I and III
II and IV
III and IV
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Recommendations
T
elephone Consumer Protection
Actof 1991
Rule 2210
Testimonials
Institutional communications
Retail communication
Comparisons
Correspondence
Recruitment advertising
Public appearance
Performance data
Research reports
Generic Advertising
Hypothetical illustrations
4. 2. 1
Fund underwriters (sponsors) must be FINRA member firms. Only member firms
may receive selling concessions.
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286
to the underwriter at the current NAV. The underwriter then adds the sales charge and sells
the shares to the investor at the POP. The sales charge is split among the various salespeople.
4. 2. 1. 3 Fund to Investor
Some funds sell directly to the public without using an underwriter or a sales force and
without assessing a sales charge. If an open-end investment company distributes shares to the
public directly (without the services of a distributor) and the fund offers its shares with no
sales charge and a 12b-1 fee of .25% or less, the fund is called a no-load fund. The fund pays
all sales expenses.
TA K E N O T E
4. 2. 2
Remember that there are no discounts for the public or nonmember firms. Only
member firms may receive a discount from the POP and then only if they have a written sales agreement.
Previously, automatic reinvestment of distributions at NAV was included as a feature investment companies had to offer in order to charge the maximum 8.5% sales
charge. However, all newly formed investment companies (since April 1, 2000) are
now required to offer this feature regardless of sales charge percentage.
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4. 2. 2. 2 Class A Shares
Class A shares typically charge a front-end sales charge, also called a front-end load.
Because the sales charge is deducted from the investors funds, less than 100 cents of the investors dollar is actually invested. Class A shares may also impose an asset-based sales charge, the
12b-1 fee, but it is generally less than the 12b-1 fee imposed by the other share classes. As a
result, the operating expense ratio of Class A shares is less than Class B or Class C shares.
EXAMPLE
The ABC Growth and Income Fund Class A shares have a 12b-1 fee of .15
(15cents per $100). As such, a $10,000 investment in the fund would have an
annualcharge of $15 automatically deducted. If the value of the investors account
increases to $20,000, the 12b-1 fee would increase to $30 annually.
In addition, Class A shares typically allow sales charge discounts from the front-end load,
called breakpoints.
4. 2. 2. 2. 1 Breakpoints
Breakpoints are available to any person. For a breakpoint qualification, person includes
married couples, parents and their minor children, corporations, and certain other entities. Investment clubs or associations formed for the purpose of investing do not qualify for
breakpoints.
The following are breakpoint considerations.
Breakpoint levels vary across mutual fund families. There is no industry standardized
breakpoint schedule.
Mutual funds that offer breakpoints must disclose their breakpoint schedule in the
prospectus and how an account is valued for breakpoint purposes.
The SEC further encourages that breakpoint discount availability information be accessible through various means of communication including Websites.
Discounts may be the result of a single large investment, a series of aggregated investments, or a promise to invest via a letter of intent (LOI).
Purchases made by the same investor in various accounts can be aggregated to qualify
for a breakpoint discount. Eligible accounts include traditional brokerage, accounts held
directly with a fund company, 401(k), IRA, and 529 college savings.
Shares purchased in the same fund family other than money market accounts are eligible
to be aggregated together to qualify for a breakpoint discount, including those held at
separate broker/dealers.
You can expect a question on who is eligible for breakpoints. Married couples,
parents with minor children, and corporations are eligible. Parents combined with
adult children (even if they are legally considered dependents) and investment clubs
are not eligible.
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The discounts of sales charges are spelled out in a mutual funds prospectus, but the table
below illustrates a typical example.
Purchase Amount
Sales Charge
$0 to $24,999
6.00%
$25,000 to $49,999
5.50%
$50,000 to $99,999
5.00%
$100,000 to $249,999
4.00%
$250,000 to $499,999
3.00%
$500,000 to $999,999
2.00%
$1,000,000 +
0.00%
TA K E N O T E
EXAMPLE
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289
Backdating the Letter. A fund often permits a customer to sign a letter of intent as late as
the 90th day after an initial purchase. The LOI may be backdated by up to 90 days to include
prior purchases but may not cover more than 13 months in total. A customer who signs the
LOI 60 days after a purchase has 11 months to complete the letter.
EXAMPLE
5.00%
4.25%
3.75%
3.25%
backdated 90days.
If the letter of intent is not completed, the sales charge amount that applies
4. 2. 2. 2. 3 Rights of Accumulation
Rights of accumulation, like breakpoints, allow an investor to qualify for reduced sales
charges. The major differences are that rights of accumulation:
are available for subsequent investment and do not apply to initial transactions;
allow the investor to use prior share appreciation and reinvestment to qualify for breakpoints; and
do not impose time limits.
The customer may qualify for reduced charges when the total value of shares previously
purchased and shares currently being purchased exceeds a certain dollar amount. For the purpose of qualifying customers for rights of accumulation, the mutual fund bases the quantity of
securities owned on the higher of current NAV or the total of purchases made to date.
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TA K E N O T E
5.00%
4.25%
3.75%
3.25%
4. 2. 2. 2. 4 Combination Privilege
A mutual fund company frequently offers more than one fund and refers to these multiple
offerings as its family of funds. An investor seeking a reduced sales charge may be allowed
to combine separate investments in two or more funds within the same family to reach a
breakpoint.
4. 2. 2. 3 Class B Shares
Class B shares do not charge a front-end sales charge, but they do impose an asset-based
12b-1 fee greater than those imposed on Class A shares.
EXAMPLE
The ABC Growth and Income Fund Class B shares have a 12b-1 fee of .75 (75
cents per $100). As such, a $10,000 investment in the fund would have an annual
charge of $75 automatically deducted. If the value of the investors account increases
to $20,000, the 12b-1 fee would increase to $150 annually.
Class B shares also normally impose a contingent deferred sales charge (CDSC), also
called a back-end load, which is paid when selling shares. Because of the back-end load
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291
and 12b-1 fee, Class B shares may not be referred to as noload shares. The CDSC normally
declines and eventually is eliminated over time. Once the CDSC is eliminated, Class B shares
often convert into Class A shares. When they convert, they will be charged the same (lower)
asset-based 12b-1 fee as the Class A shares.
Class B shares do not impose a sales charge at the time of purchase, so, unlike Class A
share purchases, 100 cents of the invested dollar are invested.
The following table contains a typical CDSC Schedule for Class B shares:
Year
CDSC
5%
4%
3%
2%
1%
6+
0%
Larger investments are usually more suited to Class A shares if they are eligible for sales
charge discounts.
TA K E N O T E
An investor buys $10,000 of the ABC Growth and Income Fund with the expec
tation of holding the investment for many years. However, 18 months after the initial
purchase, the investor needs to sell the shares to meet unexpected financial needs.
Using the chart above, we can see that the shares have a CDSC of 4%. The rule is
that the charge is based upon the LOWER of the original purchase price or the current
NAV. So, if the current NAV is $15,000, the CDSC will be 4% of the original $10,000
or $400. If, however, the NAV is only $9,000, the charge will be 4% of $9,000 or
$360.
4. 2. 2. 4 Class C Shares
Like Class B shares, Class C shares do not impose a front-end sales charge on the purchase, so all of the customers funds are invested. Often Class C shares impose a small charge,
such as 1%, if shares are sold within a short time (usually within one year). Class C shares typically impose a 12b-1 asset-based fee comparable to Class B shares, that is, higher than Class
A shares. Class C shares generally do not convert into Class A shares, so the asset-based sales
charge will not be reduced over time.
Class C shares may be less expensive than Class A or B shares for investors with a shortterm time horizon because there is little or no sales charge. However, the annual expenses
could be higher than both Class A and B shares if shares are held for a long time.
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292
sum or over a period of time, and with a long-term time horizon, Class A shares make the
most sense because of the reduced sales charge and lower 12b-1 fees.
For investors that dont qualify for breakpoints (and who are unlikely to qualify for break-
points within 13 months) and a long-term time horizon (five years or more), Class B
shares are most suitable because of the greater amount of funds invested up front.
For investors with a time horizon of less than five years, Class C shares make the most
sense because of the low (or nonexistent) sales charge upon redemption.
Given below is a tabular summary of the characteristics of Class A, Class B, and Class C
shares, with no-load shares added for comparison purposes.
Mutual Fund Share Class Table
Front-end load
Back-end Load (CDSC)
Class A
Up to 8%
No
12b-1 Fee
0 to .25%
Class B
No
Yes; drops to
0 after 68 years
Up to .75%
Expense Ratio
Breakpoints
LOI
Rights of Accumulation
Conversion
Low
Class C
No
1%; drops to
0 after 1 year
.75%; for life of
account
Medium
Yes
N/A
N/A
N/A
No
No
No
Investor
High amount
Long time
horizon
Converts to Class A
after 68 years
Low amount
Long time horizon
Low amount
Short time horizon
Amount neutral
Time horizon neutral
No-Load
No
No
0 to .25%
Low
Class A
Class B
Class C
No Load
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293
6. Level load
7. Time horizon neutral
8. Recommended when investing for short time horizons
4. 2. 3
TA K E N O T E
Certificates for mutual fund shares may be requested by an investor (typically not
the case).
The price at which shares are redeemed is the NAV; it must be calculated at least once per
business day. The redemption requirement may be suspended when:
the NYSE is closed other than for a customary weekend or holiday closing;
trading on the NYSE has been restricted;
an emergency exists that would make disposal of securities owned by the company not
reasonably practical; or
the SEC has ordered the suspension of redemptions for the protection of the companys
securities holders.
The fund must then pay the proceeds of the redemption within seven calendar days.
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294
Breakpoints are not allowed for investment clubs and a parent and child above the
age of majority. They are allowed for corporations, husband and wife, or a custodial account for a parent and minor child.
A fund may only charge an 8.5% sales load if it offers breakpoints and rights of
accumulation.
Mutual fund shares that have been redeemed are cancelled; they are never reissued.
conversion privilege
breakpoints
letter of intent
rights of accumulation
I and II
I and III
I and IV
II and IV
2. A mutual fund is quoted at $16.56 NAV and $18.00 POP. The sales charge is
A.
B.
C.
D.
7.5%
7.75%
8%
8.5%
4. A customer purchased mutual fund shares with a net asset value of $7.82 and an
8% sales charge. She paid a sales charge of
A.
B.
C.
D.
$.68
$.74
$.80
$.87
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5. Which of the following statements regarding an LOI and breakpoints are TRUE?
I.
II.
III.
IV.
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
Terms and Concepts Checklist
Class A shares
Breakpoints
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296
U N I T
T E S T
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297
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298
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A N S W E R S
A N D
R A T I O N A L E S
299
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300
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Q U I C K
Q U I Z
301
A N S W E R S
1. C.
2. RC.
3. PA.
4. RC.
5. RR.
6. IPR.
2. T.
3. T.
Quick Quiz 4.D
1. F. Within 10 days of first use
7. IC.
3. T.
4. F.
6. T.
5. F.
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302
1. F.
2. F.
3. T.
4. T.
5. A.
6. B.
7. B.
Quick Quiz 4.F
1. D. The Telephone Consumer Protection Act
of 1991 covers all registered representatives.
Each firm must have a Do-Not-Call list that
every registered representative is required
to check before soliciting any person. The
act applies to commercial solicitation and
does not include a university survey group or
nonprofit organization.
2. A. Under the TCPA of 1991, calling hours for
cold calls are between 8:00 am and 9:00 pm
in the customers time zone. The National
Do-Not-Call list copy may be no more than
31 days old.
Quick Quiz 4.G
1. B.
2. C.
3. D.
4. A.
5. A.
6. C.
7. D.
8. C.
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5
Opening and Servicing
Customer Accounts
303
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OBJECTIVES
When you have completed this Unit, you should be able to:
list the required steps to open an account;
detail the different types of customer accounts;
understand ethical business practices;
distinguish circumstances and processes of the Code of Procedure and Code of
Arbitration Procedure; and
interpret the USA PATRIOT and other related Acts.
304
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305
5. 1 OPENING ACCOUNTS
TAXPAYER ID NUMBER
BRANCH#
AGE
SSN
RR#
DATE
ACCOUNT#
TAX ID
LEGAL NAME(S) AND MAILING ADDRESS
HOME
CASH
ACCOUNT TYPE
BUS
MARITAL STATUS
ACCOUNT REGIS.
TELEPHONE NO.
HOME
BUS
TELEPHONE NO.
HOME
BUS
SPOUSE
REFERENCE
EMPLOYMENT
EMPLOYER'S NAME
YES
DUPLICATE
YES
NO
CONFIRMS?
NO
YEARS EMPLOYED
ADDRESS
CLIENT'S OCCUPATION
TYPE OF BUSINESS
DIVIDENDS
DOCUMENTATION
MARGIN AGR
JOINT ACCT
TRADING AUTH
CORP/PART AGR
RETIRE ACCT
SIG CARD
YES
NO
COMMODITY
MARRIED
SINGLE
DIVORCED
WIDOWED
SINGLE
JTIC
JTWROS
INV CLUB
CORP
RETIRE
PARTNER
OTHER
HOLD
MAIL
U.S.
CITIZEN?
YES
NO
RCVD
PEND
PEND
PEND
RCVD
RCVD
RCVD
PEND
RCVD
PEND
RCVD
OPTION
MARGIN
CHECKING
VERIFIED
SAVINGS
NOT VERIFIED
NAME
OCCUPATION
AGE
EMPLOYER
ADDRESS
ANNUAL INCOME
INVESTMENT EXPERIENCE
INVESTMENT OBJECTIVES
SPECULATION
RETIREMENT
IS CLIENT NOW OR HAS CLIENT
TAX
EVER BEEN A CORPORATE
OFFICER OR OWNER OF 10%
OF ANY CORPORATION'S
OWN
RENT
HOME
SECURITIES?
NO. OF DEPENDENTS
YES
NO
IF YES, NAME:
ANNUAL INC
GROWTH
INCOME
GRO/INC
NET WORTH
BRANCH MGR APPROVAL
DATE
REFERRAL
PROSPECT
ACQUAINTANCE
INITIAL TRANSACTION
DESCRIBE:
BUY
SELL
OTHER
INITIAL DEPOSIT
DISCRETIONARY AUTHORIZATION
FULL
LIMITED
NONE
FINRA requires firms to ask questions to open and service an account. Before opening an
account, a firm must verify the identity of any person seeking to open an account (reviewed
later in this unit) and obtain, at a minimum, the following information:
name;
date of birth;
address; and
Social Security number if individual, or tax identification number if other legal entity (if
the customer has no Social Security number, it must be applied for, and this fact must be
entered on the account card).
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306
In addition, the SEC requires firms to attempt to obtain the following additional
information:
telephone number;
employment status;
annual income;
net worth (excluding primary residence); and
investment objectives regarding certain accounts.
The customers signature is not required on the new account form. The only signature required to open an account is a partner, officer, or manager (a principal), signifying that the account has been accepted in accordance with the members policies and
procedures for acceptance of accounts.
Accounts may be opened by any legally competent person above the age of majority.
Individuals who have been determined legally incompetent may not open accounts.
Ideally, when opening an account, representatives should know all essential facts about a
customers current financial situation, present holdings, risk tolerance, needs, and objectives.
Such information should be updated periodically as situations change.
If a customer only provides minimum information and refuses to provide all information
requested, the account may still be opened if the firm believes the customer has the financial
resources necessary to support the account. If sufficient information has not been received
to determine suitability, recommendations cannot be made and only unsolicited trades may
occur.
The completed form must be sent to the customer within 30 days. After that, account
information must be updated no less frequently than every three years. Anytime the account
is amended, an updated form must be sent to the customer within 30 days.
5. 1. 1
ACCOUNT OWNERSHIP
Accounts can be opened with various types of ownership. The principal types of ownership are individual, joint, corporate, and partnership. Celebrities and affluent customers sometimes request an account be designated by a number or symbol, for privacy purposes. This is
possible provided the member has filed a written statement signed by the customer attesting
to the ownership of the account.
5. 1. 2
TRADING AUTHORIZATION
Accounts may be opened with someone other than the owner having the authority to buy
and sell securities. This is known as trading authorization or power of attorney. The primary
types of trading authorization are discretionary, custodial, and fiduciary.
DiscretionaryA registered representative (or some other person) has been given written authorization from a customer to make trading decisions for the customer. Principal
approval is required before a registered representative may have discretionary authority
over a client account.
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CustodialA competent adult has been designated to act on behalf of a child, who is the
5. 1. 3
PAYMENT METHOD
Customers may trade for securities in a cash or margin account. In a cash account, customers pay the full purchase price of securities. Margin accounts allow customers to borrow
part of a securitys purchase price through the broker/dealer.
5. 1. 4
SECURITIES TRADED
Customers must have special approval to make certain types of trades in their accounts,
particularly options transactions. Normally, no special authorization is required to buy or sell
stocks, bonds, or mutual funds.
5. 1. 4. 1 Interpositioning
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.
Generally, interpositioning results in a less favorable price to the customer as the third
party will trade at the inside market and then tack on a little something for itself.
5. 1. 4. 2 COD Orders
Some customers may want to establish an account 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 bank and the account
number of the customer on file with the agent bank. In such transactions, members must get
assurances from the customer that proper instructions have been given to the agent bank to
receive securities against payment (cash on delivery (COD)).
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5. 1. 5
5. 1. 5. 2 Documents Required
In addition to the new account form required for all accounts opened, other specific applications may be required, including:
customer agreements;
loan consent agreements;
IRA contracts;
Keogh forms;
partnership agreements;
corporate charters;
simplified employee pension plan (SEP) applications;
annuity contracts;
trust documents;
mutual fund applications; and
full or limited powers of attorney.
5. 1. 5. 2. 1 Mailing Instructions
A customer gives specific mailing instructions when opening a new account. Statements
and confirmations may be sent to someone who holds power of attorney for the customer if the
customer requests it in writing and if duplicate confirms are also sent to the customer.
Your firm is permitted to hold mail for a customer (e.g., statements and confirmations)
who will not be receiving mail provided that:
the member firm receives written instructions that include the time period the request is
being made for up to three months (requests may be granted for periods longer than three
months for an acceptable reason such as safety or security concerns, but not merely for the
sake of convenience);
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the member firm informs the customer of any alternate methods that the customer may use
to receive or monitor account activity such as email or through the member firms website
(the member must obtain customer confirmation that this information regarding alternate
methods was received); and
the member verifies at reasonable intervals that the customers instructions still apply.
Additionally, during that time that a member firm is holding mail for a customer, the
firm must be able to communicate with the customer in a timely manner to provide important account information. The firm must take actions reasonably designed to ensure that a
customers mail is not tampered with or used in a manner that would violate FINRA rules or
federal securities laws.
While holding mail is a courtesy that firms are permitted to extend to customers, the
rule does not require them to. If extending the courtesy is consistent with the broker/dealers
in-house rules, the written request by the customer to do so implies that the customer is also
giving the broker/dealer permission to do so.
5. 1. 5. 3 Retirement Accounts
Each type of personal and corporate retirement account has its own forms and applications. The most important are those that establish the firms custodial relationship with the
retirement account owner, necessary for IRS reporting purposes.
5. 1. 6
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5. 1. 6. 1 FINRA Requirements
The FINRA rule requires that a person associated with a member, prior to opening an
account or placing an initial securities order with another member, notify both her employer
and the executing member, in writing, of her association with the other member.
The employee is responsible for disclosing that he is an associated person of a FINRA member firm when opening the account. Duplicate confirmations and statements must be sent to the
employer broker/dealer if the employer requests them.
When opening an account for an employee of another member firm, the following three steps must occur.
The account holder must be advised in writing that his employer will be notified of
this account.
The employer must receive written notification that the account is being opened.
If the employer requests duplicate confirmations, they must be sent.
Note that the duplicate confirmations must be made available upon request by
the employing firm. Also note that certain accounts do not require these notification
steps. For example, mutual funds or variable contracts purchased directly from the
issuer are exempt from these rules.
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I only
I and III
II and III
III and IV
Customer information
Customer identification program
(CIP)
Account ownership
Account approval
Accounts for employees of other
Trading authorization
Discretionary account
Custodial account
Fiduciary account
broker/dealers
5. 2 TYPES OF ACCOUNTS
When an account is opened, it is registered in the name(s) of one or more persons. They
are the account owners and are the only individuals who are allowed access to and control of
the investments in the account.
5. 2. 1
INDIVIDUAL ACCOUNTS
A single (individual) account has one beneficial owner. The account holder is the only
person who may:
control the investments within the account; and
request distributions of cash or securities from the account.
A special type of designation for an individual account is a transfer on death (TOD)
account, sometimes referred to as pay on death (POD). This allows the account holder to
specify who is to receive the account on his death and thus avoid probate but not estate taxes.
The account remains the holders property during his lifetime and, unlike changes to a will,
the names and percentage allocations to the beneficiaries may be changed with no legal documentation other than written notice to the broker/dealer.
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5. 2. 2
JOINT ACCOUNTS
In a joint account, two or more adults are named on the account as co-owners, with each
allowed some form of control over the account. In addition to the appropriate new account
form, a joint account agreement must be signed, and the account must be designated as either
tenants in common (TIC) or joint tenants with right of survivorship (JTWROS).
The account forms for joint accounts require the signatures of all owners. Both types of
joint account agreements allow any or all tenants to transact business in the account. Checks
must be made payable to the names in which the account is registered and must be endorsed
for deposit by all tenants (although mail need be sent to only a single address). To be in good
delivery form, securities sold from a joint account must be signed by all tenants.
5. 2. 2. 1 Tenants in Common
Tenants in common (TIC) ownership provides that a deceased tenants fractional interest
in the account be retained by that tenants estate and not passed to the surviving tenant(s).
all parties.
TA K E N O T E
5. 2. 3
Suitability information must be gathered from all of the joint tenants before making recommendations for the benefit of the account.
POWER OF ATTORNEY
A full power of attorney allows someone who is not the owner of an account to deposit or
withdraw cash or securities and make investment decisions for the account owner. Custodians,
trustees, guardians, and other people filling similar legal duties are often given full power of
attorney.
A limited power of attorney allows an individual to make only trading decisions.
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A person with power of attorney over an account might be an investment adviser for an
individual customer or a trustee in the case of a trust account. In either case, the broker/dealer
firm must obtain a copy of the trust agreement or investment adviser contract as well as a signature from the designated person and the date on which the power of attorney was granted
to him.
Monthly or quarterly account statements continue to be sent to the owner of the account.
They may also be sent to the person holding power of attorney at the owners request.
Upon the death of the account holder, the power of attorney immediately terminates.
5. 2. 4
DISCRETIONARY ACCOUNTS
An account set up with preapproved authority for a registered representative to make
transactions without having to ask for specific approval is a discretionary account. Discretion
is defined as the authority to decide:
whether to buy or sell (action);
which security to buy or sell (asset); and
the number of shares or units to buy or sell (amount).
Discretion does not apply to decisions regarding the timing of an investment or the price
at which it is acquired.
5. 2. 4. 1 Discretionary Authority
A customer can give discretionary power over an account only by filing a trading authorization or a limited power of attorney with the broker/dealer. No transactions of a discretionary
nature may take place without this document on file. Principal approval is required before
discretionary authority can be granted to a registered representative.
Once authorization is given, the customer is legally bound to accept the registered representatives decisions, although the customer may continue to enter orders on his own.
The customer may give discretion for the account only to a specific individual. If the registered representative leaves the firm or in any way stops working with the account, discretionary authority ends immediately.
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TA K E N O T E
EXAMPLE
If a customer asks a representative to sell 1,000 shares of XYZ stock, the order is
not discretionary even though the customer did not specifically say when or at what
price.
Action
Asset
XYZ stock
Amount
1,000 shares
5. 2. 5
CUSTODIAL ACCOUNTS
Minor children cannot own securities. However, securities may be purchased for the benefit of a minor in a custodial account.
There are two types of custodial accounts. Both the Uniform Gifts to Minors Act
(UGMA) and Uniform Transfer to Minors Act (UTMA) accounts require an adult or a
trustee to act as custodian for a minor (the beneficial owner). Cash or securities and other
forms of property may be given to the account without limitation.
UGMA accounts will be discussed first.
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5. 2. 5. 2 Custodian
Any assets given to a minor through an UGMA account are managed by a custodian until
the minor reaches the age of majority. The custodian need only be a competent adult, has full
control over the minors account, and may:
buy, sell, or hold securities; and
exercise rights or warrants.
The custodian may also use the property in the account in any way he deems proper for
the minors support, education, maintenance, general use, or benefit. However, the account
is not normally used to pay basic expenses associated with raising a child, such as food and
clothing.
Registered representatives must know the following rules regarding UGMA custodial
accounts.
An account may have only one custodian and one minor or beneficial owner.
A minor may be the beneficiary of more than one account and a person may serve as custodian for more than one UGMA provided each account benefits only one minor.
The donor of securities may act as custodian or may appoint someone else to do so.
Unless acting as custodians, parents have no legal control over an UGMA account or the
securities in it.
The registered representative is not responsible for determining if an appointment is valid
or whether a custodians activities are appropriate.
5. 2. 5. 5 Fiduciary Responsibility
UGMA custodians are charged with fiduciary responsibilities in managing a minors
account. Certain restrictions are placed on what is considered proper handling of UGMA
investments. This means that, since they are charged with investing or managing money for
others, they must exercise special care in selecting investments. The most important limitations follow.
UGMAs may be opened and managed as cash accounts only.
A custodian may not purchase securities in an account on margin or pledge them as collateral for a loan.
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A custodian must reinvest all cash proceeds, dividends, and interest within a reasonable
period of time. Cash proceeds from sales or dividends may be held in a noninterest-bearing
custodial account for a reasonable period, but should not remain idle for long.
Investment decisions must take into account a minors age and the custodial relationship; commodities futures, naked options, and other high-risk securities are examples of
inappropriate investments. To ensure appropriateness of investments, some states use a
legal list, a list of investments compiled by a state agency such as the State Banking Commission, from which a fiduciary must select investments for the account he is managing.
Other states use the prudent investor rule. This rule, technically known as the Uniform
Prudent Investor Act of 1994, says that in determining liability for losses, investments are
compared to what a prudent investor would have done under similar circumstances. All
that is required is to act with skill and caution.
Options may not be bought in a custodial account because no evidence of ownership is
issued to an options buyer. Covered call writing is normally allowed.
Stock subscription rights or warrants must be either exercised or sold. They may not be
allowed to expire unexercised.
Under the UPIA of 1994, UGMA custodians may grant trading authority to a qualified
third party.
Custodians may loan money to an account but may not borrow from it.
A custodian may be reimbursed for any reasonable expenses incurred in managing the
account but may not receive compensation if also the donor. The UGMA/UTMA rules permit any custodian to receive reimbursement for expenses in handling the account, such as
postage or copying documents. However, only a custodian who is not the donor can be compensated for actual management of the account.
5. 2. 5. 6 Taxation
The minor is the accounts beneficial owner and is responsible for any taxes on the account;
however, in most states, it is the custodians responsibility to see that taxes are paid. The
minors Social Security number appears on an UGMA/UTMA account, and the minor will
be taxed at his parents marginal rate on income exceeding an indexed level until the child
reaches age 19 or 24 if a full-time student. This is known as the kiddie tax.
Individuals may give gifts up to an indexed dollar maximum per year to any
number of individuals without incurring a gift tax. If the gift exceeds the current dollar
maximum for the year, the donor, not the recipient, must pay the gift tax.
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5. 2. 5. 8 UTMAs
Although UTMA and UGMA share many characteristics, there are a few important differences. First, although UGMA accounts may not hold real estate (real property), certain
partnership interests, and other types of intangible property, UTMA accounts may. Thus,
UTMA accounts offer greater investment choice.
In many states, UTMA account assets are not required to be transferred upon the age of
majority of the beneficial owner (the child). In many UTMA states, the custodian may delay
transferring the UTMA assets to the beneficial owner until he becomes age 21 or 25 (depending on the particular state statute).
or margin accounts.
Executor of an estate
Business associate
Custodian of an UGMA/UTMA account
Close relative
I and II
I and III
II and IV
III and IV
2. A customer would like to open an UGMA account for his nephew, a minor. The
uncle may
A. open the account provided the proper trust arrangements are filed first
B. open the account and name himself custodian
C. only move ahead if he gets a legal document evidencing the nephews parents approval of the account
D. be custodian for the account only if he is also the minors legal guardian
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3. An investor wishes to provide for his 3 nephews after his brother dies. Under the
Uniform Gifts to Minors Act, which of the following actions may the investor
take?
A.
B.
C.
D.
4. Securities owned by a donor and given to a minor under the Uniform Gifts to
Minors Act become the property of the minor
A. when the securities are paid for by the minor
B. on the settlement date
C. when the securities are registered in the custodians name for the benefit of
the minor
D. when the donor decides to give the securities to the minor
5. 2. 6
Individual account
Joint account
JTWROS
TIC
UGMA, UTMA accounts
Taxation of custodial accounts
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TA K E N O T E
5. 3. 2
SRO rules basically remind representatives not to lie, cheat, or steal when dealing
with customers. If you are uncertain about a question on prohibited practices or ethics, you are likely to be right if you choose the most conservative response.
5. 3. 2. 1. 1 Notification
An associated person who wishes to enter into a private securities transaction must:
provide prior written notice to his employer;
describe in detail the proposed transaction;
describe in detail his proposed role in the transaction; and
disclose if he will or may receive compensation for the transaction.
If the associated person wishes to enter into the transaction or business activity for compensation, the employing member must approve or disapprove the associated persons participation. If the member approves the participation, it must treat the transaction as if it is
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being done on its own behalf by entering the transaction on its own books and supervising
the associated person during the transaction. If the member disapproves the transaction, the
associated person may not participate in it.
If the associated person has not or will not receive compensation for the private securities transaction, the employing member must acknowledge that it has received written notification and may require the associated person to adhere to specified conditions during his
participation.
Transactions that the associated person enters into on behalf of immediate family members and for which the associated person receives no compensation are excluded from the definition of private securities transactions. Also excluded are personal transactions in investment
company products and variable contracts (life and annuity).
TA K E N O T E
5. 3. 3
Income from rental property is passive income and does not constitute an outside
business activity.
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5. 3. 3. 2 Excessive Trading
Excessive trading in a customers account to generate commissions, rather than to help
achieve the customers stated investment objectives, is an abuse of fiduciary responsibility
known as churning. Churning occurs because of either excessive frequency or excessive size
of transactions.
To prevent such abuses, self-regulatory organizations require that a principal of the member firm frequently review all accounts, especially those in which a registered representative or
an investment adviser representative has discretionary authority.
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In addition to cash gifts not exceeding $100 per person per year, the following non-cash
compensation arrangements are permitted:
Articles of reminder advertising such as pens, calendars, and so forth.
An occasional meal, a ticket to a sporting event or the theater, or comparable entertainment which is neither so frequent nor so extensive as to raise any question of propriety
and is not preconditioned on achievement of a sales target. Season tickets would not be
acceptable.
Payment or reimbursement in connection with meetings held by an underwriter or by a
member for the purpose of training or education of associated persons of a member, provided that:
the member must maintain records of all compensation received by the member or its
associated persons from offerors (the underwriters making the offer to bring you to the
seminar). The records shall include the names of the offerors, the names of the associated persons, the amount of cash, the nature, and, if known, the value of non-cash
compensation received;
associated persons obtain the members prior approval to attend the meeting, and attendance by a members associated persons is not preconditioned by the member on the
achievement of a sales target or any other incentives;
the location is appropriate to the purpose of the meeting, which shall mean an office of
the offeror or the member, or a facility located in the vicinity of such office, or a regional
location with respect to regional meetings (not a cruise ship or a resort facility);
the payment or reimbursement is not applied to the expenses of guests of the associated
person (you cant bring your significant other along without them paying their way);
and
the payment or reimbursement by the offeror is not preconditioned by the offeror on
the achievement of a sales target or any other non-cash compensation arrangement.
If the meeting is approved by the employer member, there is no problem having the sponsor directly reimburse the attendee for travel expenses incurred in conjunction with attending
the seminarthe check does not have to go to your employer first.
TA K E N O T E
This has nothing to do with awards or bonuses made available to the member
firms own employees. The firm can compensate its own personnel however it wishes,
including holding sales contests and even paying year-end bonuses based on company profits to non-registered persons.
5. 3. 3. 3. 1 Sales Contests
FINRA is concerned that a retail sale of investment company shares might be influenced
by something other than the clients best interests. To that end, FINRA has prohibited any
type of incentive compensation conditioned on the sale of any specific fund or fund group
over any other. Furthermore, a member firm cannot establish recommended, selected, or
preferred lists of investment companies if such companies are recommended or selected on
the basis of brokerage commissions expected to be earned on their sale. The point is to do what
is best for your customer, not for your pocket.
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5. 3. 3. 4 Selling Dividends
It is improper to recommend that an investor buy mutual fund shares just before a dividend
distribution. The fund shares market value will decrease by the distribution amount on the
ex-dividend date, and the customer will incur a tax liability on the distribution. A registered
representative is forbidden to encourage an investor to purchase shares before a distribution
because of this tax liability, and doing so is a violation known as selling dividends.
5. 3. 3. 5 Breakpoint Sales
In a breakpoint sale, a customer unknowingly buys investment company shares in an
amount just below an amount that would qualify the investment for a reduction in sales
charges. As a result, the customer pays a higher dollar amount in sales charges, which reduces
the number of shares purchased and increases the cost basis per share.
Encouraging a customer to purchase in such a manner, or remaining silent when a customer unknowingly requests such a transaction, is unethical and violates the Conduct Rules.
TA K E N O T E
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The customer and the representative are both registered persons with the same firm.
The customer and the representative have a personal relationship outside of the broker-
customer relationship.
The customer and the representative have a business relationship outside of the brokercustomer relationship.
5. 3. 3. 8 Misrepresentations
Registered representatives and investment adviser representatives may not misrepresent
themselves or their services to clients or potential clients. Included in this prohibition are
misrepresentations covering:
qualifications, experience, and education;
nature of services offered; and
fees to be charged.
It is a misrepresentation to inaccurately state or fail to state a material fact regarding any
of the above.
5. 3. 3. 9 Research Reports
An investment adviser or a broker/dealer may not present to a client research reports,
analyses, or recommendations prepared by other persons or firms without disclosing the fact
that the adviser or broker/dealer did not prepare them. An adviser or a broker/dealer may base
a recommendation on reports or analyses prepared by others, as long as these reports are not
represented as the advisers or broker/dealers own.
5. 3. 3. 10 Conflicts of Interest
An investment adviser must disclose in writing to a client any areas in which the advisers
interests conflict or could potentially conflict with those of the client. Examples of such conflicts include:
affiliations between an adviser and any product suppliers;
compensation arrangements for advisory services to clients in addition to compensation
from such clients for such services; and
charging a client a fee for providing investment advice when the adviser or the advisers
employer will receive a commission for executing securities transactions based on that
advice.
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TA K E N O T E
An agent may share in an account with a customer if the agent has written
consent from both the customer and the employing firm and shares in profits
and losses proportionate to his contribution. In this situation, it is permissible to
commingle agent and customer funds. A firm and a customer may never have a joint
account.
5. 3. 3. 13 Fiduciary Information
During the course of business, employees of member firms will have access to proprietary
information regarding individual customers and securities issuers. Such information must be
treated with strict confidentiality.
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5. 3. 3. 14 Market Manipulation
Market manipulation is a deliberate attempt to interfere with the free and fair operation
of the market and create artificial, false, or misleading appearances with respect to the price
of a security.
TA K E N O T E
5. 3. 3. 15 Front Running
Front running is the unethical business practice of a broker/dealer or one of its representatives placing a personal order ahead of a previously received customer order. It occurs most
frequently when the firm has received an institutional order of sufficient size to move the market. By running in front of the order, the firm or representative can profit on that movement.
Under the rules of all regulators, this is a prohibited practice.
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At or prior to the time that a customer account is opened by a member on the premises of a
financial institution where retail deposits are taken, customers must be informed orally and in
writing that the securities sold by the broker/dealer are not insured by the FDIC, are not obligations of the financial institution, and are not guaranteed by it; they carry the risks that any
securities investment carries. Furthermore, the member must make reasonable efforts to obtain
a written statement from the customer acknowledging receipt of the above information.
Selling away
Breakpoint sale
Selling dividends
Material facts
Excessive trading
5. 3. 4
CRIMINAL PENALTIES
A person who is convicted of willfully violating federal securities regulations, or of knowingly making false or misleading statements in a registration document, can be fined up to $1
million, sentenced to prison for up to 10 years, or both. The maximum fine is $2.5 million for
other than a natural person (broker/dealers or other businesses).
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For the following business practices, write U for unlawful and L for lawful.
1. An agent explains to a mutual fund client that because the fund is
invested in government securities, the client will not lose principal.
2. A customer with a nondiscretionary account calls his representative and
instructs him to immediately buy 1,000 shares of an internet company of
the representatives choosing. The representative enters an order for 1,000
shares of XYZ, which has been a market leader all week.
3. An agent receives a call from the wife of his client, advising him to sell his
XYZ stock. The agent refuses the order.
4. A client writes a scathing letter to his agent regarding stocks that the
agent had recommended that had subsequently performed very poorly.
The agent calls the client and disposes of the letter after the client is
calmed.
5. A representative borrows $10,000 from his client, First Federal Bank of
Oconomowoc, Wisconsin.
6. An agent explains that because he is so convinced of the value of ABC
Company stock, he will buy it back from the client if it is not up 10% in
three months.
Terms and Concepts Checklist
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5. 4. 1
CODE OF PROCEDURE
The Code of Procedure was created to deal with alleged violations of SRO rules and
federal securities laws. If after an investigation or audit FINRA believes a member and/or its
associated persons have violated a rule or laws, the Department of Enforcement will request
authorization from the Office of Disciplinary Affairs to issue a complaint. If a complaint is
authorized, the Department of Enforcement issues the complaint. The complaint is in writing
and signed by the Department of Enforcement. The complaint specifies in reasonable detail
the conduct alleged to constitute the violative activity and the rule, regulation, or statutory
provision the respondent is alleged to be violating or to have violated. If the complaint consists of several causes of action, each cause is stated separately. Complaints shall be served by
the Department of Enforcement on each party and filed with the Office of Hearing Officers.
As soon as practicable after the Department of Enforcement has filed a complaint with the
Office of Hearing Officers, the Chief Hearing Officer shall assign a Hearing Officer to preside
over the disciplinary proceeding.
The hearing officer appoints two panelists to serve along with him as a three-person jury.
All panelists in Code of Procedure hearings are currently in or retired from the securities
industry.
The respondent (defendant) has 25 days after receiving the complaint to file an answer
with the Hearing Officer. 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 Department 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
decisionin other words, guilty as charged.
Note that if a complaint is filed against a registered representative, it is not unusual for that
persons designated supervisor (e.g., branch manager) to be charged for failure to supervise.
5. 4. 1. 1 Offer of Settlement
A respondent has the option of proposing a settlement. An offer to settle must be in writing 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;
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include a statement consenting to findings of fact and violations contained in the com-
plaint; and
propose sanctions consistent with the Associations sanction guidelines.
5. 4. 1. 1. 1 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 finalcase closed.
5. 4. 1. 1. 2 Contested Offer
If Enforcement opposes the offer, the offer is contested. At this point the offer and the
Departments written opposition are submitted to the Hearing Officer. The Hearing Officer
may order a settlement conference between the parties in an attempt to work out a compromise
or may forward the offer and the Departments 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. The good news is that if an offer of settlement is ultimately rejected,
it may not be introduced as evidence at the hearing.
TA K E N O T E
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.
TA K E N O T E
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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 per violation, and/or a letter of censure.
5. 4. 1. 4 Prehearing Conference
Assuming the respondent does not make an offer of settlement or if an offer made is
rejected and, assuming the Department of Enforcement doesnt offer either AWC or MRV
as options, a prehearing conference is scheduled. Under Code of Procedure rules, it must be
held within 21 days of receipt of the respondents answer to the complaint, and attendance is
mandatory.
5. 4. 1. 5 Hearing
At the hearing, which resembles a courtroom proceeding, the prosecution (Department
of Enforcement) goes first. Cross-examination of witnesses is permitted. At the conclusion,
panelists convene and, within 60 days, render a written decision reflecting the majority view.
5. 4. 1. 6 Sanctions
Sanctions against a member or associated person, if found guilty, are included with the
written decision. Under the Code of Procedure, sanctions could include one or more of the
following:
censure;
fine (an unlimited amount);
suspension of registration;
expulsion of the member or revoking or cancelling the registration of an associated per-
son;
If an associated person is suspended, that person may not remain associated with the member in any capacity, including a clerical or administrative capacity (during the suspension
period, that person may not remain on the members premises). Also, the member is prohibited from paying monies that the person might earn during the suspension period. Note that
the suspended person could be paid monies earned before the suspension period.
However, it is possible for a principal to be suspended from acting as a principal and continue to function as a registered representative until the end of the suspension. During that
period, no supervisory duties may be performed.
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5. 4. 1. 7 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 the decision date; 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
taking its case to the federal court system. Appealing a decision stays the effective date of any
sanctions, other than a bar or expulsion.
5. 4. 2
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. Unresolved customer disputes must be settled
under the Code of Arbitration Procedure.
Class action claims are not subject to arbitration, and claims alleging employment
discrimination, including sexual harassment claims, are not required to be arbitrated unless
the parties agree.
The advantages of arbitration versus suits in state or federal courts are time, money, and
the fact that all decisions are final and bindingno appeals are allowed.
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TA K E N O T E
333
Customers can initiate arbitration against firms, but firms cannot initiate arbitration against customers unless the customer has given written consent.
5. 4. 2. 2 Initiation of Proceedings
Any party to an unresolved dispute can initiate proceedings by filing a claim with the
Director of Arbitration of FINRA. The statement of claim must describe the dispute, include
documentation, and state the remedy being sought (in dollars). The Director will send a copy
of the claim to the respondent.
The respondent then has 45 calendar days to respond to both the Director and 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 respondents 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.
5. 4. 2. 3 Mediation
If both parties agree, a process called mediation may take place before any hearings convene, in which the two parties meet together to work out a settlement. The process is facilitated by a mediator. The mediator has no power to decide the outcome; settlement only occurs
with both parties approval. Therefore, if successful, there is no appeal.
5. 4. 2. 4 Selection of Arbitrators
FINRA maintains a list of nonpublic and public arbitrators. A non-public arbitrator is one
who is, or was, within the past five years, associated with a broker/dealer or registered under
the Commodity Exchange Act. A public arbitrator is one who is not engaged directly or indirectly in the securities or commodities business. In disputes involving a customer, the majority
of arbitrators will be public, unless either side chooses to have an all-public panel.
5. 4. 2. 5 Simplified Arbitration
Any dispute involving a dollar amount of $50,000 or less is eligible for simplified arbitration, in which a single arbitrator reviews all of the evidence and renders a binding decision
within 30 business days. If the dispute only involves persons in the industry, it is referred to
as simplified industry arbitration. Note that both parties have to agree to this procedure, or a
formal hearing is required.
5. 4. 2. 6 Awards
All monetary awards must be paid within 30 days of decision date. Any award not paid
within this time frame will begin to accrue interest as of the decision date. All awards and
details on the underlying arbitration claim are made publicly available by FINRA.
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5. 4. 2. 7 Failure to Act
Action by members requiring associated persons to waive the arbitration of disputes is also
a rules violation.
5. 4. 2. 8 Statute of Limitations
No claim is eligible for submission to arbitration if six years or more have elapsed from the
time of the event giving rise to the claim.
problem between parties associated with the securities industry, choose the
Code of Arbitration Procedure.
Arbitration is the industry choice over civil court because it is cheaper. There
True or False?
1. In the absence of a signed arbitration agreement, customers can still force
member firms to arbitration, but member firms cannot force customers to
arbitration.
2. In customer simplified arbitration, a panel of three arbitrators reviews all
the evidence and renders a binding decision.
3. The statute of limitations for submission of a claim to arbitration is six
years.
4. Under the Code of Arbitration, a respondent to a statement of claim must
respond to the Director of Arbitration and the claimant within 45 days.
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Match the following numbers with the appropriate description below. Choices can be
used more than once.
A.
B.
C.
D.
25
45
21
30
Code of Procedure
Department of Enforcement
Response times
Offer of settlement
Initiation of proceedings
Appeals process
Code of Arbitration Procedure
Predispute arbitration agreement,
Rule 3110
Mediation
Public arbitrator
Nonpublic arbitrator
Simplified arbitration
Awards under arbitration
Statute of limitations
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for a person other than an individual, documents showing the existence of the entity, such
5. 5. 1
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337
are reported on Currency Transaction Reports (CTRs) and must be reported electronically
to the Treasury Departments Financial Crimes Enforcement Network (FinCEN) on Form
112. This requirement applies to cash transactions used to pay off loans, the electronic transfer of funds, or the purchase of stocks, bonds, and mutual funds, as well as other investments.
Information must be supplied on both the transmitter and the recipient.
There is no limit on the amount of money that can be taken out of or brought into the
United States. However, if a person or persons traveling together and filing a joint declaration have more than $10,000 in currency or negotiable monetary instruments, they must
fill out a Report of International Transportation of Currency and Monetary Instruments
FinCEN105.
The BSA, through regulations issued and administered by FinCEN, requires financial
institutions, including broker-dealers registered with the SEC, to make, keep, retain and
report certain records that are useful for the purposes of criminal, tax, regulatory investigations or proceedings.
5. 5. 2
in number or size.
If an SAR is filed, the person identified in the report must not be informed.
5. 5. 3
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Money laundering generally takes place in three stages. Placement is the stage when funds
are moved into the system. It is the most vulnerable to detection. Layering is the stage when a
confusing set of transactions is conducted to make the origin of the funds unclear. Integration
is the stage when the funds are invested in legitimate enterprises.
establish and implement policies, procedures, and internal controls reasonably designed to
TA K E N O T E
Each firms procedures must reflect their unique business model and customer
base.
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True or False?
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U N I T
T E S T
5. After a FINRA audit, the Department of Enforcement issues a formal complaint against a member
firm for violations of the Conduct Rules. This
complaint will be handled under the
A. Uniform Practice Code
B. Code of Procedure
C. Code of Arbitration
D. United States Code
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14. In what order do the three stages of money laundering take place?
I. Initiation
II. Placement
III Integration
IV. Layering
A.
B.
C.
D.
I, III, IV
I, IV, III
II, III, IV
II, IV, III
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A N S W E R S
A N D
343
R A T I O N A L E S
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Q U I C K
Q U I Z
A N S W E R S
1. B.
2. D.
3. C.
4. E.
5. A.
Quick Quiz 5.D
1. U. It is unlawful to guarantee performance of
any security. Even government bond funds
may lose principal value.
2. U. It is unlawful to enter a discretionary order
without written authorization. This order is
discretionary because the agent selected the
company.
3. L. An agent must refuse to enter an order from
someone, other than the customer, without
proper written authorization.
4. U. All written customer complaints must be
forwarded to the principal.
5. L. Agents may borrow money from customers
that are recognized financial institutions.
6. U. This agent is guaranteeing protection against
loss, and this activity is prohibited.
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3. T.
4. T.
5. A.
6. A.
7. D.
8. C.
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6
Suitability and Risk
347
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OBJECTIVES
When you have completed this Unit, you should be able to:
define the concept of suitability;
state the various items that make up a useful customer profile;
evaluate basic investment risks that customers face; and
apply skill of matching customer objectives with suitable investment recommendations.
348
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349
6. 1. 1
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350
How much do you pay in monthly expenses? Is this a stable figure? Do you expect a change
TA K E N O T E
TA K E N O T E
6. 1. 2
Items that must be added back in for the purpose of the AMT computation are
sometimes called tax-preferenced items. If the tax liability computed under the AMT
computation is greater than the taxpayers regular tax computation, the taxpayer
must pay the AMT amount.
Watch for a question that asks you to identify Industrial Development Revenue
Bonds (IDRs) as a tax preference item when calculating AMT.
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351
example). Nonfinancial considerations often carry more weight than the financial ones and
include the following:
Age
Marital status
Number and ages of dependents
Employment
Employment of family members
Current and future family educational needs
Current and future family health care needs
Risk tolerance
Attitude towards investing
Tax status
No matter how much an analysis of a customers financial status tells the representative
about their ability to invest, it is the customers emotional acceptance of investing and motivation to invest that mold the portfolio.
To understand a customers aptitude for investment, the representative should ask questions similar to the following.
What kind of risks can you afford to take?
How liquid must your investments be?
How important are tax considerations?
Are you seeking long-term or short-term investments?
What is your investment experience?
What types of investments do you currently hold?
How would you react to a loss of 5% of your principal? 10%? 50%?
What level of return do you consider good? Poor? Excellent?
What combination of risks and returns do you feel comfortable with?
What is your investment temperament?
Do you get bored with stable investments?
Can you tolerate market fluctuations?
TA K E N O T E
6. 1. 3
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6. 1. 3. 1 Preservation of Capital
For many people, the most important investment objective is to preserve their capital. In general, when clients speak of safety, they usually mean preservation of capital.
Recommendations may include money market mutual funds or certificates of deposit (CDs).
6. 1. 3. 2 Current Income
Many investors, particularly those on fixed incomes, want to generate additional current
income. Traditional debt securities such as corporate, government, municipal bonds, and
agency securities may provide steady interest income. In addition, many equity securities are
purchased for the dividends they produce; these include preferred stocks, utilities, and blue
chip stocks that have a solid dividend paying history. Lets not forget that there are many
pooled investments that can provide income as well, such as income-oriented mutual funds
and real estate investment trusts (REITs).
6. 1. 3. 3 Capital Growth
Growth refers to an increase in an investments value over time. This can come from
increases in the securitys value, the reinvestment of dividends and income, or both. The most
common growth-oriented investments are common stock and stock mutual funds.
EXAMPLE
6. 1. 3. 4 Tax Advantages
Investors often seek ways to reduce their taxes. Some products, like individual retirement
arrangements (accounts) (IRAs) and annuities, allow interest to accumulate tax deferred (an
investor pays no taxes until money is withdrawn from the account). Other products, like
municipal bonds, offer tax-free interest income.
TA K E N O T E
Municipal bonds, which provide tax-free investment income, are not suitable for
retirement accounts. Why buy tax-free interest income that will be fully taxable upon
withdrawal?
6. 1. 3. 5 Portfolio Diversification
Investors with portfolios concentrated in only one or a few securities or investments are
exposed to much higher risks. For them, portfolio diversification can be an important objective. These customers are typically retirees with large profit-sharing distributions of one companys stock or investors with all of their money in CDs or U.S. government bonds.
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Speculation
Growth
Safety
6. 1. 3. 6 Liquidity
Some people want immediate access to their money at all times. A product is liquid if a
customer can sell it quickly at face amount (or very close to it) or at a fair market price without
losing significant principal. Liquid investments include:
securities listed on an exchange or unlisted Nasdaq securities;
mutual funds; and
publicly traded REITS.
6. 1. 3. 7 Speculation
A customer may want to speculatethat is, try to earn much higher than average returns
in exchange for higher than average risks. Investors who are interested in speculation may be
interested in
option contracts;
DPPs;
high-yield bonds;
unlisted or non-Nasdaq stocks or bonds;
sector funds;
precious metals;
commodities; and
futures.
As a registered representative, one must always determine the suitability of such
recommendations.
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Recommendations
Preservation of Capital/Safety
Growth
(Balanced/moderate growth)
(Aggressive growth)
Income
(Tax-free income)
(High-yield income)
Portfolio Diversification
Speculation
2. Which of the following investments is LEAST appropriate for a client who is primarily concerned with liquidity?
A.
B.
C.
D.
Preferred stock
Municipal bond mutual funds
Bank savings accounts
Direct participation programs
3. Which of the following securities generates the greatest current income with
moderate risk?
A.
B.
C.
D.
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Zero-coupon bond
Growth stock
Mutual fund investing in small-cap issues
GNMA mutual fund
5. Which of the following would be considered nonfinancial investment considerations on a customer profile?
I.
II.
III.
IV.
A.
B.
C.
D.
Customer profile
Financial investment considerations
Nonfinancial investment
considerations
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6. 2. 1
SUITABILITY
Registered representatives must always know their client prior to making any recommendation. A customers investment objectives may lead to a recommendation to buy, sell, or
hold a security. All recommendations, even a hold recommendation, must be suitable for the
clients situation.
If a customer wishes to open an account and refuses to provide suitability information, the
account may be opened but the firm (rep) may not make any recommendations.
Selecting suitable investments to meet investor needs is an art and a science, and negotiating the difference between what the representative considers suitable and what the customer
wants is a legal, ethical, and personal dilemma.
If a customer asks a representative to enter a trade the representative feels is unsuitable, it
is the representatives responsibility to explain why the trade might not be right for the customer. If the customer insists on entering the transaction, the representative should have the
customer sign a statement acknowledging that the representative recommended against the
trade, and the representative should mark the order ticket unsolicited.
Suitability issues can involve things like the source of the investors funding. A customer
may wish to liquify some of the additional equity available on his home in order to invest in a
security. The customer must be made aware of the substantial risks inherent in such a step.
6. 2. 2
INVESTMENT RISKS
In general terms, the greater the risk the investor assumes, the greater the potential for
reward. Representatives should consider all potential risks in determining the suitability of
various types of investments. Following are the most common risks. Those that affect all investments are called systematic risks. Those that affect some and not others are nonsystematic.
6. 2. 2. 1 Business Risk
Whether caused by bad management or unfortunate circumstances, some businesses will
inevitably fail, even more so during economic recessions. Typically when a business fails, it
liquidates (sells off its assets) in a bankruptcy, pays its creditors from the proceeds, and pays
whatever is left, if anything, to its shareholders. Business risk is a form of nonsystematic risk,
it affects companies and industries individually. Business risk can be reduced by diversifying
investments.
6. 2. 2. 2 Inflation Risk
Also known as purchasing power risk or constant dollar risk, inflation risk is the effect
of continually rising prices on investments, resulting in less purchasing power as time goes on
on. A client who buys a fixed return security such as a bond, fixed annuity, or preferred stock
may not see the investment keep pace with inflation.
6. 2. 2. 3 Capital Risk
Capital or principal risk is the potential for an investor to lose all his money (invested
capital) under circumstances either related or unrelated to an issuers financial strength.
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6. 2. 2. 4 Timing Risk
Even an investment in the soundest company with the most profit potential might do
poorly simply because the investment was timed wrong. The risk to an investor of buying or
selling at the wrong time and incurring losses or lower gains is known as timing risk.
Short-term interest rates are more volatile than long-term interest rates because
they change more frequently. For your test, the Federal Funds rate is most volatile
because it changes daily. Make sure you differentiate between the question that is
asking about interest rate volatility (short term is more volatile) versus price volatility
(long term is more volatile).
6. 2. 2. 6 Reinvestment Risk
When interest rates decline, it is difficult for bond investors to reinvest the proceeds from
investment distributions and maintain the same level of return at the same level of (default)
risk. Reinvestment risk is mostly associated with bonds that mature or when a bond or preferred stock is called by the issuer.
6. 2. 2. 7 Market Risk
Both stocks and bonds involve some degree of market riskthe risk that investors may
lose some of their principal due to price volatility in the overall market (also known as systematic risk).
An investor cannot diversify away market risk. If the entire market is in a tailspin, all of
the investors securities will likely decline.
6. 2. 2. 8 Credit Risk
Credit risk, also called financial risk or default risk, involves the danger of losing all or
part of ones invested principal through an issuers failure. Credit risk is associated with debt
securities, not equity securities, and varies with the investment product.
Bonds backed by the federal government or municipalities tend to be very secure and have
low credit risk. Long-term bonds involve more credit risk than short-term bonds because of the
increased uncertainty that results from holding bonds for many years.
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Bond investors concerned about credit risks should pay attention to the ratings. Two of the
best known rating services that analyze the financial strength of thousands of corporate and
municipal issuers are Moodys Investors Service and Standard & Poors Corporation.
To a great extent, a bonds value depends on how much credit risk investors take. The
higher the rating, the less likely the bond is to default and, therefore, the lower the coupon
rate. Clients seeking the highest possible yields from bonds might want to buy bonds with
lower ratings; higher yields reward investors for taking more credit risk.
There is also a variable price difference between speculative and investment grade debt,
other things such as maturity date being equal. During times of confidence in the economy,
the price of a AAA bond and that of a BB bond, for example, will be closer together than
during periods of economic uncertainty. This reflects investors reduced willingness to take
risks during periods of uncertainty: speculative debt is discounted more than during periods of
confidence.
6. 2. 2. 9 Liquidity Risk
The risk that a client might not be able to sell an investment is known as liquidity risk.
The marketability of the securities you recommend must be consistent with the clients liquidity needs.
6. 2. 2. 10 Legislative/Political/Social Risk
Legislative risk exists because federal and state legislatures have the power to change laws
and this can impact securities (companies) negatively and result in capital loss for investors.
Risk associated with the possibility of unfavorable government action or social changes resulting in a loss of value is also called social risk or political risk. Political risk is an important risk
to discuss when recommending foreign or international investments as governments outside
the U.S. may not be as stable as ours.
6. 2. 2. 11 Call Risk
Related to reinvestment risk, call risk is the risk that a bond might be called before maturity and investors cannot reinvest their principal at the same or a higher rate of return. When
interest rates are falling, bonds with higher coupon rates are most likely to be called.
Investors concerned about call risk should look for call protection, a period of time during
which a bond may not be called. Corporate and municipal issuers generally provide some years
of call protection.
6. 2. 2. 12 Currency Risk
This is the risk that changes in the rate of exchange will adversely affect an investment. As
a rule of thumb, an investor who purchases an international fund (e.g., a foreign bond fund)
will lose if the U.S. dollar appreciates against the foreign currency. The investor will profit if
the U.S. dollar weakens (depreciates) against the foreign currency.
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A.
B.
C.
D.
E.
1. Liquidity risk, or the risk that a security cannot be sold quickly at a fair
market price
4. Systematic risk, or the risk that principal may be lost due to price volatility
of the market
5. Social risk, or the risk associated with the possibility of unfavorable government action or social changes resulting in a loss of investment value.
True or False?
6. Interest rate risk is generally associated with equity investments.
7. Default risk is the risk of losing invested principal due to the issuers financial failure.
8. Reinvestment risk is highest when interest rates are rising.
9. Liquidity risk is also known as systematic risk.
10. Bonds backed by the federal government tend to have low credit risk.
Investment objectives
Safety, capital
preservation
Investment risks
Business risk
Inflation, purchasing
Income
power risk
Growth
Capital risk
Timing risk
Interest rate risk
Tax advantages
Diversification
Liquidity
Reinvestment risk
Market risk
Credit, financial risk
Liquidity,
marketability risk
Legislative risk
Call risk
Currency risk
Speculation
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U N I T
T E S T
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362
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A N S W E R S
A N D
R A T I O N A L E S
363
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364
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Q U I C K
Q U I Z
A N S W E R S
1. C.
365
2. D.
3. B.
4. A.
5. E.
6. F. Bonds are most affected by interest rate risk.
7. T.
8. F. When interest rates are rising, there is little
reinvestment risk for debt investors.
9. F. Market risk and systematic risk are
synonymous terms that describe the risk of
investors losing money due to market price
volatility in the overall market.
10. T.
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M U T U A L F U N D C U S T O M E R
S U I T A B I L I T Y Q U I Z
Joe Smith is a registered representative with ABC Investments, Inc. Last week, Joe opened accounts for 10 new customers.
Each customer wants Joe to recommend the best mutual fund that he can find.
Joe knows that the best mutual fund for one customer is not necessarily the best choice for every customer. Before he
makes a recommendation, he collects important information about the customers needs, goals, and financial status. For
example, Joe asks each customer:
What is your income?
How stable is your income?
What plans do you have for the money you invest?
What kinds of risks are you comfortable taking?
How liquid must your investments be?
How important are tax considerations?
Are you seeking long-term or short-term investments?
What is your investment experience?
After Joe has noted a customers financial status and investment objectives, he can begin to search for the most appropriate
mutual fund. Joe has prepared a brief description of each of his 10 new customers and this is followed by a list of top-performing mutual funds in 10 categories.
Which mutual fund would you recommend to each of Joes customers? After you have read the descriptions of the customers and the funds, answer each question based upon which fund best meets the customers objectives. Fund descriptions are
listed below.
The Customers
1. Andy Jones, 52, and Patty Jones, 56, have a large investment portfolio concentrated in stocks and stock mutual
funds, including an international fund. They maintain their cash reserves in a money market account at their local
bank. Andy is employed as a consultant, where he earns a $400,000/year salary. The Joneses are seeking a safe
investment because they will need to liquidate a portion of their portfolio when Andy retires in about 5 years.
They also recognize the need for additional diversification of their portfolio.
A. Spencer Cash Reserve Fund
B. MacDonald Balanced Fund
C. Spencer Tax-Free Municipal Bond Fund
D. MacDonald Stock Index Fund
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2. Sarah Davis, 30, and Jim Davis, 32, have been married for 4 years. Both work and they have no children, so their
disposable income is relatively high. They live in the suburbs and plan to buy a condominium downtown so they
can enjoy some of their favorite activities on the weekends. They need a safe place to invest the amount they
have saved for their down payment for about 6 months while they shop for the perfect unit.
3. Adam Garcia is 26 and earns $45,000/year as an advertising executive. He already has accumulated $5,000 in
a savings account and is seeking a secure place to invest the amount and begin a periodic investment plan. He
knows his long-term time-frame means he should be willing to take some risk, but he is uncomfortable with the
thought of losing money. Adam would prefer moderate overall returns rather than high returns accompanied by
high volatility.
4. Mark Blair is a retired widower, 72, seeking a moderate level of current income to supplement his Social Security
benefits and his company pension plan. Mark is a Depression-era grandfather of 6 with a conservative attitude
toward investments. An equally important goal for him is capital preservation.
5. Helen Wong is 29 and is seeking a long-term growth investment. She is concerned about the loss of purchasing
power as a result of inflation and often complains about high commissions and charges that reduce her investment returns. When she was in college, she took a few economics courses and firmly believes that securities
analysts cannot consistently outperform the overall market.
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6. Gina and Peter Stout, both 42, have two children, ages 14 and 12. The Stouts have spent the past 10 years accumulating money to provide for their childrens education. Their oldest child will enter college in 4 years and they
are not willing to take risks with the money they worked hard to accumulate. They need a safe investment that
provides regular income to help them meet tuition payments.
7. Pat Long, 60, and Sadie Long, 58, are married and have raised 3 children. Both have decided to retire this year
and are looking forward to an active retirement. They have accumulated a nest egg of about $1 million, which
they plan to use to travel the world, pursue their hobbies, and care for their health. Both are concerned about rising inflation and are comfortable with a reasonable level of risk.
8. Amy Cain, 50, and Eric Cain, 48, have a combined annual income of more than $200,000. Their portfolio consists
of common stocks and bonds that offer a wide range of safety and return potential. The Cains are becoming
even more concerned about the effects of rising inflation in the U.S. economy. They are seeking to invest a small
percentage of their portfolio in a fund that will provide additional diversification.
9. Mike and Mary Cole are both 34 and employed in their computer software business. They have one daughter,
age 4. The Coles want to begin accumulating the money required to send their daughter to one of the nations
top universities in 14 years. In addition, they have not yet begun to accumulate money for their retirement.
4/23/2015 2:33:27 PM
370
10. Liz Scott, 45, is single and in search of maximum capital appreciation. She inherited a substantial amount of
money a few years ago and has taken an active interest in managing her investments. Her portfolio is diversified
among common stocks, tax-exempt bonds, international investments, and limited partnerships. She has a longterm time frame and is not averse to risk.
ATF Biotechnology Fund. The fund seeks maximum capital appreciation through investment in stocks of companies
providing innovative products in the biotechnology sector, including pharmaceutical developers and medical equipment
suppliers. Fund management seeks to evaluate emerging economic and political trends and to select individual companies that may benefit from technological advances.
ATF Capital Appreciation Fund. The fund seeks to achieve maximum capital appreciation with little or no pursuit of
current income. The fund invests in stocks of small and medium-size companies that demonstrate significant long-term
growth potential. The funds management believes that despite year-to-year fluctuations, the strategy of investing in
companies that show strong earnings growth can result in superior investment returns.
ATF Overseas Opportunities Fund. The fund seeks maximum capital appreciation by investing in common stocks
of companies located outside the United States. The management selects well-established companies that are listed on
their native stock exchanges and that have demonstrated high earnings potential. Although the fund may be affected by
fluctuations in currency exchange rates, over the long term it may provide protection against downturns in U.S. markets.
Laramie Equity Income Fund. The fund seeks primarily current income, with secondary objectives of capital growth
and growth of income. Its portfolio consists of common stock, preferred stock, and convertible securities of large, wellestablished companies with a history of paying high dividends. Its equity concentration can help protect against the loss
of purchasing power owing to inflation.
MacDonald Balanced Fund. The fund seeks to preserve capital, to generate current income, and to provide long-term
capital growth. Its strategy is to invest 60% of its portfolio in common stocks and 40% in bonds and fixed-income securities. Through diversification, the fund intends to provide protection against downturns in the market. In its endeavors
to produce positive returns during market decline, the fund may not participate fully in rising stock markets.
MacDonald Investment-Grade Bond Fund. The fund seeks high current yield accompanied by reasonable risk.
It invests most of its portfolio in corporate bonds having one of the top three ratings according to Moodys and Standard
& Poors. It seeks to reduce the risk associated with interest rate fluctuations by investing a portion of its assets in shortterm corporate debt.
MacDonald Stock Index Fund. The fund seeks to duplicate the price and yield performance of Standard & Poors
Composite Index of 500 stocks. The fund invests in each of the indexs 500 stocks in approximately the same composition as the index. The portfolio is not actively traded and therefore features a low turnover ratio.
Spencer Cash Reserve Fund. The funds objectives are to maintain a stable net asset value and to provide current
income. The fund invests in high-quality short-term obligations, including U.S. Treasury bills, commercial paper certificates of deposit, and repurchase agreements. Check-writing privileges are available.
4/23/2015 2:33:27 PM
371
Spencer Tax-Free Municipal Bond Fund. The fund seeks to maximize tax-exempt current yield. It invests in a portfolio
of high-quality municipal debt obligations. The portfolio is diversified among securities issued by many different state
and municipal taxing authorities. Income distributions provided by the fund are exempt from federal income tax.
XYZ Government Income Fund. The fund seeks to maximize safety of invested principal while providing current
income. By investing in a broad range of debt securities issued by the U.S. Treasury as well as by government agencies
such as the Government National Mortgage Association, the fund provides reduced risk. It aims for a current yield higher
than the yield of short-term debt instruments and money market instruments.
4/23/2015 2:33:27 PM
372
M U T U A L F U N D C U S T O M E R S U I T A B I L I T Y
Q U I Z A N S W E R S A N D R A T I O N A L E S
1. C. Spencer Tax-Free Municipal Bond
Fund The Joneses are almost entirely
invested in the stock market. As they
approach retirement, they should shift
some of their portfolio to bonds. Because
they are in a high tax bracket, a municipal
bond fund best meets their objectives of
diversification and safety.
2. C. Spencer Cash Reserve Fund Jim and
Sarah Davis are preparing to make a major
purchase within the next 6 months. They
require a highly liquid investment to keep
their money safe for a short time. The
money market fund best matches this
objective.
3. B. MacDonald Balanced FundAdam
Garcia is a young investor who is at
the beginning of his investment cycle.
For other investors in his situation, an
aggressive growth fund might help achieve
maximum capital appreciation over a
long-term timeframe. However, Adam is
risk averse and has not had any experience
investing in the securities markets. A
balanced fund is a good place to begin
investing for moderate return and low
volatility.
4. C. XYZ Government Income FundMark
Blair requires maximum safety and current
income. While all fixed-income funds
aim to provide current income, the U.S.
government bond fund offers the best
combination of safety and a higher yield
than a money market fund.
5. B. MacDonald Stock Index FundHelen
Wong requires a mutual fund that offers
the potential for long-term capital growth.
She believes money managers cannot
consistently outperform the overall market;
this indicates that an index fund that
attempts to match the performance of
the stock market is the most appropriate
investment for her.
4/23/2015 2:33:27 PM
Common Abbreviations
ADR/ADS American depository receipt (share)
BA bankers acceptance
BD broker/dealer
CD certificate of deposit
Principal of Securities
373
4/23/2015 2:33:28 PM
4/23/2015 2:33:28 PM
Calculations
To Calculate
Dividend Yield (or Current Yield for Stocks)
Parity
Use Formula
Annual Dividend
Current Market Price
Annual Interest
Current Market Price
Par Value
Conversion Price
Bond Market Value
Number of Shares on Conversion
Corporate Rate (100% Tax Bracket)
Municipal Rate
(100% Tax Bracket)
Fund Net Assets
Number of Shares Outstanding
POP NAV
POP
NAV per Share
(100% Sales Charge Percentage)
NAV + Sales charge
Total of Share Prices
Number of Investments
Total Dollars Invested
Number of Shares Purchased
Issued Shares Treasury Shares
Assets Liabilities
375
4/23/2015 2:33:28 PM
4/23/2015 2:33:28 PM
Glossary
A
account executive (AE) See registered representative.
accredited investor As defined in Rule 502 of Regulation
allocation and management aimed at achieving maximum return. Aggressive investors place a high percentage of their investable assets in equity securities and a
far lower percentage in safer debt securities and cash
equivalents, and they pursue aggressive policies including margin trading, arbitrage, and option trading.
use by newspapers, magazines, billboards, radio, television, telephone recordings or other public media where
the firm has little control over the type of individuals
exposed to the material.
377
4/23/2015 2:33:28 PM
378
Glossary
distribution.
the amount of each payment during an annuitys distribution stage. The calculation takes into account the
value of each accumulation unit and such other factors
as assumed interest rate and mortality risk.
financial instrument in two different markets simultaneously to take advantage of a momentary price
disparity.
between members, member organizations, their employees, and customers to be heard and settled by either
FINRA or a designated arbitration panel. Once the
process is agreed to by both parties, there is no appeal.
tive bids and sellers enter competitive offers simultaneously. The NYSE is an auction market. Syn. double
auction market.
ties from one trading account to another at a different brokerage firm or bank.
4/23/2015 2:33:28 PM
379
Glossary
B
back-end load A commission or sales fee that is charged
tions assets equal the sum of its liabilities plus shareholders equity.
policy is to have at all times some portion of its investment assets in bonds and preferred stock as well as in
common stock in an attempt to provide both growth
and income.
BD See broker/dealer.
state.
4/23/2015 2:33:28 PM
380
Glossary
issuers default, based on an analysis of the issuers financial condition and profit potential. Standard & Poors,
Moodys Investors Service, and Fitch Investors Service,
among others, provide bond rating services.
each share of common stock. It is calculated by subtracting intangible assets and preferred stock from total
net worth, then dividing the result by the number of
shares of common outstanding. Syn. net tangible assets
per share.
C
call (1) Option contract giving the owner the right to
corporation and its bondholders or preferred stockholders giving the corporation the option to redeem its
senior securities at a specified price before maturity and
under certain conditions. Syn. call feature.
4/23/2015 2:33:28 PM
381
Glossary
real estate, and other property, held for the long term.
deals in instruments with more than one year to maturitythat is, long-term debt and equity securities.
out of the corporations current earnings or accumulated profits. The board of directors must declare all
dividends.
maintains the qualification, employment, and disciplinary disclosure histories of the more than half a million
registered securities employees of member firms through
the automated, electronic Web CRD system. You can
go to the FINRA Website to get CRD information or
call them toll-free.
of or creditorship in a corporation.
method of handling securities-related disputes or clearing controversies between members, public customers,
clearing corporations, or clearing banks. Such disputes
involve violations of the Uniform Practice Code rather
than the Conduct Rules. Any claim, dispute, or controversy between member firms or associated persons must
be submitted to arbitration.
4/23/2015 2:33:28 PM
382
Glossary
for arranging a securitys purchase or sale. A commission must be fair and reasonable, considering all the
relevant factors of the transaction.
kerage firm that oversees the firms trading and marketmaking activities. It ensures that the firms employees
and officers abide by the rules and regulations of the
SEC, exchanges, and SROs.
settlement date, and money due from or owed to a customer. It is sent or given to the customer on or before
the settlement date.
4/23/2015 2:33:28 PM
383
Glossary
per par value amount that the holder would receive for
converting a convertible bond or preferred share. Syn.
conversion rate.
that can be exchanged for common stock at specified prices or rates. Dividends may be cumulative or
noncumulative.
cost basis The price paid for an asset, including any com-
be established for the purpose of paying qualified education expenses for the designated beneficiary of the
account. Although contributions to ESAs are not tax
deductible, the distributions are tax-free as long as the
distributions are taken to pay for allowable educational
expenses. The maximum annual contribution is $2,000
per beneficiary.
will default in the payment of either principal or interest. Syn.default risk; financial risk.
4/23/2015 2:33:28 PM
384
Glossary
tion Procedures.
ing all investment, management, and distribution decisions in an account maintained in the best interests of
another. Mutual funds have custodians responsible for
safeguarding certificates and performing clerical duties.
D
dealer (1) An individual or a firm engaged in the business
due.
level of prices.
4/23/2015 2:33:29 PM
385
Glossary
face value.
preferred stock investment. Yield is calculated by dividing the annual dividend by the stocks current price.
4/23/2015 2:33:29 PM
386
Glossary
securities becomes effective, allowing the underwriters to sell the newly issued securities to the public and
confirm sales to investors who have given indications of
interest.
1974.
the buyer is not entitled to receive distributions previously declared. Syn. ex-dividend date.
requirements (although not from the antifraud requirements) of the Securities Act of 1933. Examples include
U.S. government securities and municipal securities.
the money supply, usually with the intention of lowering interest rates and combatting deflation.
F
face-amount certificate company (FAC) An invest-
4/23/2015 2:33:29 PM
387
Glossary
Formed in July 2007 by merger of the National Association of Securities Dealers (NASD) and New York
Stock Exchange Regulation, Inc. It is the self-regulatory
organization for the over-the-counter securities market
and for members of the New York Stock Exchange.
publicly held corporation that buys conventional mortgages and mortgages from government agencies, including the Federal Housing Administration, Department
of Veterans Affairs, and Farmers Home Administration.
Syn. Fannie Mae.
mittee that makes decisions concerning the Feds operations to control the money supply.
that directs the operations of the Federal Reserve System. The President appoints board members, subject to
Congressional approval.
4/23/2015 2:33:29 PM
388
Glossary
explaining a contractual plans sales charge and operation. The letter must be sent within 60 days of a sale.
During the free-look period, the investor may terminate
the plan without paying a sales charge. Syn. 45-day
letter.
G
general account The account that holds all of an
government, backed by its full faith, credit, and taxing power, and regarded as having no risk of default.
The government issues short-term Treasury bills,
medium-term Treasury notes, and long-term Treasury
bonds.
4/23/2015 2:33:29 PM
389
Glossary
source derived.
a variable life insurance policy, other than the variable death benefit and the minimum death benefit,
and including but not limited to any accidental
death and dismemberment benefit, disability income
benefit, guaranteed insurability option, family income
benefit, or fixed-benefit term rider.
H
hedge fund A form of investment company which, as
null or void.
such as prices on a particular date. Indexes are frequently used in technical analysis.
4/23/2015 2:33:29 PM
390
Glossary
level of prices.
tutes the illicit use of nonpublic information in making securities trades and the liabilities and penalties
that apply. Syn. Insider Trading Act.
that trades securities in large enough share quantities or dollar amounts that it qualifies for preferential
treatment and lower commissions. An institutional
order can be of any size. Institutional investors are
covered by fewer protective regulations because it is
assumed that they are more knowledgeable and better able to protect themselves.
relating to the sensitivity of price or value to fluctuation in the current level of interest rates; also, the
risk that involves the competitive cost of money. This
term is generally associated with bond prices, but it
applies to all investments. Bonds carry interest rate
risk because if interest rates rise, outstanding bonds
will not remain competitive unless their yields and
prices adjust to reflect the current market.
tax liabilities and deductions for U.S. taxpayers.
recommendations in return for a flat fee or a percentage of assets managed. (2) For an investment company, the person who bears the day-to-day responsibility of investing the cash and securities held in the
funds portfolio in accordance with objectives stated
in the funds prospectus.
municipal or government securities dealer that underwrites or distributes new issues of securities as a dealer
or that buys and sells securities for the accounts of
others as a broker. Syn. investment securities business.
4/23/2015 2:33:29 PM
391
Glossary
investable assets according to an investments relative safety. The pyramid base is composed of low-risk
investments, the mid portion is composed of growth
investments, and the pyramid top is composed of
speculative investments.
J
joint account An account in which two or more indi-
that covers two or more people, with annuity payments continuing as long as one of the annuitants
remains alive.
K
Keogh plan A qualified tax-deferred retirement plan for
L
large-cap A measurement of a stocks market capitaliza-
investor to buy mutual fund shares at a lower overall sales charge, based on the total dollar amount
of the intended investment. An LOI is valid only if
the investor completes the terms of the agreement
within 13 months of signing the agreement. A letter
of intent may be backdated 90 days. Syn. statement of
intention.
4/23/2015 2:33:29 PM
392
Glossary
liabilities are debts payable within 12 months. Longterm liabilities are debts payable over a period of
more than 12 months.
license See Series 6; Series 7; Series 26; Series 63; Series 65.
life annuity/straight life An annuity payout option
secondary market. When the policy being sold is variable life, it is treated as the sale of a security subject
to all federal and FINRA regulations.
examination attesting to the knowledge and qualifications necessary to sell certain specified investment
products.
to cash in the marketplace. A large number of buyers and sellers and a high volume of trading activity
provide high liquidity.
M
Maloney Act An amendment enacted in 1938 to
4/23/2015 2:33:29 PM
393
Glossary
municipal bonds and operates either as a unit investment trust or an open-end fund. The funds objective
is to maximize federally tax-exempt income.
self-regulatory organization that regulates the issuance and trading of municipal securities. The Board
functions under the Securities and Exchange Commissions supervision; it has no enforcement powers.
4/23/2015 2:33:30 PM
394
Glossary
offers new equity shares in an actively managed portfolio of securities. All shareholders participate in the
funds gains or losses. The shares are redeemable on
any business day at the net asset value. Each mutual
funds portfolio is invested to match the objective
stated in the prospectus. Syn. open-end investment
company; open-end management company.
N
Name Rule The Name Rule requires that any investment
company whose name implies a certain type of portfolio composition must have at least 80% of its assets
invested as implied.
are registered if that person is other than the beneficial owner. This is a brokerage firms role when
customer securities are registered in street name.
4/23/2015 2:33:30 PM
395
Glossary
ally identifiable financial information that is not publicly available. Non-public information includes but
is not limited to name, address, city, state, Zip code,
telephone number, Social Security number, credit
card number, bank account number and financial
history.
years or less.
O
odd lot An amount of a security that is less than the
offer (1) See ask. (2) Under the Uniform Securities Act,
meeting the requirements of SEC Rule 482. Performance data may be presented, but orders may not be
taken for fund shares.
P
par The dollar amount the issuer assigns to a security. For
4/23/2015 2:33:30 PM
396
Glossary
Boards Regulation T, the period of time corresponding to the regular way settlement period administered
by FINRA.
value of $1,000.
capital gains.
4/23/2015 2:33:30 PM
397
Glossary
the income of high-income earners than that of lowincome earners (e.g., graduated income tax).
Q
qualification See registration by qualification.
qualified retirement plan A corporate retirement plan
that meets the standards set by the Employee Retirement Income Security Act of 1974. Contributions
to a qualified plan are tax deductible. Syn. approved
plan.
discretion in a fiduciary account to only those investments that a reasonable and prudent person might
make.
R
rating An evaluation of a corporate or municipal bonds
or trust that uses the pooled capital of many investors to invest in direct ownership of either income
property or mortgage loans. These investments offer
tax benefits in addition to interest and capital gains
distributions.
tors establishes that determines which of its stockholders are entitled to receive dividends or rights
distributions.
4/23/2015 2:33:30 PM
398
Glossary
engaged in the investment banking or securities business. According to FINRA, this includes any individual who supervises, solicits, or conducts business
in securities or who trains people to supervise, solicit,
or conduct business insecurities. Anyone employed
by a brokerage firm who is not a principal and who is
not engaged in clerical or brokerage administration
is subject to registration and exam licensing as a registered representative. Syn. agent (under state laws);
stockbroker.
4/23/2015 2:33:30 PM
399
Glossary
risk
1. b
usiness or financial risk The risk that the busi-
2. c
redit risk A risk that applies with debt securities
and principal are payable only from the specific earnings of an income-producing public project. See also
general obligation bond; municipal bond.
4. m
arket risk The uncertainty that a particular
5. m
oney rate or interest rate risk Interest rates
6. p
urchasing power or inflation risk The uncer-
S
sales charge The term used to describe the cost involved
4/23/2015 2:33:30 PM
400
Glossary
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.
that established the Securities and Exchange Commission. The act aims to protect investors by regulating the exchanges, the over-the-counter market, the
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.
to buy mutual fund shares by implying that an upcoming distribution will benefit them.
4/23/2015 2:33:30 PM
401
Glossary
Separate Trading of Registered Interest and Principal of Securities (STRIPS) A zero-coupon bond
which entitles the successful candidate to sell securities and give investment advice in those states that
require Series 65 registration.
until the last of two parties dies. Its most commonly used for husband and wife and generally the
annuitants receive the smallest payments when
this option is selected.
4. u
nit refund Settlement option that allows the
interest.
4/23/2015 2:33:30 PM
402
Glossary
Another is distributor.
corporation.
back of a stock certificate and is used for transferring the stock to the new owners name. A separate
stock power is used if a securitys registered owner
does not have the certificate available for signature
endorsement. Syn. irrevocable stock power; power of
substitution.
4/23/2015 2:33:31 PM
403
Glossary
T
taping rule A FINRA requirement of firms that hire an
taxation.
executed.
recording the names and holdings of registered security owners, seeing that certificates are signed by the
appropriate corporate officers, affixing the corporate
seal, and delivering securities to the new owners.
4/23/2015 2:33:31 PM
404
Glossary
behalf.
U
UGMA See Uniform Gifts to Minors Act.
UIT See unit investment trust.
underwriter An investment banker who works with an
securities to be given to a minor and held in a custodial account that an adult manages for the minors
benefit. Income and capital gains transferred to a
minors name are generally taxed at a lower rate.
65.
guidelines for member firms business dealings in securities with other member firms and customers.
amount by which the market value of portfolio holdings on a given date exceeds or falls short of their cost is
considered unrealized gain or loss.
4/23/2015 2:33:31 PM
405
Glossary
V
variable annuity A retirement contract or policy issued
the BOD and on matters of corporate policy, particularly the issuance of senior securities, stock splits, and
substantial changes in the corporations business. A
variation of this right is extended to variable annuity
contract holders and variable life policyholders, who
may vote on material policy issues.
W
warrant Security that gives the holder the right to pur-
Y
yield Rate of return on an investment, often expressed as
Z
zero-coupon bond Corporate or municipal debt
4/23/2015 2:33:31 PM
4/23/2015 2:33:31 PM
Index
Symbols
12b-1 asset-based fees 404
12b-1 fees 112, 112113
20-day cooling off period 404
20-day cooling-off period 186
45-day free-look letter 129
45-day letter 388
75-5-10 test 91, 401
401(k) plan 388
401(k) plans 241
403(b)(7) 240
403(b) plan 388
403(b) plans 240241
457 plans 229
529 Plans 236
A
acceptance, waiver, and consent 330331
account executive (AE) 377
accounts
for employees of other brokers 309
SIPC coverage of 245
statements of 106
types of 310315
accredited investor 195, 377
accrued interest 377
accumulation plans 128
accumulation stage 142, 377
accumulation unit 377
accumulation units 142
active military service 183
Act of 1933 377
Act of 1934 377
additional issues 186
additional offerings 7. See alsoadditional
issues
adjustable-rate dividend 20
adjusted gross income (AGI) 377
adjustment bonds. Seeincome bonds
administrative fee 151152
Administrator 377
ADR 377
ADS 377
advertisement 377
advertisements
tombstone 191
advertising 269
generic 269
review and approval of 269
AE 377
affiliated person 377
agency basis 377
B
backdating 379
back-end load 379
back-end sales load 112, 290291
balanced fund 379
balanced funds 118
balanced investment strategies 123
balanced investment strategy 379
balance of payments 72
balance sheet 5, 379
balance sheet equation 379
bankers acceptance 64
bankers acceptance (BA) 379
bank-grade bonds. Seeinvestment-grade
bonds
Bank Secrecy Act (BSA) 336
barring 331
basis 218219, 220, 227
basis point 34, 379
BD 379
bear 379
bearer bond 379
bearer bonds 32
bearish position. Seeshort (bearish) position
bear market 379
beneficiary 243
best efforts arrangement 187
best-efforts offering 379
beta 121
beta coefficient 379
bid 379
bid price 4, 89
blend/core funds 117
blue-chip stock 379
blue-sky 379
blue-skying 186, 190
blue-sky laws 180, 379. SeeUniform
Securities Act
board of directors 10, 100101, 379
bona fide quote 379
bond 379
bond fund 379
407
4/23/2015 2:33:31 PM
408
Index
C
call 380
callable bond 380
callable preferred stock 1920, 381
callable securities 38
callable Treasury bonds 47
call buyer 380
call date 380
call feature 380
call option 2728
call premium 38
call price 380
call protection 380
call provision 380
call risk 39, 358, 380
call writer 380
capital 381
4/23/2015 2:33:31 PM
Index
D
dealer 384
dealers and broker/dealers
definition of 4
registration of 173, 210
death benefit 144, 152, 227
death benefit provision 384
debenture 384
debentures 56
debt financing 384
debt securities 30, 42
debt security 384
debt service 38
debt-to-asset ratio. Seeasset-to-debt ratio
declaration date 384
declaration date of dividend 204
declaration of dividend 204205
decline, economic 66
deduction 384
default 384
default risk 384. Seecredit risk
defensive industry 384
defensive investment strategies 122
defensive investment strategy 384
deferred annuity 141, 384
deferred compensation plan 384
deferred compensation plans 229
defined benefit plan 384
defined-benefit retirement plan 240241
defined contribution plan 384
deflation 67, 384
delivery 384
demand deposit 384
Department of Enforcement (DOE) 171,
329
depression 68, 385
derivative 27, 385
DERP 205
designated examining authority (DEA)
203
detachable warrant 26
devaluation 385
directed brokerage arrangements 324
direct management 139
direct participation programs 94
disclaimer, SEC 98, 193
disclosure requirements 95, 96, 98, 125,
173, 176, 310
discount 34, 385
discount bond 385
discount rate 70, 72, 385
discretion 385
discretionary account 385
discretionary accounts 306, 307
discretionary order 385
disposable income (DI) 385
distribution 385
distributions 231
distribution stage 385
distributor of mutual fund. Seeunderwriter
409
E
earned income 385
earnings per share (EPS) 385
economic concepts 6672
Education IRA 385
Education IRAs. SeeCoverdell Education
Savings Accounts (CESAs)
Education Savings Account 385
EE savings bond 385
effective date 386
effective prospectus 192193
elasticity 386
Electronic Communications Networks
(ECNs) 198
eligibility 239
Employee Retirement Income Security
Act (ERISA) of 1974 retirement
plan regulations 242243
Employee Retirement Income Security
Act of 1974 (ERISA) 386
endorsement 386
EPS 386
equipment trust certificates (equipment
notes) 56
equity 5
equity financing 386
equity option 386
equity securities
listings of 1517
equity security 386
ERISA 386
ESA 386
estate tax 386
ethical business practices 319325
excessive trading 321
exchange 386
4/23/2015 2:33:31 PM
410
Index
F
face amount certificate companies (FACs)
88
face-amount certificate company (FAC)
386
face value 386
fair dealing rules 320323
family of funds 221, 290291
Fannie Mae 386
FDIC 386
Fed 387
Federal Communications Commission
(FCC) 283
federal covered investment advisers 212
federal covered security 190
Federal Deposit Insurance Corporation
(FDIC) 387
Federal Farm Credit Banks (FFCBs) 42
federal funds 387
federal funds rate 71
Federal Home Loan Bank (FHLB) 387
Federal Home Loan Mortgage Corporation
(FHLMC) 387
Federal Home Loan Mortgage Corporation
(Freddie Mac) 42, 50
Federal National Mortgage Association
(FNMA) 387
Federal National Mortgage Association
(FNMA, Fannie Mae) 42, 50
Federal Open Market Committee (FOMC)
70, 387
Federal Reserve Board (FRB) 6970, 210,
387
FRB 388
free-look letter 388
free-look period 154
front-end load 388
front-end load companies 129
front-end loaded 110
front-end sales load 111, 287
frontier funds 118
frozen account 203, 388
full disclosure 96
Full Disclosure Act 388
full faith and credit bonds. Seegeneral
obligation bonds (GOs)
full power of attorney 388
full trading authorization 388
fully registered bond 388
funded debt 388
funding 388
fund manager 388
fund of funds 119
funds of hedge funds 93, 120
fungible 388
G
general account 136138, 388
general obligation bond (GO) 388
general obligation bonds (GOs) 43, 53
General Securities Representative 388
generic advertising 269, 388
gift tax 220, 316
GNMA 388
good delivery 207, 312, 388
Government National Mortgage Association (GNMA) 388
Government National Mortgage Association (GNMA, Ginnie Mae) 42, 49
government security 388
gross domestic product (GDP) 66, 389
gross income 389
growth 354
growth and income fund 389
growth fund 389
growth funds 116117
growth industry 389
growth of investment 121122, 352
growth stock 389
guaranteed bonds 56
guaranteed dollar annuity 389
guaranteed security 389
guarantees 325
guardian 389
H
hearing 331
hedge fund 389
hedge funds 92
HH savings bond 389
high-yield bond funds 119
high-yield bonds 36
holder 389
4/23/2015 2:33:31 PM
Index
I
immediate annuity 141, 389
immediate family 389
immediate family, definition of 196
immediate family members 325
incidental insurance benefit 389
income bond 389
income bonds 56
income fund 389
income funds 116
income statement 389
indefeasible title 389
independently prepared reprint 266
independently prepared reprint (IPR) 389
index 389
index annuities 136
index funds 117
indication of interest (IOI) 389
indications of interest 191
individual accounts 311
individual registration 173
individual retirement arrangement (IRA)
389
individual retirement arrangements (accounts) (IRAs) 233
rollovers and transfers 233
industrial development (revenue) bond
(IDB) 390
industrial development revenue bonds 350
industry fund 390
inflation 67, 390
inflation risk 136, 356
information barrier 247
inherited property 220
initial public offering (IPO) 186, 390
initiation of proceedings 333334
inside information 390
inside market 199
insider 390
Insider Trading Act 390
Insider Trading and Securities Fraud Enforcement Act of 1988 247248,
390
inspection rights 11
institutional account 390
institutional communication 390
institutional investor 390
institutional sales material 280
integration 338
interest 390
interest rate risk 35, 60, 390, 399
interest rates 32, 67, 7172
benchmark 7172
J
joint account 391
joint accounts 312313, 325
joint life with last survivor 391
joint life with last survivor annuity 145
joint tenants with right of survivorship
(JTWROS) 312, 391
joint with last survivor 401
jumbo CDs. Seenegotiable CDs
junior security 11, 13
junk bonds 36, 43
K
Keogh plan 391
Keogh plans 238
kiddie tax 316
know your customer rule 391
411
L
large-cap 391
large-cap funds 116
last in, first out (LIFO) 391
layering 338
legal list 391
legal opinion 54
letter of intent (LOI) 288289, 391
level load 112. See12b-1 fees
leverage 392
liabilities 56
liability 392
liability, limited 11
of stockholders 11
LIBOR 72
license 392
life annuity 145
with period certain 145146
life annuity/straight life 392
life annuity with period certain 392
life insurance. See alsovariable life insurance
taxation of income and proceeds from
227
life only (straight life) 401
life settlement 392
life with period certain 401
limited liability 11, 392
limited partnership 94
limited power of attorney 392
limited principal 392
limited representative 392
limited securities representative 179
limited trading authorization 392
liquidation
of mutual fund shares 130, 218220
liquidation priority 34. See alsojunior
security; senior security
liquidity 37, 63, 353, 354, 392
liquidity risk 358, 399
listed securities 16
listed security 392
loans
against life insurance policy 152153
LOI 392
long 392
long (bullish) position 11, 13
long-term gain 392
long-term loss 392
loss carryover 392
lump-sum payment 141
M
mailing instructions 308
Maloney Act 392
Maloney Act of 1938 3, 210
management company 392
management fee 88, 102, 392
management investment company 8991
4/23/2015 2:33:32 PM
412
Index
N
name rule 116
Name Rule 394
NASD. SeeNational Association of Securities Dealers (NASD)
Nasdaq 394
Nasdaq stocks 16
National Association of Securities Dealers
(NASD) 3
NAV 109, 394. Seenet asset value (NAV)
NAV of fund 394
NAV per share 394
negotiability 394
negotiable CDs 64
negotiable certificate of deposit (CD) 394
negotiated markets 199
negotiated underwriting contract 187
net asset value (NAV) 109, 394
net change 394
net investment income 214, 394
net investment return 394
net worth 5, 394
new account form 394
New Housing Authority bonds (NHAs)
42
new issue market 394
New York Stock Exchange 15
New York Stock Exchange (NYSE) 3, 394
no-load fund 394
no-load funds 115
nominal owner 394
nominal yield 394
noncumulative preferred stock 394
nondiscrimination 243, 394
nondiversification 394
nondiversified management company 395
nonfixed UIT 88
nonfixed unit investment trust 395
noninterested person 101
nonmarketable government securities 45
non-Nasdaq securities 16
nonpublic arbitrator 333
nonpublic personal information (NPI)
249, 395
nonqualified retirement plan 395
nonqualified retirement plans 229
O
odd lot 23, 395
offer 395
offer of settlement 329
offers of free service 274
Office of Foreign Assets Control (OFAC)
338339
office of supervisory jurisdiction (OSJ)
173, 319
omitting prospectus 269, 395
open-end funds 111
open-end investment company 395
open-end investment company (mutual
fund) 90
open-market policy. Federal Reserve 69
option 395
option income funds 116
Options Clearing Corporation (OCC) 27
options disclosure document 27
Options Disclosure Document 395
opt-out method
order memorandum 395
orders, customers
sales charges 111120
settlement of trades 202204
ordinary income 395
OTC 395
OTC market 395
outside business activities 320
outstanding stock 8, 395
over-the-counter bulletin board (OTCBB)
16
over-the-counter market (OTC) 3
over-the-counter (OTC) 395
over-the-counter (OTC) market (second
market) 198
P
paid-in surplus (paid-in capital) 9
painting the tape 326
par 395
parity 19, 5859, 395
participating preferred stock 19, 395
participation 396
partnership 396
partnership accounts 309
par value 9
passive investment 320
pass-through certificate 396
pass-through certificates 49
Patriot Act 335
payment date 396
payment period 396
pay on death (POD) 311
4/23/2015 2:33:32 PM
Index
Q
qualification 190, 397
qualification examinations 179
qualified retirement plan 397
qualified retirement plans 228
quantitative risk management 122
quotation 397
quote machine 397
R
rating 397
ratings. Seebonds, ratings of
rating service 397
real estate investment trust (REIT) 397
real estate investment trusts (REITs) 93,
352
realized gain 215216, 397
recession 68, 397
413
4/23/2015 2:33:32 PM
414
Index
residual rights 11
restrictions on investment companies 98,
120
retail communication 264, 399
retail investor 399
retirement account 399
retirement plans 229
403(b) plans 240241
corporate 240242
deferred compensation 229
defined-benefit vs. defined-contribution
240241
payroll deduction 229
qualified vs. nonqualified 229
return on investment (ROI) 399
revenue bond 399
revenue bonds 54
right 399
right of accumulation 399
right of withdrawal 399
rights agent 399
rights of accumulation 286, 289
rights of contract holders 154
rights offering 2526, 399
rights of shareholders 99
risk 355358, 399
business 356
call 39, 358
capital 356
credit 357
currency 358
extension 51
inflation 356
interest rate 357
liquidity 358
market 357
of stock ownership 13
prepayment 49
reinvestment 357
timing 357
unlimited 13
risk management, quantitative 122
rollover 399
rollover, IRA 233
Roth 401(k) plan 241
Roth IRA 399
Roth IRAs 234
round lot 15, 23, 399
Rule 17f-2 174, 210
Rule 72t 232
S
safety 122123
sales charge 110, 399
sales charges 111119
for variable-life insurance 153154
sales literature 399
sales load 400
sales loads 125
same day settlement. Seecash settlement
sanctions 331
savings bond 400
Savings incentive match plans for employees (SIMPLEs) 237
scheduled premium policy 400
SEC 400
secondary market 3, 400
secondary offerings 187. See alsosecurities, markets; trading, regulation
of
second market. Seeover-the-counter
(OTC) market (second market)
SEC release IA-1092 212
SEC Rule 134 193
SEC Rule 498 272
SEC Rule 501 195
SEC Rule 506 195
Section 457 plans 229
Section 529 plans 236
sector fund 400
sector funds 92
secured bonds 5556
securities 196. See alsotrading, regulation of
exempt vs. nonexempt 188
issuance of 185188, 188
issuance of new 9597
registration of 98
trading of 197198
Securities Act of 1933 97, 98, 189, 400
Securities Acts Amendments of 1975
400
Securities and Exchange Commission
(SEC) 3, 209210, 400
Securities Exchange Act of 1934 3,
208211, 400
Securities Investor Protection Act of
1970 245
Securities Investor Protection Corporation (SIPC) 245246, 400
security 400
self-employed 401(k) plan 239
Self-Employed 401(k) Plans 238
self-regulatory organization (SRO) 400
self-regulatory organizations (SROs) 3,
210
sell 400
selling away 400. Seeprivate securities
transactions
selling concessions 285
underwriting 186
selling dividends 323, 400
prohibited 218
selling group 400
selling groups 187
senior securities 13, 31
SEP 400
separate account 151, 400
Separate Trading of Registered Interest and Principal of Securities
(STRIPS) 401
Series 6 401
Series 7 401
Series 7 licenses 180
Series 26 401
Series 26 license 181182
Series 63 401
Series 65 401
Series 65 license 180
Series EE bond 401
Series EE bonds 48
Series HH bond 401
Series HH bonds 48
settlement 401
settlement date 207, 401
settlement options 401
share identification 401
share identification accounting 219
share of beneficial interest 401
shares of beneficial interest. Seeredeemable shares
sharing in accounts 325326
short 401
short (bearish) position 11, 13
short sale 11
short selling 99100
simplified arbitration 333, 401
simplified employee pension plan (SEP)
402
Simplified Employee Pension (SEP) plan
237
single account 402
single payment deferred annuity 402
single payment immediate annuity 402
single premium deferred annuity (SPDA)
141
single premium variable life insurance
282283
sinking fund 38
SIPC 402
small-cap 402
small-cap funds 116
social risk 358
solicited trade 402
special deals 402
specialized fund 402
specialized funds 92, 117
special situation fund 402
special situation funds 117
speculation 353
speculative bonds 36
split offering 187
sponsor 402
sponsor of mutual fund. Seeunderwriter
spot checks 279
spousal account 402
spousal IRA 230
spread 402
spread load 402
spread-load companies 129
spread-load plans 153
SRO 402
4/23/2015 2:33:32 PM
Index
T
tape recording of conversations 177
taping rule 403
taxability 403
taxable gain 403
taxation of annuities 224
tax bracket 52, 213, 403
tax-deferred annuity 403
tax-equivalent yield 53, 403
tax-exempt bond fund 403
tax-free bond fund 403
tax-free equivalent yield 53
tax-free income 121
tax-free (tax-exempt) bond funds 119
U
U-4. SeeForm U-4
U-5. SeeForm U-5
UGMA 404
UIT 404
uncontested offer 330
uncovered options, prohibited 9899
under common control with) 383
underwriter 103, 404
415
V
value funds 116
variable annuity 137140, 142, 405
1035 Exchange provision 227
comparison of, to mutual funds
139140
guidelines for sales literature 281282
phases of 142
4/23/2015 2:33:32 PM
416
Index
warrant 405
warrants 2627
wash sale 405
wash sales 221
wash trades 326
whole life (WL) insurance 148
withdrawal plan 405
withdrawal plans 130
wrap account 323
writer 405
written supervisory procedures 335
yield 405
bond 4042
dividend, of stock 2223
yield curve 405
yield to maturity (YTM) 405
Z
zero-coupon bond 405
zero-coupon bonds 5758
4/23/2015 2:33:32 PM