Every product we’ve discussed so far is bought and sold in brokerage accounts. Maintained by broker-dealers, investors utilize these accounts to buy and sell securities. This was an important section for the SIE exam, so you’ll probably feel somewhat familiar with the topics discussed. As a review, we’ll cover these fundamental topics:
When a customer opens a new brokerage account, they must submit certain pieces of information. Additionally, registered representatives must follow specific procedures when opening accounts. The most important items submitted are called the “four critical pieces of information.”
You may have heard of the Patriot Act, which was signed into law after the 9/11 attacks in 2001 to prevent terrorism and money laundering. The Patriot Act requires financial firms to verify the identities of their customers, which prevents customers from creating accounts under fake personas.
To accomplish this, the firm must collect four pieces of critical information from the customer as a part of their Customer Identification Program (CIP):
If a customer is a non-resident alien, they must provide their foreign passport and their US tax identification number (TIN)
After collecting these, the firm follows one of two procedures to verify its customer’s identity. The traditional way involves comparing their information with a government-issued ID, like a driver’s license, passport, or military ID. The ID used must be currently valid and include a picture, which is why birth certificates cannot be used.
The modern way of verifying a customer’s identity utilizes credit bureaus. You’ve probably heard of TransUnion, Experian, and Equifax, which are the three largest credit bureaus. When a customer submits their four pieces of critical information, the brokerage firm checks one of the credit bureaus to confirm that the information matches with an actual person. If one or more pieces do not match, the firm cannot do business with the customer until it’s resolved. For example, if the customer mistakenly provided the wrong address, they must fix the issue before their account is approved.
The four critical pieces of information are required by the Patriot Act, but other items must be obtained by the firm prior to doing business with the customer. Occupation is one of those items; it’s the firm’s responsibility to confirm whether or not its customer is an affiliate* of a publicly traded company or works in the industry.
*An affiliate (or insider) is any officer, director, or 10% shareholder of an issuer.
Brokerage firms know it’s possible their employees will come in contact with inside information. To ensure that insider trading does not occur, firms must supervise the accounts of their registered representatives. Additionally, if a registered representative wants to open an account at another brokerage firm, they must obtain written approval from their employer, notify them when the account is opened, and provide them with duplicate statements and trade confirmations if requested. By asking about the customer’s occupation, firms can effectively follow these rules.
Firms must ask for many pieces of information when an account is opened, but some items are voluntarily provided. In particular, suitability questions are always optional for a customer to answer.
Suitability questions include:
Obviously, items like annual income and net worth may be sensitive information for a customer to provide. However, the firm requires this information in order to make proper recommendations to their customers. Recommendations may only be made if the firm feels like it fully understands the customer’s financial situation.
If the customer refuses to provide answers to suitability questions, the firm will be unable to recommend or suggest specific investments. Essentially, all of the customer’s trades must be unsolicited and submitted without the firm’s guidance.
When an investor fills out a new account form, they must determine what type of account they will open. Cash accounts are regular brokerage accounts that require the customer to pay 100% for any securities they purchase. Margin accounts allow the investor to borrow from the broker-dealer for investment purposes, leading to increased gain and risk potential (leverage). We’ll discuss margin accounts in detail later in this chapter.
After the account type is picked and the new account form is properly filled out, the firm goes through a specific process to open the account.
First, the account application must be signed by the registered representative and their principal (supervisor). In some situations, the registered representative assisting the customer signs the form and states the information on the form is correct to the best of their knowledge. This is not always required, but typically accomplished if they will be servicing the account regularly. In many instances, there will be no registered representative signature (especially if the account is opened online by the customer).
Next, the principal reviews the new account form to ensure all required information was submitted and that normal account opening protocols were followed. If the form is “in good order,” the principal will sign the form, which effectively approves the account. There’s no legal requirement for the customer to sign the new account form, which allows firms to open accounts over the phone.
After the account is approved, the firm must send the customer a confirmation of the information they provided on the new account form within 30 days of account opening. Language is included on the confirmation that requests the customer review the information for accuracy and notifies the firm if something is incorrect. The firm is also required to verify customer information every three years. To do so, they send another form disclosing current information on file and request the customer contact them if anything needs updating.
When a customer opens an account at a brokerage firm, they’re likely to be asked to sign an arbitration agreement. Although signing is voluntary, arbitration agreements force any disputes between the customer and the firm into binding arbitration. The customer will be unable to sue the firm in court, but they can gain restitution for any disputes with the firm through FINRA’s arbitration system. Arbitration is a faster and more efficient process than a lawsuit, but customers are only forced into arbitration if they sign an arbitration agreement. Arbitration is discussed in further detail in a future unit.
Brokerage statements provide a historical view of account activity, security values, and overall balances. Broker-dealers are legally obligated to provide their customers with a transparent view of their assets. At the very least, statements must be sent to customers on a quarterly basis.
Although the firm must send consistent statements by mail (unless the investor elects for electronic delivery), customers may request their mail be held for short periods of time. For up to three months, customers may request that statements be held for any reason. If they prefer for their mail to be held longer, they must submit a request in writing and have a legitimate reason for the request, typically relating to military deployment, safety, and security-related issues. A customer’s mail being stolen or massive civil unrest in the customer’s city are examples of legitimate reasons. If the customer follows this procedure, the firm may hold mail for an additional three months (up to six months total).
Statements can be sent through the mail or electronically. To ensure a broker-dealer doesn’t send electronic statements to customers without internet access, the customer must specifically request for electronic statements to be sent. Known as the “access equals delivery” rule, the firm must have reasonable proof that the customer has internet access. To accomplish this, most firms require their customers to request electronic delivery of statements online.
Access equals delivery also applies to deliveries of official documents like a prospectus. We learned how a prospectus must be delivered to a customer purchasing an IPO in the primary market chapter. If there’s proof the customer has internet access, sending them the link to the prospectus on the SEC’s website constitutes successful delivery.
If you’re interested in seeing a real-world example of an electronic prospectus, check out Uber’s prospectus from their IPO in 2019.
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