Every product we’ve discussed so far is bought and sold in brokerage accounts. Broker-dealers maintain these accounts, and investors use them to buy and sell securities. As a review, we’ll cover these fundamental topics:
When a customer opens a new brokerage account, they must provide certain information. Registered representatives also have specific procedures to follow during the account-opening process. The most important items are the “four critical pieces of information.”
You may have heard of the Patriot Act. It was signed into law after the 9/11 attacks in 2001 to help prevent terrorism and money laundering. One key requirement is that financial firms must verify customer identities, which helps prevent accounts from being opened under false identities.
To do this, the firm collects four pieces of critical information as part of its 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 this information, the firm verifies the customer’s identity using one of two methods.
The traditional method compares the customer’s information to a currently valid government-issued photo ID, such as a driver’s license, passport, or military ID. The ID must be valid and include a photo, which is why a birth certificate can’t be used.
The modern method uses credit bureaus. You may have heard of TransUnion, Experian, and Equifax, the three largest credit bureaus. The firm checks the customer’s four critical pieces of information against a credit bureau database to confirm the information matches a real person.
If one or more items don’t match, the firm can’t do business with the customer until the issue is resolved. For example, if the customer accidentally provides the wrong address, they must correct it before the account can be approved.
The four critical pieces of information are required by the Patriot Act. In addition, the firm must obtain other information before doing business with the customer. One key item is the customer’s occupation. The firm uses this to determine whether the customer is an affiliate* of a publicly traded company or works in the securities industry.
*An affiliate (or insider) is any officer, director, or 10% shareholder of an issuer.
Brokerage firms recognize that employees may come into contact with inside information. To help prevent insider trading, firms must supervise the accounts of their registered representatives.
Also, if a registered representative wants to open an account at another brokerage firm, they must:
By collecting occupation information, firms can apply these rules appropriately.
Firms must request many pieces of information when an account is opened, but some items are voluntary. In particular, suitability questions are always optional for a customer to answer.
Suitability questions include:
Some of these items (like annual income and net worth) can feel sensitive. Even so, firms use this information to understand the customer’s financial situation and make appropriate recommendations.
If the customer refuses to answer suitability questions, the firm can’t recommend specific investments. In that case, the customer’s trades must be unsolicited, meaning the customer places trades without the firm’s recommendation.
When an investor fills out a new account form, they must choose what type of account to open.
After the account type is selected and the new account form is completed, the firm follows a set process to open the account.
First, the account application is signed by the registered representative and the principal (supervisor).
Next, the principal reviews the new account form to confirm that:
If the form is “in good order,” the principal signs it, which approves the account. There’s no legal requirement for the customer to sign the new account form, which is why firms can open accounts over the phone.
After the account is approved, the firm must send the customer a confirmation of the information on the new account form within 30 days of account opening. This confirmation asks the customer to review the information for accuracy and notify the firm if anything is incorrect.
The firm must also verify customer information every three years. To do this, it sends another form showing the current information on file and asks the customer to contact the firm if updates are needed.
When a customer opens an account at a brokerage firm, they’re often asked to sign an arbitration agreement. Signing is voluntary, but if the customer signs, disputes between the customer and the firm must go to binding arbitration.
That means the customer can’t sue the firm in court, but they can seek restitution through FINRA’s arbitration system. Arbitration is typically faster and more efficient than a lawsuit, but it only applies if the customer signs 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 required to give customers a clear view of their assets. At a minimum, statements must be sent quarterly.
Statements are typically sent by mail unless the investor chooses electronic delivery. Customers can also request that their mail be held for short periods:
Examples of legitimate reasons include a customer’s mail being stolen or significant civil unrest in the customer’s city. If the customer follows this procedure, the firm may hold mail for an additional three months (up to six months total).
Statements can be delivered by mail or electronically. To avoid sending electronic statements to customers who don’t have internet access, the customer must specifically request electronic delivery. Under the “access equals delivery” rule, the firm must have reasonable evidence that the customer has internet access. Most firms meet this requirement by having customers request electronic delivery online.
Access equals delivery also applies to official documents like a prospectus. For example, if there’s proof the customer has internet access, sending a link to the prospectus on the SEC’s website counts as delivery.
If you’d like to see a real-world example of an electronic prospectus, check out Uber’s prospectus from their IPO in 2019.
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