Performance guarantees

If you’ve prepared for a securities exam other than the Series 63, you’re probably aware of the sensitivity surrounding the term ‘guarantee.’ In most scenarios, it’s a forbidden term that could relate to an unethical and/or illegal practice. The same applies to this exam, but let’s first cover the one area that the word can legally be used:

A security is considered guaranteed when a third party (usually an insurance company) pledges to cover any unpaid interest, dividends, and/or principal. However, this doesn’t mean an investor can’t lose money on a guaranteed security. Market value is not considered if third-party insurance kicks in. For example, let’s assume an investor purchases a $1,000 principal (par) bond* for $1,200. If the bond defaults (meaning the issuer is unable to pay back the borrowed funds), the insurance would only cover the $1,000 principal and any unpaid interest to that point. The $200 premium the investor paid for the bond would be uncovered.

*The specifics related to bonds and other securities are generally not tested on the Series 63. You should know what the term ‘guaranteed security’ refers to and what’s covered by the third party. The exam typically doesn’t go much further than that.

Outside of guaranteed securities, the term ‘guaranteed’ is usually related to unethical activities. In particular, financial professionals must never guarantee a security will perform in a certain manner. This includes:

• Guaranteeing a client will make a return
• Guaranteeing a client will not lose money
• Refunding any transaction or advisory fees for bad performance

One of the defining characteristics of a security is the possibility of loss. Performance guarantees and securities simply don’t mix. As nice as it might be being provided a guarantee against loss, it’s not feasible for broker-dealers, agents, investment advisers, or investment adviser representatives (IARs) to offer them. What if a registered person guarantees more than they’re able to handle? Guarantees pose a threat to the financial health of securities firms, especially in the event of a significant bear market (e.g. the Great Recession). Therefore, all financial professionals should avoid performance guarantees.