General disclosures

General disclosures

These are four general disclosures that must be made by both broker-dealers and investment advisers (and by agents and IARs by extension):

• Conflicts of interest
• Internet-related disclosures
• Disclosure of capacity
• Third-party research

Conflicts of interest
A good starting point is the Merriam-Webster definition:

A conflict of interest exists when a financial professional could personally benefit from something connected to a client interaction. For example, an investment adviser might be compensated by an issuer for recommending that issuer’s security to clients. If a recommendation could benefit the adviser, the client should know that.

Conflicts of interest aren’t automatically illegal or improper. The problem is when a conflict exists and isn’t disclosed. Here are common examples you’ll see tested:

• Recommending a security that financially benefits a registered person (beyond normal transaction or advisory fees)
• Recommending a security directly tied to an officer, director, or partner of the firm
• Recommending securities issued by their own firm or an affiliated firm
• Recommending a more expensive product or service resulting in higher compensation for the financial professional
• Recommending a security that will be sold out of the firm’s inventory
• Offering a product or service at a discounted rate only to a specific type of client
• Recommending a proprietary investment or service*

Notice that most of these conflicts involve recommendations.

• Broker-dealers can recommend securities, but their core business is executing transactions.
• Many broker-dealer trades are unsolicited, meaning the customer initiated the trade without influence from a financial professional.

In unsolicited situations, broker-dealers aren’t subject to a fiduciary duty, so conflicts of interest are less likely to arise.

Investment advisers must act in a fiduciary capacity with their clients. That means advisers should remove and/or mitigate conflicts of interest as much as possible. If a conflict still exists, it must be disclosed.

• Ongoing (permanent) conflicts are typically disclosed in the brochure.
• If a conflict arises unexpectedly, it must be disclosed during the recommendation or before trade execution.

Internet-related disclosures

When financial professionals communicate with investors online, they must follow specific protocols to stay compliant with regulatory requirements. In 1997, the North American Securities Administrators Association (NASAA) released an order relating to internet communications. As the internet became a major communication channel, regulators needed a consistent approach - especially around state registration.

A key question is whether online activity counts as “doing business” in every state where readers happen to live. For example, suppose an IAR is registered and operating in only one state, but discusses securities in an online comment thread (Facebook, Reddit, etc.). People from all 50 states respond. Does the IAR now need to be registered in all 50 states?

It depends on what the communication looks like. Under the 1997 NASAA order, registered persons are not considered to be “transacting business” if the following requirements are met:

• The registered person discloses they may only perform securities-related services if properly registered in a client’s state
• Any individualized responses must comply with relevant rules and regulations
• The firm maintains a system that ensures these communications comply with applicable rules and regulations
• Communications are general and non-specific if engaging investors in states the person isn’t registered in

Additionally, the same NASAA order requires agents and IARs to:

• Prominently disclose the firm they’re affiliated with
• Ensure their communications are properly supervised
• Ensure their firm authorizes these communications
• Ensure their communications remain within the scope of their abilities

Keep in mind these rules apply only to online communications an agent or IAR makes while acting in a professional capacity. They generally don’t apply when the person isn’t discussing securities or is speaking purely in a personal capacity. For example, an agent posting a general comment about the stock market on Facebook in their free time would generally fall outside the administrator’s jurisdiction, as long as the post is personal and doesn’t reference professional affiliations.

Disclosure of capacity

To comprehend the concepts discussed in this section, you must be knowledgeable in regards to agency and principal capacities. Follow this link for a refresher on the topic.

The capacity in which a securities transaction occurs must be disclosed to investors.

In most cases, broker-dealers disclose capacity on the trade confirmation after the transaction is executed. Trade confirmations must be sent to investors by settlement, which is typically the first business day after a trade occurs (depending on the security; the details are not important for the Series 63).

Most capacity disclosures happen after execution, but some situations require disclosure before the trade.

In particular, pre-disclosure is required if an investment adviser’s recommendation will result in a principal transaction. For example, an adviser recommends ABC Company common stock, and the shares will be sold out of the adviser’s inventory if the client agrees. Because the adviser is on the other side of the trade, this creates a conflict of interest that must be disclosed during the recommendation.

Agency cross transactions also require certain pre-disclosures. This type of transaction occurs when an investment adviser “crosses” two of their own clients in the same trade. For example, suppose an adviser has two clients - Leon and Ebony. On a quick phone call with their assigned IAR, Leon expresses interest in buying Tesla stock. Later that day, the IAR reviews Ebony’s account and determines her current Tesla position is unsuitable. The IAR recommends that Ebony liquidate the position, and she agrees. The IAR then contacts Leon, matches the two clients on the trade, and earns an advisory fee from Ebony.

That example would not be unethical if the following conditions were met (according to NASAA rules):

• Written disclosure provided to clients documenting the details of an agency cross transaction
• Written approval from each client to perform this type of transaction
• A confirmation with trade details is provided by the settlement of the trade
• An annual disclosure is provided to all clients detailing:
  • Total number of agency cross transactions performed
  • Total compensation received in connection to these transactions
• The client’s written approval may be rescinded at any time
• A recommendation was made only to one of the two clients

In the example above, the transaction was only recommended to Ebony, which satisfies the last condition. Beyond that, the written disclosures and approvals must be obtained and retained before executing an agency cross transaction. The annual disclosure requirement also applies to all clients. If those disclosures and approvals were in place, the Leon and Ebony trade would be a compliant agency cross transaction.

Third-party research

Financial firms and their representatives may provide access to third-party research reports as an ongoing service. These reports often include investment insights on specific securities from professional analysts. With that added information, clients can better understand the markets and make more informed decisions.

NASAA rules emphasize one major requirement: disclose the source. The registered person must not imply the research is their own.