Customer agreements

It’s important to understand the basics of opening brokerage and advisory accounts for customers and clients. If you’ve prepared for another finance exam like the SIE, Series 6, or Series 7, you’ve likely seen much of the process and paperwork before. This chapter also introduces concepts that are more specific to the Series 63.

We’ll cover these customer agreements related to opening accounts:

• New accounts
• Margin accounts
• Options accounts

New accounts

Clients and customers must provide specific information to open new accounts with broker-dealers and investment advisers. The requirement to collect this information comes from the Patriot Act, which was signed into law after the 9/11 attacks in 2001 to help prevent terrorism and money laundering.

A key goal of the law is identity verification: financial firms must verify who their customers are to reduce the risk of accounts being opened under false identities.

To do this, firms must collect four pieces of critical information as part of their Customer Identification Program (CIP):

• Name
• Date of birth
• Address
• SSN or TIN

A non-US person (non-resident alien) does not need a US SSN or TIN. Any ONE of these satisfies the identification number requirement: a TIN, a passport number and country of issuance, an alien identification card number, or the number and country of issuance of another government-issued document showing nationality or residence and bearing a photograph. Citizenship is confirmed through this process, which is another account opening disclosure required.

After collecting the four CIP items, broker-dealers and investment advisers verify the client’s identity. This is typically done by comparing the information provided against:

• A government-issued ID (e.g., driver’s license, passport, and/or military ID), or
• A credit database (e.g., TransUnion, Experian, and/or Equifax)

Firms also request information about the client’s financial situation. This is known as suitability information, and it’s especially important for investment advisers. Typical suitability information includes the client’s net worth, number of dependents, risk tolerance, investment objectives, time horizon, and liquidity needs - in short, their financial status and goals. Notably, a client’s educational background isn’t part of this list; it doesn’t tell a firm anything about which investments are suitable for them.

Technically, investors are not legally required to provide suitability information. However, if any of this information is missing, the firm can’t make recommendations. In that case:

• Any trades must be unsolicited (the client initiates them without a recommendation).

Unsolicited trading is common at broker-dealers, especially for self-directed customers. For many investment advisers, missing suitability information is a practical problem: if they can’t provide advice, the advisory relationship often doesn’t make sense.

The customer account record
The CIP items above verify identity. Separately, FINRA Rule 4512 governs the account record itself - the information a firm creates and maintains for each account, including the customer’s name and residential address, tax identification number, date of birth, employment status and occupation, annual income, net worth, and investment objectives. The associated person who opens the account signs the record, and a principal (supervisor) approves it in writing.

The firm must also furnish the customer a copy of this record - the copy may exclude the date of birth and tax identification number - within 30 days of opening the account, and again at least once every 3 years afterward. This gives the customer a chance to review the information and flag anything that’s changed, which keeps suitability information current as circumstances evolve.

The North American Securities Administrators Association (NASAA) issued an updated rule in 2013 regarding advisory contracts. To comply, contracts that clients sign with investment advisers must be in writing and must include these disclosures:

• The services to be provided
• Term of the contract (length of time it covers)
• Advisory fees to be paid
• Formula for computing the advisory fee
• Amount of fees returned if contract terminated prematurely
• If discretionary authority is provided to the adviser and/or IARs
• No assignment* may be made without client’s authorization
• The adviser will not keep capital gains made (unless the client is qualified)
• Advisers structured as partnerships will notify clients if the partnership structure changes

Sidenote

Assignment of contracts

When the investment adviser controlling a client’s account materially changes, assignment has occurred. NASAA defines it as:

Any transaction or event that results in any change to the individuals or entities with the power, directly or indirectly, to direct the management or policies of, or to vote more than 50 percent of any class of voting securities of, the investment adviser or federal-covered investment adviser as compared to the individuals or entities who had such power as of the date when the contract was first entered into, extended or renewed.

In simple terms, assignment occurs when control of the advisory firm changes in a way that effectively transfers the client’s advisory relationship.

In its most basic form, assignment would occur if an adviser transferred a client’s contract to a completely different firm. For example, assume a client has ABC Advisers managing their assets. If the business is sold to XYZ Advisers, assignment occurs once XYZ begins managing ABC’s former clients.

Assignment isn’t inherently unethical or illegal, but it must be voluntary. If the client approves the assignment in writing, it complies with securities rules and regulations. Any involuntary assignment is unlawful.

Investment advisers structured as partnerships are a common source of assignment questions. Many advisory firms are partnerships, where two or more persons own, manage, and control the business. Assignment occurs if a majority (more than 50%) of the partnership changes.

For example, assume Acme Advisory Partners has three partners: Robert, Denzel, and Jada. If Robert and Denzel sell their partnership interests to Sally, assignment has occurred. Two of the three original partners (66%) changed, which is a majority change. Even if the firm keeps its original name (Acme Advisory Partners), the adviser must obtain written approval from all clients to continue managing their accounts.

Corporations can be subject to similar assignment rules if more than 50% of the voting shares change hands.

Using the same example, assume only Robert sells his interest to Sally. In that case, one of the three original partners (33%) changed, which is a minority change. This is not assignment, but it still requires written notification to clients within a reasonable amount of time.

NASAA rules also prohibit the use of hedge clauses in advisory contracts:

It is unlawful for any investment adviser, investment adviser representative, or federal-covered investment adviser to include in an advisory contract, any condition, stipulation, or provisions binding any person to waive compliance with any provision of [the Uniform Securities Act].

In plain terms, a hedge clause exists when a client “signs off” on an adviser or IAR not complying with the law.

You might wonder why a client would ever agree to that. One reason is that a client might want the adviser to do something the rules don’t allow. For example, a client who doesn’t meet qualified status might want the adviser to ignore NASAA rules so the adviser can charge performance fees. That’s both unethical and illegal.

Although hedge clauses are generally unlawful, regulators often allow hedge clauses that address “uncontrollable events.” These are typically events such as:

• Weather-related disasters (e.g., hurricanes, earthquakes)
• Communication disruptions (e.g., telephone lines going down)
• War
• Government shutdowns
• Other large-scale catastrophes (e.g., global pandemics)

For example, an adviser may include language stating they may not be able to fulfill their fiduciary obligations in the event of a natural disaster.

Sidenote

Disclosure of non-public client data

In general, registered persons are prohibited from disclosing non-public client data (e.g. account activity, contract details) without explicit approval from the client. This rule generally applies to all situations unless trading authority or legal jurisdiction applies. If a client’s partner, spouse, or any other third party has power of attorney, they may be provided non-public information related to the account any time a request is made.

Legal jurisdiction typically refers to a governmental entity empowered to request this information. Here’s a list of entities that could be provided non-public client data without their approval:

• Judges requesting information via court orders
• Police investigators via subpoena
• Federal Bureau of Investigation (FBI)
• Internal Revenue Service (IRS)
• State administrator
• Securities and Exchange Commission (SEC)
• Financial Industry Regulatory Authority (FINRA)

Margin accounts

Margin accounts allow investors to borrow money for investment purposes. This creates leverage, which means gains and losses are amplified.

In addition to a new account form, investors opening margin accounts must also complete and sign the margin agreement. This document has three subsections:

• Hypothecation agreement
• Credit agreement
• Loan consent form

The hypothecation agreement is where the customer pledges securities as collateral for the margin loan. Just as a home serves as collateral for a mortgage, securities held in a brokerage account serve as collateral for margin borrowing. If the customer can’t repay the loan, the broker-dealer can liquidate (sell) securities in the account to pay off the loan.

The credit agreement describes the terms of the margin loan, including how margin interest is calculated, the repayment schedule, and other loan terms. It also discloses whether the investor’s credit will be checked.

The loan consent form is the only optional part of the margin agreement. If signed, it allows the broker-dealer to lend the customer’s securities to other investors for short sales. Although there’s no legal requirement for it to be signed, most broker-dealers won’t open margin accounts without it.

The margin agreement must be signed and submitted (except for the loan consent form) promptly after the first executed margin trade. This is slightly different from the FINRA rules you may have learned while preparing for the SIE, Series 6, or 7 exams.

Margin accounts are risky. If you borrow money to invest and the investment loses value, you may still owe the borrowed funds back. In other words, you can lose more than the value of your account.

Because of these added risks, investors opening margin accounts receive additional disclosures. These disclosures emphasize that:

• The investor can lose more than the account is worth, and
• Securities in the account serve as collateral for the loan

Options account

An option is a contract between two investors to complete a transaction at a fixed price. There are two types of options:

• Calls
• Puts

Calls are contracts that give the option owner the right to buy stock at a fixed price. For example, an investor who buys an ABC 35 call has the right to buy 100 shares* of ABC stock at $35. Another investor sold the 35 call and has the obligation to sell 100 shares at $35 if the buyer exercises the contract.

*Option contracts typically cover 100 shares of stock per contract.

Puts are contracts that give the option owner the right to sell stock at a fixed price. For example, an investor who buys an ABC 35 put has the right to sell 100 shares* of ABC stock at $35. Another investor sold the 35 put and has the obligation to buy 100 shares at $35 if the buyer exercises the contract.

Valuing an option
Every option contract has two key numbers, and only one of them moves. The strike price (also called the exercise price) stays fixed for the life of the contract - $35 in both examples above. The premium is the price the option buyer pays the seller for the contract, and it’s the cost of buying the option. The premium moves constantly with the market, and more valuable options carry higher premiums.

Part of that premium reflects the option’s intrinsic value - the profit the holder would receive by exercising the contract immediately. Intrinsic value equals the amount the option is in the money:

• A call has intrinsic value when the stock trades above the strike. With ABC at $40, the ABC 35 call lets the holder buy at $35 what’s worth $40 - $5 of intrinsic value per share.
• A put has intrinsic value when the stock trades below the strike. With ABC at $30, the ABC 35 put lets the holder sell at $35 what’s worth $30 - again $5 of intrinsic value.
• An option that’s at the money (stock price equals strike) or out of the money has no intrinsic value. It isn’t worthless - a premium may still reflect time remaining on the contract - but exercising it wouldn’t benefit the holder.

The exam concentrates on the account-opening process above, but NASAA also lists options valuation as a testable subject, so be ready to identify a contract’s premium and calculate its intrinsic value.

When an investor wants to open an options account, securities rules and regulations require a specific process:

1. Investor fills out a new account form
2. Investor is provided the ODD
3. Account is approved by the firm supervisor
4. First trade “opens” the account
5. Investor returns signed options agreement within 15 days

Let’s break down each step individually:

Investor fills out new account form
Opening an options account starts with the new account form. The same structure and rules discussed above (including CIP procedures) apply here.

Investor is provided the ODD
After the new account form is completed, the investor must receive the Options Disclosure Document (ODD). The ODD explains the characteristics, risks, and benefits of options. The ODD is produced by the Options Clearing Corporation, the primary options regulator.

Delivery of the ODD must occur prior to opening an options account or any options-related discussion. For example, a firm must provide the ODD if it mails options marketing materials to an investor who has not yet received the ODD.

Account is approved by firm supervisor
Next, the new account form is sent to a firm supervisor for approval. The supervisor confirms that required documentation has been provided and that proper account-opening procedures were followed.

First trade “opens” the account
Once the account is approved, the investor may place options trades. The first executed trade technically opens the account.

Investor returns signed options agreement within 15 days
During the account-opening process, the investor should receive the options agreement. By signing it, the investor confirms they have read the ODD, understand the characteristics of options, and that their suitability information is accurate as of the time they sign.

The investor has 15 days from account opening to return the signed options agreement. If it isn’t returned on time, the account will be restricted to transactions that only close out options positions.