Customer agreements | Communications | Ethics

It’s important to be aware of the basics related to opening brokerage and advisory accounts for customers and clients. If you’ve prepared for another finance exam like the SIE, Series 6, or 7, you’re probably well aware of the process and paperwork involved. Still, there will be a number of concepts unique to the Series 63 covered in this chapter. We’ll be discussing the following customer agreements related to opening accounts in this chapter:

New accounts
Margin accounts
Options accounts

New accounts

Clients and customers must submit specific pieces of information in order to open new accounts with broker-dealers and investment advisers. The requirement to attain this information comes from the Patriot Act, which was signed into law after the 9/11 attacks in 2001 to prevent terrorism and money laundering. This law requires financial firms to verify the identities of their customers, which aims to prevent the creation of accounts under fake personas.

To accomplish this, financial firms must collect four pieces of critical information from the customer as a part of their Customer Identification Program (CIP):

Name
Date of birth
Address
SSN or TIN

If a customer is a non-resident alien, they must provide their foreign passport and their US tax identification number (TIN). Citizenship is confirmed through this process, which is another account opening disclosure required.

Collecting the four pieces of critical information allows broker-dealers and investment advisers to verify their client’s identities. 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).

Information related to a client or customer’s financial situation is also requested. Known as suitability information, these disclosures are especially important to investment advisers. In order to make suitable recommendations, financial professionals should be aware of their clients’ financial status, risk tolerance, and goals.

Technically, investors are not legally obligated to provide suitability information to financial firms. However, recommendations cannot be made if any of this information is kept private. All trades would be required to be unsolicited (no recommendations) if any suitability information is lacking. Most advisers turn away clients unwilling to provide this information. If recommendations aren’t allowed, what exactly are they offering the client? Unsolicited trades are fairly normal at broker-dealers, especially for self-directed customers.

The North American Securities Administrators Association (NASAA) issued an updated rule in 2013 regarding advisory contracts. To be compliant, contracts clients sign with investment advisers must be in writing, plus must make 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 its most basic form, assignment would occur if an adviser handed over a client’s contract to a completely different firm. For example, let’s assume a client has ABC Advisers managing their assets. If the business was sold to XYZ advisers, assignment would occur once XYZ began managing ABC’s former clients. There’s nothing inherently unethical or illegal about assignment as long as it’s voluntary. If the client approves the assignment in writing, it complies with securities rules and regulations. Involuntary assignment of any form is unlawful.

Investment advisers structured as partnerships are consistently a focus for test questions on assignment. Many advisory firms are set up as partnerships, where two or more persons own, manage, and control the business. Assignment would occur if a majority (more than 50%) of the partnership structure changes.

For example, let’s assume Acme Advisory Partners is comprised of three partners: Robert, Denzel, and Jada. If Robert and Denzel sell their partnership interest to Sally, assignment has occurred. Two of the three (66%) original partners changed, resulting in a majority change. Even if the business (now comprised of Jada and Sally as the only partners) retains its original name (Acme Advisory Partners), written approval must be obtained from all clients to continue managing their accounts. Corporations could be subject to the same assignment rules if more than 50% of the voting shares change hands.

Using the same example, let’s instead assume only Robert sells his interest to Sally. In this scenario, only one of the three (33%) original partners changed, resulting in a minority change. This adjustment would not be considered assignment, and only require 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 their adviser or IAR breaking the law. It might be a bit confusing as to why a client would allow this, but there are some valid reasons why the idea might be entertained. For example, what if a client that didn’t meet qualified status wanted their adviser to disregard the NASAA rules in order to charge them performance fees? Obviously, this is both unethical and illegal.

While they’re generally unlawful, securities regulators tend to allow hedge clauses specific to “uncontrollable events.” These events are typically related to weather (e.g. hurricanes, earthquakes), communication disruptions (e.g. telephone lines going down), war, government shutdowns, and other large-scale catastrophes (e.g. global pandemics). For example, an adviser may put language in a contract 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 allows clients to leverage themselves with their securities, resulting in amplified gains and losses. In addition to a new account form, investors opening margin accounts must additionally fill out and sign the margin agreement. This document contains three subsections:

Hypothecation agreement
Credit agreement
Loan consent form

The hypothecation agreement involves the customer pledging securities as collateral for their margin loans. Just like a home is collateral for a mortgage, securities held in a brokerage account serve as collateral for margin loans. If a customer borrows money from their broker-dealer and is unable to repay the loan, the broker-dealer can liquidate (sell) the securities in their account to pay off the loan.

The credit agreement contains the details of the margin loan, including the method of calculating margin interest, the repayment schedule, and the general terms of the loan. Additionally, a disclosure is provided if 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 out the customer’s securities to other investors for short sales. Although there’s no legal requirement for it to be signed, most broker-dealers do not 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. Think about it - what if you borrowed a friend’s money and invested both your and your friend’s money in a security that becomes worthless? Not only did you lose your money, but you also owe your friend their money back. Margin accounts work the same way, except swap out your friend for the broker-dealer.

Because of the added risks, investors opening margin accounts are provided with additional disclosures. It’s important investors understand they can lose more than their accounts are worth, and that the investments in their accounts are collateral.

Options account

While you don’t need to be concerned with the specifics, an option is a contract between two parties (investors) to perform a transaction at a fixed price. There are two types of options - calls and puts.

Calls are contracts that allow the option owner to exercise a right to purchase stock at a fixed price. For example, an investor purchasing an ABC 35 call gains the right to purchase 100 shares* of ABC stock at $35. There’s another investor that sold the 35 call, and they have the obligation to sell 100 shares at $35 should the option buyer exercise the contract.

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

Puts are contracts that allow the option owner to exercise a right to sell stock at a fixed price. For example, an investor purchasing an ABC 35 put gains the right to sell 100 shares* of ABC stock at $35. There’s another investor that sold the 35 put, and they have the obligation to buy 100 shares at $35 should the option buyer exercise the contract.

Again, don’t worry about the specifics related to options. The test may focus on the opening of an options account, but it’s very unlikely to see exam questions on aspects of specific option contracts.

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

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

Let’s break down each step individually:

Investor fills out new account form
The first step to opening any account involves a new account form. The same structure and rules we discussed above (e.g. CIP procedures) apply here.

Investor is provided the ODD
Once the new account form is filled out, the investor must be provided the Options Disclosure Document (ODD), which is an options booklet of characteristics, risks, and benefits of options. If you want to see the real ODD, click the link above. The ODD is a creation of the Options Clearing Corporation, which is the primary options regulator.

Delivery of the ODD must occur prior to opening an options account or any options-related discussion. For example, financial firms must provide the ODD if mailing options marketing materials to an investor that has not yet received the ODD.

Account is approved by firm supervisor
After the new account form is filled out, it’s sent to a firm supervisor for approval. Their role is to confirm necessary documentation has been provided and proper account opening procedures have been followed.

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

Investor returns signed options agreement within 15 days
At some point during the account opening process, the investor should be provided the options agreement. This agreement confirms they’ve read the ODD, understand the characteristics of options, and that their suitability information is valid when they sign the options agreement. The investor has 15 days from account opening to return the signed options agreement. If they do not return it in time, the account will be restricted to only performing transactions that close out options positions.

Key points

Customer identification procedure

Firms must verify the identities of their clients
The following information must be collected:
- Name
- Date of birth
- Address
- SSN or TIN
Client information must be verified by comparing it against:
- Government-issued ID, or
- Comparison against a credit database

Disclosure of non-public client data

Strictly prohibited without client approval
Does not apply to:
- Third parties with trading authority
- Legal authorities

Assignment of contract

Occurs when an adviser transfers the contract to another adviser
May only be done with written client approval
Considered assignment:
- Majority change to an adviser set up as partnership
Minority changes to an adviser set up as partnership is not assignment
- Still requires written notice to clients

Hedge clauses

An attempt to gain client approval to avoid compliance with the law
Generally prohibited
Hedge clauses relating to “acts of god” or other uncontrollable events ARE allowed

Margin accounts

Allow investors to pledge securities in return for borrowing money
Generally used by investors for leverage
- Amplified gains and losses
Margin agreement components
- Hypothecation agreement
- Credit agreement
- Loan consent form.

Options accounts

Process for opening:
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