In addition to making disclosures to the state administrator and/or Securities and Exchange Commission (SEC) during the registration process, broker-dealers and investment advisers are required to make ongoing disclosures to their clients. We’ll cover three categories of these disclosures in this chapter:
In a future chapter, we’ll discuss various fees broker-dealers charge outside of commissions, markups, and markdowns. Those are disclosed in fee schedules that must be made available to customers. The North American Securities Administrators Association (NASAA) offers a model fee disclosure template that most broker-dealers utilize. This information must be made available to customers, and most broker-dealers include them in account applications and on their websites.
Agents representing broker-dealers must create an order ticket for each order they place, which leaves a historical record. The order ticket involves all of the details of a trade, which includes:
After an order ticket is submitted, each agent’s supervisor is required to review their work “promptly,” which usually means by the end of the day. When an agent places orders for their customers, their boss should check to ensure they’re placed properly. Sometimes referred to as the principal, supervisors have the ability to update the order if there’s a mistake. Even if the agent notices the mistake first, the principal must approve changes made to the ticket.
Agents are likely to encounter a customer placing an unsuitable order. For example, a retired customer with limited resources may want to place a trade for a very risky stock. It’s the responsibility of financial professionals to inform their customers of the risk they’re encountering. However, if they refuse to listen and insist on placing the order, the order must be placed. Ultimately, the customer is in charge of their finances and securities transactions.
In this situation, it’s a best practice for agents to document these discussions. Firms maintain files on every customer that includes transaction history and notes on previous interactions. The investor’s expectations may be wrong and could result in losing significant amounts of money. Conversation notes could help cover the firm’s liability. If the trade resulted from a recommendation, the firm could be held liable if the trade was unsuitable.
The most important disclosures made by an investment adviser are typically presented in the brochure. Let’s refresh ourselves on the three important sections of this disclosure document:
The primary purpose of each is to ensure clients are informed about the person they entrust their money with. Not only do these documents disclose the specifics related to products and services offered, but the client also has access to the history of the firm and its investment adviser representatives (IARs). If the adviser has a checkered past or is employing an IAR with a criminal record, this information can be gathered from the brochure.
NASAA disclosure-related rules also regulate solicitors, sometimes referred to as promoters. Let’s first take a look at NASAA’s definition of a solicitor:
“Solicitor” means any individual, person, or entity who, directly or indirectly, receives a cash fee or any other economic benefit for soliciting, referring, offering or otherwise negotiating for the sale or selling of investment advisory services to clients on behalf of an investment adviser.
In a nutshell, a solicitor is any person that is compensated to connect potential clients with advisers. While a solicitor could be an employee of the adviser, they could also be a separate third party. For example, an individual with a marketing background networks in their city and finds prospective clients for an adviser.
This type of arrangement is legal and ethical as long as certain protocols are followed and disclosures are made. The rules governing solicitors of state-registered advisers require the solicitor:
Be registered as an IAR
This one is pretty simple - the solicitor must be registered as an IAR of the firm they solicit business for.
Not be subject to a statutory disqualification
Promoters are treated just like financial professionals. If they have a checkered past, they cannot solicit on behalf of an adviser. We learned about statutory disqualifications in a previous chapter, but these are past actions or punishments that prevent a person from gaining registration (effectively barring them from the industry). Let’s review what qualifies as one:
Maintains a written agreement with the adviser
Solicitor-related regulations require the adviser and the promoter to create a written agreement between both parties. Additionally, the adviser is responsible for maintaining the agreement in their records, which could be requested by the state administrator. The agreement must describe the following:
Must deliver brochures
During the solicitation of any prospective client, the solicitor is required to deliver two brochures. Form ADV Part 2A, which is the adviser’s brochure, must be delivered in writing to the potential client. Additionally, a solicitor’s brochure must be created and delivered in writing as well. The required disclosures in this document include:
Obtains signed receipt of brochures from a prospective client
In addition to providing both the adviser’s and solicitor’s brochures, the promoter is required to obtain a signed receipt from the prospective client that simply affirms both disclosures were received. The investment adviser is required to maintain the signed receipt in their records.
Prior to 2020, solicitor rules for federal-covered advisers were essentially the same as those at the state level. In 2020, the Securities and Exchange Commission (SEC) finalized a new rule that simplified how solicitors were regulated. You’ll notice a few similarities in these requirements:
The solicitor must disclose the following:
Additionally, these rules must be followed:
*Essentially the same items that must be in the agreement between a state-registered adviser and their solicitor (discussed above) are the same here.
Last, the solicitor may not*:
*Although these prohibitions are specifically for solicitors of federal-covered advisers, you can assume the same applies at the state level.
You may have noticed two big omissions from the state-based solicitor rule. First, solicitors are not required to be registered as IARs. Second, there is no brochure delivery requirement for promoters. Given the adviser must provide the brochure to the client, the SEC felt forcing the solicitor to deliver it was redundant. As discussed above, the promoter must make disclosures at the time of solicitation. The SEC rule specifically states the disclosures must be made “clearly and prominently,” but does not explicitly require them to be put in writing.
Securities rules and regulations have continually pushed for further transparency in relation to investment advice. One particular concern for regulators is how an IAR’s personal securities holding may influence their recommendations to clients. For example, let’s assume an IAR personally owns stock in a thinly traded company. Knowing added demand for the security will result in its market price rising, they recommend it to a number of their clients even when it may not be totally suitable for their situation. Obviously, this would be a problem.
Rules applicable to both federal-covered and state-registered advisers have been recently created and implemented to prevent this type of behavior. Employees of advisers (typically IARs) with access to certain nonpublic information must continually disclose their personal securities holdings to their compliance departments. Let’s go through the details.
These disclosure rules only apply to access persons.
As stated above, most, if not all IARs of a registered adviser will qualify as an access person. These roles require access to client accounts, portfolio holdings, and details related to recommendations. To attain the transparency discussed above, securities regulators require access persons to fully disclose their personal holdings and transactions to their employing firms. This allows compliance officers to cross-reference recommendations made to clients against their personal investing activity. These two reports must be filed by access persons regularly:
Holdings reports
A holdings report provides a detailed view of an access person’s personal portfolio. This report will include:
The timing of the filing of the holdings report also must be known. It must be filed:
Transaction reports
These reports contain exactly what you would expect - transactions. In particular, the following must be disclosed:
Transaction reports must be filed no later than 30 days after the end of the quarter in which the transactions occurred.
Securities regulators provide three exceptions to the required filings of holdings and transaction reports. In particular, no filing is required for:
We’ll cover these four general disclosures required to be made by both broker-dealers and investment advisers (plus agents and IARs by extension):
Let’s kick this section off with a definition from the Merriam-Webster dictionary:
A conflict of interest exists when a financial professional could personally benefit from something related to a client interaction. For example, an investment adviser being compensated by an issuer for recommending their security to clients. Wouldn’t you want to know if your adviser had a financial interest in recommending a specific security, product, or service to you?
Conflicts of interest are not inherently problematic or illegal. However, a conflict could be considered unethical (and potentially criminal) if undisclosed. That’s the key - disclose it, and all is well! There are seemingly endless examples of conflicts of interest, but here are some key ones to be aware of:
As you can see, nearly all the conflicts of interest listed above relate to recommendations. While broker-dealers can recommend securities, their business is primarily focused on executing transactions. The majority of trades executed by broker-dealers are unsolicited, meaning the trade was the customer’s idea without influence from a financial professional. In these scenarios, broker-dealers are not subject to a fiduciary duty and don’t run into too many conflicts of interest.
Investment advisers must always act in a fiduciary capacity with their clients. Therefore, advisers must move to remove and/or mitigate conflicts of interest as much as possible. If it continues to exist, the conflict must be disclosed. Permanent conflicts of interest are typically disclosed in the brochure. If a conflict happens to occur spontaneously, it must be disclosed during the recommendation or prior to trade execution.
When financial professionals engage investors online, certain protocols must be followed in order to ensure compliance with regulatory requirements. In 1997, NASAA released an order relating to internet communications. When the internet started becoming a larger part of our culture in the late 1990s, it was important to establish a general regulatory mindset, especially in relation to registration.
The big question - would engaging investors online be considered an action requiring registration in all states those investors were currently residing in? For example, let’s assume an IAR registered and operating in one state only is discussing securities in an online comment thread (on Facebook, Reddit, etc.). Users from all 50 states are engaging in conversation with the IAR. Does this mean the IAR must be registered in all 50 states?
It depends on the type of conversation being had. According to the 1997 NASAA order, registered persons are not considered as “transacting business” if the following requirements are met:
Additionally, the same NASAA order requires agents and IARs to:
Keep in mind these rules only apply to online communications an agent or IAR engages in while acting in a professional capacity. These rules generally do not apply when not discussing securities or when conversing in a personal manner. For example, an agent posting a comment about the stock market on a Facebook comment thread in their free time would generally not be subject to the rules posted above. As long as the comment was posted in a personal capacity and didn’t reference their professional affiliations, it would fall outside of the administrator’s jurisdiction.
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 security transaction occurs must always be disclosed to investors. In most scenarios, broker-dealers disclose this on trade confirmations after a 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 65).
While most disclosures of capacity occur after a trade has been executed, some instances require pre-disclosure. In particular, a pre-disclosure must be made if an investment adviser’s recommendation will result in a principal transaction. For example, an adviser recommends ABC Company common stock, which will be sold out of the adviser’s inventory if the client agrees to the trade. This is another example of a conflict of interest that must be disclosed during the recommendation.
Agency cross transactions also require some pre-disclosures to be made. This type of transaction occurs when an investment adviser “crosses” two of their own clients on the same trade. For example, let’s assume 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 analyzes Ebony’s account and identifies her current position in Tesla stock as being unsuitable. The IAR recommends Ebony liquidate the position, and she agrees. The IAR gets back in touch with Leon, connects the two clients on the trade, and earns an advisory fee from Ebony.
The previous example would not be considered unethical if the following conditions were met (according to NASAA rules):
In the example above, the transaction was only recommended to Ebony. This complies with the last condition listed above. Beyond this requirement, written disclosures and approvals must be retained prior to executing an agency cross transaction. And don’t forget about the annual disclosures that must be made to all clients. As long as the proper disclosures and approval existed in the Leon and Ebony example, it would’ve been a compliant agency cross transaction.
Financial firms and their representatives may provide access to third-party research reports as an ongoing service. Many of these reports offer investment insights on specific securities from the perspective of professional analysts. With the added data and information, clients are better equipped to understand the financial markets and succeed as an investor.
There’s one big requirement cited in NASAA rules - disclose the source! It’s important the registered person does not insinuate it was their own research in order to impress their client.
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