Customer agreements

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 65 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, a financial professional 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 the 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

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.

*Performance fees are covered in depth in a future chapter, but they involve the adviser keeping a portion of the capital gains it makes for its clients. A common performance fee structure is 2 & 20, meaning the adviser charges 2% of assets under management (AUM) and keeps 20% of the gains made.

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.

Margin accounts

The process of opening a margin account has already been covered in a previous chapter. This section should serve as a review.

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 than 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

As we learned in an earlier unit, an option is a contract between two parties (investors) to perform a transaction at a fixed price.

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