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 adds several concepts that are especially important for the Series 65.
We’ll cover these customer agreements related to opening accounts:
Clients and customers must provide specific information to open new accounts with broker-dealers and investment advisers. This requirement comes from the Patriot Act, which was signed into law after the 9/11 attacks in 2001 to help prevent terrorism and money laundering. The law requires financial firms to verify customer identities, helping prevent accounts from being opened under false identities.
To do this, firms must collect four pieces of critical information as part of their Customer Identification Program (CIP):
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.
Once the firm collects these four items, it verifies the customer’s identity. Verification is typically done by comparing the information to:
Firms also request information about the client’s financial situation. This is called suitability information, and it’s especially important for investment advisers. To make suitable recommendations, a financial professional needs to understand the client’s financial status, risk tolerance, and goals.
Technically, investors are not legally required to provide suitability information. However, if the firm doesn’t have enough suitability information, it can’t make recommendations. In that case, any trades must be unsolicited (meaning the client initiates the trade without a recommendation). Unsolicited trading is common 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 comply, contracts that clients sign with investment advisers must be in writing and must disclose:
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 is language where a client “agrees” to let the adviser or IAR avoid legal responsibilities or waive compliance with securities law.
You might wonder why a client would ever agree to that. One reason the idea might come up is if a client who doesn’t meet qualified status wants the adviser to ignore NASAA rules so the adviser can charge performance fees*. That would be 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.
Although hedge clauses are generally unlawful, regulators often allow hedge-clause language that addresses truly “uncontrollable events.” These are typically large-scale disruptions such as:
For example, an adviser might include language stating they may not be able to fulfill fiduciary obligations during a natural disaster.
The process of opening a margin account has already been covered in a previous chapter. This section is a review.
Margin accounts allow investors to borrow money for investment purposes. This creates leverage, which can amplify both gains and losses.
In addition to a new account form, investors opening margin accounts must also complete and sign the margin agreement. This document has three subsections:
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 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 debt.
The credit agreement describes the margin loan terms, including how margin interest is calculated, the repayment schedule, and other loan terms. It also discloses whether the investor’s credit may 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 to sign it, 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 FINRA rules you may have learned while preparing for the SIE, Series 6, or Series 7.
Margin accounts are risky because the investor can lose more than the cash they deposited. If the investment declines sharply, the investor still owes the borrowed funds back to the broker-dealer.
Because of these added risks, investors opening margin accounts receive additional disclosures. These disclosures emphasize that:
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 specific process:
Let’s break down each step:
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.
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.
The ODD must be delivered before opening an options account or having any options-related discussion. For example, if a firm mails options marketing materials to an investor who hasn’t received the ODD, the firm must include 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 is complete and that proper account-opening procedures were followed.
First trade “opens” the account
Once 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 signing date.
The investor has 15 days from account opening to return the signed options agreement. If it isn’t returned on time, the account is restricted to transactions that close out existing options positions.
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