Customer agreements

It’s important to know 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 Series 66-specific rules and disclosures.

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. 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):

• 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.

Collecting these four items allows broker-dealers and investment advisers to verify identity. Verification is typically done by comparing the information to:

• 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 a client’s financial situation. This is called suitability information, and it’s especially important for investment advisers. To make suitable recommendations, financial professionals need to understand a client’s financial status, risk tolerance, and goals.

Technically, investors aren’t legally required to provide suitability information. However, if the information isn’t provided, the firm can’t make recommendations. Any trades would have to 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, advisory contracts must be in writing and must disclose:

• 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

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 contract to a different controlling party.

In its most basic form, assignment would occur if an adviser handed over 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 test focus. 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 interests change.

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 (66%) original partners changed, which is a majority change. Even if the firm keeps its original name (Acme Advisory Partners), it 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. Now only one of the three (33%) original partners changed, which is a minority change. This is not assignment, but it still requires written notification to clients within a reasonable amount of time.

When new partners are admitted instead of existing partners selling or leaving, the math works differently: you measure the newcomers’ share of the partnership after they join, not against the original partner count alone. The formula is partners added ÷ (original partners + partners added). For example, a partnership of 10 equal partners admits 12 new equal partners. The newcomers hold $12/22\approx 55\%$ of the post-admission partnership, a majority change, so assignment occurs. If instead the partnership admits 5 new equal partners, the newcomers hold $5/15\approx 33\%$, a minority change, which is not assignment (note that dividing 5 by the original 10 partners alone would incorrectly suggest a 50% change) - though clients must still receive written notice.

NASAA rules also prohibit 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 “signs off” on the 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 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.

*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 clauses limited to “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 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

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. Borrowing 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:

• Hypothecation agreement
• Credit agreement
• Loan consent form

The hypothecation agreement is the customer’s pledge of securities as collateral for the margin loan. Similar to how a home secures a mortgage, securities in the brokerage account secure the margin loan. If the customer can’t repay the loan, the broker-dealer can liquidate (sell) securities in the account to satisfy 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 a margin account 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 exams.

Margin accounts are risky. If you borrow money to invest and the investment loses value, you can lose your own funds and still owe the borrowed amount. With margin, the broker-dealer is the lender.

Because of these added risks, investors receive additional disclosures. The key points are that:

• investors can lose more than the account’s value, and
• securities in the account serve as collateral for the loan.

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 specific process:

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

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
Once the new account form is completed, it’s 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
After approval, 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’ve 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 only close out existing options positions.