Textbook
1. Introduction
2. Investment vehicle characteristics
3. Recommendations & strategies
4. Economic factors & business information
5. Laws & regulations
5.1 Securities laws
5.2 Definitions
5.3 Registration
5.4 Enforcement
5.5 Communications
5.5.1 Disclosures
5.5.2 General disclosures
5.5.3 Performance guarantees
5.5.4 Customer agreements
5.5.5 Correspondence & advertising
5.6 Ethics
6. Wrapping up
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5.5.1 Disclosures
Achievable Series 66
5. Laws & regulations
5.5. Communications

Disclosures

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:

  • Broker-dealer disclosures
  • Investment adviser disclosures
  • General disclosures

Broker-dealer disclosures

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:

Definitions
Ticker symbol
A set of characters that represent an investment. Every publicly traded stock has its own unique ticker symbol, which makes it easy to track a stock without typing out the full business name. Examples of ticker symbols:
  • TGT = Target Corporation

  • HD = Home Depot Inc.

  • AXP = American Express Company

CUSIP
In plain terms, like a social security number of a security. It’s a unique alphanumeric figure that is assigned to each security. Examples of CUSIP numbers:
Solicited orders
A trade recommended to a customer by a financial firm or its representative.

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, a supervisor has 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.

Investment adviser disclosures

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.

Solicitors for state-registered advisers

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 for connecting 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.

Definitions
Prospective client
A person a financial professional aims to sign as a client

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
  • Not be subject to a statutory disqualification
  • Maintains a written agreement with the adviser
  • Must deliver brochures
  • Obtains signed receipt of brochures from a prospective client

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:

  • Subject to denial, suspension, or revocation by any securities regulator
  • Any felony or securities-related misdemeanor conviction in the past 10 years
  • Subject to any injunction or other court-related order prohibiting work in the securities industry
  • Has filed a registration application with inaccurate or false information
  • Has willfully violated a securities act (e.g. Uniform Securities Act, Investment Advisers Act of 1940)

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:

  • The solicitation activities the solicitor will be engaged in
  • How the adviser will ensure all applicable laws and regulations will be followed

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 the following:

  • Name of the solicitor and the adviser they’re soliciting for
  • Nature of the relationship between the solicitor and the adviser
  • A statement confirming the solicitor is being compensated for their services
  • Terms and description of the compensation to be received by the solicitor
  • Disclosure if the client will be charged a higher fee than normal to compensate the solicitor

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.

Sidenote
Solicitation of impersonal advisory services

The promoter is not required to register as an IAR if they only solicit impersonal advisory services. For example, a solicitor attempts to sell an adviser’s newsletter that includes market commentary and general recommendations (nothing specific to any one client).

Sidenote
Nominal fees

It’s possible a third party connects clients with an adviser and is not technically considered a solicitor. In particular, this occurs if the third party is compensated a nominal fee (nothing more than a few hundred dollars). This often occurs when professionals from other industries recommend an adviser’s services. For example, an accountant prepares their clients’ taxes, and then recommends the services of an adviser in return for a $200 finder’s fee. In this scenario, the accountant would not be required to follow any of the rules above (although general ethical guidelines still must be followed).

Securities regulators tend to look out for sharing of asset under management (AUM) fees. If this was shared with the third party, it could not be considered a nominal fee and normal solicitor rules would apply.

Solicitors for federal-covered advisers

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:

  • If they’re a client of the adviser
  • If they’re being compensated and, if so, how much
  • Any conflicts of interest related to their relationship with the adviser

Additionally, these rules must be followed:

  • A written agreement must exist between the adviser and solicitor*
  • The solicitor may not be subject to any statutory disqualification

*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*:

  • Make an untrue, inaccurate, or misleading statement
  • Discuss potential benefits without discussing potential risks
  • Reference the adviser’s recommendations in a way that is not fair and balanced
  • Present the adviser’s performance in a way that is not fair and balanced

*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.

Sidenote
De minimis fees

If a promoter is collecting a “de minimis” (small) fee for their services, the SEC does not require a written agreement to be in place between the adviser and solicitor. De minimis fees are defined specifically as $1,000 or less.

Access person disclosures

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.

Definitions
Access person
Any supervised person of an investment advisor who:
  • Has access to non-public information regarding any client’s purchase or sale of securities
  • Has access to non-public information regarding the portfolio holdings of any reportable fund (e.g. a mutual fund)
  • Is involved in making securities recommendations to clients, or who has access to such recommendations that are non-public

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
  • Transaction reports

Holdings reports
A holdings report provides a detailed view of an access person’s personal portfolio. This report will include the following:

  • Securities owned by the access person
  • Name of broker, dealer, or bank where the portfolio is held
  • The date the holdings report is submitted

The timing of the filing of the holdings report also must be known. It must be filed:

  • No later than 10 days after the person becomes an access person, and the information must be current as of a date no more than 45 days prior to the date the person becomes an access person
  • At least once each 12-month period thereafter on a date selected by the investment adviser, and the information must be current as of a date no more than 45 days prior to the date the report was submitted

Transaction reports
These reports contain exactly what you would expect - transactions. In particular, the following must be disclosed:

  • Date of the transaction
  • Security traded and any relevant details (e.g. number of shares)
  • Nature of the transaction (e.g. buy, sale, short sale)
  • Price the security was traded at
  • Name of the broker, dealer, or bank performing the transaction
  • The date the transaction report was filed

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:

  • Activity in which the access person had no direct or indirect control over
    • For example, the access person is a beneficiary of a trust account owning and trading securities, which is managed by a separate third-party trustee
  • Transactions related to an automatic investment plan
    • For example, dividends received from a mutual fund that are automatically reinvested
  • Transactions the adviser has direct access to
    • For example, an IAR maintains an account with their employing adviser’s affiliated broker-dealer (the adviser can access this account at any time)
Key points

Order tickets

  • Must be prepared prior to order entry
  • Promptly reviewed by principals
  • Changes subject to principal approval

Order ticket components

  • Customer identifier
  • Cash or margin account
  • Registered representative identifier
  • Long or short sale
  • Security identifier (symbol or CUSIP)
  • Number of shares or units
  • Order type
  • Date and time
  • Solicited or unsolicited order
  • If the order is discretionary

Solicitor (promoter)

  • Any person compensated for connecting prospective clients with an adviser

Requirements for solicitors of state-registered advisers

  • Must be registered as an IAR
  • May not be subject to statutory disqualification
  • Must maintain written agreement with the adviser
  • Must deliver adviser’s and solicitor’s brochures to prospective clients
  • Must obtain signed receipt of brochures

Requirements for solicitors of federal-covered advisers

  • Must disclose if they’re a client
  • Must disclose if being paid and, if so, how much
  • Must maintain written agreement with the adviser
    • Unless the solicitor is paid $1,000 or less
  • May not be subject to statutory disqualification

Solicitors may not:

  • Make untrue, inaccurate, or misleading statements
  • Discuss benefits without potential risks
  • Reference adviser’s recommendations in an unfair or unbalanced way
  • Present the adviser’s performance in an unfair or unbalanced way

Access person

  • Any supervised person of an investment advisor who:
    • Has access to client accounts
    • Has access to fund portfolios
    • Provides recommendations

Holdings reports

  • Disclose securities personally owned by access persons
  • Must be:
    • Filed no later than 10 days after becoming an access person
    • Filed annually thereafter
    • Current within 45 days of filing

Transaction reports

  • Disclose securities transactions personally performed by access persons
  • Must be filed no later than 30 days after the end of the quarter

Exceptions to access person filing requirements

  • Activity in which the access person had no direct or indirect control over
  • Transactions related to an automatic investment plan
  • Transactions the adviser has direct access to

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