The general process

Investors use brokerage accounts held at broker-dealers to buy, sell, and hold securities. This chapter explains the general process of opening a new account, including:

• Required customer information
• Optional customer information
• Account opening process
• Statements
• Trade confirmations

Required customer information

Customers must provide certain information when opening a new brokerage account. Registered representatives also have specific procedures they must follow. Collecting the four critical pieces of information is a legal requirement for opening a financial account.

The Patriot Act, signed into law after the September 11th, 2001 attacks, was designed to help prevent terrorism and money laundering. One key requirement is that financial firms must verify customer identities, which helps prevent accounts from being opened under false identities.

To do this, the firm collects four critical pieces of information as part of a Customer Identification Program (CIP):

• Name
• Date of birth
• Physical address*
• SSN or TIN**

*While a customer may request mail to be sent to a P.O. box, a physical mailing address must be on file.

**If a customer is a non-resident alien, they must provide their foreign passport and U.S. tax identification number (TIN).

Sidenote

Recordkeeping requirements

Financial firms are required to maintain CIP records for at least five years.

After collecting this information, the firm uses one of two methods to verify the customer’s identity:

• Documentary verification: The firm compares the information to a valid government-issued photo ID (such as a driver’s license, passport, or military ID). The ID must be current and include a photo, which is why a birth certificate can’t be used for identity verification.

• Non-documentary verification: The firm verifies the information using credit bureau databases. TransUnion, Experian, and Equifax are commonly used. The broker-dealer checks whether the submitted information matches a real person in those records. If any key item doesn’t match, the firm can’t do business with the customer until the issue is resolved (for example, correcting an incorrect address).

The firm must also obtain additional information before doing business with the customer. One important item is the customer’s occupation, because the firm must determine whether the customer:

• Is an affiliate (insider) of a publicly traded company, or
• Works in the securities industry

If the customer is an affiliate of a publicly traded company, the brokerage firm must apply the provisions of Rule 144.

Definitions

Affiliate

An officer, director, or 10%+ shareholder of an issuer

Sidenote

Rule 144

Rule 144 prohibits affiliates from quickly selling significant amounts of their “control” stock. Control stock is any stock held by an affiliate in the company they are an affiliate of. For example, all the Tesla Inc. stock (ticker: TSLA) held by Elon Musk is considered control stock. Affiliates like Mr. Musk are limited to liquidating (selling) the greater of the last four week’s trading average, or 1% of the outstanding shares, up to four times a year.

If the customer is a registered representative in the securities industry, they’re prohibited from purchasing common stock initial public offerings (IPOs). This restriction helps prevent securities professionals from buying up IPO shares before the public has access. The firm identifies whether these restrictions apply by asking for the customer’s occupation.

Brokerage firms must also supervise their employees’ accounts to help prevent misconduct, including insider trading. Insider trading occurs when a trade is executed based on material, non-public information. To reduce the risk of securities laws being violated, firms supervise the accounts of their registered representatives.

If a registered representative wants to open an account at another brokerage firm:

• They must obtain written approval from their employer.
• They must notify their employer when the account is opened.
• The firm carrying the account must provide duplicate statements and trade confirmations to the employing firm if requested.

Optional account information

Firms must request many items when an account is opened, but some information is provided voluntarily. In particular, suitability questions are always optional for the customer to answer.

Suitability questions include:

• Investment objective
• Risk tolerance
• Investment experience
• Investment goals
• Investments held at other firms
• Marital status
• Annual income
• Net worth
• Tax status
• Liquidity needs

Some of these items (such as annual income or net worth) can feel sensitive. Even so, the firm needs enough information to make suitable recommendations. Solicited trades (transactions based on a recommendation) may only be made when the firm understands the customer’s financial situation.

This requirement comes from FINRA Rule 2090, commonly called the “know your customer” (KYC) rule. The firm must obtain the essential facts about a customer before taking certain actions, such as making recommendations.

If the customer refuses to answer some or all suitability questions, the firm can’t recommend specific investments. In that case, the customer’s trades must be unsolicited (not based on a recommendation) and placed without the firm’s guidance.

Sidenote

Recordkeeping

FINRA and the SEC require broker-dealers to maintain customer records for six years. If a customer closes their account, the firm must take a “snapshot” of the customer’s information and maintain those records for six years after account closing.

Account opening process

When a customer completes a new account form, they must choose an account type.

• Cash accounts are standard brokerage accounts that require 100% payment for any securities purchased.
• Margin accounts allow the investor to borrow cash and securities from the broker-dealer for investment purposes. This can increase both potential gains and potential losses through leverage. Margin accounts are covered in detail later in this unit.

After the account type is selected and the new account form is completed, the firm follows a defined process to open the account.

First, a securities principal (supervisor) reviews the new account form to confirm that:

• All required information is included, and
• Standard account-opening procedures were followed

This review is typically performed by a Series 9/10 license holder (a General Securities Sales Supervisor). If the form is in good order, the principal signs it to approve the account.

There’s no legal or regulatory requirement for the customer to sign the new account form, which allows accounts to be opened over the phone. However, many firms require customers to sign agreements to firm policies, which may include terms of service and a pre-dispute arbitration agreement.

Sidenote

Pre-dispute arbitration agreements

Pre-dispute arbitration agreements require disputes between the customer and the broker-dealer to be resolved through binding arbitration. The customer can’t sue the firm in the U.S. court system, but they can seek restitution through FINRA’s arbitration system. Arbitration is generally faster and more efficient than a lawsuit, but it applies only if the customer signs the agreement.

If the pre-dispute arbitration agreement is part of a larger customer agreement, the arbitration section must be highlighted. If the agreement is signed, the member firm must provide the customer with a copy within 30 calendar days. If the customer requests another copy later, the member firm must provide it within 10 business days of the request.

This form of dispute resolution is discussed in further detail in a future chapter.

Within 30 days of account approval, the firm must send the customer a confirmation of the information provided on the new account form. The customer verifies the information through negative confirmation (affirmation), meaning the customer responds only if something is incorrect. If the customer doesn’t respond, the firm treats the information as accurate.

The firm must also follow up and verify the information on file every 36 months (three years).

Statements

Account statements provide a historical view of account activity, security values, and overall balances. Broker-dealers must give customers a clear view of their assets.

At a minimum, firms must send account statements quarterly (every three months). However, monthly statements must be sent if the customer holds penny stocks in the account. Statements may also be delivered electronically (such as by email) if the customer requests.

Definitions

Penny stock

An unlisted stock (one that does not trade on a stock exchange) trading below $5 per share

Firms must send statements consistently by mail unless the customer elects electronic delivery. Customers may request that mail be held for short periods:

• For up to three months, mail may be held for any reason.
• To hold mail for longer than three months, the customer must submit a written request and show a legitimate reason (e.g., military deployment, safety, or security-related issues).

FINRA’s rule on holding mail does not explicitly state how often mail can be held. For example, there is no rule against a customer requesting mail be held for three months, then taking a month break, then requesting another hold for three months. All that is required is for the firm to determine “reasonable intervals” for the mail hold instructions to apply. Additionally, firms must educate their customers on other ways to obtain their mail securely (e.g., by email).

Trade confirmations

In addition to statements, customers receive trade confirmations when a transaction occurs. Trade confirmations detail of the following:

• Customer’s name
• Account number
• Security bought or sold
• Number of contracts, shares, or units traded
• Date and time of the transaction
• Fees and/or commissions
• Capacity of firm (agency or principal)

Trade confirmations must be sent at or prior to the “completion of the transaction.” In practice, the broker-dealer must send the confirmation by the time the trade settles. Like statements, trade confirmations may be delivered by mail or electronically.

Sidenote

Error accounts & trades

An error account, which is owned and maintained by a member firm, holds securities obtained through erroneous trades. For example, let’s assume a customer tells their assigned representative to buy a call option contract. Mistakenly, the representative goes long a put contract. If the mistake is the firm’s or its representatives’ fault, the firm must absorb the security and “make it right” for the customer*.

*“Making it right” in this example would likely require the firm to separately purchase the call option (for the customer) and provide the execution price they would have obtained if the representative had submitted the order correctly. Generally, firms must ensure the customer’s intended trade request is fulfilled.

When an erroneous trade (sometimes referred to as a ‘trade error’) is identified by a representative, an error report must be made to a securities principal. If the principal confirms the transaction is the fault of the firm or its representative(s), they work to rectify the situation. If the incorrect security was traded, it is typically placed into the firm’s error account. Firms typically designate a principal or team of principals to continuously monitor and manage the error account.

In some instances, a securities principal may discover a trade was placed correctly but was misreported. For example, a customer requests to purchase a call option, and the trade is placed correctly by their assigned representative. Later, the customer receives a trade confirmation incorrectly reporting a purchase of a put option. The customer is granted the correct transaction in these scenarios, and the firm must update the trade confirmation (or the documentation that incorrectly reported the trade).

Another “error” scenario involves crediting a trade to the wrong account. For example, a representative receives a trade request from Customer A. The trade is executed but mistakenly placed in Customer B’s account. If an error like this occurs, it can be fixed by a securities principal. Known as a cancel/rebill, the principal would note the reason for the error and approve the “fix” in writing, then make the adjustment in the firm’s internal systems.

Professional customer

A professional customer is a non-broker dealer that places 390 or more orders per day, across all markets, on a monthly basis for an entire calendar quarter. This classification can affect how the customer’s orders are handled in regards to order routing, fees, and execution priority. Professional customers are usually treated differently from retail customers, so they may not receive the same protections or priority in order execution. Professional customers are placed in a separate supervisory category due to their expertise, risk assessment, suitability obligations, and modified institutional-customer exemptions.

Key points

Four critical pieces of information

• List:
  • Name
  • Date of birth (DOB)
  • Address
  • SSN or TIN
• Must be collected as per Patriot Act
• Must be verified through:
  • Valid government-issued I.D.
  • Credit bureau database

Customer occupation

• Must confirm if the customer is:
  • Affiliate of publicly traded company
  • A registered financial representative

Suitability questions

• Not required to be answered
• Firms cannot make recommendations without this information

Customer record retention requirements

• Must maintain records for six years
• Records also maintained six years after account closing

Cash accounts

• Require full payment for transactions

Signatures on new account form

• Customer does not sign
• Registered representative may sign if servicing account
• Principal must sign to approve the account

Required firm actions

• Must confirm customer info within 30 days of account opening
• Must confirm customer info every 3 years

Pre-dispute arbitration agreements

• Forces customer disputes to binding arbitration facilitated by FINRA
• If signed, copy must be provided to customer within 30 calendar days
• Firm must provide another copy if specifically requested by customer within 10 business days

Quarterly statements

• Can be sent by mail or electronically

Monthly statements

• Sent if the customer holds penny stocks
• Can be sent by mail or electronically

Holding mail

• Can hold customer mail for up to 3 months
• Additional 3 months for a legitimate reason

Trade confirmations

• Provides trade details after the transaction
• Sent by completion of the transaction
• Can be sent by mail or electronically

Error accounts

• Firm account that holds incorrectly traded securities

Cancel/rebill

• Process to fix a security trade placed in the wrong account
• Principal must note reason for the error in writing

Professional customer

• A non-broker dealer that places 390 or more orders per day, across all markets, on a monthly basis for an entire calendar quarter