Investors utilize brokerage accounts maintained at broker-dealers to hold and trade securities. This chapter covers the general process of opening a new account, and these are the specific areas we’ll discuss:

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

Required customer information

Customers must submit certain pieces of information when opening a new brokerage account. Additionally, registered representatives are required to follow specific protocols and procedures. Gathering the “four critical pieces of information” is a legal requirement to open a financial account.

The Patriot Act, a legislation signed into law after the September 11th, 2001 attacks, was primarily created to prevent terrorism and money laundering. The law requires financial firms to verify the identities of their customers, which prevents customers from creating accounts under fake personas. To accomplish this, the firm must collect four pieces of critical information from the customer as a 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 follows one of two procedures to verify its customer’s identity. The traditional method involves comparing the provided information against a government-issued I.D., like a driver’s license, passport, or military I.D. The I.D. must be currently valid and include a picture, which is why birth certificates cannot be used for identity verification.

The modern way of verifying a customer’s identity utilizes credit bureaus. TransUnion, Experian, and Equifax, which are the three largest credit bureaus, are utilized in this process. When a customer submits their “critical information,” the broker-dealer checks data housed by the credit bureaus to confirm that the information provided matches an actual person. If one or more pieces do not match, the firm cannot do business with the customer until the mismatch is resolved. For example, if the customer mistakenly provided the wrong address, they must fix the issue before their account is opened.

The firm must obtain other items before doing business with the customer. The customer’s occupation is one of those items, as it’s the firm’s responsibility to confirm whether or not their 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 enforce 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 rule prevents securities professionals from buying up IPOs and leaving nothing for the public. The firm will know if these restrictions should be imposed by asking for the customer’s occupation.

Brokerage firms must also supervise their employees’ accounts to prevent misconduct, which includes insider trading. Insider trading occurs when a trade is executed based on material, non-public information. To prevent securities regulations or laws from being broken, firms must 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 and notify them when the account is opened. Additionally, the firm maintaining the account for the representative must provide the employing firm with duplicate statements and trade confirmations if requested.

Optional account information

Firms must ask for many pieces of information when an account is opened, but some items are voluntarily provided. In particular, suitability questions are always optional for a 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

Items like annual income or net worth may be sensitive information for a customer to provide. However, the firm must obtain this information to make suitable recommendations. “Solicited trades” (transactions based on a recommendation) may only be made if the firm can fully understand a customer’s financial situation. This provision is a part of FINRA Rule 2090, commonly known as the “know your customer” (KYC) rule. Firms must ensure they obtain all the necessary facts about a customer before performing certain actions (like making recommendations).

If the customer refuses to answer some or all suitability questions, the firm cannot recommend or suggest specific investments. All of the customer’s trades must be “unsolicited” (transactions not based on a recommendation) and submitted 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 determine what type of account they will open. 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, often leading to increased gain and risk potential (leverage). We’ll discuss margin accounts in detail later in this unit.

After the account type is determined and the new account form is completed, the firm goes through a specific process to open the account.

First, a securities principal (supervisor) reviews the new account form to ensure all required information was provided and standard account opening protocols were followed. This job is typically performed by a person holding the Series 9/10 licenses (known as a General Securities Sales Supervisor). If the form is “in good order,” the principal will sign the form, effectively approving the account. There’s no legal or regulatory requirement for the customer to sign the new account form, which allows firms to open accounts over the phone. However, many financial institutions require their customers to sign agreements to firm policies, which may include terms of service and an arbitration agreement.

Sidenote

Pre-dispute arbitration agreements

Pre-dispute arbitration agreements force any disputes between the customer and the broker-dealer into binding arbitration. The customer cannot sue the firm in the U.S. court system, but they can gain restitution for any disputes with the firm through FINRA’s arbitration system. Arbitration is faster and more efficient than a lawsuit, but customers are only forced into arbitration if they sign the agreement. The only problem - virtually all broker-dealers require customers to sign arbitration agreements. This form of dispute resolution is discussed in further detail in a future chapter.

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 in the future, the member firm must provide it within 10 business days of the request.

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 on file by negative confirmation (affirmation), which means the investor only needs to respond if the information on file is incorrect. If the customer does not respond, the firm assumes the details on file are correct. Additionally, the firm must follow up with the customer 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 are obligated to provide customers a transparent view of their assets. At a minimum, firms must send account statements to customers quarterly (every three months). However, monthly statements must be sent if a customer holds penny stocks in their account. Additionally, statements may be sent electronically (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

Although the firm must send consistent statements by mail (unless the investor elects for email delivery), customers may request their mail be held for short periods. For up to three months, customers may request that statements be held for any reason. For the mail to be held longer than three months, the customer must submit a request in writing and demonstrate a legitimate reason for the request (e.g., military deployment, safety, and 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.” Essentially, the broker-dealer must send the trade confirmation by the time the trade settles. Like statements, trade confirmations may be distributed 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