Chapter 6: Investment Advisory Practices
An adviser enters bunched orders for several clients during the trading day. After seeing which trades are profitable, the adviser allocates the profitable executions to favored accounts and the losing executions to other clients. Each security was otherwise suitable for every participating account. Which statement most accurately describes the practice?
A. It is fraudulent because allocations may not be based on known post-execution results.
B. It is permitted because each security was suitable.
C. It is permitted if the favored accounts pay higher advisory fees.
D. It is prohibited only when the transactions involve options.
Answer: A — It is fraudulent.
Trade allocations must be based on a fair, predetermined method. An adviser may not wait to see which trades are profitable before assigning them to favored accounts.
Which statement may violate the antifraud provisions of the Uniform Securities Act?
A. “The bond is rated investment grade by an independent rating agency.”
B. “The Administrator has approved this security as a safe investment.”
C. “The fund’s value may decline because of market conditions.”
D. “The issuer’s financial statements are available in its prospectus.”
Answer: B.
Registration with a regulator does not indicate that the regulator approved the investment, passed on its merits, or guaranteed its safety.
Under the Uniform Securities Act, an offer is best defined as:
A. The completed exchange of a security for cash
B. Every attempt to dispose of, or solicitation to buy, a security for value
C. The delivery of a final prospectus
D. The physical delivery of a security certificate
Answer: B.
A sale is the resulting contract or agreement to dispose of a security for value.
Under Regulation Best Interest, a broker-dealer making a recommendation to a retail customer must:
A. Place its own financial interests ahead of the customer’s interests when disclosed
B. Recommend only securities that are guaranteed against loss
C. Act in the retail customer’s best interest and not place its interests ahead of the customer’s
D. Apply the rule only to discretionary accounts
Answer: C.
Reg BI requires more than basic suitability and prohibits a broker-dealer or associated person from placing its interests ahead of the retail customer’s interests.
Which mutual fund share class typically charges a front-end sales load, has lower ongoing 12b-1 fees, and may offer breakpoint discounts?
A. Class A
B. Class B
C. Class C
D. Institutional shares only
Answer: A — Class A.
Class A shares are generally most suitable for longer-term investors, particularly those investing enough to qualify for reduced sales charges.
Explain the primary difference between the traditional Prudent Man Rule and the Uniform Prudent Investor Act regarding how investment prudence is evaluated.
The traditional Prudent Man Rule focused heavily on conservative investments, preservation of capital, and the safety of each investment.
The UPIA evaluates prudence based on the entire portfolio, rather than judging each investment in isolation. It recognizes risk-and-reward trade-offs, encourages diversification, and permits an individually risky investment when it is appropriate within the client’s total portfolio.
Distinguish among commingling, conversion, and proper segregation of customer securities.
An agent calls a client in another state and recommends a security. Identify the states that generally have jurisdiction over the offer.
Jurisdiction generally exists in:
The location where payment is made or securities are delivered does not, by itself, establish jurisdiction.
A customer has $220,000 of securities and $290,000 of cash in an individual brokerage account. The customer also has a separate IRA containing $400,000 of securities at the same broker-dealer. Determine the SIPC protection available for each account and explain what SIPC does not insure.
For the individual account:
The separate IRA is treated as a separate customer capacity and its $400,000 in securities is covered.
SIPC protects customers when a broker-dealer becomes insolvent and cannot return covered cash or securities. It does not protect against market losses or ordinary investment declines.
Compare rights and warrants based on who receives them, subscription price, and normal life span.
Rights:
Warrants:
A trustee invests a small portion of a diversified trust portfolio in a speculative biotechnology stock. The remaining assets are invested in securities consistent with the beneficiaries’ objectives, risk tolerance, and income needs. The biotechnology stock later declines substantially. Under the UPIA, which statement is most accurate?
A. The trustee automatically violated the UPIA because fiduciaries may never purchase speculative securities.
B. The trustee violated the UPIA because every investment must independently preserve principal.
C. The investment may be prudent if the total portfolio’s risk-and-return profile remained appropriate.
D. The investment is permitted only if every beneficiary separately approved it in writing.
Answer: C.
The UPIA applies the standard of prudence to the portfolio as a whole. An individual investment may be risky without creating a violation when it fits within a properly diversified and suitable portfolio.
An agent wishes to borrow $20,000 from a brokerage customer. The customer agrees and signs a written loan document, and the agent’s broker-dealer also provides written authorization. Under the NASAA model rule described in the chapter, the arrangement is:
A. Permitted because both the customer and broker-dealer approved it in writing
B. Prohibited because agents may never borrow from customers
C. Permitted only if the customer is an immediate family member
D. Prohibited unless the Administrator personally approves the loan
Answer: A.
For a broker-dealer agent, borrowing or lending may be permitted when both the customer and the broker-dealer provide written authorization. The rule is more restrictive for IAs and IARs.
An agent in California mails an offer to a client’s Arizona residence. The client is temporarily in Wyoming and has the mail forwarded there. The client receives the letter in Wyoming. Which Administrator has jurisdiction based on the offer?
A. California only
B. Arizona only
C. California and Wyoming
D. California, Arizona, and Wyoming
Answer: A — California only.
The offer originated in California. It was directed to Arizona but was not received there, and the USA disregards the state to which mail is merely forwarded.
A client inherits stock that had a $15-per-share cost to the decedent. The stock’s market value was $28 on the date of death. The beneficiary sells it eight months later for $32. Which statement is correct?
A. The basis is $15, and the gain is short-term.
B. The basis is $28, and the gain is long-term.
C. The basis is $32, and there is no gain.
D. The basis is $15, and the gain is long-term.
Answer: B.
Inherited securities generally receive a basis equal to their market value at death, and the beneficiary’s holding period is treated as long-term.
A mutual fund has securities and cash worth $108 million, liabilities of $8 million, and 5 million shares outstanding. What is the fund’s NAV per share?
A. $18
B. $20
C. $21.60
D. $23.20
Answer: B — $20.
The NAV equals net assets divided by outstanding shares.
Identify four specific obligations that the SEC associates with an investment adviser’s fiduciary duty.
An adviser must:
(Best execution considers overall execution quality and does not always mean choosing the lowest commission.)
Identify the clients from whom an IA or IAR may generally borrow money or securities, or to whom the IA or IAR may lend.
An IA or IAR may generally borrow from or lend to a client only when the client is:
A family relationship by itself does not create an exception when the family member is also an advisory client.
Explain the jurisdiction rules for offers made through:
For radio or television, the offer is made in the state from which the broadcast originates.
For a newspaper or magazine, the offer is generally made in the state of publication. However, when more than two-thirds of the publication’s circulation is outside that state, the offer is treated as being made in no state.
Compare joint tenants with right of survivorship with joint tenants in common regarding ownership percentages and the disposition of a deceased owner’s interest.
In JTWROS, owners generally have equal undivided interests, and a deceased owner’s interest passes automatically to the surviving joint owner or owners.
In JTIC, ownership percentages may be unequal, and a deceased owner’s interest passes through the owner’s estate rather than automatically to the other account holders.
Explain how the following mutual fund distributions are generally taxed:
Which of the following is generally an acceptable use of client-generated soft dollars?
A. Paying an IAR’s annual licensing fee
B. Purchasing a computer terminal for the advisory office
C. Obtaining portfolio-analysis software used for client accounts
D. Reimbursing employee travel and entertainment expenses
Answer: C — Obtaining portfolio-analysis software used for client accounts.
Soft dollars may be used for qualifying research and brokerage services that benefit advisory clients. They may not ordinarily pay salaries, overhead, marketing, travel, licensing fees, or computer hardware.
An agent may share in the profits and losses of a customer’s account when:
A. The agent contributed investment research to the account
B. The customer gives oral approval before each transaction
C. The customer and broker-dealer approve the arrangement in writing
D. The agent guarantees that the client will not lose principal
Answer: C.
The sharing arrangement requires written approval from both the customer and the agent’s broker-dealer. The agent may not guarantee profits or reimburse losses.
Which statement correctly distinguishes a cease and desist order from an injunction?
A. Only a court may issue either action.
B. The Administrator may issue an injunction but must request a cease and desist order from a court.
C. The Administrator may issue a cease and desist order but must ask a court to issue an injunction.
D. Both actions require a criminal conviction.
Answer: C.
A cease and desist order may be issued by the Administrator. An injunction is a court order that the Administrator may seek but may not personally issue.
Which account permits an owner to retain control of assets during life while naming a beneficiary who receives the assets outside probate at the owner’s death?
A. Transfer on Death account
B. Custodial account
C. Margin account
D. Joint Tenants in Common account
Answer: A — Transfer on Death account.
The beneficiary has no present ownership rights while the account owner is alive.
Which statement correctly distinguishes an ETF from an ETN?
A. An ETF is an unsecured debt obligation, while an ETN owns a securities portfolio.
B. An ETF generally owns underlying assets, while an ETN is an unsecured debt obligation of an issuer.
C. ETFs cannot trade intraday, while ETNs always trade only at NAV.
D. ETNs are investment companies, while ETFs are insurance contracts.
Answer: B.
An ETN exposes the investor to the credit risk of the issuing financial institution, while an ETF generally holds assets or derivative positions designed to track an index.
An adviser directs client transactions to a broker-dealer that charges more than several competitors. In exchange, the broker-dealer provides proprietary research, market data, and trade-analysis software that the adviser uses when managing client accounts. Explain the conditions that must be met for the arrangement to qualify for the soft-dollar safe harbor.
Answer:
The arrangement may qualify if:
The adviser must also conclude that the higher commission is justified by the overall value provided to clients.
A client sends an agent a text message complaining that the agent made an unsuitable recommendation. The agent believes the complaint is unfair and deletes the message without notifying the firm. Explain why the agent’s conduct is improper.
A complaint delivered electronically may still constitute a written complaint. The agent must forward it to the appropriate supervisor, and the broker-dealer must respond and preserve a copy.
A broker-dealer files to withdraw its state registration while the Administrator is investigating previously undisclosed misconduct. Explain when the withdrawal normally becomes effective and whether the withdrawal prevents later disciplinary proceedings.
A withdrawal normally becomes effective 30 days after filing, unless a pending proceeding causes the Administrator to set another effective date.
The Administrator may begin a proceeding for up to one year after the withdrawal becomes effective. Withdrawal cannot be used to escape responsibility for prior violations.
A 72-year-old client unexpectedly requests that $90,000 be transferred to a newly identified caregiver. The firm reasonably suspects financial exploitation and begins an internal review. Under the NASAA Model Act, which action is appropriate?
A. The firm must process the transfer because the client signed the request.
B. The firm may delay the disbursement and provide required notifications within two business days.
C. The firm may permanently freeze the account without contacting regulators.
D. The firm may disclose the matter only to the caregiver.
Answer: B.
The firm may delay a suspicious disbursement, notify authorized parties unless they are suspected, and notify the Administrator and Adult Protective Services within the required period. The initial delay generally lasts no more than 15 business days, subject to an authorized extension up to 25 business days.
Which exchange is not permitted as a tax-free Section 1035 exchange?
A. Life insurance for life insurance
B. Life insurance for a nonqualified annuity
C. Nonqualified annuity for another nonqualified annuity
D. Nonqualified annuity for life insurance
Answer: D — Nonqualified annuity for life insurance.
A tax-free exchange does not automatically mean that the replacement is suitable; new surrender periods, charges, and expenses must also be considered.
At a minimum, an IAR’s duty to inquire generally requires obtaining a client’s:
A. Income, net worth, investment goals, and time horizon
B. Political affiliation, educational history, and credit score
C. Employer’s financial statements and tax identification number
D. Complete medical records and family history
Answer: A — Income, net worth, investment goals, and time horizon.
The amount of information required may vary with the service, but an adviser must make a reasonable inquiry into the client’s financial circumstances, experience, objectives, and investment time frame.
A brokerage firm purchases stock for its proprietary account immediately before executing a customer’s known block purchase, expecting the customer’s order to increase the stock’s price. This practice is known as:
A. Capping
B. Frontrunning
C. Marking the close
D. Selling away
Answer: B — Frontrunning.
Front running involves trading with advance knowledge of a large customer transaction to benefit from its expected market impact.
Which federal filing is used by a public company to report a significant event that shareholders should know about before the next quarterly or annual report?
A. Form 10-K
B. Form 10-Q
C. Form 8-K
D. Schedule 13G
Answer: C — Form 8-K.
Form 10-K is annual, Form 10-Q is quarterly, and Form 8-K reports material current events. Chapter 9 distinguishes issuer reports from beneficial-ownership reports.
Which statement correctly distinguishes a defined benefit plan from a defined contribution plan?
A. A defined benefit plan specifies the employee’s annual contribution, while a defined contribution plan guarantees retirement income.
B. A defined benefit plan promises a formula-based retirement benefit, while a defined contribution plan provides an individual account whose value depends on contributions and performance.
C. Both plans guarantee the same retirement benefit.
D. Only defined contribution plans are subject to ERISA.
Answer: B.
Investment risk is generally borne more heavily by the employer in a defined benefit plan and by the participant in a defined contribution plan.
A 6% bond is trading at 120, while another 6% bond is trading at 80. Rank each bond’s nominal yield, current yield, and yield to maturity from highest to lowest.
For the bond trading at a premium of 120:
Nominal yield>Current yield>Yield to maturity
For the bond trading at a discount of 80:
Yield to maturity>Current yield>Nominal yield
A premium bond loses value as it approaches par at maturity, while a discount bond gains value toward par.
A prospective client refuses to provide complete information concerning income, outside investments, and net worth. Explain how an IAR must treat the missing information when determining whether advice is suitable.
The IAR may not assume that the client has undisclosed income or assets. The adviser must construct any recommendation using only the information that is known and should treat unavailable assets or income as though they do not exist.
Without sufficient information, the adviser may be unable to provide suitable advice or prepare a comprehensive financial plan.
Compare a principal trade with an agency cross trade and identify one critical consent requirement for each.
A principal trade occurs when the adviser buys securities from, or sells securities to, an advisory client from the adviser’s own account. The adviser must disclose its principal capacity and obtain the client’s consent before each transaction.
An agency cross trade occurs when the adviser acts as agent for an advisory client and for the person on the other side. The adviser must obtain written, revocable consent and may not recommend the transaction to both sides; one side must be unsolicited.
Distinguish the central regulatory purposes of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940.
Compare a Coverdell Education Savings Account with a Section 529 plan regarding control, eligible expenses, and contribution or beneficiary considerations.
Both may provide tax-free growth and tax-free withdrawals for qualifying educational expenses.
A Coverdell ESA is a custodial education account with contribution and eligibility limitations and may cover qualifying elementary, secondary, and higher-education expenses.
A 529 plan is state-sponsored, generally permits much larger contributions, allows the account owner to retain control, and permits the beneficiary to be changed to another qualifying family member.
An investor owns 100 shares of a stock and is concerned about a significant short-term decline but does not want to sell the shares. Which option strategy provides the most direct downside protection while preserving upside potential?
A. Sell an uncovered call
B. Buy a put
C. Sell a put
D. Buy an additional call
Answer: B — Buy a put.
The stock plus a long put is a protective-put position. The put establishes a minimum sale price while allowing the investor to continue participating in an increase in the stock.
A client instructs her adviser not to invest in tobacco manufacturers. The adviser later allocates the client’s account to a private money manager whose portfolio contains several tobacco stocks. The adviser knew the manager could not honor the restriction but failed to discuss this fact with the client. Which statement is most accurate?
A. The restriction is irrelevant because the private manager has discretion.
B. The adviser may have breached its fiduciary duty by failing to address the client’s restriction.
C. Client restrictions apply only to tax-qualified accounts.
D. The adviser is protected because tobacco stocks are legal investments.
Answer: B.
Advisers should follow client-imposed investment restrictions when possible. When a restriction cannot be honored through a subadviser or program, that limitation should be addressed before the client’s money is invested.
An adviser’s covered employee contributes $500 to a candidate who can influence the selection of advisers for a public pension plan. The employee is eligible to vote for the candidate. Shortly afterward, the advisory firm is selected to manage the plan. Which consequence is most likely?
A. The firm may continue receiving compensation because the employee could vote for the candidate.
B. The contribution is permitted because it was less than $1,000.
C. The firm may be subject to a two-year prohibition on receiving compensation for the advisory services.
D. The contribution affects only the employee’s personal securities account.
Answer: C.
An eligible voting employee may generally contribute no more than $350 per election without triggering the pay-to-play restriction. A prohibited contribution may result in a two-year compensation ban.
A customer purchases securities in violation of the USA and later sues the seller. The customer paid $20,000, received $600 in income, and incurs reasonable court costs and attorney’s fees. Ignoring state-determined interest, which amount forms the starting point for the customer’s recovery?
A. $19,400 plus court costs and attorney’s fees
B. $20,000 without any additional costs
C. The current market value of the securities
D. $20,600 less court costs and attorney’s fees
Answer: A.
Civil recovery generally equals the purchase price, plus interest and reasonable legal costs, minus income received from the security.
A trustee manages a trust for an income beneficiary and a remainder beneficiary. The income beneficiary requests a high-yield strategy that would substantially increase the risk to the trust’s principal. Explain whose profile should be considered and how the trustee must treat the competing beneficiaries.
Suitability is based on the beneficiaries’ needs and objectives, not the trustee’s personal profile.
The trustee must act prudently and impartially. The trustee may not favor the income beneficiary at the unfair expense of the remainder beneficiary unless the trust document authorizes that treatment.
An equity-indexed annuity is linked to an index that rises 12%. The contract has an 80% participation rate and an 8% cap. Calculate the preliminary participation-rate return, determine the credited return after applying the cap, and explain why the investor does not receive the index’s full 12% gain.
Participation-rate return: 12% x 80% = 9.6%
Because the contract has an 8% cap, the credited return is 8%.
The insurer limits upside through participation rates, caps, spreads, and indexing methods in exchange for providing minimum guarantees and protection from certain index declines.
An IAR discovers that a client needs assistance establishing a trust, determining the tax consequences of a business sale, and evaluating life-insurance coverage. The IAR is not an attorney, accountant, or licensed insurance professional. Explain the IAR’s proper response and the confidentiality restrictions that continue to apply.
The IAR should refer the client to qualified outside professionals:
The IAR may not disclose client information—or even acknowledge the existence of the client’s account—to those professionals without the client’s consent, unless disclosure is otherwise required by law.
An advisory firm reposts a favorable third-party article, adds the comment “Excellent review of our firm,” and later pays the author to publish another favorable ranking. Explain the concepts of adopted and entangled content and the adviser’s regulatory responsibility for both items.
The first item is adopted content because the adviser affirmatively approved and distributed the third-party material.
The second item is entangled content because the adviser paid for or influenced its creation.
Both are treated similarly to the adviser’s own advertising. The firm must verify the accuracy of the content, ensure it is not misleading, provide required compensation and conflict disclosures, and supervise its use.
Compare the civil and criminal time limits and penalties described under the Uniform Securities Act.
A civil action generally must be brought no later than:
For criminal violations, the model statute provides a five-year limitation period when no other state limitation applies. The stated maximum criminal penalty is generally a $5,000 fine, three years’ imprisonment, or both. The Administrator refers criminal matters to the appropriate prosecutor; the Administrator does not personally impose imprisonment or criminal fines.
Identify the three components of FINRA’s suitability standard discussed in the client-profile section.
(RCQ)
Describe the difference between a futures contract and a forward contract:
A futures contract is standardized, exchange-traded, generally liquid, and subject to daily settlement and margin requirements.
A forward contract is privately negotiated, customized, traded over the counter, and carries greater counterparty and liquidity risk. The manual identifies futures-versus-forward distinctions and futures profit-and-loss calculations as core Chapter 11 concepts.