Chapter 1: Regulatory Foundations
Under the Uniform Securities Act, corporations, partnerships, issuers, governmental entities, and natural individuals may all fall under which broad definition?
A. Person
B. Security
C. Broker-dealer
D. State Administrator
A — Person.
Under the USA, a person is a broad legal category that may include individuals, corporations, partnerships, issuers, and governmental entities.
State and federal regulators are evaluating an arrangement as a possible investment contract. Identify all four elements of the Howey Test that must be present for the arrangement to be considered a security.
1. An investment of money
2. In a common enterprise
3. With an expectation of profit
4. Solely from the efforts of others
Which combination correctly matches each financial professional with the appropriate form and filing system?
A. Broker-dealer—Form U4 through IARD; Agent—Form BD through CRD
B. Investment adviser—Form BD through CRD; IAR—Form ADV through IARD
C. Broker-dealer—Form BD through CRD; Agent—Form U4 through CRD; Investment adviser—Form ADV through IARD; IAR—Form U4 through IARD via CRD
D. Broker-dealer and investment adviser—Form ADV; Agent and IAR—Form U5
Answer: C.
Identify the primary purpose of each of the following:
Answer:
Which investment adviser is most clearly required to register with the SEC as a federal covered adviser based solely on regulatory assets under management?
A. An adviser with $125 million under management
B. An adviser with $95 million under management
C. An adviser with $75 million under management
D. An adviser with $40 million under management
Answer: A — An adviser with $125 million under management.
An adviser with at least $110 million in regulatory AUM generally registers with the SEC.
A securities firm earns a commission for locating the opposite party to a customer’s transaction. The same firm earns a markup when it sells securities from its own inventory. Identify the capacity in which the firm is acting in each transaction.
The firm acts as a broker when it locates the opposite party and earns a commission. It acts as a dealer when it trades from its own inventory and earns a markup or markdown.
Which of the following products is considered a security under the Uniform Securities Act?
A. A fixed annuity
B. A variable annuity
C. A whole-life insurance policy
D. A fixed endowment contract
Answer: B — A variable annuity.
Variable annuities invest through separate accounts and are securities. Fixed insurance products are generally not securities.
A registrant files an irrevocable document appointing the state Administrator to receive legal papers on its behalf. Identify the document and explain its purpose.
The document is a consent to service of process. It appoints the Administrator to accept legal papers on behalf of the registrant when the registrant cannot otherwise be reached within the state.
Which pairing correctly identifies the investment-adviser brochure and the brochure supplement?
A. Part 1A and Part 1B
B. Form ADV-W and Form ADV-E
C. Form U4 and Form U5
D. Form ADV Part 2A and Form ADV Part 2B
Answer: D — Form ADV Part 2A and Form ADV Part 2B.
SEC Release IA-1092 applies the investment-adviser definition to persons whose securities advice may not be their principal business. Explain how the release affects financial planners, pension consultants, sports representatives, and persons who recommend investment managers or asset-allocation programs.
These persons may be investment advisers when securities advice is a regular or integral part of their business and they receive compensation. The advice does not have to be their principal business. Recommending investment managers or asset-allocation programs may also satisfy the advice component of the IA definition.
Orion Manufacturing is preparing an initial public offering. Its human-resources director administers an employee stock-purchase plan as part of her regular duties and receives no transaction-based compensation. The chief financial officer solicits members of the public and receives a bonus based on the number of shares sold. Who is required to register as an agent of the issuer?
A. Both individuals
B. The chief financial officer only
C. The human-resources director only
D. Neither individual
Answer: B — The chief financial officer only.
The CFO solicits public investors and receives transaction-based compensation. The HR director performs a regular administrative duty involving an employee plan and is not treated as an agent of the issuer.
A developer sells condominium units together with mandatory participation in a rental pool. Buyers do not manage the properties, select tenants, or determine rental rates. They expect the developer to operate the project and distribute the resulting profits. Explain why the arrangement may be treated as an investment contract rather than merely a purchase of real estate.
The arrangement satisfies the Howey Test because the buyers invest money in a common enterprise with an expectation of profit derived from the developer’s managerial efforts. The mandatory rental arrangement converts the transaction from a simple real-estate purchase into a potential security.
A broker-dealer maintains custody of customer securities and has net capital below the level at which the state would waive additional financial protection. The Administrator is concerned that customers may receive court awards arising from violations of the Uniform Securities Act. The firm offers to deposit acceptable securities instead of purchasing insurance. Which statement is correct?
A. The Administrator may require SIPC membership instead of a bond.
B. Only agents, not broker-dealers, may be required to post financial protection.
C. The firm must purchase errors-and-omissions insurance and may not deposit securities.
D. The Administrator may require a surety bond or permit an acceptable cash or securities deposit.
Answer: D — The Administrator may require a surety bond or permit an acceptable cash or securities deposit.
A surety bond protects against court awards arising from USA violations. Cash or acceptable securities may sometimes be deposited in lieu of the bond.
Adviser One is terminating its registration. Adviser Two maintains custody and must report the results of an independent surprise examination. Adviser Three has a non-U.S. managing partner who must appoint an official to receive legal papers. Adviser Four is temporarily unable to access IARD because of an electrical outage. Identify the appropriate Form ADV filing for each adviser.
Answer:
An accountant occasionally recommends that tax clients participate in employer retirement plans. The recommendations are incidental to the accounting practice, and no separate advisory fee is charged. A second firm regularly provides securities advice for compensation but has its principal office in one state, advises only residents of that state, and does not advise on exchange-traded securities. How should the two persons be classified under federal law?
A. Both are excluded from the investment-adviser definition.
B. The accountant is excluded, while the second firm may be exempt from federal registration.
C. The accountant is exempt, while the second firm is excluded.
D. Both are exempt reporting advisers.
Answer: B.
The accountant may be excluded because the advice is incidental to the accounting profession and no separate compensation is received. The second firm meets the IA definition but may qualify for the local exemption from federal registration.
A firm regularly provides securities recommendations to clients and receives compensation for its services. Its receptionist schedules appointments and mails reports but does not solicit advisory services, manage portfolios, supervise advisers, or give advice. Apply the ABC test and identify the regulated capacity of the firm and the receptionist.
The firm is an investment adviser because it provides securities Advice, as a Business, for Compensation. The receptionist is not an IAR because her duties are solely clerical or ministerial.
An issuer files a state registration statement but does not submit the required filing fee. Which statement is correct?
A. The underwriter is solely responsible for the filing fee.
B. The Administrator must pay the fee and recover it after the offering.
C. The issuer is responsible, and registration may not become effective until the fee is paid.
D. The fee is optional when a registration statement has already been filed.
Answer: C — The issuer is responsible, and registration may not become effective until the fee is paid.
A complete broker-dealer application is filed on May 1, and no denial proceeding is pending. State the normal effective date and time, explain whether the Administrator may accelerate it, and identify the annual expiration date.
The registration normally becomes effective at noon on May 31, the 30th day after filing. The Administrator may grant effectiveness earlier. The registration expires annually on December 31.
Which statement correctly distinguishes a temporary Form ADV-H hardship exemption from a continuing hardship exemption?
A. Temporary relief generally extends the electronic deadline for seven business days, while qualifying small advisers may receive continuing relief involving a paper submission processed through FINRA.
B. Temporary relief permanently waives Form ADV, while continuing relief lasts seven days.
C. Both exemptions allow an adviser to avoid filing Form ADV entirely.
D. Continuing relief is available only to advisers with at least $110 million under management.
Answer: A.
Temporary relief generally provides a seven-business-day extension. A qualifying small adviser may obtain continuing hardship relief and submit a paper version that FINRA enters into IARD.
Classify each of the following as excluded from the investment-adviser definition, exempt from federal registration, or neither, and explain the controlling condition:
An excluded person is outside the Advisers Act definition. An exempt adviser remains an investment adviser but is relieved from registration.
An officer of an investment advisory firm does not personally manage client accounts. However, she supervises employees who determine and deliver securities recommendations. Under the Uniform Securities Act, the officer is most likely considered:
A. An agent
B. A broker-dealer
C. An investment adviser representative
D. An issuer
Answer: C — An investment adviser representative.
An individual who supervises employees who give securities advice or manage client portfolios may meet the IAR definition.
A security’s state registration became effective on March 15. Identify its normal expiration date and explain why December 31 is not the appropriate expiration date.
The registration normally expires one year after its effective date, so it expires on March 15 of the following year. Securities registrations do not automatically expire on December 31; that date generally applies to registrations of persons such as broker-dealers and agents.
Which recordkeeping classification is correct for a broker-dealer under the chapter’s summary rules?
A. Advertising, order tickets, and confirmations—three years; blotters, general ledgers, and customer statements—six years; organizational documents—lifetime
B. All records—five years
C. Advertising—six years; customer statements—three years; organizational documents—ten years
D. Order tickets—lifetime; general ledgers—three years; advertisements—six years
Answer: A.
A client gives a state-registered adviser oral discretionary authority. State the maximum period during which the adviser may generally rely on that oral authority and identify the order terms that may be selected without creating discretionary authority.
Oral discretion may generally be used for up to 10 business days. Selecting only the time and price of execution does not constitute discretionary authority. Choosing the security, action, or amount requires discretionary authorization.
Which person is generally excluded from the federal investment-adviser definition, rather than merely exempt from registration?
A. An adviser whose only clients are insurance companies
B. A qualifying foreign private adviser
C. A family office that satisfies the family-office conditions
D. A qualifying private-fund adviser
Answer: C — A qualifying family office.
The other choices generally describe advisers that meet the definition but may qualify for exemptions from federal registration
Identify the federal law that primarily governs each of the following:
A well-established corporation has operated for more than three years, has substantial net worth, has previously registered securities with the SEC, and has a widely held class of equity securities. Which state-registration method is specifically designed for qualifying seasoned issuers?
A. Registration by qualification
B. Notice filing
C. Registration by coordination
D. Registration by filing or notification
Answer: D — Registration by filing or notification.
This method is designed for well-established issuers that meet detailed financial and operating requirements.
An employee of an issuer sells the issuer’s exempt municipal securities without receiving transaction-based compensation. Another employee sells the issuer’s nonexempt common stock to members of the public and receives a commission. A registered representative of a broker-dealer sells the same exempt municipal securities for compensation. Determine which individuals must register as agents and explain why the exemption applicable to a security does not automatically exempt every salesperson.
The issuer employee selling exempt municipal securities without transaction-based compensation may qualify for an agent-of-issuer exemption.
The employee selling nonexempt common stock to the public for a commission must register as an agent of the issuer.
The registered representative selling exempt securities on behalf of a broker-dealer must still register as an agent. An individual representing a broker-dealer in effecting securities transactions is an agent even when the security itself is exempt.
Under NASAA’s model minimum financial requirements, which net-worth amounts generally apply to a state-registered adviser with limited discretion but no custody and an adviser with custody?
A. $5,000 and $10,000
B. $10,000 and $35,000
C. $25,000 and $50,000
D. Positive net worth and $100,000
Answer: B — $10,000 and $35,000.
A broker-dealer provides securities advice that is solely incidental to its brokerage business and receives no special compensation for the advice. Explain why the broker-dealer may be excluded from the IA definition and why operating a managed wrap-fee program may eliminate that exclusion.
Answer:
A broker-dealer is excluded when its advice is solely incidental to brokerage activity and it receives no special compensation for that advice.
A managed wrap-fee program charges a fee for a package that typically includes advisory or portfolio-management services. Because advisory services and compensation are central to the arrangement, the broker-dealer exclusion is unavailable, and the firm or an affiliate must register as an investment adviser.
A state securities Administrator brings an action under the Uniform Securities Act against a local registrant. In a separate matter, the SEC brings an action under the Investment Advisers Act of 1940. Although both proceedings concern securities activities, they arise under different regulatory systems. Which statement correctly classifies the two actions?
A. Both actions arise under federal law.
B. Both actions arise under state law.
C. The first arises under federal law, while the second arises under state law.
D. The first arises under state law, while the second arises under federal law.
Answer: D — The first arises under state law, while the second arises under federal law.
The Uniform Securities Act is state law. Statutes with years in their titles and matters involving the SEC generally indicate federal law.
A corporation is registering a new offering with the SEC under the Securities Act of 1933. It submits the federal prospectus and related documents to a state Administrator and wants the state registration to become effective at approximately the same time as the federal registration. The issuer is not relying on a federal-covered-security exemption. Identify the state-registration method and the principal timing requirements that must be satisfied.
The issuer is using registration by coordination.
Remember,
The state registration generally becomes effective at the same time as the federal registration if:
An issuer offers exchange-listed securities and shares of a registered mutual fund in State A. How may State A generally treat these securities?
A. Require full registration by qualification for both offerings
B. Treat them as federal covered securities, while potentially requiring notice filings and fees
C. Prohibit the offerings unless the Administrator approves their investment merits
D. Require registration by coordination because both securities are federally registered
Answer: B — Treat them as federal covered securities while potentially requiring notice filings and fees.
A state-registered adviser delivers its brochure at the moment a new client signs the advisory contract. The brochure was not provided 48 hours in advance. Three business days later, the client decides to terminate the agreement. Explain the contractual right the adviser must provide and how the result would differ if the brochure had been delivered at least 48 hours before execution.
Answer:
Because the brochure was delivered at contract execution rather than at least 48 hours beforehand, the client must be allowed to terminate the contract without penalty within five business days.
if the brochure had been delivered at least 48 hours before execution, the five-business-day penalty-free cancellation right would not be required under the state brochure-delivery rule.
Which statement correctly describes the federal brochure-delivery rule for an SEC-registered investment adviser?
A. The brochure must always be delivered 48 hours before contract execution.
B. Delivery is required only after the client has paid the first advisory fee.
C. Delivery at contract execution requires a five-business-day cancellation right.
D. The brochure must generally be delivered before or at the time the advisory contract is entered into.
Answer: D — The brochure must generally be delivered before or at the time the advisory contract is entered into.
The 48-hour rule and five-business-day cancellation provision apply to state-registered advisers, not federal covered advisers.
Shares issued by a registered investment company are offered in several states. Explain why the shares are not registered separately in each state and identify the state-level filing process that may still be required.
Registered investment-company shares, such as mutual fund shares, are federal covered securities and are exempt from formal state registration. However, a state may require a notice filing, copies of documents filed with the SEC, and a filing fee.
A newly created issuer is conducting an intrastate offering and will not file a federal registration statement. The issuer does not qualify to use registration by filing. Which state-registration method will generally be required, and who determines its effective date?
A. Qualification; the state Administrator
B. Coordination; the SEC
C. Notice filing; the issuer
D. Filing; the underwriter
Answer: A — Qualification; the state Administrator.
Qualification is used when no federal registration is being filed or the federal registration is already effective. The Administrator determines the effective date.
A federal covered adviser has $130 million under management and maintains an office in State A. One of its IARs also works from that office. Distinguish among:
Answer:
Which pair of advisers may qualify for an exemption from state registration under the Uniform Securities Act?
A. An adviser with an office in the state and only institutional clients, and an adviser with an office in the state and three retail clients
B. An adviser with no office in the state and eight retail clients, and an adviser with an office in the state and no clients
C. An adviser with no office in the state and only institutional clients, and an adviser with no office in the state and no more than five noninstitutional clients
D. Any adviser with fewer than 15 clients, regardless of office location
Answer: C.
The two principal exemptions are:
Compare the private-fund-adviser exemption and the venture-capital-adviser exemption. Explain why qualifying firms may be considered exempt reporting advisers and identify the Form ADV filing and amendment obligations that remain despite the exemption from full registration.
Answer:
A qualifying private-fund adviser may rely on an exemption when it advises only private funds and remains below the applicable U.S. private-fund AUM threshold.
A qualifying venture-capital adviser may rely on the exemption when it advises only venture-capital funds; the exemption is not eliminated merely because of the adviser’s AUM.
Both may be classified as exempt reporting advisers. They generally must:
A state attempts to impose a broker-dealer net-capital requirement that exceeds the applicable federal requirement. Which federal law most directly limits the state’s ability to impose the stricter standard?
A. The National Securities Markets Improvement Act of 1996
B. The Securities Act of 1933
C. The Investment Company Act of 1940
D. The Uniform Securities Act
Answer: A — The National Securities Markets Improvement Act of 1996.
NSMIA reduces duplication between state and federal regulation and prevents states from imposing certain broker-dealer requirements that are more restrictive than federal standards.
A registration statement contains materially misleading information, and the issuer refuses to correct it. Identify the administrative action that may be taken against the registration and the two broad findings the Administrator generally must make before taking that action.
The Administrator may issue a stop order to deny, suspend, or revoke the registration.
The Administrator generally must find that:
A federal covered adviser has no office in State B but has six noninstitutional clients who reside there. One of its IARs serves those clients entirely from an office in State A and never maintains a place of business in State B. State B requires the documents filed with the SEC and a state fee. Which statement is correct?
A. The adviser and IAR must both complete full registration in State B.
B. Neither the adviser nor the IAR has any filing obligation in State B.
C. The adviser may be required to notice file, but the IAR is not required to register solely because of the six clients.
D. The adviser must register by qualification, while the IAR must file Form ADV.
Answer: C.
The federal covered adviser may be required to notice file because it has six noninstitutional clients in the state. The IAR of an FCA generally registers based on office location, not client count.
A state-registered adviser’s fiscal year ends on December 31. Distinguish among the deadlines and obligations for:
Answer:
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.
An advisory firm has $105 million in regulatory assets under management and serves clients in eight states. It also acts as the investment adviser to a registered mutual fund, and one of its IARs maintains an office in State A. State A wants the firm and the IAR to complete full state registration before conducting business. Determine the proper registration level for the firm, the state-registration obligation of the IAR, and any filing authority State A may retain over the firm.
The firm is a federal covered adviser because it advises a registered investment company, regardless of its $105 million AUM. The firm registers with the SEC, not with State A.
The IAR must register in State A because the IAR maintains an office there. State A may require the federal covered adviser to complete a notice filing, submit documents filed with the SEC, and pay a fee, but it cannot grant or revoke the firm’s federal registration.
A broker-dealer completes an unsolicited secondary-market transaction for an existing customer. It also participates in a properly structured private placement to a limited number of sophisticated investors. Later, an agent solicits the public purchase of an unregistered, nonexempt corporate security. Which statement correctly describes the transactions?
A. All three transactions are exempt.
B. The first two may be exempt transactions, but the third is prohibited.
C. Only the public solicitation is exempt.
D. None of the transactions may qualify for an exemption.
Answer: B — The first two may be exempt transactions, but the third is prohibited.
An unsolicited nonissuer transaction and a qualifying private placement may be exempt transactions. Public solicitation of an unregistered, nonexempt security is prohibited.
A properly registered Canadian broker-dealer has no place of business in a U.S. state. Explain whether it and its agents may conduct each of the following activities:
Answer:
A state-registered advisory firm is headquartered in New York. One IAR has offices in New York and Pennsylvania and serves eight retail clients in Connecticut, where neither the firm nor the IAR has an office. Which statement most accurately describes the registration obligations?
A. The firm and IAR need only register in New York.
B. Only the firm must register in Pennsylvania and Connecticut.
C. The IAR registers only where offices are maintained, while the firm never registers based on client count.
D. The firm must evaluate registration in New York, Pennsylvania, and Connecticut, while the IAR may also be required in Connecticut because the retail-client count exceeds the de minimis threshold.
Answer: D.
For a state-registered adviser, the firm must register where it has offices and where its noninstitutional client count exceeds the de minimis limit. Its IAR may also be required to register where the IAR has an office or exceeds the applicable retail-client threshold.
An SEC-registered adviser uses an affiliated entity as the qualified custodian of client assets and sends account statements prepared only by the adviser. Identify the independent verification, surprise-examination, account-statement, and internal-control-report requirements that may arise from this arrangement, and explain why an affiliated custodian creates greater regulatory concern.
Answer:
The adviser must generally ensure that client assets are held by a qualified custodian and that clients receive account statements directly from the custodian.