Key U.S. Securities Laws and Regulatory Roles

FINRA Series 7 Question Answer - 1934 act is aimed at brokers (secondary market). established SEC. Mandates annual reports. - Identifies the following activities as being Securities Exchange Act of 1934 criminally fraudulent: - Abusing discretionary authority - Churning Insider trading - Regulation T Anyone who is an officer, executive, director or 10%-or-more owner of the company, as well as his or her immediate family. - Insider status Insider Trading only has to do with equity ownership, not debt holding. - Must ACT on information to be criminal Act of 1934 created SEC Regulates brokerage firms, transfer agents, agencies, SROs. - Antifraud provisions - Annual reports Securities and Exchange Commission (SEC) clearing Proxy Material - Segregation of customer assets - Supervision (principal) - Regulating Representatives (U-4) Principal reviews and approves: - account opening - transactions Supervision Process (roles of a principal) marketing material/ads - correspondence - customer complaints - Corp. bond issues over $5 million must include a formal written Trust Indenture Act of 1939 agreement (an indenture) - Requires trustee be appointed for all bond issues Defines the responsibilities and limitations placed of Investment companies: open-end mutual funds, UITs, closed-end funds. Investment Company Act Of 1940 Enforced by SEC - Have a BOD - Charge fee for advice - Wrap fee (% of AUM) Solicitation of non-NASDAQ and non-listed equity securities traded OTC for less than $5/share - Suitability statement required pre-trade Penny Stock Cold-Calling Rule (excluding established customers) - Monthly statements regardless of acct activity - provide disclosure information Currency Transaction Reports (CTRs): deposits in one day over $10k Bank Secrecy Act Suspicious Activity Reports (SARs): $5k or more, structuring AntiMoney Laundering 3 stages (placement, layering, integration) No concern for investment Anti-Money Laundering risk Bring trade reporting uniformity - Order Protection Rule: ensure that receive the best price (prohibits trade-throughs) - Minimum Regulation NMS (National Market System) investors Increment Pricing Rule: sub penny pricing allowed <$1/share Improve access to quotations from trading centers Expansion (recovery) Peak Decline (recession) Trough *Recession = 6 Business Cycle consecutive months *Depression = 6 consecutive quarters/18 months Leading Economic Indicators (where we - building permits - manufacturers' new orders - S&P 500 index - M2 are headed) (amount of $ ppl have) - # new unemployment claims Coincident Economic Indicators (where we - GDP - industrial production - personal income (# hours worked) are now) manufacturing/trade sales Lagging Economic Indicators (where we - corporate profits - duration of unemployment - prime rate have been) (determined by banks) Congress/Presidential - taxation - government spending: Economic Influences: Fiscal Policy demand/supply-side economics - Keneysian Federal Reserve - money supply M1: cash/checks M2: M1 + CDs + money market + overnight repos (increase = good) M3: M2 + Economic Influences: Monetary Policy jumbo/negotiable CDs + term repos - alter money supply = alter economy (Friedman) Laffer Economy self-regulates Reserve requirement - multiplier (most drastic) - fed funds rate Federal Reserve Board (FRB) discount rate Controlled by FRB increase rate = slow economy - rate banks charge Discount rate for loans (bank's overnight loan rate); bank to bank; most volatile rate; tool of Federal Funds rate last resort; amount of $ banks must have in reserve most frequent way to regulate money - fed buys t-bills = increase money supply/decrease interest rates (ease money supply) - fed sells Open Market Operations (FOMC) t-bills = decrease money supply/increase interest rates (tighten money supply) - minimum deposit = 50% (reg T) - <$2k = full amount - $2k - $4k = Margin Account deposit requirements $2k minimum - >$4k = 50% minimum deposit Margin Account: SMA - can't lose with change in market value - use to buy securities Margin Account: Long account 25% long market value = minimum maintenance (firm may require requirements more as a house call) Margin Account: Short account 30% short market value = minimum maintenance (firm may require requirements more as a house call) Defensive (noncyclical) - ppl will use regardless of economic health Economic Industry: Defensive food - utilities (always make money/highest payout ratio) - clothing drugs - tobacco - liquor Economic Industry: Cyclical - steel - heavy equipment - capital goods - autos Economic Industry: Counter cyclical precious metals (high when market is down) current = next 12 months; cash in bank + receivables + inventory Company assets fixed = real estate intangibles = patent, goodwill, brand recognition Company balance sheet Assets = liabilities + net worth Assets - liabilities = net worth current = next 12 months; wages, interest, operations long term = Company liabilities bonds - Indicates recession - Fed has tightened short-term rates (raises) The Fed's influence = primarily on the short end of the yield curve. The Inverted Yield curve discount rate, which it sets, and the federal funds rate, which it influences, are short-term rates. SIPC covers each separate customer. industry-funded org. - Account coverage up to $500,000 in securities, ($250,000 max cash). - In SIPC margin accounts, the equity, not the market value, is used for securities coverage purposes. - commodities not covered When a municipal bond is purchased at a discount the amount of the discount is accreted. Accretion is the process of adjusting the cost Accretion basis each year upwards, until maturity. At maturity the cost basis will equal PAR. The loss transaction the loss is disallowed under the wash sale rule and therefore not deductible. A wash sale occurs when the same Wash sale rule shares are purchased within 30 days before or after the date of sale that the loss is incurred. The unusual combination of inflation (a rise in prices) and high unemployment (stagnation). This generally occurs when the economy Stagflation isn't growing (there is a lack of consumer demand and business activity), yet prices for goods are still rising. Securities Investor Protection Act of 1970 determination of a broker/dealer's financial failure is made under the provisions of this act must be filed within 10 business days of first use if the communication Retail communication - Investment does not include a performance ranking. For retail communications Companies that do include a performance ranking, a 10 day pre-filing is required. - takes into account a stock's sensitivity to risk that cannot be Capital asset pricing model (CAPM) lessened by diversification. - takes into account systemic and nonsystemic risk - investors rewarded for taking risks When securities are inherited, the heir receives a cost basis Cost basis - inherited securities calculated as of the deceased party's date of death Municipal bonds - taxation Tax exempt for corporations and individuals. When a FINRA member places a third party between it and the best Interpositioning available market. Original issue discounts are accreted, which allows for a step-up in Accreting Interest cost basis. Accretion on original issue discount municipal bonds is not taxed. Insider Trading and Securities Fraud Enforcement Act of 1988 corporate outsiders who make trades at about the same time as contemporaneous traders insiders. They are granted the right to sue inside traders for damages sustained. CAV A municipal bond originally issued at 90 with a 10-year maturity will have a compound accreted value (CAV) after 5 years equal to: CAV= cost basis of the bond, in this case, after 5 years accretion. There are 10 points to accrete (the difference between the issue price of 90 and par) over 10 years. One point each year will be added, the adjusted cost basis will be 90 + 5, or 95. (Reaganomics) - reduced tax rates will result in a healthier economy, Supply Side Economic Theory which will generate more taxes to compensate for the reduced rates - tax strategy used to lock in capital gains in a long position and defer Shorting against the box them to a later period. - selling short shares that are currently owned in the long position when a profit already exists in the long position. - greater than 1.0 signify that the stock will fluctuate more than the Beta coefficients market as a whole. - the higher the beta is, the greater the risk - beta measures a security's systemic risk (associated with the market) - municipal bond is bought at a premium, the premium must be amortized over the life of the bond. - At maturity, no capital gain or Bond taxation - amortization loss would occur because the premium would have been fully amortized. - reduces cost basis and reported interest income A cash or currency transaction totaling more than $10,000 on a single FinCEN Form 112 business day must be reported on FinCEN Form 112. - municipal bond purchased at discount, discount must be accreted for cost-basis purposes. - the accretion is taxable as ordinary income. Bond taxation - accretion - At maturity, cost basis is accreted to par. Therefore, there is no reported gain or loss on redemption. - copy sent to customer w/in 30 days - firm verifies acct information New Account Form every 36 months TOD Joint Account transfer on death - owner ID successor - new person is full new owner - either party makes decisions - assets divided evenly - $ stays in JTWROS Joint Account account (not distributed to estate upon death) - for married couples - keep proportional interest - proportionate distribution - upon death, TIC Joint Account cxl open orders and await instructions from estate - assets transfer to estate - for unrelated people - anyone can give instructions look for permitted investment strategies - "silent" assumes that it's Fiduciary accounts not allowed Rep has authority over: - buy/sell (action) - security (asset) - quantity Discretionary accounts (amount) **if rep makes any one of these, it's discretionary **timing and price are not significant UGMA - assets transfered to minor at age 18 UTMA - assets retained until age 25 **one custodian for one minor **funds irrevocable **no UGMA vs UTMA margin, short sales, options **carries minor's SSN **unlimited contributions - cancel open orders - mark account deceased - await instructions and Account status upon death legal papers - new BD validates with old firm w/in one business day - transfer w/in Account transfers 3 business days BDs required to: - verify identity of new customers - maintain records USA Patriot Act - determine if person is known/suspected terrorist - maintain customer identification program (CIP) Office of Foreign Asset Control (OFAC) - maintains list of ppl viewed as threats in US. - Must freeze assets - firm can hold for up to 2 months (domestic travel) - up to 3 months Holding customer mail (foreign travel) - request made in writing investment advisory account - provide group of services like asset Wrap account allocation, portfolio management, administration institutional customer select one firm (prime broker) to provide custody; other firms handle trades. - prime broker facilitates clearing, Prime Brokerage Account lending, settlement - enables customer to trade at multiple brokerage houses and maintain central master account FINRA: notify in writing before any transactions; supply duplicate Opening accounts for other BD employees copies upon request MSRB: notify in writing before any transactions; supply duplicate (ELNs) are debt instruments - have a partial fixed return as well as a Equity Linked Notes final payment linked to the performance of a single stock or equity index. - Some are exchange traded while others trade OTC. Ethics Outside buisiness activity Private Securities Transactions / Selling Away Borrowing from customers Soft dollar arrangements Painting the Tape Marking the Close Front running Interpositioning Ways to generate income Seeking capital growth Seeking Tax advantages Seeking liquidity Seeking preservation of capital; safety Seeking balanced or moderate growth Seeking aggressive growth/speculation Seeking tax free income Seeking to keep pace with inflation Interest rate risk Reinvestment risk Bond duration Modern portfolio theory Dollar cost averaging Constant ratio plan Constant dollar plan Regressive taxes Progressive taxes Taxable interest income - bonds Bond's effective after tax yield - BDs required to maintain written supervisory procedures - principal must enforce rules - BD may have own house rules (more stringent, not less) - Conduct Rules deal with ethical treatment of customers - must be disclosed in writing - permission is not required - BD can reject/restrict affiliations - passive investments (ltd partnership) is exempt - sale of securities outside a rep's regular business - prior written notice required - describe transaction and role - disclose compensation (BD must approve/disapprove. if approved, BD supervises) - allowed in the case of family or business relationships - " if customer is in business of lending (ie bank) - " members of same firm - written notice and permission generally required - must be disclosed - allowed: research reports, financial journals, analytical software, seminars - when one party sells a stock with the understanding that it will be repurchased later in the day - intent is to make it appear that stock has more activity - falsely reporting trades to influence the closing price of a stock - when a rep places an order to buy or sell [personal positions in front of the block order (10,000+ shares) - adding another BD to a transaction when there is no benefit to the customer - purpose is to generate commissions or fees corporate and muni bonds, govt securities, some stocks (utilities and REITS), money market funds, annuities, some mutual funds - not Zero Coupon bonds -refers to an investment's value over time - common stock / mutual funds - IRA - annuities - muni bonds (tax-free interest income) - Money market funds = liquid - DPP, annuities, bank CDs = illiquid - Govt securities - Ginnie Maes - blue-chip stocks - technology stocks or sector funds - muni bonds - stock portfolio - VAs - bonds with long-term maturities, low coupons and deep discounts are most susceptible - mortgage-backed instruments are susceptible - Zero coupon bonds are not subject to reinvestment risk - measure (in years) that a bond will pay for itself - lower coupon = greater duration - longer maturity = greater duration - zero coupons = duration equals maturity - bond duration of 9 = owner receives interest back in 9 yrs - attempts to quantify and control risk - determine the relationship between risk and reward in the total portfolio vs specific securities - periodic purchases of a fixed dollar amount in one or more stocks average cost is always less than the average market price - helps to control the cost of investing - buy/sell securities that keep the portfolio balanced between debt and equity - stays in line with pre-determined ratio buy and sell so that a set dollar amount is invested at all times sales, excise, payrool, property, gas = independent of income - greater impact on low income familes - estate and income tax - greater impact on high income families Corporate bonds: taxed at all levels US Govt: T bills/notes/bonds are exempt from state/local tax Mortgage-backed securities: taxable at all levels (Fannie Mae/Freddie Mac) Muni bonds: interest is federal tax exempt (triple exemption for territories) - stated YTM on muni bonds = effective after tax yeild - exception is bonds purchased at discount in secondary market (after-tax yield is b/w YTM and CY) Alternative Minimum Tax (AMT) Tactical asset allocation Maloney Act Securities Act of 1933 Shelf offerings Rule 144 Random Walk Theory Earnings before interest and taxes (EBIT) Technical analysts Highly leveraged companies FRB rates designed to prevent taxpayers from escaping their fair share of tax liability through certain tax breaks - attempts to capitalize on short-term market swings - market timing strategy. Provides for the establishment of SROs (FINRA, MSRD, CBOE) Paper act / full and fair disclosure act / new issues act / truth in securities act / prospectus act used by publicly traded companies to issue additional equity or debt securities. The issuer must sell the securities within 3 years after the registration is declared effective. Restricted stock (unregistered), held by nonaffliliate: 6 mo hold + sell freely thereafter Restricted stock (unregistered), held by affliliate: 6 mo hold + volume limits thereafter Control stock (registered), held by affliliate: no hold + volume limit The direction of any stock, sector, or market in general is unpredictable. The theory is based on the "efficient market" theory, which holds that the stock market is perfectly efficient with prices reflecting all known information at any given time. the amount of money a company has retained before paying taxes and interest on outstanding debt issues. This can be found by looking at the income statement for the company. rely on price and trading trends - not interested in the specific financial information of an issuer; PE ratios are of greater interest to fundamental analysts. - interested in market statistics indicative of future buying, - have the largest amount of their capitalization in debt instruments. Leverage is the use of someone else's money at a fixed cost to benefit the common shareholders. - setting the reserve requirement, the discount rate, and the initial margin requirement for nonexempt securities. The federal funds rate is heavily influenced by Fed action, it is not set by the Fed. and neither is the prime rate