S24 Study Manual L123

Series 24
General Securities Principal Examination

Study Manual – 44th Edition
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L123
Table of Contents
Introduction
About the Series 24 Examination .....................................................................................................................1
Registering for the Examination .................................................................................................................................. 1
Taking the Exam.......................................................................................................................................................... 1
About the Training Program ........................................................................................................................................ 2
Study Manual............................................................................................................................................................... 2
Final Examinations ...................................................................................................................................................... 2
Standardized Test-Taking Tips.........................................................................................................................3
Test-Taking Pitfalls ...................................................................................................................................................... 4
Study Calendars ...............................................................................................................................................4
Chapter 1 – Public and Private Offerings
Introduction ......................................................................................................................................................6
Types of Financing Transactions ................................................................................................................................. 6
Securities Act of 1933 ......................................................................................................................................7
SEC Registration Forms .............................................................................................................................................. 7
The Registration Process ............................................................................................................................................ 7
Prospectus Delivery Requirement ............................................................................................................................. 10
SEC Rule 3a4-1 – Associated Persons of Issuers .................................................................................................... 11
The Trust Indenture Act of 1939 ................................................................................................................................ 11
Categories of Issuers .....................................................................................................................................12
Shelf Registration ...................................................................................................................................................... 14
Alternative Methods of Raising Capital...........................................................................................................15
Types of Prospectuses ...................................................................................................................................15
Types of Offering Communications ........................................................................................................................... 17
Gun-Jumping Provisions ........................................................................................................................................... 18
Regulation S-K ...............................................................................................................................................18
Projections ................................................................................................................................................................. 19
Regulation S-X ...............................................................................................................................................19
Communication-Related Liability (Section 11 of the Act of 1933) .............................................................................. 20
Exemptions from Registration – Securities.....................................................................................................20
Exempt Securities...................................................................................................................................................... 20
Other Exemptions ...................................................................................................................................................... 21
Exemptions from Registration – Transactions ................................................................................................23
Private Placements.................................................................................................................................................... 24
Regulations Pertaining to Private Placements........................................................................................................... 26
Regulation D .............................................................................................................................................................. 26
FINRA Rules Regarding Private Placements .................................................................................................28
FINRA Rule 5122 – Member Private Offerings.......................................................................................................... 28
FINRA Rule 5123 – Private Placement of Securities................................................................................................. 29
Selling Unregistered Securities ......................................................................................................................29
Rule 144 .................................................................................................................................................................... 29
Rule 144A.................................................................................................................................................................. 31
Regulation S .............................................................................................................................................................. 32
Rule 145 .................................................................................................................................................................... 33
Create a Chapter 1 Custom Exam............................................................................................................................. 33
Chapter 2 – Underwriting
The New Issue Marketplace ...........................................................................................................................35
Underwriting Securities ..................................................................................................................................35
Underwriting Commitments ....................................................................................................................................... 35
Types of Underwriting Commitments......................................................................................................................... 36
FINRA Rules on Securities Distribution ..........................................................................................................38
FINRA Filing Requirements ....................................................................................................................................... 38
Review of Underwriting Agreements ......................................................................................................................... 39
Public Offerings of Securities with Conflicts of Interest ............................................................................................. 41
Settlement of Syndicate Accounts ............................................................................................................................. 42
Regulation M ..................................................................................................................................................43
Rule 101 – Activities of Distribution Participants ....................................................................................................... 43
Rule 102 – Activities of Issuers ................................................................................................................................. 45
Rule 103 – Passive Market Making ........................................................................................................................... 46
Rule 104 – Stabilization ............................................................................................................................................. 47
Penalty Bids and Syndicate Covering Transactions .................................................................................................. 48
Rule 105 – Short Sales in Connection with an Offering............................................................................................. 49
FINRA Rules Regarding Regulation M ...................................................................................................................... 49
FINRA New Issue Allocations and Distributions Rule................................................................................................ 50
Other SEC Rules Affecting Underwriters ................................................................................................................... 51
Recordkeeping .......................................................................................................................................................... 51
The New Issue Rule .......................................................................................................................................52
General Exemptions .................................................................................................................................................. 54
Conclusion ................................................................................................................................................................. 54
Chapter 3 – The Securities Exchange Act of 1934 and Related Rules
Scope of the Securities Exchange Act of 1934...............................................................................................56
Trading Suspensions and Emergency Authority........................................................................................................ 57
Violations of the Exchange Act .......................................................................................................................57
Sarbanes-Oxley Act (Sarbox or SOX) ............................................................................................................57
Reports, Forms, and Schedules Filed under the Act of 1934 .........................................................................59
Reporting Requirements............................................................................................................................................ 59
Insider Trading Regulations ...........................................................................................................................63
Tippers and Tippees .................................................................................................................................................. 63
Important Insider Trading Legislation ........................................................................................................................ 63
Rule 10b5-1 Plans ..................................................................................................................................................... 65
Manipulation .............................................................................................................................................................. 66
Tender Offers ............................................................................................................................................................ 66
Prohibition on Open Market Purchases During the Tender Period ............................................................................ 67
Partial Tender Offers ................................................................................................................................................. 67
Tenders—Prohibited Practices .................................................................................................................................. 68
Going Private Transactions ....................................................................................................................................... 68
Rules Regarding Mergers and Acquisitions ...................................................................................................69
Regulation M-A .......................................................................................................................................................... 69
Regulations Regarding Fairness Opinions ................................................................................................................ 69
Hart-Scott-Rodino (HSR) Act ..................................................................................................................................... 70
Issuer Repurchases .......................................................................................................................................70
SEC Rule 10b-18....................................................................................................................................................... 70
Chapter 4 – Supervision of Research
Research Analysts and Research Reports.....................................................................................................73
Investment Banking and Research Department Control Issues ................................................................................ 73
Research Reports Prior to the Effective Date .................................................................................................74
Communication with the Subject Company ............................................................................................................... 75
Quiet Periods ............................................................................................................................................................. 77
Emerging Growth Companies ................................................................................................................................... 79
Compensation and Personal Trading .............................................................................................................79
Analyst Compensation............................................................................................................................................... 79
Personal Trading ....................................................................................................................................................... 80
Research Reports and Public Appearances Disclosures .......................................................................................... 82
Other Requirements .................................................................................................................................................. 85
Regulation AC (Analyst Certification) ........................................................................................................................ 85
Chapter 5 – General Supervision
Written Supervisory Procedures .....................................................................................................................88
Supervision of Registered Representatives............................................................................................................... 88
Corequisite and Representative Qualification (Top-Off) Exams .....................................................................89
Form U4 .........................................................................................................................................................90
Hiring from Disciplined Firms or Hiring Disciplined Individuals .................................................................................. 93
Updating Form U4 ..........................................................................................................................................94
Industry Requirements for Supervision ..........................................................................................................96
Qualifications of Supervisors ..................................................................................................................................... 96
Producing Managers ................................................................................................................................................. 97
Annual Certification of Compliance and Supervisory Processes ............................................................................... 97
Continuing Education .....................................................................................................................................98
Regulatory Element ................................................................................................................................................... 98
Firm Element ............................................................................................................................................................. 99
Inactive Status—Military Duty.................................................................................................................................... 99
Maintaining Qualifications Program (MQP) ............................................................................................................... 99
Anti-Money Laundering (AML) and the USA PATRIOT Act ..........................................................................100
Mandatory AML Compliance Programs ................................................................................................................... 100
Required Reports .................................................................................................................................................... 101
Penalties .................................................................................................................................................................. 102
Business Continuity Plan (BCP) ...................................................................................................................102
Supervision ..................................................................................................................................................103
Supervision of Lines of Business ............................................................................................................................. 103
Failure to Supervise................................................................................................................................................. 103
Supervision of Business Location ............................................................................................................................ 104
Broker-Dealer Networking Arrangements ................................................................................................................ 108
Additional Considerations.............................................................................................................................109
Red Flags ................................................................................................................................................................ 110
Create a Chapter 5 Custom Exam........................................................................................................................... 110
Chapter 6 – Business Conduct Rules
FINRA Membership Requirements...............................................................................................................112
New Member Application Review Process .............................................................................................................. 112
FINRA Manual ......................................................................................................................................................... 112
Executive Representative ........................................................................................................................................ 112
Dealing with Non-Members ..................................................................................................................................... 112
Suspended Members .............................................................................................................................................. 113
Compensation Issues ...................................................................................................................................113
Churning (Excessive Trading) ................................................................................................................................. 114
Sharing in Accounts................................................................................................................................................. 114
Influencing or Rewarding Employees of Others (The Gifts Rule) ............................................................................ 114
Splitting Commissions ............................................................................................................................................. 115
Charging Customers for Services ............................................................................................................................ 115
Prohibited and Fraudulent Practices ............................................................................................................116
Personal Activities of Employees .................................................................................................................117
Outside Business Activities ..................................................................................................................................... 117
Private Securities Transactions ............................................................................................................................... 117
Accounts at Other Broker-Dealers and Financial Institutions .................................................................................. 117
Borrowing and Lending Practices with Customers .................................................................................................. 118
Soft-Dollar Compensation ....................................................................................................................................... 119
Resolving Problems .....................................................................................................................................119
Complaints............................................................................................................................................................... 119
Code of Procedure .................................................................................................................................................. 120
Code of Arbitration................................................................................................................................................... 122
Mediation ................................................................................................................................................................. 123
Chapter 7 – Communications with the Public
Categories of Communications ....................................................................................................................126
Correspondence ...................................................................................................................................................... 126
Institutional Communication .................................................................................................................................... 126
Retail Communication ............................................................................................................................................. 127
Social Media ............................................................................................................................................................ 127
Internal Review Procedures .........................................................................................................................129
FINRA Filing and Review Requirements ......................................................................................................131
Retail Communication ............................................................................................................................................. 131
Exclusions from the Filing Requirements ................................................................................................................ 132
Summary of Approval and Filing Requirements ...........................................................................................134
General Standards of Communications with the Public................................................................................134
Investment Analysis Tool Requirements ................................................................................................................. 137
Communications Regarding Investment Companies....................................................................................138
SEC Rule 156 – Investment Company Sales Literature .......................................................................................... 138
Use of Investment Companies Rankings in Retail Communication ......................................................................... 139
Bond Mutual Fund Volatility Ratings ........................................................................................................................ 141
Collateralized Mortgage Obligation (CMO) Communication .................................................................................... 141
Variable Life Insurance and Variable Annuity Communications ...................................................................142
Chapter 8 – Packaged Products and Other Investment Vehicles
Packaged Products ......................................................................................................................................145
Federal Regulation – Investment Company Act of 1940 ..............................................................................145
Classifications of Investment Companies ................................................................................................................ 146
Hedge Funds ........................................................................................................................................................... 146
How Mutual Funds Are Organized........................................................................................................................... 147
The Mutual Fund Prospectus and Recent Interpretations ............................................................................147
The Prospectus ....................................................................................................................................................... 147
Mandatory Summary Information ............................................................................................................................ 148
Mutual Fund Profiles................................................................................................................................................ 148
Rule 135a – Generic Advertising for Investment Companies .................................................................................. 148
Statement of Additional Information (SAI) ............................................................................................................... 148
Omitting Prospectus ................................................................................................................................................ 148
Yield Calculations and Performance........................................................................................................................ 149
Distribution of Fund Shares ..........................................................................................................................149
Sales Charges and Classes of Shares .................................................................................................................... 150
Discounts from the POP .......................................................................................................................................... 151
Fees and Charges ................................................................................................................................................... 153
Taxation of Mutual Funds ........................................................................................................................................ 154
FINRA Rules Regarding Investment Companies .........................................................................................154
Distribution Agreements .......................................................................................................................................... 154
Sales Practice Rules ............................................................................................................................................... 155
Regulating Investment Advisers ...................................................................................................................157
The Investment Advisers Act of 1940 ...................................................................................................................... 157
Antifraud Provisions of the Investment Advisers Act ............................................................................................... 158
Another Retirement Planning Tool – Variable Products ...............................................................................158
Taxation of Variable Annuities ................................................................................................................................. 158
FINRA Rules Concerning Variable Products ........................................................................................................... 159
Deferred Variable Annuity Contracts – Suitability Concerns and Compliance Issues ............................................ 160
Direct Participation Programs .......................................................................................................................162
Master Limited Partnerships (MLPs) ............................................................................................................164
Limited Liability Companies (LLCs) ..............................................................................................................164
Real Estate Investment Trusts (REITs) ........................................................................................................164
American Depositary Receipts or Shares (ADRs or ADSs) ..........................................................................166
Promissory Notes .........................................................................................................................................166
Structured Products......................................................................................................................................166
Reverse Convertible Securities—Third-Party Derivative Securities ........................................................................ 167
Chapter 9 – Equity Trading
Trading Overview .........................................................................................................................................169
Exchange Markets........................................................................................................................................170
Unlisted Trading Privileges ...................................................................................................................................... 171
Market Makers..............................................................................................................................................171
Market-Maker Quotes .............................................................................................................................................. 171
Markups/Markdowns ............................................................................................................................................... 172
The Inside Market .................................................................................................................................................... 172
Selling Short ............................................................................................................................................................ 173
Regulation National Market System (NMS) ..................................................................................................173
The Order Access Rule ........................................................................................................................................... 173
The Order Protection Rule....................................................................................................................................... 174
Minimum Pricing Increment ..................................................................................................................................... 175
The Nasdaq Stock Market Listing Criteria ....................................................................................................175
Nasdaq Capital Market Standards ........................................................................................................................... 176
Nasdaq Global Market Standards............................................................................................................................ 176
Nasdaq Global Select Market Standards................................................................................................................. 176
Nasdaq Services and Systems.....................................................................................................................177
Information About Nasdaq Securities ...................................................................................................................... 177
Registration as a Nasdaq Market Maker ......................................................................................................178
Voluntary and Excused Withdrawals ....................................................................................................................... 178
Market Participant Identifier (MPID) .............................................................................................................179
Market Access (SEC Rule 15c3-5) ...............................................................................................................180
The Nasdaq Market Center Execution System........................................................................................................ 181
Book Processing (Execution Priority) ...................................................................................................................... 181
CQS Transactions (and Its Connection to the Third Market) ........................................................................182
Consolidated Quotation System (CQS) ................................................................................................................... 182
Regulation ATS (Alternative Trading System) ..............................................................................................183
Electronic Communication Networks (ECNs) .......................................................................................................... 183
Dark Pools ............................................................................................................................................................... 184
Intermarket Trading System (ITS) ................................................................................................................184
Alternative Display Facility (ADF) ............................................................................................................................ 184
The Order Access Rule ........................................................................................................................................... 184
Performance Standards........................................................................................................................................... 185
OTC Equity Securities ..................................................................................................................................185
OTC Pink Market ..................................................................................................................................................... 186
OTC Equity Trading Rules ...........................................................................................................................187
SEC Rule 15c2-11 – Initiation of Quotations for Non-Exchange-Listed OTC Equity Securities .............................. 188
Information to Be Collected ..................................................................................................................................... 188
Information About the Quote ................................................................................................................................... 189
Submission of Information to FINRA ....................................................................................................................... 189
FINRA Rule 6432 – Compliance with the Information Requirements of SEC Rule 15c2-11 .................................. 191
Chapter 10 – SEC Trading Rules
Regulation NMS ...........................................................................................................................................193
SEC Rule 602 – The Quote Rule............................................................................................................................. 193
Industry Rules on Quotations .................................................................................................................................. 194
The Limit Order Display Rule .......................................................................................................................194
Prohibition Against Trading Ahead of Customer Orders...............................................................................196
Basic Requirements ................................................................................................................................................ 196
Exceptions ............................................................................................................................................................... 197
Applications ............................................................................................................................................................. 198
Price Improvement .................................................................................................................................................. 199
Volume-Weighted Average Price (VWAP) Orders................................................................................................... 200
Disclosure Rules ..........................................................................................................................................201
SEC Rule 605 (Market Center Reports) .................................................................................................................. 201
SEC Rule 606 (Broker-Dealer Order Routing)......................................................................................................... 201
SEC Rule 607 .......................................................................................................................................................... 202
SEC Regulation SHO ...................................................................................................................................202
SEC Rule 200 – Definitions and Order Marking ...................................................................................................... 203
SEC Rule 201 – Circuit Breakers ............................................................................................................................ 203
Short Exempt ........................................................................................................................................................... 204
SEC Rule 203 – Borrowing and Delivery Requirements ......................................................................................... 204
SEC Rule 204 – Closeout Requirements ................................................................................................................ 207
Short-Interest Reporting .......................................................................................................................................... 207
Create a Chapter 10 Custom Exam......................................................................................................................... 207
Chapter 11 – SRO Trading Rules
Order Tickets ................................................................................................................................................209
Components of an Order Ticket .............................................................................................................................. 209
Additional Information .............................................................................................................................................. 210
Executing Orders for Customers ............................................................................................................................. 211
Types of Orders............................................................................................................................................212
Order Qualifiers ....................................................................................................................................................... 213
Adjustment of Open Orders ..................................................................................................................................... 214
Nasdaq Quote Rules ............................................................................................................................................... 215
Extended Trading Hours.......................................................................................................................................... 215
Nasdaq Trading Halts...................................................................................................................................216
Trading Halts on OTC Securities ..................................................................................................................217
Market-Wide Circuit Breakers.................................................................................................................................. 217
Limit Up – Limit Down (LULD) ................................................................................................................................. 218
Example................................................................................................................................................................... 218
FINRA Conduct Rules ..................................................................................................................................219
Best Execution......................................................................................................................................................... 219
Fair Prices and Commissions – The 5% Policy ....................................................................................................... 219
FINRA Sanctions ..................................................................................................................................................... 222
Markups and Markdowns on Debt Securities .......................................................................................................... 223
Charges for Services ............................................................................................................................................... 223
Handling Errors........................................................................................................................................................ 224
Prevention of Rogue Trading .......................................................................................................................224
Trading in Anticipation of a Research Report .......................................................................................................... 225
Front Running .......................................................................................................................................................... 225
Securities with Limited Quotations or Pricing Information ....................................................................................... 226
Foreign Securities with No U.S. Market ................................................................................................................... 226
Trade Shredding ...................................................................................................................................................... 227
Electronic Blue Sheets ............................................................................................................................................ 227
Fraudulent Devices ......................................................................................................................................227
Marking-the-Close/Marking-the-Opening................................................................................................................. 227
Anti-Intimidation/Coordination Interpretation ........................................................................................................... 228
Payments for Market Making ........................................................................................................................228
Chapter 12 – Trade Reporting
Trade Reporting ...........................................................................................................................................231
The Automated Confirmation Transaction (ACT) Technology Platform................................................................... 231
Unrecognized Trades .............................................................................................................................................. 233
Special Reporting Requirements ............................................................................................................................. 234
Reporting Trades in Nasdaq-Listed and Other Exchange-Listed Securities............................................................ 235
Alternate Display Facility Reporting ......................................................................................................................... 237
Reporting Transactions in OTC Equity Securities ................................................................................................... 238
OTC Reporting Facility (ORF) ................................................................................................................................. 238
Consolidated Audit Trail (CAT) ................................................................................................................................ 239
Clearly Erroneous Transactions .............................................................................................................................. 242
Trade Reporting and Compliance Engine (TRACE) .....................................................................................244
Reporting Requirements.......................................................................................................................................... 245
Bond Dissemination Information .............................................................................................................................. 245
Reporting Times ...................................................................................................................................................... 246
Chapter 13 – Customer Accounts
Telemarketing ..............................................................................................................................................249
Use of Stockholder Information for Solicitation ........................................................................................................ 250
New Account Documentation .......................................................................................................................250
Required Information ............................................................................................................................................... 250
Know Your Customer and Suitability ....................................................................................................................... 252
Verification and Ongoing Updating of Client Information ......................................................................................... 253
Regulation Best Interest (Reg BI) .................................................................................................................254
Financial Exploitation of Specified Adults – FINRA Rule 2165 .....................................................................256
Death of the Account Owner ........................................................................................................................258
Customer Accounts – Policies and Procedures............................................................................................258
Trading Authorizations............................................................................................................................................. 258
Discretionary Accounts ............................................................................................................................................ 259
Miscellaneous Rules and Disclosures ..................................................................................................................... 259
Account Registration – Forms of Account Ownership ............................................................................................. 260
Types of Accounts ................................................................................................................................................... 263
Penny Stock Regulations .............................................................................................................................264
Exclusions from the Penny Stock Definition ............................................................................................................ 265
Penny Stock Disclosure Rules ................................................................................................................................ 265
Penny Stock Sales Practice Requirements ............................................................................................................. 265
Retirement Accounts ....................................................................................................................................266
Qualified Plan Accounts .......................................................................................................................................... 266
Customer Identification Program (CIP).........................................................................................................268
SEC Regulation SP and Identity Theft .........................................................................................................269
Privacy of Consumer Financial Information ............................................................................................................. 269
Identity Theft – FTC Red Flags Rule ....................................................................................................................... 270
Securities Investor Protection Act ............................................................................................................................ 270
Confirmations and Account Statements .......................................................................................................272
Confirmation Statements ......................................................................................................................................... 272
Account Statements ................................................................................................................................................ 273
Chapter 14 – Operational Issues
Uniform Practice Code .................................................................................................................................275
Clearing – An Overview................................................................................................................................275
Clearing and Introducing Firms ............................................................................................................................... 277
Carrying Agreements............................................................................................................................................... 278
Client Instructions .........................................................................................................................................278
Forwarding Official Communications ....................................................................................................................... 279
Holding of Client Mail............................................................................................................................................... 279
Special Client Delivery and Payment Arrangements ....................................................................................280
Prime Brokerage...................................................................................................................................................... 281
Settlement ............................................................................................................................................................... 282
Customer Payment Is NOT Settlement ................................................................................................................... 283
Other UPC Issues ........................................................................................................................................284
Dividends ................................................................................................................................................................. 284
Delivery of Securities....................................................................................................................................285
CUSIP Numbers ...................................................................................................................................................... 285
Failure to Settle – Closeouts ................................................................................................................................... 287
Marks-to-the-Market ................................................................................................................................................ 288
Rejection and Reclamation...................................................................................................................................... 288
Transferring Accounts ............................................................................................................................................. 288
Bulk Transfers of Customer Accounts ..................................................................................................................... 290
Complaints ...................................................................................................................................................290
Chapter 15 – Margin
Margin ..........................................................................................................................................................293
Opening a Margin Account ...................................................................................................................................... 293
Margin Risk Disclosure Document........................................................................................................................... 294
Hypothecation.......................................................................................................................................................... 294
Margin Process........................................................................................................................................................ 296
Regulation T (Reg T) ............................................................................................................................................... 296
Long Accounts .............................................................................................................................................298
Initial Margin ............................................................................................................................................................ 298
Excess Equity and SMA .......................................................................................................................................... 299
Restricted Account .................................................................................................................................................. 300
Minimum Maintenance Requirement ....................................................................................................................... 301
Minimum Initial Equity Requirement ........................................................................................................................ 302
Short Accounts .............................................................................................................................................302
Minimum Maintenance Requirement ....................................................................................................................... 303
Day-Trading Margin......................................................................................................................................303
Portfolio Margin ............................................................................................................................................304
Chapter 16 – Financial Responsibility
What’s Net Capital?......................................................................................................................................308
Computation of Net Capital ..................................................................................................................................... 308
Haircuts and Deductions ......................................................................................................................................... 308
Subordination Agreements ...................................................................................................................................... 310
Aggregate Indebtedness (AI)................................................................................................................................... 312
Debt-to-Equity Requirement .................................................................................................................................... 314
Reporting Requirements.......................................................................................................................................... 315
Net Capital Violations and Early Warning Procedures ............................................................................................ 316
Beyond Capital: Safekeeping Customer Funds and Securities ....................................................................318
The Customer Protection Rule ................................................................................................................................ 318
Customer Free Credit Balances .............................................................................................................................. 320
Securities Investor Protection Act ............................................................................................................................ 320
Securities Counts .................................................................................................................................................... 320
Securities Information Center .................................................................................................................................. 321
FINRA Rules............................................................................................................................................................ 322
Fidelity Bonds .......................................................................................................................................................... 322
Books and Records ................................................................................................................................................. 324
Six-Year Records and Posting Requirements ......................................................................................................... 324
Three-Year Records and Posting Requirements ..................................................................................................... 324
Lifetime Records...................................................................................................................................................... 325
SERIES 24 INTRODUCTION
About the Series 24 Examination

The Series 24 Examination is a three-hour and 45-minute examination consisting of 150 multiple-choice
questions. The minimum required passing score is 70% (105 correct out of the 150 questions). The questions
are divided into the following five content areas:
Content Areas:
Section Description Chapters Questions
Supervision of Registration of the Broker-Dealer and Personnel
1 5, 6 9
Management Activities
2 Supervision of General Broker-Dealer Activities 5, 6, 8, 13, 14, 15, 16 45
3 Supervision of Retail and Institutional Customer-Related Activities 7, 11, 13, 14 32
4 Supervision of Trading and Market Making Activities 9, 10, 11, 12, 13 32
5 Supervision of Investment Banking and Research 1, 2, 3, 4 32
TOTAL 150
Note: Each examination will include 10 additional, unidentified pre-test questions that do not contribute
towards the candidate’s score. These 10 questions are randomly distributed throughout the examination and
will not be identified as experimental items.
Registering for the Examination

To register for the Series 24 Examination, you must complete the Form U4 application. Your sponsoring firm
will then send both Form U4 and your fingerprints to FINRA for processing. Give yourself ample time for
processing to be completed. Once your information has been processed, a confirmation will be sent to your firm.
Taking the Exam

In order to take an exam, you will need to make a test appointment. Please use the following information to
schedule an appointment and/or to learn more about the examination center:
Prometric Exam Centers
www.prometric.com/finra/
800.578.6273
The website will provide you with the most up-to-date information regarding “Test Center Security” and “Test
Break Policies.” At the testing facility, you will be provided with:
 A four-function calculator
 Two dry-erase boards
 Dry-erase pen
Copyright © Securities Training Corporation. All Rights Reserved. 1

INTRODUCTION SERIES 24
For more information regarding scheduling an exam, what to expect on the day of your exam, and what happens
after your exam, please use the following link which provides information from FINRA:
www.finra.org/sites/default/files/external_apps/proctor_tutorial.swf.html
About the Training Program

Securities Training Corporation’s Series 24 Training Program is designed to assist students in passing the
Series 24 Examination regardless of an individual’s prior experience or educational level. The program
consists of the following materials:
1. A study manual containing 16 chapters complete with review questions and explanations
2. Eight online final examinations with detailed explanations
We recommend that you visit our website www.stcusa.com to determine whether there have been any changes
or supplemental materials created for this exam.
Study Manual
The study manual represents the first phase of your exam preparation and divided into 16 chapters:
Chapter 1: Public and Private Offerings
Chapter 2: Underwriting
Chapter 3: The Securities Exchange Act of 1934 and Related Rules
Chapter 4: Supervision of Research
Chapter 5: General Supervision
Chapter 6: Business Conduct Rules
Chapter 7: Communications with the Public
Chapter 8: Packaged Products and Other Investment Vehicles
Chapter 9: Equity Trading
Chapter 10: SEC Trading Rules
Chapter 11: SRO Trading Rules
Chapter 12: Trade Reporting
Chapter 13: Customer Accounts
Chapter 14: Operational Issues
Chapter 15: Margin
Chapter 16: Financial Responsibility
After reading each chapter, STC strongly suggests that students go to their my.stcusa.com dashboard and create
a 10-question Custom Exam that contains only questions pertaining to the chapter just completed. The Custom
Exam may be taken with or without the explanations shown after each question is answered. Students
shouldn’t proceed to the next chapter until they fully understand the explanation for any questions that were
answered incorrectly.
Final Examinations
The final examinations and corresponding explanations represent the most important part of your test
preparation. These examinations will assist you in applying the information that you learned in the study
manual to questions that are posed in the multiple-choice format and used in the Series 24 Examination.
2 Copyright © Securities Training Corporation. All Rights Reserved.

SERIES 24 INTRODUCTION
An examination should first be taken with the SHOW EXPLANATIONS turned on. As you read a question,
try to answer it. However, whether your answer is correct or incorrect, read the entire explanation. You may
find it helpful to highlight or take notes on any facts you didn’t know for use in future studying.
Studying each explanation is a crucial step to passing the Series 24 Examination. By concentrating only on the
correct response and disregarding the explanation, you run the risk of memorizing answers without fully
understanding the underlying concepts.
After completing all of the examinations with SHOW EXPLANATIONS switched on, and if time permits based
on the calendar you’re following, begin the process over again by retaking each examination without the
explanations shown. If taking the test for the second time, you should strive to achieve a score of 85% or better
to show maximum retention of the material.
Standardized Test-Taking Tips

As with any standardized test, you may be able to increase your score by employing good test-taking
techniques. An efficient technique will ensure an overall understanding of the question while helping to avoid
careless errors. It will also help you to stay alert throughout the entire exam. The following list is a step-by-
step approach that may work well for you:
Step 1: Read the question the first time through without trying to answer it. At this point, merely form an
understanding of the substance of the question.
Step 2: Carefully read the four choices. Remember, since a multiple-choice examination actually gives you
the answer, your job is to recognize the correct choice from among the distractors. By keeping these choices in
mind when you reread the question, you will be able to pinpoint the important information and filter out any
extraneous material.
Step 3: Reread the question slowly and stop at the end of each sentence to absorb the information. You
may need to exaggerate this in the beginning as you get used to applying the intense concentration required to assure
that you recognize all of the important facts and catch the misleading words or phrases (e.g., not, except, etc.).
Step 4: Make sure that you fully understand what the question is asking. You cannot possibly answer a
question correctly before you know what it’s asking. You may need to look back to the question for additional
facts before you are ready to choose your answer.
Step 5: Read each choice a second time. As you read a choice, decide whether it’s a possible answer. If you’re
able to eliminate three of the four choices, then you have your answer. However, if you only eliminate one or two,
it will still help you narrow it down to your best choices. Reconsider the remaining choices by comparing their
differences and decide which answer is more correct. Once you have made your decision, DON’T LOOK BACK!
It’s important that you practice your technique so that you become proficient by the time you sit for the Series 24
Examination. The best place to practice is on the simulated final examinations. Not only will this practice build your
technique, it will also help you to identify potential problem areas. A list of common test-taking problems follows.

INTRODUCTION SERIES 24
Test-Taking Pitfalls
Reading the Question Too Fast Part of the battle in attempting to pass a standardized examination is
determining what a question is asking. Regardless of how many times you read a question, you cannot absorb
the information if you read the question too quickly.
Changing Answers Going back and changing an answer means that you are second-guessing yourself. If
you employ a good test-taking strategy, there is nothing you will gain from going back to a question for a
second time. If you think you are likely to obtain the information you need from another question, remember
that this examination is written by expert test writers who are not going to give anything away.
Formulating an Answer Too Quickly When you are ready to answer a question, make sure to consider all
four of the choices that are given. Don’t formulate an answer on your own and merely look for that choice
while disregarding the others. Remember, there will often be more than one correct choice and, while your
choice may be right, it may not be the best response.
Making Careless Errors Don’t form preconceived notions when reading a test question. Always read what is
written, not what you expect to see. By keeping an open mind, reading the questions slowly, and reading them
at least two times through, you should be able to avoid these types of errors.
Study Calendars
STC provides sample study calendars which are designed to help students in organizing their time and
allowing for a manageable amount of daily study. Remember, these calendars are simply suggestions for how
you may plan your studies. Feel free to make any modifications that you deem appropriate.
The calendars are available for download on your student dashboard on www.my.stcusa.com.
 Click on the link to “Calendars and Crunch Time Facts” that appears below the Series 24 Securities
Program course title
 Choose the calendar that best fits your needs

Chapter 1
Public and Private

Offerings

CHAPTER 1 – PUBLIC AND PRIVATE OFFERINGS SERIES 24
This chapter will focus on the differences between the two main types of securities offerings—public and
private. Special emphasis will be given to the regulatory requirements that apply to the issuers that are
associated with these transactions.
Introduction
Types of Financing Transactions

Public Offering versus Private Placement For an issuer that intends to raise capital, there are two main
types of offerings—public offerings and private placements. The main advantage for the issuer in conducting a
public offering is the large number of investors (both retail and institutional) who are permitted to participate.
However, the disadvantages are the cost and the length of time needed to undertake this type of offering due to
the requirements of the Securities Act of 1933. On the other hand, if an issuer is considering a private
placement, the main advantages are that it’s faster and less costly than a public offering. Private placements are
exempt offerings, which means that registration with the Securities and Exchange Commission (SEC) is not
required. However, the disadvantage faced by an issuer that’s engaged in a private placement is the limitation
as to whom the offering may be directed and/or the number of investors that may participate.
Private placements are conducted under the provisions of Regulation D of the Securities Act of 1933. These
offerings are intended to make access to capital more convenient for small companies that could not generally
bear the costs of a normal SEC registration. Depending on the intentions of the issuer, the offering may be
conducted under Rule 504 or 506 of Regulation D. A Rule 504 offering is for issuers that will not be raising
more than $10 million over 12 months, while a Rule 506 offering has no dollar limit.
Initial Public Offering (IPO) Versus a Follow-On Offering If an issuer is conducting an IPO, it’s the first
time that the entity is selling securities to the public. Most issuers that conduct IPOs sell common stock (equity
securities) in order to raise capital. If a company has common stock that’s already publicly traded and intends
to raise additional capital through a sale of more common stock, the issuer is considered to be conducting a
follow-on offering.
Private Investment in Public Equity (PIPE) A PIPE offering is a private placement of securities in which a
broker-dealer assists an issuer by helping distribute restricted (unregistered) securities to a small group of
accredited (wealthy or institutional) investors. These restricted securities are purchased from an issuer that already
has publicly traded securities outstanding. The securities are soon sold in the public marketplace after the SEC
declares the registration statement effective. Once the PIPE offering is announced, the company’s share price will
often decline. This is in part a reflection of the increase in the number of shares that will become outstanding
(potential dilution), but it’s also due to the perception that the company not only is in need of capital, but that it has
limited means available to raise the capital and that the pricing of the shares is below the price of the common
stock (at the time of the announcement). Hedge funds are frequent purchasers of this type of offering.
Prior to the offering, a registered salesperson is permitted to solicit and accept indications of interest from
investors for the purchase of the PIPE. PIPE financing investors often only hold the restricted securities for a
short period and will quickly resell them in the public marketplace since most of these offering require the
issuer to file a registration statement.

SERIES 24 CHAPTER 1 – PUBLIC AND PRIVATE OFFERINGS
Securities Act of 1933

Unless an exemption is available, the Securities Act of 1933 requires issuers to register their securities with the
SEC. The process of registering securities includes the filing of a registration statement with the SEC and the
preparation/distribution of a prospectus. Section 5 of the Act states that it’s unlawful to use an instrument of
interstate commerce (e.g., mailings) to sell a security unless a registration statement is in effect.
The Securities Act of 1933 attempts to prevent fraud in the sale of new issues by requiring that investors are
provided with enough relevant information about the offering to make an informed investment decision. This
information is provided through a registration statement, which is a public document that’s filed with the SEC.
A registration statement provides full disclosure of all material information about the issuer and the offering.
SEC Registration Forms

Form S-1 Form S-1 is the basic registration form that most companies are required to use when conducting
initial public offerings. Foreign issuers file an equivalent document, which is Form F-1.
Form S-3 An S-3 registration statement—often referred to as a short form registration statement—is used by
seasoned issuers of securities. The minimum requirement to file an S-3 is for the issuer to have a public float of
$75 million in voting and non-voting common equity. An issuer is prohibited from filing an S-3 registration
statement if it has failed to pay a dividend on any issue of its preferred stock, failed to pay interest on a bond, or
if it’s delinquent in its SEC filings. Foreign issuers file an equivalent document, which is Form F-3.
Form S-4 The SEC requires an issuer to file Form S-4 if securities are being offered as a result of a business
combination (e.g., merger, acquisition, consolidation, reclassification of securities, or transfer of corporate
assets). The SEC believes that investors should still be provided the protection of securities laws when
securities are offered in this manner.
Form F-6 SEC Form F-6 is a filing that investment firms must file if they intend to offer American
depositary receipts (ADRs) of a foreign issuer.
The Registration Process

Next, let’s examine the three phases of the registration process for securities.
The following is a summary of the process which will be described in this section:
Pre-Registration Period Cooling-Off (Waiting) Period Post-Effective Period
- Prepare registration statement - Extends for 20 days from - Final prospectus issued
- No discussions with customers amendment, unless accelerated - Sales confirmed
Filing - Preliminary prospectus delivered Effective - 25/40/90-day aftermarket prospectus
Date - Blue-Sky the issue Date requirement for dealers
- Hold due diligence meeting (described below)
- Accept indications of interest
(no sales)

IPO Process For an IPO, the issuer files Form S-1. Part of Form S-1 is the preliminary registration
statement (red herring or preliminary prospectus), which is used as a disclosure document for potential
investors, but is not fully complete. In most cases, the offering price is omitted from the red herring (although a
price range is permitted). If any material information is added or altered as it relates to the original filing, an
amended Form S-1 must be filed. Reasons for making an amended filing include stale or outdated financial
statements, a change in the number of shares being offered, material changes related to the issuer’s business,
change of officers or directors, and additional required exhibits. As a general rule, the date on which a
registration statement becomes effective is the 20th day after the filing date. Any amendment to a registration
statement that’s filed prior to the effective date will initiate a new 20-day period.
When the issuer files what it considers to be the final amendment, it may then request an accelerated effective
date if it doesn’t want to wait 20 days to sell the securities. The request is made by the issuer and the managing
underwriter and may be made either orally or in writing. The SEC must be notified by no later than the second
business day before the day that it wants the registration to become effective. The SEC reviews the issuer’s
filing to ensure that there’s adequate information concerning the securities being offered. Since the SEC is
focused on protecting the public, it wants to be certain that the investors have been provided with full and fair
disclosure. Once the offering price has been established, the information that was originally omitted in the
preliminary registration statement is contained in a final prospectus that’s filed with the SEC. This includes the
offering price as well as other information based on the offering proceeds, such as the underwriting spread, the
underwriter’s allocation, underwriter’s discounts, and the proceeds to the issuer.
Under the Securities Act of 1933, a registration statement must contain detailed information about the issuer,
its business, its owners, and its financial condition. Much of the information that’s required in a registration
statement is aimed at the disclosure of the following information:
 The character of the issuer’s business
 A balance sheet with data that’s no older than 90 days prior to the filing of the registration statement
 Financial statements that show profits and losses for the latest fiscal year and for the two preceding fiscal years
 The amount of capitalization and use of the proceeds of the sale
 Monies paid to affiliated persons or businesses of the issuer
 Shareholdings of senior officers, directors, and underwriters, and identification of individuals who hold at
least 10% of the company’s securities
The Pre-Registration or Pre-Filing Period The process of registering a new issue begins with the pre-
registration period. During this phase, the issuer prepares the registration statement with the help of its underwriters
(i.e., the broker-dealers that will sell the new issue). However, the underwriters may not discuss the new issue with
their customers during this period. When the registration statement is ready, the issuer files it with the SEC. This
filing date signifies the end the pre-registration period. Although federal law doesn’t define the time between the
decision by the company to proceed with an offering and the filing date, the term quiet period is often used.
Due Diligence The Securities Act of 1933 also governs the underwriters and any person that assists in the
preparation of the registration statement or the sale of the new issue. Such persons may be liable for false or
misleading information that’s contained in the registration statement and prospectus. To safeguard against potential
problems, the underwriters are required to perform a due diligence investigation of the issuer and the offering. A
final meeting—referred to as bring down due diligence—is held just prior to the issuance of the final prospectus.
The term bring down refers to process of bringing all of the parties involved in the offering (the underwriter, issuer,
attorneys, and other interested parties) are brought up-to-date since the last due diligence meeting.

The Cooling-Off (Waiting) Period The second phase in the registration process is the cooling-off period.
During this time, the SEC reviews the registration statement to determine whether it’s complete and to ensure
that it doesn’t contain misleading statements. However, the SEC does NOT judge the investment merits of the
issue and it does NOT judge the appropriateness of the pricing of the issue. If the SEC believes that the
registration statement or prospectus is incomplete or misleading, it sends a deficiency letter to the issuer. The
issuer must then refile an amended registration statement for it to again be reviewed by the Commission.
During this time:
Underwriters are Permitted to: Underwriters are Not Permitted to:

 Discuss the issue  Sell the new issue (since the deal has not
 Provide the red herring (a preliminary prospectus that been priced)
includes a price range)  Accept payment for the new issue
 Record the names of potential purchasers (indications
of interest are non-binding for either party)
Road Show A road show encompasses meetings with prospective customers and brokers that are generally
held by an investment banker and an issuer before a securities offering. These can be live, real-time
presentations to a live audience in a physical setting. However, to reach a larger audience, many are electronic
(either live or recorded). Electronic live road shows are considered oral communications, whereas recorded
road shows are considered graphic (written) communications.
State or Blue-Sky Laws State securities regulations, which are codified under the Uniform Securities Act
(USA), are often referred to as Blue-Sky Laws. In addition to the federal securities laws, every state has its own
set of securities laws that are designed to protect investors against fraudulent sales practices and activities.
Although these laws do vary from state to state, most state laws typically require companies that are making
offerings of securities to register their offerings before they can be sold in a particular state, unless a specific
state exemption is available. The laws also handle the registration of brokerage firms, their agents (registered
representatives), and investment adviser representatives.
Under Blue-Sky Laws, traditional insurance products, in which returns are guaranteed by the insurance
company (i.e., general account products), are not securities. Examples include whole life insurance and fixed
annuities. On the other hand, variable products, in which the returns are tied to the performance of a separate
account, are considered securities.
The Post-Effective Period Generally, the effective date of the registration statement is 20 days after the last
amendment is filed in response to a deficiency letter. The SEC may choose to accelerate this process upon
request of the issuer and underwriters. The effective date represents the end of the cooling-off period and the
beginning of the post-effective period.
The price of the offering (public offering price or POP) is typically set by the underwriters on the morning of
the effective date, at which point sales of the offering may begin. The purchaser must be given a copy of the
final prospectus (which includes the public offering price) by no later than the time a sale is confirmed.
Broker-dealers must take reasonable steps to fulfill written requests for a prospectus.

During the cooling-off period, the preliminary prospectus is sent; however, after the effective date, a final
prospectus is provided. In some cases, information that was not included in the final prospectus is subsequently
disclosed in a post-effective amendment which becomes effective immediately upon filing.
In the case of a company that has not previously filed financial reports with the SEC, a preliminary prospectus
must be delivered at least 48 hours before the sale is confirmed to any person expected to purchase the new
issue. This ensures that the final prospectus will not be the first written information that’s received by
purchasers about the new issue.
Prospectus Delivery Requirement

A dealer that sells securities in the secondary market must provide prospectuses to customers if new securities
of that class were recently sold by the issuer under a registration statement. If the issuer of the securities
already has publicly traded securities outstanding, a prospectus must be delivered to purchasers for 40 days
after the effective date. However, for IPOs, prospectuses must be delivered for 90 days after the effective date.
There are two exceptions to the prospectus delivery requirement:

1. If the issuer was subject to the reporting requirements of the Securities Exchange Act of 1934 prior to the
filing of the registration statement, there’s no prospectus delivery requirement for dealers.
2. If the issuer was not a reporting company prior to filing, but will be listed on an exchange as of the
effective date, the requirement applies for 25 days. (This is the most typical situation.)
The main purpose of this rule is to provide investors with information concerning an issue of securities. If the
issuer was already a reporting company, information is readily available to the public through the SEC’s
EDGAR system (which is why the period is only 25 days).
For example, if an issuer is already listed on an exchange and sells a new issue of common stock,
there’s no prospectus delivery requirement. If the offering is an IPO and the issuer will be listed
on an exchange, the prospectus delivery requirement is 25 days. On the other hand, if the offering
is to be quoted on the OTC Pink Market (which is not an automatic quotation system), the
delivery requirement is 90 days for an IPO and 40 days for a secondary offering.
Reporting Status at After the Offering, Dealers

Exchange Listing Status
the Time of Filing Must Provide a Prospectus for:
Non-Reporting Will be listed 25 days
Non-Reporting Will NOT be listed and it’s NOT an IPO 40 days
Non-Reporting Will NOT be listed and it’s an IPO 90 days
Aftermarket prospectus
Reporting Currently listed
requirement does NOT apply
* A reporting company is defined as:

 An issuer of securities that’s listed on a national securities exchange (e.g., NYSE or Nasdaq)
 Any other publicly traded corporation that has total assets of more than $10 million and more than
500 shareholders

When a prospectus is used for more than nine months after its effective date, as is the case with redeemable
open-end investment company shares (mutual funds), the prospectus must contain up-to-date information
that’s not older than 16 months.
Unlawful Representations The Securities Act of 1933 requires disclosure of material facts regarding securities
that are sold publicly. Both criminal and civil penalties may be imposed for violations of the law, such as:
 Failing to file the registration statement
 Making a material misstatement and/or material omission of important facts in a registration statement
 Selling the security publicly before the registration is effective
 Failing to provide a copy of the final prospectus to a purchaser
SEC Rule 3a4-1 – Associated Persons of Issuers

The Sale of Securities by Employees of an Issuer In small offerings, an issuer may use its personnel to sell
its securities. According to SEC Rule 3a4-1, associated persons of an issuer may participate in a securities
offering without being defined as a broker-dealer as long as they:
 Don’t receive commissions or transaction-based compensation in connection with the offer
 Are not associated with a broker-dealer
 Are not subject to statutory disqualification
In addition, associated persons of the issuer must meet any one of the following three criteria:
1. The associated persons must limit sales activities to financial institutions (broker-dealers, registered
investment advisers, registered investment companies, banks, savings and loans, and trust companies), or to
certain very limited types of transactions (e.g., employee benefit plans for stock options or retirement plans).
2. The associated persons must primarily perform other duties for the issuer (or will be performing these
functions once the offering ends), have not been associated with a broker-dealer during the last year, and
don’t participate in sales of securities for any issuers more than once per year.
3. The associated persons prepare written communications (approved by an officer or director), but don’t
solicit potential investors.
The Trust Indenture Act of 1939

New issues of corporate bonds must be registered under the Securities Act of 1933 and are also subject to the
Trust Indenture Act of 1939. (Please note that municipal bonds, government bonds, and other exempt
securities are not subject to the Trust Indenture Act.) According to the Trust Indenture Act, a corporation that
issues more than $10 million of debt must provide an indenture (agreement) between the issuer and a trustee
that will act on behalf of the bondholders. The trustee is typically a bank or trust company that must act in the
bondholders’ interest. All of the terms of the issue must be specified in detail in the indenture, which the
trustee signs on the bondholders’ behalf.
Bond Indenture A bond’s indenture consists of two parts—protective covenants and the process for handling
issuer defaults. Covenants are protective agreements that the borrower pledges for the protection of the lender.
Covenants can be positive, which require certain actions on the part of the issuer, or negative, which limit certain
actions. An example of a positive covenant is if an issuer is required to maintain a minimum amount of working
capital or debt coverage ratio, while a negative covenant restricts an issuer from selling assets or issuing additional
debt. If debt covenants are broken, the loan may become due immediately.

In a bond indenture, a cross default clause provides protection to issuer’s bondholders by triggering a default if
any of the bonds that are issued by the same company are defaulted. In other words, a default on one loan
automatically places a company in default of other loans, even if no payments were missed.
Categories of Issuers
The previous discussion of the registration process focused primarily on a new issuer’s initial public equity
offering. However, the process of raising capital for existing public companies may differ based on the
category of the issuer. SEC Rule 405 defines the different categories of issuers and this will determine the level
and type of communications that an issuer may make regarding the new issue offering. The categories also
distinguish a level of familiarity (or unfamiliarity) with issuers within the securities industry.
For example, some issuers may be followed by the media and financial analysts, whereas others are not
regularly followed and may not have the same type of recognition. An issuer’s categorization affects its status
during the registration of new issues and determines the amount of additional disclosure that’s required to
facilitate the issuance.
The following issuer categories have been created.
Well-Known Seasoned Issuer (WKSI) An issuer that qualifies as a well-known seasoned issuer is required
to file reports under Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 and must meet the
following requirements:
 The issuer must be eligible to register on Form S-3 (the short form of the registration statement) or Form
F-3 (the registration statement for certain foreign private issuers).
 Within 60 days of the determination of eligibility, the issuer must have either:
‒ A worldwide market value of outstanding voting and non-voting common equity held by non-
affiliates of $700 million or more, or
‒ In the last three years, issued at least $1 billion aggregate principal amount of non-convertible
securities, other than common equity, in primary offerings for cash (not exchange) registered under
the Securities Act of 1933
 The issuer cannot be ineligible.
Majority-Owned Subsidiary A majority-owned subsidiary of a well-known seasoned issuer qualifies as a

well-known seasoned issuer in connection with the offer and sale of its own securities if the following
conditions are met:
 The securities are non-convertible, other than common equity, and the parent company is a well-known
seasoned issuer that fully and unconditionally guarantees the securities.
 The securities are guarantees of non-convertible securities, other than common equity, of the parent
company or another majority-owned subsidiary where the non-convertible securities are fully and
unconditionally guaranteed by the parent company.
 The securities are non-convertible investment-grade.

Well-known seasoned issuers may use a free writing prospectus (FWP) for securities that are or will be the
subject of a registration statement. A free writing prospectus is an offer to sell or a solicitation of an offer to
buy securities in the form of a written communication. An FWP is used in conjunction with, not in lieu of, a
registration statement. (Details regarding an FWP are included later.)
Seasoned Issuer A seasoned issuer is one that’s eligible to use Form S-3 or Form F-3 to register a primary
offering of securities, but doesn’t meet the other requirements of a WKSI. A seasoned issuer has a public float
(i.e., shares held by public investors) of less than $700 million, but greater than $75 million.
Unseasoned Issuer An unseasoned issuer is one that’s required to file reports under Section 13 or Section
15(d) of the Securities Exchange Act of 1934, but doesn’t meet the requirements to file on Form S-3 or Form
F-3 for a primary offering of its securities.
Non-Reporting Issuer A non-reporting issuer is one that’s not required to file reports under Section 13 or
Section 15(d) of the Securities Exchange Act of 1934. This definition applies even when an issuer is filing
such reports on a voluntary basis.
Ineligible Issuer An ineligible issuer is one that’s not permitted to use a free writing prospectus, including:
 An issuer that’s required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934,
but has not done so
 A blank-check company or a shell company
 An issuer offering penny stock
 A limited partnership offering with the securities being sold through methods other than a firm-
commitment underwriting
 An issuer that has filed for bankruptcy, or a filing was made against the issuer for insolvency in the past
three years. This provision will terminate if the issuer has filed an annual report or a registration statement
which includes audited financial statements.
 An issuer or an entity of an issuer convicted of a felony or misdemeanor that involves securities laws
violations or violations of antifraud provisions in the past three years
 An issuer that has been or is the subject of a refusal or stop order under the Securities Act of 1933
Issuer Type Filing Form Requirements

A minimum of $700 million public float or
S-3 ASR (Automatic Shelf
WKSI a minimum of $1 billion in public debt
Registration) [described below]
issuance over last three years
Seasoned Issuer S-3 (Shelf provisions) A minimum of $75 million public float
Unseasoned Issuer S-1 Less than $75 million public float
Non-Reporting Issuer
S-1 N/A
(IPO or OTC Pink Market)

Shelf Registration
Rule 415 allows issuers to file registration documents and offer the subject securities on a delayed or continuous
basis. The advantage of the delayed distribution is that it allows the issuing company and its underwriters the
flexibility of selling the securities when market conditions are most favorable. Many issuers of debt securities
file shelf registrations that allow them to issue bonds when interest rates are lower.
The provisions of the rule are available for securities being sold on behalf of the issuing company and for
securities being issued for entities such as employee benefit plans, securities being issued upon conversion of
other securities, and securities being issued in connection with business combination transactions.
For offerings that fit the following criteria, a shelf registration statement may be used for three years after an
initial effective date of a registration statement:
 An offering that will begin immediately and last for a period greater than 30 days from the effective date,
or
 An offering for securities that are registered on Form S-3 or F-3, offered and sold on an immediate,
continuous, or delayed basis by or on behalf of the registrant or a majority-owned subsidiary of the
registrant
There’s no limit to the amount of securities that may be offered for any issuer that’s eligible to file under the
shelf registration rules.
The phrase “pay-as-you-go” may be used to refer to a WKSI that files a Form 3 ASR and then pays the
registration fee to the SEC as it sells securities “off the shelf.” Only a WKSI is permitted to file a Form S-3
ASR and utilize this type of procedure. All other issuers are required to pay the SEC registration fee when
they file the appropriate form to raise capital.
A well-known seasoned issuer is permitted to file an immediately effective shelf registration statement. A
prospectus that’s filed as part of an automatic shelf registration may omit information that’s unknown or is not
available to the issuer. For example, the filing may list different types of securities that may be offered during
the three-year period.
In addition, a form of prospectus that’s filed as a part of an automatic shelf registration statement may omit
information as to whether the offering is a primary offering, an offering on behalf of persons other than the
issuer, or a combination of the two. Other information that may be omitted includes the plan of distribution for
the securities, a description of the securities registered, other than an identification of the name or class of such
securities, and the identification of other issuers.
One of the advantages of a company achieving the well-known seasoned issuer status is that the issuer is
permitted to file an S-3 ASR (automatic shelf registration), which means that it can offer securities without SEC
review. A seasoned issuer may benefit from shelf registration, but not the automatic shelf registration that’s
afforded to issuers with WKSI status. If a company files an ASR and it’s no longer a well-known seasoned
issuer, it should amend its automatic shelf registration statement. After the loss of WKSI status, an issuer may
continue to sell securities registered under a previously filed automatic shelf registration statement until the date
on which its next Form 10-K (annual report) is required to be filed. The issuer accomplishes this by filing an
amended Form S-3, which converts the offering to a regular shelf registration that requires SEC review.

Alternative Methods of Raising Capital

Crowdfunding The term "crowdfunding" generally refers to the use of the Internet by small businesses to
raise capital through limited investments from a large number of investors. The Jumpstart Our Business
Startups (JOBS) Act established crowdfunding provisions that allow early-stage businesses to offer and sell
securities. Under SEC rules, the general public can invest in capital being raised by startup companies.
As with stocks and bonds, any person can invest in crowdfunding offerings. However, due to suitability
concerns revolving around the illiquid nature of these types of securities offerings, a person is limited in the
amount that can be invested during any 12-month period in these securities. The actual amount that a person
can invest is inflation-adjusted and based on the person’s net worth and annual income. Companies are
prohibited from offering crowdfunding investments directly to investors; instead, they must use a broker-
dealer’s online platform or a funding portal. The broker-dealer or funding portal must be registered with the
SEC and be a member of FINRA.
At-the-Market Offerings An at-the-market offering of securities is sold at the prevailing market price directly
into the secondary market through a designated broker-dealer, rather than through a traditional offering of a fixed
number of shares at a fixed price. Issuers may use a shelf registration to initiate an at-the-market offering, with
the securities being sold at various prices during the day, reflecting the supply/demand profile for that issuer.
Only issuers that register their securities under Form S-3 or Form F-3 may engage in this type of offering.
A broker-dealer that participates in the primary or secondary distribution of a security and is not permitted to
trade on a national securities exchange may not represent that the security is being offered at-the-market
(i.e., priced based on the current secondary market value) unless the member firm has reasonable grounds to
believe that an independent market for the security exists. It’s misleading and fraudulent to describe an
offering as at-the-market when the firm controls that market.
Types of Prospectuses
Prospectus Definition According to the Securities Act of 1933, a prospectus is defined as any notice,
circular, advertisement, letter, or communication (regardless of whether it’s written or broadcast on television
or radio) that offers a security for sale. An exemption from the definition is made for tombstone
advertisements, which only provide limited information (described later). The large disclosure document that’s
typically provided to purchasers of new issues is the statutory prospectus.
Preliminary Prospectus (Red Herring) A preliminary prospectus may be filed as a part of the
registration statement and used prior to the effective date of the registration statement. The following
information may be omitted:
 The offering price of the issue
 The underwriting discounts (or commissions)
 Discounts to dealers
 The amount of proceeds to be received by the issuer
 Conversion rates and call prices
 Other matters dependent on the offering price

Free Writing Prospectus A free writing prospectus (FWP) is any written communication that constitutes
an offer to sell or a solicitation to buy the securities related to a registered offering and is generally used after
the registration statement has been filed. An FWP doesn’t meet the standards of a statutory prospectus, but it
must be filed with the SEC on the date of first use. An FWP must include a legend which recommends that
investors read the statutory prospectus before investing. Examples of free writing prospectuses include press
releases, e-mails, preliminary or final term sheets, and marketing materials. Please note, the FWP may be
used as a disclosure document for new issues by both well-known seasoned issuers and seasoned issuers.
Communications By Well-Known Seasoned Issuers Well-known seasoned issuers are granted greater
flexibility regarding communications at any time, including written offers other than a preliminary prospectus.
Under SEC Rule 163, free writing prospectuses may be used by a well-known seasoned issuer prior to the
filing of a registration statement (and may also be considered a pre-filing offer) and, according to SEC Rule
164, the WKSI may use it after the filing.
The following is an example of the process that a WKSI may follow under a shelf registration which
incorporates the use of a free writing prospectus:
 The issuer must file an S-3 ASR registration form for a specified dollar amount and type(s) of securities
that it’s planning to offer.
 Each time the issuer offers securities, it will file both a preliminary and then a final prospectus supplement
with the SEC (for the specific securities being issued).
 If the company issues a press release announcing the offering or term sheets describing the offering,
they’re defined as a free writing prospectus. These may be used prior to the filing of the prospectus.
A term sheet is a very frequently used type of free writing prospectus and provides a summary of the specific
securities being offered. For example, for a debt offering, the term sheet includes the issuer, the name of the
security, the size, maturity, coupon, price to the public, yield-to-maturity, the spread to a benchmark Treasury
security, and other relevant information. According to SEC Rule 433, the issuer is permitted to use a term
sheet for each offering, provided it’s filed with the SEC as a free writing prospectus. As a part of the
recordkeeping rules, a free writing prospectus must be retained for three years.
If an offering by (or on behalf of) a well-known seasoned issuer will be registered under the Act of 1933, a
legend within the free writing prospectus must be included. The legend indicates whether the issuer will file a
registration statement and how a prospectus may be obtained. The FWP will typically contain a hyperlink to
these other documents that are filed with the SEC. If the free writing prospectus is distributed without the
legend, it should be amended and retransmitted as soon as it’s practical.
Other Users of Free Writing Prospectuses Seasoned issuers may also use a free writing prospectus, but
only after a registration statement has been filed. Unseasoned and non-reporting issuers are also permitted to
use a free writing prospectus after the filing of a registration statement, but they’re also required to include a
statutory prospectus. These issuers are permitted to use a hyperlink to accompany or precede the free writing
prospectus.

Use of Free Writing Prospectus (FWP)

Issuer Type When May FWP Be Used? Delivery Requirements
At any time (use during Reference delivery
WKSI
pre-registration is acceptable) (access to statutory prospectus delivery)
Seasoned Reference delivery
Post Filing
Issuer (access to statutory prospectus delivery)
Unseasoned Preceded by or delivered with
Post Filing
Issuer a statutory prospectus
Non-Reporting Preceded by or delivered with
Post Filing
Issuer a statutory prospectus
Types of Offering Communications

The SEC created definitions for the following different types of communications made by issuers and broker-
dealers that are engaged in an offering:
 Written Communications Written communications include those that are written, printed, broadcast on
television or radio, and also include graphic communications. Graphic communications are
communications that are made using electronic media (e.g., audiotapes, videotapes, e-mail, text messages,
faxes, CD-ROMs, Internet websites, and computer networks).
 Oral Communications Oral communications are live and in real time. Communications that are live
and retransmitted using graphic communications methods to a live audience are still considered oral
communications for purposes of securities offerings. Discussions between registered persons and
customers regarding the new offering are not permitted until after the filing date.
 Research Reports If a research report includes information about a new offering, it may be considered a
prospectus in violation of the Act of 1933.
 Advertising Any advertising campaign that’s related to the offering is prohibited.
 Internal Syndicate Memoranda These communications cannot be distributed to customers.
 Tombstones These ads are often published in a newspaper and surrounded by a black border. They
contain such limited information that no offer is considered to be made. The regulatory phrase used for
these ads is Communication Not Deemed a Prospectus. Tombstones may contain:
‒ The name of the issuer
‒ The full title of the security and the amount being offered
‒ A brief description of the issuer’s type of business
‒ The price of the security and the date of sale
‒ The identity or names of the underwriters
‒ A statement indicating that registration is not yet effective and the orders for the securities cannot be
accepted until registration is effective
‒ The contact information of the person or organization sending the communication (e.g., name,
address, phone number, and e-mail address) and a statement of participation or expected participation
in the distribution of the security
‒ An anticipated schedule for the offering (approximate commencement date of the proposed sale to
the public) and a description of marketing events (including dates, times, locations, and information
on how to attend)

‒ The exchanges or other markets on which any class of the issuer’s securities are or will be listed
‒ The names of selling security holders, if disclosed in the prospectus that’s filed with the
registration statement
Gun-Jumping Provisions
The gun-jumping provisions of the Securities Act of 1933 restrict the type of communications that may be
made during a registered public offering. The theory is that clients should make purchase decisions based on
the contents of a prospectus, rather than on ancillary information released by the issuer and/or its
underwriter(s). For many years, the preliminary prospectus was the only permitted written form of information
available regarding the offering between the filing date and the effective date (cooling-off period) of the
registration statement of a new issue. Since there are various other forms of communications that may be
made, there are multiple exceptions under the gun-jumping provisions.
Gun-Jumping Safe Harbors There are safe harbors from the gun-jumping provisions for information
released by or on behalf of reporting and non-reporting issuers. This allows certain types of activities and
communication during the period between the filing date and the effective date (quiet period). One safe
harbor allows the issuer or a person acting on its behalf to continue to publish or disseminate regularly
released factual business and forward-looking information at any time. Information is considered to be
regularly released if, in the past, the issuer has released or disseminated the same type of information in the
ordinary course of its business. The information must be consistent in timing, manner, and form of release. A
person acting on the behalf of the issuer cannot be an offering participant that’s an underwriter or dealer, and
the issuer must approve the release of the information prior to its dissemination.
Factual business information includes Information about the issuer, business or financial developments of the
issuer, advertisements or information about the issuer’s products and/or services, dividend notices, and
information in reports that are filed with the SEC under the Securities Exchange Act of 1934
Forward-looking information includes earnings forecasts (e.g., revenue projections, loss of income, loss of
earnings per share, capital expenditures, dividends, and capital structure), future management operations plans
(e.g., plans related to products or services), statements about future economic performance (e.g., statements
from management discussion and analysis), and information in reports filed with the SEC. Forward-looking
information provides a safe harbor from liability for issuers, provided the statements were made in good faith.
If the statements were made without a reasonable basis, the statements may be considered fraudulent.
Reporting issuers are permitted to publish regularly released factual business information and forward-looking
information. A non-reporting issuer (or a person acting on its behalf) is permitted to continue to publish
regularly released factual business information that’s meant for use by suppliers and customers rather than
investors (or potential investors)
Regulation S-K
Regulation S-K is a crucial component of the SEC disclosure system and sets forth many of the disclosure
requirements for registration statements that are filed under the Act of 1933 and other reports that are filed
under the Securities Exchange Act of 1934. Some of the reports include going-private statements, tender offer
statements, and proxy statements. Some of the issues addressed include projections, material contracts,
executive compensation, and management reports on internal controls.

Projections
Regulation S-K is a set of SEC rules that stipulate the detailed disclosure requirements (other than financial
statements) that are applicable to the Securities Act of 1933 and Securities Exchange Act of 1934. Many
disclosure documents that are filed in conjunction with a merger or an acquisition (e.g., a Form 8-K, proxy
statement, tender offer statement, or registration statement) may contain projections regarding the future
performance of the combined entity. These are often referred to as forward-looking projections.
However, Regulation S-K requires a registrant to have a reasonable basis for making assessments regarding the
company’s future performance and establishes guidelines for the format employed when presenting projections
(estimations) that appear in non-financial statements that are contained in registration statements. Often revenue,
net income, and earnings per share are financial items that are projected for a specified period.
The SEC permits, but doesn’t require, outside reviews of the projections that are made by the registrant. When
using an external reviewer, the required disclosures are:
 The qualifications of the reviewer and the extent of the review
 The relationship between the registrant and the reviewer
 Material factors regarding the process and how the outside review was sought or obtained
Regulation S-K requires specific disclosures which impact registration statements, tender offer statements,
annual reports, proxy statements, and other SEC related filings. Examples include:
 A description of the type of securities being offered for sale and the use of proceeds
 Compensation and ownership details concerning the company’s management
 The details of information that’s required on SEC Form 8-K (material change form)
 Certain details from SEC Form 10-K (annual report)
Reference Documents A registrant is permitted to incorporate another document into a registration

statement or other SEC filing by reference if the document is on file with the SEC. Normally, documents on
file with the SEC for longer than five years may not be incorporated into a registration statement.
Regulation S-X
Regulation S-X sets forth the form and content for financial statements that are filed under the Securities Act
of 1933 and for reports filed under the Securities Exchange Act of 1934. These statements include:
 Registration statements, annual reports, and proxies
 Registration statements and shareholder reports filed under the Investment Company Act of 1940
 Registration statements and annual reports filed under the Public Holding Company Act of 1935
The regulation also requires a registrant to maintain effective internal controls regarding its financial reporting;
therefore, the preparation of an attestation report must be completed by an independent accountant. The
attestation report may state that the registrant has a material weakness, which indicates that a material
misstatement within the report may not be prevented or detected on a timely basis.
For reference, Regulation S-K is generally focused on qualitative descriptions, while the Regulation S-X
focuses on financial statements.

Communication-Related Liability (Section 11 of the Act of 1933)

False Registration Statement According to the Securities Act of 1933, the persons that may be sued for
untrue statements and material omissions from a registration statement include:
 Every person who signed the registration statement
 Every director or partner of the issuer at the time of the filing
 Every accountant, engineer, or appraiser named as having prepared or certified any part of the registration
statement
 Every underwriter of the security
Under Section 11, the above parties are exempt from liability if they can prove that they had no knowledge of
the fraud and properly notified the Commission. This includes an accountant or other professional who refused
to sign or certify any of the documents that were used to prepare the registration statement. This is referred to
as the Section 11 defense and cannot be used by an issuer.
SEC Rule 176 Rule 176 of the Securities Act of 1933 describes the circumstances affecting the
determination of what constitutes reasonable investigation and reasonable grounds for belief under Section 11
(civil liabilities). This is part of the due diligence process and addresses who can be sued if there’s a false
registration statement. The relevant circumstances of an underwriter involve the type of underwriting
arrangement, the role of the underwriter, and the availability of information with respect to the issuer. The
Section 11 defense requires the underwriter to perform extensive due diligence. In addition, directors of the
issuer and any person who signed the registration statement may also use this defense.
Civil Liability for Salespersons Any person who offers or sells a security in violation of the registration
provisions of the Act of 1933 and who doesn’t exercise reasonable care regarding untrue statements is liable
for the:
 Investment amount
 Plus a reasonable amount of interest on the investment
 Minus the amount of income received from the investment
Any information that’s conveyed to a purchaser after the time of sale is not taken into account when
determining whether a prospectus included an untrue statement or omitted to state a material fact.
Exemptions from Registration – Securities

Exempt Securities
Certain securities are exempt from the registration and prospectus requirements of the Act due to the nature of
the issuer. Among the exempted securities are:
 U.S. government and U.S. government agency securities
 Municipal securities
 Securities issued by non-profit organizations
 Short-term corporate debt instruments (e.g., commercial paper) that have maturities not exceeding 270 days

 Securities issued by domestic banks and trust companies (but not bank holding companies)
 Securities issued by small business investment companies (exempted by federal legislation regarding
small businesses)
Other Exemptions
Rule 147 and Rule 147A Rule 147 was created as a safe harbor under the statutory intrastate offering
exemption which is provided by the Securities Act of 1933. The rule (also referred to as the intrastate
exemption) allows companies to raise capital from their in-state investors.
Typically, companies that are selling new securities are required to register their securities with the SEC; however,
under Rule 147, if a company is conducting an offering and only selling its securities to its state residents, the
offering is exempt from registration. Today, the strict issuer eligibility requirements and developments in both
company business practices and communications technology have made Rule 147 outdated.
Amendments to the existing Rule 147 and the implementation of a new rule—Rule 147A—became effective
on April 20, 2017. These new rules updated and modernized the existing intrastate offering framework and
permit a company to raise money from investors who reside within its state without being required to register
the offers and sales at the federal level.
Although similar to Rule 147, the new Rule 147A allows for multi-state offers (not sales), which means that:
 Issuers are permitted to use general solicitation and publicly available websites to locate potential in-state
investors. Although offers are able to be made outside of the state, all sales must still be limited to in-state
residents.
 Companies are able to be incorporated or organized outside of the state in which they conduct the offering
as long as they have their principal place of business in that state. Principal place of business is defined as
the location from which the principal officers, manager, or partners primarily direct, control, and
coordinate the activities of the issuer.
− For example, ABC is incorporated in Delaware, but its principal business is conducted in New
Jersey. Under Rule 147A, ABC is allowed to sell securities to residents of New Jersey.
Both the amended Rule 147 and the new Rule 147A include the following provisions:
 For an issuer to sell securities in a state, it must have its principal office (under Rule 147) or principal
place of business (under Rule 147A) in that state and satisfy one of four “doing business” requirements.
By satisfying one of the four new requirements, the issuer can avoid having to comply with all three of the
80% tests for assets, revenue, and proceeds of the offering.
− If a Rule 147 or 147A issuer subsequently changes its principal place of business after issuing
securities, it will not be able to conduct another intrastate offering under these rules in another
state for a period of six months from the date of last the sale in the previous state.
− An issuer is considered to be “doing business” in a state as long as it meets just one of the
following four new requirements:
1. At least 80% of its consolidated gross revenues are derived from the operation of a business or of
real property that’s located in the state or territory or from the rendering of services within the state
or territory;

2. At least 80% of its consolidated assets are located within the state or territory at the end of its most
recent semi-annual fiscal period prior to the first offer of securities under the exemption;
3. At least 80% of the net proceeds from the offering are intended to be used by the issuer, and are in
fact used in connection with the operation of a business or of real property, the purchase of real
property located in, or the rendering of services within the state or territory; or
4. A majority of the issuer’s employees are based in the state or territory (this fourth requirement was
not included in the original Rule 147)
 An issuer must utilize a reasonable belief standard when determining the residency of the purchaser at the
time of the sale of securities. This standard is supported by the requirement that the issuer obtains a written
representation from all purchasers as to their residency.
− If the purchaser is a legal entity (e.g., a corporation, partnership, trust, or other form of
business organization), residency is defined as the location where, at the time of the sale, the
entity has its principal place of business.
 Resales to persons who reside outside of the state in which the offering is conducted are restricted for a
period of six months from the date of the sale by the issuer to the purchaser.
− A legend requirement applies in order to notify offerees and purchasers about the resale restriction.
Regulation A Under Regulation A, if an issuer limits the amount of capital that it raises over a 12-month
period, the offering is exempt under the Act. However, it’s not a complete exemption since the issuer must file
an offering statement with the SEC and provide an offering circular to prospective purchasers. Advantages of
conducting a Regulation A offering rather than a full registration include lower legal and filing fees and a
shorter time needed to prepare documents. In addition, securities that are offered under Regulation A may be
offered to any investor and there’s no resale restriction.
The Jumpstart Our Business Startups (JOBS) Act expanded Regulation A (which originally limited the amount
of capital to $5 million) into the following two tiers:
 Tier 1 – Sales of up to $20 million are permitted within a 12-month period. Of that amount, no more than
$6 million may be sold on behalf of selling shareholders.
− The offerings are subject to both SEC and blue-sky review
− Continuing disclosure information must be filed
 Tier 2 – Sales of up to $75 million are permitted within a 12-month period. Of that amount, no more than
$22.5 million may be sold on behalf of selling shareholders.
− The offerings are subject to SEC review, but not blue-sky review
− This tier has stricter continuing disclosure information and filing requirements
Additional Information Regarding Regulation A

 Current SEC reporting companies cannot use Regulation A
 Both U.S. and Canadian companies are eligible
 The offerings may be for either equity or debt securities

The following chart summarizes the Regulation A rules:
Regulation A Tier 1 Regulation A Tier 2

Maximum offering size $20 million $75 million
Time period 12 months 12 months
Maximum amount that may be $6 million $22.5 million
offered by existing shareholders (30% of maximum offering) (30% of maximum offering)
Required audited financial
No Yes
statements/ ongoing reporting
Offering Statement Although Regulation A offerings are exempt from the registration and prospectus
requirements of the Securities Act of 1933, issuers cannot make written or oral offers unless a Form 1-A
offering statement has been filed with the SEC. If there’s no delaying action or suspension, an offering
statement is considered qualified with the SEC on the 20th calendar day after filing.
Preliminary and Final Offering Circulars After filing with the SEC, but before qualification, a preliminary
offering circular may be used to make a written offer of securities if it contains substantially the same information
as will appear in the final offering circular (excluding pricing information) and clearly states that the information
contained within is subject to change and that no sales may take place without a final offering circular and a
qualified offering statement. A preliminary or final offering circular must be furnished to a prospective buyer at
least 48 hours prior to mailing the confirmation of sale. If a preliminary offering circular is used, a final offering
circular must be delivered to the purchaser with the confirmation.
Test the Waters It’s acceptable for issuers to test the waters as a means of gauging investor interest prior to
filing an offering statement with the SEC. The materials that may be distributed when testing the waters are
limited to factual information that must include a description of the company’s business, the background of the
CEO, and a statement that no money should be sent to the issuer by interested investors. The SEC may halt a
Regulation A offering if any of the terms, conditions, or regulatory requirements of the deal are deficient. This
includes failure to provide the SEC with a copy of a script used in any radio or TV broadcast and the solicitation
of money for the issue prior to completion of the review by the SEC. Additionally, there must be at least 20 days
separating the use of a solicitation statement and the first sale of securities.
If a company intends to test the waters, it may use general solicitation and advertising prior to filing an offering
statement with the SEC. Therefore, the issuing entity has the advantage of determining whether there’s enough
market interest in the securities before it incurs the full range of legal, accounting, and other costs associated
with filing an offering statement. The issuer cannot solicit or accept money until the SEC staff completes its
review of the filed offering statement and the company delivers the prescribed offering materials to investors.
Exemptions from Registration – Transactions

In some cases, the manner in which securities are being offered exempts them from the registration
requirements of the Act. Let’s first examine private placements.

Private Placements
As described earlier, the main advantages in raising capital privately are that legal and registration expenses
are less costly and the issuer is able to raise capital more quickly. In certain situations, private offerings may be
the only method that an issuer can undertake to raise capital due to market conditions and/or a company’s
financial condition. The process of structuring and pricing the securities may involve more (not less)
negotiation due to demands by institutional investors. The investment bank typically acts in an agency (not a
principal) capacity and doesn’t commit its own capital for a private placement issue.
In a private placement, both the issuer and investors have obligations and liabilities. The issuer agrees to
provide all relevant material information concerning the company to permit an investor to decide whether to
invest. Although it may not be a regulatory requirement, the issuer will typically provide a disclosure
document (i.e., a private placement memorandum) to avoid violations of the antifraud provisions (as found in
numerous securities laws). A disclaimer contained in the memorandum will state that the appropriate
regulators have not passed on the accuracy or adequacy of the information provided in the document.
Any investor who agrees to purchase the securities must acknowledge that he understands the risks of investing
and that he may lose his entire investment. The investor also agrees not to share information that’s found in the
offering document since the release of material, non-public information may violate securities regulations.
Placement Agent The term placement agent refers to a firm—often a broker-dealer—that agrees to find
institutional investors who will, in turn, purchase the securities of an issuer in a private placement. The firm
agrees to act in an agency (rather than a principal) capacity and will receive a fee for selling the securities.
Since the term is used in connection with private placements, these intermediaries will only offer securities to
accredited or institutional investors.
Placement Agent Agreement The placement agent agreement specifies all of the terms and conditions
between a company that intends to issue securities through a private placement (the issuer) and the investment
bank that has been hired to act as its agent. The role of the investment bank is to find institutional investors to
purchase the securities.
This agreement typically includes the following features:

 The issuer’s pledge to provide business and financial information.
 Both the issuer and the investment bank agree not to disclose confidential information unless they receive
prior approval.
 The agreement should state the amount of cash and/or securities the issuer agrees to pay as compensation.
‒ The fee could be based on a percentage of the securities or may include warrants to purchase the
company’s stock.
 Other legal terms and conditions, including:
‒ The length and termination date of the offering
‒ Which state law governs the agreement
‒ Expenses to be reimbursed by the issuer
‒ The fact that each party agrees to comply with all applicable federal and state regulations

Engagement Letter An engagement letter is signed by the company that plans to issue securities and the
investment bank that’s hired (engaged) to market the securities to institutional investors. The terms and
conditions agreed upon by the two parties are found in the private placement agreement. The investment bank
will advise the company regarding the amount, pricing, type, and structure of the securities to be issued. General
solicitations are not permitted in a private placement; therefore, a road show is not a part of this process.
Teaser The executive summary of a private placement memorandum (PPM) is typically a short document
and is also referred to as a teaser. An investor will receive this document to determine whether she may be
interested in the offering. If she is, she will then receive the complete PPM.
Term Sheet For a private placement, the term sheet will contain only information on the securities being
offered. Some of the information that’s found in this document includes the name of the issuer, the types of
securities that are being offered and their characteristics, the price, aggregate proceeds, the expected closing
date, liquidation preference (in the case of a bankruptcy), voting rights, and any other specific terms and
conditions of the offering.
Confidentiality Agreement Prior to receiving a private placement memorandum, an interested investor will
sign a confidentiality agreement (also referred to as a non-disclosure agreement, or NDA). The investor agrees
not to disclose confidential information that’s found in the PPM, unless it’s done to provide information to his
financial adviser. The adviser may be an accountant, attorney, banker, or other financial professional who will
use the PPM to evaluate the offering.
The confidentiality agreement typically contains a provision which requires the return of the disclosure
documents if the securities are not purchased. Another acknowledgement by the investor is that the issuer is
under no obligation to complete the offering.
Subscription Agreement The subscription agreement is a sales contract for the sale of securities in a
private placement and sets forth the terms and conditions of the offering.
The agreement typically contains the following information:

 A statement in which the investor agrees that she alone or, with the assistance of a purchaser representative,
has sufficient knowledge and experience to evaluate the risks and merits of the investment
 A statement by the investor providing her annual gross income and net worth
 A statement regarding the status of the investor, and the category of accredited investor (This is also referred
to as the qualification of investor section.)
 The number of shares (or units) and the price per unit that the investor is purchasing
 A statement by the investor acknowledging that she has received and carefully reviewed a numbered copy of
the appropriate disclosure document and any other related information concerning the issuer
 A statement in which the investor verifies that she understands the investment is illiquid and involves a high
degree of speculative risk
 A statement in which the investor verifies that she understands the securities being purchased have not been
registered and may not be sold unless a registration is effective
 A statement as to the investor’s state of residency

Regulations Pertaining to Private Placements

Section 4(a)(2) – The Private Placement Exemption This section of the Act of 1933 is the most widely
used registration exemption for offerings by issuers that do NOT involve a public offering. Public advertising
of the offering and general solicitation of investors is prohibited.
To qualify, the purchasers must have sufficient knowledge and experience in finance and business to
understand and evaluate the risks and merits of the investment. Also, they must have access to the same
information normally provided in a prospectus and agree not to resell or distribute the securities to the public.
The provisions of Regulation D (described below) fall under Section 4(a)(2) of the Securities Act of 1933.
Section 4(a)(5) – Accredited Investor Exemption According to Section 4(a)(5) of the Securities Act of
1933, an issuer’s offering may be considered an exempt transaction if the following conditions are met:
 The amount of the offering is limited to no more than $5 million
 No advertising or public solicitation is being used to offer the securities
 The offering is sold only to accredited investors, and
 Purchasers are provided with a prospectus that complies with Act of 1933 disclosure provisions
Please note, this exemption is different from Regulation D which limits the number of participating non-
accredited investors to no more than 35.
Regulation D
SEC Regulation D provides an exemption from registration to private placements of securities by issuers if
several conditions are met. In addition, there’s a requirement for a uniform notice of sale (Form D) to be filed
with the SEC by no later than 15 days after the first sale of the securities. Form D is a brief notice that
includes the names and addresses of the issuer’s promoters, executive officers and directors, and some details
about the offering, but contains little other information about the issuing entity.
Based on the needs or requirements of the issuer, it may choose to offer its securities under Regulation D
Rule 504 (less common) or Rule 506 (more common). Rule 506 has two sections (described below).
Rule 504 Under Rule 504, the issuer’s offering cannot exceed $10 million within a 12-month period. The
issuing corporation is permitted to offer and sell the securities to an unlimited number of investors without
regard to their experience and sophistication. Although the issuer is not required to provide a disclosure
document to the investors, anti-fraud provisions of both federal and state law continue to apply.
The following three types of issuers are NOT permitted to use the Rule 504 exemption:
1. A company that’s subject to the SEC’s reporting requirements (a reporting company)
2. An investment company, and
3. A development stage company with no specific business plan or purpose (e.g., a blank-check company)
Rule 506(b) Under Rule 506(b), there’s no limit to the amount of capital that an issuer can raise in a private
offering. Also, for these types of offerings, an unlimited number of accredited investors are permitted to
purchase the securities, but no more than 35 non-accredited investors.

An accredited investor is defined as:

 A financial institution (such as a bank, insurance company, and investment company), a large tax-exempt
plan, and a private business development company
 A director, executive officer, or general partner of the issuer
 Certain entities (e.g., pension funds and trusts) that have at least $5 million in assets and were not formed
for the purpose of purchasing securities offered though Reg D
 Any investment adviser that’s registered with the SEC or a state
 An individual who has attained a certain professional certification or designation including:
‒ Any individual with a current Series 7, Series 65, or Series 82 registration that’s in good standing
 An individual who meets one of the following two financial tests:
1. Has a net worth at the time of the purchase, either individually or with a spouse, of at least $1 million
2. Has gross income for each of the last two years of at least $200,000 ($300,000 with spouse or spousal
equivalent*), with the expectation of at least the same income in the current year
* Spousal equivalent is defined as a co-habitant who occupies a relationship that’s similar to a spouse.
Please note, a sophisticated investor is not the same as an accredited investor. A sophisticated investor is an
individual who has superior knowledge of financial matters; (e.g., a certified financial planner or certified
public accountant). Since a sophisticated investor doesn’t necessarily satisfy the financial requirements of an
accredited investor, the types of investments allowed made may be limited.
Number and Type of Investors When determining the number of purchasers, the relative of a purchaser who
resides at the same address is excluded, as is a trust that’s 50% owned by a purchaser. A single entity, such as an
institution or a partnership that’s owned by several persons, is generally considered a single purchaser. However,
if an entity (e.g., a partnership, limited partnership, or joint venture) is formed for the sole purpose of acquiring
the offering, each participant is counted as a separate purchaser. Among the provisions of the rule, the issuer
must determine the suitability of the issue for the potential purchaser by verifying the purchaser’s financial
means and investment knowledge.
When marketing a private placement, general solicitation (e.g., cold calling or advertising) of investors is
generally prohibited or severely limited. The issuer may neither advertise in the general media nor disseminate
information to the public regarding the sale. For that reason, an investment seminar that’s open to the public is
prohibited. However, an investment seminar that’s limited to potential purchasers who are accompanied by
their purchaser representatives (defined shortly) is permitted.
According to Rule 506(b), non-accredited investors who purchase Regulation D offerings must be restricted to
those who, alone or with their purchaser representative, have the knowledge and experience in financial and
business matters to be able to evaluate the merits and risks of the investment. Therefore, only 506(b) offerings
specify the need for investor sophistication or the use of a purchaser representative.
Purchaser Representative The role of the purchaser representative is to ensure that non-accredited
investors are able to evaluate the merits and risks of the prospective investment in the issuer’s stock. To avoid
conflicts of interest, the following restrictions are placed on purchaser representatives:
 They may not own 10% or more of the stock of the issuer,
 They may not be an affiliate, director, officer, or employee of the issuer unless they’re related to the
purchaser by blood, marriage, or adoption

Purchaser representatives must be knowledgeable and experienced in financial and business matters. The
potential investor must designate a person to be his purchaser representative in writing for each individual
offering. Blanket approval to represent a potential purchaser in all Regulation D offerings is not permitted.
Restricted Securities Securities that are issued under Regulation D are not registered with the SEC and are
therefore restricted. The issuer is required to place a legend on the certificates to indicate that the securities are
unregistered, and must obtain a written statement (an investment letter) from purchasers that they will sell the
stock only if it’s registered or sold under an exemption. The issuer must also issue stop transfer instructions to
the transfer agent to ensure that no illegal sales occur.
Information Whether an issuer has a duty to furnish information to prospective purchasers depends on the
nature of the persons who are purchasing the offering. If only accredited investors are offered the securities,
then no disclosure information is required to be provided. However, if non-accredited investors are offered the
securities, the issuer must provide specified written information (referred to as an offering memorandum) to all
purchasers (both accredited and non-accredited) which discloses detailed financial information. Purchasers
must be given the opportunity to ask questions regarding the issue and must be informed that the securities will
not be registered under the Securities Act of 1933.
506(c) For issuers that seek to privately raise an unlimited amount of capital, requirements of the JOBS Act
created the need for the SEC to establish Rule 506(c). Rule 506(c) includes the following stipulations:
 The company CAN use general solicitation or advertising to market the securities.
 The privately placed securities are referred to as restricted securities.
 Sales may be made only to accredited investors (as defined above).
 The company must take reasonable steps to verify that its investors are accredited, which may include
reviewing documentation (e.g., W-2s, tax returns, bank and brokerage statements, and credit reports).
FINRA Rules Regarding Private Placements

FINRA Rule 5122 – Member Private Offerings
FINRA Rule 5122 requires a firm that privately places its own securities or those of a firm that it controls (has 50%
of more ownership) to file with the Corporate Financing Department a private placement memorandum, term sheet,
or other offering document at or prior to the first time the documents are provided to any prospective investor. The
reason for the filing is to address the potential conflict of interest. Rule 5122 supplements (rather than replaces) the
private placement rules of Regulation D of the Securities Act of 1933. The rule provides two types of exemptions.
The first exemption is based on the types of investors, while the second is based on the types of offerings.
1. Types of investors that are exempt from the rule are:
‒ Institutional investors, which includes banks, insurance companies, investment companies (mutual
funds), and investors with total assets of at least $50 million
‒ Qualified institutional buyers as defined under Rule 144A
2. Types of offerings that are exempt from the rule are:
‒ Exempt securities defined under the Securities Act of 1933
‒ Exempt offerings under Regulation S or Rule 144A

‒ Offerings of variable contracts, securities in a commodity pool, or equity and credit derivatives
‒ Offerings of unregistered, investment-grade debt or preferred securities
‒ Offerings of a member firm’s securities sold in a public offering
FINRA Rule 5123 – Private Placement of Securities

FINRA Rule 5123 relates to member firms that sell an issuer’s securities in a private placement offering. In a
private placement the issuer is not required to file any offering documents with the SEC; therefore, there’s a
lack of information available to FINRA when member firms offer private placements to their customers.
For that reason, this rule requires a member firm to provide FINRA with a copy of any private placement
memorandum (PPM), term sheet, or other offering documents that are used in connection with the sale within
15 calendar days of the first sale. If no offering documents are to be used, FINRA must also be notified of this
fact. Rather than approving or disapproving of any private placement offerings, FINRA simply requires the
filing of the offering documents.
The same exemptions that are available through FINRA Rule 5122 also apply to Rule 5123. Although FINRA
provides an extensive number of exemptions from the filing requirement for sales that are made to certain
accounts/investors and for specific offerings, both rules apply to the sale of private placements to individuals
who meet the accredited investor definition.
Selling Unregistered Securities

Although private placements allow the issuer to avoid the expense of registration under the Securities Act of
1933, the investors that purchase these securities end up with restricted stock. Restricted stock cannot be sold
unless it’s registered under the Act or sold under an exemption. Since registration for these investors is usually
too difficult and expensive, other means of selling the restricted securities must be found.
Rule 144
Under certain conditions, Rule 144 permits the resale of restricted (unregistered) stock that’s been acquired
through a private placement and also permits the resale of control stock. Control stock is stock that has been
acquired in the open market by an affiliated person of the issuer (e.g., an officer or director of the issuer, or
greater than 10% shareholder of the issuer).
For example, when Janis was hired as the CEO of Oldline Corporation, the company gave
her 10,000 shares of stock. This stock was not registered with the SEC and is, therefore,
considered restricted. Later, Janis bought 5,000 shares of Oldline stock in the open market
through her RR at Uptick Securities. Since this stock was trading freely in the open market,
it’s not restricted stock. However, because it’s now owned by a person who controls the
issuer (the CEO of the company), it’s considered control stock.
Any stock that’s acquired by control persons, even if it was purchased in the open market, must be sold either
pursuant to a registration statement or by means of an exemption. Rule 144 is typically the least expensive
method of disposing of control stock, especially for relatively small amounts, since the SEC effectively
registers the securities as long as the seller has met certain tests. Rule 144 is a resale provision; it’s not a
method that’s used to raise money for an issuer.

Upon filing Form 144 to notify the SEC of the impending sale, the restrictive legend may be lifted (share
registration) and all or part of the position may be eligible for sale through traditional channels. The sales
charges are similar to those for normal transactions; however, the fees are generally larger on private
placements and registered offerings.
Availability of Information In order to take advantage of the exemption provided by Rule 144, there must
be adequate public information available regarding the issuer. This refers to the type of financial information
that reporting companies must file with the SEC.
Holding Period For purchasers/acquirers of restricted stock, the shares must generally be held for six
months. However, if the issuer is a non-reporting company, the holding period is one year. The holding period
begins at the time that the securities were acquired by the original purchaser and must have been fully paid for
at the time of purchase. Once restricted stock is sold, it’s considered part of an issuer’s public float.
The holding period applies to:

 An individual who purchased stock and wants to subsequently sell the stock
 An individual who acquired the stock as the result of a gift from the original purchaser
 Securities that are acquired by a trust from a beneficiary who was the original purchaser
 Securities that are acquired by a pledgee from a pledgor who was the original purchaser
If the restricted securities are held by the estate of a deceased individual who was not affiliated with the issuer,
the holding period under Rule 144 is waived. On the other hand, if the deceased was affiliated with the issuer,
the normal holding period is applicable. The sale of the securities for an estate is subject to all of the other
provisions of Rule 144.
As it relates to control stock, there’s no mandatory holding period before the stock may be sold. A control
person who acquires stock through an open-market purchase may sell the stock at any time. However, if an
affiliated person acquires restricted stock, she’s subject to the six-month holding period.
For example, in the preceding example, the 5,000-share block of Oldline stock that was
purchased by Janis in the open market is control stock and not subject to the holding
period. However, the 10,000 shares of unregistered stock given to Janis by the
corporation is restricted stock and is subject to the holding period.
There’s an exception to the requirements of Rule 144 regarding the sale of restricted stock by non-affiliates.
A person who has not been an affiliate of the company for at least three months prior to the sale, and who has
owned the stock for at least one year prior to the sale, may sell the securities without complying with the
restrictions of Rule 144.
For example, Bill was the chief financial officer of ABC Corporation. Four years ago,
he received some unregistered shares of ABC as a bonus. On July 1, 2019, Bill
resigned from the company to work with a new firm. On October 1, 2019, Bill will be
eligible to sell his shares without being concerned about the restrictions of Rule 144
since he (1) will have held the shares for at least one year, and (2) will have been
unaffiliated with ABC for at least three months.

The Nature of the Transaction The broker-dealer that handles the sale under Rule 144 may do so through
brokers’ transactions or in transactions that are made directly with market makers. Brokers’ transactions are
defined as transactions that are made on an agency basis only and don’t involve solicitations, except in the
following two cases:
 A broker (the firm) may make inquiry of a customer who has indicated an unsolicited interest in the
securities within the preceding 10 business days.
 The broker may make inquiry of another broker that has indicated an interest in the security within the
preceding 60 days.
Notice of Sale An individual who sells securities pursuant to Rule 144 must notify the SEC at the time the
sell order is placed with a broker or when an order is executed directly with a market maker. The requirement
for notifying the SEC applies to the sale of both restricted and control stock and is completed by filing Form
144, which is effective for 90 days. However, notice is not required if the amount of the sale doesn’t exceed
5,000 shares and the dollar amount doesn’t exceed $50,000.
Limitation on Amount There’s a limitation on the amount of stock that may be sold under Rule 144 during
any three-month period. If the stock is listed on an exchange, the maximum that may be sold is the greater of
1% of the total shares outstanding or the average weekly volume of the past four weeks. However, if the stock
is traded in the over-the-counter market, the limitation is 1% of the total shares outstanding. If the client owns
shares greater than these amounts, Form 144 may be refiled at the conclusion of the current 90-day period.
For example, let’s assume that an issuer has 7,000,000 shares outstanding and the average
weekly volume of trading for the past four weeks was 60,000 shares. In this case, 1% of the total
shares outstanding is 70,000 shares. Since the limitation is the greater of 1% or the average
weekly volume, the holder can sell 70,000 shares. If there were 4,000,000 shares outstanding,
1% would equal 40,000 shares and the greater amount of 60,000 shares could be sold.
Non-Exclusive Please note that while Rule 144 provides a means of selling unregistered stock, it’s not the
only resale method and it doesn’t limit the availability of other exemptions for such sales.
Rule 144A
Rule 144A permits the sale of restricted securities (except for sales by the issuer) to qualified institutional
buyers (QIBs) without the conditions imposed by Rule 144. Rule 144A was designed to permit sales of
restricted securities to sophisticated investors, thereby creating a more liquid private placement market.
Ineligible Securities The following securities are ineligible for Rule 144A transactions:
 Offers or sales of securities that are the same class as those listed on an exchange or quoted on Nasdaq,
including certain convertibles and warrants
 Securities issued by registered investment companies

Qualified Institutional Buyers (QIBs) The securities offered under Rule 144A may be debt or equity, may
be offered by either a domestic or foreign issuer, and may be resold immediately to another QIB. These
qualified institutional buyers must satisfy the following three-part test:
1. The buyer must be eligible, which includes:
– Insurance companies
– Registered investment companies
– Registered investment advisers
– Small business development companies and certain other business development companies
– Private and public pension plans
– Certain bank trust funds
– Corporations, partnerships, business trusts, and certain non-profit organizations
2. The buyer must be purchasing for its own account or the account of other QIBs.
3. The buyer must own and invest at least $100 million of securities of issuers that are not affiliated
with the buyer.
Certain buyers are subject to special tests as alternatives to the three-part test just described. For example,
broker-dealers are QIBs if they own and invest $10 million of securities of issuers that are not affiliated with
the dealer, or if they act as riskless principals for other QIBs.
Notification In a Rule 144A transaction, please note that it’s the purchaser that must be a QIB. The seller is
NOT required to be a QIB. However, the seller must reasonably believe that the buyer is qualified. In addition,
the seller (or its agent) must notify the buyer that the seller is relying on Rule 144A.
Information In order to be eligible under Rule 144A, issuers must be willing to provide owners and
prospective purchasers, on request, certain items of current financial and other information. This condition
doesn’t need to be satisfied for issuers that are reporting companies under the Exchange Act, foreign private
issuers that are exempt from Exchange Act reporting, or certain foreign governments.
Regulation S
When foreign companies issue securities in their home country, they’re of course subject to any laws that their
home country has in place. However, they’re clearly not subject to U.S. regulations. For many years, what was
not so clear was whether and how U.S. laws applied to U.S. companies that issue securities outside of the
United States. The SEC clarified this situation by implementing Regulation S. Today, if a U.S. company issues
securities under Regulation S, it’s not required to register the offering under the Securities Act of 1933.
According to Regulation S, a U.S. company may issue an unlimited amount of securities (quickly) outside of
the country without filing any documentation with the SEC.
Only a non-U.S. person (of any type) may buy an overseas offering that’s being sold under Regulation S. A
U.S. person is defined as any individual who’s a resident of the U.S. as well as any partnership, estate, or
account that’s held for the benefit of a U.S. resident. A U.S. citizen who’s traveling or vacationing outside of
the U.S. for a significant part of the year is still classified as a U.S. investor.

To qualify for a Regulation S exemption (safe harbor), the transaction must be conducted offshore. An offshore
transaction is one in which no offer is made to a person in the United States and either (1) at the time the buy
order is originated, the buyer is outside the United States or (2) the transaction is executed through the facilities
of a designated offshore securities market. In addition, there cannot be a directed selling effort in the United
States. This precludes activities such as sending printed material to investors in the U.S., conducting
promotional seminars in the U.S., or advertising the offering in the U.S. by radio, TV, or in print media.
An overseas (non-U.S.) investor who acquires securities pursuant to Regulation S may sell the securities
overseas immediately through a designated offshore securities market. However, depending on the type of
securities involved, there’s a distribution compliance period (holding period) that applies to the resale of the
securities into U.S. markets.
 For non-convertible debt, the holding period is 40 days. For example, if a U.S.
 For equity securities of reporting companies, the holding period is reporting company issues
six months. its equities in France, the
 For equity securities of non-reporting companies, the holding period is purchasers are subject to a
one year. six-month holding period.
Rule 145
Rule 145 defines certain types of reclassifications as sales that are subject to the registration and prospectus
requirements of the Securities Act of 1933. They include:
 The reclassification of the securities of an issuer that involves the substitution of one security for another
 A merger or consolidation in which the securities of a corporation are exchanged for the securities of
another corporation
 A transfer of assets from one corporation to another
A Form S-4 filing is required for all transactions under Rule 145. However, stock splits, reverse stock splits, or
changes in par value are not considered reclassifications and are not subject to the rule.
Subject to Rule 145: Not Subject to Rule 145:

▪ Reclassifications ▪ Stock splits
▪ Mergers/Consolidations ▪ Reverse stock splits
▪ Transfers of assets ▪ Change in par value
The next chapter will cover the structuring of deals between issuers and investment bankers and will also
examine several SEC and SRO rules concerning the activities of the participants in a deal.
Create a Chapter 1 Custom Exam

Now that you’ve completed Chapter 1, log in to my.stcusa.com. From your Dashboard, select Final Exams,
then scroll down and select Create a Custom Exam. Now, select Chapter 1 and, at the bottom of the screen,
enter 10 questions in the Number of Questions box, and then select Build Exam.

Chapter 2
Underwriting

SERIES 24 CHAPTER 2 - UNDERWRITING
This chapter will focus on the activities of the underwriting syndicate and will expand on the information
regarding public and private offerings that’s been previously described. Additionally, details will be
provided of both SEC and FINRA requirements regarding underwriting and distribution procedures.
The New Issue Marketplace

As described earlier, when a corporation intends to raise capital, it typically does so by issuing securities. When
an issuer is offering securities to the public for the first time, the process is referred to as its initial public offering
(IPO). In the future, when securities are subsequently issued by a company, the transaction is referred to as a
follow-on offering. In either case, these capital raising events are considered new issues, primary offerings, or
primary distributions, since new shares are created and the issuer receives the proceeds from the sale.
Some offerings are split sales, with some of the shares offered by the issuer and the balance offered by selling
shareholders. The shares being sold by the company are newly created and constitute a primary offering. The
company (as the issuer) receives the proceeds of that portion of the sale. The existing shares that are sold by
shareholders are a secondary offering and the proceeds go to the individual sellers, not the issuer. If the offering
is split, it’s important for the underwriters to disclose to any purchaser that a portion of the deal proceeds will be
paid to the selling shareholders (rather than the company). Selling shareholders may be officers of the company or
early-round investors (e.g., private equity investors and venture capital funds) that are seeking to cash out or
minimize their holdings of the company.
Underwriting Securities
When a corporation needs to raise a large amount of capital, it will often use the services of an investment banking
firm that will advise the issuer on the most efficient and cost-effective way to raise funds. One of the methods that
may be used to raise capital is a public offering of securities. In the underwriting process, the investment banker
that structures the offering for its client will also normally participate in the placement/sale of the securities.
In a securities distribution, a letter of intent (LOI) is typically the first step in the process between an
investment banking firm and an issuer of securities. The LOI stipulates the amount of money that the company
intends to raise as well as the underwriter's compensation. It’s generally signed prior to the registration
statement being filed and is non-binding.
Underwriting Commitments
The sale of a public offering is typically conducted through a group of broker-dealers that’s referred to as an
underwriting syndicate. The responsibilities and level of liability of the syndicate members is dependent on the
type of underwriting commitment involved.
Let’s review the typical composition of the firms that distribute an issuer’s securities.
Syndicate The lead broker-dealer (investment banker) will form a syndicate and take on the role of syndicate
manager (managing underwriter). Other broker-dealers will be invited to participate in the distribution.

CHAPTER 2 – UNDERWRITING SERIES 24
An agreement will be signed by the participants, which is referred to as a syndicate agreement or an agreement
among underwriters. The agreement will specify each participant’s rights and obligations. Ultimately, the role
of the syndicate is to guarantee (underwrite) the sale.
Selling Group In some cases, the syndicate will recruit other broker-dealers to assist in the sale of the offering.
These firms comprise the selling group. The selling group members do NOT assume financial liability in the
offering; instead, they act as placement agents. Any shares that they don’t sell are retained by the syndicate, which
remains financially liable for the unsold shares. To join a selling group, a broker-dealer must sign a selling group
agreement, which describes the relationship/ responsibilities between the selling group and the syndicate.
Types of Underwriting Commitments

Firm-Commitment If the syndicate agrees to purchase the entire issue and absorb any securities that are not
sold, it’s engaging in a firm-commitment underwriting. The syndicate is acting for its own account and risk and
agrees to purchase the entire issue. The syndicate is firmly committing itself to selling the entire amount of the
offering and, if it’s unable to do so, it must absorb any of the unsold shares.
For example, a corporation wants to sell $10,000,000 of stock, but the underwriters
are only able to sell $8,000,000 of the total. In this case, the syndicate members will
absorb $2,000,000 of unsold stock in their own accounts.
Market-Out Clause This clause enables the syndicate to cancel its commitment if certain events occur that
make the marketing of the issue difficult or impossible. This includes an adverse material event that affects the
(proposed) issuer or general dislocation in financial markets which is caused by an external event.
Best-Efforts When underwriters agree to place (sell) as much of the new offering as they can, but are able
to return any unsold securities to the issuer, they have agreed to a best-efforts underwriting. The underwriters are
acting in the capacity of an agent for the issuer, rather than as a principal for their own accounts. They will
make a bona fide effort to sell the entire issue but, if unsuccessful, they will return the unsold portion to the
issuer without penalty. This type of underwriting is less expensive for an issuer since the underwriter is not
agreeing to commit any capital.
For example, a corporation wants to sell $10,000,000 of stock, but the underwriters
are only able to sell $8,000,000 of the total. In this case, the underwriters will return
the $2,000,000 of unsold stock to the corporation.
All-or-None Under certain circumstances, a corporation may require a specific minimum amount of capital to
be raised. The concern is that raising a lesser amount will limit the corporation’s ability to achieve its
objectives. In this case, the issuer may specify that all of the issue must be sold or the entire distribution will be
cancelled. This type of distribution is referred to as a best-efforts, all-or-none. As in the simple best-efforts
arrangement, the underwriters will act as agents for the issuer and attempt to sell as much of the offering as
possible. However, if the entire issue is not sold, any sales that had been made must be cancelled and the
money must be returned to the subscribers.
A variation of an all-or-none offering is referred to as a best-efforts, mini-maxi underwriting. In this case, the
issuer will set a minimum threshold of sales that must be met so that the offering is not cancelled. However, once
that minimum is met, additional sales may be made up to a specified maximum amount.

For example, a corporation wants to sell $10 million of stock. Based on the company’s
capital needs, it requires that at least 70% of the offering be placed. Therefore, a minimum of
$7 million must be sold or the entire issue will be cancelled. Once the minimum sales level
has been satisfied, the underwriters will continue to sell the remaining securities ($3 million)
without the risk that the offering will be cancelled.
Escrow Account The escrowing of funds is covered by SEC Rule 15c2-4 of the Securities Exchange Act of
1934. If a broker-dealer is participating in a form of distribution—other than a firm-commitment
underwriting—it must either promptly forward funds to the issuer or establish an account with an escrow agent
that has agreed in writing to hold the funds.
In an all-or-none and mini-maxi underwriting, the deal may be cancelled if a certain amount of the issue is not
sold. For this reason, any client funds that are directed to purchasing the securities must be placed in this escrow
account. If the contingencies outlined in the offering document are not satisfied, the funds will be returned to the
subscribers. The subscribers’ funds must be deposited promptly in a separate bank account, with a bank acting as
the escrow agent. The escrow agent only releases funds in the escrow account when the contingencies are met.
If the underwriting is successful, the issuer receives the offering proceeds less underwriter fees. However, if
the offering fails, all clients’ funds must be returned in their entirety with no deductions permitted for offering
expenses. If an underwriter has a best-efforts arrangement with an issuer, but doesn’t promptly transmit the
funds to the issuer, the underwriter is also obligated to use an escrow account.
Standby Agreements If a corporation wants to sell additional shares to the public, it may do so through a
preemptive rights offering. In this process, the current shareholders will be granted the opportunity to purchase
the new issue security before it’s made available to the public so that they’re able to maintain their percentage
of ownership. A existing shareholder may exercise or sell the rights. Under a standby underwriting
arrangement, the syndicate agrees (in return for a fee) to purchase any unsubscribed shares that remain after
the rights offering. In other words, if the current shareholders (or purchasers of the rights) fail to subscribe to the
stock, the investment banker will purchase the residual shares on a firm-commitment basis.
Type of Underwriting Liability for Unsold Shares Comments
Firm-Commitment Yes Syndicate must absorb losses on unsold shares
Best-Efforts No Unsold shares are retained by the issuer
Best-Efforts: All-or-None No Offering is cancelled if all shares are not sold
Offering is cancelled if a preset minimum is not sold,

Best-Efforts: Mini-Maxi No
but sales may continue up to a preset maximum
Syndicate agrees to buy any shares that are not

Standby Yes
purchased by the stockholders in rights offering

FINRA Rules on Securities Distribution

In addition to SEC regulatory requirements, firms that are engaged in a new issue distribution are subject to
various SRO rules. Now, let’s examine the Financial Industry Regulatory Authority (FINRA) rules that
specifically apply to new issues.
FINRA Filing Requirements

Broker-dealers are generally required to file with FINRA certain documents and information that relates to
securities offerings. The FINRA Corporate Financing Rule has the following two different filing requirements
that are based on whether the securities are registered or exempt from registration:
1. If the securities are to be registered, the required disclosures must be filed with FINRA by no later than
three business days following the filing of the issuer’s registration statement with the SEC (or any state
securities commission).
2. If the issue is exempt from registration, the disclosures must be filed with FINRA at least 15 business
days prior to the anticipated offering.
Member firms are not permitted to sell a new issue of securities unless the appropriate documents have been
filed and FINRA has provided an opinion which indicates that it has no objections to the proposed
underwriting arrangement, especially in regard to the fairness of the underwriter’s compensation. If FINRA notifies
the managing underwriter that the terms of the underwriting compensation are unfair and unreasonable, the
managing underwriter must notify the other syndicate members of FINRA’s ruling and instruct the members not to
offer the securities to clients.
FINRA Filing The following documents must be filed with FINRA for review:
 Copies of the registration statement, offering memorandum, offering circular, or any other document used to
offer securities to the public
 Copies of the final registration declared effective by the SEC or any equivalent offering document
 Copies of any proposed underwriting agreement, agreement among the underwriters, consulting agreement,
letter of intent, underwriter’s warrant agreement, escrow agreement, or any other document that describes the
underwriting terms or arrangements
 Copies of any pre- and post-amendments to the registration statement or other offering document
Information to be Filed The managing underwriter must file the following information with FINRA:
 An estimate of the maximum offering price
 An estimate of the maximum underwriting discount, or commission, underwriters’ counsel fees, maximum
finders’ fees, and a statement of any other type of compensation that may accrue to the underwriter
 A statement concerning the affiliation with any member firm of an officer or director of the issuer, or a
beneficial owner of 5% or more of the issuer’s securities
 A detailed statement explaining any other arrangement entered into during the 180-day period prior to the filing
date of the offering, where the firm received items of value, warrants, or options from the issuer
 A statement demonstrating compliance with any exception to the definition of underwriting compensation

Offerings Exempt from Filing The following types of securities offerings are not subject to FINRA filing
requirements:
 Securities offered by an issuer (corporate, foreign government, or foreign agency) that have unsecured non-
convertible debt with a term of at least four years, or non-convertible preferred stock rated by a nationally
recognized statistical rating organization (NRSRO) (e.g., S&P or Moody’s) in one of its four highest rating
categories
 Offerings of any securities that are permitted to be registered with SEC registration statements Form S-3 or F-3,
and offered through shelf registration
 Offerings of securities by a foreign private issuer organized under the laws of Canada using SEC Form F-10
 Exchange offers of securities in which the securities to be issued or being acquired are listed on a national
securities exchange (e.g., the NYSE or, Nasdaq)
 Offerings of securities by a church or other charitable institution that’s exempt from SEC registration
Exempt Offerings The following offerings are exempt from the Corporate Financing Rule:
 Securities exempt from SEC registration under Regulation D (private placements)
 Securities of open-end investment companies (mutual funds)
 Variable contracts
 Municipal securities offerings
 Tender offers
 Securities registered with the SEC and issued as a result of a merger or acquisition, spin-off, or any other similar
transaction that doesn’t result in public ownership of the member firm
Offerings Required to be Filed All other public offerings must be filed with FINRA including real estate
investment trusts (REITs), rights offerings, direct participation programs (limited partnerships), securities
offered pursuant to SEC Regulation A, and exchange offers that do not involve the issuance of securities that
are listed on the NYSE, NYSE-American, or Nasdaq Global Market.
In addition, certain offerings that are exempt from SEC registration are still required to file under this rule.
This includes securities issued pursuant to SEC Rule 147 (intrastate offerings) and securities issued by banks,
savings and loan institutions, or common carriers.
Along with the offering previously mentioned, any initial public offering or securities being offered by the
member firm or any of its affiliates are subject to FINRA’s Corporate Financing Rule.
Review of Underwriting Agreements

As previously stated, underwriting agreements must be submitted to FINRA’s Corporate Financing
Department for review of the fairness of the underwriter’s compensation. The agreement is typically submitted
by the managing underwriter, although it may also be submitted by another syndicate member or the issuer.
When a syndicate is selling the securities of a member firm, the member firm that’s issuing the securities is
responsible for the filing.
Fairness of Compensation FINRA reviews all distributions in which a member firm is participating in order
to ensure that the compensation paid to the member firm is not excessive or unfair. However, FINRA will not
pass judgment on the merits of the issue or on the public offering price.

In determining whether the underwriting compensation is fair, the following factors are taken into
consideration:
 The offering proceeds
 The amount of risk assumed by the underwriters, which includes whether the offering was underwritten on a
firm-commitment or best-efforts basis, and whether the offering was an IPO or secondary
 The type of securities being offered
What is Compensation? FINRA includes the following items received by an underwriter in the
distribution of a public offering as compensation:
 The underwriting discount or commission
 Reimbursement of expenses to the underwriter
 Fees and expenses of the underwriters’ counsel (but not reimbursement of Blue-Sky fees)
 Finder’s fees, whether in the form of cash and/or securities
 Wholesaler fees and special sales incentive items
 Financial consulting and advisory fees, whether in the form of cash and/or securities
 Common or preferred stock, warrants, options, and any other equity security, including convertible securities
received for acting as a private placement agent or for providing or arranging loans or M&A services, at the
time of the offering
 Compensation to be received by the underwriter as an adviser to the issuer’s board of directors
 Compensation expected to be received as a result of exercising or converting, within one year following the
effective date of the offering, any warrant or convertible security
 Fees for a qualified independent underwriter
 Compensation paid to any member in connection with a proposed offering that was not completed, unless the
member doesn’t participate in the revised offering
What is NOT Compensation? The following items are NOT considered underwriting compensation. The
reimbursement of issuer-related expenses originally paid by the managing underwriter is not considered
compensation, such as:
 Registration fees (including state or Blue-Sky fees)
 Accounting fees
 FINRA filing fees
 Prospectus printing costs
 Cash compensation for acting as a placement agent
 Providing a loan for M&A-related services
 Non-convertible securities and derivatives that are acquired at a fair price, in the ordinary course of business,
and unrelated to the public offering.
When determining whether an item of value is considered compensation, FINRA examines the 180-day period
immediately preceding the filing date of the registration statement until the date that sales begin.
Prohibited Arrangements FINRA describes prohibited terms and conditions within the Corporate
Financing Rule. Some of the prohibited arrangements include:
 Reimbursement for miscellaneous expenses
 Reimbursement for salaries of investment banking personnel

 Commissions paid by an issuer to a member firm prior to the commencement of the public sale of the securities
being offered
 The payment of any compensation by the issuer to a member firm in connection with an offering that was not
completed
 The receipt of a security, warrant, or option that has a duration exceeding five years and has more favorable
terms than those that were offered to the public
 Any non-accountable expense allowance that exceeds 3% of the offering proceeds
Restrictions on Securities Received The sale of securities that are acquired in connection with an offering
is restricted for a period of six months following the effective date of registration. Options or warrants that are
acquired in connection with the offering may be exercised at any time, but the securities received upon
exercise are restricted for the remainder of the initial six-month period. In a unit deal (stock plus options), the
underwriter’s options cannot be issued with terms that are better than those which are afforded to public
customers. In essence, the underwriter cannot receive options with a lower strike price and/or a longer life.
Also, the maximum life of an underwriter’s warrant is 60 months.
Public Offerings of Securities with Conflicts of Interest

Member firms that participate in a distribution of securities may find themselves facing conflicts of interest. One
such situation occurs when broker-dealers are involved in a public offering of their own stock, or the stock of an
affiliated company. In such cases, to ensure that conflicts of interest are handled properly, member firms must
follow specific FINRA guidelines. As with any other issuer, the firm is also subject to the requirements of the
Securities Act of 1933 and applicable state laws.
A conflict of interest exists if any of the following conditions apply and the member firm is participating in a
public offering:
 The securities are to be issued by the member.
 The issuer controls or is under the control of the member.
 At least 5% of the net proceeds, not including the underwriting compensation, is intended to reduce or retire the
balance of a loan extended by the member.
Definition of Affiliate The term affiliate refers to an entity that controls, is controlled by, or is under
common control with the member. Control is defined as having ownership of 10% or more of the common or
preferred equity or subordinated debt of another entity, or a right to 10% or more of the profits or losses of a
partnership. The term common control means the same person or entity controls two or more entities.
Therefore, a conflict exists if the member is underwriting its own securities, the securities of an entity in which
it has a 10% ownership, the securities of an entity which owns 10% of the member, or the securities of an
entity in which another company owns 10% of both the member and the issuer.
A member firm is not permitted to participate in a public offering in which it has a conflict of interest unless
the offering complies with either one of the following two conditions:
1. Any conflicts of interest must be prominently disclosed in the prospectus. In addition, one of the following
three conditions must be met:
a. The member that is primarily responsible for managing the offering does not have a conflict of
interest or is not an affiliate of any member that does have a conflict, or

b. The securities being offered have a bona fide public market, or

c. The securities being offered are investment-grade
2. A qualified independent underwriter (QIU) must participate in the preparation of the offering documents. A
QIU is a firm that has served as a manager or comanager in at least three public offerings of a similar size
and type during the three-year period preceding the filing of the registration statement. If a QIU is used,
there must be a prominent disclosure in the prospectus or offering document. The disclosures must explain
the conflicts of interest, the name and the role of the qualified independent underwriter, and a brief
statement regarding the role and responsibility of the qualified independent underwriter. The member firm
is also required to notify FINRA when the offering is completed.
One of the critical responsibilities of any underwriter is the due diligence investigation. If the underwriter is
selling its own stock or that of an affiliate, it may be difficult for the member to perform the due diligence
investigation in an objective manner. Therefore, in self-underwritings or underwritings for affiliates, FINRA
may require the participation of another broker-dealer that acts as a qualified independent underwriter. The
qualified independent underwriter would not have any conflicts of interest and would participate in the
preparation of any offering documents. The QIU would exercise the same due diligence as any underwriter,
even if not actively selling the new securities.
Please note that only one of the two conditions listed above must be met—either provide disclosure and
comply with any one of the three conditions described in condition one or have a QIU participate and make
certain disclosures as required under condition two.
Discretionary If a member firm is participating in a distribution of securities in which it has a conflict and it
intends to place some of the stock into the account of a customer for whom the member firm holds
discretionary authorization, the member firm must obtain prior written approval regarding the proposed
transaction from the customer before it may sell the stock to the customer. This approval is in addition to the
power of attorney (POA) that must already be on file.
Disclosure of a Control Relationship If a broker-dealer that’s controlled by a public company has a customer
who wants to purchase the stock of that company, the broker-dealer must disclose the control relationship to the
customer prior to accepting the order. If this initial disclosure was verbal, written disclosure must also be
provided prior to settlement (completion of the transaction). This is in addition to a disclosure that’s placed in the
prospectus. Once again, if the control relationship transaction involves a discretionary client, an additional
written permission must be obtained for each transaction.
Settlement of Syndicate Accounts

The syndicate settlement date occurs when the issuer delivers (new issue) securities to the account of the
underwriting syndicate. Syndicate managers must, no later than 90 days following the syndicate settlement date,
provide each syndicate member with an itemized statement of syndicate expenses.
FINRA rules require the syndicate manager of a firm-commitment public offering to immediately, but by no
later than the scheduled closing date, notify the Uniform Practice Department (Operation Department) of any
anticipated delay in the closing of an offering beyond the closing date in the offering document.

Regulation M
Most aspects of new securities offerings are governed by the Securities Act of 1933; however, the Securities
Exchange Act of 1934 contains some provisions that affect the sale of new issues, particularly the activities of the
underwriters that participate in a follow-on offering. Before major federal securities laws were passed in the 1930s,
syndicate members often conditioned the market for the new issues they were about to sell. After these
underwriters sold their allotments and stopped their behind-the-scenes activities, the stocks involved would
often drop precipitously, thereby causing unwary investors to suffer large losses.
In order to regulate trading practices involving new issues and those who initially profit from the sale of new
issues, the SEC enacted Regulation M. Regulation M covers both IPOs and existing issuers offering additional
securities to the public. Under the rules comprising Regulation M, the SEC restricts distribution participants
(e.g., underwriters and issuers) from bidding for or making purchases in the secondary market of stock that’s
being offered in a distribution. This restriction is in effect for a limited period revolving around the effective date.
Regulation M attempts to prevent upward price manipulation before the pricing of the deal, which would result
in the issuer receiving more proceeds and the underwriters receiving greater fees. However, certain exceptions
are permitted when the SEC believes the chances of manipulation are low. The Commission also makes
exceptions under specific conditions for market makers as well as for syndicates that want to support
(stabilize) the price of the new issue.
A market maker is defined as a broker-dealer that stands ready to buy or sell a minimum quantity of shares
(usually 100) of a specific stock on a regular and continuous basis at a publicly traded quoted price. By
performing this function, these firms help to create and maintain liquidity for the securities in which they make a
market. A brokerage firm is required to qualify as a market maker in a particular security. This process will be
covered in detail later in this Study Manual.
Rule 101 – Activities of Distribution Participants

The purpose of this part of Regulation M is to prevent those interested in a distribution from manipulating secondary
market trading for their own benefit. Distribution participants include syndicate members, selling group
members, and any other broker-dealers that help to sell the security being offered to the public (the subject
security). These participants are not permitted to buy or bid for the subject security within a critical time frame
that’s referred to as the restricted period.
Length of the Restricted Period The restricted period generally begins five business days prior to pricing,
or whenever the broker-dealer becomes a participant, whichever comes later. The restricted period ends when
the broker-dealer’s participation ends. However, if the subject security has an average daily trading volume (ADTV)
of at least $100,000 and the issuer’s public float value is $25 million or more, the five-business-day standard is
reduced to one business day.
In the case of a distribution regarding a merger, acquisition, or exchange offer, the restricted period is defined as
beginning on the day that the proxy solicitation materials are first disseminated to holders of the securities and
ending on the completion of the distribution.

The following table summarizes the length of the restricted period for different offerings:
Five days prior to pricing Public float is less than $25 million, and ADTV less than $100,000
One day prior to pricing Public float is between $25 million and $150 million, and ADTV at least $100,000
 Actively traded security – Public float at least $150 million and ADTV of $1 million
No Restricted Period
 Municipals, Governments, non-convertible investment grade debt
Normal trading and Normal trading and

Restricted Period
market making market making
↑ ↑ ↑
1 day or 5 days End of
before pricing Pricing distribution
Reference Security The prohibition on purchases or bids doesn’t only apply to the subject security
(security that’s the subject of a distribution), it also applies to any reference securities into which the subject
security may be converted. For example, if an ABC Company convertible bond is being distributed, the bond is
the subject security and ABC common stock is the reference security.
Together, subject and reference securities are referred to as covered securities and both are subject to the
restrictions of Rule 101. Note that, while common stock is a reference security for an offering of rights,
warrants, or convertibles (subject securities), the reverse is not true.
Exceptions to Rule 101 There will be many cases in which the restrictions of Rule 101 don’t apply
because of the exceptions allowed. However, exceptions are not a license to interfere with market forces.
Activity that’s obviously manipulative will still violate general SEC antifraud rules. Exceptions to Rule 101
include the following:
 Transactions involving government and municipal bonds, non-convertible investment-grade debt and preferred
stock, and registered investment company securities
 Actively traded securities, which are those with a value of ADTV of at least $1 million, and where the public
float of the issuer’s common stock value is at least $150 million
 Odd-lot transactions
 The exercise of any option, warrant, right, or similar instrument during the restricted period, regardless of when
it was acquired
 Unsolicited brokerage transactions and unsolicited purchases when acting as a principal
 Securities of domestic and foreign issuers that are eligible for an exemption from the Securities Act of 1933
under Rule 144A if sold to qualified institutional buyers (QIBs), and certain Regulation S transactions
 Transactions in the subject security that are part of a basket strategy, if the basket is not used for manipulation.
The subject security must be no more than 5% of the basket, which must contain at least 20 securities.
Unaccepted bids and purchases that don’t exceed 2% of the security’s ADTV are exempted from the rule if the
broker-dealer maintains and enforces written policies and procedures designed to prevent violations. Once
inadvertent transactions are discovered, subsequent de minimis transactions are NOT exempted.

Research Both the former trading practice rules and Rule 101 prohibit underwriters from inducing others to
purchase a covered security. In the past, this prohibition was interpreted to include the distribution of research
reports by participating broker-dealers. Although the SEC granted certain types of no-action relief for normal
research report mailings, it was still often unclear as to what was or was not acceptable.
Rule 101 of Regulation M addresses this issue more clearly. Research reports that refer to covered securities
may be distributed during the restricted period if they meet the conditions of Rules 138 or 139 of the Securities
Act of 1933. This usually requires that such reports be distributed with reasonable regularity in the normal course of
business. The SEC also expects that the recipients of the reports regularly receive the broker-dealer’s research.
So, for example, adding new recipients to the mailing list is permitted if it’s intended that they will receive
research in the future as well. Sending a single report to a potential customer during the restricted period
doesn’t qualify for the exception.
Regulation M and IPO Allocations Regulation M also applies to initial public offerings by preventing
underwriters and broker-dealers from influencing the price prior to the completion of the distribution. The SEC has
indicated that any attempt to influence the aftermarket price of an IPO during the distribution is a manipulative act.
This situation may occur if the offering is over-subscribed and underwriters are allocating a limited number of
shares to their institutional clients.
When allocating shares of a new issue, a broker-dealer may take into consideration whether the client is an
institutional or retail investor, the size of the client’s order, or whether the client has quickly flipped previous
allocations of IPOs. Broker-dealers cannot base the allocation decision on a client’s commitment to purchase
additional shares in the secondary market.
During the distribution period for an offering of securities (regardless of whether it’s oversubscribed), it’s a
violation to allocate IPO shares based on placing prearranged purchase orders in the aftermarket at specified
prices. This tie-in arrangement—also referred to as laddering—can inflate the aftermarket price of the IPO and
is considered a manipulative act under Regulation M. This is true regardless of whether the orders were
executed in the aftermarket. The placement of the orders may have the effect of causing other market participants
to buy or bid for the security at higher prices. In addition, it’s a violation to encourage clients, prior to the trading of
an IPO, to provide information on the price and number of shares they’re willing to purchase in the aftermarket.
If an offering is over-subscribed, the best course of action is to allocate the shares on a pro rata basis using a fair
allocation system. Although there’s no regulatory requirement on how to allocate an over-subscribed issue, a
fair system is the best method for the manager to follow.
Rule 102 – Activities of Issuers

Let’s consider a situation in which a person holds thousands of shares of stock in a company that’s conducting an
offering. A concern is that the person may be tempted to push the price of the stock up just before the company’s
follow-on offering hits the street? Due to this temptation, Regulation M prohibits issuers and selling security
holders (mainly insiders) from supporting or raising the price of a security being distributed. This restriction
means that they cannot purchase or bid for a covered security or induce others to do so.

Exceptions to Rule 102 Rule 102 contains some exceptions that are similar those of Rule 101, including those
for unsolicited purchases, transactions in Rule 144A securities, exercise of convertible securities, odd-lot
transactions, and transactions in exempted securities. However, since issuers and selling shareholders don’t
play the same role in the market as intermediaries (e.g., broker-dealers), some of Rule 101’s exceptions are not
available to them. For example, issuers CANNOT bid for or purchase the following:
 Actively traded securities of the issuer or an affiliate
 Basket transactions involving a covered security
 Inadvertent (de minimis) transactions
 Unsolicited transactions executed through a broker-dealer
In addition, the Rule 101 provision that allows the issuance of research on a covered security under certain
conditions is not available to the issuer or its affiliates.
Rule 103 – Passive Market Making

The liquidity of Nasdaq stocks can be adversely affected when market makers that are syndicate members suspend
their normal activity during an offering because of Rule 101. Therefore, Regulation M contains Rule 103,
which permits distribution participants to continue making markets in a Nasdaq stock that’s the subject of an
offering during the Rule 101 restricted period, but only on a passive basis. This means the market maker
cannot enter a bid or effect a purchase at a price that exceeds the highest independent bid on Nasdaq. Since the
bids and purchases made by a passive market maker are limited by the highest independent bid, passive market
making is not allowed if no independent bid exists on Nasdaq.
Limit on Quantity Purchased A passive market maker’s daily purchase limit is the greater of 30% of its
ADTV in the stock (as determined by FINRA) or 200 shares. Once a passive market maker’s net purchases
(purchases in excess of sales) for that day exceed its purchase limit, it must withdraw from the market for the
rest of the day. However, a passive market maker that’s near the limit is allowed to execute any single order,
even if the daily limit would be exceeded. However, after that execution, it must withdraw from the market for
the rest of the day.
For example, let’s assume that a passive market maker’s daily purchase limit is 10,000
shares and it currently has net purchases of 9,500 shares. It may purchase 1,000 shares
at this point if it’s a single order, even though its total net purchases will exceed its limit.
Of course, it must then withdraw from the market. The firm cannot aggregate orders
into a single transaction for purposes of evading the rule. Two 500-share tickets could
not be combined into a 1,000-share transaction in the above example.
Limit on Price Purchased In a falling market, when the last independent bid drops below that of a passive
market maker, the passive market maker may maintain its bid until its purchases have reached or exceeded the
lesser of two times the minimum quote size for that security (as set by FINRA), or the passive market maker’s
remaining daily limit. If twice the minimum order size is executed, the passive market maker must drop its bid to
or below the highest independent bid. If its daily purchase limit is reached first, it must withdraw from the
market for the rest of the day. In a rising market, a passive market maker may raise its bid when the best
independent bid rises, but is not required to do so.

Example: Dotted Line Capital (DTLN) is involved in the secondary offering of BNBR. Under
Rule 103, Dotted Line may continue to act as a market maker (MM). MM A is independent
and at the inside bid for BNBR at 16.59. DTLN may enter a bid or effect a purchase up to,
but not greater than, 16.59. The bids in the market for BNBR are as follows:
Bids
MMA 16.59 (Independent)
DTLN 16.59 (Passive MM)
MM C 16.50 (Passive MM)
If MM A lowers its bid to 16.45, DTLN must lower its bid to 16.45 after having purchased
200 shares of BNBR or upon reaching its remaining daily limit. DTLN could not lower its
bid to 16.50 since MM C is also a passive market maker.
Rule 104 – Stabilization

Stabilizing is defined as the placing of any bid, or the effecting of any purchase, for the purpose of pegging,
fixing, or otherwise maintaining the price of a security. By definition, stabilizing is a manipulative activity.
However, in certain cases, the SEC considers its benefits (facilitating an orderly distribution) to outweigh its
disadvantages. Stabilization by an underwriter is a permitted manipulative activity as long as the
Commission’s rules governing it are followed.
Rule 104 of Regulation M tries to strike a balance between the desirability of an orderly distribution and the need
to prevent manipulation of a new offering. Purchases by the syndicate that are not necessary to prevent or retard a
decline in the security’s price, or which have a manipulative purpose, are illegal. Also, stabilization is not
permitted in an at-the-market offering (an offering of securities at other than a fixed price).
Initiating a Stabilizing Bid Only one participant in a distribution may enter a stabilizing bid in a security. The
maximum price at which a stabilizing bid may be initiated is the last independent sale price or the highest bid in
the market. In the case of an IPO, the bid may not be higher than the POP. The application of the rule depends on
whether stabilizing begins when the security’s principal market is open or closed. A security’s principal market is
the market that accounts for most of the security’s trading volume.
Initiating Stabilizing When the Principal Market Is Open After the opening of quotes for the security in the
principal market, stabilization may be initiated in any market at a price no higher than the last independent
transaction price for the security in the principal market if (i) the security has traded in the principal market on the
day stabilizing is initiated or on the preceding business day, and (ii) the current ask price in the principal market
is equal to or greater than the last independent transaction price. If either of the preceding conditions is not
satisfied, stabilizing may not be initiated in any market after the opening of quotes in the principal market at a
price higher than the highest current independent bid for the security in the principal market.

Example: Let’s assume that BNBR stock has just opened for trading in its principal
market; however, no transactions have taken place in the stock. Dotted Line Capital
(DTLN), a participant in the IPO of the security, wants to maintain a stabilizing bid in
the security. MMA, an independent market maker, is at the inside bid for BNBR at 24.55.
DTLN cannot enter a bid higher than the highest independent bid (as shown below).
Bids
MMA 24.55 (Independent)
MMB 24.54 (Independent)

DTLN 24.55 (Stabilizing)
Suppose BNBR was trading in the principal market for one day prior to DTLN’s attempt
to place a stabilizing bid. The last transaction in BNBR was at a price of 24.56 and the
current ask price is 25.00. DTLN is able to maintain a bid of 24.56.
Initiating Stabilizing When The Principal Market Is Closed When the principal market for the security is
closed, the price at which stabilization may be initiated is generally limited to the lower of the price at which
stabilizing could have been initiated in the principal market at its previous close, or the last independent
transaction or bid in the market on which stabilizing will be initiated. Any person entering a stabilizing bid must
grant priority to any independent bid at the same price, regardless of the size of the independent bid. Once initiated,
a stabilizing bid may be raised to match independent bids in the market.
Penalty Bids and Syndicate Covering Transactions

The syndicate manager must provide written notice to FINRA if it intends to impose a penalty bid on a subject or
reference security under Rule 101, or if it intends to engage in syndicate covering transactions under Rule 104. The
notice must be provided prior to the start of either of these activities.
The notice must include (i) the identity of the security and its Nasdaq symbol, and (ii) the date the member
intends to impose the penalty bid and/or conduct syndicate covering transactions. A Regulation M Trading
Notification Form—part of the Underwriting Activity Report (UAR)—can be used for reporting this information.
By no later than 30 days after the effective date of the offering, the manager must also maintain information in
its files about the amount of the syndicate short position.
Penalty Bid A penalty bid is an arrangement that permits the managing underwriter to reclaim a selling
concession from a syndicate member in connection with an offering when the securities originally sold by the
syndicate member are purchased in syndicate covering transactions (covered next). It is called a penalty bid
because the syndicate manager will not pay a selling group member whose customer buys a new issue and
immediately sells it back to the syndicate at the stabilizing bid. Penalty bids are identified on Nasdaq by the
abbreviation PBID.
Syndicate Covering Transaction A syndicate covering transaction is the placing of any bid or the
effecting of any purchase on behalf of the sole distributor or the underwriting syndicate or group to reduce a
short position created in connection with the offering.

Syndicate short positions can arise from overallotments, in which syndicate members sell more than the number
of shares being offered. This can occur if the syndicate anticipates that some indications of interest will be
withdrawn by customers. In some cases, the short position can be covered by syndicate stabilizing purchases.
Green Shoe Clause If there’s a rising market for the offering, it could result in significant losses to the
underwriters. To manage this type of situation, the lead underwriter may invoke the Green Shoe option (if
available). This is a provision that may be included in the registration statement which allows the syndicate to
purchase up to 15% more shares than were originally registered, on the same terms and at the same price as the
original shares, to cover overallotments. However, as with any aspect of a new offering, overselling by a
syndicate is covered by antifraud rules and cannot be manipulative.
Disclosure and Notification If a syndicate decides to stabilize, it must notify the market in which stabilizing
will occur and must disclose the purpose of the stabilizing bid to the person with whom the bid is entered. There’s
no specific time limit on how long a syndicate may maintain a stabilizing bid. However, once the syndicate has
completed the distribution, the rules regarding stabilization would no longer apply.
Rule 105 – Short Sales in Connection with an Offering

Regulation M Rule 105 addresses the concern for the participation of large institutions as buyers in securities
offerings. It has been argued that the price-setting power had been transferred from the underwriters to large
institutions. This occurred when investors felt that securities offered by an existing issuer would not be
successful and stock would be sold short and then covered with positions purchased from underwriters. This
activity disrupted the orderly distribution of the securities.
Rule 105 stipulates that it’s a violation for any person to sell short the security that’s the subject of an offering,
and then purchase the offered security from an underwriter, if the short sale was executed during the period
beginning five business days prior to the pricing of the offering and ending with the pricing of the issue.
If the pricing of the offering occurs within five business days of the filing of the registration statement, then
Rule 105 applies from the filing date until the pricing of the issue. The rule doesn’t apply to those offerings that
are not conducted on a firm-commitment basis. The basic concept is that a person is prohibited from buying
securities in a firm-commitment underwriting if that person sold short that security during the restricted period.
Bona Fide Purchase Exception This exception allows a person who was not aware of the offering, or
changes her mind, to close out the short sale at least one business day prior to the day of the pricing and still
purchase the offered securities.
FINRA Rules Regarding Regulation M

According to SRO rules, a member firm is required to submit certain forms to FINRA in connection with
underwriting practices and SEC Regulation M. For any Nasdaq security that’s part of a distribution which is subject
to Regulation M, the managing underwriter may request an Underwriting Activity Report (UAR) from FINRA’s
Corporate Financing Department. The report will identify whether the security’s restricted period begins one day
or five days prior to pricing, or whether it’s exempt as an actively traded security. The underwriter is not
required to use the UAR and may use sources to determine the Regulation M status of the issuer.

For those securities that are not exempt, the manager must submit to Nasdaq Market Operations by no later than
the day prior to the commencement of the restricted period a Restricted Period Notification Form. This form must be
filed with FINRA for both exchange-listed securities and OTC equity securities. A security quoted on the OTC
Pink Market is an example of an OTC equity security. For those securities that will be listed on the NYSE, a
form must also be filed with the exchange.
Some of the information that’s required to be disclosed is whether the syndicate manager intends to effect
syndicate short covering transactions, impose a penalty bid, or place a stabilizing bid. If a firm intends to stabilize
an offering, FINRA’s Market Regulations Department must be provided with prior electronic notification.
FINRA prohibits the entry of a stabilizing bid for an OTC equity security. In addition, other information that
must be disclosed is the name of the security, the stock symbol, type and number of shares being offered, date
and time of the pricing, names of the managing underwriter and syndicate members (but NOT the selling
group members) and, if applicable, the beginning and ending of the Regulation M restricted period. These
records must be maintained for three years.
FINRA New Issue Allocations and Distributions Rule

Quid Pro Quo Allocations FINRA prohibits member firms from engaging in activities that are referred to
as quid pro quo or kickbacks. Essentially, firms cannot use their allocations of new issues (especially those that
are oversubscribed) as a means of obtaining compensation that’s excessive in relation to the services they’re
providing. However, member firms are permitted to allocate new issue shares to customers based on the
customers’ willingness to separately retain the member firm for other services provided that the customers
have not paid excessive compensation in relation to those services.
Spinning Spinning is defined as a member firm allocating shares of a new issue to certain corporate decision
makers. Although this activity is prohibited, it doesn’t apply to the allocations made to all corporate employees.
Instead, the rule applies to both public and non-public companies that may be considering an investment
banking relationship with the member firm and includes the executive officers and directors of former, current,
or prospective customers and any person who’s materially supported by the executives or directors.
The rule specifically states that it’s a violation to allocate shares of a new issue to those customers if:
 The company is currently an investment banking services client of the member firm or the member firm has
received compensation from the company for investment banking services in the past 12 months
 The person who’s responsible for making the allocation decision knows or has reason to know that the member
firm intends to provide, or expects to be retained by the purchaser for, investment banking services within the
next three months, or
 On behalf of the company they represent, the executive officers or directors make an expressed or implied
condition that their company will use the member firm to provide future investment banking services
Flipping Flipping is defined as the initial sale of a new issue that occurs within 30 days following its offering
date as an IPO. In many circumstances, flipping creates downward pressure on the price of the security in the
secondary market and, therefore, underwriters may attempt to discourage these types of sales. FINRA prohibits a
member firm and any person associated with a member firm from directly or indirectly recovering, or attempting
to recover, any portion of a commission or credit that was paid or awarded to an associated person who
originally sold shares of a new issue that were flipped by a customer. An exception to this prohibition is
available if the managing underwriter has assessed a penalty bid on the entire syndicate.

Market Orders FINRA rules prohibit a member firm from accepting a market order for a new issue prior to
the commencement of trading for that stock in the secondary market. This rule applies to all new issues,
including both exchange listed and OTC equity securities. An initial public offering may experience volatility
as it begins to trade; therefore, once these securities begin to trade in the secondary market, there may be a
large difference between the public offering price and the price at which the stock begins to trade in the
secondary market. If a customer places a market order for a new issue, the price received by the customer may
be much higher than the IPO price.
Other SEC Rules Affecting Underwriters

Prohibited Representations Underwriters cannot represent a sale as a contingent offering, such as all-or-
none, unless the distribution meets certain conditions. Investors must receive a prompt refund unless (1) all of
the securities being offered are sold at a specified price within a specified period, and (2) the issuer receives
the total amount to which it’s due by a specified date.
Disclosure of Interest in a Distribution A broker-dealer that receives a fee from a customer for advising the
customer about securities is an investment adviser. If such a broker-dealer attempts to sell securities that are part
of a distribution in which the broker-dealer is participating, this is considered a conflict of interest. Therefore, the
broker-dealer must give or send the customer written notice disclosing its participation in the distribution. The
notice must be given or sent, at or before, the completion of the transaction.
Recordkeeping
Syndicate Records According to SEC Rule 17a-2, an underwriter that will be stabilizing an issue, effecting
a syndicate short covering transaction, or implementing a penalty bid, must maintain a record of the following
information:
 The percentage participation or commitment of each member of the syndicate
 The names and addresses of the members of the syndicate
 The dates for which the penalty bid was in effect
 The name and class of any security stabilized or any security in which a syndicate short covering transaction
was executed
 The price, date, and time at which each stabilizing purchase or syndicate short covering transaction was executed
In addition, each syndicate member must receive information from the manager regarding the name, date, and
time at which the first stabilizing purchase was executed, and the time that stabilizing was terminated. These
records must be kept for a minimum of three years.
Stabilization Records Typically, the syndicate manager places a stabilizing bid or conducts the syndicate’s
short covering transactions. However, if a syndicate member (not the manager) executes a transaction, the firm
is required to notify the manager within three business days of execution. The manager must maintain these
records as part of its recordkeeping responsibilities.

The New Issue Rule

FINRA believes that restrictions should apply to the sale of all new issues, not only those that are over-
subscribed and that trade at an immediate premium in the aftermarket. Under the New Issue Rule, a FINRA
member firm should make a bona fide offering of new issues to the public and not withhold any shares for its
own account, its employees’ accounts, or the accounts of any other industry insiders. The rule prohibits
FINRA member firms from selling shares of a new issue to any account in which a restricted person has a
beneficial interest. However, an exemption exists that allows personnel of limited broker-dealers to purchase shares
of a new issue. A limited broker-dealer restricts its business to investment company/variable contract securities or
direct participation programs. For example, a registered representative who’s employed by a firm that sells
only mutual fund shares is exempt from this rule.
The rule contains definitions of key terms, a number of exemptions, and an obligation that the broker-dealer
should obtain a representation from the account holder which states that he’s eligible to purchase new issues.
The following section details the specifics of the rule.
New Issues New issues include all initial public offerings of equity securities that are sold under a
registration statement or offering circular. However, the following securities are NOT considered new issues
and may be sold to restricted persons:
 Secondary offerings
 Private offerings, including securities sold pursuant to Regulations D and 144A
 All debt offerings, including convertible and non-investment-grade debt
 Preferred stock and rights offerings
 Investment company offerings
 Exempt securities as defined under the Securities Act of 1933
 Direct participation programs (DPPs) and real estate investment trusts (REITs)
 Rights offerings, exchange offers, and offerings made pursuant to an M&A transaction
 American depositary receipt (ADR) offerings that have a preexisting market outside the U.S.
Preconditions for Sale Prior to selling a new issue to an account, a firm must meet certain preconditions for
sale. A firm must obtain representation from an account holder, or any authorized party of an account, stating
that the account is eligible to purchase new issues in accordance with the New Issue Rule before distributing a new
issue to that account. The representation from the account holder may be in the form of an affirmative statement
that positively declares that the account is eligible.
For accounts that are held by banks, foreign bankers, broker-dealers, investment advisers, or other conduits
that purchase new issues on behalf of their customers, the firm must obtain a representation that all of the
conduit’s purchasers of new issues are in compliance with the rule. A firm may use electronic communications
to verify account eligibility for new issues, but may not rely on oral statements.
A member firm that sells new issues must reverify eligibility every 12 months and must retain copies of all
information and records that are used in verification for a minimum of three years. Note: this recertification of
eligibility is not the responsibility of individual RRs, but rather of the firm itself.

Prohibited Sales A member firm or any person who’s associated with a member firm is prohibited from offering
or selling a new issue to any account in which a restricted person has a beneficial interest. Additionally, a member
firm or any person associated with a member firm may not purchase a new issue unless an exemption applies.
Restricted Persons A restricted person is not permitted to purchase shares of a new issue unless an
exemption applies. The following are considered restricted persons:
 FINRA member firms and any associated person (i.e., employee) of the member firm
 An immediate family member of an employee of a member firm. Immediate family members include a spouse,
children, parents, siblings, in-laws, and any other person who’s materially supported by an employee of a
member firm. (Under the rule, aunts, uncles, and cousins are not defined as immediate family members and are,
therefore, not considered restricted persons.)
The previously listed immediate family members are only considered restricted persons if any one of the
following three conditions apply:
1. The employee gives/receives material support to/from the immediate family member. Material support is
defined as providing more than 25% of the person’s income or living in the same household as the person
associated with the member firm.
2. The employee is employed by the member firm that is selling the new issue.
3. The employee has the ability to control the allocation of the new issue.
For example, Jon is employed by ARW Investment Bank and he supports his
brother. His brother is considered a restricted person.
Another example: Keith is employed by NJF Investment Bank and his firm is the
managing underwriter of Mattco IPO. Keith’s immediate family members are
restricted from purchasing any of the shares in the Mattco IPO from NJF.
Other restricted persons include the following:

 Finders and fiduciaries, such as attorneys and accountants who are involved in the offering of the new issue and
anyone whom they materially support
 Portfolio managers purchasing for their own account, which include persons who can buy or sell securities on
behalf of institutional investors (e.g., banks, investment companies, investment advisers, insurance companies,
savings and loan institutions) as well as anyone whom they materially support. These are people who are in a
position to direct future business to the firm, which is the reason for their restricted status. (It’s important to
remember that a portfolio manager is only a restricted person if she’s purchasing an equity IPO for her personal
account. There’s no restriction if she’s purchasing shares for the fund that she manages.)
 Persons who own a broker-dealer. This generally defines anyone who owns 10% or more of a brokerage firm,
which requires them to report their interest on Form BD as a restricted person.
Anti-Dilution Exception A restricted person, such as an employee of a broker-dealer, is not permitted to

purchase shares of an equity IPO unless an exception applies. One of the exceptions is referred to as the anti-
dilution provision, which allows the restricted person to maintain her equity ownership percentage as long as
certain conditions are met. The restricted person’s interest must have been held for a period of one year prior to
the effective date of the offering. Also, the amount being purchased doesn’t increase her equity ownership
percentage, and the new issue that’s purchased is not sold, pledged, or transferred for a period of three months
from the effective date.

General Exemptions
The New Issue Rule also provides a number of general exemptions. The exemptions allow a new issue (as
defined under the rule) to be sold to the following accounts:
 Investment companies that are registered under the Investment Company Act of 1940
 The general or separate account of an insurance company
 A common trust fund
 An account in which the beneficial interest of all restricted persons doesn’t exceed 10% of the account. (This is
a de minimis exemption which allows an account that’s partially owned by restricted persons to purchase a new
issue if all restricted persons combined own 10% or less of the account.)
 Publicly traded entities other than a broker-dealer or its affiliates that engage in the public offering of new issues
 Foreign investment companies
 ERISA accounts, state and local benefit plans, and other tax-exempt plans under IRS Code 501(c)(3)
Another exemption allows a broker-dealer to purchase shares of a new issue if the offering is under-subscribed.
This means that an underwriter is able to place shares in its own investment account if there’s no unmet public
demand. This exemption doesn’t allow an underwriter to sell shares of an under-subscribed issue to other
restricted persons.
Issuer-Directed Securities SRO rules permit certain persons that are related to the issuer to purchase
shares of a new issue as long as the issuer specifically directs securities to them. Those that fall under this
exemption include the following:
 The parent company of an issuer
 The subsidiary of an issuer
 Employees and directors of an issuer
This exemption allows a registered representative to purchase shares of an equity IPO in her employing broker-
dealer, or the parent or subsidiary of the broker-dealer. In addition to a registered representative, other restricted
persons (e.g., immediate family members of employees of a broker-dealer and finders and fiduciaries that are
involved with the offering) are allowed to purchase shares of a new issue, provided they’re employees or
directors of the issuer.
Conclusion
This concludes the discussion of the primary markets. The next chapter will focus on the Securities Exchange Act
of 1934—the federal law that regulates the secondary or trading markets. This law is very broad in scope and
covers diverse activities including the ongoing reporting requirements of issuers and insiders, prohibited activities
that are considered to be market manipulation, and also establishes rules regarding both proxies and tenders.

Now that you’ve completed Chapter 2, log in to my.stcusa.com and create a 10-question custom exam.

Chapter 3
The Securities Exchange

Act of 1934 and Related
Rules

CHAPTER 3 – THE SECURITIES EXCHANGE ACT OF 1934 AND RELATED RULES SERIES 24
This chapter will examine the regulation of the secondary market. The primary piece of regulation
that governs this area is the Securities Exchange Act of 1934. Attention will also be paid on more
recent legislation, such as the Hart-Scott-Rodino and Sarbanes-Oxley Acts.
Scope of the Securities Exchange Act of 1934

While the focus of the Securities Act of 1933 is fairly narrow (the registration and sale of new issues), the
Securities Exchange Act of 1934 covers many activities in the securities markets, including:
 Regulation of transactions in the secondary market, including anti-manipulation rules and regulation
of the extension of credit in securities transactions
 Registration and regulation of broker-dealers
 Registration and regulation of securities exchanges
 Oversight of industry self-regulatory organizations (SROs)
 Registration and regulation of companies with securities trading in the secondary market, including
regular financial disclosures, proxy rules, and insider reporting
Certain securities, such as U.S. government and municipal securities, are exempt from some parts of the
Securities Exchange Act. Exempt securities are not subject to the restrictions that apply to credit extension,
proxy solicitation, insider reporting requirements, and prohibitions against price manipulation on an exchange.
The SEC The Exchange Act authorized the creation of the Securities and Exchange Commission (SEC),
which has been charged with enforcing the securities laws and with creating rules to implement those
laws. Members of the SEC are appointed by the President of the United States with the advice and consent
of the Senate. There are five commissioners; however, no more than three of the commissioners may be
from the same political party. The commissioners are appointed to five-year terms, must engage in the
full-time business of the Commission, and cannot participate in securities transactions during their tenure.
Interstate Commerce Most of the provisions of the Act of 1934 cover securities transactions that are
part of interstate commerce. With the increase in international transactions, there’s a question as to when a
cross-border transaction is governed by the Act.
Foreign Internal Market Exception Interstate commerce doesn’t generally include transactions that
take place in a foreign internal market, such as a foreign stock exchange, even if the order originated
inside the United States. For example, if a broker-dealer in New York calls a broker-dealer in Tokyo and
arranges an OTC trade over the phone, the Exchange Act applies since the transaction was between a state
and a foreign country. However, if a broker-dealer in New York sends an order to the Tokyo Stock
Exchange and it’s executed on the floor of the exchange, the Exchange Act doesn’t apply since the trade
was executed in a foreign internal market. Any disputes about the execution itself will be governed by the
rules of that foreign exchange. However, it’s important to note that an activity which did take place in the
U.S. in connection with a foreign transaction (e.g., a solicitation) may be subject to the antifraud rules of
the Securities Exchange Act of 1934.

SERIES 24 CHAPTER 3 – THE SECURITIES EXCHANGE ACT OF 1934 AND RELATED RULES
Trading Suspensions and Emergency Authority

Section 12(k)(1) of the Securities Exchange Act gives the SEC the authority to impose certain trading
suspensions if it finds the action is in the public interest and for the protection of investors. The SEC may:
 Suspend trading in any security (other than an exempted security) for a period not exceeding 10
business days and
 Suspend all trading on any national securities exchange or otherwise (in securities other than exempted
securities) for a period not exceeding 90 calendar days. This type of suspension cannot take effect if the
SEC notifies the President of the United States and the President disapproves of the suspension.
Section 12(k) of the Securities Exchange Act gives the Commission the authority, in an emergency, to
issue orders to alter, supplement, suspend, or impose requirements or restrictions with respect to any
matter that’s subject to SEC or SRO regulation. The SEC must determine that the order is in the public
interest and for the protection of investors, and is necessary to:
 Maintain or restore fair and orderly securities markets (other than markets for exempt securities), or
 Ensure prompt, accurate and safe clearance and settlement of transactions in securities (other than
exempt securities).
Emergency orders cannot remain in effect for more than 10 business days, including extensions. For the
purpose of this rule, the term emergency represents a major market disturbance that’s characterized by (a)
sudden and excessive fluctuations of securities’ prices generally, or a substantial threat of such
fluctuations, that threaten fair and orderly markets, or (b) a substantial disruption of the safe or efficient
operation of the national system for clearance and settlement of securities, or threat to such operation.
Violations of the Exchange Act

If the SEC determines that any person has engaged in or is about to engage in any action that violates the
Act, SEC rules and regulations, the rules of an exchange, FINRA rules, or Municipal Securities Rulemaking
Board (MSRB) rules, the SEC may seek an injunction in any federal court. The SEC may also transmit
evidence of such violations to the attorney general who may, if appropriate, institute criminal proceedings.
Violations of the Act or SEC rules and regulations, including false or misleading statements in any report
or application, are subject to criminal penalties. For individuals, the maximum fine is $5,000,000,
imprisonment for 20 years, or both. For business entities, the maximum fine is $25,000,000. If violators
can prove that they were not aware of the rule or regulation violated, a fine, but not imprisonment, may be
levied against the offender. The SEC will notify a broker-dealer and its designated examining authority
(DEA) of any violations that are determined by the Commission.
Sarbanes-Oxley Act (Sarbox or SOX)

Congress passed this legislation as a response to a series of accounting scandals and bankruptcies
involving public corporations. Among other things, the Act required the SEC to implement new disclosure
and corporate governance rules for publicly traded companies and make senior management more directly
accountable for the company’s internal control system and the financial information released to the public.

The following is a summary of the major components of this legislation.
Annual Reports A company’s management must institute a system of internal controls so that its financial
reports will be as accurate and reliable as possible. An assessment of the effectiveness of these controls and an
attestation by the company’s public accounting firm must be contained in the company’s annual report.
Financial Disclosure Annual and quarterly reports that are filed with the SEC must disclose all
material off-balance sheet transactions. Companies using non-GAAP (pro forma) financial data must also
include the comparable GAAP calculations and a reconciliation of the two sets of figures.
CEO and CFO Certifications of Annual and Quarterly Reports The Sarbanes-Oxley Act requires
the principal executive officer and the principal financial officer (also referred to as the chief executive
officer and chief financial officer) of public companies to personally certify that the company’s quarterly
and annual reports are accurate and complete, and that effective controls and procedures have been
established relating to the disclosure of all material information.
Loans to Officers and Directors Sarbanes-Oxley prohibits publicly traded companies from making
personal loans to their executive officers and directors. This prohibition doesn’t apply to executives of
lending institutions in the ordinary course of their business or to executives of broker-dealers who use
loans to purchase securities in margin accounts.
Disclosure of Insider Transactions Under Sarbanes-Oxley, all insider transactions are now reported
electronically by the end of the second day following the date of the transaction. The company must also
make this information available to the public on its website.
Code of Ethics for Senior Executives The Act requires all public companies to either establish a formal
code of ethics for their principal executive and financial officers, or disclose in the annual report why the
company doesn’t have a code of ethics. NYSE rules require all listed issuers to have a formal code of ethics.
Section 404 Section 404 of the Sarbanes-Oxley Act requires an SEC-reporting company (public
company) and its internal auditor (accounting firm) to test the internal controls that are relevant to its
financial reporting. This stress test is considered the most costly component of SOX and has a greater
impact on smaller firms.
Although the requirements are only applicable to public companies, many private companies voluntarily
comply with Section 404 as part of their best practices. In addition, any private company that seeks to go
public, or is acquired by a public company, is required to comply with Section 404.
Audit Committee The following rules relate to the audit committee of an SEC reporting company:
 According to Sarbox, in general, each member of the audit committee must be a member of the board
of directors of the issuer and be independent.
 According to Regulation S-K, the issuer must disclose either:
– That it has at least one audit committee financial expert serving on its audit committee, or
– That it doesn’t have an audit committee financial expert serving on its audit committee.

• If it has a financial expert(s) on its audit committee, it must disclose the name(s).
• A financial expert is generally defined as a person who understands GAAP and financial
statements, has audit experience, can evaluate financial statements, can understand internal
controls over reporting systems, and understands the audit committee functions.
 According to the listing requirements of the NYSE and Nasdaq, an issuer must have at least one
person on the audit committee who meets the definition of a financial expert.
As a matter of practice, most reporting issuers have at least one financial expert serving on their audit
committee.
Reports, Forms, and Schedules Filed under the Act of 1934

Various forms, schedules, and reports are required to be filed according to the Act of 1934. The SEC
provides free access to all of its filings through its Electronic Data Gathering, Analysis, and Retrieval
(EDGAR) system.
Reporting Requirements
Public Companies A publicly traded corporation is required to register with the SEC if it has total assets
of more than $10 million that are held of record by either (1) 2,000 or more persons, or (2) 500 or more
persons who are not accredited investors, or if its securities trade on a national securities exchange (e.g., the
NYSE or Nasdaq). This registration requirement is in addition to the requirement for the issuer to register
its securities under the Securities Act of 1933 when they’re first offered to the public. For example, a
private company that has 2,000 or fewer shareholders is not required to file reports with the SEC.
Rules 13a-11 and 13a-13 of the Act require issuers of securities that are registered with the SEC (Section
12 securities) to file an annual report on Form 10-K and quarterly reports on Form 10-Q. (Such issuers are
referred to as reporting companies.) The rule doesn’t apply to foreign governments, foreign private issuers,
and issuers of American depositary receipts (ADRs).
Forms 10-K and 10-Q For an SEC reporting company, Form 10-Q is required to be filed after the end
of each of the first three fiscal quarters of each fiscal year. The last quarter results are included in the
annual results, which is reported through the company’s Form 10-K. Form 10-Q states in its instructions
that no report is required to be filed for the fourth quarter of any fiscal year.
Form 10-K (also referred to as the annual report) will include information that a company is required to
disclose to the SEC. This information is then available to the public. Some of the information include: the
business line and assets of the company, any legal proceedings in which the company is involved, risk
factors, footnotes of accounting policies, the market for the company’s equity securities, and a list of the
company’s directors and executive officers. The document also gives a detailed overview of the past
year’s results of the company and its business.

Form 8-K If an event occurs that could materially affect the issuer’s financial condition or share price, a
report must be made to the SEC on Form 8-K. Unless otherwise specified, the report must be filed within
four business days of the triggering event. The form is broken down into nine sections.
1. Business and Operations—Termination of a material, definitive agreement or bankruptcy or receivership
2. Financial Information—Completion of an acquisition or disposition of an asset, results of operations
and financial condition, an off-balance-sheet arrangement, and material impairment
3. Securities and Trading Markets—Notice of delisting, unregistered sale of equity securities
4. Accountants and Financial Statements—Change in the certifying accountant
5. Corporate Governance and Management—Change in control of the company, the resignation or election
of a director, amendments to corporate bylaws, code of ethics, and change in shell-company status
6. Asset-Backed Securities—Securities Act updating disclosures, failure to make a required distribution,
and change in servicer or trustee
7. Regulation FD—(described next)
8. Financial Statements and Exhibits—The latest financial statement, which is included in the press
release announcing the company’s latest financial results
9. Other Events—Material events not listed in the form
Compliance with Regulation FD (Fair Disclosure) Due to the concern that the selective disclosure of
insider information to research analysts and large investors was unfair, the SEC adopted Regulation FD.
Regulation FD bars issuers from selectively disclosing material, non-public information to securities
professionals (including employees of broker-dealers and investment advisers), or to shareholders if it’s
reasonably foreseeable that they will trade on the information.
Regulation FD applies to disclosures by senior company officials and those who regularly communicate
with research analysts and investors, such as the company’s investment relations or public relations
departments. If any of these people disclose non-public, material information to analysts or investors, the
company must also disclose the information to the public. Unless a specific exclusion is provided, Rule
100(b)(1) of Regulation FD lists the following four categories of persons to whom selective disclosure
cannot be made:
1. Broker-dealers and their associated persons
2. Investment advisers, certain institutional investment managers and their associated persons
3. Investment companies, hedge funds, and affiliated persons
4. Any holder of the issuer’s securities, under circumstances in which it’s reasonably foreseeable that
such person would purchase or sell securities on the basis of the information
Rule 100(b)(2) provides an exclusion for disclosure made to any of the following:
 Communications made to a person who owes the issuer a duty of trust or confidence (e.g., an attorney,
investment banker, or accountant)
 Communications made to any person who expressly agrees to maintain the information in confidence
 An entity whose primary business is the issuance of credit ratings, provided the information is
disclosed solely for the purpose of developing a credit rating and the entity’s ratings are publicly
available

How quickly the information must be disclosed is dependent on whether the selective disclosure was
intentional or unintentional.
 If the disclosure was intentional, then the company must simultaneously disclose the information to
the public.
 If the disclosure was unintentional, the company has 24 hours to publicly disseminate the information,
or until the opening of the next trading day on the NYSE if the disclosure takes place during a
weekend or holiday, whichever is later.
The company may fulfill its disclosure requirements by filing Form 8-K with the SEC or by some other
method that’s reasonably designed to reach a broad spectrum of the investing public (e.g., issuing a press
release or broadcasting the information on the Internet).
Regulation FD doesn’t apply to disclosures that take place in the normal course of business with those that
have a duty to keep the information confidential, such as the company’s accountants, lawyers, and
investment bankers.
Schedules 13D and 13G Section 13(D) of the Exchange Act requires any person who acquires more
than 5% of an issuer’s equity securities to notify the issuer, the exchange on which the securities are
traded, and the SEC within 10 days after the acquisition.
A 13D filer (which may be referred to as an activist investor) is required to provide the following information:
 The security and issuer
 The identity and background of the filer. This may be an individual or a group.
 The source and amount of funds, or considerations that were used for the purchase. This section will
indicate whether the funds used to purchase the securities were borrowed or came from an existing cash
position of the filer.
 The purpose of the transaction. This is a very important section and indicates whether the filer wants to
acquire the company, purchase the shares because it believes they’re undervalued, or for any other reason.
 The interest in securities of the issuer, the number of shares, and percentage ownership of the filer
 The contracts or relationships with respect to securities of the issuer. The filer may have a standstill
agreement with the issuer restricting it from taking certain actions.
 Any material to be filed as exhibits. For example, a merger agreement or tender offer agreement, if that’s
the purpose of the filer’s transaction, or Schedule 13D that was filed under a joint filing agreement.
Schedule 13G is an alternative to Schedule 13D and is typically filed by institutional investors (e.g., mutual
fund companies) that have no intention of influencing or controlling the issuer (passive investors). The
person that files either form is required to promptly update the schedule to include any material change.
Schedule 13F SEC Rule 13f-1 of the Securities Exchange Act of 1934 requires quarterly filings when
institutional investment managers (e.g., investment companies, holding companies, and hedge funds)
exercise investment discretion over at least $100 million in equity securities. The schedule includes
information concerning the securities that are owned by the filer. This form must be filed regardless of
whether the filer is registered with the SEC. The SEC publishes a list of equity securities that will require an
institutional investment manager to file Form 13F. This list is referred to as the Official List of Section 13(f)
securities. Generally, the list includes exchange-traded stocks (e.g., the NYSE, NYSE-American, or Nasdaq),
equity options, warrants, shares of closed-end investment companies, and certain convertible debt securities.

For the purpose of determining which securities are equity securities and whether the filing of Form 13F is
required, any equity security that’s registered pursuant to Section 12 of the Securities Exchange Act is
included. In addition, closed-end investment company securities that are registered under the Investment
Company Act of 1940 are considered 13(f) securities; however, open-end investment company (mutual
fund) securities registered under the Investment Company Act of 1940 are not considered 13(f) securities.
Shares of exchange-traded funds (ETFs) are considered 13F securities. OTC Pink Market securities that
are not issued by Section 12 reporting companies are not included under 13(f).
Beneficial Ownership Reports (Insiders) For purposes of SEC Rule 16a-1, an insider is defined as
a director, officer, or owner of more than 10% of the stock of a corporation. These individuals are
considered to have the ability to control or influence the actions of the corporation. Individuals are
required to report to the SEC within 10 days of becoming insiders regarding the amount of the issuer’s
equity securities they own. They’re also required to report any changes in their position by no later than
the second business day following the change in position. When an individual becomes an insider, the
initial filing is accomplished on Form 3, while changes in beneficial ownership are filed on Form 4.
Form 5 is an annual filing by insiders which covers certain transactions, such as gifts.
Short-Swing Profits To prevent unfair use of information which they may have, insiders are prohibited
from taking certain actions in regard to the stock of the corporation to which they’re affiliated. Insiders
cannot sell the stock short; however, on certain occasions, some may use a technique that’s referred to as
shorting against the box (i.e., executing a short sale against a long position that’s held elsewhere) to ensure
timely delivery of securities that may be in legal transfer. Insiders are not allowed to make short-swing
profits in the stock of the corporation for which they’re insiders. Short-swing profits are those that are
earned within six months of the purchase. For example, if an insider sells stock at a profit within six
months of its acquisition, the corporation may sue for recovery of the profit (a process that’s referred to as
disgorgement). This restriction also applies if an insider sells stock that was held longer than six months
and then repurchases it within six months of the sale at a lower price than the previous sale price.
Annual Proxy Statements on Form 14A SEC Rule 14a-6 relates to the filing of information on the
Proxy Statement (Form 14A). The SEC requires a company to provide shareholders with a proxy
statement at least 20 calendar days prior to its annual meeting and it contains information that will be
voted on during the meeting. If the issuer is using the internet to notify its shareholders of the availability of
the proxy statement, it must do so at least 40 calendar days prior to the meeting. Detailed information
concerning proposed executive compensation and ownership percentages is required in this document.
A broker-dealer that holds customer stock in street name is required to forward proxy material or any other
material it received from the issuing corporation as long as the corporation provides reimbursement of all
out-of-pocket expenses, including reasonable clerical expenses. Under industry rules, a member firm
cannot execute a proxy to vote stock that’s registered in its name unless the member firm is the beneficial
owner of the stock, or the member firm holds the stock as executor, Administrator, guardian, trustee, or in
a similar fiduciary capacity with authority to vote.

Insider Trading Regulations

Now that the reports filed by insiders have been covered, let’s examine one of the most important
Exchange Act rules that apply to insiders—Rule 10b-5. As it relates to the purchase or sale of any security,
this rule makes it unlawful to:
 Employ any device, scheme, or artifice to defraud
 Make any untrue statement of a material fact or omit to state a material fact that’s necessary in order to
make the statements made, in light of the circumstances under which they were made, not misleading
 Engage in an act, practice, or course of business that operates as a fraud or deceit upon a person
An individual who sells a security based on an untruthful statement or the omission of a material fact can
be held liable to the purchaser for any monetary damages. However, the seller will not be held liable upon
demonstrating that he used reasonable care and was not aware of the untruthful statement or omission.
Although this rule has been used to prohibit many types of fraudulent securities activities, one of its most
important applications is concerned with insider trading. Insider trading involves the purchase or sale of
securities using material, non-public information about those securities in a fraudulent manner. The fraud
typically involves either the misuse of confidential information by a person who has a fiduciary duty to
shareholders (e.g., an officer or director), or the misappropriation of confidential information from an
employer (e.g., a broker-dealer employee who misappropriates and uses sensitive information). Please
note: Trading by a firm or individual based on information regarding a large client’s potential buying or
selling doesn’t constitute insider trading. This prohibited practice is referred to as trading ahead, which
will be described in a later chapter. If a corporation has material information, it must release it to the
public before any person may use the information to complete a transaction. It’s inappropriate to release
the information only to broker-dealers, financial analysts, shareholders, or any other limited group. To be
considered public information, it must be provided to the financial news media, which must then have a
chance to disseminate it.
Tippers and Tippees

In some situations, material, non-public information is passed from one person (the tipper) to another
person (the tippee), with the tippee then trading on the information. If the tippee knew, or should have
known, that the information was confidential, both the tippee and the tipper may have violated insider
trading rules. For instance, let’s assume that a member of a corporation’s board of directors tips a relative
about a pending takeover involving the corporation. If the relative trades on the information, it’s likely that
this violates the Exchange Act.
Another example is an investment banking representative who’s working on a deal with a company and
tips off a trader. A broker-dealer is responsible for the actions of its representatives even if the broker-
dealer doesn’t use the information to trade for its own account.
Important Insider Trading Legislation

Over the years, several high-profile insider trading cases involved broker-dealer employees. The Insider
Trading Sanctions Act of 1984 (ITSA) and the Insider Trading and Securities Fraud Enforcement Act of
1988 (ITSFEA) were both responses to these cases.

Establishment of Procedures The ITSFEA required broker-dealers to establish, maintain, and enforce
written policies and procedures that were reasonably designed, taking into consideration the nature of the
broker-dealer’s business, to prevent the misuse of material, non-public information by the broker-dealer or
its associated persons. The ITSFEA stipulates that any individual who purchases or sells a security while
in possession of material, non-public information, or communicates such information to another party in
connection with a transaction, may be liable for trading violations under the Act.
Broker-dealers are not only required to create such written policies, they must also ensure that they’re
implemented. A broker-dealer with a written, well-thought-out system of procedures to prevent insider
trading may still be subject to SEC penalties if it fails to follow through on the procedures. These
procedures should contain several key elements, including:
 A system for monitoring employees’ personal trading and trading in firm proprietary accounts
 Restriction or monitoring of trading in securities in which the firm has access to insider information
(watch lists and restricted lists)
 Procedures to restrict access to files containing confidential information, including the establishment of
information barriers (described next)
 Education of employees regarding insider trading issues
Information Barrier Procedures An information barrier consists of a set of procedures for preventing
the transmission of confidential information from one department to another within a broker-dealer. These
barriers are sometimes physical and sometimes procedural. For firms that have access to confidential
information, the importance of implementing adequate information barrier procedures cannot be
overstated. In order to account for the differences in the way various broker-dealers operate, the SEC has
not mandated any particular system; however, there’s no safe harbor for a firm’s information barrier
procedures. The burden is on the firm to be able to show that its procedures are adequate.
Restricted and Watch Lists Only firms that engage in investment banking, research, or arbitrage
activities are required to maintain restricted and watch lists. However, these firms must have written
procedures to address the use of material, non-public information by their employees. The restricted and
watch lists include securities that employees are either restricted or prohibited from trading, or issues that
are subject to closer scrutiny by the member firm. The restrictions or limitations associated with the lists
apply to both employees and to solicited transactions with customers.
The restricted list must be distributed to employees, while the contents of the watch list are generally
known only to selected members of the legal and compliance departments. The firm’s written supervisory
procedures should include a description regarding when and why securities have been added to, or
removed from, the lists. The restricted and watch lists should include the name of the contact person who
added the security to, or deleted it from, the list; however, the rationale for the decision is not required.
SRO Rules FINRA supervisory rules require a written report to be filed by a member firm within five
business days of any internal investigation if the firm has violated insider trading rules or has been involved
in any manipulative or deceptive practices. This written report must also include the completion of the
investigation, any internal disciplinary action taken, and any referral to FINRA, the SEC, or any other SRO.

Consequences of Insider Trading Violations Violations of insider trading rules by broker-dealer

employees can have serious consequences for both the individual and the firm.
Civil Penalties Insider trading violations may result in civil penalties of up to three times the amount of
gain achieved or loss avoided in the transactions. The SEC may also demand disgorgement of profits or,
put another way, the inside trader will be required to give up the profits earned.
Criminal Penalties The ITSFEA substantially increased the criminal penalties for violations of the
Exchange Act, including insider trading. An individual is subject to fines of up to $5 million and/or
imprisonment for up to 20 years, for each violation. Corporations and other non-natural persons may be
fined up to $25 million per violation. The Department of Justice (DOJ) is responsible for criminal actions.
SEC Whistleblower Program and Bounties The Whistleblower Program was created by Congress to
provide monetary incentives for individuals to come forward and report possible violations of the federal
securities laws to the SEC. Under this program, eligible whistleblowers are entitled to a bounty award of
between 10% and 30% of the monetary sanctions collected in actions brought by the SEC and/or actions
brought by certain other regulatory and law enforcement authorities. The program also prohibits retaliation
by employers against employees who provide the SEC with information about possible securities violations.
Rule 10b5-1 Plans

Insiders are generally prohibited from buying or selling a security based on material, non-public
information. For this reason, they’re blacked out (prohibited from buying or selling the subject security)
around material events (e.g., earnings releases). However, many corporate executives may want to
purchase or sell securities in which they’re considered a corporate insider or considered to be aware of
material, non-public information.
A 10b5-1 plan allows a person to have an affirmative defense against insider trading if certain conditions
are met.
 The following must be executed prior to the person becoming aware of the insider information:
– A written, binding plan has been entered into to purchase or sell the security
– The plan instructs another person to purchase or sell the security for this person
• The details of the plan must describe:
– The specified amount of securities to be purchased or sold, and the price and date on
which the securities were to be purchased or sold or,
– Include a written formula or algorithm for determining the amount of securities to be
purchased or sold, and the price and the date on which the securities were to be
purchased or sold
 The person who created the plan is not permitted to exercise any subsequent influence over how, when,
or whether to effect purchases or sales, and the individual who makes the purchase and sale decisions
must not be aware of the material, non-public information.
The corporate insider is not permitted to be involved in the decisions to purchase or sell the securities.

Manipulation
Although insider trading is the most high-profile application of Rule 10b-5, there are many other actions that
are prohibited because they’re considered deceptive or manipulative. For example, the Securities
Exchange Act of 1934 prohibits price manipulation. This includes wash sales, matched orders, and pool
activities that are designed to raise or depress prices of securities.
A wash sale represents the purchase and sale of securities by an individual without any beneficial change of
ownership for the purpose of raising or depressing the price of the security.
For example, let’s assume an individual places an order with Broker-Dealer A to buy
10,000 shares of XYZ stock at $40 and, at the same time, places an order with Broker-
Dealer B to sell 10,000 shares of XYZ stock at $40. Since there’s no chance for any profit
or loss, it’s obvious that the investor’s intention is to manipulate the price of the stock
by making it appear as though there’s active trading in the issue.
When these transactions appear on the Consolidated Tape, the activity is referred to as painting the tape.
Matched orders are similar to wash sales since they involve two persons acting in concert to buy and sell a
security for the purpose of raising or depressing its price. Pools or syndicates that are formed for the
purpose of raising or lowering the price of a security are also prohibited.
An individual who suffers damages because of the manipulation of the price of a security may sue the
manipulator for recovery of the damages. Action must be brought within three years of the manipulative
activity or within one year of discovery.
Tender Offers
According to Section 14 (Proxies) of the Securities Exchange Act of 1934, any person who makes a tender
offer and becomes the owner of more than 5% of a company is required to file Schedule TO (tender offer)
with the SEC’s Office of Mergers and Acquisitions as soon as it’s feasible on the commencement date. To
protect the interests of shareholders, SEC rules (Regulation 14E, among others) require that tender offers
be conducted in a way that’s fair. The following conditions are established by the rule:
1. Shareholders must be notified of a tender offer by no later than 10 business days from the date the
tender is made.
2. Management of the subject company must advise shareholders of whether they recommend or
decline the tender offer, or express that they have no opinion and remain neutral, or are unable to take
a position on the tender offer.
3. Tender offers must generally be held open for at least 20 business days from the time they’re
announced to the security holders.
4. If the person making the offer increases or decreases the percentage of the class of securities being
sought, the consideration being offered, or the dealer’s soliciting fee, the offer must remain open for
at least 10 business days from the date that notice of the change is given to security holders.
5. In order to extend the offer, the person making it must make a public announcement (such as a press
release) by no later than the earlier of (i) 9:00 a.m., Eastern Time, on the next business day after the
scheduled expiration date of the offer, or (ii) for exchange-listed securities, the opening of the
exchange on the next business day after the scheduled expiration of the offer. The notice must also
disclose the approximate number of securities tendered to date.

6. It’s considered fraudulent for a person making a tender offer to fail to pay the consideration offered,
or fail to return the securities tendered, promptly after the offer is terminated/withdrawn. (Prompt
payment generally means no more than two business [settlement] days from the end of the offer.)
Prohibition on Open Market Purchases During the Tender Period

SEC Rule 14e-5 Buyers that are engaged in a tender cannot buy additional shares on the open market
once the tender has commenced. According to SEC Rule 14e-5, a covered person in a tender offer cannot
purchase the common stock or convertible securities of the same issuer during the period that the tender is
open. A covered person is an issuer or individual that’s making the tender offer, or the investment bank
that’s acting as the dealer-manager in the transaction.
The dealer-manager is typically a broker-dealer. The SEC has created a number of exemptions to permit
firms to transact their regular business during the tender offer period. Some of the exempt activities include:
 Purchases by the dealer-manager or its affiliates on an agency basis
 Purchases on a principal basis, provided the dealer-manager and its affiliates are not market makers
 Purchases by an affiliate of the dealer-manager, if the affiliate maintains and enforces written policies
and procedures that are designed to prevent the flow of information (i.e., information barriers), and the
purchases are not made to facilitate the tender offer
NOTE: A person that has made a tender offer (for stock) may purchase the issuer’s non-convertible bonds.
Partial Tender Offers

At times, the buyer is only interested in purchasing a limited number of shares. In a partial tender offer, the
exact number of shares to be accepted from any person tendering stock is unknown until all tenders are
collected and counted. For example, if a buyer is attempting to acquire 10 million shares, but 20 million
are tendered, each person tendering may potentially have only 50% of her shares accepted for tender.
What May be Tendered? Investors may tender stock that’s owned outright as well as stock they could
own based on ownership of equivalent convertible securities (e.g., convertible bonds, among others). Once
the tendered convertible securities are accepted, the investors (tenderers or tendering parties) must convert
the securities into the underlying stock and make delivery.
Note: Students are advised not to confuse the short tendering rules described below with those associated
with what constitutes a long or short sale, which will be covered in a later chapter.
It’s considered a manipulative or fraudulent act for a person to tender securities that he doesn’t own (short
tendering). In order to be considered the owner of the securities that are the subject of the tender offer, a
person must own the stock (have a long position) and be prepared to deliver it to the person making the
tender offer.
In a partial tender offer, a person is considered to own (to be long) stock if he:
 Has title to the stock (or the person’s agent has title to the stock). This includes owning the stock or an
equivalent security, such as a convertible security, warrant, or right.
 Has entered into an unconditional contract to buy the stock, but has not yet received it
 Owns a call option and has exercised the option

When tendering stock, the tendering party must have exercised a call option, but not a convertible security,
warrant, or right since those securities are issued by the company that’s the subject of the tender offer. Since
call options are not issued by the company, these securities must be exercised prior to tendering securities.
Note: The exercise requirements associated with short selling will be described under Reg SHO in a later
chapter.
Net Long Position In order to tender securities, a person must have a net-long position. If an investor
owns stock, but has also written (sold) call options (an obligation to deliver stock) with an exercise price
that’s lower than the tender price, the calls reduce the individual’s long position by the amount of shares
represented by the call options. For example, if an individual owns 10,000 shares of securities that are the
subject of a tender offer at $40, but has written 10 call options (representing 100 shares each) at an
exercise price of $35, that person’s net-long position will be reduced by 1,000 shares.
When determining an investor’s net-long position, long puts are not taken into consideration. The rationale
is that a customer who has a long put position is not obligated to sell the underlying security.
Tenders—Prohibited Practices
Inside Information and Tender Offers In addition to the insider trading restrictions that fall under the
SEC’s general antifraud rules, there’s another rule that specifically applies to inside information about
tender offers. SEC Rule 14e-3 prohibits a person from trading while in possession of material, non-public
information concerning a tender offer. In addition, a person who acquires material, non-public information
concerning a tender offer is prohibited from disclosing this information.
An exception is provided if the communication is made in good faith to:

 Officers, directors, employees, or advisers of the person making the tender offer
 Officers, directors, employees, or advisers of the person that’s the subject of the tender offer (the target)
If a tender offer is proposed, the implication is that the information has not yet been made public. A
registered person is prohibited from discussing a proposed tender offer with other registered persons
within her firm who are not involved in the transaction.
Going Private Transactions

SEC Rule 13e-3, which governs the going private transactions by certain issuers or their affiliates involves
a transaction in which an issuer or an affiliate of the issuer is purchasing its common stock. Such a
transaction will likely cause the company to become delisted from an exchange or no longer considered a
reporting issuer. The company’s intent may be to reduce the costs and administrative burden of being a
publicly traded company. The issuer is required to file a Schedule 13E-3 with the SEC and make certain
disclosures to shareholders. In addition, the issuer is required to file certain information with the SEC,
such as reports and opinions by a financial adviser. The issuer will typically attach a summary term sheet
along with other required disclosures to the proxy statement that’s provided to shareholders.

Rules Regarding Mergers and Acquisitions

Regulation M-A
Regulation M-A is designed to facilitate communications and disclosures made by companies that are
engaged in cash and stock tender offers, or mergers and acquisitions. In most domestic M&A transactions,
holders of the subject security receive a disclosure document, such as a prospectus, proxy statement, or
tender offer statement. Regulation M-A relaxes some of the technical communication requirements
between broker-dealers and investors, as it relates to cross-border mergers, acquisitions, and tender offers,
prior to SEC filings.
In general, Regulation M-A updates disclosure rules for the contemporary market while preserving
investor protections. This is accomplished by:
1. Reducing certain restrictions that conflict with the investor’s need for information
2. Setting rules to balance the treatment of cash tender offers versus stock tender offers
3. Simplifying disclosure requirements to facilitate compliance while still increasing investor understanding
Regulations Regarding Fairness Opinions

Industry rules regulate pricing or fairness opinions produced by member firms regarding transactions that
result in a change in the control or assets of a company. This is the case in mergers, acquisitions, tender
offers, or the sale of a division of a company. The pricing opinion addresses whether the price offered is
fair (within a reasonable range of prices).
The pricing opinion doesn’t address factors concerning the solvency or creditworthiness of the companies
involved in the transaction. Directors of an issuer, when contemplating acceptance of a takeover or the sale
of an asset, depend on pricing opinions to demonstrate that they have acted in the best interests of their
shareholders. The rule requires any broker-dealer that renders a pricing opinion to disclose any conflict of
interest existing between itself and the issuer.
A fairness opinion that’s provided to shareholders must include the following disclosures (if applicable):
1. Whether a financial adviser to a party in the transaction will receive compensation that’s contingent
on the completion of the merger or takeover
2. Whether the broker-dealer will receive any other significant payment contingent on the completion of
the transaction
3. Whether a material relationship existed within the past two years between the broker-dealer and any
party that’s subject to the fairness opinion
4. Whether information obtained from the party that has requested the fairness opinion has been
independently verified by the member firm
5. Whether the fairness opinion was approved by a fairness committee
6. Whether the fairness opinion addresses the fairness of the compensation paid to corporate insiders,
relative to the compensation received by public shareholders
Broker-Dealer Fairness Committee Broker-dealers often create an internal committee to render

fairness opinions. Broker-dealers are required to have written procedures addressing the following:
1. Identification of the types of transactions on which it will issue a fairness opinion

2. Identification of the circumstances in which it will use a fairness committee

3. A process used to select members of the fairness committee and the standards necessary to become a
committee member
4. A process that promotes a balanced view by the fairness committee. This is accomplished by
selecting some members from outside the deal team.
5. A process to determine whether the valuation analysis used by the committee and reflected in the
fairness opinion is appropriate
Hart-Scott-Rodino (HSR) Act

The Hart-Scott-Rodino Act is a federal antitrust law that requires certain companies or financial investors
(e.g., hedge funds planning a merger or acquisition) to file notice with the Federal Trade Commission
(FTC) and the Antitrust Division of the Justice Department before the deal is completed. The merger
cannot be completed until 30 days after the notice is filed. In certain cases, the regulators may request
more information, which will delay the completion of the merger for an additional 30 days.
These notification requirements only apply to company mergers and acquisitions that meet certain
thresholds. Two different tests are applied to determine whether filing is required (the thresholds are
adjusted annually for inflation). One test is based on the size of the companies involved, while the other is
based on the size of the deal. These provisions are intended to impact larger-sized companies and
transactions; therefore, smaller transactions are generally exempt from this Act.
HSR also requires financial investors to file and comply with the 30-day waiting period for stock
transactions and a 15-day period for cash transactions, unless the purchase was for investment purposes
only and without the intent to control the company. Broker-dealers may control or be affiliated with
investment entities such as hedge funds, private equity, and venture capital partnerships. These types of
investors may be subject to the filing and waiting periods of HSR.
Issuer Repurchases
SEC Rule 10b-18
For a variety of reasons, an issuer of securities may be tempted to illegally raise the price of its own stock.
On the other hand, there are many legitimate reasons for an issuer to purchase its own stock in the open
market, such as stock buyback plans or funding employee stock purchase plans. To balance these
legitimate interests against the possibility of manipulation, the SEC has created Rule 10b-18 to control
how an issuer, or an affiliate, may buy its own stock in the secondary market. This rule doesn’t apply to
public tender offers, for which different rules apply.
10b-18 Safe Harbor If the following conditions are met by an issuer, the SEC will assume that the
issuer is not trying to manipulate its own stock price:
 Use one broker-dealer to place bids and make purchases in any trading session. The rule permits an issuer
to use one broker-dealer during normal business hours, and a different one during after-hours trading.
 Avoid making purchases at certain times of the day. Issuers cannot make purchases that are the first
transaction reported that day and cannot make purchases during the last 30 minutes of the normal trading
day. If the securities are actively traded, the prohibition is within the last 10 minutes of the trading day.

 Limit the bid or purchase price of securities at certain prices. For securities that are quoted or reported in
the consolidated system or interdealer quotation system which displays at least two quotations, the price
cannot be higher than the highest independent bid or the last independent transaction price, whichever is
higher. For example, if the last transaction was $23.53 and the current bid/ask spread is $23.50 - $23.60,
the highest price at which the issuer could buy the stock is $23.53. For all other securities, purchases must
be effected at a price no higher than the highest independent bid obtained from three independent dealers.
 Limit the amount of stock purchased on any single day. The total volume of purchases on any single day
cannot exceed 25% of the ADTV for that security. However, once each week, in lieu of purchasing less
than the 25%, the issuer may effect one block purchase if no other 10b-18 purchases are made that day.
Note: The block purchase is not included when calculating a security’s four-week ADTV under this rule.
For this rule, a block purchase is defined as a quantity of stock that either:
a. Has a purchase price of $200,000 or more, or
b. Is at least 5,000 shares with a purchase price of at least $50,000, or
c. Is at least 20 round lots that total 150% or more of the trading volume for that security or, if trading
volume data is not available, is at least 20 round lots that total 1/10th of 1% of the outstanding shares
of the security, less the shares beneficially owned by affiliates.
Since issuer purchases can provide liquidity in periods of market turbulence, the timing and volume rule is
relaxed following a market-wide trading suspension. The Rule 10b-18 safe harbor is available to an issuer
that bids for or purchases its common stock either:
 From the reopening of trading to the close of trading on the same day as the imposition of the market-wide
trading suspension, or
 At the next day’s opening, if the market-wide trading suspension was in effect at the scheduled trading close
In the event that either of the aforementioned exceptions is used, the volume of purchases must not exceed
100% of the ADTV for that security. To use either of the exceptions, the issuer must still comply with the
price and broker-dealer conditions described previously.
Clearly, the Securities Act of 1933 and the Securities Exchange Act of 1934 cover a significant amount of
regulatory content. As potential managers, Series 24 candidates are expected to understand the basics of
these broad federal laws, but also the day-to-day requirements of managing a firm and its various
personnel, including salespersons, analysts, traders, and operations professionals. The next two chapters
will examine the procedures and rules governing these functions.


Chapter 4
Supervision of Research

SERIES 24 CHAPTER 4 –SUPERVISION OF RESEARCH
This chapter will cover the supervisory responsibilities regarding research personnel. These include
particular rules governing the actions of research personnel who work for firms that are engaged in
underwriting as well as some general disclosures and trading prohibitions for producers of all
research reports.
Research Analysts and Research Reports

Terms and Definitions The terms research analyst, subject company, and subject security will be used
extensively in this section. Under industry rules, a research analyst (associated person) is an employee of a
member firm who makes recommendations in research reports and public appearances as to whether an equity
security should be bought, sold, or held. This definition also includes employees who report to an analyst. A
subject company is the company whose equity securities are the subject of a research report or public
appearance. The term subject security is defined as an equity security that’s the subject of a research report
that’s prepared by a member firm.
The term research report is broad and is defined as any written or electronic communication that includes an
analysis of equity securities of induvial companies or industries that provides information reasonably sufficient
to base an investment decision. The report is not required to be labeled a research report and the person who
prepares it is not required to have the job title “research analyst.” For example, if an RR prepares a newsletter
or other type of communication with in-depth information on individual stocks, it’s considered to be a research
report. A Supervisory Analyst (Series 16) is responsible for approving research reports concerning debt and
equity securities, as well as other research-related communications.
Written Supervisory Procedures Firms are required to create a manual that’s designated as Written
Supervisory Procedures (WSP). This document details the regulatory structure of a firm and establishes a
member’s policies and procedures as well as those for the personnel who are responsible for their implementation.
FINRA rules concerning research analysts and research reports concentrate on the following areas:
 The relationship between the research department and other departments of the broker-dealer
 Restrictions on communication between the research department and the subject company
 Restrictions on publishing research reports and making public appearances
 Personal trading restrictions by research analysts
 Disclosure requirements in research reports and public appearances
Investment Banking and Research Department Control Issues

The information barriers that separate research and investment banking departments of a broker-dealer must be
reinforced through the supervision of these areas, including a member’s written supervisory procedures. A
member’s investment banking department is restricted from exercising any level of control over its research
department, particularly in the preparation of research reports.
The supervision and approval of reports must be conducted exclusively by supervisory personnel in the
research department. Review and approval mechanisms, whereby a member’s investment banking department or
any other non-research department has review or veto power over research reports, are strictly prohibited.

CHAPTER 4 –SUPERVISION OF RESEARCH SERIES 24
The narrow exception to this rule applies to instances where it’s necessary to consult the investment banking or
other non-research departments to review information that’s contained within a report for accuracy or to avoid
conflict. In these cases, oral and written communications for the purpose of verification and avoiding conflict
are limited. Written communications must be routed through the member’s legal or compliance department, or
copied to legal or compliance. Oral communications must be transmitted through legal or compliance
personnel, or conducted in the presence of a representative from one of these two departments.
Communications between research and investment banking departments and other non-research departments are
limited to the situations just described. Communications that are not related to verification or conflict avoidance
are prohibited. A provision outlining such prohibitions should be included in the firm’s written supervisory
procedures, and any supervisory review of correspondence should take this strict prohibition into account.
The Small Firm Exception In many smaller firms, personnel may act in a dual capacity (e.g., an investment
banker is also a research analyst). In this case, under the amended rules, the firm needs to hire additional personnel
to comply with the requirement to separate its research and investment banking departments. For a smaller
firm, such a requirement would create significant costs and a greater burden. Therefore, these smaller member
firms are offered an exception to the gatekeeper rules that prohibit member firm personnel in the investment
banking department from acting in a supervisory role over research analysts, and for the legal and compliance
department to be an intermediary between the two departments.
This exception is given to member firms that, over the previous three years, on an average per year, have
participated in 10 or fewer investment banking transactions or underwritings as manager or co-manager and
have generated $5 million or less in gross investment banking services revenues from those transactions. Firms
that use this exemption must maintain records of any communication that’s normally subject to review and
monitoring for three years. However, the Small Firm Exception doesn’t apply to restrictions on
communications between the research department and the issuer. Also, under this exception, the term
investment banking services doesn’t include municipal securities transactions.
Research Reports Prior to the Effective Date

The following rules are designed to provide a safe harbor for broker-dealers that publish research reports
around the time of public offerings. Related to new issues of securities, the Securities Act of 1933 defines a
research report as written communication that includes information, opinions, analysis, or any
recommendations with respect to securities of an issuer, regardless of whether this information provides a
reasonably sufficient basis for an investment decision.
Rule 137 – Persons Not Participating in an Offering Under certain circumstances, a broker-dealer may
distribute or publish research reports for securities that are in the registration process. These research reports
may be distributed or published by a broker-dealer that’s not a participant in the distribution (meaning the
broker-dealer may not receive or have received payment from the issuer, a selling security holder, or another
participant in the distribution). This allows a firm that’s not a member of the syndicate to issue a research report
during the cooling-off period. The research report will not constitute an offer as long as no type of consideration
(monetary or otherwise) has been received by the broker-dealer from members of the distribution.

An exception to the prohibition of payment exists for independent research and the regular subscription price for
the research report. The broker-dealer must also publish or distribute research reports in the regular course of its
business. Under Rule 137, in order for a broker-dealer to distribute a research report for securities that are in
the registration process, the issuer (over the previous three years) cannot have been a blank-check company, a
shell company, or an issuer for a penny stock offering.
Rule 138 – Non-Equivalent Securities If a registration statement has been filed for a non-convertible debt
security or a non-convertible preferred stock, a broker-dealer may, even if it’s a participant in the distribution,
publish or distribute a research report regarding the common stock and convertible securities of the issuer in
the normal course of business. If the registration statement covers common stock, convertible debt, or
convertible preferred stock of an issuer, a research report may be published or distributed regarding the non-
convertible debt or non-convertible preferred stock of the issuer.
Rule 139 – Research Reports If an issuer is subject to the reporting requirements of the Act of 1934 or is a
well-known seasoned issuer, a broker-dealer may publish or distribute a research report regarding the issuer’s
securities, even if it’s a participant in the distribution as long as certain conditions are met.
For research reports regarding a specific issuer, the report must be distributed by the dealer with reasonable
regularity in the normal course of coverage of the issuer or its securities. In addition, the report may not
represent an initiation of coverage on the company. For research reports regarding a specific industry, the
report must contain information about a substantial number of issuers in the industry and a comprehensive list
of securities that are currently recommended by the broker-dealer publishing the research report. The material
regarding the issuer or its securities cannot be given greater prominence than that given to other securities.
The broker-dealer must publish or distribute research reports in the regular course of business and similar
information that’s present in the report should also be present in other reports being published about the issuer or
its securities, and distributed by the broker-dealer. Under this rule, a research report that’s published or distributed
by a broker-dealer in conjunction with a Rule 144A offering (an offering sold only to QIBs) by a well-known
seasoned issuer is not considered an offer for the sale of the security or advertising. Similarly, a research report
that’s published or distributed by a broker-dealer regarding a Regulation S offering (an offering to investors
outside the U.S.) is not considered a selling effort and doesn’t conflict with offshore transaction requirements.
Communication with the Subject Company

Members cannot submit research reports to the subject company, except for the sole purpose of fact verification,
and then only the relevant sections may be transmitted. The full draft of the report must be sent to the member’s
legal or compliance department prior to the excerpt being sent to the subject company. If any changes are to be
made subsequent to the submission of the relevant sections to the subject company, the legal or compliance
department must be notified, and all drafts and revisions kept on file. Additionally, a subject company cannot be
notified of a change in rating until after the close of trading one business day before the public announcement.
Solicitation of Investment Banking Business Research analysts are prohibited from participating in the
solicitation of investment banking services. Investment banking services are defined as acting as an underwriter
or selling group member in an offering for an issuer. It also includes acting as a financial adviser in a merger or
acquisition, providing venture capital or equity lines of credit, private placements, private investment in a public
equity (PIPE), or serving as a placement agent for an issuer.

Solicitation includes participating in pitch meetings with clients with whom the investment banking
department may want to do business. This restriction lessens the chance of a research analyst having a conflict
of interest with the investment banking department and its goals to cultivate business, while possibly attempting
to remain unbiased in its review of that company or other companies within the same sector.
For example, John, Diana’s former supervisor, asked her to accompany him and
other members of the investment banking department to a meeting with Phone System
Gateway Inc. (PSG). PSG is a private company that intends to conduct an initial
public offering of securities. Investex wants to act as an underwriter in PSG’s IPO.
Diana is not allowed to participate in the meeting because the primary goal of the
meeting is to solicit investment banking business from PSG.
Road Shows Another form of solicitation (offer) for an investment banking service transaction is a road show.
A road show encompasses meetings with prospective customers and brokers that are generally held by an
investment banker and an issuer before a securities offering. A research analyst is prohibited from participating in
a road show that’s connected with an investment banking service transaction. Due to the goal of a road show, a
research analyst may feel pressured to say positive or optimistic things about the transaction that may not be true.
For example, Vanderpool Securities is the managing underwriter for the IPO of Toy
Poodle America, Inc. and is doing road shows on the East Coast. Jennifer is the
research analyst at Vanderpool who prepares research on Toy Poodle. She cannot
attend road shows pertaining to the IPO of Toy Poodle.
Three-Way Communications Other instances in which a research analyst may feel pressured to make positive
comments include communications with customers that may also include personnel from the investment banking
department or personnel from the issuing company. SRO rules have prohibited these types of communications. A
research analyst is prohibited from communicating with a customer or prospective customer regarding an investment
banking services transaction in the presence of investment banking personnel or personnel of the issuing company.
These types of communications are considered three-way communications.
For example, Morton, a research analyst at Foundling Frontier Securities, who

prepares research on Marble Securities, is at a research conference speaking with a
customer. As he begins to discuss the M&A between Greene Investments and Marble
Securities, the CEO of Marble Securities approaches the two. Morton cannot continue
to discuss the M&A while in the presence of the CEO of Marble Securities.
The prohibition of three-way communications also aims to prevent customers and prospective customers from
identifying a research analyst as a part of the investment banking department and their efforts to solicit
business for investment banking service transactions.
To isolate research analysts from the investment banking department, investment banking department personnel
are prohibited from, directly or indirectly, directing a research analyst to participate in the sales and/or marketing
efforts for an investment banking service transaction or to communicate with a customer or prospective customer
about an investment banking service transaction.

For example, Lauren is the director of the investment

banking department at Cash & King Investments. Her
firm is a managing underwriter for an upcoming
secondary offering. She contacts Kaleb, a research
analyst who prepares research reports on the issuer, to
assist the investment banking department with
contacting customers to discuss the secondary offering. In
this example, Lauren is violating SRO rules. Kaleb
cannot participate in contacting customers to discuss the
secondary offering.
The prohibition against investment banking department personnel directing research analysts follows the
separation of control of research and relieves pressure on a research analyst to provide overly positive
information regarding an investment banking service transaction.
Under certain circumstances, a research analyst is permitted to communicate with both prospective and
existing customers and personnel of her member firm about research and investment banking service
transactions; however, that information must be fair, balanced, and not misleading. (The communications must
be outside of the presence of personnel of the investment banking department and personnel of the issuing
company.) A research analyst’s job is to provide accurate and unbiased information regarding an issuer and
that issuer’s securities. By allowing communications under the premise that they’re fair, balanced, and not
misleading, a research analyst may objectively do her job.
For example, the CEO of Donnelly Investments called a meeting that
included different company personnel to discuss the merger between Simon
Systems, Inc. and Joliet Methodology, Corp., which was a recent news item
released to the media. Donnelly Investments is an investment banker that’s
involved in the M&A transaction. Larry is a research analyst at Donnelly
Investments who has been called to the meeting to discuss Simon Systems,
on which he prepares research. Larry may speak at the meeting about
Simon Systems and the M&A between the two companies because it has
been released to and discussed in the media, but only if there are no
personnel from the investment banking department or issuer present.
Quiet Periods
To further delineate investment banking business from research recommendations, the rules incorporate a quiet
period during which the investment banking client cannot be the subject of a research report or public
appearance. The quiet period rules apply to both initial public offerings and secondary offerings. For purposes
of this rule, an initial public offering is defined as the initial registered equity security offering by the issuer,
while a secondary offering is defined as an offering by persons other than the issuer (e.g., selling shareholders) and
registered follow-on offerings by the issuer.
The quiet period provision is designed to prevent an analyst from providing a favorable rating or making a
public appearance immediately following the offering. During this quiet period, the participating broker-
dealers (which includes both syndicate and selling group members) are prohibited from publishing or
distributing research reports or making public appearances for the subject security, and the firm’s analysts are
prohibited from making public appearances regarding the issuer of the security.

The length of the quiet period will depend on both the nature of the transaction as well as the entity that issues the
research. The rule uses the term “from the date of the offering,” which is defined as the later of the effective date
of the registration or the first date on which a bona fide offering of the securities is made to the public.
The relevant periods are as follows:
For Initial Public Offerings (IPOs)
Quiet Period for Manager/Co-manager Quiet Period for All Other Participating Firms
10 calendar days 10 calendar days
For Follow-On (Secondary) Offerings

Quiet Period for Manager/Co-manager Quiet Period for All Other Participating Firms
Three calendar days No restriction
Note: For secondary offerings, the quiet period doesn’t apply to issuers whose securities are under continuous
coverage by the broker-dealer and are actively traded as defined under Regulation M of the Securities
Exchange Act of 1934. This applies to both research reports and public appearances. As defined in the
Underwriting chapter, actively traded securities are those that have an average daily trading volume (ADTV)
of at least $1 million, and issued by an entity whose common equity securities have a public float of at least
$150 million.
Significant News Exception to Quiet Periods The occurrence of significant news or events will allow for
research reports to be published or public appearances to be made during quiet periods. This is referred to as
the Hot News Exception. However, any firm that uses this exception must obtain the authorization of its legal
and compliance department.
Significant news items or events are those that make a material impact or material change in a company’s
financial condition, operations, or earnings, and require the filing of SEC Form 8-K. Examples include the
resignation of a chief executive officer or a regulatory investigation regarding a company’s activities.
However, a general announcement regarding a company’s earnings is not considered a significant news
exception under the quiet-period rules.
For example, two days after the initial public offering of a technology company, the CEO
of the company suddenly resigns. A research analyst who’s employed at the firm that was
the managing underwriter could comment on how this may impact the company. The
analyst could write a research note and/or participate in a public appearance.
Unregistered Offerings The quiet period following secondary offerings doesn’t apply to unregistered
offerings. Therefore, there’s no quiet period regarding private placements of 144A securities and offerings
outside of the U.S. conducted under Regulation S.

Emerging Growth Companies

FINRA’s research rules conform to the requirements of the Jumpstart Our Business Startups (JOBS) Act. This
only applies to an issuer of securities that’s defined as an emerging growth company (EGC). An EGC is a
company with total annual revenues of less than $1 billion (as indexed to inflation) during the most recently
completed fiscal year.
The following two provisions apply to EGCs:

1. In connection with the initial public offering (IPO) of an EGC, the prohibition against a research analyst
participating in a pitch meeting with investment bankers is not applicable. Also, the prohibition from joint due
diligence meetings is not applicable if it relates to an IPO. However, all other restrictions concerning non-IPO
solicitations of investment banking business by research analysts remain in place.
2. The three-day and 10-day quiet periods that restrict a research analyst’s ability to publish a research report or
make a public appearance concerning a securities offering have been eliminated. Therefore, immediately
following an IPO or secondary offering, a research analyst is permitted to write a research report or make a
public appearance.
Compensation and Personal Trading

Analyst Compensation
As previously described, the personnel from investment banking are not permitted to influence the
compensation of research analysts. In addition, compensating analysts based on specific investment banking
deals, or on a percentage basis for investment banking deals, is strictly prohibited. Deal-related bonuses are
similarly prohibited. Instead, compensation should be based on an analyst’s overall contribution to the firm.
Member firms and their supervisory personnel should be able to document a totality of performance-based
compensation factors to avoid the appearance of impropriety or a charge of rule breaking. If an analyst’s
compensation is in any way based on the member firm’s investment banking revenue, this fact must be
disclosed in any research reports that are authored by that analyst.
Compensation Committee Member firms are required to form a compensation committee that will be
responsible for reviewing and approving the compensation of the firm’s research analysts. The analysts whose
compensation will be reviewed are those who are primarily responsible for the preparation of the substance in
a research report.
This compensation committee:

 Must review and approve (at least annually) the analyst’s compensation
 Must document the basis on which the research analyst’s compensation was established
 Must report to the board of directors (BOD) or, if the member firm has no BOD, a senior executive officer of
the firm
 Is not permitted to include any representative from the member firm’s investment banking department
Factors that the compensation committee will take into consideration when reviewing an analyst’s
compensation include the following:
 Individual performance of the analyst including productivity and the quality of the work

 Correlation between the analyst’s recommendations and the performance of the securities recommended
 Review of a spectrum of ratings from clients, the sales force, and other internal or external professionals,
excluding the investment banking department and independent rating services
Any analysts who are not primarily responsible for the substance of a research report (e.g., a junior analyst
who simply reports to the lead analyst) are exempt from the compensation committee’s review.
Personal Trading
A member firm’s written polices and procedures must contain personal trading limitations and restrictions that
relate to trading in securities or the derivatives of such securities whose performance is materially dependent
upon the performance of securities that are covered by the research analyst (RA). This rule applies to a research
analyst’s account, supervisors of research analysts, as well as associated persons with the ability to influence the
content of research reports. Examples of RA accounts include a joint account with a member of an RA’s
household, acting as custodian for a UTMA (minor’s) account, or one in which the RA has discretionary
authority. A research analyst’s household includes any person whose principal address is the same as the RA’s,
but not an unrelated roommate.
A person with the ability to influence the content of research reports includes a person who can review and
change a research report prior to it being published, but doesn’t include legal and compliance professionals
who are reviewing the report for compliance purposes. The rationale is that these compliance professionals are
not able to dictate a rating, recommendation, or price target.
The objective of these policies and procedures is to ensure that these individuals don’t benefit in their trading
from knowledge of the content or the timing of a research report before the intended recipients of the research
have had a reasonable opportunity to act on the information in the research report. The personal trading
restrictions only apply to securites that are covered by the research analyst. An RA is permitted to invest in a
mutual fund which holds securities that are covered by the analyst.
Inconsistent Trading A research analyst’s household is prohibited from buying or selling any security or any
option/derivative of such security in a manner that’s inconsistent with her own or her member firm’s
recommendations as reflected in the most recent research report that was published by the firm. An analyst who
has made a buy recommendation is permitted to buy or hold the security, but cannot sell or sell short that security.
For example, Pamela prepared an initial research report on The Bottle-Neck

Group and included a buy recommendation. A few days later, she entered an order
with her broker to sell her shares in The Bottle-Neck Group. In this situation, she’s
trading in a manner that’s inconsistent with her recommendation.
An analyst is also considered to be trading in a manner that’s inconsistent with a research report if she includes
a hold, neutral, or market perform rating in a report and then trades the subject security. Instead, the research
analyst who owns the security should hold the security as recommended in the report.
For example, Dan prepared a research report on the Franklin Food Corporation
with a hold recommendation. If Dan currently owns Franklin Food shares, he
cannot sell them. Also, if Dan doesn’t own shares of the issuer, he cannot buy or
sell short any securities of Franklin Food.

If an analyst trades in a manner that’s contrary to his advice to the public, it gives the impression that the analyst
was untruthful in his research and provided a fraudulent recommendation in the report. However, even in the
absence of an obvious conflict, an analyst’s personal trading habits will certainly have an impact on the way his
recommendations are perceived. Although an analyst who owns a security and gives a buy recommendation to the
public is providing advice that’s consistent with his own investments, this situation creates a clear conflict of
interest nonetheless. Since a buy recommendation will typically result in an increase in the share price of a subject
security, the positive impact that the report will have on the analyst’s personal holdings may undermine the public’s
trust in the report. The rule is designed to eliminate the appearance of conflicts that may be created when an analyst
comments on securities in which he has a personal interest.
Lastly, an analyst with a sell recommendation or a short position in a stock is neither permitted to buy the
security, nor is the analyst permitted to affect a short sale while maintaining a hold recommendation.
Financial Hardship Circumstances The following situation may occur at a broker-dealer. A research analyst
has a buy recommendation of LRR stock and owns shares of this security. But, what if the analyst has an
unanticipated and significant change in her financial condition and needs funds? Her sale of shares of LRR to
raise funds will be prohibited under the rules. FINRA’s research rules allow a firm to define financial hardship
circumstances which will permit the analyst to sell LRR despite the fact that it may be trading in a manner
inconsistent with her most recent recommendation.
Divesting Research Analyst Holdings The following situation may also occur at a broker-dealer. A person
who’s employed by the ZBT Corporation—which is listed on the NYSE—owns shares of the company and is
hired as a research analyst by a broker-dealer. The firm has an internal policy that prohibits its analysts from
holding securities that they also cover. Without exception, if the analyst covers ZBT, she’s not permitted to
divest her holdings (sell securities) and also have a buy rating on ZBT.
FINRA permits a research analyst account to trade in a manner that’s inconsistent with a research analyst’s
recommendation if the firm has instituted a policy that prohibits any research analyst from holding securities,
or options or derivatives of such securities, of the companies in the research analyst’s coverage universe.
The rule specifies that the member must establish a reasonable plan to liquidate such holdings that’s consistent with
the analyst not being able to benefit in his trading from knowledge of the content or the timing of a research report
before the intended recipients of the research have had a reasonable opportunity to act on the information in the
research report. In addition, this plan must be approved by the firm’s legal or compliance department.
Pre-IPO Shares Research analysts are prohibited from purchasing or receiving shares of a company in the
same sector that they cover prior to its initial public offering (pre-IPO shares). A sector is considered a subset
of a market such as utilities, transportation, and health care. Since analysts typically have access to important
information within the sector they cover, the information could alert them to the potential success of a
particular IPO and could create a clear potential conflict. This prohibition against pre-IPO shares is designed to
prevent associated persons and their household members from being able to purchase stock at a discount and
then sell it once the company goes public. A secondary concern is that the analyst may find it difficult to be
critical of a company if he holds pre-IPO shares.
The Firm’s Internal Polices In the past, FINRA established guidelines in terms of the number of days prior
to, or after, the publication of a research report that a research analyst was prohibited from purchasing or selling
a security that was the subject of the report. However, it decided on a different approach.

FINRA now requires the firm to create its own policies and procedures to ensure that their employees who are
covered by this rule (and their household members) don’t benefit in their trading from knowledge of the content
or the timing of a research report before the intended recipients of the research have had a reasonable
opportunity to act on the information in the research report.
Research Reports and Public Appearances Disclosures

Research Reports Research report disclosures must appear on the first page of the publication or refer to
the page on which they appear, and must not be written in a reduced typeface. However, if a member publishes a
report that makes recommendations on six or more subject companies, the report may clearly and prominently
direct the reader to where the required disclosures can be found in either an electronic or written format.
The mandatory disclosures must include the following:

 Whether the analyst (or a member of the analyst’s household) has a financial interest in the securities of
the subject company (i.e., holds shares, warrants, or options contracts of the subject company)
 Whether the firm has ownership of the subject security and whether such ownership is 1% or greater of the
outstanding stock of the subject company. Ownership must be determined as of the end of the month
directly preceding publication of the research report, allowing for a 10-day calculation period. If the report
is published less than 10 days from the end of the month, a member may ascertain ownership based on the
second-most-recent month.
 Disclosure of whether the firm makes a market in the subject security
 Any material conflict of interest about which the analyst or member knows or has reason to know
 Whether the member has received compensation for investment banking activity from the subject
company during the 12 months preceding publication, or expects to receive or seek compensation in the
three months following publication
 Whether the analyst or any member of the analyst’s household is an officer, director, or advisory board
member of the subject company
Disclosure Specifics The rules also affect the language and format of recommendations that are contained
in research reports, and the information that must accompany such recommendations. Members must clearly
outline the rating system used and must define each rating. The definition of each rating must be consistent
with its general meaning.
Members must also disclose the following:

 The percentage of all securities the firm has rated in each category (buy, hold, and sell)
 The percentage of subject companies within each rating category that are investment banking clients of the
firm or have been within the past 12 months
For example, an analyst publishes a report recommending a buy on ABC Corp. That
report must also include the fact that the analyst’s firm has made a buy recommendation
for 80% of the companies rated, and that 40% of those buy recommendations are
investment banking clients of the firm. This information may be of interest to investors
when determining how much credibility to give a particular recommendation.
 A clear and complete explanation of the rating system it uses, and what each particular rating means
 A rational basis for the recommendation and supporting analytical data

 A price chart of actual performance for the last three years and the firm’s recommendations on the
security that’s the subject of the research report (subject security), including an indication of instances in
which the member’s rating or price target has changed for any subject security the member has rated for
one year or longer
 The current market price of the subject security at the time of the recommendation
 Possible risks that may impede the security achieving the target price
A price target or recommendation is optional and therefore not required. If a price target appears on the report,
the valuation method used must be disclosed.
Language in a Research Report The regulators have published guidance concerning the use of language
in written communications with the public (research reports). Promissory, exaggerated, and flamboyant
statements are considered prohibited since they’re misleading. Investors reading this type of language may buy or
sell based on emotional, rather than a reasoned basis.
One of the concerns is improperly promoting the successful performance of past research recommendations in
written communication. It’s permissible to provide the price history of a specific security, but it’s not permissible
to mention the fact that the broker-dealer recommended the security at a lower price. If a communication
requires disclosure of the firm market-making activities, the only acceptable disclosure is, “We make a market
in the security.”
Globally Branded/ Mixed Team Research Reports Any research report that’s distributed in the U.S. is
required to be approved by a supervisory analyst or registered principal. Registration is not required of a
research analyst who’s employed by the foreign affiliate of a member firm and who contributes to a globally
branded research report. The term globally branded research report refers to use of a single marketing identity
that encompasses the member firm and one or more of its affiliates.
Additional disclosure requirements concerning globally branded research reports include the name of the
affiliate(s) that contributed to the report, the names of the foreign analysts who contributed to the report, and a
statement that such analysts are not qualified by examination in the United States.
The term mixed-team research report refers to any research report by a member firm that’s not globally branded
and includes a contribution by a research analyst who’s not considered an associated person by the member firm.
Registration in the U.S. is required of a research analyst who’s employed by the foreign affiliate of a member
firm and who contributes to a mixed-team research report.
Externally Prepared Research Reports Externally prepared research reports that are distributed by
broker-dealers will fall into one of two distinct categories:
1. Third-party research or
2. Independent third-party research
A third-party research report is one that has been prepared by an affiliate of the broker-dealer. This form of
research report must be approved by a supervisory analyst or an approved supervisory person of the broker-
dealer (e.g., a General Securities Principal).

Additionally, third-party research must include the following disclosures:

 Whether the broker-dealer has received compensation from the subject company within the preceding 12
months, or expects to receive compensation in the upcoming three months for investment banking services
related to the subject company
 Whether the broker-dealer makes a market in the subject company
 Whether the broker-dealer owns 1% or more of the subject company’s equity securities
 Any other material conflicts of interest
For example, in order to provide research on several companies to its customers, a
broker-dealer has requested analytical reports from an affiliated analysis-provider.
The reports are classified as third-party research reports and must be approved by
a supervisory analyst or approved supervisory person of the broker-dealer.
An independent third-party research report is one that has been prepared by a person or firm that 1) has no
affiliation or contractual relationship with the disturbing member, and 2) makes content determinations without
any input from the distributing member or that member’s affiliates. Since the distributing broker-dealer has no
editorial control over the content of the report, approval by a principal of the broker-dealer is not required. Any
required disclosures within the report must be based on the firm that prepared the report, rather than the firm
that’s distributing it.
For example, a broker-dealer that intends to provide information to its interested

customers has requested research on the biotech industry from an unaffiliated
analysis-provider. If the broker-dealer has no influence or editorial control over the
content of the reports, the reports are considered to be independent third-party
research and don’t require the approval of a supervisory analyst of the broker-dealer.
Public Appearances A public appearance is defined as any conference call, seminar, or public speaking
engagement that’s delivered to 15 or more persons, or one or more representatives of the media (radio, TV, or
print media interview) in which a research analyst makes a recommendation or offers an opinion concerning
an equity security.
The rule brings television and radio interviews and other public speaking activities (seminars and electronic
interactive forums) under the umbrella of public appearances for the purposes of disclosure. A television
interview is a public appearance regardless of how many people are interviewing the analyst. However, an internal
meeting is not a public speaking engagement and is not viewed as a public appearance.
The following disclosures are required during public appearances (including television and radio interviews during
which predictions may be made):
 Whether the subject company is an investment banking client of the member
 Whether the analyst (or a member of the analyst’s household) has a financial interest in the security that’s the
subject of the report (subject security)
 Whether the member firm has ownership of the subject security if such ownership is 1% or greater of the
outstanding stock of the subject company
 Any material conflict of interest about which the analyst or member firm knows or has reason to know
 Whether the analyst or any member of the analyst’s household is an officer, director, or advisory board member
of the subject company

Members must develop a procedure for disclosing the required information that’s contemporaneous with
public appearances. One way to address this issue is to draft a planned script for these appearances with the
appropriate disclaimers included, and review a transcript of the actual broadcast afterward to verify that the
disclosures were, in fact, made. In any case, each member whose analysts engage in such public appearances
must address the disclosure requirements in its written supervisory procedures.
Other Requirements
Promise of Favorable Research A research analyst or member firm cannot accept compensation from an issuer
to prepare a favorable research report. This includes any aspect of the research report. Any form of compensation
that’s received in return for favorable research, either in cash or promised business, constitutes a violation.
Termination of Research Coverage When a broker-dealer decides to terminate coverage on an issuer, the
firm must publish a final research report and provide the report to its customers in the same manner that’s
ordinarily used when distributing material. The final report must be similar in scale and scope to its past reports
and must include a recommendation, unless it’s impractical to do so. If a final recommendation is not available,
the broker-dealer must disclose its reason(s) for terminating research on the issuer and or security. However, a
broker-dealer that terminates coverage is not required to discontinue market making in the issue.
Transactions by Research Analyst Supervisors The personnel of a member firm who oversee the
activities and approve the research reports of research analysts must also obtain approval for certain securities
transactions. The specific transactions involve the equity securities of companies about which the research
analyst (who a supervisor oversees) writes research reports. Examples of personnel who fall under this
category include the director of research, members of a committee, and supervisory analysts. All of these
individuals may have direct influence or control over the preparation of the substance of research reports and the
change in ratings or price targets of a company’s equity securities.
Anti-Retaliation Under the research rules, the anti-retaliation prohibition rule prevents a member firm from
directly or indirectly retaliating or threatening to retaliate against an analyst who publishes a research report or
makes a public appearance (to be described shortly) that may have a negative effect on the member’s
investment banking relationships.
Terminations Although a member firm cannot terminate the employment of its personnel out of retribution
or retaliation, a member firm may terminate an analyst under its terms of employment guidelines or policies
and procedures. The termination of an analyst may take place as long as it’s unrelated to issuing or distributing
negative research findings or making an unfavorable public appearance.
Regulation AC (Analyst Certification)

Under Regulation AC, research analysts are required to make certifications regarding conflicts of interest
that relate to the preparation of a research report. Also, a broker-dealer that employs research analysts must
maintain records regarding public appearances that are made by its personnel who prepare research reports.
Specifically, a research analyst must make a statement which certifies that the views in the research report
accurately describe his personal views about the subject issuer’s securities and must include a statement that
certifies one of the following:
 None of his compensation is, was, or will be related to his recommendations or views expressed in the research
report, or

 Part or all of his compensation, is, was, or will be related to his recommendations or views expressed in the
research report
If the last statement is certified, the research analyst must provide the source, amount, and purpose of the
compensation. Also, a statement must be included in the report which informs readers that the compensation
may influence the recommendation or views expressed.
A broker-dealer that’s required to maintain records of public appearances by its personnel is one that publishes,
circulates, or provides research prepared by its research analysts. Records must be created within 30 days after
each calendar quarter in which its research analysts make a public appearance.
The records must include:

 A statement by the research analyst who’s performing the certifying that the views he expressed in his public
appearance(s) during the calendar quarter reflected his personal views about the subject securities or issuers
 A written statement by the research analyst who’s performing the certifying that no part of his compensation is
or will be related to the views expressed or recommendations made in his public appearances during the last
calendar quarter
If a broker-dealer doesn’t obtain the certifications regarding public appearances, it must notify its designated
examining authority (DEA). Also, for the next 120 days, it must disclose in any research report which is
prepared by the analyst that it did not provide certifications regarding public appearances. Records pertaining to
missing compensation statements must be maintained in accordance with the books and records requirement.


Chapter 5
General Supervision

CHAPTER 5 – GENERAL SUPERVISION SERIES 24
All member firms are required to have regulatory structures in place that include both the supervision of
physical locations and personnel. In addition, employees must hold the proper registrations to perform
their assigned job functions. This chapter will detail some of the general rules and regulations
surrounding the supervision of a broker-dealer.
Written Supervisory Procedures

Under FINRA rules, all policies and procedures that are used to supervise a firm must be established in a written
supervisory procedures (WSP) manual. The manual covers the scope and nature of the firm’s business activities,
its methods of operation, and specifies the detailed responsibilities of all supervisors and the review procedures it’s
required to follow. The procedures must be designed so that the designated supervisor can implement the plan and
is able to detect and prevent violations of the procedures. A copy of the written supervisory procedures must be
kept in each office or location in which supervisory activities are conducted.
The written procedures also must explain the method by which completed supervisory reviews are
documented. If the supervisory manual calls for a specific review procedure, the supervisor must not only
follow the procedure, but must also document it. The supervisory manual includes the titles, registration status,
and location of supervisory personnel and their responsibilities. A record of the names of supervisory
personnel and the dates on which their designation became effective must be prepared and maintained for three
years; however, for the first two years, the record must be kept in an easily accessible location. Amendments
must be made within a reasonable time after changes occur in rules or regulations.
Supervision of Registered Representatives

The business of FINRA members is carried out through their registered representatives. Therefore, oversight of
the activities of registered representatives is a key part of any supervisory system. Supervisory rules require the
following responsibilities.
Assignment of Each Registered Representative to a Supervisor Supervisory rules require each

registered representative to be assigned to a specific supervisor. That supervisor is required to review the activities
of the registered representative and be reasonably certain that the applicable rules and regulations are followed.
The nature of this review will depend on the area in which the representative works. The requirement for a
representative to be assigned to a particular supervisor exists to ensure that a person is designated as responsible
for the activities of that person. If the regulators find that a representative has violated an industry rule, their next
question is certain to be, “Who was assigned to supervise that person?”
Registration of Representatives All persons who are engaged in the investment banking or securities
business of a member firm must be registered, with the exception of individuals whose activities are solely
clerical or ministerial. Member organizations must investigate the good character, business repute,
qualifications, and experience of personnel whom they intend to register with FINRA.

SERIES 24 CHAPTER 5 – GENERAL SUPERVISION
Corequisite and Representative Qualification (Top-Off) Exams

In 2018, FINRA implemented a corequisite exam titled the Securities Industry Essentials (SIE) Exam. This
introductory-level exam assesses a person’s knowledge of basic securities industry information including
concepts that are fundamental to working in the industry, such as types of products and their risks; the structure of
the securities industry markets, regulatory agencies and their functions; and prohibited practices.
In order to become registered to engage in securities business, an individual must pass the SIE Exam and a
qualification (Top-Off) exam that’s appropriate for the type of business in which she will engage. Any person
who’s the age of 18 or older can take the SIE Exam without sponsorship of a member firm; however,
qualification exams (e.g., Series 6 or Series 7) can only be taken by individuals who are associated with a
member firm. Let’s review the different qualification exams and what they allow.
Series 6 – Investment Company Products/Variable Contracts Representative
Allows a representative to sell open-end investment company (mutual fund) securities, closed-end fund shares
during the distribution period, variable annuities, and variable life insurance.
Series 7 – General Securities Representative
Allows a representative to solicit, purchase, and/or sell all securities products (e.g., stocks, bonds, options,
investment company products, and variable contracts).
Series 52 – Municipal Securities Representative
Allows a representative to open accounts for, and execute transactions in, municipal securities.
Series 57 – Securities Trader Representative
Allows a representative to trade equity and/or convertible securities on an agency or principal in the over-the-
counter market; may also be taken by a person who supervises traders.
Series 79 – Investment Banking Representative
Allows a representative to advise on or facilitate equity or debt offerings, mergers and acquisitions, tender offers,
asset sales, or business combination transactions.
Series 99 – Operations Professional
Allows a person to perform the critical functions of an operations professional, including customer onboarding;
financial control; receipt and delivery of securities and funds, account transfers; and collection, maintenance,
reinvestment and disbursements of funds.
State Registration In addition to ensuring that each RR is properly registered under FINRA rules, supervisors
must be sure that RRs are also properly registered as agents in each state in which they do business. Most states
require representatives to submit the proper application and fees, as well as pass the Series 63 Examination
(which covers Uniform Securities Act—also referred to as state securities law or the Blue Sky Laws).

A potential red flag state law issue is splitting commissions. To split, each RR involved must have the proper
state registrations. Also, if a customer moves to another state, but retains the same representative, the RR may
need to obtain the required state registration to continue to service the account. At the state level, each security
sold to a customer must either be registered (blue-skyed) under state law or be exempt from registration. If more
than one state is involved (such as when the representative is in one state and the client is in another), the
security must generally be registered or exempt in each jurisdiction.
Waiting Period of Unsuccessful Candidates Registrants who fail a FINRA examination on three
consecutive attempts must wait six months to retake that exam. Please note, movement to another employer
DOES NOT alter this six-month retesting window for a candidate who has failed a given exam on three
consecutive attempts.
Exam Confidentiality FINRA considers the content of its qualification exams confidential. Any person who
violates the confidentiality rules of an exam is subject to sanctions under the Code of Procedure. Sanctions
may include the suspension or revocation of an RR’s registration. Under FINRA rules, it’s a violation to:
 Remove an exam or a portion of an exam from an examination center
 Reproduce parts of an exam
 Disclose details of an exam or receive parts of an exam from another person
 Compromise the contents of a past or present exam in any way
Form U4
The application for an individual’s registration is Form U4—the Uniform Application for Securities Industry
Registration or Transfer. Form U4 is filed with and reviewed by the FINRA’s Central Registration Depository
(CRD). The CRD is a computerized information system that FINRA maintains to provide registration information
regarding broker-dealers and registered representatives to state regulators, other SROs, and the SEC. Certain
information about the disciplinary history of registered representatives may be requested from the CRD through a
toll-free telephone number or FINRA’s public disclosure program BrokerCheck (described later). A broker-dealer
must notify its customers annually that the disciplinary history of its registered personnel is available.
On Form U4, the applicant must answer questions about personal data, including residential and business
history. In addition, the form contains a series of questions about the applicant’s history with respect to
violations of laws or SRO rules. For example, applicants are asked whether the SEC has ever entered an order
against them in connection with an investment-related activity. A Yes answer to some of these questions could
lead to a statutory disqualification. By signing Form U4, a registered person agrees to file timely amendments if
information on the form changes.
Review of New Hires Each member firm is required to establish and implement written procedures that are
reasonably designed to verify the accuracy and completeness of the information contained in an applicant’s initial
or transfer Form U4.
This review must take place by no later than 30 calendar days after the form is filed with FINRA. At a minimum,
these procedures must provide for a search of reasonably available public records to be conducted by the member, or
a third-party service provider, to verify the accuracy and completeness of the information contained in the applicant’s
initial or transfer Form U4.

FINRA retains jurisdiction over a registered representative for two years following resignation. For that reason, an
individual who wants to return to a brokerage firm as a registered representative without being required to requalify
with FINRA through examination is required to do so within that two-year period.
Disclosures by Applicant Form U4 contains a series of questions about the applicant’s involvement in any
of the following:
 Criminal legal proceedings
 Regulatory disciplinary actions A Yes answer to any item
 Civil judicial actions generally requires an explanation
 Customer complaints on the appropriate disclosure
 Terminations reporting page (DRP) of the U4.
 Financial events:
– Bankruptcies
– Liens or unsatisfied judgements
– Bonding denials
– Compromises with creditors (e.g., a short sale of an applicant’s home whereby the lender/creditor forgives
all or part of the outstanding debt)
If an applicant’s primary residence is in the process of being foreclosed by the bank, this is not a reportable event on
Form U4. Additionally, if a firm institutes a drug test for its RRs and an RR fails, this is neither a reportable item to
FINRA nor is it grounds for statutory disqualification. Instead, this is a matter between the employee and the firm.
Statutory Disqualification Statutory disqualification represents the denial of an application for registration
based solely on past transgressions, including:
 Being expelled or suspended from a self-regulatory organization
 Having a registration denied, suspended, or revoked by the SEC or another regulatory agency (including the
Commodity Futures Trading Commission and foreign regulators)
 Violating or assisting in the violation of any securities or commodities law, or the rules of the Municipal
Securities Rulemaking Board (MSRB)
 Failing as a principal or supervisor to reasonably supervise a subordinate who violates rules. However, this
doesn’t apply if (1) there was a supervisory system in place that would reasonably be expected to detect the
violation, and (2) the supervisor reasonably discharged supervisory duties under the system.
 Being convicted within the last 10 years of a felony or misdemeanor involving false reports, fraud, bribery,
perjury, crimes related to funds or securities, or any other felony
– This action could occur in a domestic, foreign, or military court
If a person is convicted of a felony and later pardoned, she must report the conviction on Form U4. The pardon
releases the individual from the punishment for a felony, but doesn’t remove the conviction.
Reporting of Felony Convictions versus Statutory Disqualification It’s important to note that only felony
convictions that occurred within the last 10 years may result in statutory disqualification; however, felony
convictions are always required to be disclosed on Form U4 regardless of how long ago they occurred. Again,
applicants are subject to statutory disqualification (SD) only if the felony occurred within the last 10 years, but
the reporting requirement is ongoing.

Reporting of Other Business Activity All persons who file a Form U4 are required to disclose any other
business activity if they’re employees, owners, directors, trustees, or agents. This disclosure includes the name
of the business, whether its investment related, the start date, and how many hours per month are devoted to
this business. Some examples include an RR obtaining a real estate or insurance license, working in a
restaurant, or being compensated for coaching a sports team However, if an RR’s spouse is engaged in outside
business activities, the RR is not required to notify the firm. In addition, unless an RR is actively involved in
rental property that she owns, any rental income received is not reportable as an outside business activity.
Any involvement in non-investment related activity for a charity (non-profit), civic, or religious organization
in not required to be disclosed. If that person was on the board of a charitable organization and the activity was
investment-related, it would be required to be disclosed.
Continued Employment of Statutorily Disqualified Persons If a broker-dealer is made aware that one
of its registered representatives is subject to statutory disqualification, the firm is required to notify FINRA by
amending the representative’s Form U4 within 10 days (an exception to the typical 30-day period). The firm
may either terminate the representative and file Form U5 or file an application for eligibility proceedings—the
Membership Continuation (MC400) application. Essentially, a broker-dealer cannot employ—in any
capacity—an individual who’s subject to statutory disqualification (often referred to as an SD) unless FINRA
gives that person permission to accept or continue in a position in the industry.
If the broker-dealer files an application for eligibility proceedings, it must be filed within 10 business days
with FINRA’s Department of Member Regulation. The department evaluates the application and makes a
recommendation to the National Adjudicatory Council (NAC) to approve or deny special permission. The
analysis of the application takes into consideration:
 The nature and gravity of the disqualifying event
 The length of time that has elapsed since the disqualifying event
 Whether any intervening misconduct has elapsed
 Any other mitigating or aggravating circumstances
 The nature of the securities-related activity in which the applicant wishes to participate
 The disciplinary history and industry experience of both the member firm and the person proposed by the firm
to serve as the responsible supervisor of the disqualified person
If the associated person is permitted to start/continue employment, the firm is required to institute heightened
supervisory procedures. The supervisor who’s responsible for an SD must include the procedures in the
application. The plan must also be tailored to the specific SD being supervised, but may include the following:
 Reviewing and approving of all of the SD person’s order tickets, incoming and outgoing correspondence, and
new account forms for suitability
 Keeping written records of all supervisory reviews and approvals
 Meeting periodically with the SD person to review his transactions with clients
 Immediately reviewing customer complaints, whether written or oral, and forwarding the complaints to the
firm’s Director of Compliance
If the NAC denies the request for permission to hire the SD person, the firm may appeal to the SEC. Even if the
application is approved by the NAC, it doesn’t take effect until the SEC has reviewed and approved the decision.

Fingerprinting Requirements Any employees of a broker-dealer must be fingerprinted if they:

 Engage in the sale of securities
 Regularly come in contact with money or securities
 Have access to the keeping, handling, or processing of securities, or the firm’s records of original entry
 Have direct supervisory responsibility over persons engaged in any of the previously listed activities
If the securities being sold by the broker-dealer don’t have a certificate (e.g., a variable annuity contract or a
mutual fund), the requirement to be fingerprinted may be waived for the appropriate persons. When an
individual submits Form U4 for examination registration, a fingerprint card is required for identification
purposes. Also, if a firm hires a foreign national and that person is applying to become registered, he’s required
to file a fingerprint card.
Please note, in order to add any direct owner/executive officer (e.g., a CEO) on Form BD, the individual must be
registered via a Form U4 or a Page 2 U4. The difference is that the Page 2 U4 registers the individual with the
firm without the individual having to take any examination, but it does require the individual to be fingerprinted.
Hard copies of the processed fingerprint cards (or any substitute record for cards that are not returned after being
processed) must be retained at the firm’s principal office for three years after a person’s termination with the firm.
Illegible Fingerprints At times, applicants may submit fingerprints electronically that are illegible. After three
successive good faith attempts to be fingerprinted, firms are not required to submit a fourth fingerprint card for
the individual. When the FBI identifies a third successive fingerprint card as “Illegible,” FINRA will request
for the FBI to conduct a search of its database based on the associated person’s name (Name Check), rather
than on the fingerprints submitted, to verify whether the database contains criminal history record information
(CHRI) on that individual.
Hiring from Disciplined Firms or Hiring Disciplined Individuals

The Taping Rule In some cases, firms may take advantage of an opportunity to hire personnel from a
competitor that’s being dissolved or undergoing difficulty. If a firm hires personnel from a member firm that has
been disciplined by a regulatory organization, special supervisory procedures often apply. Disciplined firms are
defined as those that have had their registration revoked or have been expelled by an SRO. Member firms that
meet the following criteria are subject to the Taping Rule:
 Employ at least five, but fewer than 10 registered representatives, where 40% or more have been employed by
one or more disciplined firms within the last three years
 Employ at least 10, but fewer than 20 registered representatives, where four or more have been employed by
one or more disciplined firms within the last three years
 Employ at least 20 registered representatives, where 20% or more have been employed by one or more
disciplined firms within the last three years
A broker-dealer must use special written procedures and begin the taping of conversations between its
registered personnel and customers for a period of three years. If a broker-dealer is notified by FINRA that it’s
subject to the Taping Rule, it has 60 days to comply by establishing the procedures and begin taping the of
conversations between its registered personnel and customers for a period of three years. The firm must also
create procedures for reviewing, retaining, and classifying the recordings. Finally, a report must be sent to
FINRA after each calendar quarter.

Exception A broker-dealer that’s subject to the Taping Rule has a one-time opportunity to reduce its staffing
levels below the previously described threshold levels to avoid the Taping Rule. The staff reduction must be
implemented within 30 days of the firm becoming a “taping firm.” After reducing its staffing levels, the broker-
dealer must notify FINRA. Thereafter, employees who have been terminated because of a reduction in staffing
levels under the Taping Rule cannot be rehired by the same firm for 180 days following the reduction.
Updating Form U4
Updating a Form U4 is required if a person has been convicted or charged, or pled guilty or no contest to any
felony or misdemeanor involving investments or an investment-related business or any fraud, false statements
or omissions, wrongful taking of property, bribery, perjury, forgery, counterfeiting, extortion, or a conspiracy
to commit any of these offenses.
Any unsatisfied judgments or liens (e.g., tax liens) against RRs must be disclosed to FINRA within 30 days
and must also be disclosed on Form U4. A person who has been arrested, but has not yet been charged with a
crime, is not required to report the event on Form U4 or to FINRA. However, most firms require notification if a
registered person has been arrested for any offense.
Form U5 After a registered person resigns or is terminated from a member firm, the firm is required to notify
FINRA within 30 days by filing Form U5—the Uniform Termination Notice for Securities Industry Registration.
Form U5 must include the reason that the RR left the firm as well as any applicable details. The form must be
updated within 30 days following termination if answers to certain questions change. The firm must also provide
the individual with a copy of the form. A firm is required to maintain both the initial filings and any updates to
Form U5 for a minimum of three years (in an easily accessible location for the first two of those years).
A firm has an ongoing obligation to update Form U5 if any information is inaccurate or incomplete. For example,
if a broker-dealer receives a written customer complaint after an RR has left the firm, it’s still required to notify
FINRA regardless of how long ago the RR had left the firm. However, there’s no requirement to send a copy of
the complaint to the RR. Also, since FINRA maintains jurisdiction over a person’s registration for two years after
she leaves a firm, the RR is required to notify FINRA of any change in address that occurs within that two-year
period. An individual who wants to return to a brokerage firm as a registered representative without having to
requalify by examination is required to do so within the same two-year window.
New Hire Who Was Previously Registered If a member firm hires a person was previously registered
with FINRA, the member firm must obtain and review the latest Form U5, including any amendments to the
form. Review of Form U5 must be completed within 60 days of the date that the person files an application
for registration.
Form U6 Regulators, states, and/or jurisdictions use Form U6 to report disciplinary actions against an RR or
firm. FINRA also uses Form U6 to report final arbitration awards against RRs and firms. As with Forms U4 and
U5, any information that’s processed on Form U6 feeds into the Central Registration Depository system and
some of the content may be available to the public through the BrokerCheck system.
Release of Disciplinary Information Information about the disciplinary history of a member firm or
registered representative is available to the public through BrokerCheck (FINRA’s public disclosure program).

BrokerCheck is a free website which provides information on individuals who are currently registered or have
been registered within the last 10 years. The information provided about individuals includes the following:
 The current employing firm, 10 years of employment history, and all approved registrations
 Certain legal and regulatory charges and actions brought against the RR, such as felonies, certain misdemeanors
and civil proceedings, and investment-related violations
 Formal investigations involving criminal or regulatory matters
 Written customer complaints alleging sales practice violations and compensatory damages of $5,000 or more
that were filed within the last 24 months
 Pending customer-initiated arbitrations and civil proceedings involving investment-related activities, any
arbitrations or civil proceedings that resulted in an award to a customer, and settlements of $15,000 or more in
an arbitration, civil proceeding, or complaint involving investment-related activities
 Terminations of employment after allegations involving violations of investment-related statutes or rules, fraud,
theft, or failure to supervise investment-related activities
If a person is currently registered and disagrees with information found on BrokerCheck. he must file an
amended Form U4 with FINRA. If an individual is not currently registered with FINRA (but was registered
within the last 10 years), he must submit a Broker Comment Request Form with FINRA to provide an update
or add context to the information that’s made available on BrokerCheck.
Investor Education FINRA’s Investor Education and Protection Rule requires member firms, at least once
every calendar year, to provide the following information to each customer in writing:
 FINRA Regulation’s Public Disclosure Program (BrokerCheck) hotline number
 FINRA’s website address
 A statement regarding the availability to the customer of an investor brochure that includes information
describing FINRA’s BrokerCheck
However, any member that doesn’t carry customer accounts and doesn’t hold customer funds or securities is
exempt from these provisions.
Expungement What happens if information in the CRD system is incorrect? FINRA has established
procedures that arbitrators must follow before the removal (expungement) of customer dispute-related
information connected to arbitration cases from an RR’s CRD record. This removal of information from the
CRD is permitted only if:
 The claim, allegation, or information is factually impossible or clearly erroneous.
 The registered person was not involved in the alleged investment-related sales practice violation, forgery, theft,
misappropriation or conversion of funds.
 The claim, allegation, or information is false.
Once information is removed from the CRD system, it’s permanently deleted and is no longer available to the
investing public (through BrokerCheck), regulators, or prospective employers.

Industry Requirements for Supervision

All broker-dealers are required to supervise their business, including the activities of their registered representatives.
This requirement is mandated not only by self-regulatory organizations (e.g., FINRA), but also by SEC rules. A
member organization must establish and maintain supervisory procedures to ensure that its personnel is in
compliance with securities laws and regulations and with FINRA rules. One or more principals must be designated
to review the member organization’s supervisory procedures and to take appropriate action, including
recommendations to senior management, to achieve compliance with appropriate rules and regulations.
FINRA must be notified of the identity of such persons. If individuals who are employed by a firm in a senior
management role have the ability to manage accounts, they should be supervised by a person who doesn’t directly
report to them. For example, an independent review by a compliance professional is a good business practice.
Qualifications of Supervisors
SRO rules requires all supervisory personnel to be qualified to assume their responsibilities by either their
experience or training. For example, an individual who’s an officer, general partner, manager of an office of
supervisory jurisdiction (described shortly), or a director who’s actively engaged in the securities business of the
member firm, must also register with FINRA as a principal. However, an assistant vice president of the firm is
not considered an officer and is therefore not required to be registered as a principal unless this person is engaged
in the training of other principals of the member firm. This requirement is similar to the stipulation that a person
engaged in the training of a registered representative must also be a registered representative.
In some instances, an employee may function as a principal (e.g., supervise salespersons) before passing her
exam. If an employee has been a registered representative for 18 months within the five-year period before
acting as a principal, she’s given 120 days to pass the appropriate principal exam.
Let’s first focus on the Series 24 and then review some of the other principal exams and what they allow.
Series 24 – General Securities Principal

Allows a person to manage or supervise the member’s investment banking or securities business for corporate
securities, direct participation programs, and investment company products/variable contracts. This person supervises
the activities of employees who are Series 7 registered.
Series 4 – Registered Options Principal
For a person responsible for the supervision of a firm’s options trading, ensuring compliance with the rules of the
Options Clearing Corporation or exchange, and regulations applicable to the trading of options contracts.
Series 9/10 – General Securities Sales Supervisor
For a person responsible for supervising sales activities in corporate, municipal, and options securities, investment
company products, variable contracts, and direct participation programs. Branch office managers, as well as regional
and national sales managers, may register in this capacity.
Series 16 – Supervisory Analyst
For any person whose functions involve the preparation and approval of research reports.

Series 26 – Investment Company Products/Variable Contracts Limited Principal

Allows a person to supervise the sale of open-end investment companies (mutual funds), closed-end funds during the
distribution period, variable annuities, and variable life insurance.
Series 27 – Financial and Operations Principal (FINOP)
This limited registration permits a person to supervise a broker-dealer’s financial responsibility/recordkeeping functions.
Series 53 – Municipal Securities Principal

This limited registration permits a person to supervise the activities of Municipal Securities Representatives, but also
supervise the sale of municipal bonds and municipal fund securities (i.e., selling 529 College Savings Plans or Local
Government Investment Pools, or LGIPs).
The required principal registration category is based primarily on the type(s) of securities products being offered
by the representative, not only on the type of registration held by the representative. For example, a person with a
Series 7 registration who’s only offering mutual fund shares (investment company securities) may be supervised
by a person with a Series 26 principal registration. As another example, a person who has a Series 7 registration
and is offering options contracts must be supervised by a person with a Series 4 or Series 9 principal registration.
Producing Managers
A member firm must create policies and procedures to properly supervise its supervisory personnel. For example,
a firm must have a policy to supervise a branch manager who also services customer accounts (i.e., a producing
branch manager). Written procedures must include prohibiting any employee of the firm who performs a
supervisory function (branch manager) from supervising his own activities and reporting to, or having his
compensation or continued employment determined by, a person he’s supervising. All supervisory personnel who
don’t report to the branch manager may supervise the activities of this producing manager.
Although FINRA generally prohibits any employee who has supervisory responsibilities from supervising his
own activities, there’s an exception made if alternative supervision is not possible due to the member’s size or
a supervisor’s position within the firm. This situation may occur if the supervisory person is either the firm’s
most senior executive officer (a CEO) or one of several senior executive officers (members of the BOD or
management committee). The situation may also occur if the broker-dealer is a single-person firm. For a single
person firm, it’s required to document the factors that are used to make this determination as well as how this
person will be properly supervised. Despite the fact that there’s no specific rule or interpretation which
requires the compliance director to supervise this type of activity, the compliance director is often the best
person to choose. The CEO’s sales activities are best supervised by a person who doesn’t report directly to the
CEO and is able to act independently to review his sales activities.
Annual Certification of Compliance and Supervisory Processes

According to FINRA Rule 3130, a broker-dealer must use Schedule A of Form BD to notify FINRA of the
designation of a principal who will serve as chief compliance officer for the firm. Also, each year, the firm’s chief
executive officer must certify by no later than April 1 that it has established policies and procedures to ensure
compliance with applicable industry rules and regulations.

Meetings between the CEO, CCO, and other equivalent officers must have been conducted in the preceding 12
months and a final report must have been submitted to the firm’s board of directors and audit committee at the
earlier of the next scheduled meeting or within 45 days of the execution of the certification.
Continuing Education
Certain registered and associated persons are required to participate in an industry-mandated continuing
education program. The Continuing Education (CE) requirements are divided into the following two parts:
1. The Regulatory Element – created and administered by regulators
2. The Firm Element – the responsibility of each broker-dealer
Regulatory Element
RRs are required to participate in Regulatory Element training on an annual basis for each registration that they
hold (i.e., there are two requirements for individuals who are registered in both a representative and principal
capacity). The content of the Regulatory Element will be appropriate to each representative or principal
registration category a person holds. All covered persons must complete their Regulatory Element by December
31 of the calendar year following the year in which they became registered and by December 31 of every year
thereafter. This requirement continues for as long as a person is associated with a member firm in a registered
capacity. The content of the Regulatory Element CE requirement is written by the Securities Industry/Regulatory
Council on Continuing Education and, during the computer-based training session, RRs are provided with
information about compliance, regulatory, ethical, and sales-practice standards. As they progress through the
program, RRs must answer questions based on the scenarios presented using the information they have just seen.
If the person doesn’t complete the training within the prescribed time frame, that person’s registration will become
inactive. An RR with an inactive registration is prohibited from performing any activity or receiving any
compensation that requires securities registration.
Rather than requiring a person to make a reservation at a testing center, FINRA has transitioned the delivery of
the Regulatory Element to an online format which is referred to as the CE Online Program. This program
provides participants with the flexibility to satisfy their CE Regulatory Element requirement from either a
home or office computer.
Significant Disciplinary Actions As noted above, the timing of an RR’s participation in the Regulatory
Element can be affected by a significant disciplinary action, which includes:
 Any statutory disqualification
 A suspension, or the imposition of a fine of $5,000 or more for violation of any provision of any securities law
or regulation, or any agreement with or rule or standard of conduct of any securities self-regulatory
organization, or as imposed by any such regulatory or self-regulatory organization in connection with a
disciplinary proceeding
 An order imposed as a sanction in a disciplinary action to re-enter the Continuing Education Program by any
securities governmental agency or securities self-regulatory organization

Firm Element
All registered persons and their immediate supervisors are subject to the Firm Element requirements of
Continuing Education. At least once per year, each firm must demonstrate to the regulators that it has analyzed
and prioritized the training needs of its covered personnel and has developed a written training plan based on
that needs analysis. A broker-dealer must maintain records which document the content of its program and the
completion of the program by its covered registered persons. A broker-dealer’s Firm Element plan is not
required to be submitted for regulatory review unless requested. Minimum standards for the Firm Element
require that the programs enhance brokers’ securities knowledge, skill sets, and professionalism. This type of
training must cover the securities products, services, and strategies that are offered by the firm, with particular
emphasis on:
 General investment features and associated risks
 Suitability and sales practice considerations
 Applicable regulatory requirements
Inactive Status—Military Duty

A registered person who voluntarily joins the military or is called into active duty falls into a category that’s
referred to as special inactive. This category is included in the Central Registration Depository. FINRA provides
registration relief to these registered personnel regardless of whether they return to their previous employer or
seek registration with another broker-dealer. Registered representatives who are called into active military service
are exempt from the two-year inactive status limitation that typically applies to registration reinstatement. During
the period of active military service, individuals are NOT permitted to function as registered representatives by
contacting customers; however, they may continue to receive compensation based on securities transactions.
For registered individuals who have been placed in special inactive status (i.e., serving in the military while still
registered) or who begin serving in the military within two years after voluntarily terminating their association
with a member firm, the two-year license expiration provisions will be tolled (halted). However, the tolling
period will terminate 90 days following the completion of active service. For example, if a person terminates her
registration and six months later joins the military, she must register within 21 months of the completion of
military duty.
Two-year inactive status limitation: 24 months
Joins military six-months after termination: – 6 months
90-day grace period following service discharge: + 3 months
21 months
Please note, both the Regulatory and Firm Elements of Continuing Education are deferred during active duty.
Maintaining Qualifications Program (MQP)

Under FINRA’s Maintaining Qualifications Program (MQP), individuals who terminate any of their
representative or principal registrations are able to maintain their qualifications by completing their annual CE
requirement. Individuals who pay a $100 annual fee to utilize this program are given a maximum of five years
to reregister with a member firm without being required to requalify by exam.
(If the MQP is not utilized, a person has two years to reregister without having to retake a qualifying exam.)

To be eligible for the MQP, individuals must meet the following conditions:
1. They must have been registered in the terminated registration category for at least one year immediately
prior to the termination in that category.
2. They must elect to participate in the MQP within two years from the date of termination.
3. They must complete all of their CE requirements by their due dates.
4. They cannot have been CE Inactive for two consecutive years.
5. They cannot be subject to statutory disqualification.
Anti-Money Laundering (AML) and the USA PATRIOT Act

The Bank Secrecy Act (BSA) establishes the basic framework for AML obligations that are imposed on financial
institutions. In response to the September 11, 2001, terrorist attack, the President signed into law the USA
PATRIOT Act * (an amendment to the BSA). The purpose of this legislation is to detect and deter terrorism.
Since terrorists and other criminals use laundered money to fund their operations, part of the Act concentrates on
strengthening the anti-money laundering (AML) laws. It imposes a number of new regulatory obligations on
broker-dealers and focuses renewed attention on the previously existing AML laws.
(* USA PATRIOT Act = Uniting and Strengthening America by Providing

Appropriate Tools Required to Intercept and Obstruct Terrorism Act)
Mandatory AML Compliance Programs

All broker-dealers are required to establish AML Compliance Programs which, at a minimum, include:
 Policies and procedures that can be reasonably expected to detect and report suspicious transactions and deter
money laundering
 The designation of a compliance officer who’s responsible for the firm’s AML program (there’s no requirement
for this person to be FINRA registered)
 An ongoing employee training program
 An independent audit function to test the effectiveness of the firm’s AML program
Industry rules also require AML programs to be written and approved by a member of senior management.
Testing Testing of the anti-money laundering compliance program must be conducted annually (on a
calendar-year basis). More frequent testing is required if circumstances warrant it. If the member doesn’t
execute transactions for customers, customer accounts, or act as an introducing broker with respect to customer
accounts (e.g., engages solely in proprietary trading or conducts business only with other broker-dealers), then
independent testing is required every two years.
Money laundering generally takes place in three stages:

1. Placement The money launderers place illegal cash into the flow of brokerage business, most often
through the purchase of securities.
2. Layering The launderers execute transactions in several layers in order to avoid detection or trigger
reporting requirements. For example, one form of layering involves the purchase of several blocks of
securities, each with cashier’s checks drawn on different institutions and in amounts of less than
$10,000 (this is also referred to as structuring).

Taking opposite positions on the same security (e.g., both long and short positions), and using different
customer accounts for each purchase are other sophisticated forms of layering.
3. Integration The launderers put the proceeds from the transactions back into the stream of commerce,
making them appear to be from a legitimate source. For example, securities are purchased with illegally
obtained cash, then sold and the proceeds deposited in a bank account. The funds are then used to buy
goods and services. The money has now been successfully integrated back into the legitimate economy.
Required Reports
Broker-dealers have long been required to file Bank Secrecy Act Currency Transaction Reports (BCTRs) for all
cash transactions executed by a single customer during one business day that exceed $10,000. The definition of
currency includes both cash and coins. Note that the reporting requirement is also triggered when a customer
places multiple, smaller transactions in a single day that, in the aggregate, exceed $10,000. The Financial Crimes
Enforcement Network (FinCEN) is a department of the U.S. Treasury.
For example, Monica deposits $6,000 in cash one morning at one of Megamerger
Securities’ branch offices. Later that same day, she deposits an additional $7,000 in
traveler’s checks at a different Megamerger branch office. Megamerger Securities
must file a BCTR to report these transactions since together they total more than
$10,000 and they occurred on the same day.
Monica’s actions are an example of structuring. Structuring occurs when a customer executes several small
transactions in amounts that are below the reporting thresholds in order to evade the regulations. Registered
representatives should be on the alert for clients who execute a number of transactions in amounts that are just
below the $10,000 reporting level or deposit instruments that are sequentially numbered.
A report of International Transportation of Currency or Monetary Instruments (CMIR) must be filed whenever
a person physically transports, sends, or receives cash, cash equivalents, or monetary instruments in an
aggregate amount of more than $10,000 into or out of the United States. Broker-dealers that transfer or
transmit funds (wire transfers) must collect information about any transfer of $3,000 or more, including the
names of the transmitter and the recipient. Firms must also verify the identity of transmitters and recipients
who are not established customers.
Suspicious Activity Reports (SARs) Prior to the passage of the USA PATRIOT Act, only broker-dealers
that were subsidiaries of bank holding companies were required to file SARs. Today, all broker-dealers are
required to file suspicious activity reports (SARs). The filing of an SAR is required whenever a transaction (or
group of transactions) equals or exceeds $5,000 and the firm suspects one of the following activities:
 The client is violating federal criminal laws.
 The transaction involves funds related to illegal activity.
 The transaction is designed to evade the reporting requirements (structured transactions).
 The transaction has no apparent business or other legitimate purpose and the broker-dealer cannot determine
any reasonable explanation after examining all the available facts and circumstances surrounding the transaction
(i.e., something is just not right).
The fact that an SAR has been filed is confidential as is the information that’s contained in the report.
Disclosure of this information may only be made to federal law enforcement authorities or securities regulators.
Under no circumstances may a registered representative inform the subject of an SAR that the report has been filed.

Penalties
The penalties for violating the AML laws are severe and include both criminal and civil sanctions. Under the
criminal laws, a registered representative who’s found guilty of facilitating money laundering can be sentenced
to 20 years in prison, in addition to fines of $500,000 per transaction or twice the amount of the funds
involved, whichever is greater. Violators may also face civil fines.
Registered representatives don’t need to actually know about a money laundering scheme or participate in it to
be prosecuted. RRs and their firms may also be held liable if they were willfully blind to the activity.
Business Continuity Plan (BCP)

Although a firm’s WSP is designed to establish its day-to-day policies and procedures, FINRA also requires a
firm to have plans in place if the unexpected occurs. Under FINRA Rule 4370, broker-dealers must establish a
written business continuity plan that identifies procedures to be followed in the event of an emergency or
significant business disruption. These procedures must attest that all customer obligations will be met and also
address the firm’s existing relationship with other broker-dealers and counterparties. The plan must be reviewed
annually to incorporate any changes in the firm’s business structure, general operations, or location.
While there are many elements that could comprise a business continuity plan, at a minimum, the plan must
address the following points:
1. Data backup and recovery
2. Financial and operational assessments
3. Alternative communications between customers and the firm
4. Alternative communications between the firm and its employees
5. Alternative physical location of employees
6. Regulatory reporting
7. Communications with regulators
FINRA also requires each member firm to provide to the regulator, either by means of an electronic process or
other means as specified by FINRA, prescribed emergency contact information which must include the
designation of two emergency contact persons. At least one of these individuals must be a member of senior
management and a registered principal of the member firm. If the second contact person is not a registered
principal, she must be a member of senior management who has knowledge of the firm’s business operations.
Rule 4370 also specifies that that both emergency contact persons must be associated persons of the member firm.
In the case of a small firm with only one associated person (e.g., a sole proprietorship without any other
associated persons), the second emergency contact person may be either a registered or non-registered person
with another firm who has knowledge of the member firm’s business operations. Possible candidates for this
role include the firm’s attorney, accountant, or a clearing firm contact.

Supervision
Supervision of Lines of Business
A broker-dealer must appoint a supervisor to oversee each type of business in which it engages. All
supervisors must be familiar with their specific business lines to be qualified in their area of supervision.
Although the rules don’t specify what’s meant by a type of business, some examples include:
 Retail sales  Research
 Investment banking  Clearing
 Trading departments (e.g., equity and fixed-income)
Member organizations must conduct an annual review of the businesses in which they engage to detect and
prevent violations of rules and regulations. This review must take into consideration the firm’s size,
organizational structure, scope of business activities, number and location of offices, the nature and complexity
of the products and services offered, the volume of business done, and whether the location has a principal on-
site. These review procedures must provide that the quality of supervision at remote offices is sufficient to
assure compliance with SEC and FINRA rules.
Failure to Supervise
Under the Securities Exchange Act of 1934, “failure to supervise” is a charge that can be raised against broker-
dealers or supervisors who don’t carry out their responsibility to prevent the violation of federal securities acts,
SRO regulations, state securities laws, or the firm’s own written supervisory procedures.
It’s also enforced against supervisors who fail to detect or fail to take action after detecting violations of these
regulations by the employees they supervise. Charges of failing-to-supervise may be brought not only by the SEC,
but also by FINRA and the other SROs. FINRA guidelines reflect the requirements of the Securities Exchange Act
regarding supervision.
Basic SEC Requirements The Exchange Act gives the SEC the power to sanction broker-dealers or
associated persons who have:
…failed reasonably to supervise, with a view to preventing violations [of federal
securities laws], another person who commits such a violation, if such person is subject
to his supervision.
The Act also states that a person will NOT be considered to have failed to supervise properly if:
 There are established supervisory procedures and a system for applying those procedures that’s reasonably
expected to prevent and detect violations of relevant rules
 The supervisor has reasonably discharged those duties under the system and has no reason to believe that the
system is not operating properly
This protects a conscientious supervisor from failure-to-supervise charges in the case of an employee who
successfully hides wrongdoing by using extraordinary means. However, it also requires the supervisor to use
due diligence to detect acts of deception that can reasonably be uncovered by proper supervision.

Supervision of Business Location

The method of supervision that’s required by the broker-dealer is dependent on the type of location from which
the firm conducts its business. In addition to where the firm has its main office, FINRA includes the following:
 Office of supervisory jurisdiction (OSJ)
 Branch office
 Offices which are excluded from the definition of a branch office (commonly referred to as non-branch
locations)
Office of Supervisory Jurisdiction (OSJ) Under industry rules, a member firm must appoint a principal to
supervise the activities of any location that’s defined as an office of supervisory jurisdiction. An OSJ includes
any location at which one or more of the following activities occur:
 Market making and/or order execution
 Structuring of public offerings or private placements
 Maintaining custody of customers’ funds and/or securities
 Final acceptance (approval) of new accounts
 Review and endorsement of customer orders
 Final approval of retail communication
 Responsibility for supervising other branch offices
An OSJ must have a General Securities Principal (Series 24) on the premises whose responsibilities include the
approval and review of accounts, transactions, correspondence, retail communication, and a response to
customer complaints. If the principal has jurisdiction over satellite offices, he must approve accounts and
orders within those offices and must make frequent visits to those sites.
A General Securities Principal cannot approve options-related communications or options accounts since this
is the responsibility of the Registered Options Principal (ROP). Also, a General Securities Principal cannot
be responsible for financial reporting to regulators since this is the responsibility of the Financial and
Operations Principal (FINOP). In addition to these requirements, the member organization may need to
designate other offices as OSJs to ensure adequate supervision. Among the factors a firm must consider
when making this determination are whether the branch has registered personnel who engage in retail sales
involving regular contact with public customers, whether a substantial number of RRs conduct securities
activities at this location, whether the branch is geographically distant from an OSJ, or whether the activities
at the branch are diverse or complex.
Supervision of Multiple OSJs by One Principal As described above, FINRA requires firms to designate one
or more appropriately registered principals in each OSJ with the authority to carry out the supervisory
responsibilities assigned to that office (“on-site principal”). The designated on-site principal for each OSJ must
have a physical presence on a regular and routine basis at each OSJ for which the principal has supervisory
responsibilities. FINRA generally assumes that a principal will not be designated and assigned to be the on-site
principal to supervise more than one OSJ.
If a member determines that it’s necessary to designate and assign a principal to supervise two or more OSJs,
the member must take the following factors into consideration:
 Whether the on-site principal is qualified by virtue of experience and training to supervise the activities and
associated persons in each location

 Whether the on-site principal has the capacity and time to supervise the activities and associated persons in
each location
 Whether the on-site principal is a producing registered representative
 Whether the OSJ locations are in sufficiently close proximity to ensure that the on-site principal is physically
present at each location on a regular and routine basis and
 The nature of activities at each location, including size and number of associated persons, scope of business
activities, nature and complexity of products/services offered, volume of business, disciplinary history of
persons assigned to such locations, and any indicators of irregularities or misconduct
Documentation If a member firm designates and assigns one on-site principal to supervise more than one
OSJ, the member must document the factors used to determine why the member considers such supervisory
structure to be reasonable in its written supervisory and inspection procedures (WSP). There’s no requirement
for FINRA to preapprove this activity.
Creation of Additional OSJs When making a determination as to whether to designate a location as an OSJ,
the member should consider the following factors:
1. Whether registered persons at the location engage in retail sales or other activities involving regular
contact with public customers
2. Whether a substantial number of registered persons conduct securities activities at, or are otherwise
supervised from, such location
3. Whether the location is geographically distant from another OSJ of the firm
4. Whether the member’s registered persons are geographically dispersed and
5. Whether the securities activities at such location are diverse or complex
Branch Office FINRA defines a “branch office” of a broker-dealer as any location from which one or more
of the firm’s associated persons regularly conduct the business of effecting transactions in, or inducing or
attempting to induce the purchase or sale of any security, or any location that is held out as such. In essence,
as long as a location is NOT involved in one or more of the bulleted activities listed earlier, it’s considered a
non-OSJ branch office (often simply referred to as a branch or branch office on the exam). A non-OSJ branch
office may be supervised either by a principal or a competent registered representative. Series 24 candidates
may encounter the term supervisory branch, which designates a branch that has supervisory responsibilities
over a non-branch location.
Moving a Branch Form BR is used to notify FINRA as to the status of a given branch location. Under
FINRA rules, an applicant is under a continuing obligation to revise Form BR promptly whenever the
information becomes inaccurate or incomplete. Amendments must be filed promptly, which typically means
that the applicant has 30 days to submit the revised information. Although a branch office is typically located
at a permanent location (e.g., a building), it may also be located at a movable location (e.g., a boat, recreational
vehicle, or mobile home).
Non-Branch Locations A non-branch location is not considered a branch location and, therefore, is not
required to be registered as a branch office. These locations include:
 A non-sales office (e.g., back-office sites and operations offices)
 A location of convenience that’s used occasionally and by appointment only
 The floor of an exchange

 A temporary location that’s used in a business continuity plan (i.e., a back-up office)
 A location that’s primarily used for non-securities business and from which fewer than 25 securities
transactions are executed annually (Advertisements and sales literature generated from this location must
identify the location that supervises the personnel who work at the location from which the
communication was obtained.)
 A representative’s primary residence that’s not used as an office for the public (See Primary Residence
Limitations, described below.)
 A temporary location that’s used for securities business (excluding a primary residence) for fewer than
30 business days in any calendar year (See Primary Residence Limitations, discussed shortly.) A
business day doesn’t include a partial business day during which an associated person spends at least
four hours at her branch office during normal business hours.
A location of convenience may be situated in a bank. When a member firm maintains an office at a bank as a
location of convenience, it’s permitted to display signs in compliance with federal, state, and SRO rules and
regulations to avoid confusing customers who may be under the impression that low-risk investments (e.g.,
deposits) are being offered by associated persons at the office.
Primary Residence Limitations The exemption for branch office registration for the primary residence of an
associated person applies only if the following conditions are met:
 Only one associated person, or all associated persons who reside at the same location and are members of the
same immediate family, may conduct business at the residence.
 Neither customer funds nor securities may be handled at the residence.
 The residence cannot be represented as an office of the firm, and no associated personnel may meet with
customers at the residence.
 The associated person must be assigned to a branch office and the address for that branch must be listed on the
person’s business cards, stationery, advertisements, and other communications with the public.
 Correspondence and communications with the public from the associated person must be subject to the firm’s
supervision.
 Electronic communications, including e-mail, must be made through the firm’s system.
 All orders must be entered through the branch of the associated person or through an electronic system
established and reviewable at the branch by the firm.
 Written procedures regarding the supervision of sales activities conducted at an associated person’s residence
must be maintained by the firm.
 The firm must maintain a list of all residence locations.
In creating an environment that’s similar to the actual offices of a broker-dealer, regulators require
written supervisory procedures to include standards under which an on-site review of an associated
person’s primary residence may take place. The reason for the review is to assure compliance with
securities laws and regulations.
Inspections Member organizations must review each office, which must include periodic examinations of
customer accounts. Each OSJ and any branch office that supervises one or more non-branch locations must be
inspected annually by a principal of the member firm. Branch offices that don’t supervise one or more non-
branch locations must be inspected every three years. Every non-branch location must be reviewed on a periodic
cycle that takes into consideration the nature and complexities of the activities being conducted at the branch, the
volume of business, and the number of personnel at the location.

The cycle of inspection must be included in the firm’s written supervisory procedures, and a record must be
maintained of when each inspection was conducted. Offices that are sublet to other broker-dealers are not
considered branch offices.
Conducting Inspections FINRA rules generally prohibit an associated person from conducting an inspection
of a location if the person is either assigned to that location or is directly or indirectly supervised by, or
otherwise reports to, a person who’s assigned to that location.
Inspection Requirements
Location Inspection Cycle

Office of Supervisory Jurisdiction Annually
Non-OSJ branch that supervises other locations Annually
Non-OSJ branch with no supervisory functions Every three years
Non-branch location Periodically
Personal residence Periodically
Transactional Review and Investigation A broker-dealer’s supervisory procedures is required to include

a process for reviewing securities transactions to identify trades that violate SEC and FINRA rules concerning
insider trading and manipulation. The firm is required to conduct a prompt internal investigation into any trade
in which it determines that a violation of these rules may have occurred.
A firm that engages in investment banking services has an obligation to file the following reports:
 Within 10 business days of the end of each quarter, a written report must be filed to describe each open or
completed internal investigation relating to securities transactions which may have violated securities laws.
This report must be filed regardless of whether a violation occurred.
 Within five business days of the completion of any internal investigation concerning insider trading and
manipulation, a written report must be filed which details the results of the investigation
Each report must be signed by a senior officer of the firm.

SRO Inspection Cycle for Newly Established Broker Dealers Under SEC rules, each self-regulatory
organization is tasked with the responsibility for examining newly established broker-dealers for compliance
with all applicable financial responsibility rules. The new member firm must be inspected by the SRO within
six months of the member’s registration with the SEC to assure that its operating in conformity with applicable
financial responsibility rules. The SRO is also required to conduct an inspection of the new member firm
within 12 months of its registration with the SEC to determine whether the firm is operating in conformity with
all other (non-financial responsibility) applicable SEC rules.
Broker-Dealer Networking Arrangements

If a member conducts business with the public on the premises of a financial institution at which retail deposits
are taken, it must comply with special provisions which are designed to ensure that customers can distinguish
between the activities and products of the bank or thrift and those of the broker-dealer.
Setting When it’s practical, the broker-dealer’s activities should be conducted in a location that’s physically
distinct from the area in which the financial institution takes retail deposits. The broker-dealer must clearly
display its name in the area in which it conducts business.
Agreements Any networking arrangement or brokerage affiliation arrangement between the financial
institution and the broker-dealer must be in writing. The agreement should identify the responsibilities of each
party and the compensation arrangements.
The agreement must also stipulate that supervisory personnel of the broker-dealer and examiners from the SEC
and FINRA are permitted access to any location at which the broker-dealer conducts its business.
Customer Disclosures At or before opening a customer account on the premises of a financial institution,
the broker-dealer must disclose (orally and in writing) that the securities products it buys and sells are:
1. Not insured by the Federal Deposit Insurance Corporation (FDIC)
2. Not deposits or other obligations of, and are not guaranteed by, the financial institution
3. Subject to investment risks, including possible loss of principal
The broker-dealer must also make a reasonable effort to obtain from the customer a written acknowledgment
of these disclosures. However, the compensation arrangement between the financial institution and the broker-
dealer is not required to be disclosed to customers.
Communications Confirmations and account statements that are sent by the broker-dealer must clearly
indicate that it provides the brokerage services. Retail communications that include the location of the financial
institution or are distributed on its premises must include disclosures (1), (2), and (3) that were just described.
When this is not practical (e.g., in a radio spot or on a billboard), the following shorter version may be used:
 Not FDIC insured
 No bank guarantee
 May lose value
These disclosures are not required in radio broadcasts of 30 seconds or less, electronic billboard-type signs, or
signs that are used only as location indicators.

Terminations The broker-dealer must promptly notify the financial institution if it terminates for cause an
associated person who’s also employed by the institution.
Additional Considerations
Business Cards Many salespersons or principals put their registrations on their business cards. For example,
a Series 7 registered salesperson may use General Securities Representative as her official title. But what about
other titles? For an RR to use a designation on his business card, the employing member firm must provide
approval in advance. Some firms maintain an approved list, while other firms may ban this practice. If the firm
does maintain a list and the designation that the RR wants to use is not on the list, the RR must submit it for
review by a committee that includes compliance, legal, and principals of the firm. FINRA doesn’t approve or
endorse any professional designation, but it does provide a list to assist member firms in preparing their lists.
Activities of Non-Registered Persons Although many broker-dealer employees don’t need securities
registration, the level of customer contact for these persons is limited. Non-registered persons may:
 Extend invitations to firm-sponsored events
 Inquire as to whether a prospective customer wants to discuss investments with a registered representative
 Inquire as to whether a prospective customer wants to receive investment literature from the firm
Non-registered persons who engage in these activities must be supervised closely. They cannot solicit orders or
new accounts, provide investment advice, make recommendations, give pricing information, or execute
transactions on behalf of the firm. Unless an exception applies, FINRA prohibits any firm from compensating
any person who’s not registered. The term “compensation” is broadly defined and includes any compensation,
fees, commissions, and discounts. If firms want to compensate other financial professionals (e.g., lawyers and
accountants), these person must be registered. Broker-dealers can either register these professionals directly or
rely on these professionals to be associated persons of another broker-dealer.
Under SEC Rule 15a-6, in instances where an associated person of a foreign broker-dealer is permitted to make
sales calls in the U.S., he must be accompanied by a registered representative of a U.S. broker-dealer. Any sales
that are made must be booked by the U.S. broker-dealer. This exemption is only available if the customer is a
major U.S. institutional investor. This rule was created to allow a non-registered foreign research analyst to
visit a U.S. institutional investor if accompanied by a FINRA registered person.
Annual Compliance Meeting or Interview All registered persons must participate in an annual compliance
review. This review may be an individual meeting with each representative or a group meeting. In either case, the
meeting must include a discussion of compliance issues that are relevant to the business of the representatives
involved. The emphasis of the meeting should be regulation and compliance, not product knowledge. As with any
important supervisory review, participation in the annual compliance meeting should be documented.
Traditionally, annual compliance meetings (ACMs) have been held in a physical location that allowed for face-
to-face contact. Today, due to time or cost constraints, this methodology cannot be the most effective way to
conduct an ACM. Many firms have chosen to conduct meetings by means of the Web using interactive
technologies that permit real-time interaction between the presenters and attendees.

Under FINRA rules, firms are also permitted to use prerecorded (on-demand) meetings as long as attendees are
able to ask questions and have them answered in a timely manner. Typically, firms provide attendees with
links to the firm’s compliance area and post the questions and responses in a forum that may be accessed by all
ACM participants.
Red Flags
This chapter concludes by discussing the objective of Series 24 registration. This examination is designed to
test a person’s understanding of industry and SEC rules, but it also hopes to prepare candidates for the real-
world stresses associated with managing salespersons. The SEC has emphasized that “reasonable supervision”
requires strict adherence to internal company procedure; however, managers are also expected to determine
when something may be amiss at a firm despite having only limited information. Supervisors are required to
look for any indication of real or potential violations of securities regulations. These indications of potential
wrongdoing are often referred to as red flags. Red flags must be responded to and cannot be ignored. The
shortest path to a charge of failure-to-supervise is to ignore them.
When a red flag is discovered, a supervisor must do the following:

1. Investigate the situation Supervisors must make a reasonable effort to ascertain all of the relevant facts
and circumstances that led to the red flag. This investigation should include an evaluation of all
documentation available, and often involves direct contact with the client. Regulators often like to see
communication between supervisors and clients of RRs that they supervise.
2. Document the investigation This means that all the records reviewed, interviews conducted, and clients
contacted need to be documented in writing. It’s important to show the steps that were taken and the specific
nature of conversations and interviews conducted. Often, in a formal action by the regulators, the notes
and records of the supervisor are key elements of the investigation. From a regulator’s viewpoint, if you don’t
document it in writing, it did not happen.
3. Pursue the investigation to a conclusion An investigation often involves more than one supervisor or
department. It’s important that the supervisor who initiates the investigation take responsibility to ensure
that it’s brought to some resolution. The resolution may be that no violation occurred. Customer
complaints and other allegations often stem from poor communication between the RR and the client or
between the RR and the firm or both. A red flag doesn’t necessarily mean that a violation has occurred.
Regardless of the findings, the supervisor must bring the investigation to a conclusion and must document
what the conclusion is and how it was determined.
Any investigation should be as objective as possible and should always include evidence other than the
employee’s word. This may include consulting other supervisors or members from other departments such as
compliance or legal. The employee’s prior conduct should always be taken into account. Often, violations are not
isolated incidents, but part of a pattern of ongoing misconduct. An RR with a history of previous misconduct
may, in itself, be a red flag for a supervisor to investigate.
One of the best ways to prevent regulatory violations at a firm is to carefully evaluate the employees being
hired. Hiring an RR with a demonstrated pattern of unauthorized transactions and not monitoring this person
has been viewed as a failure to supervise by some regulatory authorities.


Chapter 6
Business Conduct Rules

CHAPTER 6 – BUSINESS CONDUCT RULES SERIES 24
This chapter will examine several industry conduct rules that govern FINRA membership and the
activities of employees of a broker-dealer (and, in some cases, their spouses as well). Topics covered
include compensation issues, prohibited and fraudulent practices, and personal activities of registered
persons. The final section of the chapter will examine the two processes that come into play when an
RR and /or his firm break any of these rules—the Code of Procedure and the Code of Arbitration.
FINRA Membership Requirements

New Member Application Review Process
After receiving a broker-dealer membership application through the FINRA Gateway system, FINRA must
review and process it within 180 calendar days. First, FINRA conducts preliminary review of the application
to determine whether it’s substantially complete. If the application is found to be to be deficient, the applicant
will be given five days to correct the deficiency.
If the filing is deemed substantially complete, FINRA’s staff then has 30 days to complete its review and
determine whether more information is needed. If additional information is required, FINRA’s staff must
issue a written request within this timeframe. The applicant will then have 60 calendar days to fully respond
to FINRA’s initial request.
Along with completing an application, a member firm is subject to membership fees and assessments. After
15 days written notice, a member firm that fails to pay the required fees or assessments may have its
membership suspended or cancelled by FINRA.
After becoming a member, a firm’s registration termination must be made in writing and doesn’t go into
effect until all debts that are payable to FINRA have been satisfied.
FINRA Manual
In addition to the requirement to maintain written procedures, a member broker-dealer must make a current
copy of the FINRA manual available for examination by customers upon request. The manual may be
maintained and made available in electronic format if the member chooses. There’s no requirement for a
member firm to interpret the rules for customers or to send them a copy.
Executive Representative
Firms are required to appoint a person—an Executive Representative—to act on its behalf regarding issues
pertaining to FINRA. This person is typically a principal of the firm who has a broad understanding of the firm’s
operations. Broker-dealers also need to review and, if necessary, revise its designation of Executive Representative
on a quarterly basis. This requirement must be met within 17 business days of the end of the quarter.
Dealing with Non-Members

To encourage membership in FINRA, only members are permitted to transact business with each other on a
preferential basis as it relates to investment banking activities, transactions in over-the-counter securities, and
the distribution of new issues and investment company shares to the public. A FINRA member must treat a
non-member in the same manner that it deals with members of the public.

SERIES 24 CHAPTER 6 – BUSINESS CONDUCT RULES
This rule substantially limits the ability of non-members to transact business since they cannot receive price
concessions and discounts from FINRA members. The bottom line is that FINRA members are generally
prohibited from paying any form of compensation (including referral fees) to non-members.
Foreign Finder Exception The one exception to the payment to non-members prohibition is available to
foreign finders who refer non-U.S. clients to U.S. brokerage firms for a fee. A foreign finder is not required to
register with FINRA and is not considered an associated person of the U.S.-based member firm. For this
reason, FINRA restricts the finder’s activity on behalf of a firm to referrals. If the finder is to receive
compensation, the customers must receive a descriptive document which discloses the compensation being
paid. For a foreign finder transaction, one special disclosure is that the confirmation of each transaction
indicates that a referral or finders’ fee is being paid pursuant to an agreement. Finders are prohibited from
participating in other activities, such as asset allocation or market timing.
Suspended Members
If FINRA expels a member firm, it becomes a non-member as of the effective date of the expulsion and it
remains a non-member until the suspension ends. A broker-dealer’s FINRA membership is automatically
terminated if the SEC revokes its registration due to the member being suspended or expelled from a national
securities exchange or if the broker-dealer is deemed unsuitable for membership by the FINRA Board of
Governors. A broker-dealer may also voluntarily terminate its membership by resigning from FINRA.
Non-member broker-dealers are not required to be treated as non-members if their transactions only involve
exempt securities. Exempt securities include those that are issued or guaranteed by the United States and
securities that are issued by municipalities. The restrictions also don’t apply to transactions that are executed on
exchanges. For example, a FINRA member may pay an exchange member a commission to execute a transaction
despite the fact that the exchange member doesn’t belong to FINRA. However, the member firm cannot pay a
commission to a non-member to execute an order in the over-the-counter market.
An important note is that if a broker-dealer is a member of both FINRA and an exchange and is then suspended
from FINRA, it may continue to conduct business on the exchange without interruption. An RR who’s subject to
a sanction or other disqualification is not permitted to be associated with a broker-dealer in any capacity,
including a clerical or ministerial capacity. The firm cannot pay or credit the sanctioned or disqualified RR during
the period of the sanction or disqualification. However, selling traditional insurance products and other similar
activities are permitted since they’re not regulated by FINRA.
Foreign Broker-Dealers The restrictions that apply to non-members don’t apply to broker-dealers in foreign
countries that are ineligible for FINRA membership. Members that grant a concession to a foreign broker-dealer
must receive assurance from the foreign firm that it will abide by FINRA rules if it subsequently sells the security
within the United States. In effect, the foreign broker-dealer must agree to act like a FINRA member and deal with
non-member broker-dealers in the same manner as it deals with the general public.
Compensation Issues
The conflict between a salesperson seeking compensation while also serving the needs of a client has always been
an area of concern for managers. FINRA has a general guideline—referred to as the 5% Policy—that provides a
general framework to judge the reasonableness of a given transaction’s compensation (i.e., commission or markup).

Although the policy will be covered in greater depth in a later chapter, this chapter will detail some of the
potential red flags of which managers should be aware when they review both the motivation for a transaction and
the fairness of the compensation charged.
Churning (Excessive Trading)

Churning is considered excessive trading for the purpose of generating additional compensation for a registered
representative. But in reality, how much trading is too much? There are no specific standards to answer this
question. Ultimately, it depends on the investment objectives and financial situation of the client involved. For
that reason, there’s no number of trades or percentage of portfolio turnover that constitutes a violation. Instead,
the trading activity is viewed in light of the customer’s objectives. Also, there’s no need for a client to lose money
for a violation to occur. Series 24 candidates should be prepared for questions that involve excessive trading
occurring in discretionary accounts. It’s important to note that being granted discretion doesn’t mean that an RR
is permitted to trade excessively. All trading must be suitable as to type, size, and frequency.
Sharing in Accounts
Employees of FINRA members cannot share in the profits and/or losses in a customer’s account unless the
employee has made a financial contribution to the account and shares in the profits and/or losses in direct
proportion to the employee’s financial contribution. Additionally, the written authorization of the customer and the
employee’s member firm must be obtained prior to engaging in this activity. If the registered representative is
sharing in the account of an immediate family member, the representative is not required to share at a level
that’s proportionate to his contribution.
Influencing or Rewarding Employees of Others (The Gifts Rule)

Under this rule, FINRA member firms and their associated persons cannot provide gifts that exceed $100 per
year to any person, principal, proprietor, employee, agent, or representative of another firm if the payment or
gratuity is in relation to the business of the recipient’s employer. Each firm is permitted to create its own
policy regarding the method it uses to aggregate all gifts (e.g., using either fiscal or calendar year). The
underlying concern is that excessive gifts could cause the recipient to act contrary to the interests of the
employer and/or its clients. The rule doesn’t apply to gifts that are made by a firm to its own employees or
those that are made by an employee to a co-worker.
Valuing a Gift Generally, a gift should be valued at the greater of its cost or its market value at the time it
was given. If a gift is given to a group, a pro rata amount is deemed to have been given to each of the
individuals. For example, if a $200 gift basket is sent to a branch office of four individuals, each individual is
considered to have received a gift that’s valued at $50 ($200 ÷ 4 = $50).
Personal, De Minimis, Promotional, or Commemorative Gifts Due to the nature of some gifts and the
circumstances surrounding them, they’re more clearly personal gifts rather than gifts connected to the firm’s
business. For example, wedding gifts and congratulatory gifts on the birth of a child are personal gifts that are
excluded from the $100 aggregate limit. De minimis gifts are those that have a trivial or minimal value.
Typically, these gifts include pens, notepads, or modest desk ornaments. Promotional gifts are those that display a
firm’s logo and have nominal value, including umbrellas, tote bags, and shirts. For de minimis and promotional
gifts to be excluded, their value must be well below the $100 limit. Commemorative items that are decorative
(i.e., Lucite plaques) and serve to recognize a business transaction or relationship are excluded from the limit.

Business Entertainment Ordinary and usual business entertainment expenses are excluded from the limit
if two conditions are met:
1. The business entertainment is not so frequent as to raise a question of impropriety.
2. The member or its associated persons host the clients and guests.
Business entertainment may include a social, hospitality, charitable, or sporting event, a meal, or other leisure
activity. In addition to the event itself, the term “business entertainment” includes transportation and lodging
expenses that are incidental to the event. Generally, although no business is being conducted, a person associated
with the member firm must accompany and participate with the employee. Providing tickets, but not accompanying
the employee, is considered a gift rather than business entertainment. It’s important to note that tickets are valued at
the greater of cost or face value.
Please note that a member firm is permitted to pay an employee of another firm for services rendered as long as
there’s a written agreement which stipulates the nature of the employment, the amount of compensation to be
paid, and the written consent of the recipient’s employer. Written records of all gifts and compensation must be
retained by the member firm that’s giving the gift or compensation.
Charitable Giving Member firms generally have written supervisory procedures concerning charitable giving or
participating in charitable events. Although the cost of attending any event is important, the most relevant concern is
whether there are any conflicts of interest. The employee of an institutional investor may be a sponsor or officer of
the charity and may request that associated persons of a broker-dealer attend an event or buy a table, and this
employee may be responsible for allocating business to various broker-dealers. It’s important to remember that the
broker-dealer’s customer is the institutional investor, not the employee.
Splitting Commissions
A registered representative is prohibited from splitting commissions with a non-registered person. Also, an RR
cannot offer to rebate commissions to a customer for previous transactions.
Charging Customers for Services

A member firm may charge its customers for services such as safekeeping of securities, collection of dividends
and interest, and exchange or transfer of securities, but only if such charges are reasonable and don’t unfairly
discriminate between customers. A member firm cannot charge a customer for forwarding proxies or other
reports from a corporation. The member firm is required to forward proxy materials to its customer as long as
the soliciting corporation reimburses the member firm for the expenses involved.

Prohibited and Fraudulent Practices

The following table provides a summary of the different practices that are prohibited under industry rules:
Forgery involves a person signing another person’s name to a document without
authorization or causing another person to do so. Obviously, forgery is a serious offense
that may result in criminal prosecution as well as regulatory sanctions. Registered
Forgery
representatives need to be careful so as not to inadvertently commit a technical forgery.
This occurs when a well-meaning RR signs a client’s name to a document because she
believes that she has the client’s authorization.
Employees of member firms cannot guarantee against losses in customer accounts or in
Guarantees transactions within customer accounts. Additionally, employees cannot reimburse a
customer for losses in any way.
Parking refers to the prohibited practice of temporarily holding a position for a customer,
Parking
often to avoid certain regulatory filing or net capital requirements.
Knowingly failing to follow a customer’s instructions regarding his account is a fraudulent
Failure to Follow
practice. Even if the agent believes that the customer’s instructions are not in his best
Customer Instructions interest, the agent is not permitted to ignore the customer’s direction.
A member firm that acts on behalf of a corporation as a trustee is not allowed to use
Use of Stockholder
information about the corporation’s shareholders for solicitation purposes. However, if the
Information corporation directs the firm to do so, this is permitted.
Firms and RRs are not permitted to release client information to a third party including
Failure to Protect the
spouses, attorneys, and accountants without the written consent of the account owner.
Confidentiality of
Exceptions to this prohibition exist if the firm is legally bound to do so to parties such as
Client Information the SEC or IRS.
A FINRA member firm is prohibited from influencing third parties or outside parties to
comment favorably on any security that it’s advertising to its clients. For example, a
Undue Influence
member firm is not allowed to compensate a newspaper employee to make favorable
comments about an investment company security it’s recommending.
Transactions must be made at prevailing market prices and brokers are prohibited from
Transactions
adjusting prices, except if a trade is being made on an “as of” basis to correct an error. It’s
Executed at Artificial
considered a fraudulent and manipulative practice for brokers to adjust prices to alter a
Levels portfolio manager’s realized profit or loss.
Securities that are owned by clients must be kept separate from those that are owned by
the broker-dealer. Customer securities must be segregated from the firm’s securities and
Commingling of
identified in a way that clearly shows each individual customer’s ownership interest in the
Funds securities. This is true even for securities that are registered in street name (i.e., in the
broker-dealer’s name).
Misrepresentation of Firms may inform clients that they’re FINRA or SIPC members. However, firms may not
SIPC or FINRA imply that SIPC membership protects a client against market loses or that FINRA
Membership membership denotes any type of endorsement or approval from the regulators.

Personal Activities of Employees

Outside Business Activities
Registered representatives who are employed at FINRA member firms must provide written notice to their
employing broker-dealer before participating in any business activities which are outside the scope of their
normal relationship with the firm. The purpose of the written notification is to guard against potential conflicts
of interest. For example, let’s assume that a registered representative is on the board of directors of a publicly
traded company. If the RR’s employing broker-dealer recommends that company’s securities, a conflict of
interest exists. Keep in mind, even part-time employment by a registered representative must be reported to the
employing broker-dealer. This employment information would be reported under Other Business on Form U4.
Remember, this is only required for business activity. If an RR obtains a real estate or insurance license, this
would be reported; however, if an RR was involved with a non-profit or religious organization, this would not
be reported. If an RR’s spouse is engaged in outside business activities, the RR is not required to notify the
firm. Unless an RR is actively involved in rental property that she owns, any rental income received is not
reportable as an outside business activity.
Private Securities Transactions

Private securities transactions are those that are executed outside of the regular scope of an associated person’s
employment with a member firm. These types of transactions may include the participation in traditional public
offerings, private placements, and arranging loans. An associated person who engages in these types of
transactions must provide written notice to his employing member firm. If the person’s member firm is not made
aware of such activities, this practice may be referred to as selling away. Notification must be made regardless of
whether compensation is to be received.
 If the associated person will receive compensation for the transaction, the employing member firm must
provide written determination as to whether it approves of the person’s participation. If approval is provided,
any transactions must be recorded on the member’s books.
 If the associated person will NOT receive compensation for the transaction, the employing member firm must
provide written acknowledgement of its receipt of the notification and may require the associated person to
adhere to specific conditions in order to participate in the transaction.
Accounts at Other Broker-Dealers and Financial Institutions

For supervisory reasons, member firms are required to monitor the personal accounts that their employees (both
clerical and registered persons) open or establish with a brokerage firm other than the one at which they’re
employed. For example, if a registered person of ABC Brokerage approaches another financial institution in an
attempt to open an outside (away) account to trade securities, both the employee and the firm must observe
special rules prior to the account being opened. For this rule, the term financial institution refers to a broker-
dealer, investment adviser, bank, insurance company, trust company, or investment company.
Employee Requirements Employees who intend to open outside accounts in which securities transactions
may be executed are required to obtain the prior written consent of their firm. In addition, before an outside
account is opened, the employees are required to provide written notification to the executing firm of their
association with another member firm.

Related and Other Persons This rule also applies to any account in which securities transactions can be
executed and in which the employee has beneficial interest, including any account that’s held by:
 The employee’s spouse
 The employee’s children (provided they reside in the same household as, or are financially dependent on,
the employee)
 Any related person over whose account the employee has control, and
 Any other individual over whose account the employee has control and to whose financial support the
employee materially contributes
Previously Opened Account If an employee had opened an account prior to the time that he became
associated with a broker-dealer, the employee is required to obtain the written consent of his employer within
30 days of the beginning of his employment in order to maintain the account. Also, the employee is required to
provide written notification to the executing firm of his employment with another broker-dealer.
Once an account has been opened for a member firm employee, the executing firm is not required to obtain the
employing firm’s approval prior to the entry of each order. However, the employee’s activities are subject to
any rules or restrictions that have been established by his employing firm.
Executing Broker-Dealer Requirements Upon written request, the executing firm is required to send
duplicate copies of trade confirmations, account statements, or any other transactional information to the
employee’s broker-dealer.
Exemptions The requirements of this rule don’t apply to accounts that are limited to transactions involving
redeemable investment company securities (mutual fund shares), unit investment trusts, variable contracts, or
529 plans.
Borrowing and Lending Practices with Customers

Registered individuals cannot borrow money from, or lend money to, a customer unless certain conditions are
met. These conditions include implementing written procedures which permit such activity and satisfying any
one of the following provisions:
1. The customer and the registered person are immediate family members. Under this rule, the definition of
immediate family is broad and includes parents, grandparents, mother-in-law or father-in-law, husband or
wife, brother or sister, brother-in-law or sister-in-law, son-in law or daughter-in-law, children,
grandchildren, cousin, aunt or uncle, or niece or nephew, and any other person who’s (directly or
indirectly) supported to a material extent by the registered person.
2. The customer is a financial institution that’s regularly involved in the business of extending credit or
providing loans.
3. Both parties are registered with the same firm.
4. The loan is based on a personal relationship between the customer and the registered person.
5. The loan is based on a business relationship independent of the customer-broker relationship.
If the conditions indicated in provisions 3, 4, or 5 prevail, the registered person is required to notify her employing
firm prior to the entering of these arrangements. The firm is also required to preapprove these arrangements in
writing and maintain the written approvals for a period of at least three years after the borrowing or lending
arrangements has terminated or for at least three years after the registered person has been terminated.

Soft-Dollar Compensation
Some investment advisers receive research and other services from broker-dealers in return for directing their
advisory clients’ securities transactions through the broker-dealer. These agreements are referred to as soft-
dollar arrangements. The adviser is permitted to receive research reports, software, seminars, and other
services for the benefit of its clients. However, the adviser is NOT permitted to receive reimbursements for
travel expenses, furniture, or equipment since these primarily benefit the IA and not the client. The SEC has
sanctioned broker-dealers that have provided products and services to investment advisers under soft-dollar
arrangements that were clearly not acceptable.
Resolving Problems
Complaints
FINRA defines a complaint as … any written statement of a customer or any person acting on behalf of a
customer alleging a grievance involving the activities of the member or a person associated with the member
in connection with the solicitation or execution of any transaction or the disposition of securities or funds of
that customer.
Members are required to maintain a separate file of all written complaints, including e-mail and text messages,
in each office of supervisory jurisdiction for four years. Upon receipt, customer complaints must be forwarded
to a principal for review. The file must also contain a description of actions taken by the member (if any)
regarding the complaint and must contain, or refer to another file that contains, any correspondence regarding the
complaint. Response to a customer’s written complaint may be in either written or oral form. The original
complaint must be forwarded to a principal for purposes of being reviewed and initialed. It’s important to note
that even if a member has not received any complaints, a complaint file (even if it’s empty) must still be maintained.
Reporting Requirements Member firms may be required to file a report with FINRA regarding certain
customer complaints and other incidents that may arise. If the reporting requirement is triggered, a member firm
must report these events promptly, but no later than 30 calendar days after learning of them. Events that may
require reporting include the discovery by the firm that it or one of its associated persons:
 Is the subject of any written customer complaint involving allegations of theft, misappropriation of funds or
securities, or forgery
 Has been found to have violated any securities law or regulation or any standards of conduct of any government
agency, self-regulatory organization, financial business, or professional organization
 Has been denied registration or has been expelled, enjoined, directed to cease and desist, suspended, or
otherwise disciplined by any securities, insurance, or commodities regulator, foreign regulatory body, or self-
regulatory organization
 Has been named as a defendant in any proceeding brought by a domestic or foreign regulatory body or self-
regulatory organization alleging the violation of any securities, insurance, or commodities regulation
 Has been indicted or convicted of, or pleaded guilty to or no contest to, any felony or misdemeanor involving
securities, bribery, burglary, larceny, theft, robbery, extortion, forgery, counterfeiting, fraudulent concealment,
embezzlement, fraudulent conversion, or misappropriation of funds
 Is a defendant or respondent in any securities or commodities-related civil litigation or arbitration that resulted
in an award or a settlement of more than $15,000 (for any associated persons) or more than $25,000 (for
member firms)

 Is the subject of any action taken by the member firm against an associated person of that firm that results in a
suspension, termination, withholding of commissions, or the imposition of fines in excess of $2,500
 Is a director, controlling stockholder, partner, officer, or sole proprietor of, or an associated person with, a
broker-dealer, investment company, investment adviser, underwriter, or insurance company that was
suspended, expelled, or had its registration denied or revoked by any domestic or foreign regulatory body, or
pleaded no contest to any felony or misdemeanor in a domestic or foreign court
If the firm discloses some specific events to FINRA by filing Form U4 or U5 and it indicates that the
information reported corresponds to a FINRA Rule 4530 reporting obligation, a separate filing is not required.
Quarterly Reports FINRA members are required to provide FINRA with statistical and summary
information about customer complaints on a quarterly basis, even if the complaint doesn’t trigger the preceding
reporting requirement. The report is due on the 15th of the month following the end of the calendar quarter in
which the complaints were received. If no complaints were received during the quarter, no report is due.
Confidential Settlement of Complaints The terms of a customer’s settlement against a broker-dealer may
be confidential; however, this means only that the customer may not disclose the terms. The registered person
is still required to report the terms to the Central Registration Depository (CRD).
This next section will cover FINRA’s procedures for conducting disciplinary actions against members and
registered representatives (Code of Procedure) and for resolving disputes (Code of Arbitration).
Code of Procedure
The Code of Procedure describes FINRA’s process for imposing disciplinary action against member firms and
their associated persons. Disciplinary actions may be taken by FINRA for violations of FINRA rules, violations
of SEC rules, or failure to pay dues or assessments.
Disciplinary Proceedings If FINRA’s Department of Enforcement believes that a member firm or associated
person has violated a rule or law under its jurisdiction, the Department will request authorization from the Office
of Disciplinary Affairs to issue a complaint. The firm or person named in the complaint is referred to as the
respondent. The respondent must file a response to the complaint within 25 days of receiving it. If the respondent
fails to answer within the required time, the Department will issue a second notice. Failure to answer the second
notice within 14 days can be treated as an admission by the respondent to the allegations in the complaint.
In answering a complaint, the respondent may request a hearing. (If a hearing is not requested, the right to one
is waived.) The hearing is held before a Hearing Panel which consists of a Hearing Officer and two panelists
who are appointed by the Chief Hearing Officer. The Hearing Officer is an attorney who’s employed by FINRA.
The other members of the panel are persons associated with, or retired from, member firms who have an
expertise in the area under dispute and have served on local and/or national FINRA committees. The Hearing
Officer must provide the respondent with 28 days’ notice of the hearing.
The Hearing Officer may call a pre-hearing conference to prepare the parties for the hearing or to otherwise
make the process more efficient. Documentary evidence is generally submitted prior to the hearing. The
hearing provides an opportunity for witnesses to give testimony. Any witness who’s under the jurisdiction of
FINRA must testify under oath. Within 60 days after the Hearing Panel has stopped accepting evidence, it
must render a written decision that’s been arrived at by majority vote.

At any point before the hearing has begun, the respondent may propose an offer of settlement to the Hearing
Panel. If accepted, the respondent waives the right to appeal. On the other hand, if the offer is rejected by the
Panel, the hearing will proceed to a conclusion.
Sanctions A Hearing Panel may impose any of the following penalties:

 Censure a member firm or an associated person
 Fine a member firm or an associated person
 Suspend the membership of a firm or suspend the registration of an associated person, either for a definite
period or until specified conditions are met
 Expel a member firm or cancel its membership; revoke or cancel the registration of an associated person
 Suspend or bar an associated person from association with any member firm
 Impose any other fitting sanction
Note that if the registration of an associated person is suspended, cancelled, or revoked, that person may not
be associated with a member firm in any capacity—including clerical or ministerial positions. Also, both a
Hearing Panel and the National Adjudicatory Council may suspend or expel a member firm.
Other than a bar or expulsion, a sanction is effective 30 days after the respondent has received notice of a final
disciplinary action. A bar or expulsion is effective as soon as the decision is served on the respondent. If a
broker-dealer is suspended from membership, other member firms must treat this firm in the same manner as
they treat non-members.
Appeals Once a decision has been rendered by the Hearing Panel, the respondent has 25 days to file an
appeal with FINRA’s National Adjudicatory Council (NAC), which has both appellate and review jurisdiction.
In cases where the decision of the Hearing Panel is in favor of the respondent, the Department of Enforcement
also has the same right of appeal to the NAC. The NAC has the right to review a decision. The filing of an
appeal halts the decision until the appeal process is exhausted. Upon review, the NAC has the power to affirm,
modify, reverse, increase, or reduce any sanction, or impose any other fitting sanction.
A respondent has the right to appeal a final disciplinary action to the SEC. If dissatisfied with the SEC’s
decision, the matter may be brought before a federal court.
Acceptance, Waiver, and Consent In cases where the Department of Enforcement believes that a
violation has occurred and the member or associated person doesn’t dispute the violation, the Department may
request for the respondent to sign a letter accepting a finding of violation, consenting to the imposition of sanctions,
and waiving the right to appeal. This is referred to as a Letter of Acceptance, Waiver, and Consent (AWC). The
letter describes the rules violated and the sanctions to be imposed. If the letter is rejected by the respondent, the
disciplinary process will proceed as normal.

Minor Rule Violations If the Department of Enforcement believes that certain minor rule violations have
occurred and the respondent doesn’t dispute the violation, it may impose a fine of not more than $2,500
and/or censure the member or associated person, provided the respondent consents. By accepting these
sanctions, the respondent waives the right to appeal. If the respondent rejects the settlement, the normal
disciplinary process applies.
The rule violations that are covered under this approach are:
 Failure to have advertising and/or sales literature approved by a principal
 Failure to properly maintain advertising and/or sales literature files
 Failure to file advertisements on time with FINRA
 Failure to file timely reports of short positions
 Violations of SEC or FINRA books and records rules
 Failure to submit trading data as requested
Code of Arbitration
The Code of Arbitration is concerned with the settlement of disputes through arbitration, while the Code of
Procedure is concerned with discipline for violations of rules and regulations. The Code of Arbitration requires
that disputes between members and other members, or between members and any clearing corporation, be settled
by arbitration. Arbitration is also required in disputes between member firms and persons associated with a
member. However, an exception is made for any cases involving statutory discrimination or sexual harassment
claims. These claims will only be arbitrated if the parties agreed to arbitrate it, either before or after the dispute
arose. It’s important to note that arbitration doesn’t apply to disputes between a member firm and FINRA.
When a representative signs the application for securities industry registration (Form U4), he affirms a
statement that says, in part, “I agree to arbitrate any dispute, claim or controversy that may arise between me
and my firm, or a customer, or any other person, that’s required to be arbitrated under the rules, constitutions
or by-laws, of the SROs indicated...”
Arbitration is required if a public customer has a dispute with a member or person associated with a member.
However, the member cannot bring a public customer to arbitration unless the customer agrees to it. A customer
may initiate arbitration by filing a Submission Agreement of Claim and by paying the required deposit fee.
Respondents may file a counterclaim against the person who initiates the arbitration.
The statute of limitations for arbitration is six years from the occurrence of the event that created the dispute.
Predispute Arbitration Clause Many new account forms now contain a clause that obligates a customer to
submit any disputes with an RR or firm to binding arbitration. Industry rules require arbitration clauses to be
presented on the form in a certain format and with specific wording. If a firm chooses to include a predispute
arbitration clause in its new account form, it must be highlighted and preceded by the following disclosures:
 Arbitration is final and binding on the parties.
 The parties are waiving their right to seek remedies in court, including the right to a jury trial.
 Prearbitration discovery is generally more limited than, and different from, court proceedings.
 An arbitrator’s award is not required to include factual findings or legal reasoning, and any party’s right to
appeal or seek modification of rulings by the arbitrators is strictly limited.
 Typically, the panel of arbitrators will include a minority of arbitrators who were or are affiliated with the
securities industry.

 Immediately before the signature line, there must be a highlighted statement which indicates that the agreement
contains a predispute arbitration clause.
 Within 10 business days of a request, or within 30 days of signing, whichever is earlier, a copy of the agreement
must be given to the customer and the customer must acknowledge its receipt on the agreement or on a separate
document.
In the event of a dispute, the National Arbitration Committee will appoint a panel of one to three arbitrators
(depending on the dollar amount of the controversy) to hear the dispute. If a customer is involved, a majority of the
arbitrators will be public arbitrators (not affiliated with the securities industry) unless the parties agree otherwise.
Once notified of the composition of the panel, the customer has the right to reject the selection of an arbitrator on a
peremptory basis and has the right to an unlimited number of challenges for cause.
Simplified arbitration procedures are used if the amount in dispute doesn’t exceed $50,000. In a simplified
customer arbitration, one arbitrator decides the case based on written evidence and arguments, unless the
public customer demands or consents to a hearing or the arbitrator calls for a hearing. In a simplified industry
arbitration, one non-public arbitrator decides the case without a hearing, unless one of the parties demands one.
The arbitrators will make their determination after hearing the evidence and will make awards as deemed
appropriate. Any awards that are granted by an arbitrator must be paid within 30 days of determination or penalties
may be assessed on late payments. The findings of the arbitrators, unless the law directs otherwise, are final for
both members and customers.
Code of Procedure Code of Arbitration

Purpose Disciplinary actions for rule violations Settlement of disputes
FINRA versus broker-dealers and/or

Parties registered representatives
Broker-dealer, RRs, customers
 Fine  Expulsion
Possible negative
 Censure  Other appropriate Monetary or other compensation
outcomes  Suspension sanctions
Appeal allowed? Yes No
Mediation
Arbitration has been favored as a method of resolving disputes in the securities industry because it’s
considered less costly and time-consuming than litigation. However, arbitration has become a victim of its own
success. There are increasing delays in the process because it’s used more frequently, which results in fewer
qualified arbitrators being available. To address this issue, FINRA launched a new program to help resolve
disputes in a more informal manner—mediation.
What’s Mediation? Mediation is an informal process in which two parties to a dispute attempt to reach a
settlement without resorting to arbitration or litigation. In addition to the two opposing parties, a third person
also participates—the mediator. The mediator is a neutral person who’s knowledgeable about the securities
industry and attempts to facilitate the discussions and help the parties reach an agreement. Once two parties
agree to try mediation, they select a mediator who’s acceptable to both sides. (The mediator’s fee is split by the
parties unless they agree otherwise.)

Although FINRA will suggest a mediator initially, the parties can also select another mediator from a list that’s
provided by FINRA or they may select one on their own, with mutual agreement. Both parties then provide the
mediator with information that they believe is necessary to understand the dispute. Next, the parties meet with
the mediator in an initial joint session. Each party presents its case to the other party and the mediator. Then
the parties meet separately with the mediator in sessions that are referred to as caucuses. In the caucus, the
mediator’s job is to help each party examine the strengths and weaknesses of the case, look at the risks
involved, and consider possible settlements or resolutions. Since the discussions in the caucus are confidential,
the mediator will not reveal the discussions to the other side unless authorized to do so.
The mediation process will continue until:

 The parties resolve the dispute through a written settlement
 The mediator declares an impasse in the belief that continuing is futile
 Either party or the mediator makes a written withdrawal from the process
Partial Success Possible Even if the parties don’t reach a settlement through mediation, the process can still
be beneficial. Often, the opposing sides reach a clearer understanding of the dispute by mediating, and any
further action, such as arbitration, is often shorter and more to the point. At times, part of the issue will be
settled through mediation, leaving only the more intractable matters for arbitration. The parties don’t need to
wait until the end of the mediation process to begin arbitration; the two processes can run concurrently. This
way, if mediation is unsuccessful, the arbitration proceeding will be ready to begin. Mediation can even be
started after arbitration has begun as long as the arbitrator has not made a final decision.
Mediation Versus Arbitration

Mediation Arbitration
A negotiation process between the two parties A hearing process at which the two parties present their cases
Mediator attempts to facilitate a resolutiondoesn’t
Arbitrator imposes a binding settlement
impose a settlement
Either party may withdraw if it chooses Parties may not unilaterally withdraw
Informal discussion processparties may consider
feelings and look for creative solutions in addition to More formal processtestimony under oath
evidence
Settlement must be mutually agreeablecompromise Arbitrator decides the outcomeis more of a win or lose
may be possible decision
Parties must be willing to see strengths of the other
Useful where position of one or both parties is inflexible
side’s position
Often more expensive and time-consuming than mediation, but
Can be less costly and quicker than arbitration
usually cheaper and quicker than litigation
Process is private and any settlement is confidential Hearings are private, but the decision is public


Chapter 7
Communications with
the Public

CHAPTER 7 – COMMUNICATIONS WITH THE PUBLIC SERIES 24
Broker-dealers are responsible for the information that their registered representatives disseminate to
both existing and prospective clients. The SEC and other industry regulators have established rules for
communications with the public which must be enforced by member firm supervisors. These rules cover
all written or electronic communication as well as any oral statements that are made either over the
phone or in person. Additionally, many salespersons routinely use modern electronic communication
mediums, such as Internet chat rooms, text messages, and instant messages, in order to stay in touch
with existing clients and to prospect for new accounts. These newer forms of communication—referred
to as electronic communication—are also subject to SEC and industry rules.
Categories of Communications
FINRA divides communications with the public into three major categories—correspondence, institutional
communication, and retail communication. After defining these three categories, their finer distinctions
will be more closely examined.
Correspondence
Traditionally, correspondence has been viewed as any communication sent to one person. The typical
delivery methods include physical (paper) written letters, text messages, or e-mails. Today, FINRA’s new
definition is more precise. Correspondence is now defined as written or electronic messages sent by a
member firm to 25 or fewer retail investors within any 30-calendar-day period. The 25 or fewer clients
may be any type of client—existing or prospective.
Institutional Communication
This category includes any type of written or electronic communication that’s distributed or made
available only to institutional investors. This form of communication doesn’t include a member firm’s
internal communication and uses a broader definition of the term “institutional investor.” FINRA includes
all of the following as institutional investors:
 Banks, savings and loans, insurance companies, registered investment companies, and registered
investment advisers
 Government entities and their subdivisions
 Employee benefit plans, such as 403(b) and 457 plans, and other qualified plans with at least 100
participants
 Broker-dealers and their registered representatives
 Individuals or entities with total assets of at least $50 million
 Persons acting solely on behalf of these institutional investors
Under FINRA rules, a member firm must have policies and procedures in place that are designed to
prevent institutional communication from being forwarded to retail investors. One acceptable method is to
a place a legend on the communication which states, “for use by institutional investors only.” If a member
firm becomes aware that an institutional investor (e.g., another broker-dealer) is making institutional
communication available to retail investors, the firm is required to treat future communication that’s sent
to institutional investor as retail communication.

SERIES 24 CHAPTER 7 – COMMUNICATIONS WITH THE PUBLIC
Retail Communication
This category is defined as any written or electronic communication that’s distributed or made available to
more than 25 retail investors within a 30-calendar-day period. A retail investor is considered any person
who doesn’t meet the definition of an institutional investor. Retail communication is the broadest category
and includes both advertising and sales literature. All materials that are prepared for the public media in
which the ultimate audience is unknown are considered retail communications, including:
 Television, radio, and billboards
 Magazines and newspapers
 Certain websites and online interactive electronic forums, such as chat rooms, blogs, or social networking
sites (assuming retail investors have access to these sites)
 Telemarketing and sales scripts
 Independently prepared reprints of newspaper or magazine articles sent to more than 25 retail investors
Websites and Blogs Product information on the benefits of specific securities that’s posted on a firm’s
website is considered retail communication. Since no specific exemption applies, this information must be
filed with FINRA. An interactive blog that’s used by retail investors is considered retail communication,
but is exempt from both principal preapproval and FINRA filing requirements. Any interactive blog is
subject to supervision and review by a principal.
E-Mail and Instant Messaging A challenging aspect to e-mail and instant messages is that they
may ultimately be considered correspondence, retail communication, or institutional communication.
For example, an e-mail that’s sent only to registered investment advisers (i.e., institutional investors) is
considered institutional communication, an e-mail that’s sent to 25 or fewer retail investors is
considered correspondence, and finally, an e-mail that’s sent to more than 25 retail investors is
considered retail communication.
Combined Communications
It’s important to be able to distinguish the type of communication when a firm delivers or makes it
available to multiple types of investors. For example:
 Material is delivered to 20 retail investors and This is considered correspondence based on it being
any number of institutional investors delivered to 25 or fewer retail investors.
 Material is delivered to 30 retail investors and This is considered retail communication based on it being
any number of institutional investors delivered to more than 25 retail investors.
Social Media
FINRA considers a firm’s use of social media sites (e.g., LinkedIn, Facebook, and Twitter) as advertising,
unless an exception applies. For that reason, the content standards and rules regarding principal preapproval
apply. In addition, the firm must comply with all of the other applicable FINRA rules, as well as recordkeeping
rules. Although the use of a social networking site is subject to preapproval, posts by employees are considered
interactive content and therefore subject to review and supervision, but not approval. Conversely, static content
is material that’s posted to social media for an extended period and not considered interactive. This falls under
the definition of retail communication and, unless an exception applies, must be pre-approved by a principal. If
interactive content is copied or forwarded to a static area of a social media site, it’s considered a retail
communication and must be approved by a principal and may need to be filed with FINRA.

Personal Social Networking Sites Since preapproving the content being posted is challenging, many
member firms actually prohibit their employees from using certain social media sites for business
purposes. However, the use of personal social media sites by firm employees for non-business-related
communication is not considered advertising and is therefore not subject to FINRA rules. For example, a
post regarding a local charity event or a hyperlink to the securities firm’s website to access an article on
how the firm is helping to raise money for disaster victims is not advertising since there’s no mention of
the broker dealer’s business.
If a member firm employee posts or links to business-related communication on his personal social
networking page, this is considered advertising and is subject to rules. If the employee posts on his
personal social media site and promotes his firm’s business expertise and experience and also solicits
inquiries from customers, this is subject to applicable FINRA rules.
Hyperlinks A broker-dealer is permitted to include a hyperlink on its website to an independent third-

party’s content. In this case, the content is considered to be advertising by the broker-dealer if the broker-
dealer was either involved in the preparation of the content (entangled) or implicitly or explicitly approved
or endorsed the content (adopted). For example, if the securities firm assisted in the press release and then
posts a hyperlink to the release, the firm is considered to be entangled and to have adopted the content.
If a broker-dealer includes a hyperlink on its website to a generic article on securities, but doesn’t mention
any specific securities, it’s considered educational material and not advertising. If a firm’s website
contains a hyperlink to an independent third-party’s content, which also contains a hyperlink to another
website (secondary link), FINRA doesn’t consider this to be advertising. However, the same application
applies to stipulate that the content cannot be entangled or adopted by the firm.
Third-Party Post Posts by customers, or any other third party, are referred to as third-party posts. These
third-party posts that appear on either the firm’s or its employees’ social networking pages or sites are not
considered advertising unless the firm becomes entangled or has adopted the third-party content. Examples
include the broker-dealer or its employees paying or soliciting the third-party posts or sharing (“liking”)
the third-party posts.
If the firm or its employees solicited, paid, or shared (“liked”) these comments that are posted on social
media, they’re subject to FINRA’s advertising rule. Broker-dealers and their employees are prohibited
from posting to a third-party website using social media that it knows or has reason to know contains false
or misleading content.
Policies and Procedures A securities firm should develop policies and procedures regarding its
supervision of social media. Some of the factors that should be addressed are:
 Usage restrictions – the firm must determine which sites are restricted and which are prohibited
 Training and education – the firm must promote an understanding of the differences between personal
and business communications as well as how to respond to a client on social media
 Recordkeeping and record retention – the firm must document how it complies when using social media
 Monitoring – the firm must verify how it will monitor and review content
 Approval of social networking sites – the firm must indicate which sites are permitted and it must ensure
compliance with applicable FINRA rules

Any social networking site that’s used for business communications is subject to recordkeeping
requirements regardless of the device used (e.g., smartphone or tablet).
Public Appearances A public appearance includes any situation in which an employee who’s
associated with a broker-dealer participates in a television or radio interview, seminar or forum, makes a
public appearance, or engages in a speaking activity that’s unscripted. Although a public appearance itself
is not considered a form of communication, an associated person who makes a public appearance must
abide by the same general content standards that apply to all other communications. Due to the
spontaneous nature of public appearances, they’re not subject to preapproval by a principal of the firm or
filing with FINRA. When a person who’s associated with a member firm participates in a public
appearance, the following conditions apply:
 If a security is recommended, the associated person must have a reasonable basis for the recommendation
and disclose whether she has a financial interest in the security itself or any derivative of the security
 At the time of the public appearance, disclosure is required of any material conflict of interest that a firm or
associated person knows or has reason to know
 Each firm must establish policies and procedures that are appropriate to supervise public appearances. Any
scripts, slides, handouts, or other written or electronic materials that are used for a public appearance are
considered communication and must comply with all other provisions of this rule.
If a registered representative uses a PowerPoint presentation and the audience consists of more than
25 individual investors, the presentation is considered retail communication.
Internal Review Procedures

Internal Review and Retention Rules Correspondence and institutional communications must be
supervised and monitored by the member firm, but are not required to be approved by a principal prior to
use. However, as a general rule, retail communications must be approved by a qualified principal. This
approval must be obtained either before the communication is released to the public or before it’s filed
with FINRA—whichever event comes first (also referred to as pre-use approval). Firms are not only
required to maintain a file which contains all approved communications for three years after the last date
of use, they must also be kept in an easily accessible location for the first two years. The file must contain
a copy of the communication, the dates of first and last use, the name of the approving principal, and the
date on which approval was given. In the event that a specific form of retail communication is not required
to receive principal preapproval, the name of the person who prepared or distributed the communication
must be maintained by the member firm for three years from the date of last use. Now let’s examine the
specific requirements as they relate to each type of communication.
Correspondence A firm is required to educate and train its personnel as to the process of handling
correspondence and must maintain a record of the training. After its personnel are trained, a firm must also
institute a surveillance program to ensure its procedures have been implemented and are being followed.
Incoming Correspondence Member firms must develop written procedures for the review of incoming
written and electronic correspondence with the public that are appropriate to the firm’s business, size,
structure, and customers. The procedures may relate to its investment banking or securities business, including
the process for reviewing all incoming written correspondence that’s directed to a registered representative.

FINRA’s interest in this area is centered on properly identifying and handling customer complaints and
ensuring that customer funds and securities are handled in accordance with firm procedures. Whenever
possible, firms should review incoming correspondence before distributing it to the intended registered
representatives.
Mail that’s directed to a representative cannot be opened by the addressee or any person who’s directly
under that person’s control. A sufficiently trained non-registered person is permitted to review
correspondence. However, if a firm has a large number of one- or two-person offices, it may be required to
use alternative procedures. Although FINRA doesn’t mandate specific procedures, the procedures must be
designed to assure proper handling of complaints and funds. Examples of possible procedures for
reviewing incoming correspondence include:
 Forwarding opened mail related to the firm’s securities or investment banking business to an office of
supervisory jurisdiction (OSJ) or a branch manager for review on a weekly basis
 On a weekly basis, forwarding to a supervising branch a log of all checks and securities products that have
been sold
 Providing clients with an address and telephone number for the broker-dealer’s central office and informing
them that they may contact the broker-dealer directly regarding any matter (e.g., the filing of a complaint)
 Verifying that the procedures regarding all incoming written correspondence are being followed
Review of Correspondence In the course of the supervision and review of correspondence and internal
communications, a supervisor/principal may delegate certain functions to persons who are not required to be
registered. However, the supervisor/principal remains ultimately responsible for the performance of all necessary
supervisory reviews, regardless of whether she delegates functions related to the review. Accordingly,
supervisors/principals must take reasonable and appropriate action to ensure that the delegated functions are properly
executed and should evidence performance of their procedures sufficiently to demonstrate overall supervisory control.
The supervisor or principal remains ultimately responsible for the performance of all necessary supervisory reviews.
FINRA permits the use of lexicon-based screening tools or systems (those based on sensitive words or phrases);
however, firms that use automated tools or systems in the course of their supervisory review of electronic
communications must have an understanding of the limitations of those tools or systems. Further supervisory
(human) review may be necessary in light of those limitations. These tools must review each item and flag high-risk
items for additional (human) review. With respect to communications being reviewed by electronic surveillance
tools that are not selected for further review, a firm may demonstrate that the electronic surveillance system has a
means of electronically providing evidence that every piece of correspondence has been reviewed by the system.
Sampling or spot checking by the system is not considered sufficient review. The evidence of review must be
chronicled either electronically or on paper and must clearly identify the reviewer, the internal communication or
correspondence that was reviewed, the date of review, and the actions taken by the member as a result of any
significant regulatory issues identified during the review. Merely opening a communication is not sufficient review.
Institutional Communication By FINRA rule, member firms must establish written procedures for the
internal review of institutional communication to be performed by a principal. The procedures must also
incorporate supervision, education, and training requirements for the registered representatives who work in
the institutional sales department. A member firm is also required to maintain documentation that shows that
its personnel have been trained and institute surveillance and follow-up procedures to assure its policies are
being followed. The institutional communication itself, the source(s) of any chart, table, illustration, or graph,
and the name of the person who prepared it, must be kept on file for three years after the last date of use.

Retail Communication As previously described, most retail communication must be approved prior to
first use by an appropriately approved and qualified registered principal. A Supervisory Analyst (Series 16)
may approve research reports concerning debt and equity securities, as well as other research-related
communications, provided he has sufficient technical expertise in the area. Certain forms of retail
communications must be approved by supervisors who have specific registrations. For example, any
communication that pertains to options will require the approval of a Registered Options Principal.
In the following circumstances, retail communications are not required to receive principal preapproval:
 Another firm has previously filed the material with FINRA and it has not been materially altered
 The communication was posted on an online interactive electronic forum (social media)
 The communication doesn’t make a financial or investment recommendation, it doesn’t promote the firm’s
products or services, and it’s not a research report
This last exception applies to most routine communication between registered representatives and their
customers. It also applies to market letters since they’re not considered research reports. Firms must still
monitor these retail communications in the same way they handle correspondence. Generally, if the retail
communications don’t require preapproval, then they’re not required to be filed with FINRA.
FINRA Filing and Review Requirements

Correspondence and institutional communications are not required to be filed with FINRA; instead,
they’re subject to spot-checking by FINRA.
Retail Communication
Depending on the content of the retail communication, some types are required to be filed with FINRA
10 business days prior to their first use, while other types are required to be filed within 10 business days
of their first use. If pre-use filing is required, a firm cannot use the material until it’s in a form that’s
acceptable to FINRA.
For the first year as a FINRA member, a new brokerage firm is required to file with FINRA all broadly
disseminated retail communications 10 business days prior to their first use. The term “broadly disseminated”
is meant to indicate that the materials have been created for generally accessible websites, the print media, or
television or radio. FINRA may also require any firm that has departed from the standards of this rule to file
some (or all) of its communications 10 business days prior to use. The types of communications that must be
filed and the length of time for filing will be provided by FINRA. This filing requirement begins 21 calendar
days after the firm receives written notice from FINRA.
Some of the additional forms of retail communication that must be filed with FINRA at least 10 business days
prior to their first use include materials pertaining to:
 Registered investment companies that include rankings or comparisons that have been created by the
investment company itself
 Security futures

On the other hand, retail communications that pertain to the following products must be filed with FINRA
within 10 business days of being published:
 Promotes or recommends either a specific registered investment company (RIC) or a family of RICs
(provided the material doesn’t include fund-created rankings or comparisons). This category includes
mutual funds, closed-end funds, exchange-traded funds, unit investment trusts, and variable products.
These materials may promote or recommend either a specific registered investment company (RIC) or
family of RICs.
 Publicly traded direct participation programs (DPPs)
 SEC-registered collateralized mortgage obligations (CMOs)
 Any security registered with the SEC and derived from or based on a single security, a basket of securities,
an index, commodity, a debt issuance, or a foreign currency. This includes publicly offered structured
products (e.g., exchange-traded notes [ETNs]).
Filing of Television or Video Retail Communication If a broker-dealer has previously filed a draft
version or storyboard of a television or video retail communication pursuant to a filing requirement, it
must also file the final filmed version within 10 business days of first use or broadcast.
Date of First Use and Approval Information With each filing that’s made to FINRA, a member firm is
required to provide the name, title, and Central Registration Depository (CRD) number of the registered
principal who approved the retail communication, along with the date on which the approval was given.
Spot-Check Procedures All of the written and electronic communications that are created by a member
firm may be subject to spot-check procedures. FINRA may request that certain communications be submitted
within a certain time frame that’s specified by FINRA’s Advertising Department.
Exclusions from the Filing Requirements

Although certain forms of communication are not required to filed, principal approval is typically required
when they’re used by the firms or their representatives. The following types of communications are not
required to be filed with FINRA:
 Retail communications that have been previously filed with FINRA’s Advertising Department and are
being used without any material changes. Typically, information that’s distributed by broker-dealer and
created by third parties (e.g., a mutual fund) is filed by the third party and not the broker-dealer.
 Retail communications that are based on templates that were previously filed with FINRA’s Advertising
Department and any changes are limited to updates of more recent statistical or other non-narrative
information. If the template itself is changed, a new filing requirement is triggered.
 Retail communications that simply identify a member firm’s national securities exchange symbol, or
identify a security for which the member is a registered market maker, or identify that the member firm
offers a specific security at a stated price
 Retail communications that are posted on an interactive electronic forum (e.g., social media websites and
online bulletin boards). Although the various forms of social media are considered communications,
they’re exempt from FINRA’s filing requirement.

 Retail communications that don’t make any financial or investment recommendation and don’t promote a
product or service by the member firm.
– This broad category is also exempt from the principal pre-use approval requirement and includes:
 Recruitment advertising
 Advertising relating to changes in a broker-dealer’s name, personnel, electronic or postal
address, ownership, office, business structure, officers or partners, or telephone number
 Advertising related to a merger with or acquisition by another member firm
 Tombstone advertisements, prospectuses which have been filed with the SEC, and mutual fund profiles.
– It’s important to remember that this exclusion doesn’t cover broker-created, broadly
disseminated free writing prospectuses (FWPs). These unrestricted free writing prospectuses are
also required to be approved in advance by a principal and are classified as retail communication.
 Press releases that are made available only to the media
 Any reprint or excerpt of an article or report that’s issued by a publisher, provided the publisher is not
affiliated with the member firm or issuer of the securities mentioned in the reprint and neither the member
firm nor issuer of the securities mentioned in the reprint has commissioned the reprint
 Correspondence and institutional communication
 Communications that simply refer to types of investments as part of a listing of products and services
offered by the member firm
FINRA Communications Rules

Is Principal Is FINRA
Category What does it include?
Preapproval Required? Filing Required?
Written and electronic communications
distributed to 25 or fewer retail investors
Correspondence No No
during a 30-calendar-day period (e.g.,
letters, e-mail, and texts)
Written or electronic communications

Institutional
that are intended exclusively for No No
Communications
institutional investors
Written and electronic communications Yes, unless they (1) don’t contain
distributed or made available to more an investment or financial
than 25 retail investors during a 30- recommendation or promote the
Retail It depends on the
calendar-day period (e.g., publicly firm’s products or services, (2)
Communications product and the firm
available websites, newspaper and were posted during an interactive
magazine ads, television and radio electronic appearance, or (3) were
spots) previously filed with FINRA

Summary of Approval and Filing Requirements
The following retail communications must be filed with FINRA:

At least 10 business days prior to use Within 10 business of first use
1. Investment company communications that 1. Investment company communications with NO self-
include self-created rankings created rankings (this includes mutual funds, closed-end
funds, ETFs, UITs, and variable insurance products)
2. Security futures communications
2. Direct participation program (DPP) communications
3. Collateralized mortgage obligation (CMO)
communications
4. Derivative communications, such as exchange-traded
notes (ETNs)
For the following communications, NO principal approval is required

1. Retail communications
– Material that makes NO financial or investment recommendation and does NOT promote a product or
service of the member firm
– Market letters that make NO financial or investment recommendation
– Material that’s posted on an online interactive electronic forum
2. Correspondence
3. Institutional communications
General Standards of Communications with the Public

This chapter has detailed a broad range of potential communication mediums. Regardless of the delivery
method, communications with the public must be based on principles of fair dealing and good faith, be fair
and balanced, and provide a sound basis for evaluating the facts in regard to any particular security or type
of security, industry, or service. Firms cannot omit any material fact or qualification if the omission will
cause the communication to be misleading.
Predictions and Projections of Performance A firm may not make any false, exaggerated,
unwarranted, or misleading statements or claims in any communication. Statements such as “XYZ stock
will advance in price” are not allowed because of the implication that the price will definitely advance.
Also, a firm may not publish, circulate, or distribute any communication that the firm knows or has reason
to know makes any promissory statements or claims, contains any untrue statement of a material fact, or is
otherwise false or misleading.
Firms must ensure that their statements provide balanced treatment of risks and potential benefits.
Communications cannot contain disclaimers or hedge clauses that are misleading or inconsistent with the
rest of the material. Rules also require communications to be consistent with the risks of fluctuating prices
and the uncertainty of dividends, rates of return, and yields inherent in investments.

Ultimately, firms must consider the nature of the audience to which communication will be directed and
provide details and explanations that are appropriate to the intended audience.
Communication cannot predict or project performance or imply that past performance will reoccur.
However, firms are permitted to utilize:
 A hypothetical illustration of mathematical principles, provided that it doesn’t predict or project the
performance of an investment or investment strategy
 An investment analysis tool, or a written report produced by an investment analysis tool, provided
sufficient disclosures are made
Comparisons In retail communications, any comparisons between investments or services must disclose
all of the material differences between them, including (as applicable) investment objectives, costs and
expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, and tax features.
Disclosure of Firm Name All retail communications and correspondence must contain the name of the
member firm that’s sponsoring the material. If the firm has a fictional name or alias by which it’s
commonly known, that name must also be included. For blind recruiting ads, a firm’s name is not required to
be provided. However, recruiting ads must be reasonable and they cannot exaggerate the opportunities
available or the salaries that potential employees should expect.
Tax Considerations In retail communications and correspondence, unless income is free from all applicable
taxes, any references to tax-free or tax-exempt income must indicate which income taxes apply. If income from
an investment company that invests in municipal bonds is subject to state or local income taxes, this fact must
be stated, or any illustration must make it clear that the income is free only from federal income tax.
Communications cannot characterize income or investment returns as tax-free or exempt from income tax when
tax liability is merely postponed or deferred, such as when taxes are payable at the time of redemption. For
example, it’s prohibited to state that an investment in a retirement account is not subject to income tax,
when the fact is that taxes may be required at the time the funds are withdrawn from the account.
When a member firm creates a comparative illustration of tax-deferred versus taxable compounding, both
computations must use the same investment amounts and gross investment rates of return—which may not
exceed 10%. The illustration must use and identify actual federal income tax rates, and if any state income tax
rates are used, it must disclose that the tax is only applicable to investors who reside in that state. Any tax rates
that are used in an illustration which is intended for a target audience must reasonably reflect the audience’s tax
bracket(s) as well as the tax character of capital gains and ordinary income.
As applicable, the illustration must disclose the degree of risk in an investment’s assumed rate of return
(including a statement that the assumed rate is not guaranteed), the possible effects of investment losses on the
relative advantage of the taxable versus tax-deferred investments, the extent to which tax rates on capital gains
and dividends would affect a taxable investment’s return, the fact that ordinary income tax rates apply to
withdrawals from a tax-deferred investment, and the potential impact resulting from federal or state tax
penalties (e.g., withdrawing funds before a certain age or using funds for non-qualified expenses).

Testimonials In member firm communications, if a testimonial is used that relates to a technical aspect of
investing, the provider must have the knowledge and experience to form a valid opinion. Any retail
communication or correspondence which includes a testimonial about the investment advice or investment
performance of a member or its products must prominently disclose the fact that the testimonial:
 May not be representative of the experience of other customers
 Is not a guarantee of future performance or success
 Is a paid testimonial (which is the case if more that $100 is paid to the provider of the testimonial)
Recommendations Any retail communications that include a recommendation must have a reasonable
basis and must include:
 The price at the time of any equity security recommendation
 Whether the member firm makes a market or whether the member firm intends to buy or sell the
recommended security for its own account (i.e., is acting in a principal capacity)
 Whether the member firm or any associated person who’s directly or materially involved in the preparation
of the content has a financial interest in any security of the issuer being recommended and the nature of the
financial interest
 Whether the member was the manager or co-manager of any of the issuer’s securities offerings within the
last 12 months
 Information supporting the recommendation or the offer to provide such information
Any retail communications or correspondence cannot refer to past specific recommendations of the
member firm that were or would have been profitable unless the following is provided:
 A list of all recommendations for the same type of security for the past year. Longer periods may be
displayed if they’re shown consecutively and include the last year.
 The communication must state the name of each security recommended, the date and nature of each
recommendation (whether it was a buy, hold, or sell), the date and the price at the time of the
recommendation, as well as the price or price range on which any recommendation was to be acted
 A cautionary legend which appears prominently and warns investors not to assume that future
recommendations will be profitable
A research report is exempt from these recommendation requirements as long as proper disclosures are
made. In addition, prospectuses and fund profiles are not subject to the content standards of FINRA’s
Communications with the Public Rule since they’re subject to SEC standards.
Use of FINRA’s Name A firm is permitted to use FINRA’s name, or any other corporate name owned
by FINRA, in one of more of the following ways:
 In any communication—Provided that it neither states nor implies that FINRA or any other SRO endorses
or guarantees the firm’s business practices, selling methods, the type of security offered, or any specific
security. Any reference to FINRA’s review is limited to “Reviewed by FINRA” or “FINRA Reviewed.”
 In a confirmation statement for an OTC transaction—Provided it states, “This transaction has been
executed in conformity with the FINRA Uniform Practice Code.”
 On a member’s website—Provided that the member firm includes a hyperlink to FINRA’s internet address
in close proximity to its indication of FINRA membership. For example, XAM is a registered broker-
dealer and FINRA member (http://www.finra.org/).

Investment Analysis Tool Requirements

This form of communication is defined as an interactive technology tool that produces simulations and
statistical analysis to present the likelihood of various investment outcomes if certain investments are
made or certain investment strategies or styles are followed. In other words, it allows customers to enter
information into a software program which then, in turn, produces a suggested asset allocation. Although these
tools have been used on an institutional level for years, the emergence of online brokerage accounts and
trading, along with the availability and usage of these models by retail investors, has prompted FINRA to
redefine the use of these tools.
A member that offers or intends to offer an investment analysis tool (whether customers use the member's tool
independently or with assistance from the member) must provide FINRA’s Advertising Regulation Department
access to the investment analysis tool upon request.
A member that offers an investment analysis tool exclusively to “institutional investors,” is not subject to
the post-use access and filing requirement if the communications relating to or produced by the tool meet
the criteria for “institutional communication.” However, a member that intends to make the tool available
to, or that intends to use the tool or any related report with, any “retail investor” will be subject to the
filing and access requirements.
If a firm’s retail communications (e.g., brochures) simply mention the tool as one of its available services,
the firm is not required to either provide clients with the disclosures or file with FINRA. If the retail
communications refer to the tool in more detail, but don’t provide access to the tool, firms only need to
provide the following disclosures:
 The criteria and methodology of the tool as well as its limitations and key assumptions
 The universe of investments that are considered in the analysis, an explanation as to how the tool
determines which securities to select, and whether the tool favors certain securities
 The fact that investment results may change over time
 Any bias inherent in security selections, such as:
– Securities in which the firm makes a market or serves as an underwriter
– Whether the firm expects to receive revenues connected to its trading in those securities
These disclosures must be clear and prominent and, when using the tool, broker-dealers must display the
following statement:
IMPORTANT: The projections or other information generated by (name of the investment

tool) regarding the likelihood of various investment outcomes are hypothetical in nature, do
not reflect actual investment results, and are not guarantees of future results.
The disclosures must also indicate whether the investment analysis tool favors certain securities that are
offered by the broker-dealer. The disclosure also must indicate whether the tool is limited to searching,
analyzing, or in any way favoring securities in which the member makes a market, serves as underwriter,
or has any other direct or indirect interest.

Communications Regarding Investment Companies

There are numerous additional requirements regarding communications with the public that relate to
investment companies. This section will provide detail of those provisions that are most likely to be
encountered by a Series 24 candidate.
SEC Rule 156 – Investment Company Sales Literature

After the SEC declares a registration to be effective, investment companies may use written sales materials as
long as the materials are accompanied or preceded by a current prospectus. Any sales literature that’s used
by a fund must meet the standards of SEC Rule 156. Rule 156 defines sales literature as any
communication that “offers to sell or induces the sale” of shares in an investment company (mutual fund).
This includes all written materials, as well as any material prepared for television, radio, or Internet.
Communications between issuers, underwriters, and dealers may also be considered sales literature if
there’s a reasonable expectation that the materials may find their way into the hands of prospective
investors, or that the information contained in these communications may be given to investors in the
course of selling the fund’s shares.
In some cases, a mutual fund may want to distribute a circular that’s not considered a prospectus. In doing
so, the circular may only contain limited information, including:
 The fund’s objectives
 The fund’s emphasis on growth or income Performance figures cannot
 The names of the fund’s principal officers be included in the circular.
Rule 156 states that it’s unlawful for an investment company to sell its shares using any sales literature
that’s materially misleading. Sales literature is materially misleading if it:
 Contains any untrue statement of a material fact or
 Omits a material fact that’s necessary to prevent the statement from being misleading
Whether a particular statement is misleading depends on the context in which it’s made. Sales literature
may be misleading if it fails to properly explain, qualify, or limit the claims it makes about the investment,
or fails to mention the importance of general economic or financial conditions. Funds must also ensure that all
of their sales literature is current, complete, and accurate.
Past Performance If not properly qualified, representations about a fund’s past or future performance
may easily mislead investors. Portrayals of the income that a fund has generated in the past or of the way its
assets have grown may also be misleading. To avoid this problem, most investment company sales
literature discloses that “past performance is not indicative of future returns.” Generally, funds are required
to report one-, five-, and 10-year performance figures. If a fund has not been in existence for 10 years, it
must show one-year, five-year, and life of the fund performance figures. Performance figures are always
reported after fees are deducted, but before taxes are paid.
Characteristics and Attributes Statements about the characteristics or attributes of an investment company
may be misleading; therefore, positive statements about possible benefits must be balanced with equally
prominent statements about risks or limitations.

Funds should not make exaggerated or unwarranted claims about the skill of their managers or their
investment techniques. Also, they should not make unwarranted or insufficient comparisons between the
fund and other investments or indexes. Statements about a fund’s investment objectives may lead investors
to believe that these goals are certain to be achieved. For this reason, funds often disclose that there’s no
guarantee that their investment objectives will be met.
Misleading Fund Names The SEC amended the Investment Company Act to prohibit fund names that
were likely to mislead investors. Under these rules, a registered investment company whose name suggests
that it focuses on a particular type of security or industry must invest at least 80% of its assets in those
securities. For example, a fund that’s listed as the ABC Stock Fund must invest 80% of its assets in stocks,
while a fund that’s listed as the XYZ Bond Fund must invest 80% of its assets in bonds.
Under normal circumstances, a fund with a name implying that it concentrates on the securities of a specific
country or geographic region must invest 80% of its assets in the securities of that country or region. Also, a
fund with a name suggesting that its distributions are tax-exempt must invest 80% of its assets in tax-exempt
investments. In other words, its portfolio must be invested so that 80% of the income that the fund produces
is tax-exempt. Finally, these rules prohibit funds from using names suggesting that they have the guarantee or
approval of the U.S. government. A name that uses the words guaranteed or insured, or anything similar in
conjunction with United States or U.S. government, is considered misleading and deceptive.
Use of Investment Companies Rankings in Retail Communication

Investment companies (mutual funds) that receive superior performance rankings relative to their peers
may decide to emphasize this fact in their retail communications. FINRA has created guidelines on the use
of rankings in communications with the public to prevent the misuse of this type of information. If an
investment company uses a ranking symbol rather than a number in its communications, the symbol must
be explained. These rules don’t apply to any reprint or excerpt of an article or report that’s issued by a
publisher, provided the publisher is not affiliated with the member firm or issuer of the securities
mentioned in the reprint and neither the member firm nor issuer of the securities mentioned in the reprint
has commissioned the reprint (i.e., independently prepared reprints).
Ranking Entity Members cannot use investment company rankings in any retail communication other
than (1) rankings created and published by ranking entities or (2) rankings created by an investment
company or an investment company affiliate, but based on the performance measurements of a ranking
entity. A ranking entity is defined an organization that provides the public with general information about
investment companies, is independent of the investment company and its affiliates, and has not been hired
by the investment company or its affiliates to assign the fund a ranking (e.g., Morningstar).
SEC Standardized Yields For rankings that are based on yield, the SEC has established two
standardized yields that must be used. Money-market funds are required to use a seven-day standardized
yield, while bond funds are required to use a 30-day standardized yield. In addition, any rankings based on
total return must be accompanied by these yield rankings.
Required Disclosures A headline or other prominent statement in communication is not permitted to

state that an investment company or investment company family is the best performer in a category unless
it’s actually ranked first in the category.

All retail communications containing an investment company ranking must disclose:

 The name of the category (e.g., growth, asset allocation, balanced)
 The number of investment companies in the category
 The name of the ranking entity and publisher of the ranking data (i.e., name of the magazine
 The length of the period (or the first and ending date of the period)
 The criteria (total return or yield) on which the rankings are based
 The fact that past performance is no guarantee of future results
 Whether the ranking for investment companies that assess front-end sales loads take them into account
 Whether the ranking is based on total return or the current SEC standardized yield
 If the ranking consists of a symbol (a star system) rather than a number, the meaning of the symbol must be
explained (e.g., a five-star ranking indicates that the fund is in the top 10% of all investment companies)
Categories The choice of a category on which a ranking is based must provide a sound basis for
evaluating that fund. A ranking must be based on either:
 A published category or subcategory created by a ranking entity, or
 A category or subcategory created by an investment company or affiliate, but based on the performance
measurements of a ranking entity
Retail communications cannot use any category or subcategory that’s based on the asset size of an
investment company or investment company family, regardless of whether it was created by a ranking entity.
Time Restrictions If a member firm includes an investment company ranking in any retail
communications, at a minimum, it must be current to the most recent calendar quarter. With the exception
of money-market funds, retail communications must use rankings that are based on a period of at least one
year unless the ranking is based on yield.
An investment company ranking based on total return must be accompanied by total return rankings that
are provided by the same ranking entity, relating to the same investment category, and for the same period.
The required periods are:
 One year for investment companies in existence for at least one year
 One and five-year periods for investment companies in existence for at least five years, and
 One, five, and 10-year periods for investment companies in existence for at least 10 years
Short-, medium-, and long-term performance may be used if the ranking entity doesn’t provide rankings for
one-, five-, and 10-year periods. Rankings based on yield may be based only on the current SEC standardized
yield, but must be accompanied by the total return rankings for the time periods just mentioned.
Multiple Class/Two-Tier Funds If investment company rankings are being used for more than one
class of investment with the same portfolio (A and B shares), the retail communication must provide a
prominent disclosure of this fact.
Investment Company Families In addition to individual funds, member firms may use rankings for
investment company families provided these rankings comply with the rule.

As an example of many of the investment company concepts previously mentioned, the following are
some sample disclosures found on the websites of member firms:
“Current performance may be higher or lower than the quoted past performance,
which cannot guarantee future results. Share price, principal value, yield, and return
will vary, and you may have a gain or loss when you sell your shares. For the most
recent month-end performance, please click on the name of the fund above. The
performance information shown does not reflect the deduction of redemption fees; if it
did, the performance would be lower.”
“ABC Personal Finance compiled its list of the 25 best funds for your goals. ABC favors
funds run by seasoned managers who take a long-term view and have proved themselves
able to weather numerous storms. Also, ABC prefers funds with low to below-average
fees. The ending date for performance and fee data was March 9, 20XX.”
“For funds with at least a three-year history, an XYZ Star Rating is based on a risk-
adjusted return measure (including the effects of sales charges, loads, and redemption
fees) with emphasis on downward variations and consistent performance. The top 10%
of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars,
the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a
fraction of one fund within this scale and rated separately.”
“XYZ Ratings are for the share classes cited only; other classes may have different
ratings. The funds offer multiple classes of shares, each with a different combination of
sales charges, ongoing fees, and other features. These different investor share classes
are invested in a common portfolio. Institutional shares are sold to a limited group of
eligible investors, including certain retirement plans and investment programs.”
Bond Mutual Fund Volatility Ratings

Bond mutual fund volatility ratings are descriptions that are issued by an independent third party to
measure how sensitive the NAV of a bond fund is to changes in economic and market conditions. The
evaluation is based on objective factors, such as the credit quality of the fund’s individual portfolio
holdings, the market price volatility of the portfolio, the funds’ performance, and specific risks, such as
interest-rate risk, prepayment risk, and currency risk.
The fund’s sales literature (retail communication) must contain a disclosure statement which includes the
following information:
 The name of the rating entity
 The most current rating and the date of current rating
 A link or website address that includes the criteria and methodologies used to determine the rating
 A description of the rating which includes the methodology behind the rating, whether the fund paid for the
rating, and the types of risks that are measured by the rating
Collateralized Mortgage Obligation (CMO) Communication

Collateralized mortgage obligations (CMOs) are mortgage-backed securities that use the principal and interest
payments from underlying mortgages to create various classes of securities—referred to as tranches.

CMOs are unique in that they’re self-liquidating securities due to the fact that investors receive both interest
and principal payments at the same time. FINRA has created specific rules that member firms must follow
when providing CMO communication to retail investors.
Disclosure Standards and Required Education Materials All retail communications and
correspondence must include the term collateralized mortgage obligation within the name of the product
and must disclose that any applicable government agency backing only relates to the face value of the
securities, not any premium paid. Broker-dealers must also offer retail investors educational material
about the features of CMOs and the material must include a glossary of terms that are applicable to
mortgage-backed securities.
Claims about safety, guarantees, product simplicity, and predictability must be accurate and not
misleading. Due to their unique characteristics, CMOs cannot be compared to any other types of
investments, such as a certificate of deposit.
A statement must be included to indicate that a CMO’s yield-to-average life (expected return of
principal) will fluctuate depending on (1) the actual rate at which holders prepay the mortgages
underlying the CMO, and (2) changes in current interest rates.
Variable Life Insurance and Variable Annuity Communications

Variable annuities and variable life insurance policies are complex products. As a cross between securities
and insurance, variable products have some unique features that may easily confuse investors.
Consequently, FINRA has established specific guidelines for any written materials that are used to sell
these products to the public. Since registered representatives often prepare customized illustrations for
customers who are interested in variable products, these guidelines also apply to any individual
communications provided to clients, such as letters, e-mails, and computer-generated illustrations.
Identification as an Insurance Product All communications with clients must clearly identify the
product being discussed as a variable annuity or variable life insurance policy. Many companies use
proprietary names for their products which may inadvertently confuse investors about the product they’re
buying. For example, if the Bigrock Insurance Company issues a variable life insurance policy and calls it
the “Still Standing Policy,” Bigrock is required to include a statement in its advertising to clearly identify
this product as life insurance. However, if the policy was called the “Still Standing Variable Life Insurance
Policy,” then no additional description is necessary.
Since there are significant differences between variable products and mutual funds, presentations to
customers should never state or imply that variable products are mutual funds. However, there’s a
similarity in the rules related to performance advertising for variable products and mutual funds. As with
mutual funds, when the advertising for a variable product includes past performance, it must show the
average annual return over one-, five-, and 10-year periods. If the entity has not been registered for these
periods, performance must be shown for the life of the variable product.
Liquidity Customers who withdraw funds from variable products after a short period often incur
significant surrender charges and/or tax penalties. Therefore, these products should never be described as
short-term, liquid investments.

A presentation that implies that an investor may easily access her cash value either through loans or other
means, must also clearly describe the negative impact of early withdrawals. For a variable life insurance
policy, any discussion about loans and withdrawals must also include an explanation of the impact that these
actions may have on a policy’s cash value and death benefit.
Guarantees The insurance company that issues a variable product will often guarantee some of its
features. For example, an insurance company may guarantee that a variable life insurance policy will
always have a minimum death benefit if the policyholder continues to pay all of the required premiums. These
guarantees should not be overemphasized or exaggerated since they ultimately depend on the insurance
company’s solvency.
Material that’s provided to clients should never represent or imply that these guarantees apply to the separate
account. With the exception of a fixed account that’s option offered by some companies, neither the principal
value of the separate account nor its investment returns are ever guaranteed. Similarly, clients should not be
told that the ratings given to the company (AAA, BBB, etc.) also apply to the separate account.
Hypothetical Illustrations of Variable Life Insurance Policies FINRA strictly prohibits its members
from projecting or predicting investment results. However, life insurance companies customarily provide
their clients with hypothetical illustrations that assume various rates of return in order to demonstrate how
the policies work. These illustrations show how the performance of the underlying subaccounts affects the
policy’s death benefit and cash values.
Both the SEC and FINRA allow the use of hypothetical illustrations if the following guidelines are met:
 No assumed rate of return may be higher than 12% and one of the assumed rates of return must be 0%
 The assumed rates of return must be reasonable given the market conditions and investment options
 The cash values and death benefits must reflect the policy’s maximum mortality and expense charges for
each assumed rate of return
The illustration must also include a prominent statement which explains that (1) its purpose is to show how
the performance of the underlying subaccounts could affect the policy’s cash values and death benefits, (2)
it’s hypothetical, and (3) it doesn’t project or predict investment results. Generally, the illustration should not
compare the hypothetical returns of a variable life insurance policy to another product, although comparisons
with term policies are acceptable provided certain conditions are met.
Other Content Restrictions Comparisons between variable products and other types of investments must
be clear, fair, and balanced. Sales materials for variable life insurance policies that mention the investment
aspects of these products must also discuss their insurance features in a balanced fashion. Advertisements for
single premium variable life insurance policies may emphasize their investment features provided that an
adequate explanation of their insurance features is also included.


Chapter 8
Packaged Products
and Other Investment
Vehicles

SERIES 24 CHAPTER 8 – PACKAGED PRODUCTS AND OTHER INVESTMENT VEHICLES
This chapter will describe packaged products, which include mutual funds and variable annuities.
Also included in this chapter is the examination of direct participation programs (DPPs). Series 24
candidates should focus their study efforts on the sales practice issues that are associated with all of
these different products.
Packaged Products
A packaged product is a security that allows customers to indirectly participate in various investments,
typically through a pool in which many investors participate. For example, rather than purchase common
stock directly, an investor could choose to invest in a common stock mutual fund. Other examples of
packaged products include unit investment trusts, variable life insurance contracts, and variable annuities.
Students who are studying for the Series 24 Examination are expected to understand the basic
characteristics of these products, but the greatest test emphasis is likely to be placed on regulatory issues
surrounding these vehicles. Supervising principals are expected to understand who on their staff is eligible to
sell these investments, as well as identify potential sources of sales infractions. Of special interest to regulators
are the practices of switching or policy replacement in which RRs encourage clients to move funds from
one packaged product to another. Series 24 candidates should be prepared for questions concerning these
activities and must be able to determine whether the proposed asset movement is justified or whether the
salespersons are only suggesting the transaction(s) to earn additional compensation.
Registrations Required for Packaged Products Before examining these securities, let’s review the
proper registrations that are required by FINRA for both salespersons and managers who are involved in
investment company and/or variable product transactions. As described earlier, there are several different
registrations that pertain to both salespersons and principals. For exam purposes, the assumption is that a
salesperson who holds a Series 6 or 7 registration may engage in the sale of investment company products
(e.g., mutual funds). With the addition of the proper state insurance registration(s), these persons may sell
variable annuities and/or variable life policies as well. A Series 24, 26, or 9/10 registered principal, with
the appropriate insurance registrations, may review transactions in all of these product lines.
Traditional Insurance Products Under federal and state securities laws (blue-sky laws), traditional
insurance products are not considered securities because they offer returns which are guaranteed by the
insurance company. This includes universal and whole life insurance policies, as well as fixed annuities.
These products are regulated by State Insurance Commissioners, not by the SEC and FINRA.
Federal Regulation – Investment Company Act of 1940

Since most packaged products are sold as new issues, they must comply with the registration and prospectus
requirements of the Securities Act of 1933. In addition, the packaged products covered by this chapter are all
regulated by the Investment Company Act of 1940. The purpose of the Act is to protect the interests of small
investors who pool their funds to invest in these products. The Act is especially concerned with any potential
conflicts of interest that exist for the portfolio managers and distributors (defined later) of these companies.

CHAPTER 8 – PACKAGED PRODUCTS AND OTHER INVESTMENT VEHICLES SERIES 24
An investment company is a corporation or trust which allows investors to pool their funds in order to
obtain diversification and professional management. Investment companies are generally organized as
corporations in the same manner as any business corporation. However, some have been established as
trusts and, as such, are supervised by trustees rather than directors.
The Act requires all investment companies to register with the SEC by filing Form N-1A. The registration
statement and prospectus must clearly state the fundamental investment objectives of the fund and these
objectives may be changed only with the approval of a majority of the outstanding shares.
Annual reports must be sent to the SEC, while semiannual reports must be sent to shareholders. These
reports must include (among other things) a balance sheet, an income statement, a list of securities owned,
and a statement of recent changes in the portfolio.
Classifications of Investment Companies

The Act defines and classifies investment companies into three basic types—face-amount certificate
companies, unit investment trusts, and management companies.
Face-Amount Certificate Company These companies issue installment-type certificates that pay a stated
amount at the completion of the plan. Face-amount certificates are not an important product today.
Unit Investment Trust (UIT) This type of investment company is established under an indenture or
similar instrument. Unit investment trusts issue only redeemable securities, each of which represents an
undivided interest in a specific portfolio of securities. Since the portfolio remains fixed for the life of the
trust, there’s no need for day-to-day management of the portfolio. A board of trustees oversees the
operation of the trust, but doesn’t provide active management.
Management Company These companies hold a portfolio of securities on behalf of investors. The
portfolio is managed by an investment adviser that follows an investment strategy which is consistent with
the objectives of that particular investment company. Management companies are further divided into two
sub-classifications—closed-end investment companies and open-end investment companies. Today, open-
end investment companies—also referred to as mutual funds—are the most important type of investment
company. Mutual fund shares always remain in the primary market and cannot be purchased on margin.
Hedge Funds
Hedge funds are private investment pools for wealthy, sophisticated investors that, unlike mutual funds,
are not required to register with the SEC. Most hedge funds share a number of characteristics. They’re
organized as limited partnerships or limited liability companies and, as such, are permitted to pass through
both income and losses to investors. The general partner or managing member manages the fund’s
portfolio and makes all of the investment decisions. The manager usually has a significant personal stake
in the fund and the manager’s compensation is heavily tied to the fund’s performance. Hedge funds
typically seek to achieve absolute positive investment performance. In other words, they set a definite
performance goal (e.g., 8%, rather than measuring their performance against a benchmark, such as the
Dow Jones Industrial Average).

Hedge funds may use strategies that mutual funds cannot and are generally considered to be riskier
investments. They have the flexibility to sell stocks short, trade in futures and commodities, or switch all
of their assets into cash if the needs arises. Hedge funds are also much less liquid than mutual funds. Most
require their investors to wait at least one year before redeeming their shares. In other cases, the fund may
only allow investors to redeem their shares at certain times of the year. Most hedge funds also have very
high minimum investment requirements and are typically sold under Reg D to accredited investors.
How Mutual Funds Are Organized

A mutual fund owns a portfolio of securities and, in turn, is owned by its shareholders. The fund represents
a portfolio of securities that it holds for its owners, whose interests are protected by the fund’s directors or
trustees. The following parties are involved in the distribution and operation of the fund:
 Board of Directors – Supervises the overall operations of the fund
 Custodian – Holds the cash and securities of the fund and may perform clerical functions, including acting
as transfer agent, registrar, or dividend disbursing agent
 Distributors (wholesalers or underwriters) – Manage the sales effort and recruit other broker-dealers to
assist in selling the fund shares and, in doing so, may receive a discount on customer orders. The distributor
also sets the public offering price.
 Investment Adviser or Manager – Manages the fund’s portfolio of securities. The contract between the
investment company and the investment adviser must detail the compensation being paid to the adviser and
must be approved twice per year by either the board of directors or the shareholders. The contract may be
cancelled without penalty with 60 days’ notice.
The Mutual Fund Prospectus and Recent Interpretations

The Prospectus
A mutual fund’s prospectus provides relevant details regarding a particular fund. Due to the sheet size, it’s
easy to get lost in all of the legal details and miss the information that matters most to investors. Below is
list of the information found in the prospectus:
 Investment objectives, investment policies, and restrictions
 Principal risks of investing in the fund
 Performance information
 The fund’s investment adviser/manager(s)
 Operating expenses (the costs that are deducted from the fund’s assets on an ongoing basis)
 Sales charges (what investors pay when they buy/redeem fund shares)
 Classes of shares offered by the fund
 The method by which the fund’s NAV is calculated
 The method(s) by which investors purchase or redeem shares
 Exchange privileges (whether the investor can exchange shares in one fund for another one)
For years, the SEC has labored with balancing the desire to provide full disclosure to clients under the
Securities Act of 1933 versus the reality that it’s unlikely that the average investor will have either the
time or the inclination to read through a lengthy prospectus.

Mandatory Summary Information

To improve the readability of the traditional prospectus, the SEC now requires mutual fund companies to
list summary information at the front of their standard (long form or statutory) prospectus. This
information must be presented in a concise, plain English format, and in the following standardized order:
 Investment objectives and goals
 Costs (including a fee table)
 Principal investment strategies, risks, and past performance
 Background information on management
 Purchase and sale procedures
 Tax information
 Financial intermediary compensation
Mutual Fund Profiles

Under SEC Rule 498, mutual funds are permitted to create a summary prospectus (profile) that includes
the same information that’s now required in the summary section of the traditional prospectus. An investor
may purchase shares based on this document alone, but must be made aware of other information that’s
available to potential buyers. On the cover page of the profile, the fund must list an Internet address where
additional documents are available free of charge. All of these additional documents listed below must be
readable on a computer screen and able to be printed into a paper format:
 The statutory (full) prospectus
 The Statement of Additional Information
 The most recent annual and semiannual reports
Rule 135a – Generic Advertising for Investment Companies

SEC Rule 135a permits the use of advertising that describes, in general terms, how investment companies
(mutual funds) work. As long as the material doesn’t mention a specific investment company, it’s NOT
considered an offer and may be used without a prospectus. The material may refer to different generic
types of funds, such as balanced funds, growth funds, income funds, etc. However, the ad cannot discuss
the desirability of owning or purchasing the shares of a particular investment company.
Statement of Additional Information (SAI)

The statement of additional information provides more detailed information about a mutual fund and its
investment policies and risks. Unlike the prospectus, the statement of additional information is not
required to be given to any person who’s interested in purchasing the fund’s shares; however, it must be
provided to any person who requests it.
Omitting Prospectus
SEC Rule 482 permits investment companies to use advertisements that meet specific conditions by
technically classifying them as prospectuses. Because these advertisements may include ONLY
information that’s contained in the prospectus, but are not required to include everything that must be in
the prospectus, they’re referred to as omitting prospectuses.

An omitting prospectus advertisement must conspicuously state where investors may obtain a prospectus
which contains more complete information about the investment company and that it should be read
carefully before investing. An omitting prospectus cannot contain an application to invest.
Unlike a tombstone ad, an omitting prospectus may contain performance information as long as several
restrictions are observed. The ad must include a legend which discloses that the data enclosed represents
past performance and that it’s not indicative of future returns. It also must state that returns and principal
may fluctuate and that investors who redeem their shares may receive more or less than their initial
investment. (Ads for money-market funds don’t need to include the part of the disclaimer that applies to
fluctuations of principal.) If the fund charges a sales load or similar fee, the maximum charge must be
disclosed. If the performance information doesn’t reflect the impact of the sales load, the ad must indicate
that the sales charges would reduce the fund’s performance.
Yield Calculations and Performance

Yield Yield calculations for funds (other than money-market funds) must be based on a 30-day (one-
month) period and accompanied by an equally prominent disclosure of total return. The 30-day yield is
completed by dividing the net investment income per share by the NAV on the last day of the period. This
income is annualized by assuming that the amount of income is generated each month over a one-year period
and compounded semiannually. The ad must state the length of the base period and the day it ends. A tax-
equivalent yield must be accompanied by a disclosure of the tax rate assumed in the calculation.
Performance As with prospectuses, total-return calculations must be for one-, five-, and 10-year periods,
unless the fund has been in existence for less than 10 years. In that case, the calculations must cover the time
since the fund’s registration became effective. The calculation must assume the reinvestment of dividends
and distributions during the period, and take into consideration the impact of all sales charges and fees.
Money-Market Funds If the yield of a money-market fund is quoted, it must be the current yield over a
seven-day period calculated according to the SEC’s prescribed formula. The ad must disclose the length of
the base period and the day it ends. As an alternative, both current yield and effective (compounded) yield
may be displayed as long as the base period for each is identical and each is given equal prominence.
Although money-market funds attempt to maintain a NAV of $1.00 (by crediting dividends daily),
performance is not guaranteed. Ads for money-market funds must also include a statement that the fund is
not insured or guaranteed by the U.S. government, the Federal Deposit Insurance Corporation (FDIC), or
any other government agency. No guarantee of performance may be stated or implied.
Distribution of Fund Shares

Sponsor As described earlier, the sponsor (distributor) of the fund is its principal underwriter. The
sponsor (also referred to as the wholesaler) assumes the responsibility for selling the fund’s shares to the
public. Generally, an individual fund is part of a larger entity that’s referred to as a fund complex (or
family) which typically sells several different funds.

The sponsor has an exclusive agreement with the fund family, which allows it to purchase fund shares at
the current net asset value (detailed shortly). The shares may then be resold to the public at their full
offering price, either through outside dealers that are recruited by the sponsor or through the sponsor’s
own sales force.
Dealers The dealer purchases the shares from the sponsor at a discount from the public offering price to
fill an investor’s order. Dealers must have a signed selling agreement with the sponsor in order to sell the
mutual fund’s shares and must be FINRA members to receive a discount or concession.
Sales Charges and Classes of Shares

Sales Charges The distributor and dealers for a mutual fund are its sales force and they must be
compensated in some way. This is usually done through a sales charge that’s paid by the purchaser. The
various methods for assessing a sales charge will be described next. Please note that sales charges are non-
negotiable. All firms must honor the pricing that’s found in the prospectus. Individual broker-dealers and
their RRs cannot compete for mutual fund sales based on price.
Today, most funds offer investors multiple classes of shares—typically referred to as Class A, Class B,
Class C, etc. The difference in classes has to do with the way in which sales charges and distribution
charges are assessed for each class of shares. Investors can choose between shares with front-end loads
and small or no 12b-1 fees, back-end loads with higher 12b-1 fees, or some combination thereof. A 12b-1
fee is an ongoing, asset-based sales charge that’s deducted from the customer’s account on a quarterly
basis. These fees are used to pay for the cost of distributing the fund’s shares to the public, such as
concessions, advertising, and prospectus printing.
Class A Shares When mutual fund shares are purchased with a front-end load (A shares), investors
must pay the public offering price, which consists of the NAV plus a sales charge.
The basic formula for calculating the POP is as follows:
NAV + Sales Charge = POP
The sales charge of a mutual fund share is stated as a percentage of the POP. Under industry rules, the
maximum sales charge for a mutual fund is 8 1/2% of the POP. The sales load or sales charge percentage
is computed by subtracting the net asset value from the public offering price, and then dividing the
difference by the public offering price.
For example, if a mutual fund has an NAV of $9.50 and a POP of $10, then the
sales charge is 5%.
POP – NAV = Sales Charge
$10.00 – $9.50 = $.50
Sales Charge $.50

= Sales Charge Percentage = 5%
POP $10.00

Back-End Loads and Contingent Deferred Sales Charges Some funds allow investors to buy
shares at the NAV, but they impose a sales charge when the investor redeems the shares. This is a deferred
sales charge or back-end load (B shares). The amount of the back-end load typically decreases the longer
the investor owns the shares. If the investor holds the shares long enough, no sales charge is imposed upon
redemption. This is referred to as a contingent deferred sales charge (CDSC).
The following is an example of a contingent deferred sales charge scale:
Years Since the CDSC as a Percentage of the

Purchase was Made Dollar Amount Invested
0–1 4.0%
1–2 3.0%
2–3 2.0%
3–4 1.0%
4 or more None
When shares purchased at different times are redeemed in an account that’s subject to a contingent
deferred sales charge, the charge is calculated so that the investor pays the lowest charge possible. Shares
that are held the longest must be redeemed first. The charge is calculated based on the lesser of either the
original value of the shares when purchased or the current NAV.
Class C Shares Class C shares assess what’s referred to as a level load, which means there’s an ongoing
fee (typically 1.0%) for as long as the investor holds the shares. As a result, this increases the expenses of the
fund and diminishes returns (similar to the 12b-1 fee with Class B shares). These shares are most suitable for
investors who will hold their shares for a short period (more than one year, but less than three years).
Although there’s no front-end load, a back-end load may be assessed if shares are redeemed within one year.
No-Load Funds No-load funds are open-end investment companies that sell their shares to the public at
their net asset value, without any sales charge added. For these funds, the net asset value and the ask
(offer) price are the same.
Redemption Fees These fees are designed to discourage short-term trading of mutual funds. A redemption
fee is assessed to an investor when shares are redeemed prior to a fund-established holding period. The fee is
paid back to the fund and helps to defray the transaction costs associated with short-term trading.
Discounts from the POP

Breakpoints Mutual funds must be quoted at the maximum sales charge percentage that the particular
fund charges. However, most mutual funds have sales breakpoints on front-end loads, which are dollar
levels at which the sales charge is reduced. A fund’s breakpoints must be clearly stated in its prospectus.

An example of a breakpoint table follows:
Amount Deposited Sales Charge as % of Offer Price

Less than $10,000 8.5%
$10,000 but less than $25,000 7.5%
$25,000 but less than $50,000 6.0%
$50,000 but less than $100,000 4.0%
$100,000 but less than $250,000 3.0%
$250,000 but less than $500,000 2.0%
$500,000 and over 1.0%
Although this fund must be quoted at an offering price that reflects the 8 1/2% maximum, a person who
invests $10,000 or more will actually pay a lower percentage sales charge. Note: Breakpoints are created
by the fund itself. Individual RRs or broker-dealers are not permitted to offer discounts other than those
that are found in the table. These discounts are only available for purchasers of Class A shares and apply
to all purchases within a given fund family as opposed to an individual fund. Immediate family members
(husbands, wives, and minor children) may aggregate purchases to qualify for a discount. For exam
purposes, if a situation is presented and the client has a large sum to invest, assume that Class A shares are
the best choice for a given fund.
Letter of Intent A letter of intent enables an investor to qualify for the discount made available by
breakpoints without immediately depositing the entire amount required. The letter states the investor’s intention
to invest the money needed over the next 13 months. The letter of intent may be back-dated for 90 days and it’s
non-binding to the investor. In other words, an investor will not be penalized for failing to make the additional
investments. However, the mutual fund will hold some shares in escrow until the letter is completed. If the
purchases don’t take place as described in the letter, the customer will not have earned the lower sales charge
and the fund will redeem sufficient shares from escrow to impose the appropriate sales charge.
Rights of Accumulation Rights of accumulation give investors the right to receive cumulative quantity
discounts when purchasing mutual fund shares. It permits a mutual fund investor to receive a reduced sales
charge based on the total investment within a family of funds (fund complex) for shares that are purchased
in the same class. The current market value of the investment (rather than the original purchase price) plus
additional investments is used to determine the applicable sales charge. There’s generally no time
limitation that applies to rights of accumulation.
Who Qualifies for Breakpoints and Rights of Accumulation? Breakpoints, letters of intent, and
rights of accumulation are available to any person, which includes an individual, spouse, minor children
(typically those under the age of 21), a fiduciary for a single fiduciary account, or a trustee for a single
trust account. Whether the fund is held at different broker-dealer is irrelevant since it’s an agreement
between the investor and the mutual fund company. Pension plans and profit-sharing plans that qualify
under the Internal Revenue Code are also eligible. Other groups, such as investment clubs, may qualify as
long as they were not formed solely for the purpose of paying reduced sales charges.

Others That Qualify for Discounts Mutual fund companies are also able to provide discounts to other
investors as detailed in the fund’s prospectus. These others typically include employees of the fund
company or the investment adviser, as well as the employees of broker-dealers that have entered into
selling arrangements with the fund company.
Shares Class Summary

Class A Class B Class C
Contingent deferred sales
Have a level load, which is an
Sales Charges: Front-end load charge assessed if shares are
ongoing fee (typically 1.0%)
held less than 6 to 8 years
Higher than for Class A Higher than for Class A

12b-1 Fees: Low or none
shares shares
Often convert to Class A Most suitable for short-term

Breakpoints available for
Other: shares after 6 to 8 years; no investors; no conversion to
large purchases
breakpoints available Class A shares
Fees and Charges

12b-1 Charges Normally, distribution expenses for a mutual fund, including advertising and
commissions, may be paid only out of the sales charge, not out of the fund’s portfolio assets. However,
SEC rules allow mutual funds to assess a charge on fund assets to pay distribution costs if certain
conditions are met. These plans—referred to as 12b-1 plans—may be used to finance a variety of
distribution activities, including commissions to salespeople. This plan permits the board to enter into
contracts with the principal underwriter that involves payments to the underwriter. The 12b-1 charges are
based on an annual rate, but the charges may be accrued and paid over shorter periods, such as monthly.
Distribution expenses that can be paid from 12b-1 charges don’t include management fees, custodial
expenses, legal expenses, accounting expenses, and transfer agent expenses.
Continuing Commissions Section 12b-1 fees cannot be used to pay up-front commissions, but they may
be used to pay continuing commissions (trailers) on the sale of certain packaged products (e.g., mutual
fund shares) to a retired RR or other beneficiaries. The retired representative may be able to receive these
commissions for sales of investment company periodic payment plans that were initiated prior to
retirement if the representative has a bona-fide contract with the firm to receive such commissions and
agrees to not solicit new orders or accounts after retiring.
Service Fees Service fees are charges that are deducted under a 12b-1 plan and used to pay for personal
service or the maintenance of shareholder accounts. An example of such expenses is trailing commissions
(trailers). Registered representatives, who have sold fund shares to customers, receive these payments in
years following the original sale to compensate the RR for continuing to service the client’s account.
Administrative Charges These are charges that are deducted from the net assets of an investment
company to pay the various costs associated with running the fund. These fees may be used to pay parties
such as custodian banks and/or transfer agents

Appropriate Share Class Recommendations Recommending for customer to buy one class of shares
instead of another is acceptable if there’s a reasonable basis for believing that the recommendation is suitable
for the customer. The suitability of a class of shares with a particular sales charge/fee mix is often based on
the length of time the customer intends to hold the investment and the amount the customer intends to invest.
Taxation of Mutual Funds

Mutual funds typically operate on a conduit or pass-through basis. Subchapter M of the IRS Code provides
beneficial tax treatment for regulated investment companies (RICs). Basically, if an investment company
passes through at least 90% of its net investment income (dividend and interest income minus expenses), it
will not be taxed on what it has passed through to shareholders. Investment income, whether reinvested in
the fund or received by the investor in cash, is taxable to the investor. It’s important to remember that the
investor will be taxed based on the type of security that generated the income. When scrutinizing potential
sales and repurchases among funds, managers must be aware that even if these transactions occur within
the same fund family, they’re still taxable events.
FINRA Rules Regarding Investment Companies

Several parts of FINRA rules apply to the activities of members and their employees in connection with
investment company transactions.
Distribution Agreements
A written sales agreement must be in effect between an underwriter and a member firm before the member firm
may receive a discount on the sale of mutual fund shares. The selling agreement must set forth the amount
of the discount and must include the condition that, if a customer redeems shares within seven business
days after the purchase, the dealer must refund to the underwriter the full concession received on the original
sale. The underwriter must then turn over to the fund both its share and the dealer’s share of the sales
charge. Any person who’s not a party to a selling agreement must pay the full public offering price.
Members cannot purchase fund shares at a discount from an underwriter unless the underwriter is also a
member. This effectively restricts non-member underwriters from distributing their shares through
member firms. If a broker-dealer wants to sell shares of an open-end investment company, it must have a
signed selling agreement with the fund. The broker-dealer may purchase shares only for its own
investment account or to fill a customer’s order. The broker-dealer is prohibited from buying the shares
for inventory, with the intention of selling them to a customer at a later date.
Firms (including underwriters) that engage in retail transactions involving purchases of investment
company shares for their customers must transmit the payments they receive from the customers to the
investment company (or its designated agent):
 By the end of the second business day following receipt of a customer’s order OR by the end of one
business day following receipt of a customer’s payment, whichever is the later date

 If a broker-dealer receives payment from another broker-dealer or dealer bank, it must transmit the funds to
the investment company within two business days after receiving the money.
Sales Practice Rules

Selling Dividends Selling dividends refers to the prohibited practice of inducing an investor to purchase
mutual fund shares on the basis of an impending dividend. For example, let’s assume that a mutual fund
has announced that it will pay a dividend of $1 per share to holders of record as of December 30. A
registered representative tells customers to purchase the fund’s shares on December 20 at $10 a share. In
this case, the investors will be listed as holders of record on the record date and will be entitled to the
distribution. The investors may be under the impression that they will receive a 10% return on their
investment almost immediately and will, therefore, be inclined to purchase the fund. Unfortunately, the
$1 dividend is already included in the price paid for the shares and will create immediate tax liability for
the investor. However, the fund will trade ex-dividend by the amount of the distribution, which means the
investor could wait until the ex-dividend date and buy the shares at a lower price (without the dividend).
Breakpoint Sales FINRA also prohibits breakpoint sales. A breakpoint sale occurs when a registered
representative sells mutual funds shares for an amount just below the point at which a sales charge
discount would be earned without informing the client about the availability of a sales breakpoint. A
breakpoint sale can also occur if a client’s funds are invested in several different mutual fund families so
that the amount in any one fund family is below a breakpoint. Investing in fewer funds would result in
lower sales charges without sacrificing diversification.
Limits on Asset-Based Charges FINRA members cannot sell shares of investment companies that
have asset-based sales charges in excess of .75% of average annual net asset value. Members are also
prohibited from selling mutual funds that pay service fees of more than .25%.
Disclosures Any broker-dealers that sell mutual fund shares with an asset-based sales charge must
ensure that the prospectus discloses that long-term shareholders may pay more than the economic
equivalent of the maximum front-end load as permitted by industry rules. However, this disclosure is not
required for money-market funds that assess asset-based charges of .25% (i.e., 25 basis points) or less.
Use of the Term No-Load Registered representatives cannot refer to a mutual fund as no-load or as
having no sales charge if it has a front-end sales charge, deferred sales charge, or 12b-1 fee that’s greater
than .25% of average annual net assets. For example, a fund with no initial sales charge, but with a 12b-1
charge of 1%, is not a no-load fund. Although the customer is paying only the NAV when the shares are
purchased, a charge is being deducted from the portfolio each year to pay distribution expenses. In that
case, the 12b-1 charge has the same function as a front-end or deferred sales charge. Please note, a no-load
fund may have a redemption fee since this fee is paid back to the fund and not considered a sales charge.
Switching Switching refers to the practice of liquidating shares in one fund and then purchasing new
holdings in a different fund family within a short period. Switching is often a disadvantage for clients who
may incur sales or redemption charges that will reduce their returns as well as potential tax consequences.
A registered representative is prohibited from recommending for a client to switch funds in order to
generate additional commissions. A salesperson who recommends for a client to switch funds must be able
to show a definite investment advantage for the client.

Since many fund families allow investors to exchange the shares of one fund within the complex for
another without sales charges, an RR who does advise a client to exchange (switch) funds should keep
these transactions within the same fund complex whenever possible. However, even exchanges that are
executed within the same fund family are still taxable events. Series 24 candidates should be especially
vigilant in examining the motivation behind any exchange/switch recommendations.
Execution of Investment Company Portfolio Transactions The Anti-Reciprocal Rule prohibits

member firms from selling open-end investment company shares based on the commissions received or to
be received from the investment company. The member firm cannot pay additional compensation for the
sale of certain investment companies, or prepare a preferred or recommended list of certain investment
companies, in order to generate additional sales for the purpose of benefiting from commissions to be paid
by the investment company for executing trades for its portfolio.
In no way does this prohibition limit member firms from preparing a list of recommended investment
companies if the purpose is to provide their employees and customers with information that will assist
them in making investment decisions based on investment merit. The prohibition doesn’t apply to paying
extra compensation for the sale of investment companies in general if the purpose is to generate additional
sales through bona fide sales contests that don’t favor one investment company over another.
Member Compensation Mutual fund underwriters cannot pay dealers a discount or concession in the form
of a security, such as stocks or warrants. With certain exceptions, registered representatives are prohibited
from receiving compensation for the sales of investment company or variable contract (IC/VC) products, either
in cash or otherwise from any person other than the member firm with whom they’re associated. Cash
compensation includes any discount, concession, commission, service or other fee, asset-based sales charge,
loan, override, or cash employee benefit received in connection with the sale and distribution of investment
company or variable contract securities. Non-cash compensation is any compensation that’s not cash
compensation, and includes merchandise, gifts and prizes, travel expenses, meals, and lodging. For example, an
RR cannot accept compensation directly from a mutual fund distributor for selling shares of its funds. Instead,
the distributor should make payments to the broker-dealer, which in turn determines the RR’s compensation.
De Minimis Exceptions There are several exceptions that may permit RRs to receive cash or non-cash items
from outside parties. For example, representatives may accept gifts of up to $100 per person per year from a
person who’s affiliated with an IC/VC issuer or distributor. Gifts of occasional meals, as well as tickets to
sporting events, the theater, or comparable entertainment, are also acceptable as long as they’re not excessive.
However, both exceptions are based on the assumption that the gift is not preconditioned on the achievement
of a sales target, although gifts may be used to recognize past performance or to encourage future sales.
The Training and Education Exception FINRA recognizes that IC/VC issuers and distributors (which
are referred to as offerors) perform a valuable service when they provide training to member firms and their
RRs regarding the products and services they offer. For that reason, industry rules permit offerors to pay or
reimburse for meetings that serve an educational function. However, the following conditions apply:
 RRs must have their broker-dealer’s permission to attend the meeting.
 Attendance cannot be tied to the achievement of a sales target.
 The location of the meeting must be appropriate.
 Payments or reimbursements for guests of RRs (e.g., spouses) are not permitted.

In-House Incentive Programs A broker-dealer is free to create its own internal sales programs with non-
cash incentives, such as merchandise and vacation trips. A firm may even accept contributions by offerors
to its non-cash programs. However, FINRA has placed some conditions on these arrangements. One of the
restrictions requires that a non-cash incentive program for variable contracts or investment company
securities be based on the RR’s total production for all variable contract or investment company products
that are distributed by the broker-dealer. In addition, the credit earned by an RR toward the incentives
being offered must be equally weighted among the products in the program.
Regulating Investment Advisers
The Investment Advisers Act of 1940

Today, many broker-dealers are also registered as investment advisers (IAs). This step is taken so that
they’re able to go beyond effecting securities transactions in their clients’ accounts or in their own
accounts. If a broker-dealer intends to offer a product which involves advisory service (e.g., a wrap
account), it must be appropriately registered.
The Investment Advisers Act regulates firms that are established as investment advisers (IAs). The Act
both defines the term investment adviser and provides a number of exclusions from the IA definition. To
meet the investment adviser definition, a firm must satisfy all three parts of an ABC Test which includes:
 Providing Advice,
 Operating as a Business, and
 Receiving Compensation for the advice
Examples of investment advisers include firms that manage mutual fund portfolios as well as firms that
manage wrap accounts and collect a single fee to cover the costs related to investment advice along with
the costs of transactions.
Exclusions from the IA definition are available to broker-dealers, publishers, and specific types of professionals
(lawyers, accountants, teachers, engineers). For the professionals to be excluded, the investment advice being
provided must be incidental to their actual profession. For example, if an accountant decides to hold himself out
to the public as an investment adviser and charge a separate fee for that service, the exclusion will NOT apply.
The result of the Investment Company Act and the Investment Advisers Act is that a mutual fund must
register with the SEC as an investment company and the firm that manages the assets of the mutual fund’s
portfolio must register as an investment adviser.
Wrap Accounts A wrap account is a brokerage account in which a client is charged a single fee for all
services, including investment advice, execution services, and administration. The fee is typically based on
a percentage of assets under management. Since part of the fee is for investment advice, a broker-dealer
that offers a wrap account product is generally considered an investment adviser. At this point, the firm’s
advisory activities are regulated under the Investment Advisers Act of 1940. Therefore, a supervising
principal should be aware of some of the basic regulations that apply to investment advisers.

Antifraud Provisions of the Investment Advisers Act

The antifraud provisions relating to investment advisers and their investment adviser representatives
(IARs) don’t refer to dealings in securities, but instead focus on fraudulent conduct by IAs and IARs when
providing advisory services to clients. An investment adviser is considered a fiduciary that owes its clients
good faith and must provide full and fair disclosure of all material facts. This means that it’s an investment
adviser’s duty to disclose material facts to clients whenever the failure to do so would defraud or operate
as a fraud or deceit on any client or prospective client.
Conflicts of Interest An investment adviser must disclose all potential conflicts of interest with a
client. Generally, the adviser must disclose all relevant facts so that the client can make an informed
decision about the specific conflict involved. A conflict of interest may involve an IAR who may act in
more than one capacity when dealing with a client. For example, an IA that intends to implement a client’s
financial plan through a broker-dealer or insurance company with whom the IA is associated, should
inform the client that it will also be acting as an agent on the transactions.
Another example of a conflict is that of a broker-dealer that’s receiving or will be receiving a fee from a
customer for investment advice, and intends to sell the customer a security that it’s underwriting. Prior to
the completion of the transaction, the broker-dealer is required to provide the customer with written
disclosure that it’s participating in the underwriting.
An Investment Adviser Representative Who’s Also a Registered Representative If an IAR is

dually registered as an RR of a broker-dealer and provides investment advisory services outside the scope
of her employment with the broker-dealer, she must disclose to her advisory clients that the advisory
activities are independent from her employment with the broker-dealer. Additional disclosures are required
if the IAR recommends that her clients execute securities transactions through the broker-dealer with
which the IAR is associated.
Another Retirement Planning Tool – Variable Products

Many clients seek to supplement their work-based retirement programs with independent savings. A variable
annuity (VA) often fulfils this goal. These products share many of the features of mutual funds, but grow on a
tax-deferred basis. Variable annuities are an agreement between a contract owner and an insurance company. The
contract owner is the person who owns the annuity. Although the contract owner may designate any
person she wants as the annuitant, the annuitant and the contract owner are typically the same person.
Essentially, a client gives the company a specific amount of money (either lump-sum or periodically) and,
in return, the company promises to provide the annuitant with income either immediately or at some point
in the future. Funds are invested in the separate account of the insurance company and, since returns are
not guaranteed, these products are considered securities under U.S. securities laws and are subject to
prospectus delivery requirements.
Taxation of Variable Annuities

The IRS divides all annuities into two categories—qualified and non-qualified. A qualified annuity is
funded with pre-tax contributions, which means that the funds go into the contract without having been
taxed. For that reason, an investor is limited on the amount that she may contribute.

It’s important to note that once funds are in an annuity (qualified or non-qualified) the earnings grow on a
tax-deferred basis. Therefore, at the time of distribution from a qualified annuity, both the earnings and the
original contribution are taxed at the same rate as the person’s ordinary income. Put another way, the
investor has a zero-cost basis and 100% of the distributed funds are taxable as income. Please note,
annuity distributions never generate long-term capital gains.
Any person may purchase a non-qualified annuity and contribute an unlimited amount of money since the
contributions are made with after-tax dollars. The funds invested after income tax has been paid will not
be taxed again when they’re withdrawn. In a non-qualified variable annuity, the total amount of after-tax
contributions represents the investor’s cost basis.
For example, a customer has made a $50,000 contribution into a non-qualified
variable annuity. Later, the account has a value of $90,000 and the customer withdraws
the full value of the contract. In this case, the $40,000 of earnings is taxable as
ordinary income, while the remaining $50,000 is a non-taxable return of capital.
FINRA Rules Concerning Variable Products

FINRA rules that govern the sale of variable annuities and variable life insurance policies are similar to
those for investment companies. Although variable products are issued by insurance companies, they’re
considered securities and are regulated by federal securities laws. This means that a prospectus is required to be
filed with the SEC under the registration provisions of the Securities Act of 1933 in order to provide full and
fair disclosure. A copy of the prospectus must precede or accompany every sales review. Variable products
are funded by separate accounts, which generally must be registered as investment companies under the
Investment Company Act of 1940.
Selling Agreements FINRA members that are principal underwriters of variable products cannot sell
them through another broker-dealer unless that firm is also a FINRA member. There must be a sales
agreement in effect between the underwriter and the broker-dealer. As is true with mutual funds, this agreement
must state that if a client cancels the contract within seven business days after the application is accepted, the
broker-dealer will return the sales commission to the insurance company that issued the contract.
Broker-Dealer of Record The broker-dealer that’s offering the variable annuity of an insurance company
is referred to as the “broker-dealer of record.” If an RR has sold a variable annuity to a customer and then
subsequently changes firms, the insurance company is only permitted to change the broker-dealer of
record if the new firm has a signed selling agreement with the insurance company.
Applications and Premium Payments A FINRA member must transmit all applications promptly for a
variable life insurance policy or a variable annuity to the insurance company that’s issuing the contract. A
firm must also promptly send the issuer the portion of a client’s premium (purchase) payments that’s
required to be credited to the contract. Section 22c-1 of the Investment Company Act of 1940 allows the
insurance company to invest the investor's funds at a price that’s calculated no later than two business days
after receipt of the order at a price that’s based on the net asset value of the security as long as the
application is complete. If the application is incomplete, then the investment should be made by no later
than two business days after it is complete. If the application to invest is not completed within five business
days of receipt by the insurance company, the investor must be offered a full refund of all monies.

FINRA rules allow payments for variable contracts to be considered received when the contract
application has been accepted by the insurance company. As an alternative, it can be considered received,
by mutual agreement, when the payment from the client is actually received by the dealer. This definition
is important since FINRA members cannot offer contracts on any basis other than at a value to be
determined following receipt of payment in accordance with the contract and prospectus.
The exact price (NAV) of the shares in the separate account that are purchased by a policyowner must be
determined after the issuer receives the owner’s premium payment. The method for determining the NAV
must be in accordance with the product’s contract, its prospectus, and the Investment Company Act of 1940.
Redemptions If an insurance company doesn’t make payments promptly to contract owners who properly
tender requests for partial or total redemption, FINRA members are not allowed to participate in the sale of
variable contracts of that company.
Sales Charges For variable contracts, the percentage of the sales charge is computed on the amount
deposited in the separate account plus the sales charge. The issuer must be paid promptly and FINRA must be
notified if payment is not received within 10 business days. Also, FINRA members cannot sell the contract at
a price that’s lower than the price being paid by a customer. Under FINRA rules, there’s no statutory
maximum sales charge percentage on variable contract charges; however, the charge must be reasonable.
Deferred Variable Annuity Contracts –

Suitability Concerns and Compliance Issues
Suitability Deferred variable annuities are one of the more complex investment options for clients since
these contracts contain both insurance and investment attributes. Additionally, many clients may have
difficulty understanding the relevant taxation issues and/or weighing some of the additional charges and
expenses that are associated with these investments.
As with all recommendations, FINRA is most concerned with the suitability of a variable annuity contract
for clients. FINRA Rule 2330—Members’ Responsibilities Regarding Deferred Variable Annuities—
specifically addresses the sales practice issues associated with these products.
Under FINRA rules, prior to making a variable annuity purchase recommendation, salespersons must
make a reasonable effort to obtain information concerning the customer’s age, annual income, financial
situation and needs, investment experience, investment objectives, and investment time horizon (since most
contracts have CDSCs). Representatives must also inquire as to the customer’s intended use of the deferred
variable annuity, existing assets (including outside investment and life insurance holdings), liquidity
needs, liquid net worth, risk tolerance, and tax status.
Any RR who recommends deferred variable contracts must have a reasonable basis to believe that:
1. The customer has been informed of and understands the various features of the contract, such as
surrender periods, potential surrender charges, potential tax penalties for redemptions prior to age
59 1/2, mortality and expense fees, investment advisory fees, and the features associated with various
riders available with a given policy.

2. The customer will benefit from some feature(s) of the contract (such as tax-deferred growth,
annuitization, death benefits, etc.). These potential benefits should be weighed in light of the
additional costs associated with annuities as opposed to mutual funds or other investments.
3. The contract has subaccount choices and other features that make it suitable (as a whole) based on the
client’s objectives, tax situation, and age. In addition, the RR is required make a suitability
determination in order to appropriately allocate the funds to the proper subaccounts.
Principal Approval Once a registered representative has collected the required information on a
potential deferred variable annuity customer, the complete and correct application package and the
customer’s non-negotiable check (payable to the issuing insurance company) must be promptly forwarded
to the representative’s Office of Supervisory Jurisdiction for approval. Typically, once received, the
approving principal at the OSJ (a Series 24, 26, or 9/10 registered person) will review the application and
determine whether the proposed transaction is suitable. The broker-dealer has up to seven business days
from receipt of the application package to make this determination.
If the proposed transaction is judged suitable, the paperwork and funds are transmitted to the issuing
company. If not, the funds are returned to the customer. The broker-dealer is required to maintain a copy
of all checks and record the date(s) that the funds were received. Additionally, the firm must record the
date(s) that the funds were either forwarded to the insurance company for purchase of the contract or, if
the transaction was not approved, when the funds were returned to the customer.
Under FINRA recordkeeping rules, these records and documents may be created, stored, and transmitted
in either electronic or paper form. Additionally, signatures may be evidenced in either electronic or
traditional written (pen and paper) form. Occasionally, the broker-dealer may choose to transfer the
paperwork and client funds to the insurance company prior to the seven-business-day period. In this case,
the issuing insurance company may hold the client’s check or payment, pending broker-dealer approval.
This is permitted if the check is made payable to the insurance company, or if the firm is subject to certain
SEC net capital requirements, it may transfer the funds to the insurance company.
The net capital requirement stipulates that if the firm cashes the check, the client’s funds must be
segregated in a “Special Account for the Exclusive Benefit of Customers” and either applied to the
contract when approved, or returned to the client if not approved.
Scrutinizing 1035 Exchanges Although many contract purchases are funded with new funds, registered
representatives often seek to move client assets from existing contracts as well. Managers must be
extremely vigilant when examining the validity of a proposed transfer (typically accomplished through a
Section 1035 Exchange). A principal should determine if the proposed customer transfer results in the
client incurring a surrender charge, being subject to a new surrender period, losing existing benefits (e.g.,
death, living, or other contractual benefits), or incurring increased fees or charges (e.g., mortality and
expense fees, investment advisory fees, or charges for riders) as a result of the proposed transfer.
Also, many contracts offer bonus or premium payments to encourage purchases. While these inducements
many encourage purchase or 1035 transfers from another contract, clients must be made aware that these
upfront benefits are typically offset by higher annual charges. The central issue that managers must
consider is the cost of the exchange versus the benefit(s) received by the client from the new contract.

Firms and their supervising principals must look for patterns of unsuitable transfers and are required to
implement surveillance procedures to determine if any of the salespersons have excessive rates of deferred
variable annuity exchanges. A transaction is often viewed as an inappropriate exchange if the client has
made another 1035 deferred variable annuity transfer within the prior 36 months.
In order to protect against abusive transfers, many individual states and brokerage firms require that
registered representatives who suggest a transfer provide disclosure and acknowledgement forms to
customers. These documents often provide a comparison of the features and costs of an existing contract to
a proposed replacement contract, and may highlight the costs of the exchange. Generally, these
acknowledgment/disclosure forms are signed by both the firm and the client.
Training As part of their Firm Element Training Programs, member firms are required to develop and
document specific training policies or programs which are designed to ensure that associated persons who sell
variable annuities understand the suitability issues that are associated with these products. To maintain
compliance with FINRA Rule 2330, the training programs must also be designed to train registered principals.
Exam Application It’s likely that Series 24 candidates may encounter red flag questions concerning
inappropriate transfers (1035 Exchanges) and/or evaluation scenarios addressing suitability concerns based
on a client’s advanced age or tax situation. Students should be prepared for questions concerning VA
recommendations that are made to clients who may have cheaper alternatives to saving for retirement, such
as an IRA or a qualified work-sponsored plan. Also, remember, although they’re not specifically prohibited,
recommendations for the purchase of annuity contracts within a tax-deferred account (e.g., an IRA) deserve
special scrutiny. The reason for the concern is that VA contracts already grow tax-deferred and generally
have higher expenses than similar mutual funds that could be placed within a retirement account instead.
Direct Participation Programs

Industry rules regulate direct participation program (DPP) offerings by member firms. A DPP is an
investment that provides for flow-through tax consequences (single level taxation) to the investors. A DPP
may be structured as a limited partnership, joint venture, Subchapter S Corporation, or similar program.
Most DPPs are structured as limited partnerships (LPs) and may be sold as either public offerings or
private placements. LPs provide both passive income and passive losses for tax purposes and are
traditionally illiquid investments which are difficult to price. Real estate investment trusts (REITs),
pension plans, investment company securities, and tax-sheltered annuities are not DPPs.
Disclosures Prior to participating in a public offering of a DPP, a member must investigate whether full
disclosure has been made regarding items of compensation, physical properties, tax aspects, the financial
condition and experience of the sponsor, risk factors, and appraisals on properties. Members are prohibited
from distributing a program unless investor suitability standards are disclosed in the prospectus.
Clients must be informed that distribution payments are not guaranteed and may be modified at the
program’s discretion. In addition, they must be informed whether the distribution rate consists of the return
of principal (including offering proceeds) or borrowings, a breakdown of the components of the
distribution rate which shows the portion of the quoted percentage representing cash flows from the
program’s investments or operations, the portion which represents return of principal and that which
represents borrowings, as well as distribution payments.

When recommending the securities, members must have reasonable grounds to believe that the client:
 Will be in a financial position to realize the tax benefits of the program
 Has the financial resources to assume the risks and lack of liquidity inherent in the investment
 Meets all suitability standards
Members are required to maintain records showing the basis for determining a participant’s suitability.
Executing transactions in a discretionary account for program units is prohibited unless the member has the
prior written approval of the transaction from the client.
The enhanced suitability requirements for DPPs don’t apply if the offering is a follow-on and listed on a
national securities exchange (e.g., the NYSE or Nasdaq) or if it’s an IPO and the securities will be
subsequently listed on a national securities exchange. To place such securities in a customer’s
discretionary account would require the customer’s prior written approval unless the broker-dealer is not
affiliated with the DPP.
Limits on Compensation and Expenses Broker-dealers cannot participate in a DPP offering in

which organization and offering expenses are not fair and reasonable. The maximum amount of
compensation to the underwriters may not exceed 10% of the gross dollar amount of the securities sold
plus .5% of the proceeds for the reimbursement of bona fide due diligence expenses. If the sponsor is
affiliated with a member distributing the program, organization and offering expenses that are paid by the
program cannot exceed 15% of the proceeds received.
Participation in Rollups A limited partnership rollup transaction is one that involves the combination
or reorganization of one or more limited partnerships. Typically, several similar partnerships are combined
into a new entity, usually a corporation, REIT, or new partnership.
In some cases, member firms are compensated for soliciting the votes or tenders of customers who are
investors in the partnerships to be rolled up. To be permitted, FINRA requires that such compensation be:
 No more than 2% of the exchange value of the newly created securities
 Payable in an equal amount regardless of whether the partners vote for or against the rollup proposal
In addition, the general partner or sponsor proposing the transaction must agree to pay all of the solicitation
expenses (including expenses associated with preparatory work), even if the proposal is rejected. Any
dissenting limited partners must receive compensation based on the appraiser, not the general partners. The
general partners must use the evaluation standards that are contained in the limited partnership agreement to
value their interests and employ an independent third party to count limited partners’ votes.
Any dissenting limited partners (i.e., investors who vote against the rollup transaction) must receive
compensation that’s based on an appraisal of the partnership’s assets conducted by an independent appraiser,
rather than by the general partners or an affiliate. Generally, investors in the new entity should have voting
rights that are similar to the ones that they had in the original entity, including the right to remove the
general partner or member of the board of directors.

Master Limited Partnerships (MLPs)

A master limited partnership is a limited partnership that’s publicly traded on an exchange (NYSE) and its
securities are traded in a manner that’s similar to common stock. Since they’re exchange traded, MLPs are
considered liquid, are able to be purchased on margin, and may be sold short. MLPs combine the tax
benefits of limited partnerships (i.e., the flow through of income and losses to partners) with the liquidity
of publicly traded securities. To obtain the tax benefits of a pass-through investment, MLPs must receive
their income from qualifying sources such as exploration, mining, extraction, refining of oil and gas,
transportation (pipelines), and the production of alternative fuels (e.g., biodiesel). Other sources include
certain passive income generators such as real property income, dividends, and gains from futures and
other investment assets.
In order to qualify for MLP status and ensure that its income is not subject to corporate income tax, the
partnership must generate at least 90% of its income from these qualifying sources. As with other forms of
pass-through entities, an MLP requires investors to file Form K-1 to report their share of income,
deductions, and credits. Most MLPs are valued based on a multiple of cash flow as investors purchase
these securities for the cash distributions being paid quarterly. Ultimately, potential MLP investors must
consider whether dealing with the potential tax complications is worth their contribution.
Limited Liability Companies (LLCs)

Limited liability companies may be established in any state by filing the appropriate documents with the
secretary of state or other appropriate state authority. The tax status of LLCs is similar to partnerships in
that both gains and losses flow through to individual owners’ tax returns. The owners of an LLC are not
liable for the debts of the business. Another benefit of LLCs is that these businesses have management
structures which are more flexible than traditional C corporations. S corporations are limited to 100 or
fewer shareholders, while LLCs are permitted to have an unlimited number of participants.
Real Estate Investment Trusts (REITs)

Real estate investment trusts raise capital and invest the proceeds in real-estate-related activities and
mortgages. REITs invest in many different types of residential and commercial income-producing real
estate, such as apartment buildings, hotels, shopping centers, office complexes, storage facilities, hospitals,
and nursing homes. Their profits are derived from the rental income received from tenants and property
management fees, as well as the difference between the purchase and sales prices of portfolio properties.
Most real estate investment trusts attempt to provide investors with a stable dividend based on the income
produced from the real estate activities and/or mortgages. Many REITs trade on an exchange (e.g., the
NYSE or Nasdaq), which provides liquidity for investors.
On an annual basis, a corporation is considered a real estate investment trust if it meets the following tests:
 At least 75% of its gross income must be derived solely from real estate-related activities such as
rental income or interest received on mortgages.

 Additionally, 95% of its gross income must be derived from real estate-related activities (stated
above), or dividends and interest (such as interest on bank deposits). This means that no more than
5% of a REIT’s income may be derived from non-real estate business.
 It must be established as a trust.
 It must distribute a minimum of 90% of its income to shareholders (which means that shareholders are
responsible for paying taxes on a bulk of the income distributed by the REIT).
In addition, a REIT operating in its second taxable year must meet two ownership tests:
1. There must be at least 100 separate shareholders, and
2. Five or fewer individuals cannot own more than 50% of its common stock during the last half of its
taxable year.
Non-Traded REITs Although most REITs are traded on an exchange, shares of non-traded REITs are
not listed on an exchange and offer very limited liquidity (similar to limited partnerships). Neither non-
traded REITs nor limited partnerships (e.g., DPPs) are suitable for investors who are seeking liquidity.
Both traded and non-traded REITs invest in various types of real estate and are subject to SEC registration
requirements. Also, both normally operate as pass-through entities (conduits) under IRS Regulation M as
long as they distribute a minimum of 90% of taxable income.
Account Statement Valuation The value of a non-traded or unlisted REIT that’s purchased by a
customer is required to be disclosed on a customer account statement. Since they’re not actively traded,
FINRA requires the firm to create an estimated per value share which is based on a reliable valuation.
For both REITs and direct participation programs (DPPs), firms are permitted to use one of the following
methods to comply with the rule:
 Net Investment – At any time before 150 days following the second anniversary of breaking escrow, a
firm may include a per share estimated value which reflects the net investment that’s disclosed in the
issuer’s most recent periodic or current report.
‒ The term “Net Investment” is based on the amount that’s disclosed in the prospectus as the
Estimated Use of Proceeds. This is typically the amount of the offering price per share less
commissions, dealer fees, as well as estimated issuer offering and organization expenses.
 Appraised Value – At any time, firms may use an estimated value that’s based on the assets and
liabilities of the REIT or DPP which is:
‒ Performed at least annually
‒ Conducted by a third-party expert or service
‒ Derived from a methodology that adheres to standard industry practice
Additional Disclosures
 An account statement that provides a “net investment” per share estimated value for a DPP or unlisted
REIT must disclose (if applicable) prominently and in proximity to disclosure of distributions and the
per share estimated value the following statements:
"IMPORTANT—Part of your distribution includes a return of capital. Any
distribution that represents a return of capital reduces the estimated per share
value shown on your account statement.

 Any account statement that provides a per share estimated value for a DPP or unlisted REIT security
must disclose that the DPP or REIT securities are not listed on a national securities exchange, are
generally illiquid, and that, even if a customer is able to sell the securities, the price received may be
less than the per share estimated value provided in the account statement.
American Depositary Receipts or Shares (ADRs or ADSs)

ADR equity securities are used to facilitate the trading of foreign stocks in the United States. The ADR
represents a claim to foreign securities, with the shares themselves being held by U.S. banks abroad by a
depositary bank that issues the ADR. This process allows the company to raise capital in the U.S. and list the
ADR on the NYSE, or Nasdaq. The securities are dollar-denominated with dividends paid in U.S. dollars,
making them more attractive to U.S. investors. While ADR shareholders have dividend rights, they don’t
directly receive preemptive rights (where current shareholders are granted the opportunity to purchase a new
issue security before the public). In addition, although these securities are priced in U.S. dollars, holders of
ADRs are still exposed to foreign currency risk, since ADRs represent indirect ownership of foreign securities.
Sponsored or Unsponsored An American depositary receipt may be sponsored by the company whose
common stock underlies the ADR or it may be unsponsored. With a sponsored ADR, the company pays a
depositary bank to issue ADR shares in the United States. However, with an unsponsored ADR, the company
doesn’t pay for the cost that’s associated with trading in the U.S. An unsponsored ADR will trade in the OTC
market and will usually be quoted on a private quotation service (referred to as the Pink Sheets).
Promissory Notes
Promissory notes are a form of debt that are occasionally used by companies (i.e., loans to raise capital).
These notes are typically classified as securities and must be registered with the SEC; however, some are
unregistered and NOT subject to SEC review. Promissory notes are often sold by unregistered sellers. If
promissory notes are registered and sold through a private securities transaction, RRs that are involved in
the sale must obtain written approval by principal. If an RR fails to obtain written approval to engage in
the sale, it’s a violation that’s referred to as “Selling Away.” When selling promissory notes, any
commissions paid to salespeople are often excessive and not disclosed upfront to investors.
Some of the main regulatory concerns in the sale of promissory notes include:
 The promise of high, guaranteed returns
 Schemes that target the elderly
 Unregistered salespersons
 Selling away violations
Structured Products
Before investors purchase any securities, it’s important for them to review their financial situation,
investment objectives, risk tolerance, time horizon, diversification needs and need for liquidity with their
registered representative. This takes on even more importance as it relates to structured products.

Investors need to have significant understanding of the features, costs, and risks associated with investing
in structured products, as well as how their brokerage firms are compensated for selling these products.
These types of disclosures and details are provided through free writing prospectuses.
These products are a type of corporate debt that’s usually created by most major financial services
institutions and typically registered as securities with the SEC. Structured products are not bank deposits
and are not insured by the Federal Deposit Insurance Corporation (FDIC). These facts should be disclosed
by an RR when offering this product to clients.
Structured products are derivative securities that may be linked to any of the following underlying
(reference) assets: a stock index, foreign currency, commodity, basket of securities, change in spread
between asset classes, single security, or an interest-rate and inflation-linked product. A structured product
is typically built around a fixed-income instrument (a note) and a derivative product. The note pays a
specified rate of interest to the investor at defined intervals. The derivative component establishes the
amount of payment at maturity.
Reverse Convertible Securities—Third-Party Derivative Securities

Despite its name, these derivative products are NOT issued by a traditional corporate borrower. Reverse
convertible securities are short-term notes that are issued by banks and broker-dealers, which usually pay a
coupon rate above prevailing market rates. These derivative instruments are considered structured products
since the buyer is paid the enhanced coupon rate. However, in return, the buyer may be required to accept
shares of an underlying asset at maturity. In other words, the issuer is willing to pay a better coupon in
return for locking in a guaranteed sales price on an underlying asset. The underlying asset may be an
equity security that’s unrelated to the issuer, a basket of stocks, or even an index.
Higher Coupon, Higher Risk As noted, the reason the issuer agrees to pay this higher coupon rate is
that it has an option to sell the underlying security to the investor if the price of the security falls below a
specified value, which is referred to as the knock-in level. If the price of the underlying asset stays above
the knock-in level, the investor will receive the high coupon and the full return of her principal. However,
if the underlying asset falls below the knock-in level, the investor will receive shares of the underlying
asset at maturity, which could be worth less than the principal, thereby incurring a loss. In this case, the
investor may receive substantially less than the original principal invested.
Suitability Issues Obviously, these derivative securities are only suitable for investors who understand
their inherent risks. While the higher-than-average coupon may be appealing, reverse convertible holders
must understand that they may lose principal on their investment if the underlying asset falls in value and
they receive shares that have declined in value to purchase the asset at the agreed-to (knock-in) price. For
this reason, these products are not suitable for investors who are seeking safety of principal, even if the
issue has a high credit rating.
This concludes the Packaged Products chapter. The next section will cover Trading Markets.


Chapter 9
Equity Trading

SERIES 24 CHAPTER 9 – EQUITY TRADING
The next four chapters will examine trading markets. This area tends to be one of the most challenging for
students and comprises approximately 31 questions on the examination.
Trading Overview
Students must be able to distinguish between quotation systems, execution platforms, and trade-reporting
mechanisms. As the upcoming chapters begin to explore these concepts, refer to the following chart in order to
tie them together:
QUOTATION SYSTEMS EXECUTION SYSTEM REPORTING SYSTEM

Nasdaq
Nasdaq Market Center
Execution System Trade Reporting Facility (TRF)
CQS
 Third Market
ADF Proprietary Systems ADF

 NMS securities only  ATS
OTC Pink Market Manual Fills or

OTC Reporting Facility (ORF)
 OTC equities Proprietary Systems
Traditional Floor Exchange’s Proprietary Exchanges Proprietary

Trading Systems Reporting Mechanism
Traditionally, markets were classified as either exchanges—in which business was conducted in physical trading
venues (e.g., the NYSE), or over-the-counter marketplaces—in which trades occurred in dispersed dealer-to-
dealer networks in which participants were typically connected through phones and/or computers. Today, many
electronic trading venues are now classified by the regulators as exchanges, despite the fact that they lack a
physical trading floor (e.g., Nasdaq). Equities that are not listed on either a physical or electronic exchange are
referred to as OTC equities or non-exchange-traded securities and often trade in the OTC Pink Markets (the
electronic Pink Sheets). Many other securities, such as U.S. government bonds, some corporate bonds, and certain
derivative products, are also traded in the OTC market through various dealer-to-dealer networks.
In order to understand the process of equity trading, attention must be paid to three distinct areas—the
quotation systems, execution platforms, and reporting mechanisms for these securities. These terms will be
described in detail in the following chapters of this study manual. Students are advised to learn the acronyms
associated with each of these systems. A summary chart is included at the end of this chapter to assist students
in connecting the various quotation, execution, and reporting systems.
To begin, let’s define a few terms. Market center is a location to which orders are sent for execution (e.g., the NYSE
and Nasdaq). Market participants are those entities that use the equity markets to buy and sell securities. These
participants include retail and institutional investors, as well as broker-dealers that assist these clients to buy and
sell securities.

CHAPTER 9 – EQUITY TRADING SERIES 24
When executing transactions for customers, brokerage firms can act in one of two ways. One way is to act as
the agent for the buyer or seller. In this capacity, the firm attempts to locate another investor (the counterparty)
to take the other side of the trade. The firm then attempts to arrange the best price for its customer. Once the
trade is completed (settled), the brokerage firm receives a commission as the fee for its services. When acting in this
manner, the firm acts as a broker (agent).
In other cases, the brokerage firm may execute a transaction for a customer by taking the role of the
counterparty itself. For example, if a customer wants to buy a security, the firm might sell it to the customer
from its own inventory. Likewise, it may buy stock for its inventory from a customer who wants to sell.
Compensation for these types of transactions is built directly into the execution price by adjustments from the
dealers’ published quotes. The broker-dealers will typically charge a slightly higher price that’s referred to as a
markup (if they’re selling and the client is buying) or pay a lower price that’s referred to as a markdown (if
they’re buying and the client is selling). Since the firm is one of the parties to the transaction, it’s acting as a dealer
or principal by trading for its proprietary (own) account.
Since the relationship between the customer and the brokerage firm is quite different in the two capacities, it’s a
conflict of interest for a firm to act as both a broker and a dealer in the same transaction. However, the same firm
may act as a broker in some trades and as a dealer in others—which is these types of firms are referred to as a
broker-dealers. There are several factors that determine the mode in which a firm will operate, including the type
of business in which the brokerage firm chooses to engage and the nature of the market in which the transaction
occurs. Transparency in the market refers to the ability of market participants to view readily available
information concerning current quotes and trading information. Quoting securities refers to the ability to view the
prices at which various market participants are willing to buy and sell a specified quantity of a security.
Liquidity in the market refers to the ease (or lack of it) in which a security may be purchased or sold. If there are
large numbers of participants in the market, liquidity will be high and therefore market participants will be able to
execute their orders. Some market centers provide electronic automatic execution, while others provide manual
execution. For market participants to determine the prices at which recent transactions were executed, a reporting
system is required. Market participants are generally required to report executions in a timely manner so that they
can be disseminated and provide transparency to the market.
Exchange Markets
A large portion of securities transactions occur on exchanges. A national securities exchange is a market that’s
registered with the SEC under Section 6 of the Securities Exchange Act. A registered exchange acts as a self-
regulatory organization for its members and is required to have surveillance systems in place to detect and prevent
market manipulation.
The New York Stock Exchange (NYSE), Nasdaq, and the NYSE American are some of the best-known
national exchanges. There are also regional exchanges, including the Chicago, Philadelphia, and Boston Stock
Exchanges. Many floor-based exchanges are auction markets, but it’s important to note that a national
securities exchange is not required to have a traditional physical trading floor providing an auction market.
Exchanges that combine an auction market and electronic market can be classified as hybrid markets. In
compliance with Regulation NMS (to be described in Chapter 10), the NYSE and most of the regional
exchanges have become hybrid markets. These blended platforms provide both an auction market and an electronic
market, while others remain exclusively electronic (e.g., Nasdaq).

Nasdaq, which was the dominant force in the OTC market since its inception in 1971, became registered with the
SEC as an exchange on August 1, 2006. Unlike traditional exchanges that have a trading floor, an auction
market, and a specialist system, Nasdaq is a decentralized, negotiated market, with a market-maker system.
Communication occurs over electronic quotation, execution, and reporting systems. Nasdaq was originally
established as a quotation service and is part of the National Market System, which links Nasdaq, the NYSE,
NYSE American, and the regional exchanges.
Unlisted Trading Privileges

In some cases, exchanges will permit members to trade unlisted securities. Generally, these securities are not listed
because the issuer has not yet applied for listing. These securities are considered to have unlisted trading
privileges (UTPs). In most cases UTP securities are listed on another exchange. For example, the Chicago
Stock Exchange (CHX) trades Nasdaq securities on a UTP basis. SEC regulations require exchanges that permit
unlisted trading privileges to monitor trading in those securities and to provide information to the security’s
primary trading market for surveillance purposes.
Market Makers
A market maker is a dealer that stands ready to buy or sell a specific security. While a dealer may at times buy
or sell one or more securities for its proprietary account, a market maker is always prepared to do so. Making a
market means that a dealer is willing to take the other side of the transaction when an investor or another dealer
wants to trade a stock.
Market-Maker Quotes
Since market makers are willing to either buy or sell, they give two-sided quotes when asked for prices. The bid is
the price they’re willing to pay for the security; the offer or ask price is the price at which they’re willing to
sell the security. The difference between the bid and ask prices is the spread. For example, a market maker in
WXYZ might quote the stock at 43.35 bid, 43.40 offer. This can also be stated as 43.35 to 43.40. In this case,
the spread is $.05 (43.40 minus 43.35).
Another important part of the market maker’s quote is its size—the number of shares it’s willing to buy or sell
at the quoted price. When size is not indicated, quotes are assumed to be good for one normal unit of trading,
which is 100 shares. Larger sizes are stated specifically. For example, if the market maker in WXYZ is willing
to buy 2,000 shares and sell 3,000 shares, the quote will be 43.35 to 43.40, 20 by 30. (Size is typically quoted
in the number of round lots, with each round lot equal to 100 shares.)
Market makers must honor their quoted prices in interdealer transactions—trades with other broker-dealers—
although many institutional investors are able to trade at these prices as well. However, final pricing for retail
customers will differ since the trade prices to these clients are usually adjusted (through markups or
markdowns, described shortly) or additional charges such as commissions are added.

Diagram A shows another way of looking at market-maker quotes: Diagram A

Market
Value
This diagram shows the interdealer transactions that theoretically occur
at the market maker’s quote. Even in a stable market, not all trades will Sell at 43.40
occur at the bid or offer since market makers may transact business Market
between these two levels. If trades are done exclusively at the bid or Maker’s
Inventory
offer, each time the market maker buys at 43.35 and sells at 43.40, it Buy at 43.35
will earn $.05 per share. The more transactions that a market maker
executes, the more income it earns.
Markups/Markdowns
When buying from or selling to retail customers, the market maker typically pays less than the bid for
purchases from customers and charges more than the offer for sales to customers.
In this example, a customer who buys stock from a market maker will pay 43.45, which is $.05 more than the
price at which another dealer could purchase the stock. This difference is referred to as a markup. A customer
who sells stock to the market maker will receive 43.30, which is $.05 less than another dealer will receive in the
same transaction. This difference is referred to as a markdown. (The term markup is often used to refer to both
markups and markdowns as a group.)
Later, the industry rules which limit the size of the markups and markdowns that a dealer may charge will be
described. At times, determining exactly the markup being charged can be more complicated than the picture
presented so far.
The Inside Market

Many over-the-counter securities are quoted by more than one market maker. When buying stock, the lowest
offer is the most desirable; however, when selling stock, the highest bid is best. Together, these two prices are
referred to as the inside market. (Regulations often refer to the inside market as the National Best Bid or Offer,
or NBBO).
To illustrate, let’s assume that MNOP stock has three market makers with the following current quotes:
Market Maker #1 20.25 − 20.60
Market Maker #2 20.20 − 20.50
Market Maker #3 20.35 − 20.75
The best (highest) bid of the three is 20.35 from Market Maker #3, while the best (lowest) offer is 20.50 from
Market Maker #2. Therefore, the inside market is 20.35 − 20.50. Notice that the inside market is not
necessarily the actual quote of any single dealer, but rather a composite quote of the best prices that are
currently available. A dealer that wants to sell MNOP stock will contact Market Maker #3 since it’s willing to
buy at the highest price of 20.35.

Since there are no sizes indicated in the preceding example, the quotes are assumed to be for 100 shares on
each side. If a dealer that contacts Market Maker #2 wants to buy more than the size quoted, the potential
buyer will need to indicate that to the market maker. The market maker will then need to decide whether to
provide a quote for the size the dealer desires or for less than that amount. The new quote cannot be at the
same price as the one for the smaller size.
Market makers have an obligation to stand behind their quotes for the size and price displayed. If the market
maker is contacted by another dealer and fails to honor its quote, it’s considered backing away. The market
maker has violated FINRA and SEC rules regarding its failure to honor its displayed market and is subject to
disciplinary action. Failure to honor a quote can result in a monetary fine or suspension of the firm from
market-making activities.
Selling Short
Although a market maker presents itself as always prepared to buy or sell a specific security, there are times
when demand for the security may be so heavy that the market maker runs out of inventory. In that case, the
market maker may sell the stock short and be obligated to cover the position at some later time by buying stock
from customers or other market makers. The action of selling stock short—also termed short selling—is
defined as any sale of a security that the seller doesn’t own, or any sale that’s consummated by the delivery of a
security borrowed by (or for the account of) the seller.
Selling short can cause substantial losses if the stock rises sharply. Therefore, a market maker will attempt to
anticipate market demand and adjust inventories accordingly by selling short only if necessary to maintain its
commitment to the market. Some regulations distinguish between selling short as part of a firm’s bona fide
market-making activity (i.e., selling to meet customer demand) and taking a purely speculative short position.
Investors are also permitted to sell short. Regulation SHO, which is described later, covers the rules for both
customer and broker-dealer short selling.
Regulation National Market System (NMS)

Regulation NMS is a set of rules implemented by the SEC to refine how all listed U.S. stocks are traded. The
intention is to boost transparency by improving the displaying of quotes and access to market date, as well as
to essentially ensure that investors obtain the best price on their orders. Some of the provisions of Regulation
NMS are covered in this chapter, while others will be described in the next chapter.
The Order Access Rule

SEC Rule 610—the Access Rule—was established to promote fair and equal access to quotations. The rule
promotes access to protected quotations in the following three ways:
1. It requires that market participants have make access to their quotations available on Nasdaq, the NYSE,
NYSE American, and regional exchanges through a variety of approved, private connectivity providers.
2. It places a limit on access fees of $0.003 per share in order to promote fairness and efficiency within the
National Market System.
3. Trading centers are required to establish written rules that are designed to prevent market participants from
displaying quotations which lock or cross the market.

‒ A locked market occurs when a market center displays a bid at the same price as the current lowest offer
made by another market center, or when a market center displays an offer that’s equal to the current
highest bid of another market center.
‒ A crossed market occurs when a market center displays a bid that’s higher than the current lowest offer
made by another market center, or when a market center displays an offer that’s lower than the current
highest bid of another market center.
The Order Protection Rule

SEC Rule 611—also referred to as the Order Protection Rule or the Trade-Through Rule—was established
under Regulation NMS to prevent trade-throughs of protected quotations. A protected quotation is one that’s
immediately accessible through automatic execution. Manual quotes are not protected quotations and are not
subject to the Order Protection Rule. A trade-through occurs when an order that crosses the market is executed at
an inferior price regardless of better-priced quotations that may be available at other market centers. Rule 611
requires market centers to establish written policies and procedures that are designed to reasonably prevent trade-
throughs within the National Market System by routing orders to the market center that displays the best price.
However, one exception to the Order Protection Rule is available for intermarket sweep orders (ISOs).
Intermarket MOC Orders Rule 611 creates an exception to the trade-through rule for limit orders that are
designated intermarket sweep orders. ISOs allow broker-dealers to execute trades at inferior prices in one market
while simultaneously directing orders for execution to away markets displaying protected quotations. ISOs allow
market participants to capture the size available at inferior prices (before the opportunity to get filled is missed and
subsequent prices become even less favorable). They can do so by sending multiple limit orders simultaneously to
both the market center(s) displaying inferior prices and the market center displaying protected quotations.
When using ISOs, although executions of multiple limit orders take place at inferior prices, these trades occur
simultaneously with the executions of protected quotations, thereby averting a violation of the Order
Protection Rule. The limit orders must be designated ISO for the exception to Rule 611 to be recognized.
Because the trades against protected quotations are executed simultaneously with the orders at inferior prices,
the executing broker-dealer’s best execution obligation is met in accordance with Regulation NMS. Therefore,
ISOs create a solution to the dilemma that’s encountered by broker-dealers when faced with the problem of
avoiding trade-throughs and also filling orders in the most expedient manner.
Stopped Orders Traders will often use stopped orders to guarantee a maximum or minimum price on a large
trade for an institutional client. These orders give clients the comfort of knowing that they will not pay more
than a specified amount when buying stock or receive less when selling stock. When a stop order is executed, it
may be outside the current inside market, which is normally a trade-through violation.
However, stopped orders are exempt from the Order Protection Rule and are not a trade-through violation if
they meet the following conditions:
 The transaction that constituted the trade-through was the execution by a trading center of an order for
which, at the time of receipt of the order, the trading center had guaranteed an execution at no worse than
a specified price (a stopped order) where:
– The stopped order was for the account of a customer. (A customer is defined as any person that’s not a
broker-dealer.)

– The customer agreed to the specified price on an order-by-order basis.

– The price of the trade-through transaction was, for a stopped buy order, lower than the national best bid in
the NMS stock at the time of execution or, for a stopped sell order, higher than the national best offer in
the NMS stock at the time of execution.
This exception was created primarily for institutional customers (e.g., money managers) and allows a trading
center to execute an order to complete a stopped buy order lower than the changed inside bid or a stopped sell
order higher than the changed inside offer.
There are several other exceptions to the Order Protection Rule, such as for flickering quotes and quotations
when there’s a material delay in providing a response to incoming orders. Flickering quotations occur when
there are multiple prices displayed within a one-second period. A material delay occurs when a trading center
repeatedly fails to respond to an order within one second. Also included are exceptions for benchmarked
orders, such as Volume Weighted Average Price (VWAP) orders, and a single-priced opening or closing
transaction by a market center.
Minimum Pricing Increment

Rule 612 if Regulation NMS controls sub-penny pricing increments for NMS stocks. Under Rule 612, national
securities exchanges, national securities associations, alternative trading systems (ATSs), vendors, and broker-
dealers are prohibited from accepting the following bids, offers, or indications of interest for NMS stocks:
 For stocks that are priced at $1.00 or more – any increments that are smaller than $0.01
 For stocks priced less than $1.00 – any increments that are smaller than $0.0001 (one hundredth of one cent)
For example, if a market participant is entering a limit order to sell shares of an NMS stock
and the inside market is 18.50 – 18.55 ($1.00 or more), it cannot enter an order with a price
that extends more than two places past the decimal point. (For instance, 18.559 is not
acceptable; however, $18.56 is acceptable.) If a market participant is entering a limit order
to buy 800 shares of an NMS stock and the inside market is 0.50 – 0.65 (less than $1.00), it
cannot enter an order with a price that extends more than four places past the decimal point
(0.51598 is not acceptable, while 0.5159 is acceptable).
The Nasdaq Stock Market Listing Criteria

The Nasdaq Stock Market has many rules in place to ensure that issuers and their stocks meet predetermined
standards. All Nasdaq issuers must meet qualitative criteria designed to protect the interests of shareholders.
Among these requirements—referred to as corporate governance standards—are the following:

 A majority of the issuer’s board of directors must be independent.
 An audit committee that consists solely of independent directors must be maintained.
 Shareholders must be provided with annual reports; quarterly and other reports must also be made available.
 Proxies must be solicited and statements provided for all meetings to shareholders.
 Issuers must refrain from taking certain actions or issuing securities that would disparately reduce or restrict the
voting rights of existing shareholders.

In addition to initial qualitative requirements, the issuer must meet financial and liquidity requirements. The Nasdaq
Stock Market is registered with the SEC as a stock exchange. For a security to trade on Nasdaq, the issuer must
meet listing standards, apply for listing, and be accepted by Nasdaq.
The listing standards that must be met are dependent on whether the security is classified as a Nasdaq Capital
Market (NCM) security, a Nasdaq Global Market (NGM) security, or a Nasdaq Global Select Market (NGSM)
security. The requirements for continued listing on Nasdaq are lower than those required for initial listing.
Nasdaq Capital Market Standards

Nasdaq Capital Market stocks must meet minimum requirements for financial strength, public float, market
value, and number of shareholders. In addition, the stock must have a bid price of at least $4.00 per share to
qualify for listing, and must have at least three market makers. After listing, the issue must continue to meet
standards that are somewhat lower than the initial requirements, such as a continuing bid test requirement of at
least $1.00 per share. An issue that fails to meet maintenance standards is subject to delisting. However, please
note, the company may voluntarily choose to delist its issue at any time.
Nasdaq Global Market Standards

Nasdaq Global Market issuers may qualify for initial listing on Nasdaq by meeting one of three alternative sets of
standards. However, both the initial and continuing listing standards are more stringent than those for Capital
Market issues. On balance, NGM issues are more widely known, have more volume, and have more market makers.
Nasdaq Global Select Market Standards

Nasdaq Global Select Market securities represent the top tier in the ranking of Nasdaq securities and, therefore,
have the most stringent listing and maintenance requirements. In fact, the Nasdaq Global Select Market
securities have the most stringent listing specifications in the world (even more stringent than NYSE standards).
There are three standards to use when applying for Nasdaq Global Select listing. Of the seven requirements,
only three must be satisfied under all three standards in order for a security to be listed. These include:
1. A $4.00 minimum bid price
2. Three or four market makers
3. Subject to corporate governance
The following four requirements may not be applicable, depending on which of the three standards is used in
the issuer’s application:
4. Pre-tax earnings
5. Cash flow
6. Market capitalization
7. Revenue
Delisting and Relisting If an issue is delisted from Nasdaq, the issuer must reapply and satisfy the initial
listing requirements in order to be relisted on Nasdaq. An issue that’s delisted from Nasdaq may immediately
begin trading on the Pink Open Market.

Nasdaq Services and Systems

Nasdaq offers several services and systems to member firms, some of which are also available to investors.
Information About Nasdaq Securities

The most important function of Nasdaq is the collection and dissemination of real-time, firm quotes. By
displaying this information, much of the uncertainty regarding prices in the market is removed. The exact
information depends on the level of service that’s chosen by the subscriber.
Level 1 Service Level 1 service provides subscribers with the inside market for each Nasdaq security, as
well as last sale and running volume information. It doesn’t list the quote from each market maker, as Level 2
does. Level 1 service is used mainly by individual investors and their registered representatives.
Level 2 Service Level 2 Nasdaq service provides subscribers with the names and quotes of all registered
market makers in each Nasdaq security. This service also displays the inside market for that security. This
feature is useful since some Nasdaq stocks have a significant number of market makers.
Many financial institutions use Level 2 to monitor the value of their Nasdaq holdings and to make trading
decisions. However, this level is especially important to traders at Nasdaq firms. With Level 2, a trader can
easily determine which market maker has the best price for a particular security.
Since all Nasdaq quotes are firm, the trader will only need to contact the market maker and indicate the intent to
execute the trade at the price and size shown. A trader can also try to negotiate a better price than the quote listed on
the screen. Traders can also use the Nasdaq Market Center Execution System (described later).
Level 3 Service Level 3 service is available only to the market makers that are registered in a particular
security. Although it displays the same information as Level 2, it’s also interactive. In other words, market
makers can update their quotations through the Level 3 screen for their stocks, as well as make trade and
volume reports to Nasdaq.
TotalView Nasdaq TotalView is a quotation display service that’s available to professional and non-professional
traders and shows the entire Nasdaq book for a particular security.
Subscribers pay a monthly fee for access. TotalView displays the quote size and price of a specific stock that’s
available from every market participant, including Nasdaq market makers, the NYSE, the NYSE American,
and the regional exchanges. In addition to price and size, TotalView displays the depth (aggregate number of
shares) of the market at each price level, giving traders a greater perception of market liquidity.
Nasdaq Market Velocity This measures order activity within the Nasdaq Market Center. The Nasdaq Market
Center contains Nasdaq’s order display and execution system and a trade reporting facility (TRF). This order
activity includes quotes, orders, updates, and cancellations.

Registration as a Nasdaq Market Maker

Deciding whether to make markets in specific stocks is a complicated business decision for a broker-dealer.
The broker-dealer must believe that its personnel have sufficient knowledge and the skill to generate market-
making profits. Once this decision has been made, the procedures that must be followed to enter the market are
dependent on the type of security involved. Many firms that have acted as underwriters have provided research
coverage on a security will act as a market maker.
A broker-dealer may enter quotes into Nasdaq only if it’s registered as a Nasdaq market maker. A prospective
market maker must file an application with Nasdaq that certifies its good standing with the self-regulatory
organization (SRO) and demonstrates its compliance with financial responsibility rules, including net capital
requirements. A market maker’s registration is effective only when it’s notified by Nasdaq.
In addition to the preceding general requirements, a dealer must also register in the specific issues in which it
wishes to make a market by contacting Nasdaq Market Operations. This is done by entering a registration request
through a Nasdaq terminal. Registration becomes effective on the day registration is requested. Once a market
maker’s registration in a particular issue is effective, it must enter quotes within five business days. Failure to
do so terminates the market maker’s registration in that security.
Normal Business Hours A Nasdaq market maker must be open for business as of 9:30 a.m. ET and may
close its market no earlier than 4:00 p.m. ET. (All times used in this Study Manual are Eastern Time [ET]
unless otherwise indicated.) A market maker may voluntarily open its quotes to participate in the premarket
trading session, which takes place from 4:00 a.m. to 9:30 a.m. A market maker may also voluntarily reopen its
quotes after the close at 4:00 p.m. to participate in the aftermarket trading session, which takes place from 4:00
p.m. to 8:00 p.m. The Nasdaq system operates from 4:00 a.m. to 8:00 p.m. ET.
Voluntary and Excused Withdrawals

A Nasdaq or ADF market maker may terminate its registration in a security by withdrawing its quotes in a
Nasdaq security at any time on a voluntary (unexcused) basis. However, if terminated, that market maker
cannot re-register as a Nasdaq or ADF market maker in that security for 20 business days. In the case of an
unexcused withdrawal from quoting a CQS (exchange-listed) security, the market maker may re-register
after only one business day.
A market maker may apply to Nasdaq Market Operations for excused withdrawal status for the reasons below:
1. Withdrawals for up to five business days may be granted for circumstances beyond the market maker’s
control (e.g., damage from a severe storm or a sudden illness).
2. Withdrawals of up to 60 days may be granted for legal or regulatory reasons if supporting documentation is
provided and the condition is not permanent. For example, the market maker may have come into
possession of insider information about an issuer. It may not trade the issuer’s equity securities while in
possession of that information until the information is released to the public.
3. Withdrawals for religious holidays may be granted, but application must be made one business day in
advance and must be approved by FINRA.

4. Since small firms (defined as market makers with three or fewer Level 3 terminals) may have difficulty due
to key personnel being on vacation, withdrawals may be granted if application is made one business day in
advance and includes a list of securities for which withdrawal is requested.
5. Market makers that are participants in a securities distribution (acting as underwriters) are covered by
special rules (Regulation M).
6. If a firm fails to maintain a clearing relationship with a registered clearing agency or a member of a clearing
agency (and is thereby not participating in TRF), it may reenter quotes after re-establishing a clearing
relationship. However, if the market maker’s failure to maintain a clearing relationship is voluntary, its
withdrawal is considered voluntary, not excused.
7. If a firm has a fail to deliver in a threshold security (as defined under Regulation SHO) at its clearing firm for
a period of 13 continuous settlement days, and the security cannot be borrowed in order to effect short sale
transactions as a part of bona fide market making, the firm qualifies for an excused withdrawal.
Excused withdrawals will NOT be granted because of pending news about an issuer or because of price changes
or a sudden influx of orders. Following an excused withdrawal, a market maker will re-register in the same
manner as its original registration. The new registration becomes effective on the same business day as entered.
Regulation M Withdrawals In order to comply with parts of Regulation M (described in the Underwriting
chapter), a market maker may need to be granted excused withdrawal status or passive market-maker status by
FINRA. A Nasdaq market maker is not required to act as a passive market maker. However, the syndicate
manager may apply for this status on behalf of any affected syndicate member by no later than the business
day prior to the first entire trading session of the one- or five-day restricted period under Rule 101. The
manager then notifies each affected syndicate member that it will have passive market-maker status or that its
quote will be withdrawn on an excused basis, unless that market maker directly notifies FINRA otherwise.
Passive market makers are identified on Nasdaq by the abbreviation PSMM and, in order to comply with the
net purchases limitation, a passive market maker must notify Nasdaq for an excused withdrawal.
Accidental Withdrawals There have been cases where a firm has inadvertently withdrawn from making a
market in a security because a person typed in the wrong symbol when communicating a withdrawal that was
intended for another security. A market maker can be immediately reinstated in such a situation if (1) it notifies
Nasdaq Market Operations within one hour of the withdrawal and follows up with written notification, (2) it’s
clear that the withdrawal was inadvertent and not an attempt to avoid market-making obligations, and (3) the
number of reinstatements per year is acceptable.
Depending on the number of markets that a firm makes, a range of two to six inadvertent withdrawals is
considered acceptable. Consideration will also be given to how similar the correct and incorrect symbols were.
Market Participant Identifier (MPID)

Primary MPID When a market maker registers with Nasdaq, it will be given a market participant identifier
(MPID) to enter quotes into the system. A trade that results from a posted quote should be reported using the
same MPID that was used for displaying the quote. A member firm that’s registered as a market maker in a
specific security must maintain a two-sided quote under its primary MPID.

Supplemental MPID A FINRA member firm may have additional displayable or non-displayable
supplemental MPIDs. Supplemental MPIDs are often used by broker-dealers to facilitate:
 Sponsored Access Programs (described below)
 Prime brokerage relationships
 Proprietary business
 Statistical or index arbitrage business
The non-displayable (non-attributable) quotes or orders are posted anonymously through Nasdaq’s NSDQ.
Firms must receive FINRA approval to use other identifications in addition to their primary market participant
symbol. Nasdaq rules prohibit using supplemental MPIDs by an equity market maker to engage in passive
market making or to enter stabilizing bids. Quotes using supplemental MPIDs can be one-sided and there’s no
unexcused withdrawal penalty.
Market Access (SEC Rule 15c3-5)

Broker-dealers are permitted to provide both direct and sponsored access to customers. This allows customers
and/or the firm’s proprietary trading units to send orders directly to exchanges and alternative trading systems.
Many of these customers are high-frequency traders (HFTs) and are not subject to the rules of the exchanges
since they’re not members. To an HFT, speed is paramount and these improved forms of access may get them
to markets more quickly.
Under these access methods, the broker-dealer provides these customers with a Market Participant Identifier
(MPID) so that they can trade directly with the markets. With direct access, the customers use the
infrastructure of the broker-dealer and orders pass through the broker-dealer’s system. With sponsored access,
the customers use their own system and orders don’t pass through the broker-dealer’s system. The risk is that
orders processed through these enhanced access methodologies don’t pass through the broker-dealer’s internal
risk management systems.
Since broker-dealers are responsible for both direct and sponsored access, the SEC requires firms to establish
and enforce risk-management controls and supervisory procedures to ensure that:
 Customer orders are not erroneous and don’t violate applicable regulatory requirements
 Customer transactions are within the credit and capital thresholds
 The firm has risk-management controls that are under the direct and exclusive control of the broker-dealer
The rule applies to equities, equity options, exchange-traded funds (ETFs), debt securities, and security-based
swaps. The broker-dealer is required to retain a copy of its supervisory procedures and a written description of
its risk-management controls as part of its books and records.
In addition, on an annual basis:

 The broker-dealer must review these policies and procedures, and
 The chief executive officer (or equivalent officer) must certify that the firm has effective procedures and risk-
management controls in place

The Nasdaq Market Center Execution System

As trading in Nasdaq securities has increased in volume and speed, electronic systems have been updated.
As a result, the current system provides non-discriminatory access to quotations, and order execution that’s
immediate and automatic. The system’s maximum quotation and order execution size is 999,999 shares.
The system accepts odd-lot orders (less than 100 shares), as well as mixed lot orders (a round- and odd-lot
order combined). Odd-lot orders are not displayed in the Nasdaq quote system.
The Nasdaq Market Center Execution System is an electronic, automated order quotation and execution system.
It allows for trading in all Nasdaq securities, as well as other exchange-listed securities. In addition to
providing automatic executions at firm quotes, it also reports trades automatically. Trades that are reported
automatically are referred to as locked-in.
The Nasdaq Market Center Execution System is available for trading in the premarket session from 4:00 a.m. to
9:30 a.m., in the market hours session from 9:30 a.m. to 4:00 p.m., and in the aftermarket session from 4:00 p.m.
to 8:00 p.m. Quotes are open and firm from 4:00 a.m. to 8:00 p.m. Market makers may or may not choose to
participate in the premarket or aftermarket trading sessions. Market makers that participate in the aftermarket
session must keep their quotes open until at least 6:30 p.m. and may quote until 8:00 p.m.
Anonymity An attributable quote/order shows the market participant identifier, while a non-attributable
quote/order does not. Non-attributable orders are anonymous and appear in the Nasdaq quote montage with the
market participant identifier showing NSDQ. A market maker must have a two-sided attributable quote and
must permit automatic execution against its position. Market makers are permitted to maintain more than one
attributable quote/order.
Reserve Firms have the option of using reserve quotes. This feature allows a market participant to display a
portion of its quote and hold the remainder in reserve where it’s unseen by other market participants. Both the
displayed and the non-displayed size are available for execution.
Anti-Internalization Feature The Nasdaq Market Center Execution System allows a market participant to
prevent internalization of orders. Internalization is a process in which the execution system will execute orders
internally instead of with another market participant. The Anti-Internalization feature is an exception to the
automatic book processing system that’s used by the Nasdaq Market Center and, if used by a market
participant, the system will not execute any quotes or orders entered under the same MPID.
Book Processing (Execution Priority)

In order to assist broker-dealers in their goal of obtaining best execution, Nasdaq has instituted the following
rules for order execution.
Orders are executed in the following sequence using the price/time algorithm:
1. Displayed orders
2. Non-displayed orders (the reserve portion of quotes and reserve orders)
Using the price/time algorithm, orders at the best price (highest bid/lowest offer) receive an execution prior to
orders at an inferior price. Orders at the same price are executed in chronological order based on their time of
entry into the Nasdaq book.

If two orders are placed simultaneously— one a market order and the other a limit order—the market order
will have priority. When orders are executed against a contraparty, the size of the displayed order is
decremented (decreased) by the number of shares executed.
Limit orders Price improvement is provided by the market participants that are providers of liquidity to the
market participants that are takers of liquidity. For example, if a market maker is displaying an offer to sell 1,000
shares of ABCD at 24.00, and an order to buy 1,000 shares of ABCD is entered into the system at 24.10, it will
receive an execution of 1,000 shares at the better price of 24.00, thereby receiving $.10 price improvement.
Adjustment of Quotes and Orders In response to an issuer’s corporate action (dividends and stock splits),
the Nasdaq Market Center Execution System will take the following actions concerning adjustments for open
orders and quotes:
 All bid and offer quotes will be purged from the system.
 All orders will be cancelled in the event of a reverse stock split.
 Sell orders will not be adjusted automatically by the system and should be modified by the market
participant that entered the order.
 Buy orders will automatically be adjusted by the system depending on the corporate action taken by the
issuer.
For example, with a cash dividend, the order is adjusted downward by the amount
of the cash dividend, unless the order was marked DNR.
CQS Transactions (and Its Connection to the Third Market)

FINRA rules govern over-the-counter trading in virtually all securities (except for municipal bonds, which are
governed by MSRB rules). This includes OTC transactions in other exchange-listed securities (referred to as
third-market transactions). Examples of CQS-eligible securities are stocks that are listed on the NYSE, NYSE
American, or the regional exchanges, but not Nasdaq-listed securities.
Consolidated Quotation System (CQS)

FINRA member firms that provide third-market quotes for exchange-listed securities typically do so through
the Consolidated Quotation System. A market maker must apply to Nasdaq to function as a CQS market maker
and is approved when notified by Nasdaq. As with Nasdaq, registration in additional CQS issues can be
accomplished by entering a registration request through a Nasdaq terminal. CQS provides quotations on all
common stock, preferred stock, warrants, and rights that are registered on the NYSE (Network A), NYSE
American, and certain regional exchanges (Network B).
Qualified Third-Market Maker According to the Securities Exchange Act, a qualified third-market maker
must meet the following conditions:
 Be a registered broker-dealer that’s subject to and in compliance with the SEC’s minimum net capital rule
 Have and maintain net capital of $500,000
 Have a reasonable average inventory turnover in such security
 Be ready to effect transactions for its own account at quoted prices with other broker-dealers

Market-Maker Obligations A FINRA member that accounts for 1% or more of the volume of a listed security is
required to publish quotes in that security through the CQS. CQS market-maker quotes must be firm at the price and
for the size displayed. If no size is displayed, the quote is firm for a normal unit of trading (100 shares). If a market
maker maintains quotes in a security both on an exchange and in CQS, the quotes must be at the same price.
Trading Practices FINRA has specific guidelines to cover transactions by members in the third market. The
following four rules apply regardless of whether the member firm is registered as a CQS market maker:
1. Members cannot execute transactions that are fraudulent, manipulative, or deceptive. This includes practices
such as executing a series of trades at successively higher or successively lower prices to give a misleading
appearance of market activity (a version of Painting the Tape). Likewise, wash sales, in which there’s no
true change of beneficial ownership, are prohibited.
2. Circulating information that the member knows or has reason to believe is false or misleading is prohibited.
Therefore, registered representatives must not discuss groundless rumors with clients.
3. Members cannot engage in third-market transactions in order to influence the closing price that’s reported
on the Consolidated Tape.
4. Members cannot execute third-market transactions in a security that’s the subject of an initial public
offering until the security has first opened for trading on the security’s primary listing exchange. The
exchange opening is indicated by a transaction report by the listing exchange on the Consolidated Tape.
Regulation ATS (Alternative Trading System)

Alternative trading systems (ATSs) are SEC-approved, non-exchange trading systems. An ATS provides an
alternative method to trading on an exchange and enhances the liquidity of securities in the marketplace.
Examples of these systems include a broker-dealer’s internal execution system, electronic communication
networks (ECNs) that choose not to register as exchanges, and trade crossing networks. An ATS is generally
required to register with the SEC and FINRA as a broker-dealer, but is not registered as an exchange. An ATS
doesn’t set rules or discipline its subscribers but, since it’s required to register as a broker-dealer, it’s subject to
FINRA rules and disciplinary action.
Electronic Communication Networks (ECNs)

The SEC defines an ECN as an electronic system that widely disseminates to third parties orders that are entered by
market makers, and permits such orders to be executed against in whole or in part. An ECN doesn’t include crossing
systems or internal broker-dealer order-routing systems. ECN subscribers may include institutional investors as well
as broker-dealers. ECNs are operated by a broker-dealer and may be registered as a broker-dealer (as mentioned
previously) or may choose to register with the SEC as a securities exchange. An ECN trades exclusively on an
agency basis by matching buyers and sellers within its system and charging subscribers transaction fees for its
services. Quotations that reflect subscribers’ orders are displayed on the ECN’s trading system. An ECN must also
display its best quotes to the market in order to provide transparency to other market participants.
An ECN may make its quotes accessible in one of three ways:

1. Market participants may subscribe to the services of an ECN and execute trades within the ECN’s
internal system.

2. An ECN may display its quotes on FINRA’s ADF (described next). Since the ADF is only a quotation
service and doesn’t provide executions, an ECN that displays quotations on the ADF must provide access
to its quotes through private connectivity providers.
3. An ECN may also display quotations on an SRO trading center if its quotes are closely integrated within
the SRO trading facility.
When an SRO trading center receives an order in response to a quote made by an ECN, rather than executing
the trade at the SRO trading center, the order is immediately sent by the SRO trading center to the quoting ECN for
execution. Once executed, the ECN immediately reports the execution back to the SRO trading center. In this
way, the SRO trading center and the ECN can avoid a double execution, which could occur if an order was
executed simultaneously in the ECN and at the SRO trading center.
Dark Pools
A dark pool is a private trading platform that’s often used by large institutions. The purpose of these pools is to
provide large institutional investors with the ability to buy and sell large blocks of stocks without impacting
traditional trading venues (e.g., the NYSE or Nasdaq). These pools were designed to allow investors
(e.g., mutual funds) to trade large blocks of shares between each other quickly, cheaply, and anonymously.
Pricing of dark pool trades is bound by the National Best Bid and Offer (NBBO).
Intermarket Trading System (ITS)

The Intermarket Trading System (ITS) links the national and regional stock exchanges and enables a member
on the floor of one exchange to send an order for execution on the floor of another exchange for stocks that
trade on more than one exchange. Only FINRA member firms that are registered as market makers in listed stocks
are permitted to participate in the ITS.
Alternative Display Facility (ADF)

The Alternative Display Facility (ADF) is an electronic quotation and reporting system that’s operated by FINRA. It
provides market makers and ECNs with the ability to display quotes for Nasdaq-listed securities. ADF-eligible
securities include all National Market System (NMS) securities such as Nasdaq Global Market, Nasdaq Capital
Market, Nasdaq convertible debt securities, and other exchange-listed securities (NYSE and NYSE American)
trading over-the-counter (CQS securities). For market makers, the ADF serves as an alternative to quoting on
the Nasdaq Market Center Execution System. The ADF doesn’t provide order-execution or trade-reporting
capabilities. Therefore, users that transact business based on ADF quotes must have order-execution services
available from private connectivity providers.
The ADF system operates from 8:00 a.m. to 6:30 p.m. each business day. An ADF trading center must be open
for business from 9:30 a.m. to 4:00 p.m. An ADF trading center may voluntarily open for business prior to
9:30 a.m., or stay open for business after 4:00 p.m. If the ADF Trading Center elects to stay open during these
hours, it must comply with all applicable FINRA trading rules.
The Order Access Rule

This rule stipulates that ADF market participants must provide direct electronic access to other market
participants and all other FINRA members, and/or allow for indirect electronic access to its quote.

Under the rule, market participants are either ADF-registered market makers, ECNs, or alternate trading
systems. “Direct electronic access” represents the ability to deliver an order for execution directly against
another ADF market participant’s best bid or offer without the need for voice communication. The access must
have the equivalent speed, reliability, availability, and costs that are provided to its own customers. “Indirect
electronic access” represents the ability to route an order through a market participant’s broker-dealer for
execution against the market participant’s best bid and offer without the need for voice communication. The
access must have the equivalent speed, reliability, availability, and cost that are provided to the market
participant’s broker-dealer that’s giving access to the market participant’s quotes.
Performance Standards
Since the ADF doesn’t provide order-execution services, broker-dealers that intend to participate in this venue
will need to have systems installed to ensure that quality execution speed and minimum performance standards
are met. The minimum performance standards for ADF linkages are as follows:
 The market participant must be able to certify its ability to provide automated quotations during peak
volume periods.
 ADF participants must post a marketable quote on each side of the market at least once every 30 days in
order to meet certification standards.
The performance standards must be met to ensure that adequate technology is being used to send and receive
executions in a timely manner. The systems must be able to meet peak capacity standards before authorization is
given to post quotes on the ADF. Systems certification is a process that will be used to keep market
participants current in standards. The minimum performance standards for ADF linkages are (a) a two-second
turnaround for an order that will be accepted or declined, and (b) a three or fewer second turnaround for
communication between market participants.
In the event that an ADF participant’s linkage cannot meet performance standards and suffers system outages that
leave the firm unable to post quotes or respond to orders, the firm will be suspended from quoting in the ADF.
The CEO and officers of FINRA have the right to grant an excused outage. However, when the participant
experiences three unexcused outages during a five-business-day period, it will be suspended from the ADF for
20 business days in all or specified securities.
OTC Equity Securities

An OTC equity security is generally any equity that’s not listed or traded on Nasdaq or a national securities
exchange (a non-NMS Security). This includes domestic and foreign equity issues, warrants, units, American
depositary receipts (ADRs), and direct participation programs (DPPs). Since OTC equity securities cannot be
quoted or traded on exchanges, dealers must subscribe to an inter-dealer quotation system to display and access
quote and trade information.
Members may enter a variety of quotations for OTC equities, including:

 Two-sided quotes (bid and offer)
 Bid price only or offer price only
 Unpriced indications of interest (such as bid wanted or offer wanted)
 A bid or offer that’s accompanied by a modifier which reflects unsolicited customer interest

FINRA requires market makers posting firm quotes to be for a minimum size that’s based on the price of the
security. The requirements are as follows:
Price (Bid or Offer) Minimum Quote Size Depending on the price level of the bid or
offer for a given security, a different
0.0001–0.0999 10,000 minimum size may apply to each side of the
0.10-0.1999 5,000 market being quoted by the member firm.
0.20–0.5099 2,500 For example, if an OTC equity security is
0.51–0.9999 1,000 being quoted at 0.95 – 1.05, the bid must be
1.00–174.99 100 good for at least 1,000 shares, while the
175.00+ 1 minimum size for the offer is 100 shares.
OTC Markets Group Prices of OTC equities may be obtained from the OTC Markets Group. In an effort to
create clarity in the investment process, the OTC Markets Group organizes its securities into three tiered
marketplaces—OTCQX, OTCQB and OTC Pink. The differences in the tiers are based on the quality and
quantity of the information that the companies make available.
 The OTCQX Best Marketplace is for established investor-focused U.S. and global companies that are
distinguished by the integrity of their operations and diligence with which they convey their qualifications.
To qualify, the companies must meet high financial standards, demonstrate compliance with U.S.
securities laws, and be current in their disclosures.
 The OTCQB Venture Marketplace is for entrepreneurial and development stage U.S. and international
companies that are unable to qualify for OTCQX. To be eligible, the companies must be current in their
reporting and undergo an annual verification and management certification process.
 The OTC Pink Marketplace offers trading in a wide spectrum of equity securities through any broker-
dealer. This marketplace is for all types of companies and their equities are included in this tier by reasons
of default, distress, or design.
The OTC Markets Group lists the name and phone number of the market makers for each stock. Although
many quotes are considered firm, the system may provide indications of bid and ask prices that are subject to
verification. Also, any bids wanted and offers wanted that have been entered by broker-dealers are not
considered firm. OTC Markets Group issues may often be characterized by their infrequent trading and/or the
limited number of outstanding shares.
OTC Pink Market

The OTC Markets Group was originally the National Quotations Bureau (NQB) and provided for quotes of
certain OTC equities in a hard-copy publication that was referred to as the Pink Sheets. Today, since the OTC
Pink Market is an electronic system and is updated on a real-time basis, the quotes in the system are considered
firm. Broker-dealers are able to post and disseminate their quotes through the OTC Pink Market, but can also
negotiate trades through the system’s electronic messaging capability.
The OTC Pink Market permit a broker-dealer to display a quote of any OTC equity security; however, the
broker-dealer must comply with SEC Rule 15c2-11 (described below). This quotation system provides quotes
for stocks of companies that cannot meet Nasdaq listing standards.

These issues are either SEC reporting companies or non-reporting companies. Many unsponsored ADRs, in
which the issuer doesn’t want to have its shares traded in the U.S., will be quoted in the OTC Pink Market.
These issues may trade infrequently, have a thin float, and be low-priced penny stocks.
The trading of securities that are quoted in the OTC Pink Market involves not only more uncertainty about the
companies involved, but also about whether the best price has been obtained in a transaction.
For example, let’s assume that a customer of Broker-Dealer X wants to buy 3,000 shares of
JKLM Company, an OTC equity security. JKLM is quoted in the OTC Pink Market. Since
Broker-Dealer X doesn’t make a market in the stock, it checks the system and finds that three
market makers are quoting JKLM—Market Makers P, Q, and R. Each of the market makers
are displaying unpriced indications to trade the security. To get a firm quote for 3,000
shares, X could contact any of the three market makers. The obligation of Broker-Dealer X to
provide its client with the best execution is as follows:
In any transaction for or with a customer, a member and its associated persons must use
reasonable diligence to determine the best interdealer market for the subject security
and buy or sell in such market so that the resulting price to the customer is as favorable
as possible under prevailing market conditions. FINRA provides regulatory guidance on
best execution and OTC equities under the provision which is referred to as Orders
Involving Securities with Limited Quotations or Pricing Information which will be
described in a later chapter.
OTC Equity Trading Rules

Certain portions of Regulation NMS apply to OTC equity securities. Remember, an OTC equity security is
defined as any equity security that’s not an NMS stock (i.e., OTC Pink Market equities). Since Regulation
NMS is an SEC rule, the rules listed below have been included in the FINRA rulebook:
 Sub-Penny Restrictions – For OTC equity securities, members are prohibited from displaying or accepting
from others a bid, offer, order, or indication of interest in an increment smaller than:
– $0.01 if the bid, offer, order, or indication of interest is priced at $1.00 or greater per share,
– $0.0001 if the bid, offer, order, or indication of interest is priced below $1.00 and equal to or greater
than $0.01 per share, and
– $0.000001 if the bid, offer, order or indication of interest is priced at less than $0.01 per share
 Locked and Crossed Markets – Member firms must implement policies and procedures that are
designed to reasonably avoid the practice of displaying any quotes that lock or cross the market in an
OTC equity security.
 Access Fee Cap – A member firm is prohibited from charging fees that exceed the following maximums to
non-subscribers who are seeking access to its quotes:
– $0.003 per share for stocks that are quoted at, equal to, or greater than $1.00
– 0.3% of the published quotation price per shares for stocks that are quoted at less than $1.00
 Limit Order Display Rule – An OTC market maker is required to immediately display any priced quotation in
an inter-dealer quotation system (e.g., the OTC Pink Market) that improves the market maker’s quote.
“Immediately” is defined as soon as practical, but no later than 30 seconds after receipt.

Similar to the SEC rule, this rule provides exceptions to:

– Orders that are executed on receipt
– Orders in which the customer requests “do not display”
– Odd-lot and all-or-none orders
– Orders which are sent to an ECN, national securities exchange, or another market maker that will
display the order
– Block size orders – Due to the generally lower prices of OTC equity securities, the definition of a
“block size order” is different from the SEC rule. For this rule, a “block size order” is defined as an
order for at least 10,000 shares and a market value of at least $100,000.
SEC Rule 15c2-11 – Initiation of Quotations for Non-Exchange-Listed OTC

Equity Securities
Although broker-dealers must formally register as Nasdaq market makers before entering quotes in that system,
no such procedure is required for making a market in OTC equity securities that are not traded on Nasdaq or any
other national securities exchange.
SEC Rule 15c2-11 requires broker-dealers that intend to publish quotes for an OTC equity security to either
collect and review certain information about the issuer or rely on a qualified interdealer quotation system’s
(IDQS) review of the issuer’s information. For this rule, the term “publish” means to initiate or resume quotes
in any interdealer quote medium, such as the OTC Pink Market. A broker-dealer that’s relying on IDQS
review is required to publish its quote within three business days after IDQS has made its determination
available publicly.
Information to Be Collected
Unless an exception is available, prior to initiating or resuming quotes, the broker-dealer must have in its
possession one of the following five items related to the security in question:
1. A prospectus filed with the SEC under the Securities Act of 1933 that has been in effect for less than 90
days
2. An offering circular (as specified in Regulation A) that’s become effective within the preceding 40 days
3. The issuer’s latest Form 10-K and all subsequent Form 10-Qs and Form 8-Ks (and the issuer must be
current in its filings)
4. For certain foreign securities, financial information filed with the SEC during the issuer’s last fiscal year
under Rule 12g3-2(b)
5. The following is 16 items of information about the issuer, which must be reasonably current in relation to
the day on which the quote is published:
(i) Exact name of the issuer (and its predecessor, if any)
(ii) Address of its principal executive offices
(iii) State of incorporation (if a corporation)
(iv) Exact title and class of the security
(v) Par or stated value of the security
(vi) Number of shares or total amount of the securities outstanding
(vii) Name and address of the transfer agent
(viii) Nature of the issuer’s business
(ix) Nature of the products or services offered

(x) Nature and extent of the issuer’s facilities

(xi) Names of the chief executive officer and members of the board of directors
(xii) Issuer’s most recent balance sheets, and profit and loss and retained earnings statements
(xiii)Similar information for such part of the two preceding fiscal years that the issuer or its
predecessor has been in existence
(xiv) Whether the broker or dealer or any associated person is affiliated, directly or indirectly, with
the issuer
(xv) Whether the quote is being published or submitted on behalf of any other broker or dealer and,
if so, the name of such broker or dealer
(xvi) Whether the quote is being submitted or published, directly or indirectly, on behalf of the issuer,
or any director, officer, or any person who beneficially owns more than 10% of the outstanding
shares or units of any equity security of the issuer (If so, the name of the person and the basis for
any exemption from federal securities laws for sales on behalf of the person must be disclosed.)
It’s not enough for the dealer to simply have this information on file. The rule requires the dealer to review the
information and have a reasonable basis for believing that (1) the information is accurate in all material
respects, and (2) the sources from which the information was obtained are reliable.
Information About the Quote

In addition to the preceding information, the dealer that’s publishing the quote must have on file the following
documents and information:
 A record of the circumstances involved in the publication of the quote, including the identity of the person or
persons for whom it’s being published and any information regarding the transactions provided to the dealer by
those persons
 A copy of any SEC trading suspension order for any security of the issuer during the preceding 12 months, or a
copy of the SEC public release announcing the suspension
 A copy or written record of any other material information (including adverse information) about the issuer that
comes into the dealer’s possession before the publication of the quote
Submission of Information to FINRA

Under SEC Rule 15c2-11, the documentation that’s compiled by a dealer must be submitted to FINRA, along
with a completed Form 211, at least three business days prior to entering a quote in a quotation medium. The
filing should also specify the:
 Issuer
 Issuer’s predecessor in the event of a merger or reorganization within the previous 12 months
 Type of security to be quoted (e.g., common stock, unit, ADR, or warrant)
 Quotation medium to be used
 Member’s initial or resumed quote
 Particular subsection of Rule 15c2-11 with which the dealer is demonstrating compliance
In addition, if the dealer is initiating or resuming a priced quote, the firm must specify the basis on which that
quote was determined. If the quote is initially unpriced, but is later changed to a priced quote, the firm must
supplement its filing with the rationale for the price being quoted. Under this rule, any filings must be
reviewed and signed by a principal of the member firm.

Exceptions to SEC Rule 15c2-11 The documentation and filing requirements of the rule are not required
to be followed if:
1. The security is listed on a national securities exchange (e.g., Nasdaq or the NYSE) or was traded on an
exchange on the previous business day (recently delisted). For periods outside of this time frame, a Form
211 must be filed before quoting begins.
2. A dealer is publishing a quotation on behalf of a customer, and it represents unsolicited customer interest in
buying or selling the security. Once the customer order is executed or canceled, the dealer can no longer
quote the security. (Please note, unsolicited interest from a corporate insider qualifies for this exemption.)
3. A qualified interdealer quotation system (e.g., the Pink Market) or a registered national securities association
has complied with the information review requirements and made public its determination of the securities
compliance with the rule. (OTC market makers relying on a qualified interdealer quotation system.)
4. The quote is for the security of a company with a worldwide average daily trading volume value of at least
$100,000 as reported during the 60 calendar days immediately before the publication of the quotation and
the issuer of such security has at least $50 million in total assets and $10 million in shareholders’ equity as
reflected in the issuer’s publicly available audited balance sheet that’s issued within six months after the end
of its most recent fiscal year. (Actively traded securities of well-capitalized issuers.)
5. The quote is initiated by an underwriter in that security.
6. The quote is for a municipal security.
The Piggyback Exception Another exemption from Rule 15c2-11 is referred to as the piggyback exception.
This exception applies to any security that has at least one existing one-way quote (either a bid or ask), no more
than four business days in succession have elapsed without a quote, the issuer information is current and
publicly available, and other conditions are met. Securities that meet this exception can be readily identified
since they’re labeled active in the inter-dealer quotation systems. (Quotes representing unsolicited customer
interest are not counted to determine active status.) If at least one market maker has been cleared to quote the
security on the inter-dealer quotation system under 15c2-11, but the security doesn’t yet meet the piggyback
exception, it will instead be labeled eligible.
For example, Market Maker Q wants to quote an OTC equity security, ZYXW, in the
Pink Market. Ordinarily, MM Q would need to comply with Rule 15c2-11 and file with
FINRA all of the required information, along with Form 211. However, Market Maker
P has been quoting ZYXW in the Pink Market every day for the past two months.
Therefore, MM Q can insert quotes for the stock in the Pink Market without complying
with Rule 15c2-11 by piggybacking on MM P’s quotes.
If a dealer qualifies for the piggyback exception and begins publishing quotes, it may continue to publish
quotes without complying with 15c2-11 even if the other market maker on whose quotes the exception was
based withdraws from the market. However, if the piggybacking dealer then ceases quotations, it must comply
with the rule or find another exception before resuming quotations.
Continuing the preceding example, let’s assume that MM P stops publishing quotes for
ZYXW in the Pink Market three days after MM Q had begun quoting the stock there. MM
Q may continue to quote the stock, despite the fact that the market maker on whose quotes
it piggybacked is no longer in the market. However, if MM Q stops quoting ZYXW, and
there are no other market makers quoting it in the Pink Market, MM Q would need to fully
comply with Rule 15c2-11 before resuming its quotations.

The piggyback exemption is not available, and full compliance with Rule 15c2-11 is required, if:
1. The issuer has been subject to a trading suspension issued by the SEC in the last 60 calendar days.
2. The issuer is or believed to be a shell company and quotes were initiated more than 18 months ago. (This
means that a new Form 211 must be filed after 18 months for the company to continue being quoted. This
is because there have been cases in which a shell company ceased to exist, but quotes continued.)
3. The issuer is not filing its required financial reports and public disclosures in a timely manner, which is
defined as being filed within 180 days of the end of the issuer’s reporting period.
FINRA Rule 6432 – Compliance with the Information Requirements

of SEC Rule 15c2-11
Although 15c2-11 is an SEC rule, FINRA is tasked with enforcing compliance with this rule among its broker-
dealer members. The rule specifies that a member firm (broker-dealer) is prohibited from initiating or
resuming the quotation of a non-exchange listed security (OTC equity) in any quotation medium unless the
member has demonstrated compliance with FINRA Rule 6432 and SEC Rule 15c2-11.
A firm is required to demonstrate compliance by filing Form 211 with FINRA and receiving confirmation that
the form has been processed and cleared, or by relying on a qualified inter-dealer quotation system (IDQS) that
has made a publicly available determination as described in SEC Rule 15c2-11.
To make a publicly available determination, a qualified IDQS must submit an initial information review for
each security on which it makes such a determination. The review must be filed with FINRA on a modified
Form 211 by no later than 6:30 p.m. ET on the business day following the publicly available determination.
(Note, this is an after-the-fact filing requirement, unlike BDs that are required to wait for FINRA to review and
clear Form 211 before quotes can be posted.)
The following summarizes SEC Rule 15c2-11 and FINRA Rule 6432:
 A broker-dealer that wants to publish a quote for a non-exchange listed security can either:
– File Form 211 and publish a quote when it has received notification from FINRA that it has
processed and cleared the form, or
– Rely on the qualified inter-dealer quotation system (IDQS) which has filed a modified Form 211 and
has made its determination publicly available that the firm has complied with the rule. Once this has
been made, the broker-dealer’s quote must be published within three business days.


Chapter 10
SEC Trading Rules

SERIES 24 CHAPTER 10 – SEC TRADING RULES
In Chapter 9, the basics of trading and the role of market makers were examined. Market participants, such as
market makers and other trading entities, are required to operate under various SEC rules. Chief among these
are requirements regarding the display of customers’ interest in a given security and the proper handling of
client orders. This chapter will also detail the various rules that govern the process of short selling.
Regulation NMS
Regulation NMS was implemented to modernize U.S. securities markets and mandated changes in the National
Market System (NMS), including requiring non-discriminatory access to quotations, automated execution of
orders, and limit order protection on an interexchange basis. As a result of rules imposed by Regulation NMS,
market centers that participate in the National Market System must provide automated trading systems and must
implement procedures that are designed to prevent trade-throughs at inferior prices of protected quotations. For a
quotation to be protected, it must be the best price in its respective market center, and it must be immediately and
automatically accessible.
A trade-through occurs when a market center accepts and executes an order at a price that’s
inferior to the contemporaneous inside market. For example, a trade-through has occurred
if an order to buy is executed at a price that’s higher than the lowest offer, or if an order to
sell is executed at a price that’s lower than the highest bid.
The following is an example of a trade-through. Market Center A has an inside offer of 23.60 and Market
Center B has an inside offer of 23.50. If a market order to buy is sent to Market Center A and executed at
23.60, a trade-through has occurred since there was a better (lower) price available on Market Center B.
Market Center A is prohibited from executing the buy order at 23.60 since the client should receive the better
price of 23.50. This will also benefit the market participant that was responsible for displaying the offer quote
of 23.50 in Market Center B.
Remember, NMS securities include stocks traded on Nasdaq, the NYSE, NYSE American, and regional stock
exchanges.
SEC Rule 602 – The Quote Rule

Rule 602 of Regulation NMS covers the dissemination of quotes and was devised to improve the quality and
transparency of U.S. markets. The rule covers quotes by exchanges and certain OTC market makers. In the
rule, the definition of quote size also clarifies that if a market maker doesn’t publish a quote with a size
specified, the size is assumed to be the normal unit of trading for that security, which is 100 shares.
Market-Maker Obligations Regarding Quotes This section is the heart of the rule and is often referred to as
the Firm Quote Rule. When a market maker is disseminating a quote that’s covered by the rule, it’s obligated
to execute an order presented to it at a price at least as favorable as its published quote, for an amount up to its
published quote size.
The obligation to fill an order begins when the order is presented, regardless of how the order is transmitted to
the market maker (e.g., verbally, over the phone, or in an electronic format). Failure to honor a firm quote is a
violation that’s referred to as backing away.

CHAPTER 10 – SEC TRADING RULES SERIES 24
The following are the two situations in which a presented order is not required to be honored:
1. The market maker communicated to Nasdaq a revised price or size prior to the presentation of the order.
2. The market maker just effected or is in the process of effecting a transaction at the time the order is
presented and, immediately upon completion of that transaction, communicates a revised quote to Nasdaq.
(This is often referred to as the trade ahead exception.)
Industry Rules on Quotations

In addition to SEC quote rules, OTC market makers are also bound by industry rules. Member firms may publish
or otherwise disseminate only bona fide quotes. These quotes express genuine interest in buying or selling a
security and have not been placed for manipulative or deceptive purposes. A quote that’s nominal (not firm)
must clearly be labeled as such. Likewise, a member firm which reports that a transaction occurred must know
or have reason to believe that it actually did occur.
If one member firm disseminates a quote on behalf of another firm, it must have reason to believe that the
quote is bona fide. It cannot use as an excuse that it was simply passing along another person’s quote. Quotes
include indications such as bid wanted or offer wanted, not just priced quotes.
Another rule states that if a member firm gives a priced bid or offer, the firm must be prepared to honor it at the
price and under the conditions stated. This is FINRA’s version of the Firm Quote Rule. In addition, if a member
publishes a subject quote (such as in the OTC Pink Market) and then refuses to provide an updated firm quote
when approached by another member, this is viewed by FINRA as a version of backing away. In this
circumstance, there’s a question as to whether the firm’s original subject quote was bona fide.
The Limit Order Display Rule

Prior to this rule, Nasdaq quotes represented only the prices at which market makers were willing to buy or
sell in transactions with each other. For example, let’s assume that the quotes for ABCD stock on Nasdaq
were as follows:
ABCD
Inside: 20.00 – 20.25 10 x 10
MM #1 20.00 – 20.35 10 x 10
MM #2 19.90 – 20.25 10 x 10
MM #3 20.00 – 20.35 10 x 10
These quotes represented prices at which Market Makers #1, #2, and #3 were willing to trade for their own
accounts with other broker-dealers. Customer orders were not required to be reflected in these quotes. For
example, if Market Maker #1 accepted a limit order from a customer who was willing to buy 200 shares at
20.10, it was not required to change its quote to reflect the customer interest. In addition, most market makers
believed that they were obliged to execute this order only if the inside offer price fell to the customer’s limit
price, which is 20.10 in this example.
The Display Rule Under this requirement, if a customer limit order is accepted by a market maker and the
price on the order improves that market maker’s quote, the market maker must change its quote immediately to
reflect the customer’s interest.

Under normal circumstances, the SEC interprets immediately to mean within 30 seconds. Some abnormal market
conditions that allow some relaxation of the 30-second window include market openings (and a short period
thereafter), when trading reopens after a trading halt, and when an IPO first begins trading.
To illustrate the Display Rule, consider the previous example in which Market Maker #1 accepts a
customer limit order to buy 200 shares at 20.10. Within 30 seconds, Market Maker #1 must change its
quote to 20.10 − 20.35, 2 x 10.
ABCD
Inside: 20.10 – 20.25 2 x 10
MM #1 20.10 – 20.35 2 x 10
MM #2 19.90 – 20.25 10 x 10
MM #3 20.00 – 20.35 10 x 10
Notice that the inclusion of the customer’s order in Market Maker #1’s quote also changed the inside market,
thereby narrowing the spread. A customer limit order will not always tighten the spread, but market makers
must still include it in their quote. For example, let’s assume that Market Maker #2 now receives a customer
limit order to buy 500 shares at 20.00. Market Maker #2 must reflect that customer order in its quote
immediately. The market will then appear as shown below:
ABCD
Inside: 20.10 – 20.25 10 x 10
MM #1 20.10 – 20.35 2 x 10
MM #2 20.00 – 20.25 5 x 10
MM #3 20.00 – 20.35 10 x 10
Although Market Maker #2’s customer order did not change the inside market, Market Maker #2 must still reflect it
in its quote.
Note that a market maker is not required to accept a customer limit order. The Display Rule applies only if the
limit order is accepted.
Size Another aspect of the Display Rule is that, in some circumstances, market makers are required to also
change their quotes to reflect the size of a client’s order. If the market maker is at the inside market and accepts
a customer limit order at the inside, it must change its size to reflect the customer’s interest, unless the order is
de minimis (10% or less of the market maker’s size).
For example, let’s assume that the inside market for GPKK stock is 15.40 −15.50, 10 x 10
and MM#1 quote is 15.40 −15.55, 10 x 10. The market maker accepts a limit order from a
customer to buy 200 shares at 15.40. Although the customer’s order doesn’t cause MM #1
to change its bid price, the market maker must change its size to 12 by 10 to reflect the
customer size at the inside bid. If the customer’s order had been for only 100 shares, MM
#1 would not have been required to change its size, since that amount is de minimis.

Note that if another customer submits an order to Market Maker #1 to sell 200 shares at 15.55, MM #1 is not
required to change its offer size, since the market maker is not at the inside offer price.
In some cases, a market maker will need to adjust its size because the inside market moves to its bid or offer. For
example, let’s assume that Market Maker #4 is quoting a stock at 19.65 – 20.00, 10 x 10 when the inside market
is 19.65 – 19.90. The market maker is currently holding three customer orders to sell 1,000 shares, 500 shares,
and 2,000 shares at 20.00. Notice that, although it has reflected the price of the customer orders in its quote as
required by the Display Rule, it doesn’t need to reflect the aggregate size of those orders because its offer is not at
the inside. However, if the inside market changes to 19.65 – 20.00, MM #4 must immediately update its size to
at least 3,500 shares to reflect the aggregate size of the customer orders, since its offer is now at the inside.
Exceptions As with many important rules, the Display Rule has exceptions. For example, at times a customer
may not want an order displayed as part of a market maker’s quote, particularly if it’s a large order. In such cases, a
customer may request for the order to not be displayed. A customer may also give a broker-dealer discretion as to
whether to display its orders. However, this exception must be applied carefully, since the SEC has warned that no-
display requests must be individually negotiated with customers. Standardized disclaimers or contractual language
in a broker-dealer’s new account agreements are not considered an individual no-display request by a customer.
Other exceptions include the following orders:

 Block-size orders (at least 10,000 shares or $200,000 in market value)
 Odd-lot orders
 All-or-none orders
 Orders that are sent to another market or broker-dealer which complies with the Display Rule
 Orders that are sent to an ECN which agrees to display the order
 Orders that are executed immediately upon receipt
In addition, a market maker doesn’t display orders that lock (make the bid and ask the same) or cross the
market (make the ask lower than the bid) without making a reasonable effort to execute the quote that will be
locked or crossed. This rule also applies to ECNs whose quotes appear on Nasdaq.
Prohibition Against Trading Ahead of Customer Orders

Under FINRA Rule 5320, it’s a violation of just and equitable business principles for member firms to trade
ahead of customer orders. The interpretation which describes this is referred to as the Manning Rule. The rule
applies to both exchange-listed (NYSE and Nasdaq) securities as well as OTC equity securities.
Although the Manning Rule is an SRO rule, it’s being described in this chapter due to its association with the
Limit Order Display Rule.
Basic Requirements
The provisions require market makers to protect the orders they accept from customers, regardless of whether
it was received from the customer directly or from another broker-dealer on behalf of its customer. This means
that the executing broker-dealer may not compete with that order on a proprietary basis by virtue of its position
within the market.

Simply stated, the market maker must execute the customer order immediately upon executing an order for its
own account that would have filled the customer order. In this case, immediately generally means within 60
seconds of an execution for the firm’s account.
For example, let’s assume the inside market for a Nasdaq stock is 10.00 − 10.25
and a market maker is holding a customer limit order to buy 1,000 shares at 10.00. If
the market maker buys 1,000 shares for its own account at 10.00, it must immediately
fill the customer’s order at 10.00 as well.
Unless an exception applies, a member firm that accepts and holds a customer order (limit or market) in an equity
security from either its own customer or a customer from another broker-dealer is prohibited from trading for its
own account at a price that would satisfy the customer order. The member firm may execute an order for its own
account at the same price if it immediately executes the customer’s order up to the same size at the same or a
better price. In other words, the firm must do for the client at least what it did for its own account.
Exceptions
There are several situations in which a broker-dealer may accept a customer limit order subject to terms and
conditions negotiated with the client, including the condition that the firm may trade ahead of the order.
1. Orders from institutional accounts – These are defined as orders from (i) banks, insurance companies,
S&Ls, or registered investment companies, (ii) registered investment advisers, or (iii) any other entities
that have total assets of at least $50 million.
2. Large orders, including those from retail customers – These are defined as orders for 10,000 shares or
more, unless such orders are less than $100,000 in value.
For these first two exceptions, the member firm must either provide written disclosures to the customer when
the account is opened and annually thereafter, or provide oral disclosures on an order-by-order basis that are
documented by the firm. The disclosures must indicate that the firm may trade in its proprietary account at
prices that will satisfy the customer’s order, and provide the customer with an opportunity to opt in to the
protection of the rule.
3. Intermarket Sweep Orders (ISOs) (to be described shortly)

4. The No-Knowledge Exception – If a firm has an effective system of internal controls, such as information
barriers (formerly Chinese walls) that prevent one trading unit from obtaining knowledge of customer
orders, a member firm may trade at prices that would satisfy a customer’s order. For example, if the
market-making desk of a firm is holding a customer order, no other trading desk in that firm (such as a
risk-arbitrage desk) may knowingly trade ahead of the customer’s order.
If another desk executes an order for the firm’s account that would have filled the customer order, the
market-making desk may owe the customer an immediate execution. However, as long as a firm
implements and uses information barriers that prevent the non-market-making desk from obtaining
knowledge of customer limit orders, the other desks may continue to trade at prices that are the same or
better than customer limit orders.

5. Riskless Principal Exception – The rule doesn’t apply if a firm trades for its proprietary account for the
purpose of facilitating the execution of an order from a customer on a riskless principal basis. For example, if
the firm was holding an order from a customer to buy stock at $45.00, the firm could purchase the same
stock at $45.00 if the execution was to fill a riskless principal order it received from another customer. To
comply with this exception, the firm must submit a trade report which identifies the transaction as riskless
principal and whether the firm has written policies and procedures that require the customer’s order be
received prior to the offsetting principal transaction. In addition, the customer’s order must be executed
within 60 seconds of executing the order for the firm’s account.
6. Odd Lot and Bona fide Error Transaction Exceptions – The obligations of this rule don’t apply to any
proprietary transactions for an amount less than a normal unit of trading (i.e., an odd-lot order) or to
correct a bona fide error.
Applications
 Although member firms may limit the life of a customer’s order to normal market hours (9:30 a.m. to
4:00 p.m.), the firm and the customer may agree to provide processing of a customer’s order outside
normal market hours. Under this rule, the protections apply at all times during which the customer’s
order is executable by the member firm.
 A member firm is required to make every effort to execute a marketable customer order fully and
promptly. If the firm is holding a marketable order from a customer and it has not been immediately
executed, it must make every effort to cross the order with any order that’s received by the firm on the
other side of the market at a price that’s no less than the best bid and no greater than the best offer at the
time the order is received. For example, if the market is 12.30 – 12.40 and the firm is holding a customer
market order to buy that has not been executed, the member must make an effort to cross that order with
any sell order received at the same time at a price no higher than 12.40.
Partial Executions If a firm triggers a Manning obligation, it’s required to fill only as much of the
customer’s orders as it has executed for its own account.
For example, let’s assume the market is at 10.00 – 10.25 and the firm is holding a
customer limit order to buy 500 shares at 10.00. If the firm receives a market order
to sell 200 shares and executes the order against its own position, it must fill 200
shares of the customer limit order at 10.00. It will then continue to hold the
customer limit order for the remaining 300 shares.
If a customer requests to not display an order that would be subject to the Order Handling Rules, the broker-
dealer must still protect that order under the Manning Rule.
For example, a market maker is quoting a Nasdaq stock at 10.00 – 10.25, which is also
the inside market. The MM is currently holding a customer limit order at 10.10 and
the client requests that it not be displayed. In this case, the non-displayed order
must be protected at 10.10.
The fact that a broker-dealer sends an order to a qualifying ECN or another market maker doesn’t relieve it of
its Manning obligations. It must still protect the order that has been sent away.

Price Improvement
The SEC has stated that, if a market maker holds a non-displayed limit order priced better than its quote and
subsequently receives a customer market order on the opposite side of the market, it’s not appropriate for the
firm to execute the market order at its published quote and the limit order at its limit price. Instead, the market
maker must price-improve the customer market order to the limit order price.
Under the Customer Order Protection (Manning) Rule, a minimum price improvement of $.01 (1 cent) is required
for a broker-dealer to execute a transaction for its own account while holding a customer’s held limit order. This
condition applies to NMS stocks that have a price of $1.00 or more.
For example, let’s assume that the inside market is 10.00 − 10.25 and a market maker
is holding a non-displayed customer limit order to buy 1,000 shares at 10.10. If the market
maker receives a market order to sell 1,000 shares, it must be executed at the price of
the non-displayed limit order (10.10), not the inside bid price of 10.00. The market
maker may execute the market order against the limit order or against its own
inventory. However, if it executes the market order against its inventory at 10.10, it
owes the limit order a fill at 10.10 as well, in accordance with its Manning obligation.
In addition to a broker-dealer receiving orders from its own customers, broker-dealers may enter into
arrangements with other broker-dealers to execute that broker-dealer’s customer orders. The customer orders
of another broker-dealer that are received by an executing broker-dealer are covered under the SEC Order
Handling Rules as orders that must be protected and also price-improved. Relationships in which the cross of
customer limit orders and market orders must be price-improved are referred to as payment for order flow, and
reciprocal and correspondent arrangements. Payment for order flow (PFOF) is the rebate, discount, or payment
of cash for routing orders to another broker-dealer or exchange.
For example, Mid-Point Securities has entered into a payment for order flow arrangement
with High-End Brokerage Firm. A customer of Mid-Point enters a market order to sell
XYZZ and it’s sent to High-End. High-End’s quote for XYZZ is 12.25 − 12.30. High-End is
holding a non-displayed customer limit order to buy 1,000 shares of XYZZ at 12.28. High-
End must cross the market order and the non-displayed limit order at 12.28, rather than
executing the market order to sell at the bid price of 12.25. By accepting the payment for
order flow arrangement with Mid-Point, High-End has undertaken to provide best
execution to all customer orders that are received from Mid-Point.
If a market maker doesn’t have a relationship or an understanding that it will provide best execution to the
customer orders of another broker-dealer, incoming market orders may be executed at the inside market price of
a stock without being given price improvement. However, if the market maker is holding a non-displayed customer
limit order at the time of the execution, a Manning obligation is triggered. The non-displayed customer limit
order must be executed at the same price or better than the price the market maker received for its own account.
For example, MM A’s current quote for ABCD is 9.85 − 9.98 and MM A is holding a non-
displayed customer limit order to sell 400 shares at 9.95. MM A receives a market order
to buy 1,000 shares from MM B, but MM A and MM B don’t have a relationship with one
another. If MM A executes MM B’s order at 9.98, MM A must then also execute its non-
displayed customer limit order at 9.98 in order to avoid violating its Manning obligation.

A market maker has the option of price-improving the market order in such a way that its Manning obligation
is not triggered. This could be done by executing the market order at a minimum increment above the limit order
price for a sale and below for a purchase. If the market price on NMS stock is $1.00 or higher, the minimum
amount of price improvement required is $0.01 (the minimum quote increment).
For example, the inside market for PLUP is 11.00 − 11.15. MM X is holding a non-
displayed customer limit order to sell 1,000 shares at 11.14 and it then receives a
market order to buy 1,000 shares. If MM X executes the market order against its
inventory at a price of 11.13, a Manning obligation will not be triggered.
The minimum price improvement that’s required for orders less than $1.00 is the lesser of 1/2 the inside
market spread or a fixed amount, which depends on the price of the limit order. If the price of the limit order is
greater than $.01, it’s $.01, while for orders that are priced at least $.001 but less than $.01, it’s $.001. For
OTC equity securities that lack a published inside market, the broker-dealer may calculate the inside spread by
contacting a minimum of two unaffiliated dealers for price quotes and using the highest bid and lowest offer
price to determine the spread. The broker-dealer must document the name of each firm that’s contacted and the
quotes which were received in determining the inside market.
Volume-Weighted Average Price (VWAP) Orders

A volume-weighted average price order is typically placed by an institutional investor and is viewed as the
average price of a security over a given period. A VWAP order is entered prior to the client knowing the actual
price and is calculated by totaling the dollar value of each trade (the number of shares traded multiplied by the
price of each trade) divided by the total number of shares traded over a given period (e.g., 10:00 a.m. to 10:30
a.m.). Since the broker-dealer is guaranteeing a price to a client that’s currently unknown, the firm will
typically seek the client’s permission to engage in bona fide hedging and proprietary trading, but the firm
cannot trade for its own account in a manner that would harm the client who placed the VWAP order. The firm
may execute a customer order that’s received prior to the VWAP order, but cannot share the information with
another trading desk. Other trading desks of the firm are permitted to trade shares of the stock as long as proper
information barriers are in place.
The volume-weighted average price is calculated by multiplying number of shares in each transaction by the
price of each transaction, then adding the total cost of all of the transactions, and finally dividing by the total
quantity of shares purchased. For example, a firm has executed the following transactions for a client and will
confirm these transactions on a VWAP basis:
Buy 5,000 ZXB at $20.00
Buy 4,000 ZXB at $20.20
Buy 3,000 ZXB at $20.18
The calculations for the ZXB transactions in this example are:

$100,000 (5,000 x $20.00)
$ 80,800 (4,000 x $20.20)
$ 60,540 (3,000 x $20.18)
$241,340 Total cost
Total quantity purchased = 12,000 shares
VWAP = ($241,340 ÷ 12,000) = $20.11. Therefore, the transactions will be confirmed at a price of $20.11.

Disclosure Rules
The SEC was concerned that the growth in the number of market centers was contributing to market
fragmentation. The regulator also became concerned about the lack of order-execution information at these
centers. In order to resolve these concerns, the SEC focused its attention on requiring more visibility in order
executions and routing practices. Two new rules were added to the Securities Exchange Act—SEC Rules 11Ac1-5
and 11Ac1-6. In accordance with Regulation NMS, 11Ac1-5 is now Rule 605, and Rule 11Ac1-6 is now Rule 606.
SEC Rule 605 (Market Center Reports)

SEC Rule 605 requires market centers to disclose order-execution information. Under the rule, a market center
is considered any national securities exchange or association, alternative trading system, OTC market maker,
and/or a member firm that internalizes orders. Since these categories of market centers can potentially make
markets in Global Market System securities, they’re subject to disclosure requirements.
Under Rule 605, market centers that trade National Market System stocks are required to produce monthly
electronic reports that include uniform statistical measures of execution quality for covered orders. An NMS stock is
any stock that trades in the National Market System including Nasdaq-listed, NYSE-listed, and other exchange-
listed securities.
Covered securities are defined as any Global Market System security and any other security for which a
transaction report, last sale data, or quotation information is disseminated through an automated quotation system.
A covered order is any market or limit order that’s received and executed during normal business hours
(9:30 a.m. to 4:00 p.m.). This includes an immediate-or-cancel order, but excludes any order in which the
client provides special instructions. These reports must be made public.
Under SEC Rule 605, market centers must disclose execution quality statistics on a monthly basis. This
information includes:
 Effective spreads
 The comparison of the execution of market orders (that vary in size) to public quotes
 The execution of orders that have price improvement and disimprovement, fill rates, and execution speed
SEC Rule 606 (Broker-Dealer Order Routing)

Each calendar quarter, Rule 606 requires a broker-dealer to make its order-routing information publicly
available for all non-directed orders in NMS securities, which includes securities that are listed on the NYSE,
NYSE American, Nasdaq, as well as exchange-listed options. The two main components to this rule are (1) the
quarterly reports on order routing and (2) individual customer requests for information on the firm’s order
routing relating to customers.
For orders that are externally executed for a broker-dealer, the customer can either choose the market center at
which the order will be executed or leave that determination to the broker-dealer. With a directed order, the
customer designates the location at which the order is to be executed. On the other hand, with a non-directed
order, the broker-dealer chooses the place of execution for the order because the customer has not made a
market center determination.

These order routing reports are designed to provide the public with information on how broker-dealers route their
customer orders. These reports are based on non-directed customer held orders in NMS stocks and options
contracts. A “held” order is typically entered by a retail customer and is intended to be represented in the market
or executed as soon as practicable without discretion. A “not-held” order that’s entered by an institutional
investor is one in which the broker has discretion over the time and/or price of execution. Not-held orders may
also be referred to as working orders. These orders are not considered limit orders and are not protected.
These quarterly reports must be broken down by calendar month and posted on a free website which remains
accessible for three years following the initial posting. There must be a section dedicated to option contracts,
while the section on NMS stocks must be separated into the following two categories:
1. NMS stocks that are included in the S&P 500 index and
2. Other NMS stocks
Each of these sections must include the following information:

 The percentage of total orders for the section that were non-directed orders
 The percentages of total non-directed orders for the section that were market orders, marketable limit
orders, non-marketable limit orders, and other orders
 A discussion of the material aspects of the relationship between the broker-dealers, including a description
of any arrangement of payment for order flow.
In addition, the SEC’s confirmation rule also requires a broker-dealer to include on each customer’s
confirmation a statement as to whether payment for order flow is received by the firm and the fact that the
source and nature of the compensation received in connection with the particular transaction will be provided
upon the customer’s written request.
SEC Rule 607

According to SEC Rule 607, a broker-dealer that acts as agent for a customer is required to provide written
disclosures at the time of the account opening and annually thereafter. The disclosures include the policies and
procedures regarding the receipt of payment for order flow. The firm is also required to disclose the effect that
payment for order flow has on sending orders to a specific market center.
SEC Regulation SHO

The Securities and Exchange Commission has regulated short sales since the late 1930s and the rules regulating
this process have evolved over time. In more recent times, many market participants engaged in a practice that’s
referred to as uncovered (naked) short selling in which positions were not properly borrowed prior to the initiation of a
short sale. In early 2004, the SEC adopted Regulation SHO, which modernizes the rules and creates uniform
standards regarding short sales. Regulation SHO applies to equity securities and any security that’s convertible into an
equity security (e.g., convertible bonds).
Long or Short? In simple terms, Regulation SHO clarifies the order-marking requirement of broker-dealers.

Any sell order ticket must be marked either long or short and this determination can be made based on the
following:
1. Long – The seller owns the security being sold.
2. Short – The seller doesn’t own the security being sold and will borrow the security.
The SEC clarified this basic requirement under two rules—Rule 200 and Rule 203.
SEC Rule 200 – Definitions and Order Marking

Under the rule, a person can be considered an owner of a security if he has purchased the security or entered
into an unconditional and binding contract (on both parties) to make the purchase, but has not yet received the
security. A person is also considered an owner of a security if he holds a security futures contract to purchase the
security and has received notification that the position will be physically settled and he will receive the
underlying security.
According to Rule 200, a broker-dealer must aggregate all of its positions in a security to determine its net
position, except in instances where the broker-dealer qualifies for independent trading unit aggregation.
Under this exception, to determine its net position in a security, each independent trading unit must aggregate
all of its positions.
A firm qualifies for this exception if the following criteria are met:
 The broker-dealer has a documented organization plan that identifies each aggregation unit with specified
trading objectives and supports its independent identity.
 At the time of each sale, each aggregation unit of the firm determines its net position for every security that it
trades.
 All traders in an aggregation unit follow the trading objectives or strategy of that unit and they cannot
coordinate the strategy with another aggregation unit.
 Individual traders are able to be assigned to only one aggregation unit at any time.
The order-marking requirement is a part of SEC Rule 200 and requires a broker-dealer to mark all sell orders
as either long or short. This applies to equity securities that are traded over-the-counter, on Nasdaq, or on an
exchange.
The following provides more detail regarding the marking of sell orders:
 Long – This is used when the seller owns the security being sold and it’s either in the possession/control
of the broker-dealer or it’s reasonably expected that the security will be delivered by no later than the
settlement day.
 Short – This is used when the seller owns the security being sold, but doesn’t reasonably believe that it
will be in the possession/control of the broker-dealer prior to the settlement day, or the seller doesn’t own
the security being sold, or any sale that’s effected by the delivery of a borrowed security.
 Short Exempt – This is used for a sell order in which the seller is exempt from SEC Rule 201 (described next)
SEC Rule 201 – Circuit Breakers

Rule 201 requires a trading center (as defined in Regulation NMS) to restrict short selling a covered security
at the bid or lower if the security declines by 10% or more from the prior trading day’s closing price.

Covered securities are defined as NMS equity securities that are listed on the NYSE, Nasdaq, or NYSE
American and for which transaction reports, last sale data, or quotation information are disseminated through
an automated quotation system. The rule doesn’t apply to securities quoted on the OTC Pink Market.
If the circuit breaker is triggered, the restriction applies to the display and execution of short sales and is
applicable during the remainder of the trading day through the next business day. The 10% decline is measured
against the end of the previous day’s regular trading hours. For example, if on Tuesday MAXX closed at
$30.00 and on Wednesday the stock is trading at a price of $27.00 (a $3.00 decline or 10%), the restriction will
be in effect on Wednesday and Thursday. It’s important to remember that this restriction only takes effect if an
NMS security declines by 10% or more. If the security continues to fall, the circuit breaker could be retriggered
and the restriction could extend beyond two business days.
If the restriction is in place, a trading center must have relevant policies and procedures that prevent the display or
execution of a covered security except at a price that’s above the current national best bid. For example, if the
circuit breaker is in effect and the current national bid is $26.75, a short sale is permitted only at a price above
$26.75. Rather than specify a minimum price increment above the national best bid, the SEC relies on the
current minimum price increment under Regulation NMS Rule 612.
Short Exempt
A broker-dealer is permitted to mark an order ticket short exempt under one of two conditions. This is in
addition to sell long or sell short that was previously discussed.
1. If the order is priced above the national best bid at the time it’s submitted (described previously)
2. If the order meets one of the exceptions specified in Rule 201
Exceptions to Rule 201

 A sale by a person who’s the owner of the security and who will deliver the security as soon as all restrictions
are removed
 Odd-lot transactions by a market maker
 Domestic or international arbitrage
 A short sale by an underwriter that’s effecting the transaction in connection with an overallotment
 A riskless principal transaction by a broker-dealer that’s effecting the transaction of a customer long sale,
provided certain conditions are satisfied
 Volume-weighted average price (VWAP) transactions
The exceptions may differ from many previous SEC price test rules, in that there’s no longer an exception
afforded to those persons engaged in bona fide market-making activities.
SEC Rule 203 – Borrowing and Delivery Requirements

Under Rule 203, if a broker-dealer knows or should have known that the sale of an equity security is marked
long, it must make delivery by the settlement date. The broker-dealer cannot use borrowed securities to make
delivery. However, there are three exceptions to this rule.

Exceptions It’s permissible for a broker-dealer to use borrowed securities to make delivery when:
1. The broker-dealer is lending a security to another broker or dealer.
2. The broker-dealer knows or has been led to believe that the seller owns the security being sold and will deliver
the security by the scheduled settlement date, but the seller fails to deliver.
3. Before a loan arrangement for a security to make delivery or before a fail-to-deliver, an exchange or a
securities association discovers that the sale originated from a good-faith mistake, although the broker-dealer
used due diligence regarding the sale, and the requirement of a buy-in will create an undue hardship, or the sale
had been executed at an unacceptable price.
Locate Requirements Prior to effecting a short sale, a broker-dealer must locate securities that can be used
for delivery by the settlement date. This requirement protects against uncovered short selling abuses. A broker-
dealer cannot accept an order to sell short an equity security for a person, or for its own account, unless one of
the following locate conditions is met:
 The broker-dealer has borrowed the security or entered into an arrangement to borrow the security.
 The broker-dealer reasonably believes that it can borrow the security for delivery on the date that
delivery is due.
The broker-dealer that executes a short sale transaction must document which of the aforementioned conditions apply.
In order to expedite the fulfillment of the locate provision, the SEC accepts the use of Easy to Borrow lists. These
lists, which must be less than 24 hours old, provide reasonable grounds for belief that a security on the list will be
available to be borrowed. The securities on the list must be readily available to avoid fails to deliver.
Exceptions The following exceptions allow a broker-dealer to forgo the requirements regarding the
acceptance of short sales for its account or the account of another person:
 When Broker-Dealer A has accepted a short sale from Broker-Dealer B. Broker-Dealer B must meet the
requirement regarding the acceptance of short sales for its account or the account of another person—unless
Broker-Dealer A (which is seeking to use this exception) has a contractual responsibility to comply.
 When a security is being sold on behalf of or by a person who has been determined to be the owner of such
security and the broker-dealer has been informed that the person will deliver the security when all possible
restrictions on delivery have been removed. If the person doesn’t deliver the security within 35 days after the
trade date, the broker-dealer that effected the transaction must borrow the security or buy a security that’s like in
kind and quantity in order to close out the position.
– This may occur when a client owns a convertible security that has been tendered for conversion, but
the underlying security cannot be physically delivered by the settlement date through no fault of the
customer or broker-dealer. This situation may also occur when restricted stock is sold under Rule
144, but the restricted legend cannot be removed by the settlement date.
Regulation SHO requires broker-dealers that are accepting short sale orders to first locate the securities to
determine whether they can be borrowed. However, this locate requirement has certain exceptions. One
exception is for any short sale that’s executed by a market maker in connection with bona fide market-making
activity. According to Regulation SHO, the term “market maker” refers to any dealer acting in the capacity of
a Qualified Block Positioner, any specialist permitted to act as a dealer, and any dealer that enters quotations in
an interdealer communication system (a Nasdaq market maker). This exception is only available when the
dealer is engaging in bona fide market-making activities.

Fail-to-Deliver Positions The issues of fail-to-deliver positions at clearing firms have also been addressed
under SEC Regulation SHO. Under the rule, if a broker-dealer has a fail-to-deliver position at a clearing firm in a
threshold security for a continuous period of either 13 settlement days, or 35 consecutive settlement days if the
security was sold under Rule 144, the broker-dealer must close out the fail-to-deliver immediately by
purchasing securities of a like kind and quantity. The closeout must take place on the morning of the 14th or
36th settlement date. (Under Regulation SHO, the term settlement day has the same meaning as business day.)
A threshold security is any equity security that’s registered in accordance with Section 12 of the Securities
Exchange Act, or for which the issuer must file reports in accordance with Section 15(d) of the Act and:
a. There’s an aggregate fail-to-deliver position for five consecutive settlement days at a clearing firm for
10,000 shares or more and equal to at least .5% of the total outstanding shares of the issuer.
b. A self-regulatory organization (SRO) has included the security on a threshold securities list that’s sent to
its members.
Note: A non-reporting threshold security is any equity security that’s not registered in accordance with Section
12 of the Exchange Act. Examples include stock of private companies and stock of private foreign companies
that trade in the United States (e.g., an unsponsored ADR). These securities are not subject to Reg SHO;
instead, they’re subject to a FINRA rule that’s modeled after Reg SHO.
As cited in (b), SROs are responsible for the inclusion of securities on a threshold list. Surveillance of
threshold securities is also maintained by the SROs from information provided by the National Securities
Clearing Corporation (NSCC) and must be published on a daily basis. Threshold securities may include
exchange-listed, Nasdaq, and OTC Pink Market securities.
A broker-dealer that has had a fail-to-deliver position at a clearing firm for a continuous period of 13 settlement
days in a threshold security cannot accept an order to sell short that security from another person or effect a short
sale for its own account without borrowing the security or entering into a bona fide arrangement to borrow the
security. This requirement must be adhered to until the participant closes out the fail-to-deliver position with the
purchase of securities of a like kind and quantity. Clients of the broker-dealer that have fail-to-deliver positions
and rely on that broker-dealer for clearing services, as well as market makers that generally qualify for an
exception to rules regarding short sales, must also follow limitations and restrictions surrounding fail-to-
deliver positions.
Broker-dealers that provide clearing services for other firms and have fail-to-deliver positions may distribute portions of
a fail-to-deliver position to its rightful firm. This can only be done if the broker-dealer is able to identify the account
in which the fail-to-deliver has occurred. When this distribution is made, the requirement to close out the position is
transferred to the firm that’s receiving the allocation, rather than the broker-dealer that’s providing the service. A
broker-dealer may also make arrangements with another firm to purchase securities in order to close out a fail-to-
deliver. However, the broker-dealer that’s under obligation to close out the position will not be considered to have
fulfilled the requirement if it knows or has reason to know that the other firm will not deliver the securities.
Applicability There’s one condition that affects the limitations on short sales and the close-out requirement
that’s caused by fail-to-deliver positions. The obligations of a broker-dealer with a fail-to-deliver position in a
threshold security at a clearing firm for a continuous period of 13 consecutive settlement days are not
applicable to the amount of the fail-to-deliver in the threshold security if the equity position has been created
by a registered options market maker that effected the short sale(s) to establish or maintain a hedge on options
positions and was created before the security became a threshold security.

SEC Rule 204 – Closeout Requirements

To further reduce the number of fail-to-deliver positions, the SEC adopted Rule 204 to Regulation SHO. Unless a
certain exemption applies, a broker-dealer that has a fail-to-deliver (as a result of not being able to deliver the
equity security by the settlement date) is required to immediately purchase or borrow the security to close out
the fail. If the firm is not in compliance with this rule, no short sales on this security are permitted by the
broker-dealer or any broker-dealer for which this firm clears transactions unless it has borrowed or has
arranged to borrow this security (pre-borrowed).
This rule applies to all equity securities, whereas the 13-settlement-day rule applies only to those securities that
have a large number of fails (threshold securities). This rule will also require a broker-dealer that sells an
equity security to either deliver the security by settlement date (T + 2), or immediately purchase or borrow the
security by no later than the beginning of trading on the next settlement day (T + 3).
Exceptions
 Long Sales – If the fail-to-deliver was a result of a long sale, the close-out requirement is three settlement
days following the settlement date (T + 5).
 Bona Fide Market-Making Activities – If the fail-to-deliver was the result of bona fide market-making
activities by the broker-dealer, the close-out requirement is three settlement days following the settlement
date (T + 5). Bona fide market making includes a registered market maker, an options market maker, and
other market makers that are obligated to quote OTC equities.
In both of these situations, the broker-dealer is granted two extra settlement (business) days.
 A similar exception to Rule 203 exists if the fail-to-deliver was the result of the sale of a security on behalf
of or by a person who has been determined the owner of such security, and the broker-dealer has been
informed that the person will deliver the security when all possible restrictions on delivery have been
removed. If the person doesn’t deliver the security within 35 calendar days after the trade date, the broker-
dealer must immediately close out the fail (on the 36th day) by purchasing securities that are like in kind
and quantity. An example of this is a sale under SEC Rule 144.
Short-Interest Reporting
Members must maintain a record of total short positions in Nasdaq stocks in all customer and proprietary
accounts. This information must be reported periodically to FINRA (currently, twice per month). All short-
interest reports must be made as of the close of the designated settlement date, which is currently the 15th of the
month (or the preceding business day if the 15th falls on a holiday or weekend), and as of the last trading day of
the month. The report must be received at FINRA by the close of the second business day after the calculation.
Short-interest information must also be collected and reported about listed securities. The information is reported to
the firm’s designated examining authority (DEA). The DEA for most broker-dealers is FINRA.
This concludes the chapter on SEC Trading Rules. The next chapter will cover SRO Trading Rules.


Chapter 11
SRO Trading Rules

SERIES 24 CHAPTER 11 – SRO TRADING RULES
This chapter will examine the various SRO trading rules as well as requirements for processing orders.
Special emphasis will be given to the information that’s contained on an order ticket, as well as
prohibited trading practices. At the end of the chapter, compensation arrangements and limitations
will be described.
Order Tickets
The regulators have placed increased emphasis on tracking the life of an order. For tracking purposes, one of
the most important documents is the order ticket (order memorandum).
Components of an Order Ticket

Although the order tickets that are used by different broker-dealers may not be identical, they have many
common elements. The entries on an order ticket will always include certain items.
Buy or Sell Generally, firms have different tickets—even printed in different colors—for purchases and
sales. While much of the information on the two types of tickets is similar, there are some important differences. In
particular, sell tickets must be marked either long or short (except for debt securities). As described in the
previous chapter, a sell ticket may need to be marked short exempt if the circuit breakers are in effect
(according to Regulation SHO).
In determining what’s a short sale, FINRA rules rely on the SEC’s definition—any sale of a security that the
seller doesn’t own or any sale that’s consummated by the delivery of a security borrowed by or for the account
of the seller.
Broker-dealers and their customers are considered to own securities only to the extent that they have a net long
position in a security. For example, if a customer has two accounts, one with a 1,000-share long position in a
stock and another with a 1,500-share short position in that same stock, the customer has a net short position of
500 shares.
Account Number/Name For identification purposes, the name of the customer is not always sufficient. The
customer may have more than one account, or may have the same name as another customer. If the person
entering the order is not the person whose name is on the account, the name of the person who’s entering the
order should also be entered on the ticket. This is also true for corporate accounts, especially those in which
more than one person is named on the corporate resolution.
As noted, the customer’s name or account designation must be entered on an order ticket. Exceptions are
granted if the order is from an outside investment adviser representative—a person who’s employed by the
member firm that’s providing investment advisory services (i.e., an investment adviser). This allows a member
firm to receive a large order from an investment adviser and subsequently allocate the order among customers.
Please note, there’s no exception for discretionary accounts.
Terms and Conditions If no price or other terms are indicated, the order is assumed to be a market order and
executed at the current prevailing price.

CHAPTER 11 – SRO TRADING RULES SERIES 24
The following qualifications may be imposed on the order:

 Price (limit)
 Stop or Stop-limit
 Good ‘Til Canceled (GTC) – otherwise the order is assumed to be a day order
 At-the-close or at-the-opening
 Not-held
 All-or-none (not permitted for some types of orders/markets)
 Fill-or-kill
 Immediate-or-cancel
 Do-not-reduce/do-not-increase
 Special settlement (cash, seller’s option)
 Solicited or unsolicited
Entry/Execution Information The order ticket must include the time the order was entered and, to the
extent feasible, the time of execution. This is typically accomplished by time-stamping the ticket. The price of
the fill is also to be added to the ticket upon execution of the trade.
Discretionary Order/Discretion Not Exercised If the client has granted discretionary authority to the
registered representative, this should be indicated for each order. It’s important to select discretion not
exercised if that was the case, since this indicates that the customer consented to that specific trade. (Note that
this is not the same as indicating that the trade was unsolicited.) If an order was the client’s idea, the ticket
should be marked unsolicited.
Time Stamping of Orders Pre-time stamping of order tickets in connection with block positioning is a
violation of FINRA’s books and records requirements. A firm is required to time stamp an order when it’s
entered and executed, but not in advance of their occurrence.
Additional Information
The preceding descriptions indicate the minimum items that must be recorded on a ticket. In some
circumstances, additional information should be included, especially any information that may be considered
part of the order’s terms and conditions, such as the following examples:
1. If an order has been stopped, this should be indicated on the ticket. An order is stopped if a trader
guarantees an execution, usually at the current market, while attempting to obtain price improvement on
the order. An example of price improvement is when a market maker has an offer price of $12.75 and the
firm executes the trade at $12.745. Price improvement is often measured in fractions of a cent, whereas
quotes must typically be entered in $0.01 increments.
2. Not-held orders are those in which the customer gives the executing broker-dealer discretion as to the
time and/or price of execution. This indication on the ticket is important, since not-held orders are not
protected under the Limit Order Protection Rule (the Manning Rule).
3. Under the SEC Limit Order Display Rule, if a customer requests for an order to not be displayed, it’s
prudent to note this request on the order ticket.
4. If an order is canceled, this should be noted along with the time the cancellation occurred.
The ticket for a canceled order should not be discarded. Instead, it must be retained in the same manner as an
order that’s executed.

Risk-Based Review of Trades FINRA rules require all trades to be reviewed by a principal by the end of
the day. An important question to consider is, “Which trades should be examined first?” The term risk-based
describes the type of methodology a firm may use to identify and prioritize for review those areas that pose the
greatest risk of potential securities laws and self-regulatory organization (SRO) rule violations.
In this regard, a firm is not required to conduct detailed reviews of each transaction if the firm is using a
reasonably designed risk-based review system that provides the firm with sufficient information to enable the
firm to focus on the areas that pose the greatest numbers and risks of violation. For example, a principal may
choose to first examine all of the trades of an employee under heightened supervision when conducting a
review of the day’s activity.
Executing Orders for Customers

When executing customer trades, broker-dealers act in different capacities. However, a firm may act in only one
capacity in a single customer transaction, which includes acting as agent, principal, riskless principal, or on a net
basis. An agency transaction occurs when the broker-dealer buys or sells securities in the marketplace on behalf
of a customer. The firm charges the client a commission, which is disclosed on the customer’s confirmation. In an
agency cross, the broker-dealer matches a sale from one client with a purchase from another and charges both a
commission. In a principal transaction, the broker-dealer executes a customer order by sells securities out of its
inventory or buys securities for its inventory. In this case, the broker-dealer is exposed to risk in its inventory
value. Transaction prices are based on the market price of the security, rather than the inventory value of the
dealer. If a customer is purchasing the securities, the firm charges the customer a markup above the market price
of the security. If a customer is selling the securities, the firm marks down the proceeds received by the customer.
When a firm buys for its inventory only to fill preexisting customer orders, its capacity is that of a riskless
principal. For instance, in quick succession, a dealer receives 10 customer market orders to each purchase 100
shares of stock. The firm may choose to buy 1,000 shares as principal and then resell the securities to its
customers at the same price, plus a markup. The firm must disclose its capacity as riskless principal since the
purchase by the firm and sale to the customers did not expose the dealer to price risk.
In the previous example, if the dealer had sold the securities to the customers at a different price than what it paid,
the executions are described as occurring on a net basis. In a net-basis trade, the dealer profits by charging a
different price for the securities, rather than charging a markup. FINRA rules place disclosure and consent
requirements on dealers that execute net-basis trades with customers. SEC Rule 10b-10 requires confirmations to
be sent which disclose various aspects of the trade, but doesn’t require the disclosure of compensation on net
basis trades. The markups on both principal and riskless principal trades must be disclosed.
The profit obtained in the net transaction is not disclosed on the customer’s confirmation. This specifically contrasts
with a riskless principal transaction where the markup is disclosed. Both legs of a net-basis transaction will be
reported on a principal basis to the Trade Reporting Facility (discussed in Chapter 12), since they occurred at
different prices. If a firm intends to execute a net-basis transaction with a customer, it must disclose the
conditions for handling the order and obtain the client’s permission prior to the execution of the trade. The rule
applies to transactions between a dealer and a customer, rather than dealer to dealer.
The following conditions apply to net-basis transactions:

 For non-institutional (retail) customers, written consent must be obtained on an order-by-order basis, prior
to the execution of net trades.

 For institutional customers, the firm may obtain consent in three different ways:
1. Oral permission before each net-basis transaction, or
2. Written permission before each net-basis transaction, or
3. Blanket permission through the delivery of a negative consent letter. The letter discloses the terms and
conditions of handling the order and gives the client an opportunity to opt out. If the client doesn’t express
any objections, the dealer may interpret this as permission to execute net-basis trades in the future.
 For fiduciaries, the broker-dealer must:
– Provide disclosure to the party that has been granted trading authorization
– Obtain permission from the party that has been granted trading authorization
– Follow the same disclosure and consent requirements that apply to institutional customers if the
fiduciary is an institution
Types of Orders
There are a number of different types of orders that investors may enter. Ultimately, the type of order used is
determined by the investor’s objectives.
Market Order A common type of order is the market order. This order doesn’t specify a price; instead, it’s
to be executed at whatever price is available at the time the order is entered. A market order will always be
executed, but customers cannot be certain as to what the execution price will be. This type of order is most
appropriate for actively traded issues with small spreads.
Limit Order When customers want to buy or sell securities at a specific price, they enter limit orders. A limit
order may only be executed at the specified price or better. A buy limit order may be executed at the limit price
or lower, while a sell limit order may be executed at the limit price or higher. If a member firm executes a limit
order that doesn’t satisfy the customer’s limit price, the customer is permitted to refuse the execution. Since a
limit order is entered away from the current market, it may not be executed immediately or, in some cases, at
all. It’s possible that a limit order may never be executed because the limit price is not reached or because there
was stock ahead (i.e., other orders at the same price with a higher priority).
Stop Order A stop order is primarily used to protect a profit or limit a loss on an existing stock position
(either long or short). A stop becomes a market order to buy or sell securities once the stock trades to or
through a specified price. The specific price is determined by the investor is referred to as the stop price. Once the
order is activated, the investor is guaranteed execution, but not guaranteed a specific execution price (because
it becomes a market order once activated).
Sell Stop Order A sell stop order is placed below the current market price of the security and is typically
used to limit a loss or protect a profit on a long stock position.
Buy Stop Order A buy stop order is placed above the current market price and is typically used to limit a
loss or protect a profit on a short stock position.

Stop-Limit Order A stop-limit order is similar to a stop order in that a stop price will activate the order.
However, once activated, the stop-limit order becomes a buy limit or sell limit order and will only be executed
if a specified price or better can be obtained. A stop-limit order is a combination of both the stop order and the
limit order. A stop-limit order eliminates the risk of a stop order (the uncertainty of an execution price), but
exposes the investor to the risk that the order may never be filled. Essentially, the investor could miss the
market in the security altogether.
Sell Stop-Limit Order A sell stop-limit order is placed below the current market price of the security and,
once activated, it becomes a sell limit order.
Buy Stop-Limit Order A buy stop-limit order is placed above the current market price of the security and,
once activated, it becomes a buy limit order.
Order Qualifiers
In addition to the types of orders that an investor may enter, there are various qualifications that investors may use.
Day Order Every order is considered a day order unless otherwise specified. If an order is not executed, it’s
automatically canceled at the end of the trading session. The regular trading session is from 9:30 a.m. to 4:00
p.m. ET.
Good-‘Til-Canceled (GTC) or Open Order This is an order that remains in effect until it’s executed or canceled.
At-the-Opening This is a market order-on-open (MOO) or limit order-on-open (LOO) to buy or sell at the
opening trade. If the order is not executed at the opening, it will be canceled. At-the-open orders cannot be
modified or canceled after 9:28 a.m. ET.
At-the-Close This order is to be executed at the closing price. At-the-close orders cannot be modified or
canceled after 3:58 p.m. However, at-the-close orders may be:
 Market-on-close (MOC) – an unpriced order that’s only executed at a price that’s determined by the Nasdaq or
NYSE Closing Cross, or
 Limit-on-close (LOC) – executed only if the Nasdaq or NYSE closing price satisfies the limit price
– If a market-wide trading halt closes the market early, MOC and LOC orders will be cancelled
Nasdaq Timeline for On-Close Orders

Prior to 3:50 p.m. ET  Nasdaq accepts MOC and LOC orders
 Nasdaq continues accepting MOC and LOC orders; however, they cannot
3:50 p.m. ET
be canceled or modified (EXCEPT for legitimate errors)
3:55 p.m. ET  Nasdaq cutoff for accepting MOC orders
3:58 p.m. ET  Nasdaq cutoff for accepting LOC orders

4:00 p.m. ET  The Nasdaq closing process begins

For comparison purposes, the table below represents the NYSE process for dealing with on-close orders:
NYSE Timeline for On-Close Orders

Prior to 3:50 p.m. ET  NYSE accepts MOC and LOC orders
 NYSE cutoff for entry, modification, or cancellation of MOC and LOC orders
3:50 p.m. ET
(EXCEPT for legitimate errors)
3:58 p.m. ET  NYSE cutoff for canceling MOC or LOC orders for legitimate errors
4:00 p.m. ET  NYSE regular way trading ends
On the NYSE, after 3:50 p.m., either order may only be entered on the contra side of any published imbalance
for 50,000 shares or more. For example, at 3:51 p.m., if there’s a published imbalance on the buy side, only
MOC or LOC sell orders may be entered. From 3:50 p.m. to before 3:58 p.m., cancellations of the orders are
allowed for legitimate errors only. On or after 3:58 p.m., these orders cannot be canceled for any reason.
Not-Held (NH) This qualification gives discretion as to time and/or price of execution for an order. This type
of order is typically received from an institutional investor and, if the best price is not obtained, the executing
firm will not be held responsible.
Immediate-or-Cancel (IOC) This qualifier dictates that as much of the order as possible must be executed
immediately. The portion that’s not immediately executed is canceled.
Do Not Reduce (DNR) All orders are adjusted for stock splits or stock dividends. Only orders entered that
are below the market are adjusted for cash dividends.
For the following order types, an adjustment of price must take place on ex-dividend date—specifically, the
price must be reduced by the amount of the dividend:
 Buy limit  Sell stop  Sell stop-limit
However, a customer may request for the order to not be altered by instructing her salesperson to mark the
ticket with the acronym DNR (do not reduce).
Adjustment of Open Orders

FINRA members firms that hold open orders for customers or other broker-dealers must adjust those orders on
any ex-dividend date for that security in a manner that’s similar to the adjustments which are made by
exchange designated market makers (DMMs) or specialists. If the member is holding a buy limit, sell stop,
or sell stop-limit order (orders placed below the current market price), it must subtract the dividend from the
price of the order and round the result down to the next lower quotation variation in the security’s primary
market. The minimum variation for Nasdaq securities is $0.01 for securities trading at $1.00 and above.
For example, a broker-dealer is holding a buy limit order at 24.00 for Oldline Corporation
common stock, a Nasdaq security. Oldline stock has announced a $0.525 cash dividend.
On the ex-date, the broker-dealer will subtract $0.525 from 24.00 and round the result
($23.475) down to the nearest one cent, leaving an adjusted buy limit order at 23.47.

Open orders are also adjusted proportionately for stock dividends or splits. However, in the case of a reverse
split, all open orders are to be canceled. The rule doesn’t apply to:
 Orders governed by exchange rules
 Orders marked do not reduce (DNR) or do not increase (DNI)
 Sell limit, buy stop, or buy stop-limit orders
The Nasdaq Market Center will automatically cancel open quotes that are entered into the system in response to a
corporate action (e.g., a stock split or cash or stock dividend) by an issuer. All quotes will be deleted from the
system and will need to be re-entered by the market maker.
Nasdaq Quote Rules

Market makers that place quotes in Nasdaq are subject to that system’s quote rules, in addition to the rules just
described. Generally, Nasdaq quotes must be two-sided and firm; however, there’s an exception to the requirement for
two-sided quotes for market makers that are publishing a stabilizing bid in compliance with Regulation M
(described in an earlier chapter). If a market maker updates its quote, but doesn’t specify a size for the update,
the new quote is assumed to be the same size as the previous quote.
Locked or Crossed Markets Nasdaq rules generally prohibit the entry of locked or crossed markets. A
crossed market occurs when a market maker enters a bid quote that’s higher than the ask quote of another
market maker, or an ask quote that’s lower than the bid quote of another market maker. A locked market
occurs when the highest bid and lowest offer are equal. The following example will clarify this point.
Three market makers have entered the following quotes for WXYZ stock in Nasdaq:
Market Maker #1 14.80 − 15.20
Market Maker #2 15.05 − 15.40
Market Maker #3 14.90 − 15.30
In this situation, the inside market is 15.05 − 15.20. A new market maker cannot enter
a bid at 15.20 or higher. A new bid of 15.20 would create a locked market, since the
lowest current ask price is also 15.20. A new bid of more than 15.20 would create a
crossed market. For example, a bid of 15.30 would allow a trader to buy stock from
Market Maker #1 at 15.20 and sell the stock to the new bid of 15.30. By doing so, the
trader is guaranteed a profit (arbitrage).
A new market maker cannot enter an offer of 15.05 or less. A new offer of 15.05
would create a locked market, since the highest current bid price is 15.05. A new offer
of less than 15.05 would create a crossed market. For example, an offer of 15.00
would allow a trader to buy stock at 15.00 and sell the stock to Market Maker #2 at
15.05, thereby guaranteeing a profit.
Before entering a quote that locks or crosses the market, a market maker must make a reasonable effort to
execute transactions with all market makers whose quotes would be locked or crossed.
Extended Trading Hours

Market makers are expected to offer continuous quotations during the regular trading hours of 9:30 a.m. to
4:00 p.m. ET.

Although not required, Nasdaq permits market makers to remain open during extended trading hours, which
occur both prior to and after the regular session. This extended trading window provides broker-dealer
customers with the opportunity to trade securities and manage their portfolios during more convenient hours.
However, there are special risks associated with trading during extended hours. Broker-dealers have an obligation
to their customers to disclose the material risks of extended hours of trading before permitting their clients to
engage in transactions during this period.
Some of the risks of extended hours trading include:

 Lower Liquidity Reduced order volume means that markets are less liquid during extended hours. A
customer’s order may only be partially executed, or not executed at all.
 Higher Volatility Reduced volume during extended hours also results in greater price swings in
securities that trade in the late session.
 Changing Prices The prices at which orders are executed during extended hours may be different from,
and inferior to, the prices that were available at the end of the normal trading session or the prices that will
be available when the market opens the next business day.
 Unlinked Markets Prices that are available in one trading system (such as an ECN) may not be available
to participants in another system if there’s no extended-hours linkage between the systems.
 News Announcements Many issuers delay the release of material news until after the close of the
normal trading session. The release of this news during extended hours of trading may exaggerate
price volatility.
 Wider Spreads Since market makers are not required to participate in the extended-hours session, there
may be less quote competition and wider spreads than during normal market hours.
These disclosures may be provided to a client either electronically or in paper form and, if the client can trade
online during extended hours, the disclosure statement must be on the firm’s website.
Nasdaq Trading Halts

Nasdaq has the authority to halt trading:
 In Nasdaq-listed securities that trade on Nasdaq
 In other exchange-listed securities (CQS securities) that are traded on Nasdaq when a trading suspension has
been imposed on the security by its primary exchange
 In an ADR that’s trading on Nasdaq when a trading suspension has been imposed on the underlying security by
its foreign securities exchange
Market participants cannot quote or execute any type of order in a Nasdaq security, exchange-traded security, or
an ADR for which Nasdaq has imposed a trading halt pending the release of material information. Such a
trading halt may be imposed if the issuer is about to release information that’s reasonably expected to affect the
value of its securities. Nasdaq issuers must notify Nasdaq of the pending release of such information and, at this
point, Nasdaq will determine whether a trading halt is advisable.
The purpose of a halt is to allow the information to be disseminated to the public and to give investors the
opportunity to evaluate the information and consider it when making investment decisions. Nasdaq will also halt
trading if there’s a trade imbalance or during periods of extreme market volatility if the SEC requests that it do so.

Trading Halts on OTC Securities

Quotation and trading halts may be imposed by FINRA on securities that are quoted and traded over-the-
counter. This includes stocks quoted on the OTC Pink Market, as well as American depositary receipts (ADRs)
that are quoted in the OTC market, and OTC equity securities that are not publicly quoted. Prior to halting
quotations and trading under the previous circumstances, FINRA will evaluate the information available to
determine whether a trading halt is appropriate. If FINRA determines that a basis exists to impose a trading
and quotation halt, it will do so by providing appropriate public notice. The halt will become effective
simultaneously with the announcement.
If FINRA issues a trading and quotation halt for an OTC security, FINRA member firms cannot trade the
halted security or quote it in any quotation medium. This prohibition extends to internal crosses between
customers and/or the firm’s proprietary account(s). The halt is lifted if FINRA determines that the basis of the
halt no longer exists, or if the halt has been in effect for 10 business days, whichever occurs first.
Foreign Markets No member firm may execute transactions for customers or for its own account, even on
international markets, when the security is subject to a trading halt on a U.S. market. In the case of ADRs,
FINRA doesn’t have the authority to stop trading in the underlying shares listed in a foreign market, but does
have the authority to halt trading in the ADR itself.
Market-Wide Circuit Breakers

To address extraordinary volatility across the U.S. equities markets, circuit breakers have been established by the
NYSE for trading that occurs on the exchange. However, once the levels were created, other markets agreed to
honor them. Originally, the reference index for the circuit breakers was the DJIA; however, it’s now the S&P
500. The SEC approved modifications to the circuit breakers rule which applies to all National Market System
(NMS) securities regardless of the exchange on which they trade. For example, if a market-wide trading halt is in
effect, all NMS stocks that are listed on the NYSE and those listed on the other exchanges are required to halt
trading. For any NMS stocks that trade in the OTC market, it’s FINRA’s responsibility to halt their trading.
The table below provides the details of the possible trading halts due to a decline in the S&P 500 Index:
Trigger Value Time (all times ET) Action
Level 1: 7% decline 9:30 a.m. – 3:25 p.m. 15-minute trading halt
Level 2: 13% decline 9:30 a.m. – 3:25 p.m. 15-minute trading halt
Level 3: 20% decline Any time Trading halts for remainder of the day
At or after 3:25 p.m. ET, trading shall continue unless there’s a Level 3 halt. These levels are calculated on a
daily basis and are based on the close of the previous day. For example, if the S&P 500 closed at 1,700 on
Wednesday and the index declined by 119 points (a 7% decline) on Thursday at 11:00 a.m., trading in NMS
stocks will halt on all U.S exchanges for 15 minutes.

Limit Up – Limit Down (LULD)

In order to address extraordinary short-term market volatility, the SEC created individual stock circuit
breakers. These are in addition to market-wide circuit breakers. The objective is to prevent trades from
occurring outside of applicable price bands, as well as to require exchanges and FINRA to pause trading in a
stock if the price moves by more than a specified percentage (usually 5% or 10%) in a five-minute period. The
SEC requires market centers (exchanges) to create and enforce policies and procedures that are designed to
comply with LULD requirements and trading pauses. Please note, the rule applies only to NMS securities
(which include exchange-traded funds).
Price Bands The price bands that are established under LULD are set at a percentage above and below the
reference price. The reference price for each security is based on the opening price or quote on the primary
listing exchange and, thereafter, on the trading that occurred over the preceding five minutes of trading. The
price bands below are applicable between 9:45 a.m. (ET) to 3:35 p.m. (ET). The price bands are doubled
during the first 15 minutes of trading (9:30 – 9:45 a.m.) and the last 25 minutes of trading (3:35 – 4:00 p.m.).
Previous Closing Price Percentage Parameters

 For Stocks in the S&P 500 or Russell 1,000: 5%
For stocks greater than $3.00
 For all other NMS stocks: 10%
For stock at or above $.75, up to and including $3.00 20%
For stocks less than $.75 The lesser of $.15 or 75%
Regular State When the LULD rule is applicable, trades that occur at prices that are equal to or greater
than the lower price band, or equal to or less than the higher price band (within the price bands), will not
affect trading.
Straddle State When the LULD rule is applicable and when one side of the market is outside of the price
bands, this refers to a situation where the NBB is below the lower price band or the NBO is above the upper
price band. In this situation, only one side is executable.
Limit State When the LULD rule is applicable, this situation will occur if the NBB is on or above the upper
price band, or the NBO is on or below the lower price band.
Example
Upper Band $63
Let’s assume that the reference price is $60
and the pricing parameter percentage is 5%
(lower band $57 and upper band $63).
No trades are permitted below $57 or above Reference Price $60

$63. A limit state exists if the NBO is $57 or
less, or if the NBB is $63 or higher. A straddle
state exists if the NBB is below $57 or if the
NBO is above $63.
Lower Band $57

Trading Pause If the security enters the limit state and fails to move back inside the price bands within 15
seconds, the primary listing exchange will issue a five-minute trading pause in the security. The primary listing
exchange is also permitted (but not required) to issue a trading pause if the security is in a straddle state. No
transactions are permitted during a trading pause, but bids and offers will continue to be displayed. After the
five-minute trading pause, the primary listing exchange will reopen trading using its reopening procedures and
that price will be the new reference price.
FINRA Conduct Rules

FINRA’s most general rule on business conduct states the following:
A member, in the conduct of its business, shall observe high standards of commercial
honor and just and equitable principles of trade.
Listed next are FINRA’s rules concerning trading and the business conduct of its members.
Best Execution
A member firm’s failure to use reasonable diligence when attempting to obtain the best price on purchases and
sales for its customer is inconsistent with the just and equitable principles of trade. To ascertain whether a
member firm has used reasonable diligence, the following factors are considered:
 The general character of the market in which the security trades (e.g., the price, volatility, relative liquidity, and
availability of communications)
 The size and type of transaction
 The number of markets checked
 Accessibility of the quotation
 The terms and conditions of the order which resulted in the transaction (as communicated to the member)
Unless a firm conducts an order-by-order review, the obligation to provide best execution for customer orders
requires a member firm to periodically conduct a regular and rigorous review of the quality of the executions.
The review must be conducted on a security-by-security and type-of-order basis (e.g., limit order and market
order). At a minimum, a member firm must conduct the review on a quarterly basis. However, based on the
firm’s business, it should consider whether more frequent reviews are appropriate.
When conducting this review, the firm should compare the execution quality among the various markets that
trade a security and be prepared to justify why it’s not modifying its order routing arrangements. In some
circumstances, a customer (typically an institutional investor) will direct a broker-dealer to route an order to a
specific market center or broker-dealer for execution. For situations in which the customer instructs a broker-
dealer to use another member firm for execution, the receiving (not sending) firm is subject to the best
execution guidelines.
Fair Prices and Commissions – The 5% Policy

FINRA members are not permitted to charge prices or commissions that are unfair or excessive. To assist
members in determining the level of charges that are fair, FINRA has developed a markup policy—also known
as the 5% Markup Policy.

Although it’s stated in terms of markups, the policy applies to markups, markdowns, and commissions. The
policy applies to both exchange-listed and non-exchange-listed securities regardless of whether the broker-
dealer is acting in an agency or principal capacity.
In 1943, to formulate its policy, FINRA conducted a survey of its members. Based on this survey, FINRA
stated that it was nearly impossible for guidelines to dictate what’s fair compensation on each and every
transaction. Instead, all relevant factors need to be considered in judging a particular trade. In certain cases,
markups exceeding 5% could be justified, but in other circumstances, 5% may be excessive. FINRA’s board
directed its District Business Conduct Committee to bear in mind, when investigating possible markup
violations, that 71% of the transactions surveyed were executed with markups of 5% or less. For this reason, it
has become known as the 5% Policy. Although FINRA has revisited this issue many times over the intervening
years, its basic position has remained unchanged.
In some ways, the 5% Policy seems fairly simple. If Broker-Dealer X sells stock to a customer from its inventory
at $21 per share when the prevailing interdealer price is $20, Broker-Dealer X charged a $1 per share markup.
This is exactly 5%, which is calculated by dividing the markup of $1 by the prevailing interdealer price of $20.
However, part of the judgment about what’s an acceptable markup involves the consideration of all relevant
factors. Over the years, FINRA has taken many enforcement actions against firms that it believes have
charged excessive markups. In the course of reviewing those decisions, it has (under SEC oversight)
developed some guidelines for determining what’s excessive and what’s fair. These issues tend to revolve
around two questions: (1) When is a markup of approximately 5% acceptable; when can it be more, and when
must it be less? and (2) How is the markup calculated when the prevailing interdealer price is not obvious?
Factors That Influence the Level of Markups FINRA emphasizes that 5% is merely a guideline. In other
words, in certain circumstances, it’s possible to justify higher markups, but conversely, there are times when even
5% is too much. The following several factors are considered when determining whether a markup is excessive:
 The type of security involved – Some securities carry higher markups than others as a matter of industry
practice. For example, the markups on common stock or limited partnership units are typically higher than
markups on bonds.
 The availability of the security in the market – If more effort is required to locate a particular security and
execute a transaction, a higher markup is justified.
 The price of the security – The percentage of markup generally increases as the price of the security decreases,
since lower-priced securities may require more handling and expense.
 The amount of money involved in a transaction – A transaction for a small total amount may require greater
handling expenses on a proportionate basis than a larger transaction.
 Disclosure – Disclosure to the customer that the circumstances may warrant a higher-than-normal markup helps
to make the dealer’s case. However, the circumstances also must justify the charges. Disclosure in their absence
doesn’t justify a higher markup.
 The pattern of markups – FINRA tends to be most severe with cases that show a persistent pattern of excessive
markups. However, the markup in each transaction must be justified on its own merits.
 The nature of the broker-dealer’s business – Firms that offer services to customers (e.g., research) can justify
markups higher than those of firms that don’t offer such services. However, if a firm has high expenses that
don’t benefit customers, these expenses will not justify higher charges.

Calculating Markups As described previously, markups represent the difference between the interdealer
ask price and sales prices to customers, while markdowns are described as the difference between the
interdealer bid price and purchase price of customers. For example, let’s assume that the inside market for
MNOP stock is 19.50 − 20.00 and Dealer X (a market maker) sells stock to a customer for $21.00 per share.
Dealer X calculates the markup as $1 per share, which is 5% above the interdealer offer price. This is
acceptable only if the market for MNOP is active and competitive. On the other hand, if one market maker
dominates and controls the market, and interdealer transactions don’t occur frequently at the inside, the market
is not active and competitive. In a dominated and controlled market, the inside market may not be the best
indicator of the prevailing market price.
As an example of what can happen when the market is not active and competitive, let’s assume that UVWX is
a small OTC company. It’s brought to the public by Dealer P and Dealer P is the only market maker in the
secondary market. There’s little national interest in the company’s stock other than the business solicited by
Dealer P’s registered representatives. Over the last month, Dealer P has been accumulating stock by
purchasing UVWX at $5 per share from retail customers.
During this time, its interdealer quote was 5.25 − 5.75, but it didn’t execute any interdealer trades. Suddenly,
Dealer P raises its interdealer quote to 9.50 – 10.00 and begins selling UVWX to new retail customers for
$10.50 per share.
Can Dealer P claim that it’s charging customers only a $0.50 markup above the interdealer offer of 10.00, which
is a 5% markup? No, the markup cannot be calculated in this way. Dealer P’s quote of 9.50 – 10.00 is
meaningless because it dominates and controls the market for UVWX. Dealer P is not worried about needing to
buy stock from other dealers at its bid of 9.50, because it knows there’s little interdealer activity in the stock.
Since its cost is only $5 per share, a price of $10.50 to retail customers is more than 100% profit.
Policy Enforcement FINRA has been actively enforcing its markup policy and is especially concerned that
its members use the proper methodology to calculate markups. When calculating markups, a broker-dealer
must determine:
 Whether it’s acting as a market maker or a retail broker-dealer in the transaction
 Whether the market for the stock is dominated and controlled, rather than active and competitive
 Whether actual transactions or validated quotes may be used as the best evidence of the prevailing price
FINRA recognizes that a market maker in a competitive stock is risking its capital in the active market and that the
firm is entitled to earn the spread plus a markup when selling to retail customers. A firm that’s not a market maker
(i.e., one that simply buys from market makers and resells to customers in riskless transactions) is not taking the
same risk. For firms that are not market makers, the price that the firm pays other broker-dealers contemporaneously
in retail sales is the best indicator of the prevailing price. (A dealer’s contemporaneous cost is the price paid to other
dealers for the security at or about the time it made retail sales to customers.) The sole action of posting quotes in
the OTC Pink Market doesn’t itself make a dealer into a market maker. The firm must actively participate in the market.
In active, competitive markets, such as those typically found in Nasdaq Global Market securities, the inside
offer can generally be used as the prevailing market price when calculating markups on sales to retail
customers because such quotes can typically be validated.

A quote is considered validated when:

 A competitive market for the security exists
 Interdealer sales occur with some frequency, although not necessarily contemporaneously
 On the days that interdealer sales occur, they’re consistently executed at prices at or near the quoted offers
Proceeds Transactions Proceeds transactions are those in which the customer directs the member firm to sell
a security and use the proceeds of the sale to buy another security. In this case, the member firm should
compute the markup in the same manner as if the customer had purchased for cash and should include any
compensation on the customer’s sale as well as the firm’s profit on the customer’s purchase. For example, let’s
assume that a customer instructs a member firm to sell $5,000 of ABC stock and use the proceeds to purchase
$5,000 of XYZ stock. When computing the percentage markup, the member firm should use its total
compensation (from both the customer’s sale and purchase) as a percentage of the $5,000 customer sale.
Exemptions Exempt from the provisions of the 5% Policy are securities that require the delivery of a
prospectus or offering circular since these issues are sold at a specific public offering price (e.g., initial public
offerings and mutual funds).
FINRA Sanctions
In markup cases, the most severe sanctions have occurred where a single market maker (or a few market
makers acting together) have dominated and controlled the market. In such situations, it’s inappropriate for
dealers to use quotes (e.g., prevailing market price), rather than cost. The dealer should use its
contemporaneous cost; however, if it has not recently made interdealer purchases, it should use the price it paid
customers for the stock (adjusted for an imputed markup that conforms to the 5% Policy).
Responsibilities of Broker-Dealer Personnel While sanctions in markup cases are often assessed against
the broker-dealer or its controlling persons, individual registered representatives may be held accountable as
well. Traders are particularly important since part of the job of being a trader is determining the prevailing
price. In addition, traders are in a position to know whether their firms dominate and control a market.
Registered representatives can also be held liable if they benefit from the transactions they solicit on which
excessive markups are charged. According to FINRA, registered representatives, particularly those reaping
some of the ill-gotten gains derived from unfair pricing to customers, may also be held responsible for
excessive markups and unfair pricing to customers. A salesperson may certainly be deemed to share
responsibility if he participates in determining the prices the firm charges to customers, and also where he
knew or should have known that the prices being charged are excessive based on a comparison of the gross
commission or markup to the total price charged the customer.
Registered representatives don’t merely function as salespersons. They’re securities professionals who operate
in a highly regulated environment, and they’re required to know and comply with the relevant laws and rules.
Registered representatives cannot claim ignorance of FINRA’s markup policy or case histories to avoid being
included in an investigation of a firm’s role with respect to particular securities. In short, they cannot solicit
transactions for excessive gains with regulatory impunity. So, although a broker-dealer’s markup policy may
be set at senior-management levels, it’s important for registered representatives to be aware of how the policy
affects their clients.

Markups and Markdowns on Debt Securities

FINRA has issued guidance for fair markups on debt transactions with customers. When executing such a
trade, the broker-dealer’s markup must be based on the security’s prevailing market price. The prevailing
market price of a debt security is its contemporaneous cost or contemporaneous proceeds. A dealer’s cost
(proceeds) is contemporaneous when its inventory purchase and subsequent resale to a retail customer occur in
close time proximity. If a dealer has not made a contemporaneous purchase (sale), it may present other
evidence of the prevailing market price.
In addition, market events, which may include a change in the bond issuer’s credit rating, news about the issuer
that affects debt pricing and a change in interest rates, may render the dealer’s contemporaneous cost obsolete.
A hierarchy of factors must then be used by the broker-dealer to determine the prevailing market price. The
factors are:
1. Prices of contemporaneous interdealer transactions in the same security
2. Prices of contemporaneous dealer transactions with institutional customers in the same security (in the
absence of factor 1)
3. For actively traded securities, the dealer may use the contemporaneous quotes of the same security (in the
absence of factors 1 and 2)
If contemporaneous pricing information (as previously described) is not available, then the broker-dealer may use
the contemporaneous prices of similar securities to determine the prevailing market price of a subject security.
Factors that are used to determine whether the security is similar include credit quality, collateral, a comparable
yield spread over Treasuries, and structure of the bond issue (coupon and maturity).
When similar securities are not available, economic models of valuation may be employed. These pricing
models take into account credit quality, coupon rate, call provisions, interest rates, time until maturity, face
amount, and industry sector. A markup could be unreasonable if it’s based on expenses that are excessive, or if
it fails to rely on any of the factors stated previously.
In summary, the pricing of debt instruments is prioritized as follows:

 The contemporaneous price of a dealer
 The contemporaneous price of a similar security
 The price based on a pricing model
Exemptions The following transactions are exempt from the debt markup policy:
 Transactions in municipal securities (investment-grade or non-investment-grade)
 Transactions in exempt securities (e.g., U.S. government securities)
 Transactions with qualified institutional buyers (QIBs) when the purchase or sale involves non-investment-
grade debt securities
Charges for Services

Under FINRA rules, member firms may charge customers for miscellaneous services they perform, including:
 Collecting funds due for principal, dividends, or interest
 Exchanging or transferring securities and performing appraisals

 Safekeeping or maintaining custody of securities

 Issuing physical certificates or issuing paper-based confirmations
All charges must be reasonable and cannot be unfairly discriminatory between customers. FINRA rules
prohibit members from charging for proxy distribution or the issuance of paper-based account statements.
Handling Errors
Errors Reports After examining a confirmation, an error may be detected by either the customer or a registered
representative. For example, a client may have instructed his RR to purchase 100 shares, but the firm may have
mistakenly purchased 1,000 shares. If an error is detected, the procedures to be followed depend on the nature of
the error and the firm’s own policies. However, registered representatives should not independently decide how
to correct the error. Instead, they should bring the mistake to the attention of a supervisor.
All broker-dealers are required to record any error that’s made by the firm or an RR (e.g., the wrong security or
the wrong side of the market) and maintain an error account. For example, if securities are purchased in error
for a client’s account, they’re moved from the client’s account and put into the firm’s error account and then
liquidated. The error account is created and maintained by the firm, not by RRs.
Cancel and Rebill If a registered representative executes a transaction, but uses the wrong account number,
this is an error that may be corrected. The correction is done by transferring the transaction to the appropriate
account number with the permission of a registered principal. This transfer process is often referred to as a
cancel and rebill. In some cases, an error is made using the correct account number for the client, but the
wrong account (e.g., margin account rather than an IRA). For these situations, a similar process is used to
correct the error.
Errors in Reporting If a registered representative executes a transaction correctly, but simply misstates the
execution price, the trade will stand as it was executed. For example, a client instructs an RR to buy 1,000
shares of XYZ at the market. The client is subsequently told that the trade was executed at $30, but the
actual price was $30.07. Although the erroneously reported price was better than the actual price, the client
is obligated to pay the higher (actual) price.
Prevention of Rogue Trading

Unauthorized trading has been the cause of the demise of several large broker-dealers. For this reason, the SEC
requires firms to institute policies and procedures which are designed to both detect and prevent this activity.
Some of the procedures include:

 Requiring mandatory vacations for a minimum number of days (typically 10 consecutive business days)
for persons with sensitive jobs (e.g., traders)
 Limiting access by employees to only those trading systems that are appropriate for their job function
 Protecting information concerning the firm’s monitoring and surveillance systems to prevent employees
from circumventing those systems
 Requiring the use of multiple passwords to allow access to certain systems

Trading in Anticipation of a Research Report

Over time, industry regulators have become concerned over the interaction between research departments and
trading desks—specifically concerning any adjustment in inventory by a firm’s trading department of a
security that’s the subject of a report about to be issued by the firm’s research department. This practice is
often referred to as trading ahead. In the case of a favorable report, it has been argued that the firm’s actions
could have been based on its desire to meet anticipated customer demand for that security. Without such an
accumulation, customers who want to buy the security in light of the report will be forced to pay higher prices
due to the increase in demand.
However, the regulators have not accepted this argument. In fact, FINRA created a rule that prohibits a
member from establishing, increasing, decreasing, or liquidating an inventory position in a particular security
or derivative of that security based on material, non-public, advanced knowledge of the content and timing of a
research report in that security (regardless of whether the reports are positive or negative). The rule covers all
securities of the issuer, including debt and derivatives. In addition, the rule covers both exchange-listed and
non-exchange-listed securities.
Member firms are required to establish, maintain, and enforce policies and procedures that are designed to
restrict or limit the flow of information between their research and trading departments. Therefore, the rule
requires the establishment of information barriers to isolate the research department from the trading department.
These information barriers prevent a trading department from learning of a pending research report regarding a
security in which it has a position.
Please note, inventory changes related to unsolicited order flow from retail customers or other broker-dealers
are not covered. Likewise, there’s no restriction if the research involved is for in-house use only and is in no
way being prepared for external publication.
Front Running
It’s a violation of industry rules for member firms or associated persons to execute an option order for an
account in which they have an interest or exercise discretion if they’re in possession of material, non-public
information about an imminent block transaction in the underlying security. This prohibited activity is referred
to as front running. Similarly, an order in the underlying security cannot be executed for the previously
mentioned accounts if a firm or its representatives have material, non-public information about a pending
block transaction in the related option. This prohibition applies until information about the block transaction
has been made publicly available through reporting on the Tape or through a third-party newswire service.
When a partial execution of a block occurs, the ban is still in effect until information about execution of the
entire block has been made public. A variation on this violation is the practice of shadowing, in which a
member firm executes a proprietary trade right after the client’s trade, but before the trade is reported. It’s
important to note that neither of these practices constitutes insider trading, which represents the misuse of
material, non-public information regarding an issuer.
The restriction doesn’t apply to transactions in automatic execution systems, such as the Nasdaq Market Center
Execution System, in which market makers must accept automatic executions. The rule applies only to transactions
that are required to be reported to Nasdaq, the Consolidated Tape, or the Options Price Reporting Service. For purposes
of this rule, a block is generally considered a transaction involving 10,000 or more shares, or options covering that
number of shares. However, in appropriate circumstances, FINRA may consider a smaller amount to be a block.

Interpositioning Interpositioning is generally prohibited and is defined as the insertion of a third party
between a customer and the best market. In fact, the practice is specifically prohibited when it’s to the
detriment of the customer.
For example, a broker-dealer receives an order from a customer to buy 100 shares of
XYZ at the market. The current best offer of any market maker is $40. However,
rather than buying directly from the market maker, the broker-dealer interposes
another firm that buys the stock at $40 and then sells it to the member firm at $41.
The member firm ultimately sells the stock to the customer at $42 and the two firms
share the one-point extra markup that was charged to the customer.
Keep in mind, interpositioning is not prohibited if a member firm is able to demonstrate that an execution was
advantageous to its customer as a result of the intervention of a third party (e.g., the use of a broker’s broker).
This may occur when an order is crossed with a retail order from another firm or when the member firm
determines that the market may be adversely affected (to the detriment of the customer) due to the disclosure
of the identity of the member firm. An order may also be channeled through a third party if (1) that party is an
established correspondent, (2) if the name of the customer’s member firm is provided, and (3) if the customer
is not charged for the correspondent’s services. The lack of sufficient personnel to effectively execute an order
is NOT a suitable reason for failing to obtain the best price for a customer.
The guidelines for best execution and interpositioning apply when a broker-dealer executes trades in equity or debt
securities and acts in either an agency or principal capacity. It’s important to remember that the best execution duty
applies to the price the customer received and is exclusive of any commissions, markups, or markdowns.
Securities with Limited Quotations or Pricing Information

When a broker-dealer executes a transaction in either an equity or debt security that has a limited number of
quotations or pricing information available, different guidelines apply. The market for a stock with one or two
quotes available in the OTC Pink Market is very different than a stock that’s quoted on an exchange, such as the
NYSE or Nasdaq. FINRA requires each firm to have policies and procedures in place to describe how the firm
will handle these types of transactions. Some recommended methods include contacting other sources of pricing
information or finding other means of liquidity. For example, if there are a limited number of quotes available
for ABC stock, a firm may contact another broker-dealer with whom it has traded ABC stock in the past.
Foreign Securities with No U.S. Market

If a member firm executes a transaction for a customer outside of the U.S in a security that’s not available in U.S.
markets, the best execution requirements may be substantially different. An example of this is a trade involving an
equity security for which no ADR has been created to allow it to trade in U.S. markets. Since foreign markets often
lack the same best execution requirements, firms are required to establish specific written policies and procedures
regarding their handling of customer orders for these types of securities. The policies must be reasonably
designed to obtain the most favorable terms available for customers and must take into account the differences
that may exist between U.S. and foreign markets.

Trade Shredding
Under industry rules, a broker-dealer cannot split orders into smaller ones for executions, or split executions
into multiple executions for transaction reporting with the intent of increasing a monetary or an in-kind amount
(e.g., commissions, credits, gratuities, payments, or rebates of fees) to be received because of the execution of
the orders or the transaction reporting for the orders. This prohibited practice is referred to as trade shredding.
On the other hand, breaking up or splitting orders to provide a customer with a lower cost or best execution, or
to avoid a trade-through violation of Reg. NMS, is an acceptable practice.
Electronic Blue Sheets

Electronic Blue Sheet (EBS) data files contain both trading and account holder information and provide
regulatory agencies with the ability to analyze a firm’s trading activity. Firms are expected to provide
complete, accurate, and timely Blue Sheet data in response to regulatory requests. Incomplete, inaccurate, and
untimely Blue Sheet data compromises regulators’ ability to identify individuals who are engaging in insider
trading schemes and other fraudulent activity. The trade information includes trade data for both a member’s
proprietary account and for any customer’s account.
Fraudulent Devices
As with its business conduct rule, FINRA’s rule on manipulative, deceptive, or fraudulent devices is short and
seemingly uncontroversial. It states:
No member shall effect any transaction in, or induce the purchase or sale of, any security
by means of any manipulative, deceptive or other fraudulent device or contrivance.
This rule covers several types of improper behavior, as spelled out in disciplinary cases or in additional rules
and interpretations.
Marking-the-Close/Marking-the-Opening
An example of a manipulative practice is marking-the-close. This practice was described in an SEC
administrative proceeding against a broker-dealer in the following way:
Marking-the-close refers to a series of transactions, at or near the close of trading,
i.e., at or within minutes of 4:00 p.m., which either uptick or downtick a security. . .
Marking-the-close represents a possible departure from the normal forces of supply
and demand that result in the fair auction price for a security, and is of concern to
those who regulate the markets.
Similar activity at the start of the day is considered marking-the-opening.
Motivation There are two primary motivations for marking-the-close. First, brokerage firms use a security’s
closing price in determining what their margin requirements will be for their customers. Some firms use $5 per
share as a level at which they raise margin requirements, while other firms use a lower price. When the stock
drops to that price level, firms raise their requirements to 100% equity, essentially requiring full cash payment
for the security. Second, a security’s closing price is the price shown in the newspapers as the final price for that
security for that trading session.

The concern about marking-the-close arises when the practice is repeated and a pattern develops. Marking-the-
opening may occur when options expire, since some contracts are settled based on the opening prices at
expiration. Certain program trading strategies are also executed as the market opens.
Potential Impact on the Market In addition to affecting the value of the manipulator’s position, marking-
the-close can have a wider impact on the market. For instance, if the stock being manipulated is part of an index,
the value of the index can be affected by marking-the-close activity. Indexes are used for a wide variety of
purposes in the industry and are closely watched by investors when they make purchase or sale decisions.
In addition to using trades to mark-the-close, simply changing a quote can be an example of this practice. In
one case, a trader engaged in a pattern of upticking his firm’s quote on a regular basis within five minutes of
the close. This will often cause the firm’s bid to be the highest in the market at the end of the day. When the
market opens the next day, the trader will downtick the bid.
Detection Procedures FINRA expects a firm’s written supervisory procedures to contain a process for
detecting marking-the-opening or -close violations. In addition, FINRA and the exchanges have developed
systems for generating marking-the-close reports to highlight suspicious activity. Although firms and regulators
have systems to search for possible violations, registered representatives and traders should realize that they can
be held responsible if they ignore activity that should raise a red flag. The burden for investigating red flags is
not solely on the shoulders of supervisors; RRs and traders have a duty to inquire if they believe the market is
being manipulated.
Anti-Intimidation/Coordination Interpretation
A market maker is not permitted to engage in anti-competitive or collusive activity. Under FINRA’s and
Nasdaq’s Anti-Intimidation/Coordination Interpretation, it’s considered conduct inconsistent with just and
equitable principles of trade for any member firm, or associated person, to:
 Threaten, harass, coerce, intimidate, or otherwise improperly influence another member or associated person
 Attempt to influence another member or associated person to adjust or maintain a price or quote
 Refuse to trade with or otherwise retaliate against another market maker that engages in competitive activities
 Coordinate prices, trades, or trade reports with another member or associated person
However, FINRA and Nasdaq make it clear that the interpretation leaves a market maker free to:
 Unilaterally set its own bid and ask
 Unilaterally set its own dealer spread, quote increment, or quantity of shares for its quotations
 Communicate to any person the price or size at which it’s willing to trade any Nasdaq security for the
purpose of exploring the possibility of negotiating a transaction
 Engage in any underwriting of securities to the extent permitted by federal securities laws
Payments for Market Making

No FINRA member or associated person may accept, directly or indirectly, any payment or other consideration
from an issuer, or any affiliate or promoter of the issuer, for:
 Publishing a quote (including indications of interest)
 Acting as a market maker in a security

 Submitting an application in connection with market-making activity
Issuers cannot directly or indirectly pay broker-dealers to make markets in securities. This prohibition includes
making payments to help defray personnel or technology costs associated with the market-making function.
The term consideration includes granting or offering securities on terms more favorable than those granted or
offered to the public, granting options exercisable at a price discounted from the prevailing market price, and the
purchase of securities by a member from a prohibited party at a discount to the prevailing market price.
The term promoter includes all persons other than the issuer or its affiliates who have an interest in influencing
a broker-dealer to make a market in a security. Examples include an adviser, accountant, or attorney for the
issuer, a person who owns restricted securities of the issuer, or a person who owns 5% or more of the public
float of any of the issuer’s securities.
The rule doesn’t prohibit the member from accepting (i) payment for bona fide services (e.g., investment
banking underwriting compensation), and (ii) reimbursement for registration fees paid to the SEC or a state
regulator, or for listing fees imposed by an SRO.


Chapter 12
Trade Reporting

SERIES 24 CHAPTER 12 –TRADE REPORTING
This chapter will focus on the reporting obligations of member firms. It’s important to understand the
requirements for making accurate and timely trade reports. Remember, there are three distinct processes
involved in a potential transaction that students must be able to differentiate—the quotation of the security,
the execution mechanism of the trade, and the reporting of the transaction. Although the following chart was
shown previously, it will still be helpful as a reference for linking the various quotation mediums, execution
systems, and reporting mechanisms.
Trade Reporting
QUOTATION SYSTEMS EXECUTION SYSTEM REPORTING SYSTEM
Nasdaq
Nasdaq Market Center
Execution System Trade Reporting Facility (TRF)
CQS
 Third Market
ADF Proprietary Systems ADF

 NMS securities only  ATS
OTC Pink Market Manual Fills or

 OTC equities Proprietary Systems
Traditional Floor Exchange’s Proprietary Exchanges Proprietary

Trading Systems Reporting Mechanism
The Automated Confirmation Transaction (ACT) Technology Platform

FINRA rules require the reporting of transactions involving domestic and foreign equity securities. Transactions in
OTC equity securities are reported to the OTC Reporting Facility (ORF). Transactions of Nasdaq-listed and other
exchange-listed securities (NYSE or NYSE-American) that occur over-the-counter are reported to the
FINRA/Nasdaq Trade Reporting Facility (TRF). Both the OTC Reporting Facility and the Trade Reporting Facility
make use of the Nasdaq ACT Technology Platform. The two separate and distinct reporting services contract with
Nasdaq for the use of its platform. Both the TRF and the ORF are open from 8:00 a.m. to 8:00 p.m. ET.
Although FINRA rules require members to report transactions in OTC equity securities (which include foreign
derivative equities, such as ADRs), the reporting requirement excludes foreign security transactions if they’re
executed on and reported through a foreign securities exchange, or executed OTC and reported to the regulator
of a foreign securities market.
If the trade is executed OTC and not reported by the foreign exchange or to a foreign regulator, it must be reported
by the broker-dealer within 10 seconds through the ORF. Transaction reports are posted in U.S. dollars. Essentially,
regardless of the execution venue, if the trade has been reported overseas, there’s no requirement to report it again
in the United States. If the trade has not been reported overseas, it must be reported here in the United States.

CHAPTER 12 –TRADE REPORTING SERIES 24
Transactions of securities that are quoted on the ADF and executed through private connectivity providers
are reported to the ADF reporting system. The system provides for trade reporting and is open from 8:00 a.m.
to 6:30 p.m. ET.
Nasdaq’s Automated Confirmation Transaction Technology Platform is a system that facilitates the reporting
and clearing of Nasdaq and OTC transactions by allowing order-entry and market-making firms to enter priced
trades. This information is then used to report, match, and clear transactions.
The TRF is not an order-execution system; instead, trades that are entered have already been negotiated
between the parties or have been executed in another system (e.g., the Nasdaq Market Center Execution
System). Also, TRF is not a system that’s used to report transactions on the floor of the NYSE, which is done
by the exchange on the Consolidated Tape.
Trade Reporting Transactions are reported to the TRF through the ACT Trade Report window on Nasdaq
Workstation terminals. Both the market-maker and order-entry sides of the transaction use the Trade Report
window. The market maker selects MM (the market-maker function) before entering its trade details. The order-
entry firm will select OE (the order-entry function) prior to entering information. Only the data from the market-
maker function is reported to the appropriate organization for dissemination to the market, which is Nasdaq for
securities listed on that market, or the Securities Industry Automation Corporation (SAIC) for listed stocks. To avoid
double counting in a trade between two market makers, the buying market maker reports using the order-entry
function as a non-reporting principal.
Time Stamping Broker-dealers are required to time stamp all trade tickets at the time of execution. The
execution time must be reported on all last sale reports and be expressed in hours, minutes, and seconds
based on Eastern Time.
Clearing and Comparison Rules Broker-dealers are required to input trade reports for clearing purposes.
Procedures are similar, but not identical, to those required for TRF transaction reporting. These reports are
used for clearing purposes, rather than for dissemination of trade information. In this context, the reporting
party refers to a broker-dealer that’s a member of a registered clearing agency and that’s required to report the
transaction for clearing or comparison purposes. The other side of the transaction is required to use the browse
function to accept or decline the trade. Broker-dealers that are not members of a registered clearing agency are
required to have an agreement with a clearing member firm. These non-clearing firms are referred to as
correspondent or introducing brokers (to be described in Chapter 14).
Trade reports may be submitted using either a short format or a long format. The short format is faster and allows
all of the trade details to be entered on one line. However, the long format allows the entry of information that’s
not permitted using the short format, such as give-up and T + 1 transactions. (In a give-up arrangement, an
executing broker-dealer submits trades to the TRF on behalf of a participant broker-dealer.
The participant broker-dealer agrees to accept and honor all of the trades reported on its behalf.) To establish a
give-up relationship, both firms must execute and submit a written agreement to Nasdaq. A step-out
arrangement is a method used by a broker-dealer that had previously executed a transaction to allocate part or all
of the transaction to another broker-dealer for clearing purposes.

Market-Maker Obligations Industry rules require market makers to:

 Report to the TRF any over-the-counter transactions in Nasdaq Global Market securities, Nasdaq Capital
Market securities, and CQS issues within 10 seconds (during applicable hours), and enter trade details for
all clearable and internalized transactions using the market-maker function on Nasdaq Workstation
 Correct, decline, or cancel trades when necessary
Order-Entry Firm Obligations Industry rules require the order-entry (or non-reporting principal) side to
take one of the following actions for each transaction:
 Enter a version of the trade within 20 minutes of execution using the OE Browse Function
 Accept the market maker trade entry on the TRF within 20 minutes of the execution
 Decline an incorrect market maker trade entry on the TRF to cancel the trade entry when necessary
Once a trade has been matched, either because the order-entry side accepted the trade or because the system
matched the trade details entered by the market-maker and order-entry sides, the transaction is considered
locked-in for clearing purposes.
Unrecognized Trades
Each transaction should also result in a confirmation from the contra-party. If any discrepancies exist in the
information described in the two compared confirmations, the party that discovers the discrepancies must
promptly communicate them to the contra-party. Whenever a difference is found and subsequently resolved,
the party in error should send a corrected confirmation within one business day.
DK Notice There are situation that arise in which a broker-dealer sends a confirmation to the contra-broker
(the broker on the other side of a trade), but doesn’t receive one in return. If there’s an unrecognized (i.e., a don’t
know or DK) trade and it cannot be confirmed, the party that receives the confirmation is required to promptly
notify the confirming party by sending written notice by certified mail (return receipt requested) within one
business day to indicate non-recognition of the transaction. Within two business days of the trade, the broker
will either confirm the trade or send the contra-broker a DK notice to question whether a trade occurred. The
contra-broker must then examine its records to determine whether the transaction did occur. If a member
believes that a transaction is clearly erroneous, it may cancel the trade upon notification and approval of FINRA.
After verification, if the dealer believes that a trade occurred, it should immediately notify the non-confirming
party by telephone and, within one business day, send a written notice, return receipt requested, to the non-
confirming party which indicates the failure to confirm. As soon as it receives the phone call from the dealer, the
non-confirming party should try to establish whether a trade occurred. If it determines that a trade did occur, the
non-confirming party should immediately notify the confirming party by phone and, within one business day,
send a written confirmation. If the trade cannot be confirmed, a written notice should be sent promptly to the
confirming party to indicate non-recognition of the transaction.
Reporting ECNs A reporting ECN is a participant of a registered clearing agency (for clearing or comparison
purposes) or one that has a clearing arrangement with a clearing firm. These ECNs submit trade reports to the
Trade Reporting Facility and identify themselves as the reporting party. They may also submit reports on behalf
of another reporting party (i.e., another FINRA member) as long as the reporting party is identified in the report.
Reporting ECNs include both electronic communication networks and alternative trading systems.

Canceled Trades Trades that have been reported to the Nasdaq Market Center, but have later been
canceled, must be reported as such. The cancelation of a trade report must be done by the firm that reported or
was obligated to report the trade based on an automated lock-in.
Trades that are executed during normal business hours and canceled at or before 4:00 p.m. on the date of
execution should be reported within 10 seconds. If the trade was executed during normal business hours and
canceled after 4:00 p.m., but before 8:00 p.m., the firm should use its best effort to report the cancelation by
8:00 p.m. If the trade was executed during normal business hours and canceled after 8:00 p.m., the firm must
report the transaction by no later than 8:00 p.m. the next business day.
Trade Reporting and Processing Methods According to industry rules, the following are acceptable
methods for trade reporting and processing.
 Trade by Trade Match—Both reporting parties submit data to the Trade Reporting Facility and the system
performs an online match.
 Trade Acceptance—The reporting party enters its version of the trade into the system and the contra-party
reviews the trade report and accepts or declines the trade. An acceptance results in a locked in trade. A
declined trade report is purged from the system at the end of trade date processing.
 Aggregate Volume Match is a batch type comparison run at the end of the trade day for previously entered
trades that remain uncompared. In this process, if the information of the trades match, the volume will be
added together to create a match.
 T + N—Used for next-day clearing and may be submitted until 5:15 p.m. each business day.
Requirements for Trade Reporting and Trade Processing through FINRA Facilities The requirements
of trade reporting and clearing are intended to ensure that appropriate payments are made for clearing services.
SRO rules generally prohibit a firm from submitting a clearing (non-Tape-reported) report to a FINRA facility
(e.g., the Trade Reporting Facility), unless the trade was previously reported to the same FINRA facility.
A reporting member cannot step out of a trade reported to the exchange by reporting a clearing-only
transaction to a different facility. In other words, to step out of a trade, a member must report the clearing step-
out on the same facility as the original trade report. An exception to this rule may occur in cases of riskless
principal transactions in which one leg is reported to the FINRA facility (for dissemination to the public),
while the other leg is reported as a clearing-only trade. Clearing-only trades are not reported to the Tape and
are therefore not disseminated to the public. This is an acceptable condition for riskless principal transactions
as long as one leg is reported to the public.
Special Reporting Requirements

Blockbuster Trades and Risk Management Alerts Clearing firms often place limits on the gross dollar
amount of trades on an interday or intraday basis (referred to as Super Caps) or the size of any single trade that
may be executed by brokers for which it clears (correspondent executing brokers).
Typically, a large trade that’s considered a blockbuster trade (a trade of $1 million or more to be executed
through a broker-dealer’s clearing firm) is held for 15 minutes. If the clearing firm doesn’t respond by the end
of that period, the trade is accepted.

A Risk Management Alert warns a clearing firm that one of its executing brokers is near or above its clearing
threshold. When a broker-dealer attempts to report a trade with an executing broker that’s near its limits, the
system will indicate that the trade is “held,” which means that the clearing broker must give permission for it to
be completed. The clearing broker can use Clearing Broker Scan to allow or inhibit the trade as a blockbuster or
sizeable transaction. Risk Management Alerts are based on a dollar amount, not a specific number of shares.
Reporting Trades in Nasdaq-Listed and Other Exchange-Listed Securities

Normal Trading Hours During normal trading hours (9:30 a.m. to 4:00 p.m. ET), over-the-counter
transactions in Nasdaq-listed securities that are not executed on the Nasdaq Market Center Execution System
must be reported to the TRF through the ACT Technology Platform within 10 seconds of execution. If the ACT
Platform is not available due to service or transmission problems, the trade must be reported by phone to the
TRF Operations Department. Trades that are not reported within 10 seconds must be reported as promptly as
possible thereafter and must carry the identifier .Z along with the time of the transaction.
Transactions Outside of Normal Market Hours The reporting requirements for trades that are not
executed during normal market hours depend on the exact time of execution. (All times are Eastern Time.)
 Midnight to 8:00 a.m. — Trades are to be reported to the TRF on the trade date by 8:15 a.m. using the
modifier .T. If a trade is reported after 8:15 a.m., it must be reported with the .U modifier.
 8:00 a.m. to 9:30 a.m. — Trades are to be reported to the TRF within 10 seconds of execution with the
identifier .T. Trades not reported within 10 seconds are required to use the .U modifier.
 9:30 a.m. to 4:00 p.m. (normal market hours) — Trades are to be reported to the TRF within 10 seconds
of execution. Trades not reported within 10 seconds must be reported as promptly as possible thereafter
and must carry the identifier .Z.
 4:00 p.m. to 8:00 p.m. — Trades are to be reported to the TRF within 10 seconds of execution with the
identifier .T. Trades that are not reported within 10 seconds are required to use the .U modifier.
 8:00 p.m. to midnight — Trades are to be reported to the TRF on the next business day (T + 1) by 8:15 a.m.
and designated as/of.
The chart below summarizes the preceding text:
Nasdaq-listed and Other Exchange-listed Securities

Trade executed between Report to TRF
Between 8:00 – 8:15 a.m.; designated as .T; if not reported by 8:15 a.m., it must be
Midnight – 8:00 a.m.
reported using the .U modifier
Within 10 seconds; designated as .T; trades reported later than 10 seconds. must
8:00 – 9:30 a.m.
be reported using the .U modifier
9:30 a.m. – 4:00 p.m. Within 10 seconds; if late, designated .Z
Within 10 seconds; designated as .T; trades reported later than 10 seconds must
4:00 – 8:00 p.m.
If reported T + 1 between 8:00 a.m. – 8:15 a.m. trades are designated as/of and
8:00 p.m. – Midnight must be reported using the .T modifier. If not reported by 8:15 a.m., trades must be
reported using the .U modifier.

Transactions Not Required to Be Reported The following transactions are not required to be reported to
the TRF:
 Transactions reported automatically by another system, such as the Nasdaq Market Center Execution
System. Trades that occur on the Nasdaq Market Center Execution System are executed and reported
automatically. Therefore, trade entry into the TRF is not required.
 Transactions that are a part of primary or secondary distribution private placements
 Transactions in which the buyer and seller have agreed to a price that’s substantially unrelated to the
current market for the security (e.g., to make a gift)
 Purchases or sales related to the exercise of an option or convertible at a pre-established price that’s not
related to market value
 Purchases of securities off the floor of an exchange, pursuant to a tender offer
Which Firm Reports the Transaction? To avoid double counting, the transaction is reported to the TRF
or ORF by only one side of the trade.
1. In a transaction between two member firms, the executing party is required to report.
2. In a transaction between a member firm and a non-member firm or customer, only the member firm reports.
The definition of the executing party is the member firm that received an order for handling or execution or is
presented an order against its quote and doesn’t reroute the order, and executes the transaction. If an alternative
trading system (ATS), which includes an ECN, received and executed an order, the ECN is the executing
party. If two firms meet this definition, the selling firm is required to report the transaction. This is the case if a
negotiated transaction was between two member firms and was executed over the phone.
Riskless Principal Transactions The problem of double counting can also arise in the context of a riskless
principal transaction. A riskless principal transaction is defined as a trade in which a member firm either (i)
after having received an order to buy a security, buys the security at the same price, as principal, in order to
satisfy the order to buy or, (ii) after having received an order to sell a security, sells the security at the same
price, as principal, in order to satisfy the order to sell. This definition applies to firms that make a market in the
security involved as well as non-market makers. When determining whether two trades are done at the same
price, commission, markups, and markdowns are excluded.
What’s Reported? The following information must be included in a report to the TRF:
 Nasdaq symbol
 Number of shares (round lots only)
 Price (In general, the price reported doesn’t include commissions, markups, markdowns, or service charges.)
 Whether the trade is a buy, sell, or cross (A cross is a transaction in which the broker-dealer is acting as agent
for both the buyer and the seller. It’s also referred to as a dual-agency trade.)
 Time of execution in Eastern Time expressed in military time. Military time is based on a 24-hour clock
unlike conventional time that’s based on a 12-hour clock and uses a.m. and p.m.
– For example, 1:00 a.m. conventional time is 01:00 military time, and 1:00 p.m. conventional time is
13:00 military time. Seconds must also be included in the report. For example, 13:30:15 is 1:30 p.m.
and 15 seconds.
 If applicable, sell short or sell short exempt

For clearing purposes, trade reports must include certain additional information to what’s reported to the TRF.
The clearing trade report must also include the following items:
 A symbol indicating a principal, agency, or riskless principal transaction
 Whether the party submitting the order is a market maker or on the order-entry side
 The contraside executing broker
 The contraside introducing broker in the case of a give-up trade
Alternate Display Facility Reporting

Users of the ADF include market makers that seek an alternative to the Nasdaq Market Center Execution
System and ECNs that are unable to quote on the Nasdaq Market Center Execution System because they lack
market-maker status. The ADF is a quotation system that also provides reporting services. Execution services
are supplied by private connectivity providers and trade reporting is performed within the ADF system. ADF
reporting requirements follow a similar process as the TRF and ORF, with the exception that the hours of
operation are 8:00 a.m. to 6:30 p.m.
Transactions Reported to ADF ADF-eligible securities include Nasdaq Global Select Market, Nasdaq
Global Market, Nasdaq Capital Market, Nasdaq convertible debt securities, and other exchange-listed
securities that trade over-the-counter (CQS securities). There’s one reporting option that’s different from the
TRF and ORF. The ADF will give market participants the option to enter a three-party trade. The three-party
trade option will make it easier to report riskless principal transactions and for ECNs to report trades between
themselves and their subscribers.
The ADF will also offer a trade comparison service that will do the following:
1. Compare trade information from ADF participants
2. Submit locked-in trades to the Depository Trust Clearing Corporation (DTCC)
3. Automatically transmit reports of the transactions to the particular securities information processor
(if necessary) for public dissemination
4. Allow for the monitoring of locked-in trading
Trade Reporting for ADF-Eligible Securities

Trade executed between Report to ADF
Within 10 seconds; designated as .T; trade reported later than 10 seconds must be
8:00 – 9:30 a.m.
9:30 a.m. – 4:00 p.m. Within 10 seconds; if late, designated .Z
Within 10 seconds; designated as .T; trade reported later than 10 seconds must be
4:00 – 6:30 p.m.
If reported T + 1 between 8:00 a.m. – 8:15 a.m. trade is designated as/of and must
6:30 p.m. – Midnight be reported using the .T modifier. If not reported by 8:15 a.m., trade must be

Reporting Transactions in OTC Equity Securities

Industry rules require trade reporting of transactions in OTC equity securities, which are defined as equity
securities for which real-time trade reporting is not otherwise required. This includes any equity security that’s
not listed on Nasdaq or a national exchange. OTC transactions in certain securities that are listed on regional
exchanges must be reported under this rule as well securities that are not eligible for reporting to the
Consolidated Tape. The rule also encompasses transactions in OTC Pink Market stocks. However, any
transaction in an OTC equity security must be reported, regardless of whether the security appears on any
particular quotation medium.
With the exception of foreign OTC equities, the requirements for who reports, when the information is reported,
and what’s reported are virtually identical to the rules for Nasdaq and exchange-traded securities. Reporting is made
through the OTC Reporting Facility (ORF), which uses the ACT Technology Platform. Note that when
determining who reports, a firm must determine whether it’s a market maker in that particular OTC equity
security. The rule defines an OTC market maker for such securities as a broker-dealer that holds itself out as a
market maker by entering proprietary quotations or indications of interest for a particular OTC equity security
in any interdealer quotation medium (e.g., the OTC Pink Market).
Exceptions The following transactions in OTC equity securities don’t need to be reported:
 Transactions that are part of a primary or secondary distribution
 Private placements
 Transactions in which the buyer and seller have agreed to a price that’s substantially unrelated to the
current market for the security (e.g., to make a gift)
 Purchases or sales related to the exercise of an option or convertible at a pre-established price that’s not
related to the current market value

The OTC Reporting Facility is not to be confused with the Trade Reporting Facility (TRF). The TRF is used to
report transactions of Nasdaq-listed and other exchange-listed securities that occur over-the-counter. In
contrast, the OTC Reporting Facility is used to report transactions exclusively in OTC securities that don’t
trade on Nasdaq or the other exchange markets. Both the OTC Reporting Facility and the TRF make use of the
ACT Technology Platform.
The OTC Reporting Facility is not an order-execution system. Trades that are entered into the OTC Reporting
Facility have already been negotiated between the parties or have been executed in another system. Also, the
OTC Reporting Facility is not a system that’s used to report transactions on the floor of the NYSE, since these
transactions are reported by the exchange to the Consolidated Tape.
Trade Reporting Transactions in over-the-counter (OTC) securities occurring from 9:30 to 4:00 p.m. must
be reported to the OTC Reporting Facility within 10 seconds of execution. This rule applies to both market
makers (MMs) and non-market makers, such as order-entry (OE) firms. If a transaction cannot be reported by
entering the data into the OTC Reporting Facility because of a system failure, the market participant must report
the transaction by telephone to the OTC Reporting Facility Operations Department within 10 seconds of
execution. All transactions that are not reported within 10 seconds of execution are designated as late with the
appropriate trade modifier.

OTC Securities (Including Domestic Issues, ADRs and Canadian Issues)

Trade executed between Report to OTC Reporting Facility (ORF)
Within 10 seconds; designated as .T; if trade reported later than 10 seconds, it must
8:00 – 9:30 a.m.
9:30 a.m. – 4:00 p.m. Within 10 seconds; if late, designated .Z (or .SLD)
Within 10 seconds; designated as .T; if trade reported later than 10 seconds, it must
4:00 – 8:00 p.m.
If reported T + 1 between 8:00 a.m. – 8:15 a.m. trade is designated as/of and must
8:00 p.m. – Midnight be reported using the .T modifier. If not reported by 8:15 a.m., trade must be
Transaction Reporting for Restricted Equity Securities In addition to OTC equity securities, restricted
equity securities effected under SEC Rule 144A must also be reported to the OTC Reporting Facility. Any
transaction in these securities that’s executed between midnight and 8:00 p.m. must be reported on the same
business day as the transaction. Trades executed between 8:00 p.m. and midnight must be reported on the
following business day (T + 1) and be designated as/of to denote that the execution occurred on the previous day.
Consolidated Audit Trail (CAT)

In the late 1990s, the Order Audit Trail System (OATS) was created by FINRA to preserve information related
to orders, quotes, and other associated trade data from equity trades in the National Market System (NMS) and
over-the-counter (OTC) markets. However, the OATS system had certain limitations and exemptions. In
response to the Flash Crash in 2010 that saw the Dow Jones Industrial Average drop by 1,000 points in a
manner of minutes, the SEC adopted Rule 613 to address the limitations of the OATS system.
Later, a national market system (NMS) plan to create a single, comprehensive database was approved. The
new database is referred to as the Consolidated Audit Trail (CAT) system. CAT enables regulators to more
efficiently and thoroughly track all trading activity in the U.S. equity and options markets and identify trades
that lead to potential crashes.
SEC Rule 613 requires an SRO to implement compliance rules concerning the Consolidated Audit Trail.
FINRA created the 6800 Series rule to ensure that it would be in compliance.
CAT Introduction CAT is a central repository that receives, consolidates, and retains the data over the
lifecycle of trades and orders for all eligible securities. Eligible securities include NMS stocks, listed options,
and over-the-counter (OTC) equity securities. Exchanges, self-regulatory organizations (SROs), and broker-
dealers are required to submit order information to CAT each trading day. Broker-dealers are required to
submit significant customer account information (e.g., name, address, year of birth, and Large Trader ID).
CAT’s reporting requirements apply to all U.S. exchanges, alternative trading systems (ATSs), and broker-dealers
that are registered with a self-regulatory organization (SRO).

Unlike OATS, CAT doesn’t provide broker-dealers with exemptions from the reporting requirements. Another
difference between CAT and OATS is that CAT requires the reporting of a broker-dealer’s proprietary and
market making orders, which is not required by OATS.
FINRA Rule 6830 – Industry Member Reporting Data As established by SEC Rule 613, FINRA
requires its members to report detailed information to the central repository, including:
 The original receipt or origination of an order
 The routing of an order
 The receipt of an order that has been routed
 Whether the order has been modified or cancelled
 Whether the order has been executed, in whole or in part
Time Recording and Reporting Firms are required to record industry member data contemporaneously with
the applicable reportable event. Thereafter, each firm must report the following to the central repository:
 Recorded Industry Member Data by 8:00 a.m. ET on the trading day following the day that the member
records such data, and
 Received Industry Member Data by 8:00 a.m. ET on the trading day following the day that the member
receives such data
Industry members may, but are not required to, voluntarily report Industry Member Data prior to the
applicable 8:00 a.m. Eastern Time deadline.
Error Correction If errors have been identified in Industry Member Data that a firm has submitted to the
central repository, the firm is required to submit corrected data to the repository by 8:00 a.m. Eastern Time on
the third business day following the trade (i.e., T+3).
Customer and Account Reporting Customers are represented by their CAT Customer ID (CCID), while
trading accounts are represented by their Firm Designated ID (FDID). A customer can have more than one trading
account, and a trading account can have more than one customer. A unique CCID will be assigned by FINRA to
each customer based on the customer’s Tax ID number (e.g., Social Security number) so that the regulators are
able to identify the customer when multiple broker-dealers are used to enter orders on the customer’s behalf.
To ensure that all trading account activity is reported and able to be consolidated at the firm level, each firm
will create and assign a unique identifier for each trading account. The identifier is the Firm Designated ID
(FDID). Ultimately, firms are required to report the FDID on each new order that’s submitted to the central
repository. Firms are required to assign a single FDID to each trading account and it must be unique across all of
the vendors that a firm may use to report data to CAT. For example, if a firm uses multiple vendors for reporting
to CAT, each vendor must report any activity from the same trading account using the same FDID.
To summarize, customers are represented by the CCID, while trading accounts are represented by the
FDID. Ultimately, FDIDs can represent firms or customer accounts.
Clock Synchronization Requirements One of the required data elements for each order event is time
stamping and it must be correctly reported by firms at predefined levels of granularity. To comply with the
Clock Synchronization requirements (under both SEC Rule 613 and FINRA Rule 6810) and correctly record
the timestamp fields for order events, firms are required to synchronize their business clocks internally.

At a minimum, clocks used for reporting must be synchronized:

 To within 50 milliseconds of the time maintained by the National Institute of Standards and Technology
(NIST) and that synchronization must be upheld.
– Note: The NIST clock is an atomic clock run by the U.S. Department of Commerce.
Business clocks that are solely used for manual CAT events or for the time of allocation on the Allocation
Reports must be synchronized, at a minimum, with one second tolerance.
Trading Day The trading day is used to determine the reporting deadline of CAT events, including when
error reports and firm-initiated corrections are due. For industry members, the trading day:
 Starts immediately after 4:15:00 p.m. ET and no fractions of a second on one trade date
 Ends at exactly 4:15:00 p.m. ET and no fractions of a second on the next trade date
For example, a trade that occurs at 4:16 p.m. ET on Monday is actually

considered to occur on the Tuesday trading day.
Weekends, or any day on which all equities or options national securities exchanges are closed, are not
considered a trading day. Therefore, any activity that occurs after 4:15 p.m. ET on Friday will be reported with
Monday’s activities. Other than during announced scheduled maintenance, CAT accepts submissions 24 hours
per day and seven days per week. Any reports received after the deadline will be considered late.
Reporting Obligations For eligible securities, the events that must be reported are:
 All proprietary orders, including market maker orders
 All representative (customer) orders (both agency and proprietary)
 Electronic listed quotes for NMS stocks that are sent to an exchange or the Alternative Display Facility
(ADF)
 Unlisted quotes for OTC equity securities that are received by a broker-dealer that operates an inter-dealer
quotation system (e.g., Global OTC or OTC Link)
 Unlisted quotes that meet the definition of bid or offer under the Plan and are sent by a broker-dealer to a
quotation venue that’s not operated by an SRO or broker-dealer
 Simple Electronic Option Orders, which are orders to buy or sell a single option that are not related to or
dependent on any other transaction for pricing or timing of execution, but are either received or routed
electronically by an Industry Member CAT Reporter
 Electronic Paired Option Orders, which are electronic option orders that contain both the buy and sell
side and are routed to another industry member or exchange for crossing and/or price improvement as a
single transaction on an exchange. Additionally, the events related to Simple Electronic Option Orders
subject to reporting in Phase 2b are limited to those events which involve either the electronic receipt of
an order or electronic routing of an order
– Electronic receipt of an order: the initial receipt of an order by an industry member in electronic
form and in standard format directly into an order handling or execution system
– Electronic routing of an order: the routing of an order via electronic medium in standard format
from one industry member’s order handling or execution system to an exchange or another
industry member

FINRA Rule 6840 – Customer Information Reporting For each customer, firms are required to submit
information for each active account to the Central Repository:
 The FDID
 The Tax ID or Social Security number
 Customer account information
 Customer identifying information
FINRA Rule 6850 – Industry Member Information Reporting Firms are also required to provide their
CRD number and (if obtained) their Legal Entity Identifier (LEI) to the central repository.
FINRA Rule 6860 – Time Stamps Firms are required to record and report Industry Member Data to the
central repository with time stamps in milliseconds. If a firm uses finer increments than milliseconds, it’s required
to report to the central repository with time stamps in the finer increment up to nanoseconds. Manual orders may
be recorded and reported to the central repository in increments up to and including one second.
FINRA Rule 6890 – Recordkeeping Firms must maintain and preserve CAT records for a period that’s
specified by SEC Rule 17a-4. The rule specifies retention for at least three years, with the first two years in an
easily accessible place.
Clearly Erroneous Transactions

FINRA provides a mechanism for correcting or voiding transactions when one of the terms of the contract is
clearly in error. This rule was created as the result of a complaint from a FINRA member that a trade was executed
10 points away from the inside market (obviously a mistake), but the contra-party refused to cancel the trade.
Prior to the passage of this rule, FINRA did not have the authority to adjust such a transaction, even when the error
was obvious. FINRA defines the term clearly erroneous to refer to an obvious error in any term, such as price,
number or shares, or other unit of trading, or identification of the security. FINRA will take under
consideration the circumstances at the time of the transaction, the maintenance of a fair and orderly market,
and investor protection. This rule pertains to disruptions and extraordinary market conditions and not to
unauthorized trading or market manipulation.
The determination of a clearly erroneous execution is based on certain thresholds—one for exchange-listed
securities and another for OTC equity securities.

Numerical Threshold for Exchange-listed Securities

Normal Market Hours (9:30 a.m. to Outside Normal Market Hours
Reference Price: Consolidated 4:00 p.m. ET) Numerical Guidelines Numerical Guidelines (Subject
Last Sale (Subject Transaction’s % Difference Transaction’s % Difference from
from the Consolidated Last Sale) the Consolidated Last Sale)
Greater than $0.00 up to and
10% 20%
including $25.00
Greater than $25.00 up to and
5% 10%
including $50.00
Greater than $50.00 3% 6%
Multistock event – Filings
involving five to 19 securities by
10% 10%
the same member will be
aggregated into a single filing.
Normal market hours numerical Normal market hours numerical
Leveraged ETF/ETN securities guidelines multiplied by the leverage guidelines multiplied by the leverage
multiplier (i.e., 2x) multiplier (i.e., 2x)
FINRA may also expand the numerical guidelines due to a Multi-Stock Event involving 20 or more securities
whose executions occurred within a five-minute period or less. This is done to maintain a fair and orderly
market and protect investors. For both market hours and outside market hours, FINRA uses a threshold of 30%
away from the reference price.
Numerical Threshold for OTC Equity Securities

Numerical Guidelines (Subject Transaction’s
Reference Price
Percentage Difference from the Reference Price)
$0.9999 and under 20%

Low end of range, minimum 20%
$1.0000 up to and including $4.9999
High end of range, minimum 10%
$5.0000 up to and including $74.9999 10%
$200.0000 up to and including $499.9999 5%
$1,000.0000 and above 3%
FINRA Rule 11893 governs clearly erroneous determinations involving transactions in OTC equity securities. The
rule is structured similarly to FINRA Rule 11892 that governs exchange-listed issues, but uses different numerical
guidelines when determining if a transaction is erroneous. Many of these potentially erroneous transactions occur
in periods of extreme market volatility or are the result of system malfunctions and/or disruptions.

In some cases, the determination as to whether a given transaction price is erroneous involves more than
simply examining a pricing difference. In an attempt to maintain fair and orderly markets, FINRA may
choose to use alternative reference prices in unusual circumstances and will examine other causal factors such
as (1) whether the security was subject to a stock split or other corporate action, (2) whether the stock was
recently halted or resumed trading, or (3) whether the security is an IPO when making a determination as to
whether a given trade price is fair.
Procedures for Reviewing Transactions A member firm that receives an execution that it believes is clearly
erroneous shall submit a written complaint within 30 minutes of the execution time. In the case of an Outlier
Transaction, a request may be made within 60 minutes after the transaction. An Outlier Transaction is a
transaction in the Nasdaq market where the execution price of the security is greater than three times the current
numerical guidelines. A FINRA officer or Nasdaq official has the authority to declare a transaction null and
void. The officer generally will take action within 30 minutes after becoming aware of a transaction in an
exchange-listed security. In the case of an OTC equity security, the officer will take action as soon as possible,
but in all cases by 3:00 p.m. on the next trading day.
Appeal Process A decision of a Nasdaq or FINRA officer under this rule can be appealed to the Market
Operations Review Committee (MORC) or the Uniform Practice Committee (UPC). The appeal must be in
writing and must be received within 30 minutes after the person making the appeal is given notification. For
exchange-listed securities, the decision will be made as soon as feasible. but generally on the same trading day.
On a request for an appeal made after 3:00 p.m., the decision may not be made later than the next trading day.
For OTC equity securities, the decision will be made as soon as feasible, but no later than two trading days after
the execution under review.
Trade Reporting and Compliance Engine (TRACE)

TRACE is a system that members must use to report transactions in eligible fixed-income securities and it
disseminates continuous bond sale information. TRACE was created to provide greater transparency in the corporate
bond market, but it’s not a quotation or an execution system. Broker-dealers provide quotes and will execute
transactions in corporate bonds. There’s no regulatory quote or execution system as what exists for equity securities.
TRACE-eligible securities are defined as depository-eligible, U.S. dollar-denominated debt securities, such as:
 Investment- and non-investment-grade securities
 Split-rated
 SEC registered debt securities of corporations that are in the U.S. or foreign countries
 Securities issued under the Securities Act of 1933 and purchased or sold according to Rule 144A
– U.S Treasury securities Including all marketable U.S. Treasury securities, such as Treasury bills,
Treasury notes, floating rate notes, Treasury bonds, Treasury inflation-protected securities (TIPS),
and Separate Trading of Registered Interest and Principal Securities (STRIPS)
 Debt securities issued or guaranteed by either a U.S. government agency or a government-sponsored enterprise
 Asset-backed securities
 Collateralized debt obligations (CDOs)
 Collateralized mortgage obligations (CMOs)

Split-rated securities are those that are considered investment-grade by one nationally recognized statistical
ratings organization (NRSRO) and non-investment-grade by another NRSRO. Standard and Poor’s, Moody’s,
and Fitch are examples of NRSROs.
Securities that are not required to be reported to TRACE include:

 Money-market instruments (with maturities of less than one year)
 Securities issued by foreign governments
 Development bank debt
 Municipal securities
If a broker-dealer takes an order for a TRACE-eligible security, it has an obligation to report the executed
transaction to TRACE. Both the clearing firm and the introducing broker-dealer (also referred to as the
correspondent) must sign a TRACE participation agreement. Each member that’s party to a transaction in
TRACE-eligible securities must report its side of the transaction to FINRA. In circumstances where one party
to the transaction is not a member and the transaction takes place on behalf of a customer, the member must
report the entire transaction.
For broker-dealers to be able to report transactions in TRACE-eligible securities, the managing underwriter is
required to provide certain information to FINRA. The information includes the CUSIP number, the issuer’s
name, the coupon rate, the time the new issue is priced, a brief description of the issue, and any other
information that’s deemed necessary by FINRA.
An exception to the reporting requirements is granted if the two firms sign a give-up arrangement since, in many
circumstances, the introducing firm doesn’t have direct access to TRACE. The give-up arrangement will authorize
the clearing firm to report to TRACE on behalf of the introducing firm so it may fulfill its reporting obligation.
Bond Dissemination Information

Once they’re reported, FINRA immediately disseminates transaction information for all TRACE-eligible
securities that are publicly traded. Transactions which are reported, but not disseminated, include U.S.
Treasury securities, fixed offering price transactions, CDOs, or any CMO transactions with a value of $1
million or more (calculated based on original principal balance).
TRACE reports must be submitted within 15 minutes and must include the following information:
 Committee on Uniform Securities Identification Procedures (CUSIP) number or FINRA symbol
 Number of bonds
 Price or contract amount and accrued interest
 Buy, sell, or cross transaction
 Date of execution (for as/of trades)
 Contraparty identifier
 Agent or principal
 Time of execution
 Give-up for executing broker (if any)
 Give-up for introducing broker (if any)

 Commission/markup or markdown
 Trade modifiers
 Yield-to call or yield-to-maturity
In addition, FINRA publishes aggregate trade data from TRACE and other sources which is updated daily as
well as monthly based on the type of fixed income security. This includes all types of corporate debt (including
144A offerings and convertibles), U.S. Treasury securities, structured products (e.g., mortgage-backed
securities and collateralized mortgage obligations). For U.S. Treasury securities:
 Treasury Daily Aggregate Statistics provides trading volume in U.S. Treasury securities reported to
TRACE for the prior day.
 Treasury Monthly Aggregate Statistics provides trading volume in U.S. Treasury securities reported to
TRACE for the prior month.
Reporting Times
The following table shows when and how TRACE reporting should be performed:
Trade Executed Between: Report to TRACE

8:00 a.m. – 6:29:59 p.m. Within 15 minutes (If the transaction is executed within 15 minutes of the close of the
(TRACE system hours) system, it may be reported within 15 minutes after the open on the next business day.)
Next business day within 15 minutes after the TRACE system opens. Must indicate
6:30 p.m. – 11:59:59 p.m.
as/of and must provide the transaction date
12:00 a.m. – 7:59:59 a.m. Same business day within 15 minutes after the TRACE system opens
Next business day within 15 minutes after the TRACE system opens.
Non-business-day executions The transaction must be reported as executed on the same day of the report.
(TRACE system is closed) The execution time must be 12:01:00 a.m., and the modifier must be “special price.”
The special price field will allow for entry of the actual date and time of execution.
(Non-business-day executions include Saturday, Sunday, and federal or religious holidays when the TRACE
system is closed.) Once the transaction is reported, it’s immediately available to the public.
U.S. Treasury Securities Transactions in U.S. Treasury securities that are executed from midnight (12:00
a.m.) to 5:00 p.m. are reported within 60 minutes. Transaction that are executed after 5:00 p.m. are reported on
the next business day (T+1) and designated “as/of” and include the time and date. Transactions in STRIPS are
not required to be reported.
Agency Securities Transactions in agency securities (including CDOs and CMOs securities) that are
executed during TRACE system hours are reported on the same business day within 60 minutes of execution.
New issues A List or Fixed Offering Price Transaction, or Takedown Transaction, is a primary market
(new issue) that’s executed by a sole underwriter, syndicate member, or selling group member as a discount
from the offering price. These transactions must be reported by no later than T + 1 during TRACE system
hours. The firm also must indicate as/of and provide the actual execution day.

This chapter concludes the trading portion of the Study Manual. The following chapters will cover customer
accounts including both margin and retirement plans as well as operational issues associated with markets. The
final chapter will detail the financial responsibility rules and net capital requirements.


Chapter 13
Customer Accounts

SERIES 24 CHAPTER 13 – CUSTOMER ACCOUNTS
This chapter will cover the process of prospecting for new clients and the ensuing opening of new
accounts. These accounts may be traditional brokerage accounts with no specific tax advantages, or they
may involve tax-deferred assets that are earmarked for either retirement or education. Special emphasis
will be placed on compliance with the federal customer identification program (CIP) and anti-money
laundering (AML) procedures.
Telemarketing
The process of seeking new customers may be accomplished through telephone solicitations or cold calling.
In the past, less reputable firms often used high-pressure sales techniques that bordered on harassment in an
attempt to convince prospects to invest in dubious securities—especially penny stocks (defined shortly). In an
effort to combat these abusive sales tactics and protect consumers from cold-callers, Congress passed the
federal Telephone Consumer Protection Act of 1991. The following provisions of the law have been
incorporated into SRO rules:
 Telephone solicitations may be placed only between 8:00 a.m. and 9:00 p.m. local time of the person being
called, unless that person has given prior consent to the broker-dealer. The rule applies to both wired and
wireless telephone numbers.
 When calling prospective customers, callers must provide their name, the entity or person on whose behalf the
call is made (e.g., the name of the member firm), a telephone number or address at which that entity or person
can be reached, and disclosure of the fact that the call’s purpose is to solicit the purchase of securities or related
services. This information must be provided promptly in a clear and conspicuous manner.
 Each broker-dealer is responsible for creating a do not call list which is utilized whenever a person being
solicited by telephone requests to not to be called again. Under FINRA rules, broker-dealers must honor a
person’s do not call request and place her on the list within a reasonable period which cannot exceed 30 days
from the date the request was made. Additionally, the firm must train its registered personnel as to the proper
use of the list and create a written policy describing how the list will be maintained.
 Registered representatives cannot make calls that harass or abuse the person being called. Examples of prohibited
behavior include using language that may be interpreted as threatening or intimidating, the use of profane or
obscene language, causing a phone to ring repeatedly or continuously with the intent to annoy, abuse, or harass, or
engaging a person in a telephone conversation repeatedly or continuously with the intent to annoy, abuse, or harass.
 When a broker-dealer engages in telemarketing, it’s required to ensure that its outbound telephone number is
not being blocked by the recipient’s caller identification service.
 Using pre-recorded messages is prohibited unless the broker-dealer has received the caller’s prior written permission.
FINRA recognizes that when representatives have existing relationships with customers, it may be necessary to
contact them outside of the 8:00 a.m. to 9:00 p.m. window. Therefore, the time-of-day and disclosure
requirements don’t apply to clients with whom the member firms have an established business relationship
provided the purpose of the call is to maintain or service an existing account.
An established business relationship exists between a broker-dealer and a person when one of the following
three conditions is met:
1. Within the preceding 18 months prior to the telemarketing call, the person has engaged in a securities transaction,
or has a security position, a money balance, or account activity with the broker-dealer or its clearing firm

CHAPTER 13 – CUSTOMER ACCOUNTS SERIES 24
2. Within the preceding 18 months prior to the telemarketing call, the firm making the call is considered the
broker-dealer of record for the person’s account
3. Within the previous three months prior to the telemarking call, the person has contacted the broker-dealer to
inquire about a product or service that’s offered by the firm
Member firms are prohibited from calling persons who have placed their names on the National Do Not Call
Registry of the Federal Trade Commission (FTC). Firms are required to update their do not call list by
contacting the FTC and adding any telephone number that appears on the national list. There are a number of
exceptions to this prohibition including:
 The person to be called has given her prior written consent to be contacted by the member firm
 A personal relationship exists between the RR placing the call and the person being called. Personal
relationships include the family members, friends, or acquaintances of the RR.
Use of Stockholder Information for Solicitation

Generally, it’s a violation for an RR to use a shareholder list to conduct cold calling. SRO rules prohibit the
use of stockholder information for solicitation purposes by a trustee unless the member firm is specifically
directed to do so by, and for the benefit of, the corporation.
New Account Documentation

Now that cold calling and prospecting has been examined, let’s move on to the process of opening the
account. Proper compliance with many securities industry requirements starts with how customer information is
collected and documented—both when opening and maintaining an account. Proper recordkeeping protects the
interests of the customer, the firm, and the registered representative. When opening a new account, certain
information regarding potential purchases must be obtained in order to comply with industry regulations. The
USA PATRIOT Act also imposes additional requirements on firms regarding both the verification of potential
clients’ identities and subsequent monitoring to ensure compliance with anti-money laundering regulations.
Customer information is collected on a new account form not only to satisfy regulatory requirements, but also to
help the registered representative and firm understand the customer’s investment objectives and to ensure that
suitability concerns are addressed. Of course, every firm’s new account form is slightly different, but all firms
must collect a minimum of certain types of information in order to meet industry standards.
Required Information
A registered representative who intends to open an account for a customer must obtain all required information
prior to entering the initial order in the account. Once the customer’s information is obtained, the prompt
approval of a principal is required.
According to FINRA, the following information is required to be acquired:

 The customer’s name and residence (although a P.O. cannot be used to open an account, correspondence may
be sent to a P.O. box)
 Whether the customer is of legal age

 The name of the registered representative (RR) who’s responsible for the account. If there’s more than one RR
responsible for the account, a record of the scope of responsibility for each representative is required. (Please
note, this provision doesn’t apply to institutional accounts.)
 The signature of the partner, officer, or manager (principal) who approves the account
An institutional account is one that’s established for a bank, savings and loan association, insurance
company, registered investment company, registered investment adviser, or any person with total assets of
at least $50 million.
If the customer is a business or organization rather than a person, an RR is required to obtain the names of the
individuals who are authorized to transact business for the account. (The documents that are required to open a
business account will be discussed later in this chapter.)
Prior to the settlement date of the initial transaction, a registered representative must also make a reasonable
effort to obtain the following customer information:
 Taxpayer ID number (TIN), such as a Social Security number
 Occupation and name and address of the customer’s employer
 Whether the customer is associated with another member firm
This requirement doesn’t apply to either institutional accounts or accounts in which the transactions are limited
to non-recommended investment company shares (mutual funds).
An additional provision that specifically applies to discretionary accounts requires firms to maintain a record
of the manual signature of each person who’s authorized to exercise discretion. Any of the other signatures that
are required to open an account may be provided electronically.
Required Signatures The approving principal must sign a new account form. Although many broker-dealers
have their own in-house rules which require customers’ signatures as well, industry rules don’t require the
signature of clients who are opening cash accounts. However, it must be noted that clients are required to sign
both margin and options account documentation.
Recordkeeping Requirements A member firm is required to maintain a record of customer account

information for a period of six years from the date of the last update or from the date that the account was closed.
SEC Recordkeeping Requirements In addition to FINRA’s recordkeeping requirements related to customer

accounts, SEC Rule 17a-3 also requires broker-dealers to maintain the following records for each customer or
owner of an account:
 Name
 Tax ID number
 Address
 Telephone number
 Date of birth
 Employment status, occupation, and whether the customer is associated with a broker-dealer
 Annual income and net worth (excluding principal residence)
 Investment objectives

In practice, most broker-dealers make a reasonable effort to obtain all of the above information prior to the
opening of an account. Any information that provides insight into a client’s investment experience is critical
when determining suitability; however, information regarding a client’s educational background is not required
to be collected. There may be circumstances in which customers are unwilling to provide their broker-dealers
with certain personal information (e.g., their financial background). If a good faith effort is made to collect the
information, but the prospect refuses, as a matter of good business practice an RR should document the fact
that the effort was made to obtain the data. The documentation could be as simple as writing refused in the
appropriate space on an account form, with no explanation required. Principals may refuse to approve an account
if they feel that a prospect has supplied the firm with insufficient information to appropriately assess investment
objectives and/or suitability issues.
Know Your Customer and Suitability

A broker-dealer must use reasonable diligence to learn the important facts regarding every customer. In other
words, for firms to provide appropriate services, it’s vital to know your customer. This obligation extends to
any person who’s authorized to act on behalf of a customer, such as an investment adviser that has been given
the authority to enter orders in a customer’s account. Only after a registered representative understands the
financial needs of his customers may the proper investment recommendations be made.
Suitability Broker-dealers have a suitability obligation to each of their customers. For non-institutional (retail)
customers, broker-dealers and their registered persons must have a reasonable basis for recommending a transaction
or investment strategy. These recommendations must be based on information that’s obtained from the customers
and then used to identify their investment profile. A customer’s investment profile includes the following items:
 Age  Investment time horizon
 Other investments  Liquidity needs
 Financial situation and needs  Risk tolerance
 Tax status  Any other information obtained from the customer
 Investment objectives and experience
Although customers are not obligated to provide all of the information listed above, an RR should make every
effort to obtain as much as possible in order to provide the most suitable recommendations.
The suitability requirements apply to both the recommendation of a transaction and an investment strategy
(e.g., day-trading or margin trading). An investment recommendation should be in the customer’s best interest.
The simple fact that a customer may agree to a recommendation doesn’t relieve a firm of its suitability
obligation. RRs are prohibited from placing their own interests ahead of their customers’ interests. Some
examples of potential violations of the suitability rule include:
 RRs making recommendations of one product over another in an effort to generate large commissions
 RRs making mutual fund recommendations that are designed to maximize their commissions rather than to
establish a portfolio for their customers
 RRs attempting to increase their commissions by recommending the use of margin
 RRs recommending a new issue that’s heavily promoted by their firm in an effort to keep their jobs
FINRA has established the following three main suitability obligations:

1. The reasonable basis obligation – Requires a member firm and its RRs to have a reasonable basis to
believe that a recommendation is suitable for at least some investors. If the firm or its RRs don’t
understand a product, it should not be recommended to customers.

2. The customer-specific obligation – Requires a member firm and its RRs to have a reasonable basis to believe
that a recommendation is suitable for a particular customer based on the customer’s investment profile
3. The quantitative obligation – Requires a member firm and its RRs to have a reasonable basis to believe that
a series of recommended transactions, even if they’re suitable for a customer, are not excessive when
considering the customer’s investment profile
Age-Based Suitability Concerns The age of a customer is typically one of the factors used to determine
whether a given transaction is suitable. As objectives, growth and speculation as are typically viewed in light
of the customer’s age (e.g., a younger client can afford to take more risk). Income objectives may also be
influenced by age since income-producing assets range from high risk (non-investment grade securities) to
very safe instruments (U.S. Treasury securities).
A firm may conclude that age is irrelevant in determining suitability in certain situations. For example, if a
customer is in need of liquidly to meet a short-term obligation, age is not a factor in the investment choice
since liquidity is the overriding concern. If a client is in need of capital preservation, age is also not a factor
since safety of principal is the overriding concern.
Institutional Suitability Institutional suitability obligations may vary based on the nature of the institution.
Some of these customers are sophisticated and manage billions of dollars, while others may be relative novices
in the investment process.
For a broker-dealer to determine the extent of its suitability obligations regarding an institutional customer, there
are two important guidelines:
1. The firm and the RRs servicing the account must have a reasonable basis to believe that the institutional
customer is capable of evaluating investment risks independently, both in regard to the specific securities
and the different investment strategies.
2. The institutional customer must affirmatively state that it’s exercising independent judgment in
evaluating the recommendations.
When dealing with institutional customers, firms are exempt from the customer-specific obligation that was
listed previously. However, the reasonable basis and quantitative obligations standards still apply.
Verification and Ongoing Updating of Client Information

To ensure that an RR has properly characterized a client’s profile and investment objective, copies of the account
record or the documentation of the information that’s collected must be sent to the customer either within 30 days
of opening the account or with the client’s next statement. Thereafter, periodic updates of account information
must be sent to the customer at least every 36 months. If any specific terms are used by a member firm to
describe investment objectives, their definitions must also be included in these mailings.
Change of Information If a customer provides a broker-dealer with updated account record information,
the broker-dealer must send a copy of the revised account record to the customer. Member firms are required
to send the updated documentation within 30 days after it received notification of the change or at the time the
next statement is mailed to the customer. Examples of account record changes include changes to a customer’s
name, address, or investment objective. As a standard practice, if a request is made to change a client’s
address, within 30 days of the change, notification must be sent to both the previous address on file and to the
registered personnel who are responsible for the account.

Tax Information Securities industry rules state that the representative must request the client’s Social
Security or tax ID number. However, if clients fail to provide this number, they could be subject to backup
withholding. Many firms have in-house rules that prohibit the opening of an account without this number.
A customer is also typically asked to sign a W-9 certification (although this may be a separate document
rather than part of the new account form). This certification attests that the Social Security or tax ID number
provided is accurate and that the customer is not subject to backup withholding. Those customers who are
subject to backup withholding under IRS rules are responsible for informing the broker-dealer if such is the
case. Non-resident aliens and foreign entities that are not subject to backup withholding should complete IRS
Form W-8 (Certificate of Foreign Status).
Regulation Best Interest (Reg BI)

In June of 2019, the SEC adopted a package of rulemakings and interpretations that are designed to enhance
the quality and transparency of retail customers’ relationships with broker-dealers and investment advisers.
These rules will bring the legal requirements and mandated disclosures in line with reasonable investor
expectations, while preserving access (in terms of choice and cost) to a variety of investment services and
products. Specifically, these actions include new Regulation Best Interest, the new Customer Relationship
Summary (Form CRS), and separate interpretations under the Investment Advisers Act of 1940.
Regardless of whether a retail customer chooses a broker-dealer or an investment adviser (or both), the retail
customer is entitled to a recommendation (from a broker-dealer) or advice (from an investment adviser) that’s
in the customer’s best interest and that doesn’t place the interests of the firm or the financial professional ahead
of the customer’s interests. In other words, any strategy or product that firms or individuals recommend to
retail customers must be in the customers’ best interest (not just suitable).
Who’s a Retail Customer? Currently, Reg BI only applies to retail customers. According to the regulation,
a retail customer is defined as a natural person, or this person’s non-professional legal representative, who:
 Receives a recommendation of any securities transaction or investment strategy involving securities from a
broker-dealer; and
 Uses the recommendation primarily for personal, family, or household purposes
Professional legal representatives (e.g., financial industry professionals) and other fiduciaries are not
considered retail customers.
Client Relationship Summary (Form CRS) Along with the passage of Reg BI, the SEC adopted a new
relationship summary disclosure document that broker-dealers and investment advisers must provide for retail
customer—the Client Relationship Summary (Form CRS). Form CRS must be no longer than two pages. The
purpose of Form CRS is to provide retail investors with information about the nature of their relationship with
their financial professional in a simple, easy-to-understand format. In addition to the services offered by the firm,
Form CRS will include:
 The fees, costs, conflicts of interest, and standard of conduct associated with those relationships and services
 Whether the firm or its financial professionals currently have reportable legal or disciplinary history; and
 How to obtain additional information about the firm

New retail investors must receive a copy of Form CRS by no later than the time they open a brokerage account,
place an order, or receive a new recommendation for an account type, securities transaction, or investment strategy.
Broker-dealers must file Form CRS with the Central Registration Depository (CRD), while registered investment
advisers must file Form CRS with the Investment Adviser Registration Depository (IARD) as Part 3 of Form ADV.
General Obligations Brokerage firms must fulfill the following four specific obligations in order to satisfy
their overall duty under Regulation BI:
1. Disclosure – Provide certain required disclosures regarding any recommendation made to a retail customer
and the relationship between the firm and the customer before or at the time of the recommendation.
2. Care – Exercise reasonable diligence, care, and skill in making recommendations.
3. Conflicts of interest – Establish, maintain, and enforce written policies and procedures that are reasonably
designed to address conflicts of interest.
4. Compliance – Establish, maintain, and enforce written policies and procedures that are reasonably designed
to achieve compliance with Reg BI.
Broker-dealers are subject to Reg BI, whereas investment advisers are subject to the provisions of the
Investment Advisors Act of 1940. Reg BI applies to any recommendations that are made to retail customers
and extend beyond securities or portfolio recommendations, including whether an investor should roll over a
401(k) into an IRA or recommendations as to the type of account that a retail customer should open.
Suitability Since Reg BI serves to supplement FINRA’s existing suitability rules, firms are required to
comply with both rules. However, one change implemented by Reg BI applies to the difference between a
“retail customer” (as used by Reg BI) and FINRA’s use of the term “institutional customer.” FINRA’s
definition of an institutional customer includes a natural person who has total assets of at least $50 million;
however, Reg BI doesn’t establish a dollar limit. In other words, for a natural person who has assets exceeding
$50 million, the provisions of Reg BI will apply, while for other institutional investors (e.g., banks, IAs,
investment companies), FINRA’s suitability rules apply.
Titles Under Reg BI, unless a broker-dealer is also a registered investment adviser (i.e., the firm is dually
registered as a broker-dealer and an adviser), the SEC has stated that it’s a violation of the disclosure obligation to
use either the term “adviser” or “advisor” in its title. From a practical standpoint, if a registered representative is
neither Series 65 or Series 66 registered and currently uses either of these terms in her title, her firm must provide
her with a different title that she can use on all of her marketing materials. To use either term, the representative
must take and pass either the Series 65 or Series 66 Exam.
Sales Contests Regulation BI effectively bans all sales contests, quotas, bonuses, and other non-cash
compensation that are tied to sales of specific securities or specific types of securities within a limited period.
However, compensation that’s based on other metrics, such as total sales, asset growth or accumulation, or
customer satisfaction is still permitted. Training and education meetings are also permitted as long as
attendance is not based on selling certain products within a limited period. Current SRO rules on non-cash
compensation were updated to reflect that the rules must be consistent with Reg BI.

Financial Exploitation of Specified Adults – FINRA Rule 2165

FINRA created a hotline for seniors who have questions or concerns about their brokerage accounts. One
of the major issues that was highlighted by these investors was suspected financial exploitation. In order to
address this issue, FINRA created Rule 2165 which is titled Financial Exploitation of Specified Adults.
Specified Adults According to FINRA’s rule, the term specified adult is defined as:
 Any person who is age 65 or older
 Any person who is age 18 or older and who the firm reasonably believes has a mental or physical
impairment that renders the person unable to protect his own interests. This determination should be
based on the facts and circumstances that are observed in the firm’s business relationship with the person.
To assist these specified adults, FINRA also established a process by which a firm could respond to situations
in which it has a reasonable basis to believe that financial exploitation has occurred, is occurring, has been
attempted or will be attempted. The process includes the appointment of a trusted contact person.
Trusted Contact Person If a firm suspects the existence of, or potential for, financial exploitation, it may
now contact a customer’s designated trusted contact person. A trusted contact person must be age 18 or older
and can be essential in assisting the firm in protecting the customer’s account and its assets as well as
responding to possible financial exploitation. The trusted contact person’s name and contact information
(mailing address, phone number and e-mail address) may be a part of the customer account information that
should be obtained when a member firm opens or updates an account. Although the trusted person’s contact
information is not required to open the account, a firm should make a reasonable effort to obtain it.
Financial Exploitation According to FINRA’s rule, financial exploitation includes:

 Wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds or
securities; or
 Any act or omission taken by a person, including through the use of a power of attorney, guardianship, or
any other authority, regarding a specified adult, to:
‒ Obtain control, through deception, intimidation, or undue influence, over the specified adult’s
money, assets, or property; or
‒ Convert the specified adult’s money, assets, or property
Temporary Hold Today, the rule permits a firm to place a temporary hold on the disbursement of a
specified adult’s funds or securities and also permits the firm to place a temporary hold on the execution of
any transaction when there’s a reasonable belief that the customer is being financially exploited. However, if
the firm places a hold on an account, it must allow disbursements if there’s no reasonable belief of financial
exploitation (e.g., normal bill paying).
Account Movement Between Accounts at the Same Firm The temporary hold also applies to the transfer of
assets from one account to another account at the same brokerage firm. For example, the temporary hold applies
when a relative or friend of an account owner is attempting financial exploitation and initiates the transfer of assets
to her account which is held at the same brokerage firm.

Reasons for the Hold If a member firm places a temporary hold, the rule requires the firm to immediately
initiate an internal review of the facts and circumstances that caused it to reasonably believe that financial
exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted.
Notification of the Hold By no later than two business days after the date that the member first placed the
temporary hold on the disbursement of funds or securities, the member firm must provide notification, either
orally or in writing (which may be electronic), of the temporary hold and the reason for the hold. The
notification must be provided to:
 All parties who are authorized to transact business in the account, unless a party is unavailable or the firm
reasonably believes that one party has engaged, is engaged, or will engage in the financial exploitation of the
specified adult; and
 The trusted contact person(s), unless this person is unavailable or the firm reasonably believes that the trusted
contact person(s) has engaged, is engaged, or will engage in the financial exploitation of the specified adult
The intent of the rule is to prohibit a firm from dealing with the person(s) who may be exploiting the specified
adult. For example, if the adult child of a senior investor is the trusted contact person who may be
misappropriating funds, it’s not prudent for this person to be contacted. Before placing a temporary hold, it’s
recommended for the firm to first attempt to resolve the situation with the customer. However, if the temporary
hold is placed, the firm is required to notify the trusted contact person. Once a temporary hold is initiated, the
firm is permitted to terminate it only after contacting either the customer or the trusted contract person and
discussing the situation. The customer’s objection to the temporary hold or information obtained during the
discussion with the customer or trusted contact person may be used by the firm when determining whether the
hold should be placed or lifted.
Period for the Temporary Hold Under the rule, the temporary hold will expire by:
 No later than 15 business days after the date that it was first placed on the account, unless it was otherwise
terminated or extended by another authorized regulatory entity.
If a member firm’s internal review of the facts and circumstances supports its reasonable belief that the
financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted,
the firm may extend the temporary hold for:
 No longer than 10 business days following the date identified above, unless it was otherwise terminated or
extended by another authorized regulatory entity.
Lastly, to provide greater protection, if the firm’s internal review still supports its reasonable belief of the
potential for financial exploitation, the temporary hold may be extended by the member firm for:
 No longer than 30 business days following the date identified above, unless it was otherwise terminated or
extended by another authorized regulatory entity.
Essentially, member firms are able to maintain a temporary hold on disbursements or transactions for a
maximum of 55 business days.

Death of the Account Owner

Regardless of account type, the death of a customer requires an RR to understand what actions to take. If an
individual account owner dies, any open orders for the account should be cancelled and no other activity should
occur until an authorized person provides evidence that they have the legal authority to take over the assets in the
account. This person may be designated in the deceased’s will or be appointed by a court if the person died
intestate (without a will). In either case, a new account is typically established and titled, “The estate of
(deceased’s name).” Typically, if securities or other instruments were registered in the name of the deceased
person, they will be transferred by the executor or administrator of the estate to the name of the estate. Certain
documents are usually required by the transfer agent before the change may be made. The specific documents
that are necessary are often determined by state law; however, they typically include:
 Death certificate
 Copy of the will or court appointment (letters testamentary)
 Affidavit of domicile
 State inheritance tax waiver
If the deceased customer had previously granted a power of attorney to another person, the power of attorney is
automatically terminated.
Registered representatives may be asked to provide the executor with information regarding the value of
securities for estate tax purposes. If this is the case, securities are generally valued as of the date of death or an
alternative date six months after the date of death.
Customer Accounts – Policies and Procedures

Trading Authorizations
If another person will be permitted to trade an account, additional information and documentation are required.
This type of situation can arise if the client wants to authorize a third party to have trading authority. The
persons to whom discretion may be granted include:
 Family members, such as spouses or adult children
 The customer’s registered representative
 Attorneys or investment advisers
A trading authorization is a power of attorney (POA) which allows the authorized person to trade the account.
POAs may be either durable or non-durable. A durable POA remains in effect if the account owner is declared
mentally incompetent or incapacitated. On the other hand, a non-durable POA becomes null and void in those
situations. A full trading authorization permits the authorized person to place buy and/or sell orders, but also
withdraw money and securities from the account. A limited trading authorization permits the authorized
person only to place orders for the account, but not to make withdrawals. In either case, the broker-dealer must
receive a written trading authorization that’s signed by the account owner prior to permitting the authorized
person to trade the account. The firm should also obtain the signature of each authorized person and the date
that the trading authority was granted.

Discretionary Accounts
When a registered representative is the authorized third party, the account is generally referred to as a
discretionary account. Some firms don’t permit registered representatives to accept discretionary authority at all,
while others permit their RRs to accept only limited trading authorization. If the firm permits discretionary
accounts, a principal must accept the discretionary authorization in writing before it becomes effective.
Each discretionary order must be approved promptly (i.e., on the day of the trade) by a principal, and
discretionary accounts must be reviewed frequently to ensure transactions are not excessive in size or
frequency in view of the financial resources and character of the account.
One area of concern in discretionary accounts is excessive trading—also referred to as churning. When
investigating allegations of excessive trading, the most important element in the process is to examine the
investment objectives of the customer, followed by the number and size of transactions. Investment objectives are
highly instrumental in guiding a registered representative and should always be considered prior to making any
recommendations to a customer. Frequent trades may be acceptable in the account of a day trader, but
inappropriate for many other investors. Remember, churning is defined as excessive trading based on the client’s
stated objective. The frequency is what matters, not whether the client lost money.
With discretionary accounts, the authorized third party is generally not required to obtain the account holder’s
permission to execute transactions. However, if a member firm is selling its own stock to the public and wants
to place some of the stock in the account of a customer for whom the member firm holds discretionary
authorization, the firm must obtain prior written consent from the customer before doing so.
Time/Price Exception (Not Held Order) In some cases, a registered representative may accept the
customer’s verbal authorization to make certain decisions without it being considered a discretionary account.
If a customer specifies the following:
1. The specific security (asset)
2. Whether to buy or sell the security (action) and
3. The number of shares or other units to be bought or sold (amount)
As long as the discretion is limited to the time and/or price of execution, this is not considered a discretionary
order and written authorization is not required. When a client places an order that gives her RR discretion as to
the price and/or time of execution, it’s referred to as placing a not-held order (e.g., “Buy 1,000 shares of ABC
whenever you think it’s best”). Not-held orders are limited to the trading day on which the customer’s order
was placed and must be noted on the order ticket. If the period is longer than one day, the client is required to
provide her RR with written instructions.
Miscellaneous Rules and Disclosures

Guaranteeing a Customer’s Account A customer’s account may be guaranteed by another customer of a
member firm if the guarantee is in writing. This type of agreement enables account consolidation for the
purpose of securing margin. The net positions of both accounts are reviewed and used under the agreement.
Please note that this cross guarantee cannot be used to establish the minimum equity requirement for a pattern
day trader (to be described in Chapter 15).

Forwarding to Another Address A customer may instruct his firm to have securities and/or checks
forwarded to another address permanently (e.g., to a custodian bank) or temporarily (e.g., during a vacation).
Account Registration – Forms of Account Ownership

When a broker-dealer is involved in gathering the necessary information from a customer, the customer must
specify the type of account to be opened. There are several forms of account ownership, some of which require
additional documentation along with the new account form.
Individual Account An individual account is opened by and for one person and that person is the only one
who’s able to direct activity in the account (unless a third party has been authorized). For example, if a married
person opens an individual account, that person’s spouse is not authorized to trade the account unless the
account owner has granted third-party trading authorization to the spouse.
Joint Account Joint accounts have more than one owner of record. In most cases, any joint owner may
initiate activity in the account. However, when signatures are required, all owners are normally required to
sign. For that reason, in order to transfer securities, all signatures are required.
New account information should be obtained about each account owner, not solely about the person who fills
out the application. For example, a registered representative should ask all new customers whether they’re
employed by another broker-dealer. For a joint account, this means that this question should be asked of each owner.
As with other property issues, state law generally dictates the forms of joint ownership available, including:
 Joint Tenancy with Right of Survivorship (abbreviated JTWROS or J TEN)
 Tenancy in Common (TEN COM)
 Tenants by Entirety (TEN ENT)
 Life Tenancy (LIFE TEN)
Joint Tenancy with Right of Survivorship and Tenancy in Common are the most common forms of joint
ownership. In a JTWROS account, if one tenant dies, the ownership of the account passes to the remaining
tenants without being subject to probate. In a TEN COM account, a deceased owner’s interest in the account
passes to her estate.
Transfer on Death (TOD) Most states have adopted the Uniform Transfer on Death Security Registration Act,
which permits account owners to designate beneficiaries for their accounts (less complicated than JTWROS).
This designation can facilitate the transfer of assets upon the death of the account owner by avoiding probate;
however, the assets are still subject to estate taxes. To transfer the securities, the delivery of a copy of the death
certificate is typically sufficient.
Consider the case of Wilma who wants to transfer her assets to Eddie upon her death. Wilma’s account will be titled
“Wilma Drew TOD Eddie Miles.” Once established, it’s not considered a joint account and Eddie has no rights in
the account until Wilma passes. In fact, Wilma has the right to revoke any beneficiary designation. If Wilma lives in
a state that has not yet adopted the Uniform Transfer on Death Security Registration Act, but her brokerage firm has
its principal office in a state that has enacted this legislation, she may use this ownership format.

Numbered and Nominee Accounts To protect their privacy, clients are permitted to trade under nominee
names or use an account number in lieu of their name. Firms are required to maintain records regarding the
beneficial owners of all such accounts.
Corporate Accounts Registered representatives must ensure that the person opening an account for a
corporation is authorized to do so. This is done by means of a corporate resolution, which is passed by the
board of directors of the corporate customer. The resolution appoints one or more persons to operate the
account. (Please note, the customer is the corporation, not the person who’s opening the account.) If a
corporation intends to open an options or margin account, a copy of the corporation’s charter must also be
obtained. The charter indicates whether the corporation is authorized to open such an account.
Partnership Accounts To open an account for a partnership, information about each partner should be
obtained, including name, address, citizenship, and tax identification number. Only one Social Security
number will be used for tax reporting purposes and the partnership will distribute individualized tax return
information based on the partnership documents. In addition, all of the partners should sign (where necessary)
and a copy of the partnership agreement should be put in the file. The partnership agreement will specify
which partners are authorized to execute transactions on behalf of the partnership.
Fiduciary Accounts A fiduciary is a person who acts on behalf of and for the benefit of another person.
Examples include executors or administrators of estates, trustees, guardians, receivers in bankruptcy, and
committees or conservators for incompetents.
In most cases, fiduciaries are required to provide documentation of their authority. Also, when making
investment decisions, fiduciaries are often bound by the Uniform Prudent Investor Act (UPIA). The Act is
focused on fiduciaries making decisions that are appropriate given a person’s objectives and risk tolerance.
The focus is on the management of risk, not the complete avoidance of risk.
Accounts for Incompetents An incompetent is a person who has been declared by a court as unable to
manage his own affairs. The court then appoints one or more persons as fiduciaries to manage the person’s
affairs, including financial matters. This type of fiduciary may be referred to as a conservator, a committee, a
guardian, or an incumbent, depending on the language being used by the state involved. Guardianship is a legal
arrangement that’s based on the statutes of the state of domicile under which the affairs of an individual are
managed by the guardian. To properly execute a guardianship account, the broker-dealer should be provided
with a court-certified copy of the certificate of appointment of the guardian.
In some cases, the evidence of appointment of incumbency may be issued. This document certifies that the
person listed therein is the fiduciary for another person (the account holder). Evidence of appointment of
incumbency must be dated no more than 60 days prior to presentation (i.e., 60 days old), with the exception of
a Last Will and Testament. (There’s no date or time specification for a Last Will and Testament.) If the
evidence of appointment of incumbency is dated more than 60 days prior to presentation, it must be recertified.
Accounts for Minors Member firms will not allow minors to open accounts in their own names since
they’re not legally responsible and could reject previous transactions once they reach the age of majority.
There are two approaches to opening accounts for minors—UGMA/UTMA accounts and trust accounts.

Uniform Gifts to Minors Act (UGMA)/Uniform Transfers to Minors Act (UTMA) Accounts for minors are
generally opened under the provisions of the Uniform Gifts to Minors Act (UGMA) or the very similar
Uniform Transfers to Minors Act UTMA. Under the UGMA, an irrevocable gift of cash or securities is given
to a minor by an adult donor. Under the UGMA, another minor cannot give a gift; however, this is permitted
under the UTMA. The donor appoints an adult to act as custodian for the minor. Per account, there may only
be one custodian and one minor. Please note, the donor and the custodian may be the same person. There’s
no limitation on the amount of the gift that may be given, but taxes may be due from the donor on any
amount that exceeds the gift tax exclusion (currently $17,000 per year).
A custodial account is registered in the name of the custodian for the benefit of the minor. For example, a
UGMA account could be opened as “Mary Smith as custodian for Robert Brown under the New York Uniform
Gifts to Minors Act.” However, the account is opened under the minor’s Social Security number and the minor
is responsible for paying taxes on any income that’s generated in the account.
Under the UPIA, a custodian is permitted to sign a power of attorney which grants a registered representative
or an investment adviser representative with trading authorization for the account. A custodian may receive a
fee for managing the custodial account as long as the custodian is not the donor of the assets in the account.
As a fiduciary, the custodian must act in a prudent manner when handling the account. Some of the permissible
activities include:
 Reinvesting cash that’s received into the account (e.g., dividends/interest) within a reasonable period
 Exercising rights and warrants if there’s sufficient cash in the account, or simply liquidating them
 Employing conservative options strategies (e.g., covered call writing)
 Purchasing new issues and mutual fund shares
However, there are certain prohibitions that apply to the custodian. As with most fiduciary accounts, UGMA
accounts cannot be margin accounts. In addition, stock cannot be registered in street name (UTMA does allow
holding stock in street name). Since commodity futures positions and uncovered option strategies may only be
established in margin accounts, they’re prohibited in a minor’s account.
Death of a Custodian or Child If the custodian dies without appointing a successor, a new custodian will be
named by the court. Actually, minors who are at least 14 years of age may suggest a new custodian to the
court. On the other hand, if the child dies, the distribution of assets is based on each individual state’s laws.
The funds don’t necessarily revert automatically to the deceased child’s parents.
The custodial relationship is terminated when the minor reaches the age of majority. At that time, the custodian
should transfer the securities to the beneficial owner’s individual name.
Investment Adviser Accounts As described previously, an investment adviser is a business or person that
receives compensation for providing investment advice to others. Most are registered with either the SEC or a
state and are often referred to as registered investment advisers (RIAs). Investment advisers that provide portfolio
management services often buy and sell securities for their clients on a discretionary basis. The RIA may open
one account that contains all of the advisory clients’ assets, or each client may set up a separate account and
provide the adviser with a third-party trading authorization. In either case, there must be written authorization
for the adviser to transact business in the account.

Employee Accounts Remember, there are certain disclosures and rules regarding an associated person who
intends to open a brokerage account at another firm (as described in Chapter 6). Series 24 candidates are
expected to have a thorough grasp of these requirements.
Types of Accounts
There are several types of accounts that are classified by payment method or the type of security purchased.
Some require additional documentation.
Cash Accounts In a cash account, the client will pay for any transaction in full by the settlement date. For
most securities, the settlement date is two business days after the transaction date (T+2).
Margin Accounts In a margin account, transactions require at least a 50% deposit by the customer. There
are two types of positions that may be set up in a margin account—long positions and short positions.
Although both types of positions are executed in one margin account, they’re often referred to as the long account
and the short account. When purchasing stock in a long margin account, a customer will pay part of the purchase
price (generally 50%) by the settlement date and the broker-dealer will finance the remainder of the purchase. To
open a margin account, a margin agreement or customer agreement must be signed by the client. The agreement
contains the following key parts:
 The credit agreement discloses the terms under which the broker-dealer will finance the customer’s purchase,
including both how interest is calculated and how it’s charged to the account.
 The hypothecation agreement provides that the securities purchased by the customer will collateralize the debt
to the broker-dealer. In addition, the broker-dealer is allowed to rehypothecate the securities. In other words, it’s
allowed to use the customer’s securities to obtain a loan from a bank.
 The loan consent agreement gives the broker-dealer the right to lend the customer’s securities to other clients or
broker-dealers (for short-sale purposes). Since the customer loses the right to vote the loaned stock, this part of
the margin agreement is optional.
Although selling stock short in a margin account doesn’t involve the same type of financing arrangement as a
long purchase, a margin agreement is still required since the broker-dealer is selling borrowed stock on behalf
of the customer. At any time, a customer may request that her cash account purchases be transferred into her
margin account. (Margin will be covered thoroughly in Chapter 15).
Options Accounts A new options account form must be completed for customers who want to begin
trading options, even if they already have an existing cash or margin account with the firm. Since options are
considerably more risky than many other types of investments, it’s important to have complete and accurate
documentation for these accounts.
Fee-Based versus Commission-Based Accounts Customers who purchase and sell securities are either
charged a percentage-based fee that’s based on assets under management (AUM) or they incur a charge for
each transaction. In a fee-based account, a customer is charged an annual fee for investment advice, regardless
of whether any transactions occur. On the other hand, in a commission-based account, a customer pays a
commission or other type of payment on each investment transaction. Although being charged a single fee for
all account services may seem like an attractive feature, it may not be the best approach for all customers. For
customers who favor a low turnover strategy, being charged commissions for each executed transaction may
be less expensive than a fee-based account.

On the other hand, for customers who favor strategies that involve higher turnover, the fee-based account may
be more economical than a commission-based account. Another type of payment option is referred to as a wrap
fee account. In this type of investment account, customers are charged a single, bundled, or “wrap” fee that
covers investment advice, brokerage services, administrative expenses, and other fees and expenses. The fee is
generally based on a percentage of the assets under management.
Day-Trading Accounts Special requirements apply to broker-dealers that promote the use of day-trading
strategies by non-institutional customers. Day-trading strategy refers to an overall trading strategy that’s
characterized by a customer’s regular transmission of intraday orders to effect both purchase and sale
transactions in the same security or securities. This includes instances whereby an individual transmits one or
more round-trip transactions in a single day. A round-trip transaction involves a purchase and subsequent sale
(or sale and subsequent purchase).
The day-trading rules apply if a broker-dealer affirmatively promotes day-trading activities or strategies through
advertising, training seminars, or direct outreach programs. These types of promotions typically address the
benefits of day trading, rapid-fire trading, momentum trading, or otherwise trading like a professional. A broker-
dealer is also considered to promote day trading if it uses a third party to advertise these strategies. A firm is not
considered to be promoting day trading solely by:
 Promoting efficient execution services or lower execution costs based on multiple trades
 Providing general investment research, or advertising the high quality or prompt availability of its
general research
 Having a website that provides general financial information or news or that allows the multiple entry
of intraday purchases and sales of the same security
Even if a broker-dealer doesn’t itself advertise day-trading strategies, it’s considered to be promoting day
trading if one of its principals or officials is aware that any of the firm’s registered representatives are
promoting the practice.
Consequences of Promoting Day Trading If a firm is considered to be promoting day trading, it must:
 Provide a risk disclosure statement on day trading prior to opening an account for a non-institutional customer
 Either (a) approve the customer’s account for a day-trading strategy, or (b) obtain from a customer a written
agreement that the customer doesn’t intend to use the account for day-trading purposes
A firm cannot rely on the written statement from the customer if it knows that the customer intends to day
trade in the account. In addition, if the customer signs the statement, but the firm later discovers that the
customer is using the account for day trading, the firm must approve the account for day trading as soon as
feasible, but by no later than 10 days after the discovery.
Penny Stock Regulations

As described earlier, many firms used high-pressure, cold-calling techniques to sell securities of questionable
value. The SEC has adopted several rules regarding the solicitation and sale of low-priced OTC stocks (penny
stocks) which are quoted on the OTC Pink Market. The rules were created to prevent certain types of abusive
sales practices and to ensure that investors are provided with information about the penny stock market. A
penny stock is generally defined as stock that trades for lower than $5.00 per share.

Exclusions from the Penny Stock Definition

According to SEC rules, the following are NOT considered penny stocks:
 Exchange-traded stocks (NMS securities – those listed on the NYSE, NYSE American, or Nasdaq)
 Investment company securities
 OCC-listed puts and calls
 Securities with an inside bid price of at least $5.00 per share
 Securities whose issuer has net tangible assets exceeding $2 million if in continuous operation for at least three
years, net tangible assets exceeding $5 million if in continuous operation for less than three years, or shares of a
company with average revenue of at least $6 million for the last three years
To summarize, any security that’s listed on Nasdaq or a national exchange is exempt from the definition of a
penny stock regardless of the price at which it’s being quoted. For securities that are quoted on the OTC Pink
Market, if the bid price is $5.00 or higher, the security is not considered a penny stock.
Penny Stock Disclosure Rules

SEC Rules 15g-1 through 15g-6 require customers to be provided with specific information if broker-dealers
execute penny stock transactions for them. Prior to executing any transaction for a customer in a penny stock,
the broker-dealer must provide the customer with a Risk Disclosure Document on penny stocks. The document
must contain language that’s specified by the SEC and describes the risks involved in penny stock investing
and summarizes other disclosures the broker-dealer must make to the customer. In addition, for each penny
stock transaction, the broker-dealer must disclose to the customer:
 The current quote for the security
 The compensation the broker-dealer AND registered representative will receive for the transaction
If a broker-dealer has sold a security to a customer that meets the definition of a penny stock as of the last
trading day of any month, the broker-dealer must provide a monthly statement to the customer as long as the
security is held in the customer’s account. The statement must include the identity and number of shares of
each penny stock being held for the customer’s account, and the estimated market value for the security to the
extent it can be determined.
Penny Stock Sales Practice Requirements

SEC Rule 15g-9 places certain conditions on the way broker-dealers solicit penny stock transactions from
customers. This is referred to as the Cold Call Rule. Prior to the purchase of a penny stock by a customer, a
broker-dealer must approve the person’s account for penny stock transactions according to the procedures
outlined below, and obtain from the customer a written agreement to the transaction indicating the identity and
quantity of penny stock to be purchased.
Account Approval Procedures The process of approving a customer’s account for transactions in penny
stocks requires the broker-dealer to:
 Determine that the customer is suitable for penny stock transactions based on information about the customer’s
financial situation and investment objectives
 Deliver to the customer a written statement regarding this suitability determination
 Obtain from the customer a manually signed and dated copy of the statement

Exemptions from Penny Stock Disclosure Rules and Sales Practice Requirements Securities that
are sold in the following transactions are NOT subject to the penny stock disclosure rules OR the penny stock
sales practice requirements:
 Transactions with institutional accredited investors (For the rule, “institutional” means accredited investors [not
individuals] as defined in Regulation D for private placements.)
 Private placement transactions
 Transactions with the issuer, officers, directors, general partners, or 5%+ owners of the company’s stock
 Transactions that are not recommended by the broker-dealer
 Transactions by a broker-dealer whose commissions and markups from penny stocks do not exceed 5% of its
total commissions and markups
One additional exemption to the sales practice requirements of Rule 15g-9 is available to transactions with
established customers. An established customer is one for whom the broker-dealer (or its clearing firm) carries an
account and who has executed a securities transaction, or made a deposit of funds or securities, more than one
year previously, or has made three purchases of penny stocks (from three different issuers on three separate days).
Please note, established customers are not exempt from the penny stock disclosure rules.
Penny stocks cannot be purchased on margin, but can be sold short if they satisfy the borrow rule under
Regulation SHO.
Retirement Accounts
The overall value of securities that are held by retirement plans is quite significant. Principals should be aware
of the unique rules that govern retirement plan assets when supervising registered representatives who are
engaged in activity in this area. Retirement plans include those that are opened by individuals and those that
are created by employers. Employer plans can be divided into those that qualified and those that are non-
qualified. Each plan type has different contribution limits and tax treatment.
Qualified Plan Accounts

Qualified retirement plans are those that receive favorable tax treatment. To be considered qualified, the plan
must meet the provisions that are established by the Employee Retirement Income Security Act of 1974 (ERISA).
ERISA sets IRS standards pertaining to the percentage of employees covered, the methods of distributing
benefits, the amount of contributions for each employee, the vesting of benefits, and how the plan is to be funded.
When formulating a plan, the employer should seek an advance determination from the IRS regarding the
qualification of the plan.
If established properly, a qualified plan will provide the following benefits:

1. The employer will be allowed to deduct from income all contributions made to the plan.
2. The fund that’s established to provide the retirement benefits will be exempt from taxes.
For a retirement plan to be tax-exempt (qualified), the plan must meet ERISA qualification standards that are
outlined in the Internal Revenue Code. The plan must also be structured and operated in a manner that’s
consistent with the U.S. Labor Code. Specific requirements are addressed next.

Funding A qualified retirement plan may be established as either a defined contribution or defined benefit plan.
A defined contribution plan requires that a specified annual percentage of contributions be made to the plan by the
employee with potential contributions by the employer. The total dollar contribution is based on the employee’s
annual compensation. The ultimate payout depends on the amount contributed and the earnings accumulated.
A defined benefit plan promises to pay the employee a specified amount (benefit) each year once the employee
retires. This benefit payment is typically based on age, years of service, and salary history. Actuarial
calculations are used to determine the amount that an employer must deposit each year to provide for the
retirement benefit that’s specified by the plan. Defined benefit plans allow for larger maximum contributions
than defined contribution plans. The maximum annual benefit is adjusted annually for inflation.
Investment Choices All plans are required to provide participants with a minimum of three investment
choices. Plans must also include an investment policy statement that identifies guidelines as to how the assets
are to be invested. This will include the plan’s investment objectives, preferred types of assets, time horizons,
and risk tolerance.
Vesting Vesting provisions specify the amount that an employee is entitled to keep when withdrawing from
a plan. The employer may choose one of the vesting schedules that are established by the IRS. One schedule
provides for full vesting after five years of service, while the other provides for full vesting after seven years,
but at least 20% vesting by the third year.
Participation To participate in a plan, a person must be at least 21 years old and must have completed at least
one year of full-time service. Part-time workers (those with fewer than 1,000 hours of annual employment) may
be excluded. A plan may set a waiting period if there’s 100% immediate vesting after two years.
Plan Administration All qualified plans must be in writing and communicated to employees.
Plan assets must be held in a trust or custodial account. A trustee, who has exclusive authority and discretion to
manage and control assets, must be named in writing. The trustee assumes a fiduciary role and must act in the
best interests of the participants. In addition to the trustee, the investment adviser and any other individual who
has discretion regarding the administration of the plan is considered a fiduciary. The general principles that
should be followed include diversification, liquidity of investments, and obtaining a reasonable return that’s
consistent with the cash flow requirements of the plan.
Tax Treatment of Employees As previously described, a qualified plan will allow the employer to take a
current deduction for its contributions to the plan. This contribution that’s made on behalf of the employee is
not included in the employee’s income. The employee will recognize these contributions as income when the
money is distributed to that individual. Also, income that’s earned while the funds are accumulating in the plan
is tax-deferred until it’s distributed to the employee.
Required Minimum Distribution (RMD) Most retirement vehicles require participants to begin taking
distributions by April 1 of the year after the individual turns age 73. In each subsequent year, the RMD must
be taken by December 31. If the participant fails to do so, she’s subject to a penalty on the amount that should
have been taken and the full amount is added to the participant’s taxable income.

Corporate Pension Plans Corporate pension plans may be established as defined benefit or defined
contribution. All full-time employees who are 21 years old and who have worked for the employer for at least
one year must be included in the plan. The employer may choose between the vesting schedules that were
described earlier. Contributions that are made to the plan are not contingent upon the employer’s profits.
Therefore, contributions must be made to the plan regardless of whether the company had a profitable year.
Pension plans are often non-contributory, which means that the employees may not make contributions to the
plan. Those plans that allow employee participation normally allow only after-tax dollars to be contributed.
Profit-Sharing Plans A profit-sharing plan is established by an employer to allow employees to participate

in profits that are earned by the company. This type is classified as a defined contribution plan. Funds must be
allocated to participants in a non-discriminatory fashion based on a predetermined formula. However, an
employer is not required to make a contribution to a profit-sharing plan if the company is not profitable. Also,
contributions into the plan may vary at the discretion of the employer.
Customer Identification Program (CIP)

Broker-dealers must create customer identification procedures and use reasonable measures to verify the
identity of any person who opens an account with its firm. It must also maintain records of information that was
used to verify that person’s identity and determine whether that person is listed as a known or suspected terrorist or
affiliated organization. A broker-dealer must verify a customer’s identity within a reasonable time before or
after the customer’s account is opened or the customer is permitted to execute a transaction in the account.
At a minimum, the information that’s required to be obtained from a customer includes:

 Name
 Date of birth (for an individual, not business)
 Address (for an individual this must be a residential or street address; however, other persons must supply a
principal place of business or local office)
 Identification number (taxpayer ID number, passport number and country of issuance for non-U.S. citizens,
alien ID card number, etc.)
Taxpayer ID Exception A broker-dealer that receives an application to open an account may forgo
obtaining a taxpayer ID number if that person has applied for, but not yet received the number. However, in
lieu of the number, the broker-dealer must retain a copy of the person’s application for the number.
Customer Verification A broker-dealer may use documents or non-documentary methods in order to verify
the identity of a customer.
Records Retention The broker-dealer must maintain records of the methods used to verify a customer’s
identity for five years following the closing of the account.
Specially Designated Nationals and Blocked Persons List Firms and their representatives must ensure
that they’re not doing business with any person whose name is on a list that’s maintained by the Treasury
Department’s Office of Foreign Assets Control (OFAC). This list is referred to as the Specially Designated
Nationals and Blocked Persons List, or simply the SDN List.

The SDN List identifies known and suspected terrorists, other criminals, as well as pariah nations (e.g., Syria
and Iran). Doing business with any of these individuals or entities is prohibited. If a firm discovers that one of
its clients is on the SDN List, it must block all transactions immediately and inform the federal law
enforcement authorities.
Broker-dealers will need to exercise special due diligence when opening private banking accounts for foreign
nationals. They’re also prohibited from maintaining correspondent accounts for foreign shell banks (i.e., a
bank with no physical presence in any country).
SEC Regulation SP and Identity Theft

Privacy of Consumer Financial Information
Both FINRA rules and AML requirements make it necessary for firms to collect extensive information on
customers. To avoid the misuse of this information and to protect clients’ privacy, the federal government
established certain rules. In 1999, Congress enacted the Gramm-Leach-Bliley Act. Since this massive piece of
legislation abolished the legal barriers that had kept banks, brokerage firms, and insurance companies from
affiliating as part of the same company, the specter of huge financial conglomerates with access to extensive
information from multiple sources raised concerns about client privacy. As a result, Gramm-Leach-Bliley included
provisions requiring the regulators to issue rules to protect clients’ privacy.
The SEC responded with Regulation SP (Safeguard Procedures). Regulation SP requires all broker-dealers,
investment companies, and investment advisers registered with the SEC to adopt policies and procedures which
are reasonably designed to protect the privacy of the confidential information that they collect from their clients.
They must also give their clients a description of these policies (a privacy notice). The timing of sending the
privacy notice depends on the client’s relationship with the firm. Regulation SP divides clients into two
categories—customers and consumers. A customer is a person who has an ongoing relationship with the firm,
while a consumer is a person who provides information to the firm in connection with a potential transaction.
For example, if John has a meeting with a financial adviser from ABC Securities
about establishing a financial plan, he’s a consumer (and a potential customer).
If he opens an account with ABC Securities, he’s a customer.
For every customer, a firm must provide a privacy notice when the relationship is first established and an
annually updated version of the notice thereafter. For every consumer, a firm must provide a privacy notice
before it discloses non-public, personal information to any non-affiliated third party. (A firm is not required
to provide consumers with any notice if it doesn’t intend to disclose any of this information to a non-
affiliated third party.)
Among other things, these privacy notices must state the types of personal information that the firm collects
and the categories of affiliated and non-affiliated third parties to whom the information may potentially be
disclosed. Non-public, personal information includes information obtained from the customer or customer lists
that are put together from personally identifiable information (i.e., account numbers). Publicly available
information is that which may be obtained from federal, state, or local government records or distributed
media, such as telephone directories or newspapers. This doesn’t include personal identifiers about the
customer or consumer and may be referred to as aggregated data.

Under Regulation SP, clients must be given a reasonable opportunity to opt out of information sharing. This is
done through the delivery of the privacy notice and directions for how the customer is able to positively affirm
that he wants to opt out. The methods used must be reasonable, such as a check-off box, website, or a toll-free
phone number. However, it’s considered too burdensome for a consumer or a customer to be required to write
a letter to opt out of the information sharing. If the client doesn’t opt out, it’s considered negative consent and
the firm is permitted to share information.
Identity Theft – FTC Red Flags Rule

Under the Federal Trade Commission’s (FTC) Red Flags Rule, many financial institutions (e.g., banks and
broker-dealers) are required to create and implement a written Identity Theft Prevention Program. The program
should enable a firm to:
 Identify relevant patterns, practices, and specific forms of activity that signal possible identity theft
 Incorporate business practices to detect red flags
 Detail appropriate responses to any red flags detected to prevent and mitigate identity theft
The intent of the rule is to help firms to quickly spot suspicious activities (red flags) with the goal of preventing
theft of their clients’ assets. Each firm must have written policies and procedures that address the appropriate
actions to take if identity theft is suspected and/or detected. All of these policies and procedures that are found
under these programs must be referenced in a firm’s Written Supervisory Procedures documentation.
Securities Investor Protection Act

The Securities Investor Protection Act (SIPA) establishes procedures for the protection of customers’ funds and
securities in the event that a broker-dealer becomes insolvent. Broker-dealers that use the mails or other
instruments of interstate commerce are required to be members of the Securities Investor Protection Corporation
(SIPC). SIPC provides coverage for each separate customer (retail and institutional) to a maximum of $500,000,
of which no more than $250,000 may be for cash holdings. If a customer maintains a cash and a margin account,
both accounts are combined when determining SIPC coverage. Under SIPC guidelines, the term “cash” is defined
as funds in a customer’s account that are on deposit to purchase securities. The term doesn’t include the shares of
a money market fund, which are considered securities.
If a customer maintains an individual account and an IRA account at the same broker-dealer, the accounts are
covered separately. Customers who maintain a joint account with their spouse are entitled to separate coverage.
The following examples will clarify the rule.
Customer A has a cash account and a margin account with a broker-dealer. She
has $300,000 of stock and $50,000 of cash in her cash account. In her margin
account, she has equity of $40,000. In this case, the cash account and the margin
account are combined when determining SIPC coverage. The customer is
protected for a total of $390,000.
Customer B has a cash account with $50,000 of securities and $320,000 of cash.
He’s protected for a total of $300,000 ($50,000 for securities, but only $250,000
for cash), since the maximum protection for cash is $250,000.
Customer C has a cash account with $180,000 of securities and $10,000 of cash.
She’s protected for a total of $190,000. Her securities are covered in full and her
cash is also be covered in full, since it’s less than $250,000.

What’s Not Covered? SIPC coverage applies to customers only. Therefore, it doesn’t apply to other broker-
dealers that have securities in the possession of a failed broker-dealer, subordinated lenders of a broker-dealer,
or the personal accounts of senior officers of the firm. Commodities accounts and securities positions that are
registered in the name of the customer are also not covered by SIPC. (It’s specifically street name securities that
are covered). In a margin account, only the equity (not the market value) is subject to SIPC coverage.
If a mutual fund invests in any securities (including U.S. government and agency securities) and the mutual
fund experiences financial difficulties or declares bankruptcy, the assets in the fund are protected by the
custodian bank, not the SIPC, the FDIC or the U.S. government.
SIPC Procedures If a broker-dealer becomes bankrupt, a trustee will be appointed by a federal court to
distribute funds and securities to customers. The trustee is required to notify the broker-dealer’s customers of
the insolvency and to handle the orderly liquidation of the broker-dealer. Although it seems surprising that
securities which are specifically identified as belonging to a customer are not covered by SIPC, there’s a
simple reason for this.
When the ownership of securities is able to be determined (not in street name), the securities will be distributed
to the customer without regard to the dollar limits imposed by SIPC. For example, if a person has his securities
being held by a broker-dealer, but in his name directly, SIPC’s trustee is able to forward the securities to the
customer without any issue.
If a customer has a claim for securities that cannot be specifically identified as being in the possession of the
broker-dealer, the dollar amount of the customer’s claim will be based on the market value of the securities on
the day a court is petitioned by SIPC to appoint a trustee. If there are insufficient securities in the possession of
the failed broker-dealer, the securities on hand will be distributed to the claimants on a proportionate basis.
Customers who have claims that exceed the maximum dollar limits of SIPC coverage will rank with other
general creditors for the balance of their claims. For example, a customer has stock in the possession of a failed
broker-dealer with a value of $525,000. SIPC will cover $500,000 of the customer’s stock, with the remaining
$25,000 being treated as a general creditor claim.
Notification of SIPC Membership Membership in SIPC or FINRA may be placed on business cards,
letterhead, or in advertisements as long as the notation is not more prominent than the name of the member
firm. Broker-dealers may use only the official SIPC logo with the attestation that the firm is a member, but
cannot imply that SIPC is equivalent to FDIC or that it protects the client against investment losses. The SIPC
logo must be displayed at the broker-dealer’s principal office as well as at each branch office. Please note,
mutual fund complexes are typically not SIPC members.
At the time of account opening, all member firms that are SIPC members are required to provide written
notification to all of their new customers that they may obtain information about SIPC, including the SIPC
brochure, by contacting SIPC. The firms also must provide the website address and telephone number of SIPC.
Firms are not required to send the SIPC brochure; instead, they’re simply required to provide information to
customers as to where and how they may obtain one. In addition, firms are required to provide all customers
with written notice as to the availability of SIPC information annually. In cases where both an introducing firm
and a clearing firm service an account, one of the two (not both) is responsible for compliance with these rules.

Confirmations and Account Statements

Students are often confused about the differences in the content of order tickets and confirmations. Although
there are many similarities, two important differences are that order tickets will indicate whether a trade was
solicited or unsolicited and whether a trade was discretionary or that discretion was not exercised.
Confirmation Statements
Under the provisions of SEC Rule 10b-10, broker-dealers are required to provide customers with a detailed
confirmation of each purchase or sale. The confirmation must be given or sent at or before the completion of
any regular-way transaction—which is generally the settlement date. The confirmation must include the
following information:
 The identity and price of the security bought or sold
 The number of shares, units, or principal amount
 The date of the transaction, as well as the time of execution (or a statement that the time will be furnished on
written request)
 The capacity in which the broker-dealer acted, such as:
− Agent for the customer
− Agent for another person
− Agent for both the customer and another person (referred to as a cross)
− Principal for its own account
 The dollar price and yield information on debt securities
 Whether a security is callable and the statement that further information will be provided on request
 The settlement date
Even if an RR has discretion over a customer’s account, confirmations for all transactions must be sent to the
customer. Trade confirms may be sent to an investment adviser or another third party, but only if the written
consent of the customer is obtained.
FINRA Confirmation Rules In addition to the SEC confirmation requirement, FINRA requires the firm to
disclose the markup or markdown on the transaction with non-institutional (retail) customers. This should be
disclosed as a dollar amount as well as a percentage of the prevailing market price.
Collateralized Mortgage Obligation (CMO) Confirmations Collateralized mortgage obligations represent

a pool of mortgage loans that are combined and sold as an investment. The mortgages are placed in different
tranches (groups) based on the maturity and risk level of the loans.
The following disclosures/information must be included on the confirmation of a CMO transaction:

 Nominal interest rate (coupon)  Settlement amount
 Nominal face value amount  Anticipated yield/average life
 CUSIP number, if assigned  Description of underlying securities
 Final maturity date  Specific tranche number/class

Account Statements
At least quarterly, broker-dealers are required to provide customers with a statement of account. Also, the
typical practice is to provide monthly statements for any account in which activity has occurred. Industry rules
allow for electronic delivery of statements and confirmations. A firm may charge a fee for delivery of paper
confirmations, but not for physical delivery of statements. At a minimum, the account statement must contain:
 A description of all security positions
 All money balances
 All account activity since the last statement
Account activity includes purchases, sales, interest credits or debits, charges or credits, dividend payments,
transfer activity, securities receipts or deliveries, and/or journal entries relating to securities or funds in the
possession or control of the broker-dealer.


Chapter 14
Operational Issues

SERIES 24 CHAPTER 14 – OPERATIONAL ISSUES
This chapter will examine the rules and procedures associated with the processing of transactions. These
processes are often referred to as the back end of the brokerage business or, more generally, as the clearing
of trades. The four phases that a trade goes through are:
1. Order Entry—The placing of a trade into the system either electronically or using a paper ticket
2. Execution—The occurrence of the trade or “fill” in the marketplace
3. Clearing—The agreement by executing firms as to the details of a trade
4. Settlement—The swapping of securities for funds that completes the transaction between firms
Life of a Trade
Uniform Practice Code

It’s important to realize that clients don’t get involved in the clearing and settlement of trades. Technically, the
firms are the counterparties to the trade. The movement of client securities and/or funds is an internal
occurrence at each executing firm. In essence, if a client fails to pay for a trade or deliver securities, the trade
will still stand between the two executing firms.
The Uniform Practice Code (UPC) sets standards for clearing and settlement procedures to be used by members
when dealing with one another. These standards enhance the efficiency of the inter-member dealings regarding
such procedures as the settlement of contracts, deliveries, ex-dividends, due bills, and marks to the market. The
goal of the Uniform Practice Code is to standardize the procedures for doing securities business. Interpretations of
the Uniform Practice Code are the responsibility of FINRA’s Operations Committee.
Clearing – An Overview
Modern clearing is a complicated process that involves many parties who are tied together by computer
systems. In a well-developed capital market, such as what exists in the United States, the majority of trades are
processed electronically with very few paper securities transactions.

CHAPTER 14 – OPERATIONAL ISSUES SERIES 24
Refer to the following diagram as an overview of these processes.
The Depository Trust & Clearing Corporation (DTCC) The Depository Trust & Clearing Corporation is a
securities depository and a national clearinghouse for the settlement of trades in corporate, municipal, and
mortgage-backed securities, as well as some variable products. The DTCC’s function is to automate and
centralize the clearing and settlement of trades among its members. Most major financial institutions in the
U.S. are members of the DTCC system. DTCC-eligible securities include:
 Corporate equities  U.S. Treasuries and agencies
 Corporate bonds  Mutual funds
 Municipal bonds  UITs
 Money-market instruments  Some insurance products
 Mortgage-backed bonds
National Securities Clearing Corporation The DTCC has several subsidiaries. Transactions between
members involving many common stocks, ETFs, ADRs, and convertible bonds are cleared through the
facilities of the National Securities Clearing Corporation (NSCC) if the security has been qualified for clearance
by the NSCC and both member firms involved in the trade are qualified as clearing members by the NSCC.
Each participant submits trade data to the NSCC at the end of the day. The NSCC attempts to match the data
that’s submitted by the buying and selling side of each trade. The next day, participants receive from the NSCC a
contract sheet which describes (1) the trades that compared correctly and are now ready for settlement, and (2)
uncompared trades that participants must reconcile.
Continuous Net Settlement As just described, the majority of trades today are processed electronically.
The DTCC—as the hub of the entire system—nets trades between members across all securities and across
different trading days. This process is referred to as continuous net settlement (CNS), which is used by the
DTCC and its subsidiaries for equities, corporate and municipal debt, ADRs, exchange-traded funds, and unit
investment trusts. This netting process is possible when broker-dealers employ a clearing agency (e.g., the
DTCC) to settle and clear trades.

For each security, the member firm’s buy and sell positions are netted out so that the firm owes or is credited with
one security or money balance each day for that issue. Essentially, the DTCC acts as a centralized bookkeeper
between broker-dealers. Fails to receive and fails to deliver (described shortly) are taken into account in the
netting process. Ultimately, CNS has been credited with greatly reducing the number of open fail positions.
Clearing and Introducing Firms

Clearing Firms One step below the DTCC on the trade processing hierarchy are the clearing firms
(sometimes referred to as full-service firms). These large broker-dealers perform their own order execution,
clearing, and settlement functions. Clearing firms interface with the DTCC directly. Due to the expense of
setting up trade processing operations, many smaller broker-dealers choose not to self-clear. These firms
neither process customer transactions nor operate their own back offices. Instead, they contract with another
member firm to perform these services. The firm that provides these services is the clearing firm, while the firm
that pays for these services is the introducing firm. While customers of an introducing firm consider that firm
to be their broker-dealer, their funds and securities are physically held at the clearing firm from whom they
generally also receive statements and confirmations. The confirmations, statements, and any disbursements
typically contain the names of both firms.
Introducing Firms – Fully Disclosed Accounts Many introducing firms operate through a clearing firm
on a fully disclosed basis. This means that information about each of the individual customers of an
introducing firm will be transmitted to the clearing firm and the clearing firm will hold these clients’ assets.
The clearing firm will establish a separate account for each client and will be responsible for all of the
paperwork associated with the account, such as the delivery of confirmations and statements. The client’s
confirmations, statements, and checks will be identified as coming from the clearing firm, but will contain
additional identifying information so that the client can tell to which introducing firm the paperwork is related.
For example, the client’s statement may show ABC Clearing at the top, but will also include the name and
contact information for XYZ introducing firm somewhere in the paperwork.
In some cases, the introducing firm may have its own trading desk and execute its own trades, while still
clearing through its clearing firm. In other cases, the introducing firm will rely on the clearing firm for
execution services. This is a business decision that the introducing firm must make.
Introducing Firms – Omnibus Accounts There can also be introducing/clearing relationships that are not fully
disclosed. For example, ABC Bond Brokers Inc. is a fixed-income broker-dealer in the Midwest. The firm has a
complete back-office operation that clears its bond trades and holds customer positions. However, the firm will
occasionally accept an order from a customer for common stock. Since the firm doesn’t want to set up back-
office operations to handle these infrequent accommodation transactions, it has arranged for a separate clearing
firm to execute and clear its customers’ stock trades.
In this case, ABC doesn’t provide the clearing firm with any details regarding the individual clients. Instead,
ABC uses a single account that’s specifically designated by the clearing firm as being for customers of ABC Bond
Brokerage. This type of arrangement, in which the clearing firm doesn’t have information on each individual
customer, is referred to as an omnibus account. Since the clearing firm doesn’t know which securities in the
account belong to specific customers of ABC, the recordkeeping responsibilities belong primarily to the
introducing firm. ABC Bond Brokers will maintain the individual customer account records and send
confirmations to clients, but clearing and safekeeping duties will be performed by the clearing firm.

Carrying Agreements
Clearing and introducing firms establish their relationship in a document that’s referred to as a carrying
agreement. This contract outlines the rights and obligations of each party. Additionally, details regarding the
services to be rendered by the clearing firm and the costs associated with each service will be provided. These
services include:
1. Execution and clearing of trades
2. Preparation and mailing of confirmations
3. Preparation and mailing of statements
4. Settlement of dealer-to-dealer transactions
5. Cashiering functions
6. Stock loan and margin activities
7. Recordkeeping
8. AML/CIP Compliance
Review of Agreements When a clearing member enters into a new agreement with an introducing firm or
amends an existing agreement, it must submit the agreement to FINRA for review and approval. Also, when an
introducing member enters into a new agreement with a clearing firm or amends an existing agreement, it must
submit the agreement to FINRA for review.
Clearing Agreements
Clearing Firm enters into agreement
Agreement sent to FINRA for Review and Approval
with Introducing Firm
Introducing Firm enters into
Agreement sent to FINRA for Review
agreement with Clearing Firm
Customer Notice If an introducing member clears transactions with another member on a fully disclosed
basis, each new customer must be notified in writing, upon opening an account, of the existence of the
clearing agreement.
Clearing Firm Reports When entering into a clearing agreement with an introducing broker-dealer, a clearing
firm must immediately (and annually thereafter) provide the introducing member with a list or description of all
reports (exception and other types of reports) that it offers to assist the introducing member in supervising its
activities, monitoring its customer accounts, and carrying out its functions and responsibilities under the clearing
agreement. The introducing member must notify the clearing member promptly, in writing, of those specific reports
being offered by the clearing member that the introducing member requires to supervise and monitor its customer
accounts. In addition, by no later than July 1 of each year, the clearing firm must notify the introducing firm’s chief
executive officer (CEO) and chief compliance officer (CCO) of the reports it offers to the introducing firm.
Client Instructions
Service Instructions This section contains the default instructions for completing transactions and
servicing a client’s account. Let’s review some of the choices that are available to clients.

Hold Securities in Street Name With this form, securities are held in the name of the brokerage firm as
nominee. Although these positions may be held in the firm’s vault or safekeeping area, the securities are more
often held in centralized depositories (e.g., the Depository Trust Company, or DTC). Securities are transferred
on a book-entry basis. If a firm’s new account forms don’t include an entry for this category, it’s assumed that
securities will be held in street name unless the customer specifies otherwise.
Today, a large number of customer stock is held in street name. Therefore, corporations don’t know the names
and addresses of many of their shareholders. This makes it difficult for them to send information, such as
proxies and annual reports, to those individuals. Under SEC Rule 14b-1, issuers may request such information
from broker-dealers that holding stock in street name. However, if a customer objects to the release of this
information, the broker-dealer will not provide it to the issuer, but will instead forward the material to the
shareholder. This question of whether customers object to the release of their name and address to the issuer
frequently appears on the new account form.
Hold Securities in Customer Name (Transfer and Hold) With this form, securities are transferred into the
customer’s name and are then held in segregation in the firm’s vault. The customer’s name appears on the
stockholder records of the issuer; therefore, when the issuer distributes reports, pays dividends, or mails proxies, they
go directly to the customer. Some firms may charge the customer for the service of holding stock in this manner.
Mail Securities in Customer Name (Transfer and Ship) With this form, securities are transferred into the
customer’s name and delivered to the customer. At this point, the securities are no longer recorded on the
firm’s records—the customer assumes full responsibility for them. The issuer then communicates directly with
the customer.
Hold or Mail Dividends/Interest Payments With this form, the customer may choose whether to have
dividends and/or interest payments (for street name securities) credited to the account or sent to the address of
record. Dividends and interest held in the account become a part of the account’s cash balance.
Forwarding Official Communications

One of the many services that a firm may provide to its customers is safekeeping. The securities held in
safekeeping may be in bearer form, book-entry form, street name, or registered in the name of the customer with
the firm holding them in order to avoid loss or theft. Keep in mind, the customers are the beneficial owners of
such securities. If the firm receives official communications that are directed to the beneficial owners, it must
make a reasonable effort to retransmit the information to the parties for whom it’s providing safekeeping services.
The issuer is required to provide enough copies and cover the expenses involved in sending the information to the
beneficial owners. Official communication is considered any relevant information regarding an issue that’s sent
by the issuer, a trustee, or a state or federal taxing authority.
Holding of Client Mail

A firm may hold mail for a customer who will not be receiving his mail at his usual address provided the firm:
 Receives written instructions from the customer that include the period during which the mail will be held. If
the period requested exceeds three consecutive months, the customer’s instructions must include a valid reason
for this request (e.g., safety or security concerns). However, convenience is not considered a valid reason for
this type of request.

 Gives written disclosure to the customer regarding alternative methods through which he may monitor the
account (e.g., through e-mail or the firm’s website).
 At reasonable intervals verifies that the customer’s instructions still apply.
During the time that the customer’s mail is being held, the firm is also required to ensure that the mail is not
being tampered with, held without the customer’s consent, or used by any of the firm’s associated persons in a
manner that violates securities laws.
Special Client Delivery and Payment Arrangements

Delivery versus Payment (DVP) / Receive versus Payment (RVP) In DVP and RVP arrangements,
transactions are settled directly with a third-party, often an agent bank or other custodial financial institution
for a client. In these transactions, the client is not holding funds or securities at a broker-dealer, but is still
using a broker-dealer to execute transactions. The client is instructing broker-dealers to settle trades (i.e., pay
money or deliver securities) with a bank or custodian that’s holding the client’s assets. The process reduces
counterparty risk for the broker-dealer.
A DVP transaction (also referred to as a collect on delivery (COD) transaction) occurs when a customer is
buying securities. In this case, the broker-dealer has purchased securities (at the customer’s direction) and
needs to deliver the securities to the client’s bank or custodian. However, the broker-dealer will only deliver
the securities to the client’s bank when the bank makes cash payment for the securities. (The “D” of DVP
represents the broker-dealer’s responsibility as it relates to the securities.) An RVP transaction occurs when
a customer is selling securities. In this case, the broker-dealer has sold securities (at the client’s direction) for
cash and needs to send the proceeds from the sale. The broker-dealer will only make cash payment when it
receives from the bank the securities being sold. (The “R” of RVP represents the broker-dealer’s
responsibility as it relates to the securities.)
Buying Customer Selling Customer
In both DVP and RVP transactions, the broker-dealer is not required to transfer assets until after receiving the
corresponding assets for a transaction, which eliminates the risk of the customer or their agent or custodian being
unable to fulfill their obligation (i.e., eliminates counterparty risk). Since DVP and RVP clients don’t hold assets
at a broker-dealer, their account statements will not have closing positions or balances (i.e., their account is flat).
Debits and credits will be posted in the account, as will details regarding trades (e.g., prices and commissions),
but assets will be transferred to the client’s bank or custodian.

The typical method of DVP and RVP deposit, withdrawal, and transfer of securities is by the Integrated Delivery
System (IDS). IDS is an industry-wide system that’s linked through a computer network which expedites the
movement of securities and funds between brokerage firms and agent banks. DVP transactions in non-exempt
securities are subject to Reg T settlement parameters. Typically, payment on a later date is due to the inability
of the broker-dealer to deliver securities to the customer’s bank. The broker-dealer has up to 35 calendar days
to complete delivery of the security for a DVP customer.
Industry rules require several procedures to be followed for these types of orders:
 Before accepting a DVP/RVP order, the broker-dealer should obtain the name and address of the customer’s
agent, as well as the customer’s account number with the agent. This may be referred to as an institutional
identifier.
 Order tickets must be marked to indicate these types of orders.
 The customer must provide the broker-dealer with an agreement that the customer will promptly furnish its
agent with settlement instructions for each transaction.
 DVP/RVP trades must be settled through a securities depository by book-entry procedures for all transactions
involving depository-eligible securities, except for trades settled outside the United States.
Depending on the brokerage firm’s policy, customer accounts that specify these instructions may enter the
instructions either on the new account form or on a separate form. Duplicate confirms and account statements
are sent to the agent and all pertinent information about the third-party agent is entered on the form. This data
includes the agent’s tax ID number, clearing number, and the agent’s internal account number for the
customer. This internal account number is very important, since it’s the agent’s means of identifying the
customer (who may have multiple accounts with the same agent).
Prime Brokerage
Prime brokerage is a service that has been
developed for clients that typically use the services
of several broker-dealers to execute transactions.
Prior to prime brokerage, such clients were required
to open a separate account at each executing broker-
dealer. Each broker-dealer would then provide
confirmations and statements to the client. At that
point, the client would need to combine the
information received from its various accounts to
understand its overall position.
Refer to the prime brokerage diagram to the right.
In a prime-brokerage arrangement, the client simply chooses one firm as its prime broker. Although the client
can still use several broker-dealers for execution (and as a source of research), all trades are ultimately handled
through its account at its prime broker. Therefore, the client receives one set of reports, rather than several.

Some of the conditions that must be satisfied in order to establish a prime-brokerage arrangement, including
the following:
 Prime-brokerage customers must maintain a minimum net equity of $500,000 unless the account is managed by
a registered investment adviser, in which case the minimum equity is $100,000. Typical customers are wealthy
retail customers and institutions.
 There must be a contract between the prime broker and the executing broker’s clearing firm which specifies their
responsibilities. The customers must also sign agreements with the prime broker and each executing broker.
 A broker-dealer cannot engage in prime-brokerage activities with any broker-dealer that it knows, or has reason
to believe, is in violation of SEC conditions regarding a prime-brokerage arrangement.
Orders that are placed with the executing broker are executed through an account which is maintained with the
executing broker, in the name of the prime broker, but for the benefit of the customer. The executing broker
buys or sells securities in accordance with the customer’s instructions. On the trade date, the customer notifies
the prime broker of the trade that’s filled through the executing broker. The transaction is recorded in the
customer’s account at the prime broker. The prime broker also records the transaction in a fail-to-receive/
deliver account with the executing broker.
The executing broker confirms the transaction with the prime broker through the Depository Trust & Clearing
Corporation’s Institutional Delivery Netting Service (ID Net). Thereafter, the prime broker will affirm the trade if
the information in the ID System matches the information it has from the customer.
Benefits Prime brokerage provides several benefits to large, active customers. It enables clients to centralize
their clearing and custodial services, and allows them to receive one set of comprehensive reports regarding
their portfolios. For customers who use margin accounts, the concentration of margin positions in a single
account lowers the client’s cost of funds, compared to having several smaller accounts at each executing broker.
Settlement
If all of the parties agree to the details of a trade (clearing the transaction), settlement is the next step. The day
on which the transaction must be completed between the broker-dealers that represent the buyer and the seller
is the settlement date. Rules for the settlement of contracts between member firms fall under the Uniform
Practice Code. Again, settlement occurs on the day that the buying firm must pay for the securities and the
selling firm must deliver them and receive the proceeds from the sale. The stock certificates must be in proper
order and have all of the necessary endorsements before being delivered to the buyer. This is referred to as
good delivery. If a trade occurs on a foreign exchange, the regulations of the appropriate foreign securities
exchange are applicable, even if the firms involved were U.S. broker-dealers.
Regular Way Most securities settle on a regular-way basis, which refers to the normal number of days to
complete the transaction. This number varies depending on the security involved. For corporate stocks and
bonds and municipal securities, the settlement for a regular-way transaction is two business days after the trade date
(T + 2). For Treasury securities and options, settlement occurs one business day after the trade date (T + 1).
Cash transactions settle on the same day as the trade. However, both parties must agree to the shortened
settlement prior to the execution of the trade.
Seller’s Option When the settlement cannot be completed on a regular-way or for-cash basis, the seller may
request settlement by seller’s option. At the time of the transaction, both parties to the trade may agree to a seller’s
option, which gives the selling firm additional time beyond the normal two business days to make good delivery.

When the securities become available for delivery, the seller must give the buyer a one-business-day written
notice that the securities will be delivered the following business day. The selling firm may then request for
payment to be made by the buyer in good transferable funds such as a certified or cashier’s check, in bank
drafts, or in cash.
Cash Settlement A cash settlement trade is completed on the same day as the trade. This option, which
must be agreed to by both parties, can be used for any type of security.
When, As, and If Issued The settlement date is determined by the Uniform Practice Committee. Delivery
of securities would be made to the purchaser on the date that’s declared by the Committee. If no delivery date
was declared:
 Then delivery may be made on the business day following a written notice from the seller to the purchaser
of the intention to deliver, and
 Then open market when, as, and if issued contracts that are being publicly offered through a syndicate will
be settled on the date that the syndicate contracts are settled
These trades are processed through the DTCC system.
Settlement Dates
Corporate or Municipal Two business day following trade
U.S. Government Next business day
Cash Trade/Settlement Same day

Negotiated settlement; not earlier than three business days after the trade
Seller’s Option
Seller may deliver earlier with one business day’s notice
When Issued As determined by the National Uniform Practice Committee
Book-Entry Settlement Rather than making physical delivery of securities or cash when settling securities
trades, many firms use book-entry settlement. However, if a firm intends to use book-entry settlement, all
transactions in depository eligible securities must be settled through a registered securities depository such as the
National Securities Clearing Corporation (NSCC) or the Depository Trust and Clearing Corporation (DTCC).
Depository eligible securities are those that may be deposited at the clearing agency and where ownership can
be transferred through bookkeeping entries rather than through physical delivery of certificates. Cash transfers
are also processed through book entries by the clearing agency rather than through bank routing.
Customer Payment Is NOT Settlement

In a given trade, it’s important to not confuse the customer’s obligation with the obligations of the firms involved.
Regulation T requires payment for purchases in cash and margin accounts to be made promptly, which typically
means no later than two business days following regular-way settlement (i.e., T + 4). In cash accounts, the full
purchase price must be paid, whereas in margin accounts, a specified percentage of the purchase price is due.

If the required amounts are not paid within two business days following the settlement date (the Regulation T
payment date), the broker-dealer is required to cancel the transaction by selling out the securities. The broker-
dealer is then required to freeze the account for 90 days. This means that the customer must pay for all
purchases in advance for the 90-day period. After paying in advance for the 90-day period, the customer is
considered to have reestablished credit and may once again be extended normal credit terms.
The practice of purchasing securities without paying for them in the hope of being able to profit without
any outlay of funds is referred to as freeriding and is prohibited under FRB rules.
Questions on the exam, may refer to Reg T as the SEC payment cycle; however, not all securities are subject to
this cycle. Examples of securities that are not subject to the SEC payment cycle include pre-IPO private
placements and PIPE offerings.
Extensions Under exceptional circumstances, a member firm may apply to FINRA or an exchange for an
extension of time for the payment of the amount due. This applies in such circumstances as a delay in the mails
which caused the customer’s payment to not be received on time. In this case, an extension could be granted by
FINRA or an exchange. The broker-dealer must apply for the extension prior to the Reg T deadline.
Settlement Payment
Corporate Securities in a Two business days Four business days

cash or margin account (T + 2) (T + 4 or S + 2)
Two business days Exempt from Reg. T

Municipal Securities
(T + 2) (generally on settlement)
Next business day Exempt from Reg. T

U.S. Government Securities
Next business day Four business days

Option trades
(T + 1) (T + 4)
Cash transactions for any security settle on the same day.
Other UPC Issues

Dividends
The Uniform Practice Code covers ex-dividend, ex-rights, and ex-distribution procedures (including stock splits).
Since stock transactions take two business days to settle, the ex-dividend date is one business day before the
record date. For example, if the record date is Friday, June 13 (the date on which a person must own the stock to
be entitled to a dividend), a buyer must generally purchase the shares by Wednesday, June 11, to receive the
dividend. In this case, the buyer’s trade will settle by Friday and he will be entitled to the dividend. On the other
hand, if a person purchased the stock on Thursday or later, he would not receive the dividend since he would not
own the stock on or before the record date.

The ex-dividend date represents the first day that a stock begins to trade without its dividend. Therefore, on the
ex-dividend date, the stock’s price will be reduced by an amount equal to the dividend to be paid. For example,
if a stock is paying a $.50 dividend and it closes at $20 per share on the day before the ex-date, it will open at a
price of $19.50 on the ex-dividend date. For any dividend that’s in a fractional amount, the reduction must cover
the full dividend (i.e., a dividend of $.12 ½ results in a reduction of $.13). Since the stock is reduced by the
dividend, orders that are held at a price below the market price, (i.e., buy limits, sell stops, and – if permitted –
sell stop limits), are reduced by the same amount. If an order has been designated as DNR (Do Not Reduce), the
original price on the order will remain intact. Orders that are held at prices above the market price are not
adjusted on the ex-dividend date.
Due Bills If a trade occurs prior to the ex-dividend date, the buyer is entitled to the dividend. However, if the
seller fails to deliver the securities by the record date, the seller’s name will remain on the shareholders’ record
when the dividend is paid. In this case, the seller receives the dividend, but is not entitled to it. A good delivery
requires that a due bill accompany the stock, thereby creating a liability for the seller and a receivable for the buyer.
For example, let’s assume that the record date is Friday, June 13. If an investor purchases stock on the
Wednesday, June 11, the transaction will settle two business days later, on Friday, June 13. The buyer will
receive the dividend because the transfer agent will be made aware of the name of the new owner in time to
change the shareholders’ record for the upcoming dividend. The stock will trade ex-dividend on Thursday,
June 12. From this date forward, any buyer will purchase the stock at a price that doesn’t include the dividend.
Therefore, a due bill will be required only if the buyer purchases the stock before the ex-date, but the seller
delivers the security after the record date.
A buyer can still obtain the dividend after the normal ex-date by purchasing the security in a cash settlement
trade up to and including the record date. Therefore, the ex-dividend date for a cash trade is the business day
following the record date. In the preceding example, if the investor bought stock for cash as late as Friday,
June 13, the buyer will be entitled to the dividend. The stock will not trade ex-dividend for cash contracts until
the following Monday.
Notice of Dividends SEC Rule 10b-17 requires issuers of securities to report to FINRA (not the SEC)
certain corporate actions, such as cash and stock dividends, forward and reverse stock splits, and rights
offerings at least 10 days prior to the record date.
Delivery of Securities
The Uniform Practice Code establishes the requirements for good deliveries of securities. One of the purposes
of the rule is to ensure that the securities will be acceptable to the transfer agent. The transfer agent will make
the final determination as to whether a security is a good delivery and may be transferred to the new owner.
This section will detail what constitutes good or bad delivery.
CUSIP Numbers
One aspect of good delivery is the certainty that the correct security is being delivered. Since many issues have
similar features and maturities, they may be confused with one another. CUSIP numbers are similar to bar
codes on store products and are identifying numbers that are assigned to each maturity of an issue. CUSIP
numbers are intended to help in the identification and clearance of securities.

Endorsements and Assignments A customer who sells a security is required to sign the certificate. The
typical method of endorsing a stock certificate is to sign the certificate on the back and then mail the certificate
to the broker-dealer. In order to safeguard the certificate while it’s in the mail, the seller could send the
certificate by registered mail. An alternate method is for the customer to send the certificate, unsigned, in one
envelope and to send a signed stock power in a separate envelope. In this way, if the certificate falls into
unauthorized hands, it will have no value since it’s non-negotiable. This rule doesn’t apply to Foreign Internal
Securities, which are securities that are registered only in a foreign market.
A third method that could be used to safeguard the security is to enter the name of a third party (often the broker-
dealer) on the back of the certificate. In this case, the broker’s name is entered on the certificate by the customer
and will effectively preclude any unauthorized person from negotiating the stock if it’s lost or stolen. The broker-
dealer will then sign a power of substitution when it sends the stock to the transfer agent.
An investor is able to obtain a signature guarantee from a financial institution (e.g., a commercial bank,
savings bank, credit union, or broker dealer) that participates in a Medallion signature guarantee program.
This program may be used for the gifting of securities, changing ownership in an account, or handling the
estate of a deceased family member. A Medallion imprint or stamp indicates that the financial institution is a
member of a Medallion signature guarantee program and is an acceptable signature guarantor and that the
financial institution accepts liability for any forgery. Assignments on a security must be exactly as the name
appears on the certificate, without any alteration or enlargements of any kind. In addition, the assignment must be
guaranteed (a signature guarantee) by a member firm of the NYSE or by a commercial bank. The transfer agent
will not accept a security for transfer without a proper assignment and guarantee.
Additional Documentation If an account is registered in the name of an executor or guardian and the
security is signed by the executor or guardian, the transfer agent will accept the stock without requiring
additional documentation. Transfer agents will not accept a security that’s signed by a person who’s deceased.
They will transfer the security only if it’s signed by a duly designated executor and accompanied by the
necessary legal documents. The documents that are usually required are a copy of the death certificate, an
appointment of executor, state tax waivers, and an affidavit of domicile.
Certificates that are made out in the name of a company must be signed exactly as the name appears, without
any alteration or enlargement of any kind, except that the words “and Company” may be written
interchangeably as “& Company” or “and Co.” A member of FINRA will not accept securities that are
registered in the name of a corporation unless it’s assured that the person who signs the securities is properly
designated by the board of directors to sign for the corporation (listed on a corporate resolution).
Mutilated Certificates and Coupons Mutilated certificates will not constitute good delivery unless
they’re validated by the trustee, registrar, transfer agent, paying agent, issuer of the securities, or by an
authorized agent or official of the issuer. A certificate is deemed to be mutilated if any one of the following
elements cannot be ascertained:
 Name of issuer  Coupon rate  Seal of the issuer
 Par value  Maturity date  Certificate numbers
 Signature
Gifting Securities In some cases, the owner of securities may decide to donate them to a charity. In
such cases, the donor may use one of two methods to transfer the securities to a charity.

1. If the stock is held by a broker-dealer and it’s registered in street name, the client will provide written
instructions to indicate his intention to transfer the securities to the charity. A transfer instruction form
can be submitted for account title changes and gifting; however, the signature of the donor (or donors) is
required.
2. If the stock is held by a broker-dealer in the name of the donor, the stock certificate may be endorsed or
the donor will deliver the certificates with a signed stock power.
Failure to Settle – Closeouts

The Uniform Practice Code deals with closeout procedures for failed trades (i.e., trades that were not
completed as agreed). This can result in either a buy-in or a sell-out.
Buy-In A buy-in occurs when a selling broker-dealer has failed to make proper delivery to a buying broker-
dealer. The buying broker will then purchase the securities in the open market and charge the selling broker-
dealer that failed to deliver the securities the difference between the contract price and the buy in price. A buy-
in cannot be completed sooner than the third business day following the settlement date. The broker to which
delivery is due must send a buy-in notice to the contra-broker by no later than 12:00 p.m. two business days
before the execution of the proposed buy-in.
If a selling broker-dealer that’s failing to deliver receives a buy-in notice, it has the right to notify the buying
broker that the securities are in transit or that they’re at the transfer agent. The selling broker-dealer must
provide the buying broker-dealer with the certificate numbers. In such a case, the buyer must defer the closeout
for seven calendar days.
Sell-Out If a selling broker-dealer makes good delivery to a buying broker-dealer and the buying broker-
dealer refuses to accept the securities, the selling broker-dealer has the right to sell the securities immediately
without notice in the open market and charge the buying broker-dealer with any loss that has been incurred.
Notice of Closeout A member firm that buys in or sells out another member firm must notify that member
firm of such action on the same day.
Client Closeouts The rules governing client closeouts are different than those which apply to broker-
dealers. If a client fails to pay for a trade, she’s typically sold out on T + 5, which is the day after the Reg T
payment is due. In some cases, extensions may be granted. If a client fails to deliver a position, she must be
bought in by no later than 10 days after settlement (i.e., S + 10).
Closeouts
(T + 2)
Dealer-to-Dealer Sell-Out
(Immediate sell-out for non-acceptance)
(T + 5)
Dealer-to-Dealer Buy-In
(Notification by noon T + 3)
(T + 5)
Client Sell-Out
(Next day after Reg T payment unless extension is granted)
Client Buy-In S + 10

Marks-to-the-Market
The Uniform Practice Code has established rules regarding marks-to-the-market. A mark-to-the-market occurs
when a member firm is partially unsecured on an open contract with another member firm.
For example, Broker-Dealer A lends stock to Broker-Dealer B that’s worth $50,000. The
borrowing member firm will pay the lending member firm cash equal to the market price
as collateral for the stock loan. At a later date, if the market price of the stock rises to
$60,000, Broker A has the right to demand for Broker B to send an additional
$10,000 of cash due to the rise in the value of the stock.
The mark-to-the-market is sent when there’s a difference between the contract price (in this case, the
$50,000 value of the stock when it was first loaned) and the current market price. If the price of the stock
declines to $30,000, Broker B will have the right to mark Broker A to the market and demand the return of
$20,000 of its collateral. If a member firm sends another member firm a mark-to-the-market demanding the
deposit of additional cash, the member firm that receives the demand must comply promptly. However,
there’s no specific time identified in the rule.
Rejection and Reclamation

At times, issues beyond the non-payment or non-delivery occur in a settlement process. For example, let’s assume
that a broker-dealer inadvertently delivers the wrong security. In this case, it has the right to demand the return of a
security that has been previously delivered and accepted through a process that’s referred to as reclamation. If
securities were presented for delivery and were not accepted for a valid reason, it’s viewed as rejection.
Reclamation can occur for a variety of reasons, such as when the wrong security is delivered, a due bill is not
attached when required, the signature is missing or incorrect on a registered security, or a mutilated security is
delivered without authentication by the transfer agent. Reclamation is also permitted if the transfer agent
refuses to accept delivery for any reason. This may occur if a security is improperly endorsed or if it was
discovered to be stolen.
As it relates to bonds, reclamation is permitted if a bearer bond is delivered without all of the necessary
coupons attached. Reclamation is also permitted if a specific security has been called for redemption at any time
prior to delivery. However, if an entire issue has been called for redemption, or if the specific security in
question was traded as a called security, reclamation is not permitted. For example, a transaction occurs in a
bond and, prior to delivery, the specific bond is called for redemption. In this case, reclamation is permitted.
However, if the entire bond issue were called for redemption, or if the bond had been traded specifically as a
called bond, reclamation will not be permitted.
Transferring Accounts
If a customer intends to transfer an account from one member firm (the carrying firm) to another member firm
(the receiving firm), the customer must give written instructions to the receiving firm. If both the carrying
member and the receiving member are participants in a registered clearing agency which has automated customer
securities account transfer capabilities and both are eligible to use its capabilities, they must use such a system.
An example is the National Securities Clearing Corporation’s Automated Customer Account Transfer Service
(ACATS). Both member firms are required to coordinate their activities in order to expedite the transfer.

Immediately upon receipt from the customer, the receiving firm must submit the transfer request to the
carrying firm and, within one business day, the carrying firm must either validate the instructions or protest the
transfer. The receiving firm may not be able to accept an account transfer if a client’s account is deemed to be
too risky under the receiving firm’s credit policies.
Protesting a Transfer If the transfer is protested, both the carrying and receiving parties must resolve their
differences promptly. A carrying party may protest a transfer only if:
 It has no record of the account on its books
 The transfer instructions are incomplete
 The transfer instructions contain an invalid signature
Validating a Transfer When validating transfer instructions, the carrying party must freeze the account. This
means that all open orders are canceled (with the exception of options positions that expire within seven
business days) and no new orders will be taken. Attached to the validated transfer instructions must be a listing
of all positions, money balances, and current market values for all of the assets in the account, as well as a
description of the securities being transferred which don’t have CUSIP numbers. Within three business days
following the validation, the carrying party must complete the transfer of the account to the receiving party.
Non-Transferable Assets The customer requesting the transfer must be informed, either in writing on the
transfer instructions or on a separate document, whether any of the assets in the account cannot be readily
transferred or may not be transferred within the time frame of the rule. These assets are defined as non-transferable,
and the receiving broker-dealer is not required to accept delivery of these assets. The following situations
could result in customer assets not being transferable from one firm to another:
 An asset is a proprietary product of the carrying member.
 An asset is a product of a third party (e.g., a mutual fund) and the receiving firm doesn’t maintain the
relationship necessary to receive the asset (i.e., no selling agreement with distributor).
 An asset of a bankrupt issuer is held by the customer and the carrying member doesn’t possess the proper
denominations to effect delivery and no transfer agent is available to reregister the shares.
 The asset is a limited partnership interest.
If an asset is non-transferable, the brokerage firm must notify the customer in writing and await instructions
regarding its disposition, which may include:
 Liquidation  Transfer and delivery to the customer
 Retention  Transfer to a third party
If a non-transferable asset is liquidated, distributions must be made within five business days of the customer’s
liquidation instructions.
Interfering with the Transfer of Customer Accounts Member firms and their employees are prohibited
from interfering with a customer’s account transfer request. This situation often stems from the departure of an
RR to a new member firm which may lead to existing clients choosing to follow the RR to the new firm. Under
this rule, the customer’s account must be clear of liens for money owed by the customer or any other bona fide
claim. Examples of interference include seeking a court order to stop the submission, acceptance, or delivery of
a written request from a customer to transfer her account.

It’s also important to recognize that, generally (exception noted below) no bulk or wholesale transfers of
clients may be requested by the RR to ease her paperwork burden. Transfer instructions must be completed and
signed for each separate account.
Bulk Transfers of Customer Accounts

In some circumstances, a broker-dealer may want to conduct a bulk transfer of customer accounts. Under
certain conditions, this may be accomplished through the use of a negative consent letter. A negative consent
letter is a notification which alerts customers that there has been some underlying change in the business of the
entity. If the client doesn’t respond within a specific period, the client is deemed to have consented to the
change. The recipient is not required to provide a direct response—hence, the use of the term “negative.”
FINRA has allowed the use of negative consent letters in the following situations:
 There’s a merger or acquisition of a broker-dealer and the new firm wants to transfer all of the acquired
firm’s accounts to the new entity.
 A broker-dealer seeks to enter into a clearing arrangement and wants to transfer its customers’ accounts to
the clearing member.
 A broker-dealer is no longer in business and the clearing firm wants to transfer the accounts to another
member firm.
 A broker-dealer is experiencing financial or operational difficulties and wants to transfer the accounts to
another member firm.
 A financial institution has terminated its networking arrangement with a broker-dealer and wants to
transfer the accounts to a new member firm with which it has established a relationship.
Bulk Transfers of Variable Contracts and Annuities In addition, FINRA rules don’t permit the transfer of
variable annuity contracts and/or mutual funds held directly at the issuer through the use of a negative consent
letter. Transfers of these products from one broker-dealer to another require affirmative consent on the part of
the customer through a signed client authorization sent to the issuer to change the broker-dealer of record.
Complaints
Industry rules define a complaint as:
…any written statement of a customer or any person acting on behalf of a customer
alleging a grievance involving the activities of those persons under the control of the
member in connection with the solicitation or execution of any transaction or the
disposition of securities or funds of that customer
Member firms are required to maintain a separate file of all written complaints (i.e., a letter) in each office of
supervisory jurisdiction. The file must also contain a description of actions that are taken by the member, if any,
regarding the complaint and must contain, or refer to another file containing, any correspondence regarding the
complaint. Although a principal must review each complaint, there’s no mandatory deadline for its resolution.
Note that even if a member has not received any complaints, an (empty) complaint file must still be maintained.

If a broker-dealer that clears trades for an introducing firm receives a complaint from a customer of the
introducing firm, the carrying agreement must authorize the clearing firm to submit the complaint to both the
introducing firm and the introducing firm’s designated examining authority (DEA).
Quarterly Reports FINRA members are required to provide statistical and summary information about
customer complaints on a quarterly basis. The report is due on the 15th of the month following the end of the
calendar quarter in which the complaints were received. If no complaints were received during the quarter, no
report is due.
This concludes the chapter on operations. Many of the participants just described (e.g., clearing firms and
introducing firms) will be reappear in the final chapter, which covers financial responsibility rules.


Chapter 15
Margin

SERIES 24 CHAPTER 15 – MARGIN
This chapter will examine margin accounts in which clients borrow money or securities from their broker-
dealer to facilitate trades. Series 24 candidates are reminded to ignore any house rules that they may be
accustomed to regarding these accounts and, instead, to focus on the SEC and SRO requirements.
Margin
The Securities Exchange Act of 1934 granted the power to regulate credit in the purchase of securities to the
Federal Reserve Board (FRB or the Fed). The SEC is charged with the responsibility of enforcing the rules that
the Federal Reserve Board establishes.
There are several FRB rules that govern the extension or use of credit for securities transactions, including the
following:
 Regulation T, which governs the extension of credit by broker-dealers
 Regulation U, which governs the extension of credit by lenders other than broker-dealers
 Regulation X, which governs those who borrow to buy securities
Regulation T is the most important of the three regulations for exam purposes. In a margin account, broker-
dealers can provide customers with a loan of up to 50% of their purchase price. For example, if a customer
makes a $6,000 purchase in a margin account, the firm may loan $3,000 and the customer must deposit the
remaining $3,000.
Regulation U pertains to lenders making loans to investors who use securities as collateral for the loan.
Regulation U applies to partners of a member firm who are buying for their own account as well as for
customers. The limits that normally apply under Regulation U don’t apply to transactions by broker-dealers
that are acting as market makers or underwriters. The ability of these dealers to use credit to carry their
positions is limited only by the lender’s own credit standards.
Regulation X pertains to borrowers within or outside the United States who intend to purchase or transfer U.S.
securities that are regulated under the FRB’s Regulations T and U. Borrowers who are subject to Regulation X
must ensure that the credit they secure is legitimate under Regulation T or U.
A borrower is subject to Regulation X if it (1) is within the United States and causes credit to be granted
unlawfully without adhering to Regulation T or U or, (2) is considered a U.S. person (i.e., company incorporated
in the U.S., a citizen, or a U.S. resident) who’s outside the United States and acquires credit to purchase or
transfer U.S. securities, or (3) is a non-U.S. person who’s directed by, or acting on behalf of or with, a U.S.
person.
Opening a Margin Account

The member firm’s margin department has the responsibility for compliance with applicable rules and
regulations that pertain to credit extension (Regulation T of the Federal Reserve Board and FINRA rules).
The margin department keeps records of all customer accounts and ensures that payment is made in
accordance with Regulation T requirements. When a margin account is opened for a customer, the member
firm must send the customer a statement of the amount of interest that will be charged and the method by
which interest will be computed.

CHAPTER 15 – MARGIN SERIES 24
A broker-dealer that extends credit to a customer must disclose:

 Conditions under which interest charges will be imposed
 The annual rate or rates that may be imposed
 The method of computing interest
 Whether the rates are subject to change without prior notice as well as the specific condition under which they
may be changed
 The method of determining the debit balances on which interest will be charged and whether credit is given for
credit balances
A written statement must be sent at least quarterly to all customers to whom credit is extended. When a
customer opens a margin account with a broker-dealer, the customer is required to sign the margin
agreement. The margin agreement contains a number of conditions that the customer agrees will apply to
the account. If these terms and conditions are changed by the broker-dealer, it’s required to provide written
notice at least 30 days prior to the changes.
Margin Risk Disclosure Document

A Margin Disclosure Statement is provided to all non-institutional (retail) customers of a broker-dealer who
open margin accounts at the firm. The following points must be stated:
 The customer could lose more funds than the amount deposited in the margin account.
 The firm can force the sale of securities or other assets in the account(s).
 The firm can sell the securities or other assets without contacting the customer.
 The customer is not entitled to choose which securities or other assets in your account(s) are liquidated or sold
to meet a margin call.
 The firm can increase its house maintenance margin requirements at any time and is not required to provide
the customer with advance written notice.
 The customer is not entitled to an extension of time on a margin call.
Margin Disclosures A margin disclosure statement describes the risk to a customer when trading
securities on margin. There are two delivery requirements and both of them pertain only to non-institutional
(retail) customers—one for a new a margin account, while the second is related to an annual delivery
requirement. Prior to opening a new margin account, a broker-dealer must provide the customer, individually,
in paper or electronic form, and in a separate document (or contained by itself on a separate page as part of
another document), the margin disclosure statement. In addition, any member that permits non-institutional
customers either to open accounts online or to engage in online securities transactions must post the margin
disclosure statement on the member’s website in a clear and conspicuous manner. This disclosure may be
included as part of new account documentation as long as it’s contained on a separate page from the new
account form.
Hypothecation
SEC Rule 15c2-1 relates to the hypothecation of customers’ securities. Hypothecation is the process by which
a customer pledges securities in a margin account to the broker dealer. The rule considers certain practices to
be “fraudulent, deceptive or manipulative acts.”

Some of these prohibited practices include:

 Commingling of securities that are carried for the account of a customer with those of another customer
without obtaining the written consent of each customer
 Commingling the securities of a customer with those of any person who’s not a customer of the broker-dealer,
including securities owned by the broker-dealer
 Hypothecating customer securities for a sum that exceeds the total indebtedness of all customers
With permission, broker-dealers are allowed to use their customers’ securities as collateral for bank loans
under a process that’s termed rehypothecation. The broker-dealer must obtain the consent of each customer in
order to rehypothecate the stock of the customer at a bank in a single loan account.
Amount That May Be Rehypothecated SEC Rule 15c3-3—The Customer Protection Rule—permits
broker-dealers to use stock with a value of 140% of the customer’s debit balance as collateral for a bank loan.
The broker-dealer may borrow only the amount that it has loaned to the customer, but it may collateralize this
borrowing with stock valued at 140% of the debit balance. The following example clarifies this point:
With a Regulation T margin requirement of 50%, a customer buys stock with a total
cost of $10,000 and deposits $5,000 with the firm. The firm loans the customer $5,000.
The broker-dealer wishes to replace the $5,000 that it has loaned the customer by
borrowing from a bank. Using the customer’s stock as collateral for the loan, the
amount that it may borrow from the bank is $5,000. However, the bank will require
more than $5,000 of collateral to safeguard its loan of $5,000. The broker-dealer is
allowed to use stock worth 140% of the customer’s debit balance (in this case, $7,000)
and rehypothecate this stock as collateral for the loan. The remainder of the
customer’s shares ($3,000) are considered excess margin securities and they must be
segregated. Segregation means that the broker-dealer will set these shares aside and
not use them as collateral.
A broker-dealer cannot borrow more than it has loaned to its customer. The 140% rule applies to the amount
of stock that may be used as collateral, not the amount that may be borrowed. The example from above is
used to illustrate this point.
The $5,000 that the firm loans to the customer is considered the customer’s debit
balance. The broker-dealer is allowed to take stock with a value of 140% of the $5,000
debit balance to a bank to rehypothecate as collateral for the loan. Therefore, the
broker-dealer may use stock worth $7,000. Let’s assume, in this case, that the bank is
willing to provide a loan to the broker-dealer of 80% of the value of the collateral,
which is $5,600 ($7,000 x 80%). However, the broker-dealer cannot borrow this amount.
It’s allowed to borrow only the amount that it has loaned to the customer and is
therefore restricted to borrowing only $5,000.

Margin Process
Client Broker-Dealer Bank
Fund Fund
Securities Securities
Hypothecate Rehypothecate
A customer buys $10,000 of stock on margin

Cash the B/D Stock the B/D
Debit borrows from the bank pledges to the bank
$5,000 $5,000 $7,000
(100% of debit) (140% of debit)
Stock Loans If a broker-dealer intends to loan a customer’s stock to another broker-dealer, it may do so
only if the customer has signed a loan consent agreement. Although this is generally part of the margin
agreement, it requires a separate signature. Please note that a customer is NOT required to sign the loan
consent agreement in order to open a margin account; it’s optional. If the stock is fully paid, the customer is
required to sign a separate written consent, in addition to the signed loan consent in the margin agreement,
before the broker-dealer is able to lend the stock.
When stock is loaned from one broker-dealer to another, the lender has the right to recall the stock at any
time. The borrower is required to deposit the full market value of the stock at the time of the loan, not the
Regulation T requirement. Both the lender and the borrower may periodically mark the stock to the market if
either party is unsecured. The unsecured party will have the right to demand cash payment. The lender of the
stock retains all rights to the stock, except for the right to vote.
Short Sellers For short sellers, who borrows the shares? Traditionally, shares are loaned to short sellers
who are seeking to profit from the fall in a security’s price. Short sellers are required to execute trades in a
margin account since they’re borrowing shares and the position must be marked to market as would be the
case with traditional stock buyers who are employing margin. As to be demonstrated in this chapter, Reg T
requires both stock buyers and short sellers to put up an initial deposit of 50% of the trade. However, SRO
rules will differ regarding the treatment of long and short positions.
Regulation T (Reg T)
Regulation T governs the extension of credit by broker-dealers. The rules established under Reg T determine
which securities may be purchased on credit (margin) through a broker-dealer, when payment must be made,
and the amount of credit that may be extended. The provisions of Reg T do not apply to certain transactions if
they involve exempt securities (e.g., Treasuries) and certain exempt transactions (e.g., private placements).

A confusing aspect of the exam is the difference between Reg T payment requirements and transaction
settlement. Reg T applies to the timing of payments by customers, while settlement (which is governed by the
Uniform Practice Code) refers to payment and delivery by broker-dealers. For example, the regular way
settlement on a stock trade is two business days after the trade date (T + 2); however, under Regulation T,
customers must make payment by no later than two business days following regular-way settlement (i.e., S + 2 or
T + 4).
Marginable Securities Reg T allows the purchase of several types of securities on margin; however, the
main focus of this section will be on equity securities. Marginable equity securities include:
 Exchange-listed securities
 Nasdaq securities
Equities that are traded on the OTC Pink Market (OTC equities) are not marginable.
Other securities owned by a customer that may be used as collateral include U.S. Treasuries, municipal bonds,
corporate bonds (including convertibles), and mutual fund shares that have been held for more than 30 days.
Investment Company Securities Under Reg T, open-end investment company securities (e.g., mutual fund
shares and unit investment trusts) are marginable securities and may be used as collateral in a margin account.
However, the purchase of investment company securities is also subject to the Securities Exchange Act of 1934,
which prevents the extension of credit on a new issue by a participant in the distribution for 30 days. Therefore,
a mutual fund dealer cannot extend credit on the initial purchase of shares. However, once the shares have been
held for 30 days, they may be used as collateral for a loan in a margin account that’s carried by the broker-
dealer.
Payment Deadlines Regulation T requires the prompt payment for purchases that are made in cash and
margin accounts. In cash accounts, the full purchase price must be paid; however, in margin accounts, a
specified percentage of the purchase price (50%) is due. If the required amounts are not paid within two business
days following the settlement date (the Regulation T payment date), the broker-dealer is required to cancel the
transaction by selling out the securities, unless there’s a valid reason to apply for an extension.
In both cash and margin accounts, liquidation will occur on the day after the Reg T payment date or the third
business day following the settlement date. The broker-dealer is then required to freeze the account for
90 days. This means that, during the 90-day period, the customer must pay for all purchases in advance. After
the 90-day period, the customer is considered to have reestablished credit and may once again be extended
normal credit terms.
Remember, settlement refers to the timing of payment and delivery between member firms and is governed
under the Uniform Practice Code. The Reg T payment requirement refers to when customer payment is due.

Use the following chart to keep these two concepts clear.
Settlement versus Payment

Security/Transaction Settlement Payment Date
Corporate Securities in a Two business days Four business days
cash or margin account (T + 2) (T + 4 or S + 2)
Two business days Exempt from Reg. T
Municipal Securities
Next Business Day Exempt from Reg. T
U.S. Government Securities
Next Business Day Four business days
Option Trades
(T + 1) (T + 4)
Freeriding A member firm cannot allow a customer to make a purchase and then meet the payment
through a liquidation. This means that the customer cannot purchase a stock and then sell the same stock in
order to pay the purchase price. This prohibited practice is referred to as freeriding.
For trading purposes, buying customers may sell the securities that they purchase at any time after the trade
has been executed, regardless of whether they have paid for them yet. If a customer sells the securities prior to
the settlement date, but doesn’t withdraw the proceeds and pays for the original purchase by the Reg T
payment date, there’s no violation of Regulation T and the member firm is not required to freeze the account.
Freeriding only applies if a customer sells the securities and doesn’t pay for the purchase by the payment date.
In addition, the rules don’t apply to amounts of $1,000 or less. Broker-dealers are not required to collect funds
by the Reg T payment date if the amount owed is $1,000 or less.
Extensions Under exceptional circumstances, a member firm may apply for an extension of time for the
payment of the amount due. This applies in circumstances such as a delay in the mails, whereby the
customer’s payment could have been received on time except for the time that it takes for delivery of the
mail. However, the broker-dealer must apply for the extension prior to the Reg T deadline.
Long Accounts
Initial Margin
Regulation T sets the minimum amount of margin that a customer must deposit when establishing a position.
Initial margin is the percentage of the purchase price, including the commission, that the customer must
deposit with the broker-dealer. The demand for this initial deposit is often referred to as a Reg T call or a fed
call.
The balance of the total purchase price—referred to as the loan value—is the amount that the broker-dealer may
finance. Essentially, the loan value is the complement of the margin requirement. For example, if the margin
requirement is 60%, the loan value is 40%, or if the margin requirement is 50%, the loan value is 50%. The
customer is required to pay interest on this loan.

Although the FRB has the authority to change the initial margin requirement from time to time, it has been set at
50% since 1974. Therefore, on a $10,000 purchase, the broker-dealer will require a customer deposit of $5,000
and could loan the customer the balance of $5,000 to pay for the purchase.
Meeting a Call The Regulation T margin requirement of 50% is considered the initial requirement. After
the initial margin is deposited, Regulation T doesn’t require the investor to deposit additional money if the
price of the stock declines. Despite the fact that the FRB never requires the deposit of additional cash, the
broker-dealer has the right to require additional margin for its own protection. Also, keep in mind, FINRA
will require the deposit of additional margin (a maintenance margin call—described shortly) if the account
equity declines beyond certain levels.
When stock is purchased in a margin account, the customer is required to deposit equity. However, this
doesn’t necessarily mean that cash must be deposited. Instead, a customer may deposit stock that’s fully paid
and borrow against the stock.
For example, a customer who purchases $10,000 of stock on 50% margin will receive a
margin call for $5,000. If the customer doesn’t want to deposit cash in this situation, she
may instead deposit fully paid stock with a loan value that’s equal to the amount of the
call. To determine the amount of fully paid stock that must be deposited, divide the
margin call ($5,000) by the loan value (50%). Put another way, the customer must
deposit fully paid stock worth $10,000 to meet the Reg T call of $5,000.
Only marginable stock may be deposited to meet a Reg T call. Securities that have no loan value
(e.g., OTC Pink Market equities) cannot be purchased on margin or used as collateral.
Excess Equity and SMA

Excess equity refers to equity in a margin account that’s greater than the Reg T requirement multiplied by the
market value. For example, an account has a market value of $12,000 and a debit balance of $5,000. This
account has $7,000 of equity (EQ), which is found by subtracting the debit balance (DR) from the long
market value (LMV). For long accounts, the formula to remember is LMV – DR = EQ.
The Reg T requirement on $12,000 of stock is $6,000 ($12,000 x 50%). Since the customer’s equity of $7,000
which is $1,000 more than the Reg T requirement, there’s $1,000 of excess equity in this account.
Special Memorandum Account (SMA) The Special Memorandum Account is an accounting notation that
refers to the amount of cash that may be withdrawn as a loan from a margin account. SMA will reflect excess
equity that’s created by the appreciation of securities, but also cash dividends, the sale of securities, and
voluntary deposits of cash or fully paid, marginable securities by the account holder. SMA represents a line of
credit; it’s not free cash.
For example, the market value of an account is $30,000 and the debit balance is
$10,000. The Regulation T margin requirement is 50%. The required equity in the
account is $15,000 ($30,000 x 50%); however, the current equity in the account is
$20,000 ($30,000 market value – $10,000 debit balance). Since there’s $5,000 of
excess equity in the account, a $5,000 SMA entry is created.

In order to calculate equity and SMA, the margin department generally uses the closing prices of the
preceding day. In volatile markets, the price at the time of the computation may be used.
The usefulness of SMA becomes apparent when there’s a decline in excess equity. Although an increase in excess
equity can create an SMA entry, a decrease in excess equity doesn’t reduce the SMA.
Based on the preceding example, let’s assume that the market value of the stock declines
to $20,000. The debit balance (amount owed to the broker-dealer) will remain at
$10,000, but equity will decline to $10,000. Since this is equal to the current equity
requirement on the new market value ($20,000 x 50%), there’s no excess equity in the
account. However, the previously established SMA will remain at $5,000.
Restricted Account
If an account’s equity falls below 50%, it’s referred to as a restricted account. However, there’s no
requirement to deposit additional funds unless the account falls below SRO minimum maintenance equity
thresholds (described shortly). Also, additional purchases could be made as long as the customer deposits the
amount required by Regulation T on the new purchase. On the other hand, if a margin account is restricted
but shows an SMA balance, an additional loan may be taken up to the amount of the SMA as long as the
resulting account doesn’t violate the minimum maintenance requirement. Since Regulation T is an initial
requirement, a customer is not required to deposit additional cash to eliminate the restriction.
Sales in a Restricted Account In addition, a customer who sells stock in a restricted account is able to
withdraw 50% of the amount sold. The balance of the amount sold must be maintained in the account in
accordance with the retention requirement.
For example, let’s assume that a customer has a restricted margin account and no SMA. If the customer
sells $6,000 of securities from the account, he’s able to withdraw 50% of the sale amount ($3,000 in this
case) despite the fact that the account is restricted. The remainder of the sale proceeds is used to reduce to
the debit balance. If the customer sells stock from the account, but doesn’t immediately withdraw 50% of
sales proceeds, then 100% of the proceeds is used to reduce the debit balance and the SMA balance is
increased which may be withdrawn later. Keep in mind, the use of SMA is subject to compliance with the
maintenance requirements.
Buying Power If a customer has SMA in a margin account, it may be withdrawn as a loan or used to
purchase additional securities on margin. The additional amount of securities that may be purchased based on
the SMA is referred to as buying power. Buying power is the ability to buy securities on credit and is only
applicable in margin accounts. To determine the amount of buying power in an account, the SMA balance is
divided by the Regulation T requirement of 50%.
For example, a margin account appears as follows:
LMV – DEBIT = EQ
$30,000 $10,000 $20,000
SMA = $5,000

The buying power is the $5,000 SMA balance divided by the Regulation T requirement
of 50%, which is $10,000. Another way of expressing buying power is that it’s the SMA
balance x 2. This means that this customer could purchase an additional $10,000 of
stock on margin without depositing additional cash in the account.
Minimum Maintenance Requirement

Industry rules require customers to maintain a certain minimum equity in margin accounts after initial
requirements are met. If the equity drops below this point, the member firm will make a demand for
additional margin. This is referred to as a maintenance call or a margin call. Failure to meet a maintenance
call promptly will result in the liquidation of the customer’s position.
For a long account, the minimum maintenance requirement is 25%. This means that the equity must be at
least 25% of the current market value. For example, a customer has the following long margin account:
LMV – DEBIT = EQ
$25,000 $10,000 $15,000
The LMV of $25,000 multiplied by 25% equals a $6,250 minimum equity requirement. In this case, the
customer’s equity of $15,000 is well above the minimum equity level.
By contrast, consider the following account:
LMV – DEBIT = EQ
$20,000 $16,000 $4,000
The LMV of $20,000 multiplied by 25% equals a $5,000 minimum equity requirement. The actual equity is
only $4,000 (market value of $20,000 minus a debit balance of $16,000). In this case, the broker-dealer will
call for additional equity of $1,000.
To determine the point to which the market value can decline before a long account is at the 25% minimum
equity level, multiply the debit balance by 4/3. This applies regardless of the initial margin requirement.
For example, let’s assume the debit balance in a margin account is $6,000. Multiplying the
debit balance by 4/3 indicates that if the market value of the account declined below $8,000
($6,000 x 4/3), a call will need to be sent for additional margin. If the market value declines to
$8,000 and the debit balance is $6,000, the equity will be $2,000. This means that the equity
will be exactly 25% of the market value ($2,000 equity divided by $8,000 market value).
Special Maintenance Requirements on Leveraged ETFs Exchange-traded funds (ETFs) are securities
that resemble index mutual funds; however, their shares trade throughout the day. After their initial offering,
shares of ETFs are immediately eligible for purchase on margin. Some of these products are constructed to
employ leverage with performance that’s double or triple the underlying index. Due to this inherent leverage,
these products have special maintenance requirements in excess of the typical SRO thresholds of 25% on long
positions and 30% on short positions.

The margin requirement on both leveraged ETFs and inverse leveraged ETFs can be computed by multiplying
the portfolio leverage factor by the standard SRO maintenance requirement. For example, a double long
portfolio will have a requirement of 2 x 25% (SRO long maintenance), or 50%. A triple short portfolio will
have a requirement of 3 x 30% (SRO short maintenance), or 90%.
In-House Maintenance Margin Requirements A broker-dealer may have its own in-house maintenance
margin requirements that are greater than regulatory requirements. These maintenance requirements may be
increased at any time without advance written notice. The firm’s ability to increase in-house maintenance
margin requirements is typically disclosed in its margin disclosure statement. A broker-dealer is required to
provide 30-day advance written notice of changes to be made to the terms and conditions under which credit
charges (i.e., interest) will be made, excluding any changes required by law.
Guarantees The account of a customer may be guaranteed by another customer, but the agreement must be
in writing. This means that if a customer’s account becomes under-margined, the equity in the other account
may be used as collateral for the under-margined account.
Minimum Initial Equity Requirement

In addition to the minimum percentage equity requirement, there’s also a minimum dollar requirement on a
purchase in a margin account. The minimum initial margin deposit must be $2,000 unless the amount of the
purchase is less than $2,000, in which case the customer must deposit the full purchase price. A customer is
not required to deposit more than the full purchase price of the securities.
For example, in a new margin account, a customer purchases securities with a value
of $3,000 and the margin requirement is 50%. In this case, the customer is required to
deposit $2,000, rather than $1,500. However, if the customer’s initial purchase was
$1,800 worth of stock, an $1,800 deposit is required (full purchase price).
Once the initial equity requirement has been met, no maintenance call is required if the dollar amount of equity
subsequently drops below $2,000. The $2,000 minimum applies to purchases only and not price movements. If a
customer’s account had less than $2,000 equity and that customer wanted to make an additional purchase, the
equity in the account must be at least $2,000 before the broker-dealer will extend any additional credit.
Short Accounts
A short sale involves the sale of securities that are not owned. In order to effect delivery, the broker-dealer
that handles the account will borrow stock. The customer’s account will be credited with the sale proceeds in
addition to the required cash margin deposit. This cash total is referred to as the credit balance (CR). The
customer will eventually owe the broker-dealer the borrowed stock at its current market price. This is referred to
as the short market value (SMV). In order to determine the equity in a short account, subtract the current market
value of the stock from the credit balance. For short accounts, the formula to remember is CR – SMV = EQ.
For short sales, the initial margin is the same as it is for purchases. A short sale requires the deposit of 50%
margin. The broker-dealer will borrow stock and the customer, who must eventually replace the stock
borrowed, owes the broker-dealer the value of the stock. The customer’s equity will change with fluctuations
in the market value of the stock borrowed; however, the credit balance doesn’t change.

Minimum Maintenance Requirement

In a short account, the minimum maintenance requirement is typically 30% of the market value. For example, if
the market value of the stock that’s been sold short is $25,000, the minimum maintenance requirement is
$7,500 ($25,000 x 30%). To determine how high the market value of a stock can rise in a short account for
the account to be at the 30% maintenance level, the current credit balance is multiplied by 10/13.
For lower-priced securities in a short account, the minimum maintenance requirement may be something other
than 30% of the market value of the stock. The minimum maintenance requirements for a short account is:
 If the short stock position is valued at less than $2.50 per shares:
– $2.50 per share or 100% of the current market value, whichever is greater
 If the short stock position is value at $5.00 per share or above:
– $5.00 per share or 30% of the current market value, whichever is greater
Day-Trading Margin
Special rules apply to accounts of pattern day traders. A pattern day trader is any customer who day-trades four
or more times in a five-business-day period. Day trading is defined as the purchasing and selling (or the selling
and purchasing) of the same security on the same day in a margin account, except for:
a. A long position held overnight and sold the next day prior to any new purchase of the same security, or
b. A short position held overnight and purchased the next day prior to any new sale of the same security.
If a customer meets the definition of a pattern day trader, but the number of day trades is 6% or less of total
trades for the five-business-day period, the customer will not be considered a pattern day trader. On the other
hand, if a broker-dealer knows or has a reasonable basis to believe that a customer opening an account or
resuming day trading will engage in a pattern of day trading, the firm may immediately impose the special
day-trading margin requirements.
Minimum Equity Requirement Rather than the normal minimum requirement of $2,000, pattern day
traders have a minimum equity requirement of $25,000 and this amount must be maintained in their accounts
at all times. If a trader’s equity falls below $25,000 and doesn’t meet the day trading margin call, the trader is
restricted to trading on a cash-available basis for the next 90 days. During the 90-day period, closing
transactions are permitted.
Margin Calls Day-trading buying power is limited to four times the trader’s maintenance margin excess
(determined as of the close of the previous day). For example, if an account has a long market value of
$200,000 and a debit balance of $80,000, the excess margin maintenance is $70,000 (current equity of
$120,000 minus the minimum maintenance requirement of $50,000). Therefore, the day-trading buying
power is $280, 000 ($70,000 x 4).
If a day trader exceeds her buying power limitations, she must meet a day-trading margin call within five
business days. During the time the margin call is outstanding, the account is restricted to buying power of two
times maintenance margin excess.

If the margin call is not met by the fifth business day, trading in the account is restricted to a cash-available
basis for 90 days or until the call is met. Funds that are deposited to meet the minimum equity requirement or
a day-trading margin call must remain on deposit in the account for at least two business days.
Cross-Guarantees Prohibited Pattern day traders are not permitted to meet day-trading margin
requirements through the use of cross-guarantees. Instead, each day-trading account must meet the requirements
independently, based only on the resources in that account. This prohibits cross-guarantees not only between
accounts of different customers, but also between different accounts of the same customer.
Advertising Day-Trading Broker-dealers are permitted to advertise or promote the benefits of day trading
on their website. This advertisement is defined as a retail communication, is subject to principal approval and
filing with FINRA, and a copy must be retained for three years. The broker-dealer must deliver a special
written disclosure document to customers and must post the disclosure on its website in a clear and
conspicuous manner. If a customer opens an account at a firm that promotes a day-trading strategy, he’s
permitted to engage in other activities as long as he signs a written agreement that he doesn’t intend to use the
account for the purpose of engaging in a day-trading strategy.
Portfolio Margin
Strategy-Based Margin The calculation of traditional margin requirements is based on each portfolio
position individually. Long and short stock positions require a 50% Regulation T deposit, long options
positions require a 100% deposit of the premium, while an uncovered options writer’s deposit requirement
varies based on the degree to which the positions are in-the-money or out-of-the-money.
Portfolio-Based Margin Portfolio-based margin (as opposed to strategy-based margin) is a more accurate
way to evaluate risk since it’s based on the total portfolio of the client. This approach takes into consideration
both long and short positions that are held in a client’s account. For example, in a strategy-based margin
account, if a stock is purchased at $30 and hedged by the purchase of a put with a $25 strike price, these will
be evaluated as two separate strategies. The amount at risk (the maximum loss) is calculated for each strategy.
The client’s net margin requirement will not be based on the reduced loss potential of the hedged position. On
the other hand, portfolio margining takes this simple hedging concept one step further by evaluating the net
risk of all of the positions being held in a given account.
To clarify, portfolio margining is based on the assumption that combinations of positions established (e.g., stocks
and hedges, arbitrage pairings, long and short indices and futures) by an investor may have offsetting risk
characteristics. As a result, margin is calculated based on the net risks of the eligible instruments (listed
below) in a customer’s account. This is a more sophisticated way of gauging the client’s position based on the
overall level of risk in the account. It permits a better alignment of margin requirements based on the net risk of
the entire portfolio. For that reason, portfolio margining may be referred to as risk-based margining.
The benefit of portfolio margining is that it permits clients to use a greater amount of leverage for a given
amount of capital as long as the account is appropriately hedged. Traditionally, hedge funds have been some
of the most frequent users of the additional leverage that’s afforded portfolio margin customers.

The following products are eligible for portfolio margining:

 All margin equity securities  Unlisted derivatives
 Listed options  Warrants
 Security futures products  Index warrants and related instruments
Portfolio margining sets margin requirements for an account based on the greatest projected net loss of all
positions in a product class or group (two or more portfolios that are the same type), using an SEC-approved
computer modeling system to perform risk analysis and using multiple pricing scenarios. The scenarios are
designed to measure the theoretical loss of the positions, assuming changes in both the underlying price and
implied volatility of the model. Accordingly, the margin required is based on the greatest loss that can be
incurred in a portfolio if the value of its components move up or down by a predetermined amount. The
eligible products have different theoretical valuation ranges.
For example:
 Highly-capitalized broad-based indices use a potential market increase of 6% and a decrease of 8%.
 Non-highly capitalized broad-based indices use a potential market increase of 10% and a decrease of 10%.
 Equity options, narrow-based index options, and/or security futures use a potential market increase of 15% and
a downside of 15%.
The goal of portfolio margining is to reduce excess margin calls and to lower the risk of forced position
liquidations. The end result is that there will normally be a reduction in net margin requirements if positions
are hedged appropriately.
Eligible Participants Portfolio margin is not available to small retail clients. Instead, the following entities
are permitted to engage in portfolio margining:
1. Any broker or dealer that’s registered with the SEC under the Securities Exchange Act of 1934
2. Any member of a national futures exchange to the extent that listed index options, unlisted derivatives,
ETF options, index warrants or underlying instruments hedge the member’s index futures
3. Any person that’s approved to engage in uncovered option contracts. If a customer wants to trade
unlisted derivatives, the customer must maintain equity of at least $5 million at all times.
Prior to offering a portfolio margining methodology, a broker-dealer must develop a profile of customers that
will be eligible to use it. Additionally, the broker-dealer must put in place an approval process and implement
minimum equity requirements for customers that are eligible to use portfolio margining.
Risks of Portfolio Margining and Disclosure The benefit of portfolio margining is that clients typically have
lower margin requirements. Nevertheless, portfolio margining may expose them to unexpected risks, due to the
greater leverage being afforded. If an account falls below the minimum maintenance margin, all calls must be met
within three business days. According to FINRA, customers that use a portfolio margin account must receive a
disclosure statement and sign an acknowledgement form prior to their initial transaction. This statement must
describe the special risks associated with portfolio margin accounts, which include the following:
 Portfolio margining normally allows for greater leverage in an account, which may lead to larger losses in the
event of adverse market movements.
 Because the maximum time for meeting a margin deficiency is shorter than in a standard margin account, the
risk is greater that a customer’s portfolio margin account will be liquidated involuntarily.

Due to the extremely sophisticated mathematical calculations and theoretical values used in portfolio
margining, customers may not be able to predict the size of future margin deficiencies.
Advertising Portfolio Margin To offer portfolio margin accounts, broker-dealers must notify and receive
approval from FINRA and submit this approval to the SEC. If approval is received, broker-dealers are
permitted to advertise or promote the benefits of portfolio margin on their website. This advertisement is
considered a retail communication and is subject to principal approval and filing with FINRA. A copy of the
advertisement and approval must be retained by the firm for three years.
This concludes the Margin chapter. The final chapter will examine Financial Responsibility Rules.


Chapter 16
Financial Responsibility

CHAPTER 16 – FINANCIAL RESPONSIBILITY SERIES 24
Both the SEC and FINRA have created rules to help ensure that broker-dealers operate in a financially
responsible manner and have sufficient capital to support operations. These rules help protect those with
whom the broker-dealers do business, such as customers, creditors, and other broker-dealers. An
important point to keep in mind is that if a broker-dealer runs out of capital, there’s no chance for
reorganization; its doors are closed for that day. For this reason, firms must inform regulators when
they’re nearing minimum regulatory capital thresholds through various early warning procedures.
What’s Net Capital?

Capital is the funds with which a broker-dealer needs to conduct its business. The amount of capital needed is
based on both the size of the firm and the nature of its business. Before examining the net capital levels
required, let’s take a brief look at net capital (NC) computation.
Book Equity (+/- year-to-date results)

+ Satisfactory Subordinated Loans
= Total Capital
– Non-Allowable Assets
= Tentative Net Capital
– Haircuts (Reductions on Securities Positions)
= Net Capital
Each line of this calculation will be examined in greater detail throughout the chapter. For now, it’s enough to
understand that the net capital calculation is essentially a firm’s equity plus certain loans (generally made by
partners or other owners) minus certain assets that cannot be readily converted into cash (non-allowable assets),
which brings us to tentative net capital. From this number, a certain percentage of the firm’s securities positions
(haircuts) must be deducted since these positions may not be able to be sold for full value.
Computation of Net Capital

After calculating its aggregate indebtedness and determining its required net capital, a broker-dealer must compute
its actual net capital to determine if it’s at least the amount mandated by Rule 15c3-1. Net capital is computed by
starting with net worth (equity) and making certain deductions based on the liquidity of the broker-dealer’s assets.
Haircuts and Deductions

The standard haircut for common stock held in a broker-dealer’s inventory is 15%. The standard 15% haircut can
be considered an adjustment for average liquidity. If the broker-dealer owns securities that are more liquid than
average (e.g., Treasuries), the haircut is less than 15%. If the securities are less liquid than normal, the haircut is
larger than 15%. For example, an OTC stock with less than three market makers is considered to have a limited
market, and is subject to a 40% haircut. Special haircuts are also necessary if the broker-dealer has a position
that’s relatively large compared to its total inventory (a concentration). Open contractual commitments (e.g.,
underwriting commitments) require special deductions as well.

SERIES 24 CHAPTER 16 – FINANCIAL RESPONSIBILITY
Haircut When computing net capital, the market value of securities is reduced due to the possible illiquidity
in the event that large amounts are being sold at one time. This reduction in value for net capital computation
purposes is referred to as a haircut. A haircut is applied to the net long or short position in each category of
security held.
Undue Concentration Deduction If a broker-dealer’s inventory contains one security that accounts for a
significant percentage of the market value of its total inventory, this puts the firm at extra risk if that security
suddenly declines in value. Therefore, Rule 15c3-1 assesses an extra net capital charge (an undue concentration
deduction) if any long or short position is more than 10% of the broker-dealer’s net capital before the application
of haircuts (tentative net capital). The undue concentration rule requires an additional deduction on the amount in
excess of the 10% threshold. If the security falls under the general rule for haircuts, the percentage applied is
15%. Otherwise, the percentage is one-half the normal amount. However, the undue concentration rule only
applies to that portion of an equity position in excess of $10,000 or the market value of 500 shares, whichever is
greater. In the case of debt securities, it applies only to the value of the position in excess of $25,000.
For example, Peak Holdings Inc. is a broker-dealer with the following equity securities in its inventory:
 20,000 shares of MNO, Inc. at $15 per share = $300,000 value
 5,000 shares of XYZ and Co. at $8 per share = $40,000 value
 6,000 shares of ABC, Inc. at $20 per share = $120,000 value
Peak Holdings has a tentative net capital of $2,500,000. Please note that 10% of $2,500,000 is $250,000. Since
Peak’s shares of MNO, Inc. are valued at $300,000, they create an undue concentration.
Asset: Reduction:
Cash 0%
Common stock with a ready market 15%
Limited market stock (e.g., OTCBB)

40%
 Fewer than three market makers
Assets not readily convertible into cash (e.g., furniture and fixtures) 100%
Restricted stock (private placements) 100%
Fail to Deliver A fail to deliver occurs when a broker-dealer has sold stock to a counterparty, but has not
delivered the stock by the settlement date. The fail to deliver is an asset (an account receivable) since the firm
will be paid the contract price once delivery is made. Initially, a fail to deliver is treated as a good receivable,
that is, no deduction is required. However, after three business days (following the original settlement date)
have passed, the fail to deliver is considered aged and a haircut is required.
The broker-dealer is required to treat the aged fail to deliver as stock that’s in its trading account, which
typically means a 15% haircut. The haircut is applied to the current market value of the stock, and an additional
adjustment is made for any unrealized profit or loss on the stock.

Subordination Agreements
These are loans for which the lender has agreed to accept a lower payment priority than other creditors. There
are two types of subordination agreements—a subordinated loan agreement and a secured demand note. In a
subordinated loan agreement, the broker-dealer borrows cash from an investor and the interest rate and other
terms of the loan are preset. On the other hand, a secured demand note agreement is a promissory note in
which the investor agrees to provide funds/cash during the terms of the note. The investor provides securities
as collateral.. If the loan includes securities that are subject to a special haircut (e.g., OTC stock with less than
three market makers), the securities will typically be subject to the same haircut that applies to securities which
are owned by the broker-dealer. However, securities that are typically subject to a 15% haircut (e.g., common
stock) are subject to a deduction of 30% when used to back a secured demand note.
Normally, obtaining a loan doesn’t increase a broker-dealer’s net capital since liabilities (the loan) and
assets (cash) increase by the same amount, thereby leaving net worth and net capital unaffected. If the loan
meets certain conditions, Rule 15c3-1 permits the broker-dealer to ignore the liability that’s created by the
loan when calculating its net capital. This has the effect of increasing the firm’s net capital by the amount of
the loan. Loans that meet the specified conditions are referred to as satisfactory subordination agreements.
In order to be satisfactory for net capital, the subordination agreement must meet the following conditions:
 The agreement must be in writing, it must indicate the duration of the loan, it must be for a specific amount, and
it must acknowledge that the proceeds of the loan will be used in the conduct of the broker-dealer’s business
and be subject to the risks of the business.
 The lender must agree to subordinate its claim for repayment to the claims of all other creditors.
 The loan must have a minimum duration of one year.
 The subordination agreement must be filed with the SEC at least 10 days prior to its effective date and with the
broker-dealer’s examining authority at least 30 days prior to its effective date.
If a subordinated loan is made for a period longer than one year, a provision for prepayment may be written
into the agreement, but no prepayments may be made during the first year of the loan. Under certain
circumstances, prepayments could not be made even after the first year. This is the case if the net capital of the
broker-dealer is below certain minimum amounts. Prepayment is not permitted if it causes the broker-dealer’s
ratio of aggregate indebtedness-to-net capital to exceed 10-to-1, or the firm’s net capital to fall below 120% of
the minimum dollar amount required.
Temporary Subordination Agreements As noted previously, a subordinated loan must typically have a
minimum duration of one year. However, there’s an exception for a member firm that enters into a temporary
subordination agreement (generally for underwriting purposes only). The broker-dealer is limited to no more
than three such agreements in any 12-month period and the duration of a temporary subordination agreement
may not exceed 45 days.
Minimum Dollar Requirement Brokerage firms come in all shapes and sizes and the net capital
requirements for each type differ. The minimum amount of net capital required depends on the nature and size
of the firm’s business. As described in Chapter 14, larger firms that handle their own clearing operations (i.e.,
trade processing and associated paperwork) are referred to as full-service or general securities firms. The
smaller firms that hand off this clearing function to a larger entity are referred to as introducing firms.

As explained in the chart that follows, introducing firms that don’t take in customer funds or securities need
minimum net capital of $5,000, while those that accept these items must maintain at least $50,000. Many
clearing firms currently offer a variety of services—referred to as prime brokerage—to large institutional
accounts. These prime brokers must have net capital of at least $1.5 million.
The following chart will be referred to consistently throughout the chapter:
Type of Broker-Dealer Minimum Dollar Amount of Net Capital

Carrying Firm – Carries customer accounts and receives or holds
$250,000
funds and securities (general securities firm)
Carrying Firm – Carries customer accounts; receives (but doesn’t

$100,000
hold) customer funds or securities
Prime Broker – Performs centralized clearing and account

maintenance functions for customers who execute transactions $1,500,000
through several other broker-dealers (executing brokers)
A Qualified Block Positioner or a Broker-Dealer that’s an

$1,000,000
Executing Firm in a Prime Brokerage Agreement
Firm-Commitment-Underwriter $100,000
Market Maker – Acts as a dealer; (firm that executes more than

$100,000
10 transactions per year for its own investment account)
Introducing Firm – Introduce accounts on a fully disclosed basis

$5,000
to another firm and doesn’t receive customer funds or securities
Introducing Firm – Dealer that receives customer securities for

$50,000
immediate delivery to a clearing firm
Mutual Fund Firm – Engages solely in the sale of redeemable

shares of investment company securities (mutual funds) and
$5,000
operates on a subscription basis (doesn’t accept customer funds;
instead, customer checks are made out to the distributor)
M&A Firm and DPP Firm – A broker-dealer whose activities

involve mergers and acquisitions, as well as one that does $5,000
business only in direct participation programs
Limitations on Introducing Firms As stated previously, an introducing broker-dealer that receives customer
securities is subject to a $50,000 minimum net capital requirement. Such firms engage in mutual fund sales, best-
efforts or all-or-none underwritings (but not firm-commitments), and make occasional transactions for their own
accounts. An introducing broker-dealer may receive, but not hold, securities or funds from customers if it
forwards them promptly to its clearing firm. Introducing firms that don’t receive customer securities are
subject to a $5,000 minimum net capital requirement. If the broker-dealer receives a customer check that’s
made out to a third party, the firm is not considered to be carrying customer funds if it promptly transmits the
check to the third party. The term “promptly” is defined as no later than noon of the following business day.

With regard to new issues, a $5,000 or $50,000 introducing broker-dealer may only engage in a best-efforts or
all-or-none underwriting since these types of deals don’t expose the member to capital risk. The introducing
firm may only accept checks that are made payable to the issuer, and must forward the checks to the issuer
promptly. In order to participate in a firm-commitment underwriting or to make markets in securities, a firm
needs at least $100,000 of net capital, which will permit it to act as a dealer.
Market Makers Remember, firms are required to have a minimum of $100,000 net capital to make markets.
There’s an additional requirement to maintain a minimum dollar amount of net capital for each stock in which
it makes a market. The net capital requirement is $2,500 for each stock that’s selling above $5.00 per share,
and $1,000 for each stock that’s selling for $5.00 per share or less. However, the total requirement cannot
exceed $1 million for market making.
Qualified Block Positioner The term block positioner refers to a firm that buys and sells a large quantity
of an equity security by committing its own capital. The firm must be a registered broker-dealer, must be
subject to, and in compliance with, SEC Rule 15c3-1 (the net capital rule), and must maintain minimum net
capital of $1 million. Under this rule, a “block” is defined as a single transaction with a current market value
of $200,000 or more. A firm is not required to be a registered market maker in a security to be defined as a
qualified block positioner.
Regulation SHO exempts both market makers and qualified block positioners from the locate requirements
when executing a short sale.
Aggregate Indebtedness (AI)

In addition to the minimum net capital thresholds described previously, broker-dealers are subject to
additional capital requirements based on aggregate indebtedness. In general, aggregate indebtedness
includes liabilities that are not secured by a specific asset of the broker-dealer. Liabilities that are secured
by a broker-dealer’s assets are usually excluded from AI. For example, if a broker-dealer obtains a loan
from a bank that’s secured by securities it owns, the loan is not part of its aggregate indebtedness. However,
if the broker-dealer borrows funds from a bank using customer stock as collateral (e.g., stock in margin
accounts), this liability is included.
Some of the other liabilities that are included in aggregate indebtedness are:
 Customer credit balances, which represent money owed to customers and available to them on demand
 Accounts payable, such as bills owed to vendors in the ordinary course of business

The following chart summarizes some of the items that are and are not AI:
Included in Aggregate Indebtedness NOT Included in Aggregate Indebtedness

 Fails to receive for the account of customers
 Fails to receive for the account of the firm
 Fails to receive for the account of the firm, resold
 Loans collateralized by customer securities  Loans collateralized by firm securities

 Securities loaned for the accounts of customers  Securities loaned for the account of the firm
 Customer credit balances  Trading account of the firm - sold to customers
 Accounts payable (short trading account)
 Taxes payable  Short security difference over 30 days old
 Subordinated loans
 Fixed liabilities adequately secured by assets used
in the BD’s business
 Liabilities on open contractual commitments
(A few additional entries will be included later in the chapter.)
A broker-dealer may reduce its AI by the amount that’s on deposit in the Special Reserve Bank Account in
compliance with SEC Rule 15c3-3 (described later). For example, if a firm has deposited $50,000 in this
account to satisfy its reserve requirement, this amount is subtracted when calculating aggregate indebtedness.
However, if the firm has more funds in the account than necessary under Rule 15c3-3, it may only subtract the
amount that’s required to be in the account.
One of the most important financial responsibility regulations is SEC Rule 15c3-1 — the Net Capital Rule. This
rule prevents a broker-dealer from becoming overleveraged by requiring a specific aggregate indebtedness-to-
net capital ratio (AI/NC). A broker-dealer may not continue in business if this ratio becomes too large.
A broker-dealer’s AI/NC ratio is calculated from a trial balance. The trial balance is a listing of all accounts in
a firm’s general ledger, divided into two groups—debits and credits. From the trial balance, the broker-dealer
can construct its income statement, balance sheet, and other financial statements, as well as its net capital. The
trial balance must be prepared monthly.
In calculating the AI/NC ratio, not all debts or liabilities are included—only those that fit the definition of
aggregate indebtedness. Likewise, not all of a broker-dealer’s equity or net worth is counted. Only liquid net
worth is considered.
AI-to-Net Capital Ratio In general, a broker-dealer’s net capital (NC) must be at least 1/15 of its
aggregate indebtedness. Or, put another way, the ratio of aggregate indebtedness to net capital cannot exceed
15-to-1 (AI/NC < [less than or equal to] 15-to-1). For example, if a broker-dealer has aggregate indebtedness
of $1.2 million, it must have net capital of at least $80,000 ($1,200,000 x 1/15 = $80,000).
First-Year Requirement Broker-dealers that are in their first year of operation must meet a more stringent net
capital requirement of 1/8 of aggregate indebtedness. For example, if a broker-dealer in its first year of
operation has AI of $1.2 million, it must have net capital of at least $150,000 ($1,200,000 x 1/8 = $150,000). If this
broker-dealer was carrying accounts and/or receiving and holding funds, the minimum would be $250,000.

Firms Must Meet the Greatest Requirement A broker-dealer must maintain the larger of the minimum dollar
requirement or the 1/15 of AI requirement. For example, if a general securities firm carries customer accounts,
receives and holds funds, and has AI of $1.2 million, it must have at least $80,000 of net capital in order for its
AI/NC ratio to be less than or equal to 15-to-1. However, the dollar minimum for such firms is $250,000,
which takes priority since it’s the larger requirement. On the other hand, if the firm is an introducing broker-
dealer that receives customer securities for transmittal to its clearing firm, the dollar minimum of $50,000 is
less than the $80,000 AI/NC ratio requirement, and therefore the $80,000 requirement takes precedence.
Alternative Net Capital Requirement Larger broker-dealers may elect to be governed by an alternative net
capital requirement. This requirement is based on the aggregate debit items computed under Rule 15c3-3
(described later), rather than on the basis of aggregate indebtedness. With this approach, a broker-dealer is
required to maintain net capital of $250,000 or 2% of the aggregate debit items, whichever is greater.
Summary of Net Capital Requirements Broker-dealers must meet the greatest of the three basic net
capital requirements listed below:
1. Net capital of at least 1/15 of AI (1/8 of AI in the first year of operation)
2. The minimum dollar requirement, depending on the type of business
3. The market-maker requirement, depending on the number of stocks in which markets are made
Debt-to-Equity Requirement
In addition to the minimum dollar amounts of net capital required and the limitation on the AI/NC ratio, a
broker-dealer’s equity must be at least 30% of its debt-equity total. A broker-dealer’s debt-equity total is equal
to its net worth plus the amount of its satisfactory subordination agreements. This requirement prevents a
broker-dealer from deriving too much of its net capital from subordinated loans or secured demand notes. If
the equity falls below 30% and remains below 30% for a period exceeding 90 days, the broker-dealer will be in
violation of the net capital rule.
For example, a broker-dealer has equity of $400,000 and a subordinated loan of $600,000.
Its equity is 40% of the debt-equity total. In this case, there’s no violation of the net
capital rule. The broker-dealer then suffers losses on its securities positions and its equity
drops to $200,000. Now, its total debt and equity is $800,000, of which equity is only
25%. In this case, the broker-dealer must raise its equity to 30% of the total within 90
days. Failure to increase its equity (or reduce its subordinated loan) to the point at which
its equity is at least 30% of the total is a violation of the net capital rule.
A satisfactory subordinated loan is always part of a broker-dealer’s net capital. In certain circumstances, a
subordinated loan may also be considered part of a broker-dealer’s equity for purposes of the debt-equity rule.
This means that the loan will qualify as part of the 30% minimum equity that the firm must maintain. For
purposes of this rule, in order for a subordinated loan to be treated as equity:
 The lender must be a partner or stockholder
 The loan must have had an initial term of at least three years and must have at least 12 months remaining before
it’s due
 The loan may not have any provisions for accelerated maturity (i.e., provisions that allow the lender to call in
the loan early under certain conditions)

To ensure compliance with both net capital thresholds and operational rules, the SEC’s Rule 17a-5 requires
broker-dealers to file certain financial reports with the SEC monthly and quarterly (FOCUS Reports). They
must also file comprehensive annual reports. An oath or affirmation must be attached to these reports which
states that the information contained therein is true and correct. The oath or affirmation must be made by a
general partner or a duly authorized officer.
FOCUS Reports For broker-dealers that clear transactions and carry customer accounts, the FOCUS Report
Part I must be filed monthly, within 10 business days of the end of the month. FOCUS Report Part II must be
filed quarterly, within 17 business days of the end of the calendar quarter. Broker-dealers that don’t clear
transactions or carry customer accounts must file only FOCUS Report Part IIA quarterly.
FOCUS Reports
Carrying Broker-Dealer
FOCUS Part I Monthly (within 10 business days of month-end)
FOCUS Part II Quarterly (within 17 business days of the end of the quarter)
Non-Carrying Broker-Dealer
FOCUS Part I Not required
FOCUS Part IIA Quarterly (within 17 business days of the end of the quarter)
Annual Report In addition to the monthly and quarterly reports, the broker-dealer must submit an annual
report of financial condition. Each report must be certified by an independent public accountant. Reports must
be filed as of the same, fixed, or determinable date each year unless otherwise approved by the broker-dealer’s
designated examining authority (DEA). (FINRA is typically a firm’s DEA.) Moreover, notification must be
sent to the SEC if a broker-dealer changes its fiscal year.
The annual report must be conducted by an independent public accountant. The broker-dealer is required to file
a report with the SEC when the public accountant is retained. Also, a report must be filed with the SEC if the
services of the accountant are terminated. A broker-dealer is required to notify the SEC if a new independent
auditor is hired or if there’s a dispute between the auditor and member firm regarding the preparation and
maintenance of records.
The annual report must contain a statement of financial condition, statement of income or loss, statement of
changes in financial position, statement of changes in stockholders’ equity, or partners’ or sole proprietors’ net
capital, and statement of changes in liabilities subordinated to claims of general creditors. Supporting
schedules must be included. Among these schedules are the computation of net capital and the computation of
the reserve requirement. The broker-dealer must file a supplemental report stating the opinion of the
independent public accountant regarding the broker-dealer’s membership status in the Securities Investor
Protection Corporation (SIPC).
The annual report must be filed by no later than 60 days after the date of the financial statements. If the broker-
dealer is unable to file its annual report on time, an extension may be requested from its DEA (i.e., the SRO that
examines the broker-dealer for compliance with financial responsibility rules).

The annual report must be filed with the SEC in Washington, D.C. with the SEC regional office where the
broker-dealer has its principal place of business, and with each national securities exchange and each national
securities association of which the broker-dealer is a member. An unaudited statement of financial condition
must be filed and dated six months from the date of the audited statement.
Statements to Customers Broker-dealers that hold client funds or securities are considered to have customers.
Audited annual statements must be sent to customers within 105 days after the broker-dealer files the annual
report with the SEC. The statement must contain a balance sheet that includes the amount of the broker-dealer’s
net capital and its required net capital. (Balance sheets must also be sent at the request of a customer.) If the
auditor commented on any material inadequacies during the audit, a statement must indicate that the audited
report is available for inspection at the SEC in Washington, D.C., or at the regional office where the broker-dealer
has its principal place of business. Another SRO rule requires a broker-dealer, upon request, to provide its most
recent statement of financial condition (balance sheet) to any other broker-dealer if that firm has an open
position or cash or securities at the other member firm.
Net Capital Violations and Early Warning Procedures

SEC Rule 17a-11 In addition to filing the regular financial reports just described, broker-dealers must file
special notices with the regulators under Rule 17a-11 if an unusual financial or operational event occurs. This
is referred to as supplemental reporting.
Net Capital Violation If a broker-dealer’s net capital falls below the minimum requirements of Rule 15c3-1,
it must file a notice on the day on which the violation occurs. The notice must state the broker-dealer’s net
capital and its net capital requirement. The same reporting requirement applies if the outstanding amount of
subordinated debt exceeds 70% of the debt-equity total for a period exceeding 90 days.
As with all filings under Rule 17a-11, a notice of a net capital deficiency must be filed with the SEC’s
Washington, D.C. office, with the SEC regional office where the broker-dealer has its principal place of
business, and with the broker-dealer’s DEA. Notices may be filed by telegram or facsimile.
A broker-dealer must also file a notice of net capital deficiency if it’s informed by its DEA or the SEC that its
net capital is below the amount required. This notice must be filed even if the broker-dealer disagrees with the
regulator. However, it may include the basis for its disagreement.
For example, a member firm has net capital of $60,000 and aggregate indebtedness
of $960,000. In this case, the ratio of aggregate indebtedness to net capital is 16-to-1
($960,000 divided by $60,000). Since the ratio exceeds the maximum of 15-to-1, the
broker-dealer is in violation of the Net Capital Rule and must send an immediate
telegraphic or facsimile notice to its DEA and the SEC.
A broker-dealer cannot continue to do business with less than the required amount of net capital.
Early Warning Notice Under certain circumstances, broker-dealers must also file Early Warning notices,
even when there’s no net capital violation. If a broker-dealer has a ratio of aggregate indebtedness-to-net
capital exceeding 12-to-1, or if the dollar amount of net capital is less than 120% of its minimum net capital
requirement, it must notify the SEC and its DEA within 24 hours.

The following examples will help clarify the notice requirements of this rule:
Example A A member firm has net capital of $60,000 and aggregate indebtedness of
$750,000. The firm’s ratio of aggregate indebtedness to net capital is 12.5-to-1. Although
there’s no violation of Rule 15c3-1, since its aggregate indebtedness exceeds its net capital
by more than 12-to-1, the broker-dealer must file an Early Warning notice within 24 hours.
Example B A clearing broker-dealer conducting a general securities business has net
capital of $290,000 and aggregate indebtedness of $2.5 million. The ratio of aggregate
indebtedness to net capital is 8.6-to-1, which is satisfactory. However, the broker-dealer has a
minimum net capital requirement of $250,000, since that dollar minimum is greater than
1/15 of its AI (1/15 x $2,500,000 = $166,667). The calculation of 120% times its minimum
net capital of $250,000 is $300,000. Since the firm actually has only $290,000 of net capital,
it must file an Early Warning notice with its DEA and the SEC within 24 hours.
Non-Current Books and Records If a broker-dealer fails to maintain books and records as required by SEC
Rule 17a-3, it must give notice to the SEC and its DEA on the day of the failure. The broker-dealer must file a
report within 48 hours detailing the steps that are being taken to correct the situation. This report must be
transmitted by overnight delivery.
Material Inadequacies If a broker-dealer discovers or is notified by an independent public accountant of the

existence of any material inadequacy in the broker-dealer’s accounting system, internal accounting controls, or
procedures for safeguarding securities, the chief financial officer of the broker-dealer must send telegraphic or
facsimile notice to the SEC within 24 hours and must file a report within 48 hours stating the steps being taken to
correct the situation. The broker-dealer’s designated examining authority must also be notified.
Members Experiencing Financial and/or Operational Difficulties If FINRA determines that a member
that carries customer accounts is experiencing financial and/or operational deficiencies, it must take action.
Action that can be taken by FINRA may be in the form of restrictions or a reduction in business. FINRA considers
the following situations as reasons to take action against a broker-dealer:
 There has been a reduction in excess net capital by 25% in the preceding two months or 30% or more in the
preceding three months prior to a computation.
 The broker-dealer is not in compliance with Customer Protection rules or cannot show that it is.
 The broker-dealer is unable to clear and settle transactions in a timely manner.
 Books and records have not been maintained under SEC regulations.
 The broker-dealer is not in compliance with net capital requirements or cannot show that it is.
 The firm has experienced a substantial change in the manner in which it processes its business, which may
increase the potential risk of loss to customers
If a broker-dealer is found to be experiencing financial or operational difficulties, FINRA may require that the
broker-dealer take one or more of the following actions until the regulator determines that the actions are no
longer necessary:
 Return all free-credit balances to customers promptly
 Deliver all fully paid customer securities to account holders
 Decrease or change the holdings in its inventory
 Close existing branch offices or delay the opening of new offices

 Not open new customer accounts

 Restrict the payment of salaries to officers, partners, directors, shareholders, or other associated personnel
 Arrange for an audit by an independent public accountant
 Discontinue all unsecured loans and collect all where feasible
 Accept unsolicited customer orders only
 Effect liquidating transactions only
 File special financial operating reports
FINRA may require the firm take any action that it deems appropriate to protect the public or itself.
The following chart summarizes a firm’s reporting requirements:
Supplemental Reporting (17a-11)

What problem? Report when?
 N.C. is below minimum dollar amount
Net Capital Send immediate notice on the day the
 Outstanding subordinated debt exceeds 70% of
Violation deficiency occurs
debt-equity total for a period exceeding 90 days
 N.C. is below 120% of minimum dollar amount
Early Warning Send notice within 24 hours
 A.1 to N.C. ratio is greater than 12.1
Send immediate notice on the day of
Non-Current Books Fails to maintain books and records as required by
discovery and follow with corrective
and Records SEC rules
action plan within 48 hours
Material BD discovers or is notified by independent certified Send notice within 24 hours and follow
Inadequacies accountant, of inadequacies in systems with corrective action plan within 48 hours
All reports are sent to the SEC’s Washington, D.C. office, the SEC’s regional office, and the firm’s DEA.
Beyond Capital: Safekeeping Customer Funds and Securities

Several SEC rules are designed to protect customer funds and securities that are in the possession of broker-dealers.
The Customer Protection Rule

SEC Rule 15c3-3 (the Customer Protection Rule) contains provisions to ensure the safekeeping of both
customer securities and customer funds. The rule defines a customer as any person for whom the broker-dealer
holds funds or securities, but this doesn’t include another broker-dealer, a partner, officer, or director of the
broker-dealer, or a subordinated lender.
Customer Securities A broker-dealer is required to promptly obtain and thereafter maintain physical
possession or control of all fully paid and excess margin securities that belong to its customers. The term
control of securities means that the securities are under the direct control of the broker-dealer. The rule defines
a number of sites as good control locations, including the office of the broker-dealer, in transit between its
offices, or in an SEC-approved depository.

Excess margin securities are defined as those securities whose value exceeds 140% of the debit balance of a
customer. For example, if a customer owns stock worth $10,000 and has a debit balance of $5,000, he will
have excess margin securities worth $3,000 ($10,000 – [140% x $5,000]).
A broker-dealer is required to compute daily, as of the close of the preceding business day, the quantity of
fully paid and excess margin securities that are in its possession or control and those that are not in its
possession or control. The broker-dealer is also required to take affirmative action to obtain promptly
possession and control of the required amount of securities. If a customer sells securities and fails to deliver
the securities within 10 business days of the settlement date, the broker-dealer must buy in the customer.
Under exceptional circumstances, the broker-dealer may apply to FINRA for an extension.
Customer Funds Broker-dealers are required to maintain a Special Reserve Bank Account for the Exclusive
Benefit of Customers at a bank. The Reserve Bank Account must contain cash or qualified securities (issued or
guaranteed by the U.S. government) that are set aside for the benefit of customers. This account must be
separate from other bank accounts of the broker-dealer and must be maintained solely as a reserve account for
the protection of customers. The amounts on deposit in the Reserve Bank Account cannot be used by the
broker-dealer for any purpose.
The amount that must be on deposit is the difference between customer-related credits and debits. Customer
credits represent monies the firm owes to or on behalf of customers, while customer debits represent monies
clients owe to the broker-dealer. For example, if credit items total $300,000 and debit items total $250,000, the
difference of $50,000 must be deposited in the Reserve Bank Account.
Timing of the Deposit Computations must be made weekly, as of the close of the last business day of the
week, to determine the amount of cash or qualified securities that must be on deposit. The required deposit
must be made by no later than one hour after the opening of banking business on the second business day
following the determination.
Under certain circumstances, broker-dealers are allowed to make the computation monthly. In this case, the
broker-dealer must maintain a deposit equal to at least 105% of the amount otherwise required. This method is
only available to broker-dealers whose ratio of aggregate indebtedness-to-net capital doesn’t exceed 8 to 1 and
that don’t carry customer free credits exceeding $1,000,000.
For example, if total credits are $500,000 and total debits are $400,000, $100,000
must be on deposit under the weekly deposit method. Under the monthly computation,
$105,000 must be on deposit.
If a broker-dealer fails to make the required deposit in the Reserve Bank Account
within one hour after the opening of banking business on the second day following the
computation, it must notify the SEC by telegram immediately, and must follow up the
telegram by notification in writing. Notice must also be sent to the broker-dealer’s
designated examining authority.
If the computation indicates that there’s excess cash or qualified securities on deposit, the broker-dealer may
withdraw the excess. However, the broker-dealer must maintain a record of the computation that was the basis
for the withdrawal.

Notice The broker-dealer must obtain written notification from the bank that the Reserve Bank Account is
for the exclusive benefit of customers of the broker-dealer and that the cash and qualified securities cannot be
used as collateral for a loan to the broker-dealer and is not subject to any charge, lien, or claim of any kind by
the bank or any other person.
Exemptions Certain broker-dealers are exempted from the Customer Protection Rule. The exemptions apply
to broker-dealers that restrict their activities to the sale of mutual funds and that promptly transmit all funds and
deliver all securities when received [k(1) firms ]. Broker-dealers that clear their trades through another firm on
a fully disclosed basis are not covered by the rule [k(2)(ii) firms]. Also exempt are firms that don’t carry
margin accounts, promptly transmit all customer funds and deliver all securities, don’t otherwise hold funds or
securities for, or owe money or securities to, customers, and effect all financial transactions for customers
through one or more bank accounts maintained exclusively for this purpose [k(2)(i) firms].
If a broker-dealer that’s exempt under the rule intends to engage in any transactions that will change the broker-
dealer to a non-exempt status, the broker-dealer must first obtain written approval of FINRA prior to making
the change. FINRA will base its approval for the change in status on such factors as the experience and
qualifications of the broker-dealer, the broker-dealer’s procedures for safeguarding customer funds and
securities, and the broker-dealer’s financial and operational condition. A broker-dealer must also obtain
permission to change its exemption from k(1) or k(2)(ii) to k(2)(i).
Customer Free Credit Balances

SEC Rule 15c3-3 requires a broker-dealer to advise its customers regarding their free credit balances on at
least a quarterly basis. Customers must receive written notice of the amount due to them along with a statement
that the funds are payable to them upon demand. The notice is also required to state that the funds are not
segregated and may be used in the conduct of the broker-dealer’s business. If the broker-dealer sends
statements to its customers more frequently than quarterly, notification of the free credit balances must be sent
with each statement. A broker-dealer is not required to comply with these provisions if it segregates customer
free credit balances in such a way as to preclude their use by the broker-dealer.
Securities Investor Protection Act

The Securities Investor Protection Act (SIPA) establishes procedures for the protection of customers’ funds and
securities in the event a broker-dealer becomes insolvent. Broker-dealers that use the mails or other
instruments of interstate commerce are required to be members of the Securities Investor Protection Corporation
(SIPC). Details of coverage were described previously in Chapter 13.
Securities Counts
SEC Rule 17a-13 requires a broker-dealer to make a physical examination and count of all securities in its
possession including securities that are subject to repurchase agreements, at least once in each calendar
quarter. The broker-dealer must account for all securities in transfer, securities in transit, securities pledged or
loaned, and securities failed to receive, failed to deliver, or otherwise subject to the broker-dealer’s control
but not in its possession. The broker-dealer must verify the status of all securities subject to its control but not
in its physical possession, such as securities in transfer or in transit, where this situation has existed for more
than 30 days. Broker-dealers that engage solely in the sale of redeemable shares of investment companies and
that promptly transmit all funds to the investment company are exempt from the provisions of the rule.

The broker-dealer must record on its books and records all security differences that are unresolved by no later
than seven business days after the security count. Security counts must be made at intervals that are not less than
two months apart or more than four months apart. For example, if a broker-dealer made a count on August 15,
its next count could not begin before October 15 or after December 15. The examination and count must be made
or supervised by persons whose regular duties don’t require them to have direct responsibility for the care and
protection of securities or related records. A count that’s made by a person who’s responsible for handling
securities must be supervised by a person who doesn’t handle securities.
Securities Differences A securities difference is a discrepancy between the amount of securities

recorded on a broker-dealer’s books and the amount actually counted during a periodic audit. If the amount
counted by the broker-dealer is less than the amount on its books, there’s a short securities difference. If the
amount counted is greater than the amount recorded on its books, there’s a long securities difference. To
resolve a securities difference, the broker-dealer must check the stock record, which reflects the amount and
location of stock to be certain that there are no errors in the entries. The firm must also check the receive-
and-deliver blotter and delivery tickets that are maintained by the cashier’s department, since this is where
securities are received by the broker-dealer.
A short securities difference is subject to a partial net capital deduction after seven business days. If it has not
been resolved within 28 business days, the full net capital charge must be taken. Long securities differences
involving securities that have not been resold will have no effect on net capital. Ultimately, they’re neither
deducted from nor added to net capital.
Number of Business Days Amount of Short Difference

after Discovery Deducted from Net Capital
7 25%
14 50%
21 75%
28 100%
Securities Information Center

SEC Rule 17f-1 deals with missing, lost, counterfeit, or stolen securities. The Securities Information Center
(SIC) acts as a clearinghouse for information about these securities.
Making Inquiries of the SIC Under the rule, a reporting institution (that includes exchanges, self-regulatory
associations, and broker-dealers) is required to make inquiry of the Securities Information Center with respect to
every security that comes into its possession UNLESS the security:
1. Is received from the issuer or issuer’s agent
2. Is received from another reporting institution or Federal Reserve Bank
3. Is registered in the name of the (existing) customer or that person’s nominee
4. Was previously sold to the customer by the firm, as verified by the firm’s internal records
5. Is received as part of a transaction that has an aggregate face value of $10,000 or less in the case of
bonds, or market value of $10,000 or less in the case of stocks

SIC inquiry is specifically required if:

 Stock that’s delivered by a customer is registered in street name rather than the customer’s name
 Stock is delivered by a party who’s not currently a customer of the broker-dealer
Reporting to the SIC If securities are discovered missing and criminal activity is suspected, or if securities
are suspected of being counterfeit, a report must be sent to the Securities Information Center. In addition, the
transfer agent and the Federal Bureau of Investigation (FBI) must be notified. The report must be made within
one business day of discovery.
 If securities are discovered to be missing, but no criminal activity is suspected, reports must be submitted to the
Securities Information Center and the transfer agent if the broker-dealer is unable to resolve the loss within
one business day after conducting a two-business day search.
 If securities are discovered missing as a result of an internal audit and criminal activity is not suspected,
a report must be filed by no later than 10 business days after discovery or as soon after a count or
verification of the certificate numbers can be determined.
 If securities that were reported lost or stolen are subsequently recovered, notice must be sent to the
Securities Information Center, the transfer agent and, if applicable, to the FBI, within one business day
of recovery.
SIC Reporting
Stolen or Counterfeit
Lost or Missing Recovery
Securities
SIC and transfer agent
Report to whom? FBI, SIC, and transfer agent SIC and transfer agent
(possibly FBI)
One business day after a two-
When to notify? One business day of discovery One business day of recovery
day search
FINRA Rules
While most financial responsibility rules have been created by the SEC, FINRA has additional rules that are
designed to enhance the fiscal security of members and their customers.
Disclosure of Financial Condition Member firms are required to send balance sheets to customers every
six months and (upon request) make available to customers a copy of the firm’s most recent balance sheet. A
customer is defined as any person with funds or securities in the possession of the member firm.
Fidelity Bonds
FINRA members that are required to join the Securities Investors Protection Corporation (SIPC) must maintain
a blanket fidelity bond covering officers and employees that provides against loss for fidelity (on premises or
in transit), forgery and alteration (including check forgery), securities loss (including securities forgery), and
counterfeit currency. The bond must include a provision that the carrier will promptly notify FINRA if the bond
is canceled, terminated or substantially modified.

Minimum Required Coverage A FINRA member firm that has a net capital of less than $250,000 must
maintain a minimum coverage which is the greater of; 120% of the member firm’s required net capital or
$100,000. For example, if a member firm has a net capital requirement of $50,000 its fidelity bond coverage is
$100,000 (120% of $50,000 is $60,000 which is less than $100,000.
For member firms whose net capital exceeds $250,000, FINRA has a table of required coverage, with a
maximum of $5,000,000 for member firms whose net capital requirement exceeds $12,000,000.
The following chart shows the minimum coverage required for the corresponding net capital requirements:
Net Capital Requirement: Minimum Coverage:

$250,000 – 300,000 $600,000
$300,001 – $500,000 $700,000
$500,001 – $1,000,000 $800,000
$1,000,001 – $2,000,000 $1,000,000
$2,000,001 – $3,000,000 $1,500,000
$3,000,001 – $4,000,000 $2,000,000
$4,000,001 –$6,000,000 $3,000,000
$6,000,001 – $12,000,000 $4,000,000
$12,000,001 and above $5,000,000
Deductible Firms are permitted to have a deductible provision included in their fidelity bond coverage. The
amount may be up to 25% of the coverage amount.
Review of Coverage Member firms must review their fidelity bond coverage annually, as of the anniversary
date of the issuance of the bond. The amount of coverage for the succeeding 12 months must be based on the
highest required net capital for the preceding 12 months. For example, if the highest net capital requirement
during the preceding 12 months was $450,000, the coverage for the following year must be at least $700,000.
For firms that have only been in business for one year and use the aggregate indebtedness ratio for calculating
its net capital, they may use a ratio of 15-to-1 (versus 8-to-1) to calculate the amount of their fidelity bond.
Notice of Cancellation Member firms must notify FINRA immediately if any bond is canceled, terminated,
or substantially modified.
Exemptions
 Any firm that maintains a fidelity bond required by a national securities exchange
 Any firm whose business is solely as a floor broker, floor trader, or designated market maker (DMM) and
doesn’t conduct business with the general public

Books and Records

The SEC and SROs rely on broker-dealer records and reports to monitor compliance with industry rules.
Therefore, it’s critical for a broker-dealer to maintain accurate records and file timely reports. SEC Rule 17a-3
requires broker-dealers to create specific records, while Rule 17a-4 requires those records to be kept for a number
of years after their creation. Records may be divided into those that must be retained for the life of the firm,
those that must be retained for six years, and those that must be retained for three years. Note that all records
must be kept in an easily accessible place for the first two years of their existence.
Lifetime Records Partnership articles (in the case of a broker-dealer that’s organized as a partnership), and
articles of incorporation, minute books and stock certificate books (in the case of a broker-dealer that’s
organized as a corporation), must be maintained for the life of the firm.
Posting Requirements Each required record must be created (posted) within a certain time frame.
The following listed provides details regarding the records that must be kept, for how long they’re kept, and
when the record must be posted.
Six-Year Records and Posting Requirements

 Blotters Reflects transactions as of the trade date and prepared by no later than the next business day
 General Ledger As frequently as necessary to determine compliance with net capital rules, but not less than
once per month
 Customer Account Ledgers No later than the settlement date
 Position Record No later than the business day after the settlement date or the date of securities movement
 Cash and Margin Account Records Prepared before the execution of the transaction
Three-Year Records and Posting Requirements

 Fail-to-Receive and Fail-to-Deliver No later than two business days after the settlement date
 Long and Short Stock Record Differences No later than seven business days after discovery
 Securities in Transfer, Dividends and Interest Received, Securities Borrowed and Loaned, Monies
Borrowed and Loaned No later than two business days after the date of the securities or money movement
 Order Tickets Prepared before the execution of a transaction
 Confirmation and Comparisons No later than the business day after the transaction
 Option Records No later than the business day after the option is written
 Trial Balance Prepared no later than 10 business days after the end of an accounting period
 Associated Person’s Application and Fingerprint Cards Prepared at, or prior to, commencement of
employment
 Forms U4 and U5 following the termination of affiliation with the broker-dealer
 Termination Notice Prepared after the conclusion of employment
 Written Supervisory Procedures and Manuals Must be current and following any change or update, the
former procedure or manual must be kept for three years
 Supervisory Personnel Designations Prepared at the time of designation until no longer effective

Lifetime Records
 For BDs organized as partnerships
Partnership articles Created prior to inception
 For BDs organized as corporations

Articles of Incorporation
Minute Books
Stock Certificate Books Created prior to inception
Record Posting Requirement

Six-Year Records
Must reflect transactions as of the trade date and must be prepared no
Blotter
later than the following business day
Must be posted as frequently as is necessary to determine compliance
General ledger
with the Net Capital Rule, but not less frequently than once per month
Customer account ledger Must be posted no later than the settlement date
Must be posted no later than the business day after settlement date or the
Position record
date of securities movement
Cash and margin account records Must be prepared before the execution of a transaction
Three-Year Records
Fail-to-receive, fail-to-deliver Must be posted no later than two business days after the settlement date
Long and short stock record differences Must be posted no later than seven business days after discovery
Securities in transfer; dividends and interest
Must be posted no later than two business days after the date of the
received; securities borrowed and loaned;
securities or money movement
monies borrowed and loaned
Order ticket Must be prepared before the execution of the transaction
Confirmation, comparisons Must be prepared no later than the business day after the transaction
Option records Must be prepared by no later than the business day after the option is written
Written Supervisory Procedures Former version must be retained when updating
Associated person’s application Must be prepared at or prior to commencement of employment
Lifetime Records
For BDs organized as partnerships: N/A
 Partnership articles
For BDs organized as corporations: N/A

 Articles of incorporation
 Minute books
 Stock certificate books

Exceptions A broker-dealer is not required to prepare the records required by Rule 17a-3 if it clears its
trades through a bank and the bank prepares the required records. The bank must provide the broker-dealer
with a written agreement that the records are the property of the broker-dealer. In addition, the bank must
provide the SEC with a written notification that the records are available for inspection by the SEC.
If a broker-dealer clears its trades on a fully disclosed basis through another broker-dealer, the obligation to
maintain records rests with the clearing firm. A fully disclosed account is one in which the introducing
broker-dealer turns over full responsibility for the maintenance of the account to the clearing broker-dealer.
The introducing broker-dealer will open the account and solicit orders, but will not be involved in maintaining
the account records.
Another type of clearing account is an omnibus account, in which the clearing broker-dealer will execute the orders
and clear the trades, but the introducing broker-dealer will maintain the account in all other respects. In this
case, the introducing broker-dealer will be responsible for record maintenance.
If a broker-dealer intends to use electronic storage for record keeping or retention, it must notify its
Designating Examining Authority at least 90 days prior to use.
Recordkeeping Formats As previously mentioned, under SEC Rule 17a-4, records must be kept for a
certain number of years after creation. The Commission has allowed for the maintenance of files in forms other
than paper. For example, firms may maintain files on micrographic media or electronic storage media.
Micrographic media include microfilm, microfiche, or similar methods. Electronic storage media include
methods of digital storage, such as CD-ROM.
If a firm decides to use electronic storage media, it must notify its DEA prior to the beginning of its use. Also, if a
firm decides to use a form of electronic storage media other than optical disk technology, of which the most
commonly used is CD-ROM, the firm must notify its DEA at least 90 days prior to using the other method.
Electronic storage media must also have the following capabilities. They must:
 Maintain records in non-rewriteable and non-erasable formats. To be FINRA compliant, these records must be
write once-read many (WORM). This process ensures that it cannot be tampered with once it’s written.
 Automatically confirm the quality and accuracy of the media recording process
 Maintain records in serial form with time and date information that documents the required retention period for
the information stored
 Be able to download indexes and records maintained to any medium accepted by the Commission or other SRO
of which the firm is a member
In addition to the aforementioned requirements, a firm that uses micrographic or electronic storage media must
have a place at which the SEC and its SRO can immediately review stored files and must have duplicates of
the files.
All duplicates of files maintained must be kept separate from original records. The records (original and
duplicates) must be accurately organized and indexed. The indexes must be duplicated, kept separate from
originals, and made available for examination by regulators that request a review.
Finally, all firms using electronic storage media must have an auditing system in place that shows
accountability for the input of records required to be preserved.

This concludes the Series 24 Study Manual. Students should now begin taking their Final Examinations. If you
encounter problems during this process, please remember to contact the STC HelpLine at 1-800-STC-EXAM
(1-800-782-3926).


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Series 24

General Securities Principal Examination

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DISCLAIMER STC students are provided with both a print

About the Series 24 Examination

2 Supervision of General Broker-Dealer Activities 5, 6, 8, 13, 14, 15, 16 45

3 Supervision of Retail and Institutional Customer-Related Activities 7, 11, 13, 14 32

4 Supervision of Trading and Market Making Activities 9, 10, 11, 12, 13 32

5 Supervision of Investment Banking and Research 1, 2, 3, 4 32

Registering for the Examination

Taking the Exam

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About the Training Program

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Standardized Test-Taking Tips

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Public and Private

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Types of Financing Transactions

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Securities Act of 1933

SEC Registration Forms

The Registration Process

Pre-Registration Period Cooling-Off (Waiting) Period Post-Effective Period

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During this time:

Underwriters are Permitted to: Underwriters are Not Permitted to:

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Prospectus Delivery Requirement

There are two exceptions to the prospectus delivery requirement:

Reporting Status at After the Offering, Dealers

* A reporting company is defined as:

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SEC Rule 3a4-1 – Associated Persons of Issuers

The Trust Indenture Act of 1939

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The following issuer categories have been created.

Majority-Owned Subsidiary A majority-owned subsidiary of a well-known seasoned issuer qualifies as a

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Issuer Type Filing Form Requirements

Unseasoned Issuer S-1 Less than $75 million public float

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Alternative Methods of Raising Capital

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Use of Free Writing Prospectus (FWP)

Types of Offering Communications

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Reference Documents A registrant is permitted to incorporate another document into a registration

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Communication-Related Liability (Section 11 of the Act of 1933)

Exemptions from Registration – Securities