Tax Forms

Even though NASAA claims that their Series 65 and 66 exams are not based on memorization, their exams sure do churn out their share of mindless memorization questions. Like this one:

A limited partnership uses which of the following forms when reporting taxable income?
A. 1040
B. 1120
C. 1065
D. 1031

EXPLANATION: the 1040 is used by individuals and sole proprietors. A 1031 tax-free exchange can be done on real estate investments, and the 1120 is used by corporations. Form 1065 is used by partnerships.

ANSWER: C

Sideways

Have you ever seen a college basketball game in which the opposing fans try to haze the free-throw shooter by waving colorful distractions and shouting at him?

Ever noticed how it has zero effect on a good free-throw shooter?

The Series 65 and 66 exam also like to haze the people shooting free-throws at the testing center. They know that the answer is sitting right there in front of you like an open hoop, so they have to distract you from choosing it. One trick is to overwhelm you with verbiage. Another is to present common formulae backwards. Still another is to use weird jargon that you weren't expecting. Like this possible exam question:

Joey Investor is long 1,000 shares of ORCL common stock. It is now June, and Joey feels that the market for ORCL is headed sideways over the next several weeks. Therefore, he should

A. sell 10 ORCL Jul calls

B. buy 10 ORCL Jul puts

C. sell 10 ORCL Jul puts

D. buy 10 ORCL Jul calls

EXPLANATION: Always sell options if the market is supposed to go "sideways" or "remain unchanged." That way, you get the premium now, and then the option expires. Don't sell puts if you own stock--if the stock goes to zero, you lose 100% on the stock, then you have the OBLIGATION TO BUY the stock for the strike price . . . even though it's worthless. Sell covered calls in this situation. Joey owns 1,000 shares, so he can cover 10 call options.

ANSWER: A

What if you don't know what "sideways" and/or "long" mean?

You could be in trouble. That's why I just posted this question.

An options question

Sammy Bonami buys a MSFT May 55 call @3. When MSFT rises to $62 a share, Sammy sells 100 shares short, then covers the short position by exercising the call option. What is the result of Sammy's trading activity?
A. gain of $7 per share
B. gain of $4 per share
C. loss of $10 per share
D. loss of $3 per share

EXPLANATION: this is exactly how a trader would exercise a call. In order to take advantage of the temporary market price of $62, Sammy needs to sell the stock short now. At this point he can "cover his short position" by exercising his right to buy the stock for $55 a share. He doesn't keep the full $7 a share difference, since he paid $3 a share for the right to buy the stock at $55. He keeps $4 per share.
Some test-takers would report that they have "never seen anything like this before," but, in fact, they have learned the fundamentals that would allow them to figure it out with strategy and patience. Our Pass the 65 book covers options in more detail than it probably should, and--no matter what we cover in the book--the exam wants to see if you can apply the fundamentals in a very unexpected, challenging way. You have to figure this sort of question out. Ask yourself, "what does a call buyer get to do?" He gets to buy at the strike price--okay, so have him pay the strike price and the premium. You see that he "sells" the stock for $62 a share, so that has to offset the $58 per share that he paid. Are you 100% confident with your answer? Heck no--luckily, you only need a 68.5% to pass before 1/1/10, and a 72% to pass thereafter.

ANSWER: B

Be preapred to figure things out at the testing center--no matter what you've studied, the test questions will force you to apply the concepts in unexpected, seemingly impossible ways. You don't get to spit back the little flash cards you've memorized on the Series 65 or 66. You have to use logic and test-taking skills to apply the fundamentals in a very challenging, often confusing environment.

Lucky you.

Types of Trusts

Here is a question very similar to what many of you will see on the Series 65 or Series 66:

What type of trust requires the trustee to distribute to beneficiaries immediately?

A. Simple

B. Complex

C. Irrevocable

D. Revocable

EXPLANATION: a simple trust distributes "DNI" (distributable net income) to the beneficiaries, while a complex trust can retain some of the income to build up the "corpus" or principal. The choices "irrevocable" and "revocable" have more to do with estate taxes and tax liabilities during the lifetime of the grantor.

ANSWER: a

Series 65 - Likely Test Question

A customer who recently passed his Series 65 exam reports that he saw a question similar to the following:

There is a federally covered advisor with an office in state A, who has clients in state A. He also has 3 non-institutional clients in state B and 3 non-institutional clients in state C. He has 3 more clients in state X and wants to have custody of the clients' accounts in state X. In which states does he have to register?

A. A only
B. A, B, C and X
C. A and X only
D. None, because he is federally registered


My explanation:
The answer is D because this is a federal covered adviser. They notice file in State A, where they have an office. They do NOT need to notice file in State B, State C, or State X because they aren't soliciting new business there (holding out as advisers) and have no more than 5 non-institutional clients. Even if they had more than 5 non-institutional clients in those states, they would not register there; they would only notice file there. Custody has nothing to do with this question. As a federal covered adviser, they'll meet the SEC's net capital requirements under IA Act of 1940. The only authority the states have over SEC-registered advisers is anti-fraud and notice filing authority.

Another happy Series 65 customer

When customers pass their Series 65 or 66 exams, few think to email me and let me know the good news. Still, I have hundreds of thank-you emails from ecstatic test-takers who skipped their way out of the exam center. This is one I received today, and I think you'll find some good stuff that you can apply yourself. Looking at his GoNoGo results, I asked if he had taken the Series 65 yet. He replied:

Yes, sorry did not get back to you. I have to look up the cert sheet, but I scored around 85.

Interesting observation on the test. They are getting very good at writing the questions with language and phrasing that is enough different, and fairly obscure, as to really make you have to re-read the question many times. I am sure nerves have something to do with it, but it seems they are going to great lengths to make sure no one who studied material like yours or Kaplan easily recognizes questions verbatim.

Also of note, there were less retirement vehicle questions than I expected, and more trust formation questions, which is a subject I never really remembered any questions on as I studied. Those were pure guesses for me. All in all, I seemed to “check for review” about 35-40% of the test because of the wording of so many of the questions. In the end I did not change a lot of my answers unless it was obvious I was overlooking the right answer. It just seems the test writers are getting better at making the questions and answer choices a little harder to decipher. Definitely not as easy to immediately remove 2 of the 4 choices as it used to be.

Alls well that ends well. I will gladly recommend your materials to others.

Thanks,

MPK

PS. People should not underestimate the power of an experimental question. I know we cannot “tell” which is and is not, but some of the questions will be so confusing, and I recall one that I am sure had 4 wrong answers, and one that had four right answers. Well, when you are in a game time frame of mind and extremely nervous about passing, these definitely can knock you off your game and change your focus. Remind your clients, as I am sure you do, not let any one question mess with your head — because it may be a mind bending experimental one. If you still haven’t answered in 2 minutes, click and move.

Am I ready to pass the exam?

The best part of my chosen career is the satisfaction I get helping others to pass their securities license exams. Checking my InBox last night, I found this uplifting email from a Series 65 customer:

Whoo, Hoo, I passed the 65 today with an 85%. Your training materials and test questions are awesome. They provided all I needed to learn (along with the official website readings).

Your practice test questions are right on.

This student had already taken the GoNoGo exams that you'll find at http://www.passthe65.com/. Her scores were 86% and 90%, for an average score of 88%. As usual, the score on the actual Series 65 was a bit lower, but only by 3 points. At this point, the majority of GoNoGo exam scores are + or - 6 points from the actual score on the Series 65. This is not a guarantee, but it does imply that anyone scoring in the high 70's has a high chance of passing the exam at the testing center. I encourage you to take one or both "GoNoGo exams" just before scheduling your test. If you don't like the results, send me an email at walker@passthe65.com to set up some private, online tutoring.

Remember--you want to get the 65 off your plate before the end of 2009, when the passing score jumps from 68.5% to 72%.

Higher Passing Scores Required on the 65 and 66 exams!

HEADS UP:

IF YOU NEED TO PASS THE SERIES 65 OR 66 EXAM, THE TIME TO DO IT IS BY DECEMBER 31, 2009.

Starting January 1st, the passing score for the Series 65 is going up from 68.5% to 72%. Even worse, the passing score for the Series 66 is going up from 71 to 75%.

My company, Pass the Test, is helping people get the exams done this year with coupon codes. For any product at www.passthe66.com use coupon code: 66now.

For any product at www.passthe65.com use coupon code: november

FINRA fines firms over lack of email supervision

I'm at the FINRA website this Friday morning looking for recent disciplinary actions against member firms and/or their agents. Today's firm in the time-out chair is a well-known broker-dealer with lots of branch offices and affiliate broker-dealers. Unfortunately, they did not have an adequate system in place, according to FINRA, to monitor their agents' emails or their outside business activities, or their private securities transacations. Many financial service salespeople are hard-charging entrepreneurial types who think they can do whatever they want to do to make a buck. In fact, they can't. Once you sign on with a broker-dealer, you have to notify them of any outside employment, and you can not offer securities outside their knowledge and supervision, especially if you might get caught. Remember that even though the Series 65/66 exam is for investment advisers and IARs, it still asks plenty of questions about broker-dealers and their agents. Go ahead and see the notice of disciplinary action at:
http://www.finra.org/Newsroom/NewsReleases/2009/P120393

Securities Registration

Jimmy Jones is a go-getting business owner who recently sold "units of participation" in his plastic injection molding company, totalling $290,000, to 24 investors in State A and 15 investors in State B. Jimmy did not register the units based on his belief that they were not securities. The company has now filed for bankruptcy protection and is in receivorship. The "units of participation" have no secondary market and are deemed to be worthless. Therefore
A. investors may not pursue civil suits unless filed within 3 years of the securities offering
B. whichever state represents the majority of capital invested has sole jurisdiction in this matter
C. State A, where the majority of investors reside, has jurisdiction in this matter
D. the SEC has no authority over this matter unless the securities were registered under the Securities Act of 1933

EXPLANATION: both states could claim jurisdiction and pursue separate legal actions. The SEC could definitely get involved, since this is inter-state commerce. Investors have the right to sue as long as they file within 2 years of discovery/3 years of the cause of action. Chances are, Old Jimmy never bothered to register the "units of participation" and never disclosed any risk to investors . . . or, he presented bogus financial statements, etc. If so, they will have grounds to sue. Unfortunately, Old Jimmy appears to have no money at this time.


ANSWER: A

Are you an adviser or not?

There is a subtle difference between the following two questions:

1. Is the firm an investment adviser?
2. Does the investment adviser have to register?

The first question is talking about an "exclusion," while the second is talking about an "exemption." In other words, some entities simply don't meet the definition of "investment adviser." An accounting firm that encourages clients to make IRA contributions is not an investment adviser. Neither is a bank or savings & loan. Whatever the Investment Advisers Act of 1940 or various state securities laws have to say about investment advisers, it does not apply to the accountants in our example, a bank, or an S & L. Why not?

They are not investment advisers.

On the other hand, an adviser in Rhode Island might have a couple of financial planning clients move to Massachusetts--if so, the Rhode Island investment adviser is excused/exempt from registration requirements in Massachusetts. As long as he isn't soliciting new business in Massachusetts, and as long as he has no more than 5 of these clients there, he is exempt from registration requirements.

But he is an investment adviser. And that's important to note because if you're not an investment adviser, then the Investment Advisers Act of 1940 has nothing to say to you. But, if you are an investment adviser who simply doesn't have to register--exempt--then, some parts of the Investment Advisers Act of 1940 still apply to you. At the risk of going overboard, let's look at the difference. Section 205 of the Act requires the contract between advisers and clients to contain at least 3 main items. But, it clearly doesn't apply to advisers who are exempt from registration requirements:

No investment adviser, unless exempt from registration pursuant to section 203(b), shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to enter into, extend, or renew any investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed on or after the effective date of this title, if such contract--
provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client;
fails to provide, in substance, that no assignment of such contract shall be made by the investment adviser without the consent of the other party to the contract; or
fails to provide, in substance, that the investment adviser, if a partnership, will notify the other party to the contract of any change in the membership of such partnership within a reasonable time after such change.

On the other hand Section 206, the anti-fraud statute, applies to anyone who meets the definition of investment adviser, even those who are exempt from registration requirements:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly--
to employ any device, scheme, or artifice to defraud any client or prospective client;
to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.

So, if you're not an investment adviser, even Section 206's anti-fraud statute is outside of your world. But, while an adviser with an exemption would not have to comply with Section 205's requirement for client contracts, they're still an investment adviser, so they're still stubject to Section 206's anti-fraud statute. They don't have to comply with most of the Act of 1940, but if they're an investment adviser, they had better not do anything deceptive or misleading, even if they are excused from registration.

On the test and in the real world, it is difficult to know for sure if you meet the definition of "investment adviser." The State of Ohio has an excellent flow chart that helps people decide this crucial question. Take a look at it--very helpful stuff:

http://www.com.ohio.gov/secu/docs/Investment%20Adviser%20Flowchart.pdf

Insider Trading, For Real

It's Friday morning and, as usual, I'm at the FINRA website looking up recent disciplinary actions. Today I find a well-known broker-dealer being fined for insufficient anti-money laundering policies. $600,000 is the fine, but I also know how much it costs to shoot advertisements involving helicopters, let alone running those ads in prime time, so I think their pocketbook will survive.On the other hand, the individual referenced in the link I'll post below is done. Game over. Forced early retirement. As you'll see, when a broker-dealer is called in for investment banking work, they end up knowing information no one else has, information that can move the price of the company's stock up or down with near certainty. So, investment bankers are fiduciaries who have to keep the information confidential. Don't spread the news, and--for crying out loud--don't try to buy shares of the company's stock so you can dump it when the news becomes public. Tempting, sure. But it's a criminal violation. It leaves you open to all kinds of civil suits. And--as you'll see--it tends to end a registered representative's career permanently.
See what I'm talking about here:http://www.finra.org/Newsroom/NewsReleases/2009/P120328

Economics Practice Question

On the Series 65 exam, you should expect to see at least three or four questions concerning economic indicators. Like this one:

Which of the following is/are generally associated with the economic phase known as "expansion"
A. falling CPI
B. falling interest rates
C. falling unemployment
D. all choices listed

EXPLANATION: during an expansion, everybody’s working, so unemployment is falling, decreasing, dropping, or whatever the exam wants to call it. The CPI and interest rates tend to rise during an expansion. In other words, stockholders tend to do better in an expansion while bond holders tend to do worse . . . and during a contraction, bondholders tend to do better, since falling interest rates raise the market price of their bonds, and since their fixed income stream has greater purchasing power if the CPI begins to drop (deflation).

ANSWER: C

Agency Cross Transactions

One of my Series 65 customers just asked me to explain "agency cross transactions," which are potentially "conflicts of interest" for investment advisers. I repsonded this way:

Hi, Kevin
If I'm your adviser, I'm supposed to be buying and selling securities only because it benefits you. If my advisory firm has an affiliated broker-dealer, and I start buying securities for your account or selling them from your account to our brokerage customers and pocketing commissions, that would be a major violation unless the "agency cross transactions" were disclosed to you. The fact that we get commissions when managing your portfolio could be making our buying and selling activities less than objective. So, we disclose the agency cross transactions to our advisory clients and once a year send itemized lists of all the agency cross transactions that we did while managing those accounts. We can never advise both sides of a transaction any more than a divorce attorney can represent both the husband and the wife in a divorce case. Here is the actual rule:
http://www.law.uc.edu/CCL/InvAdvRls/rule206(3)-2.html

On a related note, the affiliated broker-dealer can act as a "principal" on a transaction and instead of getting a commission, the firm charges a markup-markdown. That also requires disclosure and client consent because the firm benefits suddenly beyond just the advisory fees being charged. Remember that whenever an adviser gets compensated beyond the advisory fee, this needs to be disclosed to the advisory client. If I put you into a mutual fund and receive 12b-1 fees or sales charges (with my Series 6 or 7 license) that definitely needs to be disclosed. Is my advice totally objective? If not, I must disclose anything that could make it less than objective.

These potential conflicts of interest are laid out in ADV Part 2 (disclosure brochure) and are also disclosed on a per-transaction basis to the advisory client.

Private Placements

If the topic of "private placements" is confusing to you, you're in good company. Under the Securities Act of 1933, the maximum number for non-accredited investors is 35. For a private placement made in a particular state the maximum number is 10 under the Uniform Securities Act. In the real world there is a lot of controversy over these "Reg D offerings," and the state regulators often fight to control these things that the SEC does not require to be registered. However, don't be too quick in your understanding of a test question. For example, how would you answer this one:

Which of the following represents an accurate statement of private placements under the Reg D exemption to the Securities Act of 1933's registration requirements?
A. securities are subject to holding period requirements
B. underwriters may solicit a maximum of 35 non-accredited investors
C. suitability requirements do not apply to institutional investors
D. all choices listed

EXPLANATION: the "private placement" can not have it both ways--it can't be private if the underwriters are soliciting investors. There must be a pre-existing relationship between these investors and the underwriters. Also, broker-dealers do have suitability requirements, even when dealing with institutional investors. FINRA has sent notices to member firms reminding them that if an investment is too complex for an institutional investor, or the institution does not have the resources to do due diligence on, for example, a mortgage derivative, then the firm should not offer and sell it, no matter how "sophisticated" institutional investors might be in other areas.
ANSWER: A

Registration of Persons

The Series 65/66 exam usually asks several questions about registration issues for broker-dealers, investment advisers, and their agents/IARs. It helps to keep a little flow chart in your head, like the ones we published at http://www.passthe66.com/updates/.

For now, let's work through it with words. When you get a question about registration issues for "persons" in the securities business, the first question to ask is, "Do they have a place of business in the state?" If the answer is "yes," then the broker-dealer, agent, or investment adviser representative has to register in that state.
Period.
If the investment adviser has a place of business in the state, the adviser has to register with that state, unless they can claim eligibility for federal registration. If the adviser has $25 million or more under direct management, or if they manage investment company portfolios, or if they can click another of about a dozen reasons, they will register with the SEC. The state(s) where they have a place of business or more than 5 non-institutional clients will receive copies of the SEC paperwork, called "notice filings."
So, the first question is, "Do they have a place of business in the state?" If the answer is "no," the next question is, "Do they have non-institutional investors in that state?" If not, the agent, broker-dealer, investment adviser and investment adviser representative are excused from registration. If they want to start soliciting clients in the other state, they have to register, but if their only clients in the other states are institutional investors--pension funds, mutual funds, banks, insurance companies, advisers, broker-dealers--then they do not have to register in the other state. However, if the agent or broker-dealer have any non-institutional clients in the state, they have to register in that state, even if they don't have a place of business there. The adviser or IAR, on the other hand, can have up to 5 non-institutional clients in the other state without registering, as long as they're not soliciting new clients or "holding themselves out to the public as investment advisers."

Believe it or not, that's about as simple as we can make it. Although a picture may be clearer. Click that link above and check out the three Word Documents.

5 out-of-state clients

On the Series 65 or 66 exam there will likely be at least one question about registration issues for investment advisers with clients in other states. Maybe something like this:

Barry Mundy is a financial planner with a place of business in State A. Recently, three of his clients moved to State B. Barry has recently placed a billboard in State B offering a "total financial check-up, free of charge" with an 800-number and a link to a website. Therefore
A. Barry must register in State B because he is holding himself out to the public as an investment adviser in State B
B. Barry must register in State B because the clients who moved there were existing clients
C. Barry is exempt from registration requirements in State B because the number of clients there is 3
D. Barry is eligible for federal covered status due to the multi-state adviser exemption

You might have memorized the number 5 and decided that an out-of-state adviser with no more than 5 clients in State B is exempt from registration requirements there. And he is. Except when he isn't. See, that exemption is based on the fact that he is not holding himself out as an adviser in State B. Barry Mundy is definitely holding himself out as an investment adviser in State B, and right there he has to register in State B. He doesn't get to solicit clients and then stop when he gets to 5 . . . or solicit 5 clients. He's either soliciting clients in State B or he isn't. If he is, he has to register there. If he isn't, he can have 5 clients in that state without registering there. Most likely, they're existing clients or referrals . . . but if he wants to drum up business in State B, he needs to register there.

So the answer above is A.

Advances to Partners, Officers

As I've written, I'm not sure why investors would allow their investment adviser to also maintain custody of the account assets. I mean, if the investments are doing poorly, what's to stop the adviser from making up his own numbers, or--worse--making withdrawals out of dividend and interest income that the client never finds out about?

But, some advisers do have custody. If so, the firm has to maintain a minimum net worth. NASAA says in one of their model rules that the minimum net worth for such an adviser is $35,000. They then define "net worth" in frightful legalese. I'll include a link to the model rule at the bottom of this post, but for now, let's imagine what a test question might look like on the Series 65/66 exam:

Hickory Stick Advisory Partners are deemed to have custody of client assets. When filing their balance sheet, the firm should include in its assets which of the following items?
A. prepaid expenses
B. loans to a senior partner
C. loans to a silent partner
D. marketable securities

EXPLANATION: the NASAA model rule on minimum financial requirements for advisers specifically tells advisers not to include prepaid expenses or loans to partners--if the firm is a partnership--or to officers or stockholders--if the firm is a corporation. Seems like a good idea to me. If the advisory business is doing poorly, what are the chances that the partners are doing well enough to repay the loan they took out? Talk about some shaky assets. Marketable securities have a value--they are an asset.
ANSWER: D

http://www.nasaa.org/content/Files/NASAA%20Minimum%20Financial%20Requirements%20for%20Investment%20Advisers.pdf

Money Purchase Plan

The Series 65/66 exam may ask a question like the following:

In a "money purchase plan" contributions are
I. discretionary on the part of the employer
II. discretionary on the part of the employee
III. mandatory on the part of the employer
IV. mandatory on the part of the employee

A. I, IV
B. II, IV
C. II, III
D. I, II

EXPLANATION: someone who really knows a lot about retirement plans would probably be unable to answer this question. Since I'm just a test-prep expert, I know how the test question writers think, and I know they want me to say that the money-purchase plan involves a mandatory contribution by the employer, and the employee can also contribute (discretionary). So, I choose "C."
ANSWER: C

If you vehemently disagree with this and can explain why, send me an email walker@passthe65.com.

Out-of-State Adviser with 5 clients

A former Pass the 65(c) customer wrote me an email this evening that touches on a few important testable points. He wrote:

I used your program to pass the 65 test in AZ. Thanks so much.

One of my coworkers and I have a disagreement on the number of clients you can have vs. the number of people you can solicit outside of the state you are registered. I say you can have 5 clients outside the state. He says you can only solicit to 5 outside the state and once you solicit 5, you cannot solicit or have more clients even if you get none. Who is right?

Thanks for the help!

I RESPONDED:

Great job on passing a tough test!
Basically, the de minimis exclusion for an out-of-state adviser with no more than 5 clients in another state accomodates financial planners who might have a few clients who end up moving to various states. So, if a few of your clients move to Florida, you can be their adviser without paying licensing fees to Florida. As always, there is a catch. Remember that this exclusion is predicated on the fact that you are not soliciting new clients in the other state. If you're going to solicit clients, or "hold yourself out as an adviser," the other state is going to want you to register. Plus, how can you solicit five clients? To get five clients, I think you'd better call more than 5 people--more like 500 people. Right? The state laws generally say that an adviser can commit fraud even when just soliciting clients, so they like to get people registered if they're "holding themselves out as being an investment adviser in their state." So, your co-worker isn't quite right, either. It's not that you can solicit five people. It's a question of, are you soliciting and "holding yourself out to the public as being an adviser," or not? If you are, you have to register. If you're not, you can have up to 5 clients, as long as you have no physical presence/place of business in that other state.

Here is a snippet from a state law, Pennsylvania's. Their Act states that you're not an investment adviser if you/your firm are: a person who has no place of business in this State and, during the preceding twelve-month period has had not more than five clients in or out of this State and does not hold himself out generally to the public as an investment adviser.

The bold statements are why your buddy is partly right--in general most states won't grant you the de minimis exclusion if you're holding yourself out as being an adviser to the public in their state, which is what you'd be doing by calling or writing to potential clients, or advertising, or even handing out brochures or business cards at a garage sale. In fact, if you sat at a local tavern or diner and simply talked to anyone too slow or lonely to walk away from you about your advisory services, you would be "holding yourself out to the public as an investment adviser."

You both would probably like an absolute answer, but it would depend on the state, the wording of their own statutes, their reading of their own statutes, and their list of priorities. To be on the safe side, get registered before you start soliciting advisory clients in any state. The de minimis exclusion really only works when you have existing clients who happen to move to another state. Once you "hold yourself out to the pubic as being an investment adviser," that state likes to make you register.
And, I'd be on the safe side with all state licensing issues. You're usually talking about an annual fee of a few hundred dollars to get registered and renew each year.

Annuity Payout

If you're studying for the Series 65, I highly recommend purchasing one or more of the recorded classes at www.passthe65.com/classes.htm. Maybe you already have materials that your firm provided--these recorded classes will make sense of that stuff in a hurry.

I'm going to write a practice question on variable annuity payouts now since it's still too cold to walk the dog this morning in Chicagoland. Cody can wait--you, on the other hand, are studying for a very difficult and serious exam. Here you go then:

An annuitant chooses life with a 10-year period certain. If the annuitant lives 12 years, what happens?
A. the beneficiary receives two years of payments
B. the annuity pays out for just 10 years
C. the annuity pays out for 12 years
D. annuity units are converted back to accumulation units

EXPLANTION: with a 10-year "period certain" the annuity company will pay for at least 10 years but will also pay as long as the annuitant lives. Whichever turns out to be longer--that's how long they pay.

ANSWER: C

IRA Contributions

Let's look at a practice question concerning IRA contributions.

Which of the following could reduce the amount that an individual may contribute to a Traditional IRA?
A. Roth IRA contributions made for the year
B. High income level
C. Participation in an employer-sponsored plan
D. All of the choices listed

EXPLANATION: if you were going too fast, you might have been tricked by this one. The other choices only affect how much can be deducted from the contribution, but anyone with earned income can contribute to their Traditional IRA.

ANSWER: A

Unregistered, non-exempt securities

Even a phrase as annoying and opaque as "soliciting sales of unregistered, non-exempt securities" relates to the so-called "real world." Just two days ago a federal court issued an injunction on some people who were, allegedly, trying to issue securities without bothering to get them registered. If you read the announcement at the link at the bottom of this post, you'll see that the SEC is just an army of attorneys--no criminal charges are being discussed here. The SEC is seeking all that they can, which is "permanent injunctions, disgorgement of ill-gotten gains, and civil penalties against all defendants." In other words, they would like to use the permanent injunction as a reason to deny these people any opportunity to work the securities business or offer securities in the future. They want them to give up the money they took (disgorge). And, they want the courts to hand down a stiff monetary penalty against them. You'll notice that specific sections of the Securities Act of 1933 are referenced, and it will do you good to read it all in the native tongue. Enjoy:
http://lawprofessors.typepad.com/securities/2009/09/sec-obtains-preliminary-injunction-in-florida-against-microcap-offering-fraud.html

Misappropriating Money

Just when I start to think the material related to the Series 65/66 exam is boring, I find a headline such as the following to snap me out of my funk:

SEC Charges Illinois Money Manager with Misappropriating Investor Assets . . .

Of course, you have to love the word "misappropriating" in place of "stealing," but regulators are lawyers, and this is how they communicate. As a resident of big, scary Chicagoland, it is nice to see that some shenanigans take place downstate. As you'll see from the announcement at http://lawprofessors.typepad.com/securities/2009/09/sec-charges-illinois-money-manager-with-misappropriating-investor-assets.html this investment adviser (money manager) apparently made some false claims to investors (fraud) and used investor deposits to enjoy a high-rolling lifestyle (misappropriating/stealing).

Notice how the SEC is doing whatever they can in this case, "seeking injunctive relief, disgorgement, prejudgment interest, civil penalties and the appointment of a receiver." So, they wanted a federal judge to issue an injunction, and this is what they got for the asking: The Honorable Ruben Castillo, U.S. District Court Judge for the Northern District of Illinois, granted the SEC's request for emergency relief, including an order permanently enjoining Huber and Hubadex from committing further violations of the antifraud provisions and an order freezing the assets of Huber, Hubadex and the relief defendants. Huber, Hubadex and the relief defendants agreed to the emergency relief requested by the SEC.

So, at this point, it's a civil matter. But, the US Attorney's office can also pursue these matters in criminal court--I mean millions of dollars are involved.

In any case, read the announcement yourself. If you still think the Series 65/66 material on regulatory issues and business practices is "irrelevant," go ahead and post your comment below.

Natural Persons

Just got another great question, this one from a customer studying for his Series 63. Don't worry--the Series 63 exists on both the Series 65 and (moreso) on the Series 66 exams. The customer asked:

Can a broker-dealer be a natural person?

I responded:
The question is really asking if a broker-dealer could be set up as a sole proprietor.
The answer is--yes he could. A sole proprietor does business as himself, so he is a natural person--there is no LLC or corporate structure set up as a separate legal entity from himself.
An investment adviser could also be set up as a sole proprietor, which means he/she is a natural person doing business as him or herself. Usually, a broker-dealer or adviser would set up an LLC or corporation. When they do that, they end up with a separate legal entity/person apart from the human beings who run the business.
On the other hand, agents and IARs are always natural persons--they are employees who represent the broker-dealer or the adviser. Period.
Broker-dealers and RIAs can be natural persons, but are usually "legal persons" in the form of a corporation or LLC.

Why the exam would even go into this weird territory . . . no idea. It's NASAA's world. We just try to live in it.

Felony Drug Conviction

I just received an interesting question from a blog visitor, but he placed it after a blog written in July, and the content is just too important to leave it there, where it might get lost in the shuffle. He wrote:

Interested in acquiring the Series 7 and 66 license to obtain employment. I have a non-financial 1st-degree felony conviction (1996 drug charge), will I be accepted?



I responded:

There is no absolute black-and-white answer here, but it is extremely likely that you will be granted a license. You first have to get hired by a broker-dealer, though, to take the Series 7, and this could be the first roadblock. The firm might not want to hire any convicted felons, period. If you do get hired, you'll complete a Form U-4, and you will have to disclose the 1996 drug conviction and then explain it in detail on a DRP (disclosure reporting page). FINRA generally only uses the things that happened in the past 10 years against you, but you also have to get a salesperson or "securities agent" license from your state regulator. They might view a drug conviction as a red flag, because it represents an illegal financial scheme--they might see it in the same category as counterfeiting. Others might see it as a one-time event, a youthful indiscretion, etc.
If you can't get in as a securities agent, you could actually just take the Series 65 exam, then register your own LLC as an investment adviser through Form ADV. This form only asks about things that happened in the past 10 years, which means you don't even have to disclose the drug conviction from 1996.
With lawyers writing the rules, there is always an angle.

Economic Indicators

Once again the economy is in the news this morning. New claims for unemployment are expected to rise, as is the number of people who remain on unemployment. That's the bad news. The good news includes the fact that inflation--measured by the CPI--is virtually nonexistent. Also, inventories are low, meaning factories will have to ramp up production soon. And, building permits are expected to rise about 3.5%. As you know, building permits and new claims for unemployment are leading indicators. CPI and unemployment/employment rates are coincident indicators. And, inventory is a lagging indicator.

In the article referenced below, you will see brief mention of both fiscal and monetary policy, even though those terms are not used. You'll see that "the Fed" sees no reason to change the discount or fed funds rate. You'll also see that fiscal policy, in the form of a tax credit, can help increase demand for housing.

I invite you to read the brief article at the link below. See how the "test world" matches up with the "real world" at:
http://news.yahoo.com/s/ap/20090917/ap_on_bi_ge/us_economy

Series 65 and 66 exams are CHANGING

If you're one of those people who need deadline pressure in order to actually start studying for the Series 65/66 exams, here you go: the Series 65 and 66 are changing starting January 1st.

Yikes!

Yes, new topics are being added and--more frightening--the emphasis is shifting on both exams. For example, the 45 questions on business practices/ethics is being reduced to 40 on the Series 65. The 80/20 split between regulatory questions and securities & analysis questions is changing to 50/50 on the Series 66.

So, if you were thinking of putting off the exam until 2010, I would not recommend that. It's going to take a while to see how the exams are really changing based on imperfect feedback and educated guesswork by everyone in the test prep industry. Theoretically, the existing practice questions available should be as close as they ever were going to be, given that the Series 65 and 66 outlines haven't changed since January 2004.

Borrowing from Customers Part 2

To follow up on the previous post , another agent got in trouble with FINRA for borrowing from a customer, but ended up with a much lighter punishment:
James Kelly Breeze (CRD #2591120, Registered Representative,Medford, Oregon) submitted a Letter of Acceptance,Waiver, and Consent in which he was fined $5,000 and suspended from association with any FINRA member in any capacity for 60 days. Without admitting or denying the findings, Breeze consented to the described sanctions and to the entry of findings that he purchased a building from a customer for $850,000, with the customer agreeing to finance the entire purchase. The findings stated that Breeze had a personal relationship with the customer outside of the broker/customer relationship. The findings also stated that Breeze’s member firm’s written procedures allowed its registered representatives to borrow from customers, but prior written approval was required, and Breeze failed to obtain his firm’s written approval before entering into the borrowing arrangement with the customer.

So, even though it involved a much larger amount of money, the fact is that his firm would have allowed the agent to borrow from the customer, if he had only gotten written permission first. FINRA is reasonable; they know there's a difference between doing something your firm prohibits and doing something they don't prohibit but failing to get written approval.

Either way, what the heck are all these agents doing borrowing money from clients? I have a better idea--try making some money for your clients and do your borrowing from your bank or your bookie like everyone else.

Borrowing from customers

How would you answer an exam question like this one?

A registered representative may borrow money from a customer
A. if the customer is a relative of the representative
B. according to the firm's written supervisory guidelines
C. only if the customer is a bank or other lending institution
D. under no circumstances

EXPLANATION: reading FINRA's August summary of disciplinary actions, I see an example of a registered representative at a firm here in Chicago who is no longer a registered representative and probably never will be. Why? He borrowed money from a customer who was not a relative and never repaid the improper $29,000 loan. Of course, if the rep had repaid the loan, I doubt anyone would have found out, but he violated firm policy and FINRA rules by taking the money in the first place. So, can a registered rep borrow money from no customer ever? Not quite, so we can eliminate Choice D. Can the rep borrow $ from a customer who is also a relative? Probably, but not automatically, so we can elminate Choice A. Surely a rep can borrow from a customer if the "customer" is actually the Clover Springs National Bank & Trust, right? Probably, but the only way to borrow money from customers--should you be so crass--is to do it according to your firm's written supervisory guidelines.

ANSWER: B

Typical Series 65/66 question. Two other answers almost work, but only one answer really satisfies the issue raised in the question. I think this one will become clearer if you see the real-world version of what I'm talking about. This is from the FINRA disciplinary wrap-up for August 2009:
Terrence Thomas Alexander (CRD #3273969, Registered Representative, Chicago, Illinois) was barred from association with any FINRAmember in any capacity. The sanction was based on findings that Alexander borrowed $29,000 from a firm customer contrary to his member firm’s compliance manual, which prohibited registered representatives from borrowing from customers other than relatives; the customer and Alexander were not related. The findings stated that Alexander failed to repay the loan.The findings also stated that Alexander failed to respond to FINRA requests for documents. (FINRA Case #2007011261701).
Oh well. It doesn't make him a bad guy--who knows why he needed $29,000? It's just unfortunate that he ended up going against the compliance manual and then blowing off FINRA's requests for documents. I'm thinking he could have reduced it to a suspension and a fine if he had cooperated with FINRA, worked out a repayment plan with the customer, and shown some remorse. In fact, that's exactly what happened at a recent hearing I attended at the IL Securities Department. For whatever reason, this registered rep's broker-dealer either didn't care or didn't discover that he had borrowed a similar amount of money from a client for a real estate deal he had cooked up and then--predictably--couldn't repay the customer. The customer filed a complaint form with the Administrator, and the rep had to come in to convince the "Administrator" not to revoke his license and issue an "order of prohibition" that would make it darned tough to ever re-enter the financial services industry. The hearing officer and the attorney for the Administrator were extremely cooperative and empathetic. The registered rep promised he would repay the gentlemen as soon as he could, and after a few minutes it was decided that by such-and-such date, the (former) rep would work out a repayment plan with the client, submit it to the "Administrator's" office, and go from there. No big deal.
Then again, this registered rep had not, apparently, violated his former broker-dealer's compliance manual, or--more likely--the firm was too busy to give a rip.
In any case, agents must follow their broker-dealer's compliance manual on every single point. And, if you get a request for documents from FINRA or your state securities Administrator, turn them over forthwith.

Trading markets for securities

The inherent challenge with the Series 65/66 exam is that it covers so many topics but only for a few questions at most. You wouldn't expect the next question to show up on everybody's exam, but you would expect something like this to show up here on there. So, let's be ready for the following possible exam question:

The inside market is:
A. highest bid, lowest ask from the market maker quoting the largest position
B. highest bid, highest ask from all market makers
C. highest bid, lowest ask from all market makers
D. lowest bid, highest ask from all market makers

EXPLANATION: when a customer places a market order to buy or sell stock, he is willing to pay the best available price ASAP to get the stock or sell it. The best prices for the customer would be the highest bid--if he's selling and the lowest ask/offer price--if he's buying.
ANSWER: C

Active Military Duty

Even though the Series 65 and 66 exams are for advisers and adviser reps, the questions frequently concern the broker-dealer side of the business. Therefore, let's see if you can answer a question like this one:

Javier Gamboa is a registered representative with AmericaFirst Securities, LLC. Javier was recently called up for active military duty in Afghanistan, where he is expected to remain deployed for 28 months. Therefore which of the following statements is/are accurate?
I. Javier's license will remain in effect if he completes Continuing Education while serving active military duty
II. Javier may receive commissions on securities transactions while serving active military duty
III. Javier must requalify by exam if his active military duty assignment exceeds 24 months
IV. Javier's license will remain in effect if he completes Continuing Education requirements after serving active military duty

A. II, IV
B. I, III
C. II, III
D. II

EXPLANATION: when a registered rep or principal is called up for active military duty, the SEC/FINRA are very accomodating. The rep's license is placed on inactive status, and the CE requirements are waived, as is the requirement to requalify by exam after a 2-year-plus absence. He can earn commissions on his "book of business" and will probably cut a deal with a fellow registered rep to service his customers while he's away. Javier can not perform any of the functions of a registered rep during this period, no matter how impressive it might be for customers to get a phone call from a guy dodging RPG's as he also worries about their asset allocation strategies.
ANSWER: D

Assignment of Contract

Remember that an investment advisory firm has a contract/agreement with their clients that spells out the services provided, the fees that will be charged, how the fees will be calculated, whether the adviser has discretion over the account and many other important features. In this contract there must be a clause that states that the contract can not be "assigned to" another party without client consent. If the adviser has 1,000 clients and the adviser sells out to a bigger player, those 1,000 agreements are not automatically assigned to the new adviser--rather, contracts need to be executed all over again. If the adviser is a partnership, and partners with more than a minority ownership interest are added or subtracted from the partnership, this would also constitute "assignment of contract," requiring new contracts to be signed.

One of my tutoring clients recently discovered this next point the hard way: the prohibition on "assigning" client contracts has to do with an adviser assigning the accounts to a different advisory firm. It does not mean that the adviser is somehow prevented from taking one of their IARs off a client's account and putting a different IAR over it. The client is the client of the advisory firm, remember. An IAR (investment adviser rep) is simply an employee who represents the investment adviser. This is not assignment of contract--it is simply how things work sometimes, especially if the IAR fires off a flaming email to the principals of the firm.
Oopsie.

Series 66 sponsorship

A customer just asked:
We just moved from a broker-dealer firm to an RIA. I have a Series 7 and 63. I have been told that since our RIA is not a member of or registered with FINRA, I cannot take the 66 ... I HAVE to take to 65 because to take the 66 you have to be sponsored by a member firm. Does that make sense? Is it correct?

RESPONSE: before we determine if they're correct, let me ask you this--do you have a preference to take the Series 66 over the Series 65? If so, are you assuming that 100 questions will make the 66 "easier" than the 65? It isn't. It's just a little shorter; it also requires a 71% score to pass, and it has more of a regulatory/legalistic focus compared to the 65.
Okay, so can you sponsor yourself to take the Series 66?
Yes. How do I know? NASAA is in charge of the 65, 66, and 63 exams. At:
http://www.nasaa.org/industry___regulatory_resources/exams/926.cfm#3
We find this:
Do I need to have a sponsor before I take the Series 63, 65, or 66?
No; you can sign up without a sponsor by filing Form U-10 and paying the fee. Indicate “None” or “Not Applicable” where the form requests a sponsoring firm.

License Exams

A customer just wrote an email that touches on some issues many candidates also face. She wrote:

Since things are so competitive right now, I thought I'd pass the tests that don't require sponsorship and then worry about the 6 or 7. I'm also working on getting my CPA. Is the 65 a better choice? If I pass the 65 I don't need to pass the 7? I guess my understanding was that ultimately to be licensed I'd need the 6 or 7. Thanks for clearing up the confusion for me. And thanks for the books-they are very helpful!

RESPONSE: to work as an investment adviser representative, you need to pass the Series 65 or 66 exam in order to then register with the state(s). It makes no difference to the state regulators which exam you pass--you just have to have passed one of them within the past 2 years when you register as an IAR or set up your own advisory firm. You're right that you can self-sponsor for either the Series 65 or Series 66 exam, but remember that the Series 66 exam only works if you also have or get a Series 7. While a Series 65 would allow you to register as an IAR or RIA all by itself, the Series 66 would do nothing for you until you pass the Series 7. But, if you do pass the Series 7, you'll be glad you took this route, as opposed to passing the Series 65, then later passing the Series 7 to become a securities agent plus the Series 63, the state law exam. The Series 7 and 66 provide the shortest path to becoming an IAR and a securities agent.

Economic Indicators

If you're studying for the Series 65 or 66 exam right now, you picked a pretty good time. Every day the economy is in the news, it seems, and the news typically uses some of the same terminology you'll see on the test: new unemployment claims, unemployment rate, consumer confidence, corporate profits, GDP, recession, economic stimulus, etc. Try to relate what you're hearing, seeing, and reading in the news with what you're studying for your exam. When the media begins to chatter about new unemployment claims dropping, remember that this is a leading indicator, and it's good news. Recently, it was reported that while new claims for unemployment were dropping, the unemployment rate rose slightly. That's the difference between a leading indicator and a coincident indicator. The number of new unemployment claims was changing before it was being reflected in the number of people who remain on unemployment. GDP, a coincident indicator, has been shrinking, but since the rate of shrinkage has slowed lately, some economists point to this as "good news." The stock market, a leading indicator, has been rising since March, and many people pin their hopes of a recovery on that signal. If it seems that nobody really knows where the economy is headed over the next year or so, there is good reason for that--nobody does. But that doesn't stop anyone from reading the economic indicators and using the numbers to make predictions about the economy. Your job is to know which indicators are leading, coincident, and lagging, and to know their significance. Expect two or three questions on economic indicators on the Series 65 or 66 exam.

Sharpe Ratio

The Sharpe Ratio measures a portfolio's returns in terms of the risk taken to achieve them. Try not to get too caught up in the "math" component of this concept. Remember that each step in the formula is communicating an idea. We take the returns the portfolio is showing, but we only give the portfolio manager credit for the returns that are above the returns on risk-free 3-month T-bills. That makes sense, right? If he's putting your money at risk, he only gets credit if he does better than what you could get in a government-guaranteed T-bill. So we take the return and subtract the yield on 3-month T-bills over the period. Why do we then divide by the standard deviation? Because we are taking points off his score for the amount of variance the returns showed. If the portfolio tends to jump up 10 percent one month then drop 20 percent the next, that standard deviation is going to lower his score. So, if the portfolio earns a 9% return when T-bills returned 5%, we take 9 minus 5 to get 4. We then divide 4 by the standard deviation. The higher that number, the lower our Sharpe ratio will be--if the standard deviation is 8, the Sharpe ratio is a puny .5. If the standard deviation were only 4, however, the Sharpe ratio would be 1, which is much better. The higher the Sharpe ratio, the better the risk-adjusted return.
That's basically what you need to know about the Sharpe ratio. Now you can move on to the 9,873 other things that you need to know for your exam.

Securities must be registered

If you wonder how "real world" any of the Series 65/66 material is concerning the Uniform Securities Act, click on the title of this blog, or this link below:
http://www.cyberdriveillinois.com/departments/securities/administrative_actions/2009/may/heartland_co.pdf

See how the IL Administrator can protect IL investors from offers of unregistered securities, even if the issuer is in another state?

In the following order, you'll notice that even what seems like a private arrangement between two parties can meet the definition of a "security." Unfortunately, all that results is an "order of prohibition," which means as long as he doesn't do it again, he's okay. He doesn't have a license to take away, right? Unlike you and your co-workers, who had better be on your best behavior from Day 1.

Here's that order of prohibition:
http://www.cyberdriveillinois.com/departments/securities/administrative_actions/2009/may/cleophusrobinson_oop.pdf


See if you can make sense of the legalese. It's a good preparation for your exam, trust me.

Interest Rate Risk

Which of the following securities is most susceptible to interest rate risk?
A. straight preferred stock
B. convertible preferred stock
C. convertible debentures
D. common stock

EXPLANATION: bonds and preferred stock are subject to interest rate risk--rates up, market price down. They pay a fixed rate of return, so whenever interest rates on new fixed income securities go up, the market values of existing fixed income securities drop. Every single time. Common stock doesn't pay a fixed rate of return, so interest rates are not as relevant to its market price. The market price for common stock is based on expectation of future profits, with bits of news driving those expectations up and down every day.
All righty then. Using these fundamental concepts, we can eliminate common stock, and then, since common stock drives the value of convertible preferred and convertible bonds, we can eliminate those two choices, too. We're left with straight preferred stock, which pays a fixed rate of return, period.
ANSWER: A

Licensing, Registration

Which of the following represents a true statement concerning licensing and registration of registered representatives and investment adviser representatives?

A. passing a license exam constitutes the attainment of a license to sell securities or investment advice

B. upon passing a license exam a candidate is licensed subject to being granted a registration by the state

C. agents register with the SEC; investment adviser representatives register with FINRA

D. a conviction of misdemeanor theft does not need to be disclosed on Form ADV after 10 years

EXPLANATION: I wrote this question after receiving an email this morning from a customer studying the Series 65. He asked, "After getting a license do I need to register as an RIA?" In other words, he mistakenly thought that passing the exam = getting a license. And, he didn't realize that "license" and "registration" are two words for the same thing. Some states call it a "license," others call it a "registration." either way, passing an exam only allows you to APPLY for a license. Will you get one? Probably not if you have misdemeanor theft convictions in the previous 10 years. Believe it or not, Form ADV only goes back 10 years, while U-4 asks if you have EVER been convicted of securities-related misdemeanors or any felonies. Agents register with FINRA; IARs register with the state Administrator(s).

ANSWER:D

Arithmetic and Geometric Mean

I completed my undergraduate work at the excellent University of Illinois, where I majored in English (Rhetoric) while secretly in awe of all the engineering students who actually had to, like, study. Starting with first semester, these students had to take a five-day-a-week Calculus class, which seemed to meet only at 8 o'clock . . . in the morning! Obviously, Calculus pops up in an engineer's daily work about as often as half the Series 65/66 material will pop up in yours. Ultimately, they are both weeding-out processes designed to thin the herd of professionals to a workable number. The students who got through Calculus 101 with an A or a B went on to enjoy technical careers, and the ones who didn't apparently now write questions for the Series 65 and 66 exams.
Like the following gem that you might actually see on your test:

If an investment adviser representative needs to calculate a portfolio's expected return, he will be working with which of the following?
A. geometric mean
B. arithmetic mean
C. mean reversion
D. harmonic mean

EXPLANATION: mean reversion can be eliminated. This is what the geniuses at Long Term Capital Management based their trading strategy on, allowing them to lose $500 billion dollars 15 years ago when something happened that their models didn't, like, factor in. I don't know what the "harmonic mean" is, and I'll probably indulge in a rare academic treat of not looking it up. If we calculated an "arithmetic mean," we would be figuring a simple average that would be misleading for investing. For example, if you put $10,000 into your brokerage account and had the following returns, what would your account be worth at the end of the third year?
Year 1: -10%
Year 2: -20%
Year 3: +30%

If we try to take a simple "arithmetic mean" or average of -10, -20, and +30%, it might seem that the account should be back at $10,000. But, in fact, the account would be worth only $9,360. When the value dropped 10%, the account went to $9,000. When it lost 20%, it dropped to $7,200. If that account rises 30%, we're only back to $9,360.
So, in order to avoid this mistake, we would need to find the so-called "geometric mean," rather than the "arithmetic mean." And, if you can choose the right term on this possible test question, you will be that much closer to passing. So, there you have it.
ANSWER: A

Fiduciary Duty

I've never met the people whom NASAA pays to write the Series 65, 66, and 63 questions, but I gather they don't get out much. Many of the situations you encounter in their little test questions are about as likely to happen in the real world as a Cubs-Sox World Series.

Let's look at something that is just weird and trivial enough to make it onto your exam:


An investment adviser purchased ABC 4.5% callable debentures for the omnibus trading account last May, allocating the bonds to various client accounts. Now in April the adviser receives warrants to purchase ABC common stock as a bonus for purchasing the debentures. If the adviser places the warrants in his own account
A. he has complied with prudent investor standards, as warrants are unsuitable for bond investors
B. he has breached his fiduciary duty to his clients
C. he has engaged in standard practice for omnibus trading accounts
D. the warrants are not subject to registration requirements

EXPLANATION: if the warrants were part of the offer of the bonds, I don't see why the adviser thinks he gets to keep them. And, if he does keep them, he's putting his interests ahead of his clients, which is a breach of fiduciary duty.
ANSWER: B

Yeah, so when you get yourself licensed as an IAR or RIA, please remember not to keep all them-there warrants that issuers send your way. And, for now, be ready for a test question like this one, or even goofier.

Referrals from Investment Advisers

If an insurance agent or CPA refers clients to an investment adviser for compensation, chances are that individual or firm is considered to be acting as a solicitor for the adviser. Therefore, the adviser has to be registered and the professional acting as a solicitor can not be in-eligible for registration due to disciplinary or legal problems in the past 10 years. Most states would call the solicitor an investment adviser representative and require him to register as an IAR for the RIA, ASAP. Even if the solicitor didn't have to register, there would have to be a written agreement between the adviser and the solicitor, and the adviser would need the client's acknowledgment that they received both the RIA's disclosure brochure (ADV 2) and the solicitor's disclosure brochure.
So there's that. But, what if you saw a question like this one?

Several of your advisory clients are retired investors in need of estate planning services. Your firm does not specialize in these services and, therefore, you have an arrangement with a local tax attorney by which you receive a flat $275 referral fee for every advisory client who becomes an estate planning client of the attorney's pursuant to your referral. Therefore
A. you must disclose the referral arrangement to all clients who use the attorney's services
B. you must disclose the referral arrangement to all clients referred to the attorney
C. you need not disclose the referral arrangement
D. you have violated the Uniform Securities Act's prohibition against advisory referrals

EXPLANATION: everything the adviser does must be totally objective and, when that's not possible, disclosure of the conflict is required. If the adviser refers clients to the attorney, clients might assume he's just looking out for their interests. But, by definition, he's looking out for his own financial interests, too--so he's no longer being objective. And, maybe there are better attorneys out there at better rates. So, disclosure is definitely required.
ANSWER: B

With a Name like Smucker's

Back in the year 2000 an old friend of mine asked me to come up with a list of stocks that he might want to purchase with the fat salary and bonuses he was then making in commercial real estate. Not surprisingly, a couple of guys in their mid-30's at that time came up with 10 or 12 ideas, every single one of them a technology or internet company. We printed up the current stock price, a brief profile on the company, their current sales figures, and the 52-week high and low. My buddy's Uncle, then 67 years old, asked to see our little list and very politely pointed out, "There's just one thing missing here, guys."
"What's that?" my buddy asked.
"Earnings."
My buddy, in a somewhat condescending tone, explained to his uncle that "these days, earnings don't matter, Uncle Jim."
A few months later the tech bubble burst, NASDAQ crashed, and is still below 2,000, when it was at about 5,000 at that time!
Earnings don't matter?
Good thing Uncle Jim knew better. Five years later he passed away and, having no children of his own, left a stock portfolio worth just shy of $1 million to his three nieces and two nephews, even the one who tried to tell him that earnings don't matter. Since that time I have never bought a stock in a company that is not showing a profit/earnings. And, by golly, not one of my companies has ever gone bankrupt or had their stock de-listed--having, like, a profit can really keep a company out of trouble as it turns out. I don't buy sexy, exciting companies--I buy companies with strong brand names quietly churning out millions of dollars a year in profits. Companies like the JM Smucker Company. Most people would think--you want me to buy stock in a jelly and jam company? No. Dig a little deeper and you see that they own all of the following brands: Crisco, Jif, Hungry Jack, PET, and Pillsbury. Look at their income statement and you'll see that their sales jumped from about $2.5 billion in 2008 to $3.7 billion in 2009, after climbing steadily the previous three years. Their net profit margin is fairly high for their industry space --7.08%. We all probably use some of their products, or know people who do. Therefore, I'll become rich off the 100 shares I purchased this morning, right?
Unfortunately, no one can tell you that. I don't care if they use modern portfolio theory, technical analysis, or the kind of fundamental analysis I'm referring to in this post--nobody knows the future. Not even Warren Buffett. The name of Buffett's company, Berkshire Hathaway, by the way, comes from the first acquisition Buffett ever made, which, ironically, turned out to be one of his all-time worst investments . . . a textile manufacturer.
In any case, your assignment today is to take some big, boring company like Microsoft, IBM, J M Smucker, or Procter & Gamble, and look at a profile. What are their sales/revenue? What are their profits? Do they pay a dividend? How much, and what is the dividend yield? Smucker's (SJM) is trading for about 15 times earnings (P/E ratio), pays a dividend of $1.40, for a dividend yield of 2.9%. What about the companies that you're interested in?

Real World De Minimis

I just had a former client, who passed his Series 66 with an 80%, send me an email wondering if the de minimis exemption for out-of-state advisers with 5 clients actually applies in the real world, since he has 1 client in the state of Colorado but no place of business there.

Here is Question 8 and the answer from the Colorado Division of Securities website:

Q: Are there any exemptions from licensing for an IA located in another state, that are not FCAs?
A: The law contains a diminimus exemption from licensing for an IA that has no place of business in Colorado and has five or less clients in Colorado.

By "FCA" can you guess what they mean? Federal Covered Adviser. So, if I'm not a federal covered adviser, I have no place of business in Colorado, can I have 5 clients there without registering there? Yes. This saves you some time and money. Of course, if you defraud these Colorado residents, Colorado can come after you, and so can your state securities Administrator. But, you don't plan to do anything like that, of course.

And, of course, things change when the adviser employs an IAR with a place of business in Colorado, as # 9 on the website explains:

Q: What is required of an IA located in another state that is not a FCA, has five or less clients in Colorado and employs one or more IARs with a place of business in Colorado?
A: The difference between this question and the one immediately above is the IA employs IARs with a place of business in Colorado. It does not matter how many clients are located in Colorado. An IA should file a current Form ADV and pay the appropriate fee. For each IAR with a place of business in Colorado the IA shall file a Form U-4 for each individual and pay the IAR fee.

As you can see--and as I've written before--much of the information that you study for your exam is connected to the real world. It's just buried under a bunch of tricky exam questions filled with mumbo-jumbo. But the de minimis exemption is 5 on the test and 5 in the real world. Just thought you'd like to know that.

Rule of 72

First off, the "rule" of "72" is not a rule in the sense of "rules and regulations." It is simply a quick rule-of-thumb method of calculating future value. If you take a rate of return and divide it into 72, the answer tells you how many years it will take for your money to double. At 9%? Eight years. 72 / 9 = 8. Or, you can take the number of years in which you need the money to double and divide that into 72. The answer here gives you the required rate of return. If you want your money to double in 4 years--good luck. 72 / 4 = 18, and you aren't getting a compouned 18% return anywhere legal.
So, the Series 65/66 could easily throw a smart-aleck question like this one at you, and I'd like you to be ready for it, like a big-league hitter smiling as a rookie pitcher tries to jam him up high and inside. Ready? Let's take a look anyway:

Melody's goal is to invest $2,000 today into an aggressive growth mutual fund. At the end of her 10-year time horizon, Melody expects the account to be worth roughly $8,000. The approximate compounded rate of return required is:
A. 7.2%
B. 10.3%
C. 14.4%
D. 27.4%

EXPLANATION: using the "rule of 72" you immediately hit a speed bump when you realize that melody doesn't just want the money to double--she wants it to double twice in 10 years. Typical Series 65/66 brushback pitch. Oh well. 7.2% would be the answer if she wanted the money to double once in 10 years. I guess the rate needs to be twice as high, right? 14.4% approximately.
ANSWER: C

Investment Adviser Rep Registration

Mary Ellen represents a federal covered investment adviser in State A, with her main office there. Once a month, as she passes through State B on her way to work, she meets with 4 financial planning clients at a diner to discuss investing strategies. Therefore
A. Mary Ellen need not register in State B due to the number of clients there
B. Mary Ellen must register in State B
C. Mary Ellen need not register in State B as she has no place of business there
D. Mary Ellen may register with either State A or State B

EXPLANATION: Mary Ellen does have a place of business in State B, so the number of clients is irrelevant.
ANSWER: B

Prospectus Delivery

It's Friday morning and, as usual, I'm at the FINRA website looking for rule changes and recent disciplinary actions that relate to testable points. And, as usual, it only took a few seconds to find what I'm looking for.

Remember that the Securities Act of 1933 and the Uniform Securities Act are predicated on full disclosure of material facts in the offer and sale of securities and in the solicitation and rendering of investment advice. When investors are mislead or kept in the dark about important facts, the regulators get bent out of shape, as well they should. This morning I see that a fine broker-dealer recently got its wrists slapped over their failure to deliver prospectuses in a large number of transactions. You can read the announcement at the link below. Also, note that in most IPOs these days, the issuer can simply post the prospectus online, but for ETFs and mutual funds, a hard copy prospectus still needs to be delivered.

Enjoy. I'm off to the office to prepare for the Friday Free Broadcast.

The announcement is at:
http://www.finra.org/Newsroom/NewsReleases/2009/P119052

Defining Investment Advisers

Which of the following professionals least likely meets the definition of an "investment adviser"?

A. an accountant who charges only a nominal fee to help tax clients with allocation strategies for their retirement accounts
B. an individual who writes a financial newsletter for compensation to a group of subscribers in several states
C. a financial planner
D. an insurance agent who occasionally provides financial planning services to his clients

EXPLANATION: according to the so-called "three-pronged approach" developed by the SEC's Release IA-1092, the individual has to be giving advice that is specific to the client's situation in order to meet the definition of "investment adviser." The writer of a financial newsletter is just a publisher/writer enjoying his First Amendment rights. Of course, an adviser who never meets face-to-face with clients would still be an adviser if he wrote up his personalized recommendations and sent them to each of his clients. The key here is the specificity--is the adviser writing to a general audience, or is he advising individuals based on their unique situations? The newsletter writer is just a publisher, not an adviser. The accountant is crossing the line by charging to help with investments. The financial planner is the perfect example of an investment adviser. And the insurance agent becomes an adviser as soon as he holds himself out as a professional who provides financial planning services. The only caveat there is that if the financial advice had absolutely nothing to do with securities, the insurance agent would escape the definition of "investment adviser." But that would require him to talk only about, say, credit cards, personal budgeting, real estate, and fixed annuities.
ANSWER: B

Fundamental vs. Technical

Basically, fundamental analysis involves looking at a particular company, while technical analysis only looks at the company's stock price, or the stock market overall. While a fundamental analyst looks at financial statements to see if XYZ is selling products, making a profit, increasing shareholder equity, etc., a technical analyst couldn't care less about the company itself. A technical analyst just wants to see where XYZ's stock has been trading and figure out where it's headed next by looking at volume, charts, moving averages, etc. A fundamental analyst doesn't try to determine what a company's stock is going to do over the short-term. Instead, a fundamental analyst tries to buy an ownership stake in a great company that should grow in value over time. Price-to-earnings, price-to-book, dividend payout ratios, profit margins, etc. are concerns of the fundamental analyst. Support, resistance, breakouts, volume, and moving averages are concerns of the technical analyst. If he studies data on a company's financials, he's a fundamental analyst. If he studies market data on the company's stock price, he's a technical analyst.
Which one is more likely to lead to profits?
That's way beyond the scope of the exam, assuming anyone could answer the question in the first place. But I kind of like the results that Warren Buffett and Charlie Munger, Peter Lynch, and the "Motley Fools" have shown with fundamental analysis. A successful technical analyst? He'd probably be glad to sell you a once-in-a-lifetime-educational-opportunity that will show you how to earn millions trading the stock market for just $3,999.99.

More on Duration

We're probably going a little overboard here, but let's take a quick look at the actual formula used to calculate duration. Not that I think you'll have to calculate it on the exam, but the concept becomes clearer by fussing with the formula a little. Remember that duration is a weighted average of a bond's cash flows--the longer you have to wait to receive a significant part of your bond investment back, the higher the duration. Let's say you buy a 2-year T-note with a 5% yield. If so, you would receive exactly four interest payments and one principal payment. The total amount of money received would be $1,100. The formula would look like this:

.5($25/$1,100) + 1($25/$1,100) + 1.5($25/$1,100) + 2($25/$1,100) + 2($1,000/$1,100)

That might look crazy at first, but if we break it down, it makes perfect sense. The little ".5," "1," "1.5" and so on are representing the income payments received at the first half-year, the first year, the first year-and-a-half, etc. In parentheses, we see that the income received is a percentage of the total $1,100 that will be returned to the investor. At the very end, $1,000 of principal is returned, along with the last income payment of $25. The duration turns out to be just a little less than 2 (1.92 approximately), and, of course, if the number were higher than 2, we messed up. As the test question might say, the duration of a bond paying interest is always lower than the term to maturity. But, a zero coupon bond's duration equals the maturity. Looking at the formula above, we see that it would have to. You would only have one entry on a zero coupon bond, since it only makes one payment.

For fun, run the calculation with a bond paying 10%, and you'll see that the duration is lower with a higher coupon rate. The bond would be paying ($50/$1,200) with each interest payment and returning ($1,000/$1,200) at maturity, making the duration on this bond/note approximately 1.86.

Ah, there. Now I can get some sleep.

Duration, Interest Rate Risk

A customer just emailed me for clarification on a very tough practice question:

Which of the following securities would react the most to a change in interest rates?
A. 10-year corporate subordinated debenture
B. 11-year AAA-rated municipal bond
C. 20-year US Treasury bond
D. 20-year US Treasury STRIP

EXPLANATION: this question is about "duration," which is a measure of a bond's interest-rate risk. The textbook definition is "a weighted average of a bond's cash flows." Sounds tough at first, but it really isn't. A "weighted average" means that we give more points to certain items than others, as in school, when homework might = 10% of your grade, 40% for the midterm, and 50% for the final exam. But, rather than focus on the "weighted average" part, just remember the "cash flow" part, which is key to understanding duration. You don't have to calculate duration, but if you did, you would give more weight to certain income payments than others. What's important here is a general understanding that it is "safer" to hold bonds that pay out big income streams--it calms people down when they're getting $120 a year on a 12% bond. But, if they're getting $40 a year on a 4% bond (after paying $1,000 for the bond), that could make them a little nervous. So, bonds with high coupon rates have lower durations (less interest rate risk) than bonds with chinsy little coupon rates. Also, the longer the term on the bond, the more nervous investors are about holding it.
So, in this question we look for the longest term to maturity, which is 20 years. One of these bonds has the highest duration--is the most sensitive to interest rate changes. If we have a 20-year T-bond and a 20-year STRIP, we have to remember that zero coupons pay NO cash flow--so they have to have a higher duration than bonds of equal maturities that DO pay cash flow. Duration is founded on the concept that investors will receive part or all of the principal they paid for the bond through the interest payments received--the faster that happens, the safer it is to hold the bond. Even if it's only a 3% nominal yield on a U S Treasury bond, after 20 years, you'd collect $600 on a 20-year bond. On a 20-year zero coupon (strip), you'd still be waitin' and a hopin' you receive the par value upon maturity. So, the test wants you to know that a 20-year bond paying interest will always have a lower duration than a 20-year zero coupon. Similarly, if you loaned $1,000 to a friend, would you rather have him pay back $100 a month or give him 5 years to pay it all back in a lump sum?
Me, I'd be a lot more laid back receiving payments regularly.

ANSWER: D

Investment Adviser Registration Requirements

Here is a likely question on your Series 65 or 66 exam:

If an investment adviser is properly registered in State X, where it maintains its main office, and the adviser is also registered in State Y, what is true if the Administrator of State Y requires higher net capital than what is required in State X?
A. The Adviser must obtain a surety bond to cover State Y's requirement
B. State Y can not have a higher requirement than State X
C. The adviser does not need to comply with the higher requirement in State Y
D. The SEC must provide no-action relief to the adviser

EXPLANATION: you'll find this rule in the Investment Advisers Act of 1940, and it makes perfect sense. If the adviser is properly registered in State X and meets the state's financial requirements, the firm can not be forced to meet the other state's higher requirement. Similary, a state regulator can not tell a federal covered adviser that their net capital isn't high enough--that's the SEC's job.

ANSWER: C

Practice Question - Real Return

Here is the sort of question that makes virtually all Series 65 and 66 candidates cringe at the testing center. With all the details provided, the question can hit you hard at first. Remember, your job at the testing center is to take a deep breath, then hit back.

What is your investor's real rate of return for holding the XYZ Light Corporation's 20-year bond with the following features:

• Coupon rate 5%, paid semi-annually
• Rating A-
• Maturity date December 1, 2016
• CPI 2%
• Par value $1,000
• Purchase price 90
• Call date January 1, 2019
• Call price 101 3/8.
  
  A) 5.00%.
  B) 3.50%.
  C) 2.50%.
  D) 4.50%.
  
  EXPLANATION: once you decide to ignore the credit rating, the par value, the call date, and the call price, you can start solving the question. Take the $50 in annual income divided by the $900 purchase price, which is 5.5%. Then, reduce that by the 2% rate of inflation (CPI) and choose 3.5%. Typical Series 65 question--like a bully, it seems scary at first. Then you learn how to deal with it, and, eventually, it ceases to be a problem.
  
  ANSWER: B

Hospira?

I've mentioned that the exit strategy for my little foray into margin loans is the inevitable rise of Hospira common stock. If Hospira rises to $55, I can sell my 90 shares, pay back the margin loan and continue to hold the other shares I currently hold in an IRA. But, what is this "Hospira" I keep referring to? It's a former unit of Abbott Labs, which is another stock I own (and love). Hospira was spun off from the parent comany, which is where I got my initial dose of the stock. Later, when I became the executor of my mother's estate, I purchased 270 shares, or 90 for me and each of my two sisters. Hospira is a very simple, straightforward company--basically, they make injectables and I.V. systems for use in hospitals, clinics, and in-home care. In the past five fiscal years, their sales/revenue came in at about $2.64 billion, $2.62 billion, $2.68 billion, $3.43 billion, and $3.63 billion. Their net income (profit) has been anywhere from $107 million to $321 million most recently. The stock is not trading expensively--like most stocks these days--at only 13 times earnings. It earns $2.61 per share but--like many companies--pays no dividends. How do you make money on a stock that pays no dividends? You wait for it to rise in value, at which point you can sell for a capital gain or, perhaps, the company eventually does start paying dividends, making it both a growth and an income investment. From a technical standpoint, the short interest is very low in the stock; only about 2.5% of the shares have been sold short. The 52-week high is about $42; the 52-week low is about $21. Lately, it's on an uptrend: +7% last 5 days, +8% last 30 days, +15% last 60 days. What does this all mean for my chances of Hospira rising to $55 or higher, allowing me to sell and pay back the $5,000 I borrowed from my margin account? No idea. Luckily, the exam doesn't expect you to know something like that. The exam just wants you to have an idea what earnings and P/E ratios might be, which stocks are generally more volatile and which are generally more stable, that sort of thing. Being able to relate some of this exam material to the real world will give you a big edge when studying, so I encourage you to look up some of your favorite companies and look for testable points. Glance at the income statement, click on the "overview," and have yourself as much fun as I'm currently having at about 5 AM on a cold, dreary morning in early June.