Saturday, January 31, 2009

Custody issues for advisers

The issue of "custody" for investment advisers is one of the most challenging of all the big "testable" topics on the Series 65/66. What does it mean to have custody? In Plain English, it means to have control over client securities and/or cash in a way that would make any sensible regulator nervous. NASAA defines custody like this: holding directly or indirectly, client funds or securities, or having any authority to obtain possession of them [or has the ability to appropriate them]. Basically, if the adviser has control or access to client assets, he has custody. What's the big deal? Advisers "deemed to maintain custody" of client assets have higher net capital requirements and must be audited annually by a CPA, who will report to the Administrator on whether the books are or are not in order. Imagine for a second the frightening responsibility of maintaining custody of client assets. Every day the markets are open stock prices change. Customers buy more shares here, sell some shares there, receive a big dividend check here, a big interest check there. The cash is swept into a money market account, and somebody has to credit the proper amount of interest for all that. I mean, I have five investment accounts myself, and I do some really lousy record keeping on just those few accounts with my own money and stock inside them. I can't imagine how fast the IL Securities Department would end up shutting me down if I registered as an adviser and then indicated on Form ADV that I would be maintaining custody of client assets. If you've seen It's a Wonderful Life, I think we can safely say that I'd end up stammering worse than ole' George Bailey as the family's building & loan was about to go belly up.
What I would do instead is use a "qualified custodian." According to NASAA, a "qualified custodian" includes:

(i)A bank or savings association that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act;
(ii) A registered broker-dealer holding the client assets in customer accounts;
(iii) A registered futures commission merchant register under Section 4f(a) of the Commodity Exchange Act, holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon and
(iv)A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

So, unless you're a bank or a custodial broker-dealer, I'm not sure why you'd want to be "deemed to maintain custody." You don't want to maintain the $35,000 minimum net capital, take on the awesome responsibility of the all the record keeping, deal with the annual surprise audit, etc. This is why your exam will likely ask a question or two about custody issues. For example, you might see one like this:

In which of the following cases would an investment adviser be deemed to maintain custody of client assets and, therefore, be required to maintain a higher minimum net capital?
A. the adviser forwards a client’s third-party check to the payee within 24 hours
B. the adviser inadvertently receives a client’s securities in the mail from the client and promptly forwards them to the custodian.
C. the adviser inadvertently receives a client’s securities in the mail from the client and returns the securities two days later, keeping records of the receipt and return
D. the adviser sends the qualified custodian a billing statement and also a statement to the client but does not deliver quarterly account statements to the client directly

Pretty tough question. As always, let's take them one at a time, attempting to eliminate each answer choice until we find one that can't be eliminated. If the adviser forwards a check written to a third-party within 24 hours, the firm does not need to maintain higher net capital requirements. If the adviser receives client securities, they need to be returned to the sender within 3 business days, with detailed records of what happened, when and how they were returned, etc. If the adviser does that, he/they do not have to maintain the higher net capital requirements, the annual audit, etc. Even though the adviser in choice "D" is considered to have custody, since the adviser can appropriate money from the client's account, as long as certain "safeguards" are in place, the adviser does not have to meet the higher net capital, etc. Choice "D" describes those safeguards pretty well--send a billing statement to the custodian and to the client; the custodian will send the account statements. Why is the answer "B"? The adviser should have returned the securities to the sender, as opposed to forwarding them to another party. Because the adviser forwarded the securities, the firm, therefore, had possession of the securities (at least for purposes of an exam question).

Yes, unfortunately, your exam can get at least this detailed, even though "custody" is but one of many, many testable points. Welcome to the world of the Series 65/66. Don't worry--it will all be over soon.

Friday, January 30, 2009

Adviser Registration

As much as I enjoy writing about exam topics, I'm convinced that I can provide the biggest benefit by breaking down potential exam questions. Many candidates under-utilize test-taking strategies, and many simply don't know that the multiple choice format always has a weakness that can be exploited. The easiest structure for you to defeat is the "roman numeral" or "multiple-multiple" format. With process of elimination, we can filet the following seemingly hard question. First, you take a crack at it. Then, I'll give you my take.

Which of the following represent(s) an accurate statement(s) concerning the registration of investment advisers?
I. an investment adviser may not be organized as a sole proprietor
II. an investment adviser may not conduct business at a private residence
III. Form ADV is used for either federal or state registration
IV. Form ADV Part 1 must be updated annually
A. I only
B. II only
C. III, IV only

Step one is to look at how the roman numerals have been distributed--what could you eliminate that would quickly eliminate one or two choices? Basically, once you decide on "I," you either eliminate A and D, or you eliminate B and C. Either the answer has a "I" in it, or it doesn't, right?
So, what about the statement that advisers can't operate as sole proprietors, implying that they must be partnerships, LLC's, or corporations? Did anyone ever try to hammer that point home? An adviser can't operate as a sole proprietor? Why not? It's untrue. Check out a Form ADV, and you'll see spaces to indicate whether the adviser is a sole proprietor. So, "I" is out, knocking out anything with a "I" in it. A and D are gone.
Now, your answer either has a "II" in it, or it doesn't. Does an adviser have to have a business address, or could a sole proprietor operate from a residence? Again, a cursory familiarity with Form ADV will show you that the form asks if the address given is, in fact, a private residence. And, why not? If you're just managing a few portfolios, why couldn't you enter trades through one computer in your basement, den, attic, etc.?
So, if "II" is false, B is eliminated, and the answer to the question has to be "C." To double check that "III" and "IV" are true statements, go to and view a PDF of the paper-based Form ADV Part I. You'll quickly see that there are 4 boxes to be checked at the top. One is to indicate that you're filing with the SEC. One indicates you're filing with a state regulator. The next two boxes indicate that this is the annual update or that this is an "other than annual amendment" to report a major change that has occured rendering the information on file inaccurate or incomplete.
Try to use test-taking strategies to gain the upper hand on these annoying test questions. Use the part of the question that you know to eliminate the wrong answers. If you eliminate one answer, you go from a 25% chance of success to 33.3%. If you eliminate two wrong answers, you sit 50-50, which is pretty good when guessing. What happens when you elminate three answer choices?
Move on to the next question.

Saturday, January 24, 2009

Securities registration

I really don't get this securities stuff--federal covered, exempt, non-exempt. What the heck is going on here?

The state regulators are out to protect their investors from scams and offerings of worthless investments. They let the SEC sweat the big exchange-listed companies like IBM or MSFT. It's the small companies trying to pay their American Express bills by selling "preferred stock" or "promissory notes" to gullible investors that the states worry about. So, before even offering securities, you have to either register them or claim an exemption.

Go to and click on the "Cease & Desist." The two "William Wesley" characters referenced in this administrative order demonstrate perfectly why we have state securities registration requirements. Starbucks is federal covered--register that stock with the SEC, the federal regulator. But, this crazy investment offering 120% annual interest to folks in Arkansas--the state would really have preferred that Mr. Webb register the investments first, if only to provide some overworked government employees with a really good belly laugh at two o'clock on a hot August afternoon in Little Rock.

So, if it's a "federal covered" security, the states let the SEC worry about the registration requirements. If it's a Treasury or municipal security, a bank security, a religious organization bond, etc., it's an exempt security--not required to register. Otherwise, if the investment is, in fact, a "security," it must be registered with the states before it can even be offered--let alone sold--to investors there.

But, is the thing even a "security"? If not, the securities Administrator has nothing to say about it. If so, registration and anti-fraud requirements apply. The Howey Case says that an investment contract, which is a security, is anything where the investor puts money into some enterprise and will benefit solely through the efforts of others. He doesn't work at the enterprise. He's just an investor. If so, whatever the promoters try to call the thing they're offering him, it's a 'SECURITY' and is subject to registration requirements plus the ever-present anti-fraud rules. If I go to the diner next-door to my office and try to sell "units of participation" to the other patrons, offering people a 3% profit participation in my business in exchange for, say, $10,000, I'm offering an investment contract, which is a security. So, if I do this without registration, I would be in huge trouble if the regulators found out. The IL Securities Dept would require that I register the securities and show them the disclosure documents I plan to provide to investors. They would make me print a section devoted to risk disclosures right up front in the prospectus informing investors of material facts like this:

This is a small company with limited operating history upon which to base an investment decision

This security does not trade on any active secondary market

You should not invest any funds you can not afford to lose in this enterprise

Wouldn't that sort of disclosure scare off some investors? Absolutely, which is just fine with the securities regulators. Only if investors know what the heck they're getting into can the securities markets function properly. Keep them in the dark or mislead them with deception, and you're talking about securities fraud.

So, once again, the first question a securities regulator has is this, "Does the investment meet the definition of a 'security.'?" If not, we're done talking about it. If so, it's subject to anti-fraud statutes. Does it have to be registered?

Yes. Unless it's an exempt security such as a T-bill, a church bond, bank stock, or short-term commercial paper issued by a highly-rated company, etc. Or, if the security is being offered and sold in an exempt transaction, then registration is either not required or it's completed in a fast-track, scaled-down approach that saves the issuer time and money.

Therefore, we can say with utter certainty that all securities have to be registered, except for all the securities that do not have to be registered.

Welcome to the Series 65, 66, and 63. Don't worry--it will all be over soon.

Form ADV

Investment Advisers register with either state regulators or the SEC. Either way, they register through Form ADV. Form ADV is for adv-isers. It has two parts. Part 1 is what the adviser files with the regulators. Part 2 is what the adviser gives to prospects. The two parts of Form ADV have much overlap. And, if there are discrepancies between the information filed with the regulators on ADV Part 1 and the information shown to prospects on ADV Part 2, the adviser could be subject to harsh disciplinary action. For example, it they tell the regulators that the firm does not charge performance-based compensation, when, in fact, ADV Part 2 explains in detail how the performance-based compensation works, well that's going to generate some swift and terrifying legal action on the part of the state regulators or the SEC.
Advisers register electronically through a system called the "IARD," which stands for "Investment Adviser Registration Depository." It's administered by NASD, which is now called FINRA since people were actually starting to understand what the heck is going on, which is never tolerated long in this industry. Form ADV contains basic information on the adviser, which is usually a firm and occasionally an individual. Either way, the regulators want to know the name of the business, the ownership structure, how the firm operates, who the principals are, how much control the adviser has over client accounts and client assets, etc. If there have been disciplinary problems or lawsuits against the principals, there may be some explaining to do on Form ADV Part 1 and Part 2. If any of the information filed is misleading or false, the person filing it is subject to disciplinary action, civil penalties, and, in some cases, criminal prosecution. The "form" is filed with the initial registration, and it must be updated each year within 90 days of the close of the firm's fiscal year. Also, if a "material change" in any of the information on file occurs at any point, the firm must file an updated Form ADV promptly. So, there's the annual update that all advisers perform, and there is also the requirement to update any material information that has changed since their last filing. For example, if the firm moves, or acquires a financial planning company, or suddenly starts using discretion over client accounts, their ADV Part 1 would need to be updated promptly.
Form ADV Part 2 is the adviser's "disclosure brochure" given to prospects 48 hours before they sign an advisory contract or "at the time of signing, if the client has 5 days to cancel without financial penalty." In other words, give the prospect time to consider your advisory firm, warts and all, before he or she lets you take over the awesome responsibility of managing their money.
You could easily request a copy of a paper-based Form ADV on any adviser registered with the SEC. And, most advisers would be happy to send you a PDF of Form ADV. If you would like to view an actual Form ADV Part 2, I have one at Notice how this adviser avoids virtually all potential conflicts of interest and goes out of his way to avoid being "deemed to have custody." Notice how he clearly explains how fees are charged, and how minimum investments and advisory fees are negotiable. I'll let you take it from here. As always, if you have questions, post a comment. Chances are, if it's on your mind, other test-takers are wondering about it, too.

Friday, January 23, 2009

Registration issues for investment advisers

An investment adviser either manages portfolios for a percentage of assets, or the adviser provides financial planning services that at least partly involve securities. If you are a financial planner with a place of business in Tennessee, you need to register with the "Administrator" of Tennessee. The "Administrator" is just a model term from the model Uniform Securities Act. In the actual state of Tennessee, the "Administrator" is called the "Tennessee Securities Division," and they enforce the "Tennessee Securities Act of 1980." The Tennessee Securities Act is probably very similar to the little pretend model called the "Uniform Securities Act," but if it weren't--so what? They're a sovereign state; they can pass whatever version of securities law that they see fit, more or less. In any case, the Tennessee securities regulator would require you to register as an investment adviser. If you had no place of business in any other state, you would not have to register in any other state, unless you had more than 5 clients there. On the other hand, if you had a place of business in any other state offering financial planning services, you would have to register in that state before setting up shop. Having a place of business in a state is the most important fact to a regulator requiring registration. And, we're not talking about an "actual office," as many students like to say. On the test, if somebody meets with prospects or clients at a diner in Rhode Island to discuss or deliver financial plans, that somebody does have a place of business in Rhode Island, regardless of the number of clients, and needs to register as an adviser in that state. See, the number of clients (the magic number 5) is only relevant when the adviser does not have a place of business in the state. Once they start doing business, or even holding themselves out as being available to provide advisory services, in a state, they must register there. Remember that we're talking about the test world here. We could never make a statement that holds true in all 50 states--Wyoming doesn't even require advisers to register, for example. So, please don't post comments about exceptions in the real world. Readers of this blog have too much information to deal with as it is without going there.
Speaking of Wyoming, though, if you set up shop as an adviser in, say, Cheyenne or Laramie, Wyoming, you would actually not have to take the Series 65 or Series 66 exam. Why not? Because these exams are only required by state regulators, what the exams call the "Administrator." As it turns out, the State of Wyoming sees no reason to make investment advisers register. But, as usual, there's a catch. Since the State of Wyoming has no adviser registration requirement, the SEC steps in and asserts their authority under the Investment Advisers Act of 1940 to make that adviser register with them.
But, luckily, the SEC couldn't care less about some silly exam called the "Series 65" or "Series 66." So, I guess if you really, really couldn't pass, or didn't want to take, the Series 65 or 66 exam but really, really did want to be an adviser, you could move to Wyoming, set up shop there, and register with the SEC, which does not require any license exam. You would be a "federal covered adviser" once you submitted Form ADV, paid your fees, and had your registration accepted by the Securities and Exchange Commission. If you kept all your activities in Wyoming, you would be done with the whole registration process. Just pay your renewal fees each year to the SEC, and you're good to go. If you set up shop in any other state, or if you pick up more than 5 clients in another state, you won't quite "register" in that state, but you will provide a "notice filing" and notice filing fees to that state. You actually have an "IARD" account that is funded, and the notice filing fees for, say, Tennessee would be deducted to cover it. A notice filing is a copy of the information you provided to the SEC. If you had any representatives with places of business or more than 5 clients in another state, you need to provide that state with a U-4 for each rep, the same form used for agents of broker-dealers.
It's a little frustrating to wade through this information, as it seems to be an extreme example of "splitting hairs." And, it is. I mean, if I have to provide paperwork to the State, and I have to pay a fee, in what sense am I as a federal covered adviser not registering with the State?
In the lawyerly sense that you are not subject to that state's "books & records or net capital requirements." You notify them of your presence, but you follow the SEC's books & records and net capital requirements under the Investment Advisers Act of 1940. Also, remember that the firm might be federal covered, but investment adviser representatives working for that firm still have to register with the state--not the SEC. The SEC does not register IARs. Investment Adviser Representatives register with the states where they have a place of business and/or more than 5 individual clients.
Unfortunately, we can only allow ourselves so much excitement per post, and if I drill down any further on this topic I'm afraid we may end up over-exciting the community. Please know that I would never write about something so boring and mind-numbingly detailed unless I was sure it's a likely topic for the Series 65 and Series 66.

Thursday, January 22, 2009

Friday Free Broadcasts

If you would like to attend a regular series of Series 65 and 66 webinars, check out the Friday Free Broadcast schedule under Get Free Stuff at both and Fridays at 11 AM CST (Chicago, St. Louis, Milwaukee time zone), I broadcast to a few hundred hungry minds, usually on a Series 65 and 66-related topic. In fact, tomorrow's broadcast is on the Securities Adminsitrator, a topic that's important on both tests, as well as the Series 63.

We'll be rolling out a combined Series 65 and 66 online class very soon. The 65 will meet across eight 1.5-hour sessions. The 66 will meet along with the Series 65 candidates for 5 of those sessions. Still working out the scheduling details. As always, content is my focus. Putting things into a schedule--well, still working on it, as I say.

This stuff has NOTHING to do with the Real World!!!

In frustration, many test-takers shout that the information they're expected to learn has nothing to do with the real world.

Actually, it does.

I've attended several disciplinary hearings at the IL "Administrator's" office, and--trust me--there is much overlap between the "real world" and the test world in these cases. The first hearing centered on the definition of "investment contract" that you've seen from the Howey Case. The respondent's attorney kept arguing that what his client had offered and sold was "not even a security," but, alas, he failed to persuade the hearing officer of this, and his client ended up in hot water. He had defrauded several investors by taking their money and depositing it into one of his many business accounts, without ever, like, investing it in the program he was selling.
Oopsie. Try not to do that if you can help it, especially if you might get caught.

At another hearing, an agent had borrowed money from a client to be used toward a real estate deal that went sour. In other words, a bullet point like "borrowing money from clients" is not just a memorization point--it's a problem that many agents (and principals) run into all the time in the so-called "real world."

If you'd like to see how "real world" the test world actually is, check out some of the enforcement orders at

Also, go to your state's securities website and look for "enforcement" or "administrative actions." Most states are happy to name names, CRD and IARD numbers, etc. and tell the world to watch out for this particular agent, principal, investment adviser, adviser rep, or issuer of securities.

You'll probably enjoy studying a lot more once you see that what you're learning is, contrary to popular belief, COMPLETELY focused on the so-called "real world."

Wednesday, January 21, 2009

Series 65 or 66?

QUESTION: So, which test is easier, the Series 65 or Series 66? ANSWER: The Series 66 exam is 100 questions versus the Series 65 exam’s 130 questions. Shorter is easier, right? Not necessarily. First, the passing score for the Series 66 is 71%, while you only need a 68.5% to pass the Series 65. Second, the Series 66 is focused more heavily on rules and regulations, so if you don’t like a lot of long-winded questions on securities regulations, you’re in big trouble. Or, if you’re very comfortable on all the different types of securities, that won’t help you on the Series 66 much ,while it could make all the difference on the Series 65, with its 26 questions on “investment vehicles.” If you already have your Series 7, you can choose between the 65 or 66 exam. If you don’t and won’t have a Series 7, the Series 66 is simply not an option. Also, when I say “you can choose,” that implies that your firm says that you have a choice in the matter. I’m saying what can be done—your firm will tell you what can be done by employees of the firm. One interesting thing on this 65 vs. 66 issue is that there would be no mandatory 30-day wait between a failed Series 65 attempt and a Series 66 attempt. That means that if you already have your Series 7, you could study for the Series 65 knowing that if you don’t pass, you could then schedule a Series 66 exam as soon as you want to. But, of course, the best strategy is always to pass the Series 65 in one attempt. No one wants to go through the pressure of the exam center more than absolutely necessary.

Tuesday, January 20, 2009

Practice Questions step-by-step

As I mentioned in the previous post, your job is not to look for the right answer. Your job is to find and elminate as many WRONG answers as possible. Let's apply this strategy to the following question:

Which of the following can be determined by looking at a corporation's balance sheet?
II. net income
III. quick ratio
IV. shareholders equity
A. I, II

Step one, read the answer choices A, B, C, and D just to see how the little Roman Numerals have been distributed. Right away, you see that this question either has a "I" in it, or it doesn't. Once we make that decision, two answer choices will be eliminated.
Or, for the extreme strategists, notice that three answers have a "II" in it and three have a "III" in it. If you could eliminate either "II" or "III," then, you would be done.
I know, some of you are thinking--but that has nothing to do with learning the information!
So what? Neither does the friggin' Series 65 or Series 66. It's just a hazing ritual that the regulators use to keep a certain percentage of folks out of the business and, thereby, claim to be "providing necessary protection to investors."
It's a game, people. Play it with strategy, win it, and move on with your lives.
So, as an extreme strategist myself, I have to go for the knockout punch here. I'm looking at choice "II" and choice "III" first.
Choice "II" says "net income."
Where would net INCOME be found? Perhaps on the other financial statement called the INCOME STATEMENT?
A-ha! This question is just a bully and is about to get its butt kicked. There is a balance sheet, and there is an income statement. Net income is on the INCOME STATEMENT, not on the balance sheet. So, let's eliminate any answer choice with a "II" in it.
Let's see, that eliminates Choice A, B, and D.
Leaving us with the right answer, C.

People who say they "hate the Roman Numeral questions" aren't using strategy. These so-called "multiple multiples" are, by far, the easiest type of question to answer. You just have to be patient and analytical.

Send in a hard Series 65/66 question, and I'll break it down for the community step-by-step.

Don't look for the RIGHT answer

When you're taking a difficult and confusing exam such as the Series 65 or Series 66, test-taking strategy is key. Most people try to read the question, then look up at the ceiling and try to picture the right answer, hoping to see it below when they finally look at the four choices.

Don't do that.

Your job is not to look for the right answer; your job is to eliminate the three wrong answers.
In fact, you might want to start reading the four answer choices before reading the question itself. This helps you to see where the question is leading and may, therefore, help you to eliminate the extranneous information.

I'll be posting examples of questions broken down step-by-step, but for now, try to apply this simple but important strategy of eliminating wrong answers. Even if you only eliminate two answer choices, your odds will at least be 50-50 on even the most difficult questions.

Send me an example of a "difficult" Series 65 or 66 question, and I'll break it down step-by-step for the whole community.