Test-Taking Strategy

You have to use whatever advantages the exam gives you. The test does not involve any fill-in-the-blank, short-answer, or essay questions. That means that you don't have to use the more difficult skill of recall. You only have to use the much easier skill of recognition. Of course, the exam can use lots of synonyms, so even recognition will fail you on some questions, which is why you have to resort to process of elimination at that point. If you don't see the word you were hoping to see among the four answer choices, you can use logic and reasoning to start eliminating the wrong answers. You might only eliminate two answer choices, but that raises your odds from 25% to 50%. And, if you only have to use this method of extreme test-taking on, say, 50 questions, you'll probably get 25 or more of them right, and that is often the difference between being among the 66% of candidates who pass the test that day and the 33% who wish they had.
Of course, we now have to apply it to a potential exam question:

Which of the following types of contractual provisions may exist between an adviser and a client?
A. waiver of compliance
B. exculpatory provision
C. performance-based compensation for certain institutional investors
D. none of the above

Wow, maybe it's the earliness of the hour, but I was just hit with a flash of recognition myself--these exams bite! No wonder some of you are a little cranky. Anyway, we still have to use the advice given above to try to gain the upper hand on this question. A "contractual provision" just means that an investment adviser has the client sign an agreement/contract that spells out what the adviser will do for the client, how much the adviser will charge, how they figure that charge, whether the adviser has discretion to place trades, etc. In that contract, can an adviser have the client sign a waiver that allows the adviser to do something that does not comply with securities rules and regulations? Probably not, right? So, we eliminate "A," waiver of compliance. What if you don't know what an "exculpatory provision" is? You might be in trouble. Or, you might be a creative and analytical thinker who says (quietly at the testing center, please), "Well, 'culpability' has to do with blame or fault. 'Ex-' means without. So the adviser has the client sign a provision that whatever happens, the adviser is without fault." No way. So, we eliminate "B," exculpatory provision. Now we either determine that "C" is okay, or we choose "D."
Careful now. Too many people feel the momentum now and jump straight to "D." We can't afford that luxury. Choice "C" is saying that it's okay to charge performance-based compensation for certain institutional investors. Is that true? Yes. Why would the test want us to know that the usual prohibition against sharing capital gains/appreciation is actually okay in some cases? It likes to see us sweat. Whatever its reasons, the answer is "C."
Exhausting, isn't it? Oh well. The Series 65 and 66 exams are just a weeding out process. They want to flunk about 33% of all test takers on any given day. Of course, many of those 33% come back in 30 days or so and join the 66% who pass. Brutal, yes. Frustrating, surely. And, as much as I've grown to hate the phrase, unfortunately, it is what it is.

ADV Part 2, Disclosure Brochure

A Series 65 customer just emailed a great question:

What is the practical application of this rule?
New Clients: The brochure must be provided at least 48 hours before entering into an advisory contract, OR at the time of entering into a contract, if the client has the right to terminate the contract without penalty within five business days.

RESPONSE:
The practical application is this: give the prospect at least two business days to review the brochure (ADV Part 2) before he comes in and signs the advisory agreement/contract. Why? As you see at www.passthe65.com/extra, AdV II gives the prospect important info on your firm--who you are, what you do, how you charge compensation, who your other clients are, your disciplinary history, whether you have discretion, etc. So, the prospect needs time to review it before signing the contract.

The latest that the brochure can be provided is at the time the client signs, IF he can cancel within 5 days without losing any prepayment to the adviser. Some advisers accept a "prepayment" or upfront fee before doing any actual advising. If they take, say, $1,000 just to sit down and start looking at the client's situation, then they could give ADV 2 to the client when they sign, IF the client could cancel in 5 days and get all her money back.
Most advisers avoid the prepayment because if you take >$500 six or more months in advance, you have "custody" and you have to provide the client and the Administrator with your balance sheet, and if the liabilities EVER exceed the assets for even ONE DAY, you have big problems on your hands.

So, like most things, it's simpler than it sounds--give the client 2 business days to consider your brochure before they sign the advisory agreement. If you want to give them the brochure when they sign, you have to know that they might cancel in 5 days, and any prepayment you took has to be paid right back out.

Capital Gains

Mary Ann purchased 1,000 shares of ABC on January 1st, 2009. On December 31st, 2009, she sells the shares for a $500 capital gain. If the trade settles on January 4th, 2010, which of the following accurately describes the tax consequences?
A. the gain will be considered long-term
B. the gain will be considered short-term
C. the gain will be treated as dividend income
D. Mary Ann will report the gain or loss for tax year 2010

EXPLANATION: a long-term gain happens when you hold securities for one year plus one day. As the IRS explains at http://www.irs.gov/, your holding period starts the day after you buy the stock and stops with (and includes) the day you sell it. So, if Mary Ann buys stock on January 1st, 2009, she needs to sell it no sooner than January 2nd, 2010 if she wants a long-term capital gain. Settlement has nothing to do with holding period. When you execute the sale, you no longer hold the stock. The answer is B, the gain will be considered short-term.

Unregistered, Non-Exempt Securities

The titles to these blog posts are "click-able" links. Usually, I take you to one of our websites, but today the title takes you to FINRA's February roundup of disciplinary actions. This is the sort of thing I read Friday mornings in order to stay on top of what is important to regulators and, therefore, what types of questions the exams might begin to ask.

This morning I'm on the third disciplinary action and I see more proof that the seemingly useless information you learn concerning the Uniform Securities Act is actually as real-world as a heart attack. Even a crazy-sounding phrase such as "unregistered non-exempt securities" has a place in the day-to-day workings of the securities business. Check out this snippet from the action against Cambria Capital, LLC:


Cambria Capital, LLC (CRD #133760, Salt Lake City, Utah) submitted a Letter of Acceptance,Waiver and Consent in which the firm was censured and fined $40,000. Without admitting or denying the findings, the firm consented to the described sanctions and to the entry of findings that it conducted sales of unregistered securities that were not exempt from registration. The findings stated that the firm failed to establish a supervisory system or establish, maintain and enforce written supervisory procedures reasonably designed to achieve compliance with Section 5 of the Securities Act of 1933 to detect or prevent the sale of securities that were neither registered, exempt from registration by the firm or its representatives or to determine that securities received into customer accounts could be sold without restriction.

The Friday Free Broadcast on March 20th covers "Industry Rules & Regulations," and we'll look at several real-world disciplinary actions that illustrate testable points. I encourage you to take a look at the February summary of FINRA disciplinary actions for several reasons. One, you will see all kinds of test topics in action. Two, it will stretch your mind and give you an edge over the other test-takers who are just memorizing bullet points and hoping to wing it at the testing center. Third, this is the industry you are entering. Even if you're only on the advisory side, outside of FINRA's reach, please know that the SEC, FINRA, and the state regulators are all pretty much on the same page. An adviser would get in just as much trouble with the SEC or state regulators if they put clients into unregistered non-exempt securities or sold securities that were restricted. If it violates securities law, it's a problem.

Enough for now. Gotta get to the office and finish up Pass the 6 3rd Edition . . . or perhaps you're all waiting for the movie.

Practice Question on Registration of Broker-Dealers and Advisers

Let's look at another practice question. This one is somewhat difficult just because of the laborious language. Careful now.

Which of the following is not true concerning the registration requirements of securities professionals?
A.Broker-dealers with no place of business in a state and a limited number of non-institutional clients in a state must register.
B.Broker-dealers with no place of business in a state who limit their agents to selling exempt securities in a state need not register.
C.Investment advisers with no place of business in a state and whose only clients are institutional investors in a state need not register.
D.Investment advisers with no place of business in a state and a limited number of non-institutional clients need not register.

You've probably noticed that practice questions don't necessarily express things the way you learned them. You have to read some meaning into the words so that you think, "Oh yeah--the de minimis exemption. That's only for advisers, not broker-dealers." Once that fundamental concept comes to mind, you're half-way done. Broker-dealers need to be licensed in the state if they have any non-institutional (retail) investing clients. But, for advisers who are out-of-state, it's okay to have 5 non-institutional clients without being registered in that state. And, the out-of-state adviser can have as many institutional clients as it wants without having to register. Therefore, the answer is . . . B. The fact that the securities are exempt isn't going to relieve the broker-dealer of having to register, not if they have agents selling securities of any kind in the state.

Uniform Prudent Investor Act

Here is a question that looks very similar to something you might see on the Series 65 or 66:

According to the Uniform Prudent Investor Act, when may a trustee choose not to diversify the assets of the trust?
A. During a prolonged bear market for stocks
B. When choosing not to diversify best meets the needs of the beneficiaries
C. Under no circumstances
D. When the assets are 100% cash

Notice how a person who has not studied could easily talk himself into any of the four answers. Under no circumstances looks very tempting on a regulatory exam. Putting the assets all in cash seems pretty darned prudent, too. Hmm. Unfortunately, the Series 65/66 will pull sections out of various actual and model acts and expect candidates to be familiar with them. This question is pulling a section almost verbatim from the Uniform Prudent Investor Act, which states:

A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.

And that pretty well answers the practice question above, doesn't it? The answer, according to Section 3 of the Uniform Prudent Investor Act, is B, "When choosing not to diversify best meets the needs of the beneficiaries." As usual, the exam material seems to talk from both sides of its mouth. What it just told us is that a fiduciary/trustee should always diversify the assets of a trust, except when he shouldn't.

Oh well. That's what we're dealing with here on these exams. No need to get frustrated--we just have to deal with the exams on their own terms. Pass the test, and move on with your life.

Traditional and Roth IRA contributions

If an individual earns a high income, she can not make a contribution to a Roth IRA. That does not mean that her Roth IRA has to be closed, but, unlike with a Traditional IRA, a contribution simply can not be made if the individual makes $120,000 or more, or if the married couple filing jointly earns $176,000 or more for 2009. But, many people do not realize that there are no income limits for the Traditional IRA. Don’t worry about how much money somebody makes in the test question, or if she’s covered by an employer plan. All that would change is the amount she can deduct from her contribution. If she’s covered by an employer plan and makes a certain amount of money (say, $53,000 or more), she’d just have to keep track of how much of her contribution went in after-tax, so she doesn’t get taxed twice on that money when it comes out with everything else. But, if she has earned income, she can contribute to her Traditional IRA, either pre- or after-tax. She might not deduct 100%, or even any percent, of it, but it can still go in there. And, don’t forget this: if she’s not covered by an employer plan, she can deduct all of her contribution, regardless of her income. If you disagree with any of this, see IRS Publication 590 at http://www.irs.gov/pub/irs-pdf/p590.pdf