Exemptions for Persons

This is a follow-up to the previous post, so you might want to read "What's the Deal With Exempt Securities?" before reading this one . . . assuming you actually "want" to read anything connected to the Series 65/66 exam, that is. As we discussed in the previous post, an exempt security is simply a security that doesn't have to be registered. US Treasury securities, municipal bonds, insurance company debt obligations, etc. are all excused/exempted from the registration requirements of the Uniform Securities Act. They're still subject to anti-fraud rules, of course, but the issuers don't have to waste as much time and money completing the typical registration process. If there's nothing special about the security--it's non-exempt--the security always has to be registered.
Except when it doesn't. If it's offered and sold through an exempt transaction, then the security would not have to be registered in the typical manner. For example, if the issuer offers the investment to only 10 persons in the state, or offers it only to institutional investors, registration of the security is not required. And, if the individual in the test question represents the ISSUER of an exempt security, or represents the ISSUER in an exempt transaction, that individual does not have to register.
But, if the individual represents a broker-dealer by selling any securities, that individual has to register in any state where he has a place of business or any non-institutional clients. That seems to imply that the agent does not have to register in order to work with institutions, but that is not correct. The agent has to register with FINRA through the member firm to sell securities to any customer. Also, he has to register with every state in which he has a place of business or any non-institutional customers. If he has a place of business in New York and wants to open an account for a retail customer in Indiana, he has to be registered in Indiana. He would not have to register if he had no place of business in Indiana and the only customers there were institutions. No need for the additional registration in Indiana in that case, but that doesn't mean the agent doesn't have to be registered anywhere. Right?
If a broker-dealer has a place of business in Arkansas, they must register there. Period. If they want to serve retail customers in Louisiana, they have to register with Louisiana. If all their customers were institutions in Louisiana and the firm had no place of business there, no registration would be required by the state of Louisiana. No additional registration required in that case.
So, as always, read the questions carefully and think through them analytically. Also, hang onto the big concepts below:

• If an agent represents a broker-dealer, he has to register, period
• If an agent or broker-dealer has a place of business in the state, they have to register in the state
• If an agent or broker-dealer have no place of business in the state and no non-institutional customers, they do not have to register in that state

What's the Deal with Exempt Securities?

Maybe you've sat through one of the live classes that remain the bread and butter of the bigger vendors. If the instructor tried to teach the fundamentals of the Uniform Securities Act to you, chances are he made a lot of noise about "exempt securities" and "exempt transactions" but never quite explained what the terms mean and--more important--what they don't mean. When I used to teach for a big vendor in this industry, I had to use the sorry materials I was handed, and no matter how I tried to spin it, I could tell that many students walked out thinking the following:

• if the security is exempt, it is not subject to the Uniform Securities Act's anti-fraud statutes
• if the security is exempt, the agent doesn't have to be registered
• if it's an unsolicited order, an unregistered person at a broker-dealer can accept it
• if the customers are all institutions, the agent of the broker-dealer does not have to be registered

What the above four bullet points have in common is this: they aren't true. But, in the confusion of a four-hour Series 63 class or maybe a two-hour segment of a Series 65/66 class, it's very easy to understand why students would come out thinking that way. So, let's clear up some big points here. First, not every investment meets the definition of a "security," but if it is a "security," it is subject to the Uniform Securities Act's antifraud regulations, whether it has to be registered or not. A US Treasury note doesn't have to be registered, but if an agent offers one to me under false pretenses, that is still securities fraud. Second, all securities have to be registered except for all the securities that don't have to be. A security that does not have to be registered is an "exempt security," which means it's still a "security" subject to antifraud regulations. It just doesn't have to be registered. For example, US Government securities, municipal securities, bank securities, and highly rated commercial paper do not have to be registered. What about the agents selling them? If they work for a broker-dealer, they have to register. I mean, if agents selling municipal securities didn't have to be registered, why would there be a Series 52 for people selling municipal securities? A Treasury note doesn't have to be registered, but an agent of a broker-dealer selling Treasury notes to customers does have to be registered. The only time we care about whether the security is exempt is when the individual represents the issuer of that security and does not get special compensation to sell it. If the CFO of a company wants to essentially get a loan by selling commercial paper to an institution, she does not have to register. Or, even if the CFO wanted to sell an ownership stake in the company to institutions only, that would not meet the definition of an agent. But, again, if you represent a broker-dealer in selling securities, you have to be registered.

If a security is non-exempt, it still might escape registration if it's sold through an exempt transaction. This is the one case where an "unregistered, non-exempt security" can be offered and sold without getting in trouble. But, if you're an agent of a broker-dealer taking indications of interest for this offering, YOU have to be registered. You don't work for the issuing corporation, right?Again, if you work for a broker-dealer selling securities, you have to be registered. The security might or might not have to be.

So, if the test asked if an agent of a broker-dealer would have to register just to sell municipal securities to institutional investors, the answer would be . . . absolutely. Why? Because he's an agent of a broker-dealer. In the rare case where somebody works for the issuer of an exempt security or represents the ISSUER in an exempt transaction--getting no special compensation for the sales--that person escapes registration.

Practice Question, investment risks

The Series 65/66 exams don't like to give you a lot of questions that prove only that you've memorized something. You'd never know that from attending many of the live classes across the country, but, I assure you--it's true. NASAA doesn't like a lot of memorization. For example, you don't get to simply memorize "ADR = foreign stock, domestic market." You have to tell them how an American holding an ADR would be affected if the US dollar depreciates relative to the foreign currency. Similarly, you can't just memorize that zero-coupon bonds have "high duration" or a lot of interest rate risk. You have to know that much in order to think outside the box and apply that knowledge on a fun question like this:

If an investor purchases a 10-year US Government zero coupon bond that he plans to hold to maturity, the most important investment risk is

A. market risk

B. interest rate risk

C. purchasing power risk

D. reinvestment risk

EXPLANATION: zero coupon bonds have no reinvestment risk because there is no cash flow coming in every six months to reinvest at varying rates. Eliminate that choice. Market risk is always a problem because investors can definitely panic like a herd of buffalo--but the question says he's going to hold the thing until maturity. What does he really care about the market price if he isn't going to sell? Doesn't that also eliminate "interest rate risk," which sends the market price down when rates rise, but, again, he has no plans to sell? Yes. I think. I mean, at least I have some pretty solid reasons to eliminate those two answer choices. Can I eliminate "purchasing power risk"? No--he's locked into a fixed rate of return over 10 years. Who know where inflation will be?
That's the type of thinking you'll have to do on the exam. You won't know for sure if you're on the right path. Your job is to see if you can eliminate answer choices until you get down to the one you can't eliminate. That one is the right answer.



ANSWER: c

Cease & Desist

When an agent or an investment adviser violates securities law, the Administrator can issue an order to suspend or revoke the license. Before issuing the final order, the respondent has to receive prior notice, an opportunity for a hearing, and the writing findings of fact and conclusions of law that he and his attorneys need to explain somehow to the regulators in a more positive light. On the other hand, if somebody is out there offering securities in his company that are not registered, he has no license that can be suspended or revoked. In this case, the Administrator will issue a "cease & desist" order, with or without prior notice and a hearing. A "cease & desist" order is an official warning from the state securities Administrator to cut it out, or else. If the respondent ignores the Administrator's authority, the test calls that "contumacy." The Administrator can then ask the courts to issue a restraining order/injunction, and if the respondent blows that off, he's looking at "contempt of court," punishable by fines and even jail time. If you click the title of this blog post, you'll see a real-world cease & desist order issued in Arkansas to two gentlemen going around promising 120% annual interest from people who perhaps should have known better. As you can imagine, nobody got his money back from this program. Take a look for yourself--many testable points are illustrated in this Administrative order.

Exempt Securities in the Real World

I taught a live Series 65 class this past week for the accounting firm who does tax work for my S-corp. It was amazing how quickly this group of five CPAs can absorb new, complex information, but we definitely hit the wall when we covered the Uniform Securities Act's provisions for securities. One of the CPAs said at the end of that section, "That seems to be the most vague of all the information we've covered."
Amen, brother. Regulators like things nice and vague when it comes to "securities." They like vague phrases like "investment contract" or "anything commonly known as a security" because it allows them to fit just about anything under that category if they want to regulate it. So, step one is this: does the investment meet the definition of a "security"? If so, it is subject to anti-fraud rules, whether it has to be registered or not (exempt). That means that a fixed annuity or a whole life insurance policy is not even subject to anti-fraud regulations. Why not? Neither one is a "security." Then, there are securities that are excused from registration requirements. They're still securities, so anti-fraud rules still apply. These securities just don't have to be registered. They are excused/exempted from the registration requirements. For example bank stock does not have to be registered with securities regulators. Neither do church bonds. A church bond is sold with an offering circular rather than a prospectus. But, that doesn't imply that the investment is somehow safer than other debt securities, and the offering circular will announce that at the very beginning. To see how this stuff works in the real world, please check out an offering circular for a "church bond" or series of "mission investments," really, at:
www.bigfilespassthetest.com/securities.
You'll notice that the investments are being sold by employees, who receive no special compensation for sales (not agents). You'll notice that the expenses incurred to sell the investments are about $1 million per year. You'll notice all the disclosure that is provided . . . because even though the securities aren't registered, they are subject to anti-fraud rules. Investors have to be informed of all the risks involved; otherwise, they could sue if they lose money. Spend some time with this document, and I'm confident you will begin to understand "exempt securities" and securities registration issues in general much, much better. Enjoy.

Real-World Fundamental Analysis

I was just reading the current issue of TIME and on page "Global 14" there is an article that brought up several testable points. The article discusses a new technology called "hydraulic hybrid" that is used to build fuel-efficient, "green" garbage and recycling trucks. They run about 20% higher than the typical $200,000 for these monster trucks, and they're produced by Eaton, Parker Hannifin, and Peterbilt. There are 70,000 garbage and recylcing trucks currently driving around this nation, and they'll all have to be replaced eventually. Notice how the facts so far have been about sales and the size of a potential market--that's fundamental analysis. Given this information, a great fundamental analyst like Warren Buffett could take an envelope and a pencil and answer some basic questions on each of those three firms like:

• How many trucks will need to be replaced each year for the next 10 years?
• How big is the company's market share projected to be?
• What is their profit-per-unit-sold?
• How much will profits on these vehicles impact the company's overall net income/bottom line?
• Does the company have a competitive advantage?
• Who are the officers and directors, and what have they done in the past?

Notice how some of these questions are answered with numbers and some are qualitative. No matter how quantitative we get, it's all based on projection and speculation. Out of 70,000 vehicles that need to be replaced, we first have to guess how many of those customers will pay the higher price for the hydraulic hybrid. We could be way off there. Then, we have to guess what % of the projected market will go to the firm we're analyzing. At this point, we could be so far off that every calculation about the revenues, costs, and profits will become exponentially inaccurate. Maybe that's why the efficient market theorists have such a following? Not only do we have to get these calculations and assumptions right, but we have to do a "discounted cash flow" model to figure the "net present value." And, we'd have to somehow marry that sort of braniac calculation with the guesswork involved with deciding if a particular senior management team is trustworthy and/or more likely to succeed in this new market space than any other. So many places it could go wrong. Not to mention that this new technology exists largely through government subsidies, and so the fundamental analyst has to try to figure out if those subsidies will keep coming and, if so, will they increase or decrease? If they dry up, which company would most likely survive without them? So, we have regulatory risk (subsidies might dry up) and risk of obsolescence (the technology) also threatening to make a mockery of our sophisticated calculations. No wonder there are technical analysts who leave all this fundamental hand-wringing to others. Just tell them the stock symbol, and they'll pull up the data on its market behavior. What's the 52-week high and low price of the stock? What's the 200-day moving average for its closing price? Where's the support and resistance? What's the volume? Technical analysts study market data, your exam might say.

Fundamental analysts, on the other hand, study companies--their operations, their projected revenues and profits. And, I'm sure some of them pretend they buy stocks based on the "discounted cash flow model" when, really, they just have a feeling about this Google, Facebook, or Groupon company everybody's talking about.

Almost famous

Pass the 65 and Pass the 66 are getting just big enough now to have clients who are celebrities. If you've visited the fan page at www.facebook.com/helpmepass you might have noticed that one of our Series 7 clients sent in a photo of his smiling face with passing score in hand outside the testing center. He happens to be Whip Hubley, with film credits including Top Gun and St. Elmo's Fire.
This morning while reading the Sun-Times, I saw a full-page ad for Macy's with a familiar looking photograph at the center. Under the photo, the name Vicki Gunvalson really caught my eye. Hey, I know her, I realized. She's studying for the 65. Turns out, she's also a reality TV star on The Real Housewives of Orange County. She's in Chicago tomorrow night to autograph copies of her new book and help Macy's sell some high-end apparel.
Not only do I know Vicki through emails, but here in Chicago her sister, Lisa, has been coming in for Series 65 tutoring recently. Today she managed to pass her Series 65 on her third attempt, with a 76%. That's going to put the pressure on her famous sister, I'm thinking. I wonder if it's possible that this little back story could somehow find its way into the reality show. Maybe I go on the show and provide some private tutoring for Vicki's Series 65. Take her to the point of tears like some psychotic personal trainer--I think that's what sells on reality TV, right? Other people's pain. And, boy, I can't think of a bigger source of pain than the Series 65. Maybe it's nutty, but I think it would make for some good reality TV.
Thoughts?