Durable Power of Attorney

When people finally face their biggest fears and respond by doing some estate planning, chances are they will want to express their wishes now as to what happens should they become incapacitated. A "living will" is a document that allows an individual to express her wishes concerning life-sustaining procedures. Does she want all possible measures to be taken while she's in a coma or terminally ill, or does she want them to "pull the plug" if her quality of life is virtually non-existent? That's all that a living will does. If an individual wants to take it a step further, she can appoint someone to act as "attorney in fact" or "agent" on her behalf should she become incapacitated. She can achieve this by establishing a durable health care power of attorney. The durable health care power of attorney grants the agent or "attorney in fact" for the individual the power to make health care decisions for the individual if the individual is unable to do so after an accident or illness.

There are also general powers of attorney that appoint an agent/attorney in fact to oversee your financial matters should you be incapacitated or, perhaps, traveling overseas and unable to manage your own financial dealings. This type of power of attorney can also be made "durable." The individual, with the help of her lawyers, can draft a durable power of attorney so that it is clear when the power "kicks in." Maybe it's when a named physician determines that the individual is truly incapacitated. Or, maybe it's when two separate physicians come to that conclusion.

Whether it's a durable health care or a durable general power of attorney, the test may ask if it remains in force after the individual dies. The answer: no. The power survives the incapacitation of the individual (also called the "principal"), but not his/her death.

European Style

How would you answer the following question?

A European-style option is considered a "derivative" because
A. the option may be exercised prior to expiration of the contract
B. the value of the contract is contingent on the value of some other thing
C. the option may be exercised only at expiration of the contract
D. the option contract is created and traded on a non-US exchange

EXPLANATION: you do need to know that a European-style option can be exercised only at expiration. If you know that, you can eliminate Choice A, which describes "American-style" options. The option contract can trade on a US Exchange, so you can eliminate Choice D. Is Choice C true? Not within the context of this question. Yes, European-style options may be exercised only at expiration, but that is not what makes them "derivatives." Believe it or not, what makes them derivatives is the fact that they derive their value based on some other thing, i.e. a stock, or an index.



ANSWER: b

Custody Issues for Advisers as Trustees

Since we've been having such a rip-roaring good time discussing custody issues, let's keep bringing up points made in NASAA's page-turner of a model rule. Often the trustee of a trust is an investment adviser and not just the trust department of a bank & trust company. Investment advisers like to get paid, and it's convenient to be paid directly by the custodian of the securities account. If the adviser can appropriate/receive his fees from the custodian, the adviser does have custody. But, the adviser can avoid the higher financial requirements and the CPA surprise audit if they follow certain safeguards. To avoid those requirements, the adviser must indicate on Form ADV that it does or may have custody. The adviser needs the written authorization of the grantor (if he's still alive) or the attorneys for the trust (if it's a testamentary trust, established upon death of the grantor), the co-trustee (other than the adviser or its employees or owners), or a beneficiary of the trust. The adviser needs to send a billing statement showing the asset values and the method used to compute the fee. And, the custodian has to agree to send at least quarterly to the attorneys/grantor/co-trustee/benefiary a statement of all disbursements from the account of the trust, including the amount of investment management fees paid to the investment adviser and the amount of trustees' fees paid to the trustee.
If all of these safeguards are taken, the adviser acting as trustee can receive advisory fees directly from the qualified custodian. The adviser would have custody but would have the minimum financial net worth/bonding requirement waived.

Custody Issues

Let's cover potential exam concepts concerning custody issues since you almost certainly will get one or two questions on this stuff. First, you should probably read NASAA's model rule on custody requirements for Investment Advisers at http://www.nasaa.org/content/Files/IACustodyRules.pdf. Second, you need to understand the background here: most advisers don't want to be deemed to have custody of client assets. If they are deemed to have possession of client securities and/or cash--or the ability to appropriate securities and/or cash--advisers are generally subject to higher net worth requirements ($35,000 minimum) and the annual surprise CPA audit. So, a wise adviser usually avoids being deemed to have custody. For example, if the client sends the adviser a 3rd- party check, that check needs to be forwarded to the payee within 24 hours. If not, the adviser had custody of client assets. If the adviser receives client securities in the mail, the adviser needs to return them to the sender in 3 days to avoid being deemed to have custody of those securities. In both cases, if the adviser keeps records as to what happened, the adviser will not be deemed to have had custody and will not need to notify the Administrator by updating Form ADV. Advisers who manage client portfolios typically have the discretion to trade the account, with the account held by a custodial broker-dealer such as Charles Schwab, TD Ameritrade, or Fidelity. So far, such an adviser would not be deemed to have custody of client assets; however, the adviser will likely want to get paid by the custodian quarterly. If the adviser can obtain his advisory fee from the client's account, he does have the ability to appropriate client assets and is considered to have custody. Does he have to maintain the higher financial requirements and the CPA audit? Not if he follows certain safeguards. The Adviser needs to indicate on Form ADV that they intend to follow the safeguards, and if they do, in fact, follow them, the net worth/bonding and the CPA audit requirements are waived. Here are the safeguards:

• written authorization from the client to deduct advisory fees from the account held with the qualified custodian
• Each time a fee is directly deducted from a client account, the investment adviser must send the qualified custodian an invoice of the amount of the fee to be deducted from the client’s account and send the client an invoice itemizing the fee. Itemization includes the formula used to calculate the fee, the amount of assets under management the fee is based on, and the time period covered by the fee.

So, the adviser does have custody if he can obtain his advisory fee directly from the custodian. But, he can avoid the usual hassles related to custody by following certain safeguards. What's the big deal about custody? Well, Bernie Madoff would not have made off with people's money if they would not have let him have custody of those assets. Since their "adviser" was able to send account statements, with no independent oversight, he was able to show clients any numbers he thought they'd believe, even after all the money was gone. If the custodian is independent of the adviser, there is no reason to doubt the veracity of the account balances. When the adviser can show you whatever numbers he thinks you'll believe he can A) overcharge your account or B) mislead you into thinking that you actually have an account when, in fact, all the money was drained years ago.

Variable Annuities

The exam will likely ask you 3 or more questions on variable annuities. How would you answer something like this:

Which of the following statements is/are true of non-qualified variable annuities?
I. the annuitant's return of principal is guaranteed
II. the annuitant's net deposits into the account equal her cost basis
III. the annuitant is subject to penalties on withdrawals prior to age 59 1/2
IV. the annuitant is subject to penalties if withdrawals do not commence by age 70 1/2

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

EXPLANATION: choice "I" is true only during the accumulation phase due to the death benefit, but the statement falls apart during the annuity phase and, therefore, has to be eliminated. The variable annuity does not promise a return of principal, which is one of the risks disclosed in the prospectus and sales literature. If the annuitant dies during the accumulation period, the beneficiaries receive at least what he put in, but when the contract is annuitized, there is no guarantee on what will be received. So, eliminate choices A and C. Now, you get II and III for free because they are both in the remaining two choices. The only difference between B and D is that one contains choice "IV" and one doesn't. So, do withdrawals have to begin at age 70 1/2? Even though the 10% early withdrawal penalty is there, the annuitant does not have to start taking money out at age 70 1/2. . . not on a non-qualified variable annuity. Choice D is eliminated, leaving you with . . .



ANSWER: b

Also remember that a qualified variable annuity would be subject to lifetime maximum contributions and would force the annuitant to begin withdrawals at age 70 1/2. So, as always, read each test question very carefully.

Fiduciaries

PRACTICE QUESTION:

Which of the following are considered to be acting in a fiduciary capacity?
I. securities agent recommending an aggressive growth stock
II. investment adviser representative
III. executor of an estate
IV. CEO, when deciding on matching levels for a 401(k) plan

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

EXPLANATION: the securities agent is not a fiduciary, unless he's been granted discretion over the account. The CEO is performing a "settlor function" when deciding on matching levels--making a business decision, in other words. The executor of the estate is a fiduciary, so the answer had to contain "III".



ANSWER: b

Settlor Functions practice question

If the test asks about "settlor functions," maybe it would throw something like this at you:

An employee participant of a 401(k) plan is 61 years old. A family member, who is an attorney with a specialization in financial matters, tells her that if her company had provided a higher matching contribution she "would be a lot better off financially" now. Therefore, under ERISA, the CEO and other fiduciaries of the plan
A. can be sued up to the amount that the company could have contributed with a higher matching incentive in place
B. can not be sued for breach of fiduciary duty
C. can be sued up to the amount that the company could have contributed with a higher matching incentive plus the expected return on that amount over the holding period
D. can only be sued for breach of fiduciary duty while performing settlor functions

EXPLANATION: as we said in the previous post, the CEO's decision on how the company will match employees' contributions, or whether they will match them at all, are examples of "settlor functions" in which the fiduciaries to the plan are NOT acting as fiduciaries. Instead, they are making business decisions. So, A and C can be eliminated, and so can D. Remember, the CEO is not a fiduciary based on his title of CEO. He's a fiduciary to the plan participants and their beneficiaries only when functioning in that capacity. His or her decision to start or stop a 401(k) plan would be a "settlor function" based on how it affects the business. If, on the other hand, the 401(k) plan offered to employees does not provide enough information on the funds or the participants' balances, or doesn't allow them to alter their investment choices at least quarterly, then the CEO could be breaching his or her fiduciary duty.





ANSWER: b