Study Outline for Series 65 Critical Concepts: 1. Separate Broker-Dealers from investment Advisers 2. Separate Federal requirements from State requirements 3. Know the terminology 4. Know the exclusions and exemptions 5. Each question must be read carefully FEDERAL LAWS The Securities Act of 1933 The “Paper Act” or the Act of Full Disclosure All securities must register unless there is an exemption Prospectuses (disclosure documents) must be in writing Final prospectuses for stocks or bonds may now be posted on the Internet Registration filing begins a minimum 20 Day Cooling Off Period Prohibited activities: Selling Return money if sent in Accept non-binding indications of interest only Advertising Recommending or Soliciting issues in registration Tombstone ads Corporates: Announce the offering Mutual Funds: Rule 482 allows an Omitting Prospectus All information must come from the prospectus ‘Ad must point the reader to the prospectus to orderAllowed activities Prepare Preliminary Prospectus or Red Herring Incomplete disclosures or willful omissions prohibited Does not have offering price Does not have final numbers Does not have the effective date Contains disclosure that the information is incomplete and subject to change “The Disclaimer” Exempt Securities Exempt from filing and advertising requirements only ~ never anti-fraud “a GOVERNMENT REGULATOR'S list of CHARITIES is SHORT.” Governmental issuers U.S. Treasury Federal agencies Municipalities, state governments and agencies Issuers with a Regulator in place in 1933 State banking commissions - Securities of banks Bank stock is exempt State insurance commissions - Securities of insurance ‘companies Insurance company stock is not exempt Interstate Commerce Commission - Common carriers or railroads Small Business Administration - SBICs Charitable or non-profit organizations or fraternal societies Short-term - Maturity of 270 days or less Commercial Paper - used for current cash needs Banker's Acceptances Exempt Transactions Rule 147 Intrastate issues Bona fide intrastate requirements 9-month lockup rule restricts out-of-state secondary market salesRegulation D Private Placements No restriction on offering size Unlimited “Accredited Investors” $200M or more income the last two years $300M if a joint account OR $1.MM net worth OR An officer or director OR An accredited institution Maximum of 35 non-accredited investors Other exempt transactions Regulation A - Small dollar offerings ($5MM or less) Rule 144 ~ Individual sale of private placement stock Rule 144A - Institutional sales of unregistered stock Registration Process The registration statement must be signed by CEO CFO Majority of the board of directors The Securities Exchange Act of 1934 Attempted to control and eliminate market manipulation Churning or excessive trading is prohibited Consider customer resources, objectives and character of the account Excessive size or excessive frequency of trades Wash Sales or Trading Pools prohibited Created the false appearance of activity Matched orders, Pegging, price fixing, capping or stabilizing are prohibited Addressed transactions by insiders Insider transactions must be reported to SEC within 2 days of the trade Upon achieving 5% or greater beneficial ownership Report to SEC, issuer and marketplace If an “active” investor on Form 13DIfa “passive” investor on Form 13F Institutional equity managers Discretion over $100MM or more in equity assets insider trading is prohibited Trading based on material, non-public information “Insider” definition expanded by ITSEFA of 1988 Anyone in possession of insider information is an insider Sharing information is as bad as trading Criminal penalties of $5MM and up to 20 years prison Civil penalties Disgorgement Treble damages Private rights of action by contemporaneous traders Firms must have written policies to address insider information “Chinese Wall” doctrine isolates information to the department using the information for the benefit of the corporate customer Created the Securities and Exchange Commission Structure of the SEC Five (5) appointees as commissioners Appointed by the President with the advice and consent of the Senate Staggered five year terms Bipartisan Full-time position, i.e., resignation of other job(s) required Assets placed into a blind trust Gave regulation over margin accounts to the Federal Reserve Board Regulation T creates minimum equity standards Curb excess speculation No credit on new issues for 30 days Full payment on COD/DVP within 35 days Established Stock Exchange Registration requirements Application must demonstrate that the proposed exchange: 's in the public interest.Can self-regulate and enforce Has a tripartite board of directors Listed companies Members General public Application becomes effective 90 days after filing the application The SEC may close an exchange for up to 90 days, but must notify the President Provided for Broker-Dealer registration with the SEC Registration becomes effective after a 45-day review period Other provisions include definition of investment discretion Five parameters of a trade: Action, Security, Quantity, Price and Time If the action, security and quantity is specified by the customer, the instructions are valid If either the action, security or quantity is decided upon by the broker- dealer or rep, the trade is discretionary Price and time of execution may not be specified by the customer If the broker-dealer or representative uses judgment as to price of execution or time of execution, no discretion has been exercised Transfer Agents effect the transfer of ownership of securities Typically a bank Not an insurance company for its own separate accounts Not the OCC, which issues, assigns and clears options Minimum Net Capital requirements for Broker-Dealers were created No requirements for Investment Advisers Fidelity bonds required, based upon net capital Corporate filings with the SEC 8-K for significant corporate events 10-Q Quarterly financial statements 10-K Audited annual financials Annual reports (or form 10-K) must be sent to shareholdersThe Securities Acts Amendments of 1975 Created MSRB Broker-Dealer enforcement by NASD and SEC Bank dealer enforcement by FDIC, FRB and Comptroller of the Currency Secondary market activities only Abolished fixed commission schedules Allowed for the beginnings of a National Market System National Securities Markets Improvement Act of 1996 (NSMIA) Established the preeminence of the SEC vs. State laws and regulators Eliminated dual registration requirements for certain securities and entities Created Federal Covered Securities Created Federal Covered Advisors. Investment Company Act of 1940 Defined an investment company More than 40% of its assets in securities Banks and insurance companies are excluded Separate accounts of insurance companies are included Passive investors, i.¢., not a holding company Minimum of 100 shareholders Minimum assets of $100M for a public offering Types of investment companies Face Amount Certificate Companies - Obsolete Unit Investment Trusts - Unmanaged, Redeemable Management Companies Open-end or Mutual Funds Closed-end or Publicly Traded Funds ETFs - Track an index; sified Management Companies 75 Rule; 5/10 Suggestions With 75% of the portfolio, No more than 5% of portfolio in one stock, or No more than 10% of one company's voting shares, but No restriction on the other 25%Prohibitions for Investment Companies Margin trading Short selling Bank debt if allowed by shareholder vote Joint trading accounts More than 3% interest in another investment company Composition of Board of Directors Majority must be “outsiders” or non-interested persons Under old rules, 40% had to be outsiders Transactions with Affiliates Buying or selling from or to the investment company is prohibited Borrowing from the investment company is prohibited ‘SEC may grant exemptive relief to allow affiliate transactions Sales Charges Breakpoints are quantity purchase discounts Given to “any person” Holdings for minor children are aggregated May aggregate other related accounts, Letters of Intent (LO!) and Rights of Accumulation (ROA) Sales with no sales charge are allowed Employees of the fund, the advisor, the underwriter Contractual plan companies 12b-1 Fees Asset based “distribution fee” Reviewed quarterly Renewed annually Initial approval by both board and shareholders Renewal approvals by board only Termination by shareholders or a majority of the board Management or Investment Advisory Contracts ‘Agreement must be in writing Details all provisions, including compensation schedule Automatically terminated if assigned Can be terminated without penalty upon a maximum 60-day notice Approved initially by both the board and shareholdersTwo-year period Renewal annually (1 year period) by the board or the shareholders Changes in Investment Policy Shareholder vote required for Change of investment objectives Change of structure of the company Shareholder vote not required for Change of investments (e.g., cash position or security selection) Distribution policies Reports To the SEC Audited financials annually Semi-annual filings To the shareholders, Semi-annual reports Balance sheets and income statements Portfolio holdings and changes in the period Investment Advisers Act of 1940 Definitions Broker Effects transactions on behalf of others (agent) Is paid a commission Dealer Effects transactions for its own account and risk (principal) Earns a markup Person Broad definition, including natural and non-natural persons Can | open an account for it? Can it enter into a contract? Non-Person Deceased individuals Individuals declared legally incompetent Minors Investment Adviser‘Any person who, For compensation Engages in the business of Advising others as to the value of securities Or, as part of a regular business, issues analyses or reports concerning securities Definition specifically includes pension advisors or advisors to sports figures or other celebrities (SEC Release |A-1092) Investment Adviser Representative Individual associated with an adviser Performs non-clerical functions Direct or indirect participation in advisory activities Must register with the State Administrator Exclusions and Exemptions Exclusions - The definition of an adviser does not apply to this person Exemptions - The person is an adviser exempted by specific ruling Exclusions from the definition of investment adviser Banks, trust companies, thrift institutions, etc. Lawyers, Accountants, Teachers or Engineers When advice is incidental to their normal work Separate billing or advertising negates the exclusion Broker-dealers Wrap accounts or other asset-based fees negate the exclusion Charging for financial plans negates the exclusion Asset management fees negate the exclusion General circulation newspapers, magazines or other publications If the adviser’s business is restricted to Treasury securities Exemptions from registration Intrastate advisersAll offices in one state All customers in the same state Can give advice on no securities traded on a national exchange Advisers whose only customers are insurance companies NOT those whose only customers are investment companies Private Fund (100 investors or less; no public offering) Advisors Domestic private fund advisors with less than $150 MM in assets Foreign fund advisors No place of business in United States Less than $25MM of US client assets Advisors whose practice is limited to venture capital funds. De Minimis Fewer than fifteen advisory clients in a rolling 12-month period Person does not hold himself out as an adviser None of the clients can be investment companies Registration with the SEC File form ADV No fees for SEC registration 45-day registration (review) period Registration with SEC is required if the adviser has $100MM or more in assets under management (Federal Covered Adviser - discussed in detail in Uniform Securities Act section) Schedule | is filed to establish or notify concerning Initial eligibility Annual renewal, within 90 days of fiscal year end Changes in the way the adviser conducts business Prompt notice for significant changes Within 90 days for other changes If sold, the successor firm files a new ADV within 30 days (may be pre-filed) 10For withdrawal, form ADV-W is filed Effective in 60 days Advisers may not use the initials RIA on literature or stationery May use “Registered Investment Adviser” The title “Investment Counsel” may be used if the adviser Has giving investment advice as its principal business Primarily conducts investment supervisory services Continuous advice specific to the customer's specific needs Books and records must be maintained 5 years, with the most recent 2 years in the office Note: 6 year federal requirement for Broker-Dealers All financial records All client account records Transaction records of associated persons Compensation, including soft dollar compensation Allowable soft dollar compensation (safe harbor) includes Stock quote services Software Seminars Research reports Non-allowable soft dollar compensation includes Rent Furniture Equipment or services not related to either business Travel to seminars, Copies of ads sent to 10 or more persons (no filing requirement) Investment Advisor Brochure The adviser's brochure is comprised of Part 2 of Form ADV Part 24 Appendix 1 of Form ADV - Wrap Fee Program Brochure Part 2B of Form ADV ~ Brochure Supplement (supervised persons) Must be in a narrative format Must be written in plain English, avoiding jargon, technical or legal terms Discloses obligation as a fiduciary Full and truthful Disclosures Filed with IARD (State) or made available to SEC (Federal) atBrochure Rule (USA) Must be delivered 48 hours prior to signing contract If not, the customer has a 5-day period to cancel without penalty Assume state law if not specified Brochure Rule (Federal) Brochure must be delivered at or prior to entering into a contract Written or oral contracts (oral contracts are fraudulent under state law) Updated and delivered within 120 days of fiscal year end at no charge Exemptions to the Brochure Rule Investment companies Officers, directors, etc. of the IA who are individual clients Impersonal advice where the fee is less than $200 (state)/$500 (Federal) per year, e.g., newsletter subscriptions If impersonal and greater than minimums, brochures are provided on request only Custody Rules for Advisers Custody and Discretion are not the same Custody involves physical possession of customer securit Certain fee prepayment arrangements are deemed as custody More than $1200 (Federal) or $500 (State) in fees AND Covering 6 months or more of services AND The adviser has discretion over customer assets Automatic debit of fees is considered custody unless Prior written authorization is given Simultaneous billings are provided The adviser provides notices to the customer Adviser must provide quarterly reports to customers (custody only) Adviser must disclose adverse financial conditions (custody or prepay) 12Adviser must provide audited financial statements annually on Schedule G (custody or prepay) Surprise audit, annually Form ADV-E is the cover for the auditor's examination report Completed by IA and submitted with exam report Reports and disclosures are only sent to the customers for whom the adviser has custody Required adviser disclosures To act as principal or agent in a trade (Principal or Agency Crossing Transactions) Cannot solicit both sides of the trade Obtains written consent of both parties Discloses to both parties the compensation for the trades Annual disclosures of all transaction compensation Disciplinary actions Court injunctions or regulatory actions ‘SRO sanctions (fine exceeding $2500, suspensions or expulsion) Referral fees Solicitors must be registered Requires written agreement between the adviser and solicitor Solicitor provides client with adviser brochure and solicitor disclosure documents Customer signs acknowledgement of receipt of both Advertising Definitions Item sent to one person only: Correspondence Item sent to two or more people: Advertising Item sent to ten or more people: Advertising with retention requirement Standards No testimonials References to past performance must include All securities in the past 12 months, or All customers in the past 12 months, and 13No assurance of future performance If charts or graphs are used, the limitations and difficulty in using them must be explained Free products or services must be truly free Disclose preparer (if not IA), date of first use, non-current information Prohibited contractual and fee provisions. Contracts cannot be assigned without the client's written consent Assignment includes subcontracting or any of the following Sale of the business Merger with another business Pledge of a majority of the business’ stock as collateral Provisions for partnerships Ifa majority interest changes, written consent is required Ifa minority interest changes, notification is sent to clients Fees are typically based on a percentage of assets under management Fees based on performance (relative to an index) are allowed if The customer is an investment company or other institution OR The customer is a wealthy individual $750,000 invested with the adviser or $1.5 MM net worth or Officers, directors, eto. of the IA who are individual clients and have been in the industry over 12 months Performance-based fees are sometimes called fulcrum fees. Discretion must be performed with written power of attorney Investment advisers may use discretion with verbal authorization for a period of 10 days (state law) Enforcement provisions ‘SEC can suspend registration for up to 12 months If longer, it is a permanent bar Decisions can be appealed to the US District Court of Appeals 60 days to file the appeal 14Criminal penalties for violations $40,000 fine and/or 5 years STATE LAW The Uniform Securities Act (USA) Definitions Administrator The person charged with enforcing the Act in this state Can actually refer to the individual, the office or staff Typically Securities Commissioner or Attorney General Person Broader di ition than the federal Broker-Dealer (“the business”) Similar to the federal definition Exclusions from the definition of B-D: Agents Issuers, Banks Exempt from registration as a B-0 in this state No place of business in the state AND Only customers are non-public financial institutions Issuers Other broker-dealers Banks Insurance companies Investment companies OR only retail customers are temporary residents “Snowbirds” Vacationers Persons pursuing educational goals, etc. 15Agent (“the individual”) Individual employed by a broker-dealer or issuer to sell securities Excludes those representing the issuer with regard to exempt securities or exempt transactions Excluded if only duties are clerical or administrative Investment Adviser (“the business”) ‘Same definition as federal Exclusions are mostly similar to federal Banks Professionals Broker-dealers Publishers of any type, unless they give advice specific to the needs of the subscriber Investment advisory representative or JAR Exempt from registration in the state if: No place of business in this state AND Only customers are non-public financial institutions Other investment advisers Broker-dealers Banks Insurance companies Investment companies De Minimis exemption No more than 5 clients in the state in a rolling 12-month period Investment Advisory Representative (“the individual”) Non-clerical or administrative affiliates of the Investment Adviser Makes recommendations or gives advice Manages portfolios Solicits advisory services Has supervisory duties over advisory activities, Federal Covered Adviser: $100 million or more in assets under management 16AUM measured annually Advises registered investment companies There is a Federal exemption for the advisor These advisers register with the SEC, not with the state Representatives must still register with the state Small-size advisors (less than $25MM AUM) must register at the state Mid-size advisors ($25MM to $100 MM) may choose SEC registration If not required to register in their principal state, and If registered, would not be subject to examination by that state's Administrator, or Must register in 15 or more states Otherwise, register with the state(s) Other allowed SEC registration scenarios Pension consultants advising on $200MM or over, Affiliate advisors of a Federally registered advisor Expectation of Federal eligibility in 120 days Advisors operating in 30 or more states Internet advisors Custody Physical possession of customer funds or securities Generally not allowed Ifallowed in the state: The administrator must be notified The adviser must comply with federal law Quarterly statements Advice of adverse financial condition Annual audited financial statements Discretion is not the same as custody Sale or to Sell; Offer of Offer to Sell Sale is the disposition of securities for value Offer to sell is to attempt to effect a sale Solicitation of an offer to buy is an offer to sell Sales include the following 17Bonus included with or attached to another item sold Gifts of assessable securities These are not sales Gifts of non-assessable securities Pledge of securities as collateral Stock dividends or stock splits Mergers or other types of exchanges of stock Securities - See Appendix for detailed list Categories Stocks Bonds Options Limited Partnerships or DPPs Other, unusual securities Common threads “Certificate of...” “Participation in. “oil and Gas.. “Variable...” “Interest in. Ifit leads to a security, it is a security If it takes the place of a security, itis a security Investment Contract - the generic definition established by the courts Investment into a common enterprise ‘An expectation of profit Third-party management Things that are not securities - Much more important to know than what is a security Fixed annuities Fixed insurance Retirement plans Collectibles, Commodities, Currencies, Condos and Confirmations 18Licensing and Registration Requirements ‘Agents must be registered with a B-0 or issuer in this state to sell securities Advisory Representatives must be registered with an adviser to give advice Initial applications include a Consent to Service of Process Applications are effective at noon of the 30! day after application ‘Amendments to the application reset the 30-day period All renewals are on December 31 No prorating of fees for a partial first year of registration If transferring from one B-0 or IA to another, the successor firm pays no fee until renewal Net Capital Requirements None for agents or representatives Broker-dealers, if tested use $35,000 Investment Advisers without a bond ‘$10,000 if the adviser has discretion $35,000 if the adviser has custody A $35,000 bond will take the place of the net capital requirement Recordkeeping requirements Both client and business records must be maintained Investment Advisers - 5 years Broker-Dealers - 3 years Administrator's Authority to Deny, Suspend, Revoke Registrations of Persons 19Administrator can act at any time if the action is in the public interest AND ‘Amisleading or incomplete application has been filed The person is under an injunction The person is under the order of another jurisdiction The person is insolvent The person has been convicted in the last 10 years Any felony Money misdemeanors Accusation is a disclosure item only The person is unqualified due to inadequate education, training or experience The registration cannot be denied based solely on a lack of experience The person has failed to supervise The person has failed to pay a fee The Administrator cannot deny due process of law Before the action: Appropriate prior notification During the process: Opportunity for a hearing within 15 days After the action: “Written findings of fact and conclusions of law” Registration of Securities Registration by Notification or Filing No IPOs Must be allowed in this state by the Administrator The offering is effective upon filing the documentation Typically associated with investment companies Registration by Coordination The most common means of registration Simultaneous federal and state filing Effective date is the same as the federal Administrator must have the 3 copies of the prospectus, plus any amendments No stop order can be in effect at the state level Typically associated with interstate offerings Registration by Qualification State-by-state registration in the desired locations Administrator determines the information required in the filing and the effective date Always available 20Typically associated with intrastate offerings Registration Statements may be filed by Underwriting Broker-Dealer Issuer Secondary seller Remain open for one year if any of the securities are outstanding Administrator's Authority to Deny, Suspend, Revoke Registrations of Securities The Administrator may issue a stop order if it is in the public interest AND The registration statement is materially incomplete or misleading The Act has been violated The security would work a fraud on the investing public The terms allow for unreasonable underwriter compensation Fees have not been paid The Administrator cannot deny due process of law Prior notification Opportunity for a hearing Written findings of fact and conclusions of law Exempt Securities Exempt from filing and advertising requirements only ~ never anti-fraud “a GOVERNMENT REGULATOR'S LIST of CHARITIES is SHORT. Governmental issuers US. Treasury Federal agencies Municipalities, state governments and agencies Also Canadian or other foreign governments with which the U.S. maintains diplomatic relations Issuers with a Regulator in place in 1933 State banking commissions - Securities of banks State insurance commissions ~ Securities of insurance ‘companies Interstate Commerce Commission - Common carriers or railroads Also Public Utility Commissions (PUC) - Public utility companies 21Not SBICs Listed securities or securities senior to, equal to or otherwise comparable to listed securities Federal Covered Securities Listed on the NYSE, ASE or a major regional exchange Senior to a listed security Preferred stock or bonds of the issuer Equal to a listed security Rights or warrants of the issuer Listed on the NASDAQ National Market System, or senior to or equal to. a NMS security Securities issued by a registered investment. company Securities for which a Federal exemption is available Due to preeminence of Federal law Charitable or non-profit organizations or fraternal societies Short-term - Maximum maturity of 270 days Commercial Paper $50,000 minimum denomination ‘In the top three grades Banker's Acceptances Exempt Transactions Secondary market transactions Isolated non-issuer transactions “Manual exemption” Unsolicited non-issuer transactions Transactions between the issuer and the underwriter Fiduciary transactions Foreclosure sales Trustee sales Executor sales Sales of securities to banks, insurance companies or investment companies 22Private Placements Maximum of 10 offers ina 12-month period Institutional offers do not count against the 10 Must be held for investment purposes if a retail sale No commissions may be paid Maximum of 10 subscribers No commissions paid No payments made by the subscriber The Administrator may revoke the exemptions of Any transaction exemption The “Charity” securities exemption or securities issued in conjunction with Employee stock plans, pensions, profit sharing, savings or other benefit plans Other exemptions may not be revoked The burden of proof is on the one claiming the exemption The Administrator may require fees, ongoing reports, escrow accounts and/or special subscription forms Fraudulent and Other Prohibited Practices - See appendix for detailed list Fraud is defined as, “Not limited to Common Law deceit” All advisory contracts must be in writing No sharing in the performance of the account unless in accordance with federal laws No assignment without customer consent Events considered assignment are the same as under Federal law Partnerships have the same consent/notification guidelines Custody rules are the same as federal laws USA has net capital rules but federal law does not Suitability is always the most important consideration, taking into account all relevant financial and personal factors Splitting commissions with agents of non-affiliated firms is prohibited 23Splitting commissions with agents of affiliated firms is allowed Other prohibited practices follow broad guidelines such as Don't lie Don't cheat Don't steal Don't cover up lying, cheating or stealing Don't do insider trading If doing something is a good business practice, the opposite is probably prohibited Avoid the bad-sounding words “Deliberately failing...” “Without regard to. “without consideration for Administrator's Authority and Jurisdiction The Administrator can act within or outside the state to: Conduct investigations Subpoena witnesses and/or documents Enforce the Uniform Securities Act Enforce his rules, orders or forms Rules apply to every person functioning in the state Orders apply to one person. Forms must be used within the state Rules, orders and forms all carry weight equal to the law Obtain injunctions from courts of competent jurisdiction Maximum criminal penalties for violations is $5000 fine and/or 3 years Five year statute of limitations for fraud Overview of the Administrator's authority: The Administrator has administrative authority Deny, revoke, suspend, investigate, issue orders, etc. The Administrator brings criminal actions Cases are turned over to the District Attorney or Attorney General Criminal penalties are imposed by the judicial system 24The Administrator has no civil authority Civil cases are filed by the person harmed by an action Civil Liabilities The seller of a security can have liability to the buyer for Violations of the Act Untrue or misleading statements, or material omissions The buyer can sue for The original principal (get the money back) Interest at the state’s legal rate Less income received on the investment Attorney fees Court costs The buyer cannot sue if an offer of rescission is made by the seller first Offer must be in writing Offer must include The original principal (get the money back) Interest at the state's legal rate Less income received on the investment No attorney fees or court costs The offer must remain open for 30 days Statute of limitations on civil actions 3 years after the action or 2 years after discovery of the action (1 year for Federal) Whichever comes sooner Judicial Reviews Within 60 days in a court of competent jurisdiction The filing of an appeal does not stay or reverse the Administrator's order Stayed only if the judge specifically says so Administrator Jurisdiction - Offer or Acceptance is Key Where was the offer accepted? That Administrator is most likely to act Where was the offer directed out of or in to? Where is the buyer a resident? State from which checks, certificates, etc. are mailed are irrelevant 25Publications or broadcasts are considered actions in the originating state Publications with 2/3 of readership outside the state is not considered in-state State-Specific Considerations Concerning the Internet ‘An internet site is not considered an action in a state if: The site contains general information only (no recommendations) There is a clear disclosure that the person may only conduct business in states in which s/he is registered, or if there is an exemption Agents and IARs must disclose their principal firms Firms must properly supervise the content on the site INVESTMENT VEHICLES Common Stock - Basic Form of Corporate Ownership Rights of common shareholders Right to residual assets upon liquidation Voting rights Pre-emptive rights Valuation methods Fundamental Analysis (“Business”) Price-Earnings Ratio Earnings growth Dividend discounting mode! Asset valuation Sector Rotation Top Down Bottom Up Technical Analysis (“Trading” or “Timing”) Charts and graphs Volume trends ‘Advance/Decline ratios for market breadth Oddl-ot ratios ~ Contrary indicator Short Interest figures - Contrary indicator Point and figure (Price momentum) Head and Shoulders Top/Bottom Random Walk or Efficient Market Theory (“Dartboard” or “Discounting") 26All relevant valuation factors are immediately reflected in a stock's price One is as good as another “Efficiency frontier” Advantages of Common Stock Possibility of growth of ca Possibility of keeping up with or outpacing inflation Possibility of dividend income that may grow over time Excellent liquidity Typically excellent marketability Ability to easily diversify and adapt to changing markets Splits may increase the number of shares owned Disadvantages of Common Stock Risk of losing all capital No guarantee of dividends Volatility Relatively low income compared to other investments Possible dilution ‘American Depository Receipts (ADRs) Most convenient method of buying foreign stocks Offers diversification from American economy Currency exchange risk is present, in addition to all basic risks Developed/ Emerging Markets Higher risk/return profile in emerging markets Suitability concerns due to volatility, relative illiquidity, expenses, lack of information, political risks Preferred Stock Fixed income equity investment Priority claim to dividends and assets vs. common Moves with the bond market Advantages of Preferred Stock 27Relatively high income Relative safety compared to common Reasonable liquidity Possible cumulative feature Possible convertible feature Disadvantages Fixed dividend leads to interest rate risk Does not typically participate in growth of company No voting rights Subordinated to bonds Purchasing power or inflation risk Corporate Bonds Debt instrument Bonds are safer than stocks ‘Advantages of Corporate Bonds Reasonably high income Priority claim over any equity security in liquidation Obligation to pay interest Good marketability Good liquidity Easy to judge credit quality Diversification ‘Adding a bond component to an equity portfolio reduces market risk Modern portfolio theory Disadvantages of Corporate Bonds Interest rate risk Purchasing power risk Credit risk ~ credit quality can deteriorate over time Some marketability or liquidity risk Treasury Securities Backed by full faith and credit of the U.S. Government No credit risk No liquidity or marketability risk State tax exemption Purchasing power risk 28Interest rate risk Treasury Bills, Notes and Bonds Treasury Inflation Protection Securities (TIPS) Fixed coupon on principal that adjusts semi-annually by CPI Agencies, Mortgage-Backed Securities, CMOs or REMICS GNMA [and FNMA] have full faith and credit government backing Most other agencies are “moral obligations” only Higher interest than Treasuries; lower than corporate bonds Excellent liquidity and marketability Mortgage-Backed securities pay monthly Combination of interest and principal paid Subject to prepayment risk if rates decline Subject to extension risk if rates rise Highest level of reinvestment risk CMOs and REMICs help build in some certainty Tranches are set up by expected life Still have prepayment and extension risk Repackaged; no U.S. direct or moral obligation backing Municipal Bonds Federally taxfree ‘Sometimes state tax free Generally considered safe Many are rated by Moody's, S&P Unrated bonds are still reasonably safe Interest Rate risk Purchasing power risk Limited liquidity and marketability Zero Coupon Bonds Can be corporates, Treasuries or municipals Purchased at a discount (present value) Mature at par (future value) True compounded yield to maturity (IRR) 29Highest volatility (duration) among bonds with same maturity Cash equivalents Treasury Bills “Risk-free” benchmark Negotiable CDs Money Market funds - Not FDIC insured All offer low yields All offer safety and liquidity Trading Terminology Exchange Centralized marketplace ‘Auction-based transactions ‘Agency transactions; commissions Over the Counter (OTC) Dealer to dealer marketplace Negotiated transactions Principal transactions; markup/markdown Bid - “wholesale” price, where the dealer buys and public sells Ask or Offer ~ “retail” price, where dealer sells and public buys Firm quotes - can be relied on for an execution at that price Subject quotes - subject to change or previous purchase/sale Broker-Dealers ~ effect transactions in securities for customers and for their own accounts Specialists ~ maintain fair and orderly markets on exchanges Market Makers - maintain inventory in OTC securities to facilitate trading 30Market order - to be filled ASAP at the best price available Transaction is guaranteed, but price is not Limit order - To be filled only at a specified price or better Transaction not guaranteed, but price is if order fills ‘Stop order - to stop a loss or protect a profit Short sale - to borrow and sell a security with the hopes of buying it back later at a lower price Day order - cancelled at the close of business if not filled Open or GTC order - good until cancelled Reconfirmed in April and October Cash account - all securities are fully paid Margin account - customer can borrow from the broker-dealer to introduce leverage Higher potential gain, but higher potential loss Not suitable for fiduciary accounts, UGMA accounts, etc. Prohibited by law for investment companies and retirement accounts Typically violates Prudent Investor Rule for fiduciary accounts Risk of incurring maintenance calls Option account ~ special account for options trading Spreads - difference between the bid and the ask Efficient market - characterized by high activity and tight spreads Inside market - the highest bid and the lowest offer 31Investment Companies In general, can invest in any of the securities listed above Offer the same objectives as the securities above Except as mitigated by diversification, have same risks as the securities above Can have a mix of asset classes for asset allocation Diversification Professional management Convenience of investing small amounts Convenience of reinvesting income and capital gains Flexibility of switching from fund to fund as objectives or markets change Reduced non-systematic or selection risk Still have systematic or market risk Open-end funds. Purchased and redeemed at a price based on Net Asset Value No market risk as related to the fund itself May charge sales charges Class A shares - front end load Breakpoints typically available LOI and ROA should be used when possible Suitability for large purchases or long term 32Class B shares - back loaded; CDSC Suitability for medium term, less than breakpoint No load funds - no sales charges Expense ratios Closed-end funds Trade on exchanges just like stocks Better intra-day liquidity ‘Added layer of risk from supply and demand for the investment company shares themselves Can trade at a premium or discount to Net Asset Value Real Estate Investment Trusts (REITs) Similar in structure to a closed-end fund, which is similar to a stock 75% of assets and income must be real-estate related 90% of income must be distributed to maintain favorable tax treatment Report on a 1099 - no losses passed through Equity REITs and Mortgage REITs Derivative Securities Options Call options give the buyer a right to buy stock at a fixed price Bullish or optimistic strategy Call sellers have to make it happen for the call buyer Sell the shares if the price goes up Neutral to bearish strategy Put options give the buyer a right to sell stock at a fixed price Bearish or pessimistic strategy Put sellers have to make it happen for the put buyer Buy the shares if the price goes down Neutral to bullish strategy 33“In the Money” options are exercised “Call up” - when the market prices goes up above the strike price (exercise price of the contract), calls are in the money “Put down” - when the market prices goes down below the strike price (exercise price of the contract), puts are in the money Covered writer Buys stock and sells a call option If the stock goes up, the writer (seller) delivers the stock The most conservative strategy — allowable in IRA accounts Uncovered or Naked Writer Commits to deliver stock at a fixed price Stock can go up an unlimited amount Writer would then have to buy the stock at a high market price to deliver to the call buyer Riskiest strategy of all Options can also be used to hedge investments against adverse moves Profit from what hurts you (e.g., market decline, rising interest rates) The profit offsets your loss in the primary investment Similar to P&C Insurance Futures Establishes price and delivery date for commodities, Agricultural goods Energy products Foodstuffs Used for speculation and hedging Warrants “Sweeten” a risky investment by adding participation in the common stock Produce dilution for current stockholders Benefits of derivative securities Flexibility Leverage The ability to control a large block of something with a small amount of money 34Disadvantages Wasting assets High risk Leverage Some strategies have unlimited risk Real Estate Limited Partnerships Report on K-1 which allows for losses to pass through Can invest in a variety of property types, with risk/reward parameters to match New construction Existing buildings Raw land Government assisted housing Resort properties and condominiums Possibility of appreci Possibility of tax benefits Possibility of cash flow Highly illiquid Often high risk Concentrated investment Information on Confirmations Full itemization of transaction details The capacity in which the firm acted (i.e., agent or principal) Market making status of the firm, if applicable Disclosure of control, if any 35‘Must be sent by the completion of the trade Variable Annuities Insurance product Separate account choices allow for flexibility of investments Owner assumes market risks Tax deferred growth Taxed as ordinary income on withdrawal (LIFO) Blended stream of taxable and tax-free income on annuitization Lifetime retirement income which may keep pace with inflation Somewhat rigid and illiquid ~ long term commitment Index Annuities or Equity Index Annuities Provide percentage participation in an index, with a minimum guarantee Life Insurance Term ~ pure protection Whole life - builds cash value over time Variable - Allows for owner input into investment of cash value Employee Stock Options Nonqualified Stock Options (NSO) ~ Bargain element reported as income Incentive Stock Options (ISO) - Bargain element reported as LT Capital Gain Stock must be held two years after grant and one year after exercise 36INVESTMENT ANALYSIS, RECOMMENDATIONS AND STRATEGIES Quantitative methods Time value of money ‘As with compound interest Classic example is the “Rule of 72” Present value Given a goal of X dollars and Y% interest rates for Z years, how much it takes today to reach the goal Zero coupon bonds are priced at their net present values Net Present Value The sum of present values of an investment, less the cost Often used by manufacturing firms to justify new plant or equipment Positive NPV is desirable Future Value The amount X dollars will grow to if compounded at y% for Z years Internal Rate of Return (IRR) Takes into account the time value of money More money today is the better Current Yield The “cash on cash” yield from an investment Yield to Maturity Reflects what the market is demanding from similar debt securities of similar maturities priced at par or at a discount Yield to Call ‘Comparable to yield to maturity on premium bonds Premium bonds are likely to be retired or called for redemption early 37Expected return Projected returns based upon the risks taken Where Py, P,, P: are probabilities of achieving certain returns: Px *X% + Py*Y% + Pr*Z% Total Return Includes earnings from all sources Interest Dividends Capital gains Other distributions Holding Period Return The return on the investment, regardless of the holding period Annualized Return Assume the holding period return can be achieved for an entire year Inflation-Adjusted or Real rate of return Net out inflation from the raw rate of return After-Tax Return Nets out the effects of taxes Usually used when comparing municipal bonds to other investments Risk-adjusted Return Raw return numbers divided by Beta Results in lower numbers for higher volatility investments Results in higher numbers for lower volatility investments Risk Premium The expected return pickup from taking a higher risk Opportunity Cost The return missed by taking the lower risk Risk measurements 38Beta Volatility of a stock or portfolio compared to the market, S&P 500 has a Beta of 1.00 Standard Deviation Higher standard deviations mean greater variability and thus less predictability of returns, so higher risks R? or Correlation factors Range from 0 to 100 (spurious to direct correlation) Duration ‘A measure of volatility for bonds Stated in years, but different from maturity dates A zero coupon bond's maturity is its duration Convexity Measures bond price sensitivity to interest rate moves Useful in measuring price volatility of bonds Valuation Ratios Price to Earnings Ratio (P/E) or market multiple Market price divided by earnings Higher with growth stocks Lower with value stocks or stocks in mature industries Higher P/E means higher risk/return Price to Book Rat ‘Market price divided by theoretical breakup value of a company Used most often with financial companies Benchmark Portfolios for Comparative Performance Large capitalization use S&P 500 ‘Small capitalization use Russell 2000 Other portfolios use indices which most closely resemble the securities held 39e.g, EAFE for foreign securities Sharpe's Formula Actual Return - T-Bill rate, divided by the Standard Deviation Risk Premium divided by volatility The higher the better Monte Carlo Simulation Calculating the probability of achieving certain returns under different Wvestment circumstances Types of Risk Market Risk (Systematic) Hedge with index options or other “insurance” methods to protect Basis for Capital Asset Pricing Model (CAPM) expected return Selection or Business Risk (Unsystematic) Diversify to minimize Inflation or Purchasing Power Risk Present in all fixed income investments Raw return - Inflation = Real Rate or Inflation-Adjusted Return Interest Rate or Money Rate Risk Used with bonds or other fixed income securities Greater with longer maturities and/or lower coupon rates Credit or Default Risk Minimize by using more investment grade or Treasury securities Regulatory Risk Laws, especially tax laws, can and do change Liquidity Risk Minimize by buying larger issues, well-known, actively traded securities 40Types of Client Ownership, Liability and Taxation Individual Sets the baseline Individual responsibility for taxes Unlimited liability Transfer on Death (TOD) UGMA/UTMA Unearned income over $1900 at parents’ marginal rate Joint With rights of survivorship JTWROS) Tenants in Common (TIC) Maximum capital loss writeoff of $3000; carry forward the balance Wash sales negate tax losses Repurchasing before sale date +/- 30 days ‘Substantially identical securities Sole Proprietorship Identical to an individual “DBA” General Partnership Pass-through of taxes Unlimited liability Limited Partnership Pass-through of taxes Limited liability uc Default is pass-through of taxes Limited liability “Members” instead of shareholders S Corporation 41Pass-through of taxes Limited liability Limited to 100 shareholders € Corporation Taxed entity Limited liability Trust Simple trusts - distribute all income annually Complex trusts - can accumulate income Maximum tax rates reached quickly on undistributed income Grantor or Settlor - Gave Beneficiary - Gets Trustee - Runs (fiduciary responsibility) No margin accounts, typically No speculative investments, typically Estate Tax based on date of death valuation or 6 months afterwards Unlimited spousal transfer at first spouse's death Maximum tax rates reached quickly on undistributed income Heirs received stepped-up basis (as opposed to gifts) Taxes due 9 months after date of death Powers of Attorney or Trading Authorizations Limited General Durable Suitability Considerations Financial Goals Current Financial Status Personal balance sheet Cash flow statement Capital needs 42Safety and liquidity Current expenses Retirement, college expenses, death, disability, other future events Current investments and strategies Time horizon Other considerations Values and attitudes Risk aversion Experiences Demographics Tax considerations Portfolio Management Strategies Buy and Hold Indefinitely or until certain goals are reached Generally considered conservative Lower transaction costs Strategic Management Set the strategy - Asset allocation Rebalance Constant Ratio Plan Maintaining level percentages in asset classes Constant Dollar Plan Maintaining level dollar amounts in asset classes Surplus goes into; shortage comes out of a money fund Passive or Indexing “Be the index” - Index funds Tactical Set the strategy - Asset allocation Look for the best opportunities to maximize return in each asset class Rebalance and refocus 43Higher turnover, costs and risks Growth Investing Buying in anticipation of future earnings growth Value Investing Buying assets below their true value because of actions in the financial markets Generally lower risk than growth investing Other Considerations Market Capitalizations Micro-Cap ~ Less than $300MM Small-Cap - $300MM to $28 - Russell 2000 Mid-Cap - $2B to $10B - S&P 400 Large-Cap - Over $10B - S&P 500 ‘Smaller capitalization companies have more risk, but more potential return Larger capitalization companies have more stability, but less dramatic earnings growth potential Diversification among asset classes (asset allocation) reduces risk and enhances return The more active a management style, the more transactions costs the portfolio must support Dollar Cost Averaging Used most often with mutual funds Results in lower breakeven than the average of prices paid Does not guarantee profits Income reinvestment Typical of mutual funds or corporate DRIP plans Allows for compounding of earnings Retirement Plans and Education Funding Plans IRA Traditional (usually pre-tax contributions) Roth (after-tax contributions) 44Penalties for excess contributions, early withdrawal, excess accumulations (traditional only) To contribute after 70 ¥, use Roth SEP IRA in a group environment; all IRA rules apply SIMPLE No more than 100 employees; no other plan Pension Defined contribution benefits younger employees most Defined benefit helps older employees most 401(k) Salary reduction plan; possible employer contributions Roth 404(k) Aiter-tax employee contributions, tax-free withdrawals Employer contribution into regular 401(k) RMDs required 403(b) Similar to 4041(k) for employees of public schools or non-profits 404(c) Self-directed option mitigates plan administrator's fiduciary responsibility ERISA No discrimination among employees Administrators became fiduciaries No margin accounts 45‘Arms-length transactions to benefit the participants US gold coins OK; most other collectibles are not Withdrawals ‘Taxed as ordinary income upon withdrawal (except Roth) If pre-tax money, taxable is withdrawn first Education Plans Coverdell $2000 per child per year; tax-free if used for education 529 Plans State sponsored plan; varies from state to state Limited by gift tax limit, but can make 5 contributions in a single year; no more for the balance of the period Taxtee if used for education expenses Non-qualified plans Deferred comp plans - employee must be at risk of loss No IRS approval required Can discriminate among employees ECONOMICS AND ANALYSIS Inflation Steady rise in prices for goods and services increased money supply Higher government spending Lower tax rates Increased debt Wages increase faster than productivity ‘Consumer Price Index or CPI is the most important measure Used to determine Constant Dollars for GNP calculation Defiation ‘Steady decline in prices for goods and services Decreased money supply Lower government spending. Higher tax rates Decreased debt 46Productivity increases faster than wages Yield Curves Normal (Positive) Long rates are higher than short rates Fed loosens or has easy money policies Inverted Short rates higher than long rates Fed tightens by raising rates Generally an indication of lower rates overall Flat Transitional or markets expect Fed actions to work Economic Measurements and Indicators Gross Domestic Product (GDP) ‘Sum of all goods and services produced by labor and property within the United States over a year Economic Indicators Leading indicators change before the economy turns Investor anticipation - S&P stock prices Fuel - M2 money supply Willingness to burn the fuel - Consumer confidence “Blue Collar” factors Average manufacturing workweek Initial unemployment claims New orders for consumer goods Orders for plant and equipment New housing permits Durable goods orders 47Speed of vendor deliveries Sensitive material prices Coincident indicators move with the economy Industrial production Personal income GoP Hours worked Lagging indicators trail the economy Corporate profits Personal debt to income ratios Duration of unemployment Inventories Balance of Payments Trade deficit, Business Cycle Expansion Peak Contraction Recession: 6 months of contracting GDP and lower stock prices Depression: Extended recession - 6 quarters (18 months) Financial Statements Balance Sheet Assets vs. Liabilities and Equity Listed in descending liquidity Working Capital = Current Assets less Current Liabilities Current Ratio = Current Assets divided by Current Liabilities Net Worth = Assets less all liabilities Footnotes explain various factors Unusual events Dilution from rights, warrants or convertibles Income Statement Follows the flow of business Net Sales, less Cost of Goods Sold and SG&A, equals 48Operating Income, less Interest expense, equals Pre-tax profit, less Tax, equals Net profit after tax Cash Flow adds back non-cash expenses such as depreciation TAX CONSIDERATIONS Income taxes Interest and short-term gains at ordinary income tax rates Dividends and long-term gains at favorable rates (15% maximum) Retirement plans withdrawals at ordinary income rates Alternative Minimum Tax Makes certain deductions non-deductible and certain municipals taxable Calculate ordinary tax then AMT; pay the higher Estate and gift taxes Gift tax paid by the giver of the gift No gift tax between spouses First $13,000 gift, per person, per year, has no gift tax Excess subject to gift tax No tax to the recipient Securities carry the donor's cost basis for tax purposes Estate tax paid by the estate No estate tax at first spouse's death First $5MM of the net estate is excluded from tax Excess is subject to estate tax No tax to the recipient Securities are valued (cost basis to beneficiary) as of the date of death “Stepped-up basis” 49‘Appendix A ~ Fraudulent and prohibited practices Prohibited Practice Employ any device, scheme or artifice to defraud Make untrue statements of material facts Omit material facts Make misleading statements Engage in any act, practice or course of business that operates as fraud or deceit Provide inaccurate market quotations Misstate issuer's earings or projected earnings Make inaccurate statements as to the amount of commissions or markups Telling a customer a security wil be listed without specific knowledge Stating that registration of a security with the SEC or Administrator somehow indicates or implies approval Misrepresenting the status of customer accounts Promising a service without the intention or ability to perform the service Representing to customers that the Administrator approves of B-D, agent. IA or JAR, Using insider information to trade or sharing the information with others Recommending securities without regard to customer needs, finances, objectives Induce transactions for the purpose of generating commissions {churning} Recommending a security without reasonable grounds for the recommendation Failure to describe important facts surrounding a transaction Exercising discretion without prior, written authority Borrowing money or securities from clients Commingling customer funds or securities with the BD, IA, Agent or Representative’s Guaranteeing profits Guaranteeing against a loss Sharing in customer accounts Front Running Matched purchases Deliberately failing to follow a customer's instructions Effecting customer transactions not recorded on B-D's books without B-D consent Failing to bring written complaints to the principal for resolution Failing to inform a customer that a transaction will have higher than ordinary costs, fees or taxes Soliciting orders for unregistered, non-exempt securities Spreading rumors Recommending transactions based on rumor Faliure to describe the capacity of the B-D on a trade confirmation (Agent or principal) Trading on margin without appropriate. signed margin papers Unreasonable fees Backdating records Sharing commissions with an unregistered person Sharing commissions with an unregistered person Sharing commissions with an agent who is not with the same or an affliated fim B-D, Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes 1A, TAR Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes YesBackdating any records, including confirmations Yes Attempting to obtain a written hold harmless agreement, a void contract Yes Falling to disclose if an 1A is acting as a principal or agent in a transaction Compensation based on performance, i., not a percentage of assets under management Assigning a contract without customer approval Failing to notify a customer of a minority change in partnership ownership of the 1A Failing to notify the Administrator that an advisor has custody of customer funds or securities Disclosing confidential customer information without client consent or a court order Using thrid-party materials without proper attirbution Use of testimonials in advertising Notes: 1, Without following approval procedures and proportional to financial interest in the account 2. As must notify customers of limitations in their abilities 3. NASAA rules allow ten days for an IA to operate under verbal discretionary authority 4. Unless federal rules are followed 5. This wording applies to 8-Ds; equivalent IA practices are likewise prohibited, if applicable 6. Prohibited unless the customer is, essentially, a bank and offers no special treatment 54 Yes Yes Yes Yes Yes Yes Yes YesAppendix B ~ List of Securities under the Uniform Securities Act Note Stock Treasury stock Security future Bond Debenture Evidence of indebtedness Certificate of interest or participation in a profit sharing agreement Collateral trust certificate Preorganization certificate or subscription Transferable share Investment contract Voting trust certificate Certificate of deposit for a security Fractional undivided interest in oil, gas, or other mineral rights Put, call, straddle, option, or privilege on a security, certificate of deposit, or group or index of securities, including an interest therein or based on the value thereof Put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency In general, an interest or instrument commonly known as a “security” Certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing Includes both a certificated and an uncertificated securit Variable annuity Variable life insurance Variable contract Interest in farmland and animals or Merchandise marketing programs, franchises, or schemes Whiskey warehouse receipts Insurance company separate accounts Multilevel distributorships 52