Unit 14 | Ethical Practices & Obligations

Question 1

Investment advisers and their representatives must place their clients’ needs ahead of their own. This burden is legally known as
A. avoiding conflicts of interest.
B. making full disclosure.
C. fiduciary responsibility.
D. playing fair.

Answer 1

C. The obligation of investment advisers and lARs to place clients’ interests ahead of their own is known as acting in a fiduciary capacity.

Question 2

An investment adviser advertises in the local newspaper’s business section. The ad describes the nature of the firm’s model portfolio and indicates that the firm has outperformed the overall market by 800% over the past ten years, and, therefore, they guarantee that their clients will more than keep pace with inflation. At the bottom of the ad, in smaller print, is the following statement: “Results are not guaranteed. Past performance is not indicative of future results. These results are abnormal and cannot be expected to be repeated.” This example is
A. a properly worded disclaimer.
B. an improper hedge clause.
C. a violation of an investment adviser’s fiduciary responsibility.
D. a wrap fee account.

Answer 2

B | Hedge clauses may not be used to disclaim inherently misleading statements.
LO 14.a

Question 3

One of the most significant features of the UPIA is the ability of a trustee to delegate investment decisions to a qualified third party. Delegation is permitted as long as the fiduciary to whom the powers are delegated
A. acts with skill and caution.
B. avoids high-risk investments.
C. considers the risk/reward trade-off of each security in the portfolio.
D. avoids diversification.

Answer 3

A | The UPIA explicitly uses skill and caution when describing the fiduciary’s actions. Other components of the UPIA state that, rather than viewing individual securities, the overall effect on the entire portfolio is considered. This contemplation means that high-risk securities can be placed if the comprehensive portfolio meets the objectives. That is the benefit of diversification—something regarded as essential to the prudent investment of money belonging to others.
LO 14.b

Question 4

The following example should help you better understand 28(e):
Which of the following would not be included in the safe harbor provisions of Section 28(e) of the Securities Exchange Act of 1934?
A. Proprietary research
B. Third-party research
C. Rent
D. Seminar registration fees

Answer 4

C. Section 28(e) provides a safe harbor for those expenses paid with soft dollars that offer a direct research benefit. Rent is not included in the list of acceptable items in that safe harbor.

Question 5

State and federal regulations would permit performance-based compensation to be charged to advisory clients with
A. a minimum net worth over $1 million, exclusive of primary residence.
B. a minimum net worth above $2.2 million, excluding primary residence.
C. net income of more than $200,000 for the past two years with a reasonable expectation of continuing.
D. at least $5 million in investments.

Answer 5

B | Earlier in this course, we told you that investment advisers are never permitted to receive performance-based compensation. That is, an advisory contract cannot be structured so that the investment adviser’s remuneration is increased if the advisory account’s performance is superior. This question deals with the exception, and only when an exception is part of the question can those fees be paid. The term used to describe those eligible for this type of arrangement is qualified clients. There are two ways to qualify: one is a net worth over $2.2 million (don’t count the home), and the other is having at least $1.1 million in the account with the IA. Don’t confuse that with the qualified purchaser in Lesson 3.3’s discussion of private funds. The $1 million in net worth and the $200,000 in net income describe an accredited investor, and they don’t make the cut here.
LO 14.c

Question 6

When an investment adviser with discretion over a client’s account directs trade executions to a specific broker-dealer and uses the commission dollars generated to acquire software that analyzes technical market trends, it is known as
A. hard-dollar compensation.
B. indirect compensation.
C. investment discretion.
D. soft dollar compensation.

Answer 6

D | Soft dollar compensation is when an investment adviser derives an economic benefit from a client’s commission dollars. Software of the type mentioned here is allowable under the safe harbor provisions of Section 28(e) of the Securities Exchange Act of 1934. This situation is indeed indirect compensation and a discretionary account, but the answer that best matches the question is soft dollar. Many times on the exam, you have to select the best of the choices given.
LO 14.d

Question 7

Which of the following advisers would be déemed to have custody of customer funds or securities as defined in the Investment Advisers Act of 1940?
A. The adviser receives the proceeds of sales in the customer’s account.
B. The adviser receives a fee of $1,500 as a prepayment for the next contract year.
C. The adviser has investment discretion over the account.
D. All of the above.

Answer 7

A. Under the Investment Advisers Act of 1940, discretion and substantial prepayments are not considered custody. Access to funds in the client’s account is one of the standard tenets of custody.

Question 8

An investment adviser takes custody of a client’s funds and securities. Client account statements must be sent no less frequently than
A. monthly.
B. quarterly.
C. semiannually.
D. annually.

Answer 8

B | Whether custody is maintained by the investment adviser or a qualified custodian, statements must be sent at least quarterly.
LO 14.e

Question 9

An investment adviser’s client has had a discretionary account for three years. Which of the following may the investment adviser determine without written discretionary authority?
A. The time or price at which to enter an order
B. Which security should be purchased
C. Whether to buy or sell a particular security
D. How many shares of a particular security should be purchased

Answer 9

A | Time or price decisions alone do not require any discretionary authority. This account is well past the ten business days where oral authorization is permitted. If it was not time or price alone being determined, this IA must have written discretionary authority to determine which security, what action, and how many shares to purchase or sell.
LO 14.f

Question 10

Lending arrangements between registered agents and their customers are permitted if the customer
A. is a member of the representative’s immediate family.
B. is the mortgage broker who arranged for the mortgage on your home.
C. was your roommate in college and remains your best friend.
D. works at the desk next to yours.

Answer 10

D. You can borrow from or lend to another employee of your firm. You can also borrow from clients who are in the money-lending business. Remember, mortgage brokers don’t lend the money; they combine the lender and the home buyer. If you’d like to borrow from an immediate family member, unless that individual works for the same or an affiliated firm, the only way to do that is to terminate the client relationship.

Question 11

The primary business of ABC Advisers is providing investment advice. Therefore, under the Code of Ethics, all of its directors, officers, and partners are
A. access persons.
B. automatically registered as investment adviser representatives.
C. required to post a surety bond.
D. prohibited in engaging in personal securities transactions other than in
U.S. government securities.

Answer 11

A. As stated, if investment advice is the adviser’s primary business, all of the firm’s directors, officers, and partners are presumed to be access persons. The automatic registration provision applies only to those who function as lARs. There are no bonding requirements for lARs, and access persons can engage in personal securities transactions under the conditions of the Code of Ethics.

Question 12

Alberto is an IAR with Exceptional Analysis and Results (EAR), an investment adviser registered in three Southwestern states. Although Alberto relies heavily on the recommendations furnished by EAR’s research department, he occasionally does his research for his account. As an access person, Alberto
A. would be prohibited from trading in his account.
B. would be prohibited from trading these securities in his account until his research was publicly available.
C. must report any personal transactions quarterly.
D. can only use personal research to benefit clients.

Answer 12

C. Alberto is considered an access person. As such, any personal securities transactions must be reported quarterly. Alberto could not use research reports developed by the firm until they were made publicly available, but his research doesn’t come under that requirement.

Question 13

An investment adviser who recommends the same security to a majority of her clients is probably guilty of
A. improper use of discretionary authority.
B. bunching orders.
C. blanket recommendations.
D. using third-party reports without attribution.

Answer 13

C | When an IA recommends the same security to a high percentage of her clients, it is generally considered that individual suitability is ignored. After all, it is unlikely that the same security fits all of these clients. There is no discretion because it is a recommendation—no trade is made unless the client orders. Bunching orders is the permitted activity of combining several small orders into a larger one, frequently saving commissions for the clients.
LO 14.g

Question 14

An investment adviser who falls under the requirements of Section 13(f) of the Securities Exchange Act of 1934 must file Form 13F
A. monthly.
B. quarterly.
C. semiannually.
D. annually.

Answer 14

B | Just something to memorize-Form 13F is filed quarterly. We’ve heard of students who remember this by observing that there are 13 weeks in a quarter of a year. We think that’s pretty good.
LO 14.h

Question 15

A customer is upset with her agent for not servicing her account properly and sends him a complaint via text message about her actions. Under the Uniform Securities Act, the agent should
A. call the customer, apologize, and attempt to correct the problem.
B. tell the customer he is willing to make rescission.
C. do nothing because the complaint is not in writing.
D. bring the customer complaint to his employer immediately.

Answer 15

D. Any written customer complaint (an email or text message is considered written) must be brought to the attention of the agent’s supervisor without hesitation.

Question 16

An agent hears a rumor concerning a security and uses the rumor to convince a client to purchase the security. Under the Uniform Securities Act, the agent may
A. recommend the security if it is an appropriate investment.
B. recommend the investment if the rumor is based on material inside information.
C. recommend the security if the rumor came from a reliable source.
D. not recommend the security.

Answer 16

D. Rumors must be promptly reported to the appropriate supervisory personnel and may never be used as the basis for a recommendation.

Question 17

On occasion, two registered agents cooperate on a sale. In that case, the commissions earned may be split in all of the following cases except
A. when the agents are not registered with the same or an affiliated broker-dealer.
B. when one of the individuals is the other’s supervisor.
C. when consent to the split was not obtained from the customer.
D. when only one of the individuals has invested in the account.

Answer 17

A | Splitting commissions are permitted among individuals registered as agents for the same or affiliated broker-dealers. Splitting with your supervisor is fine, and unless something indicates there would be an additional expense, the consent of the customer is not required. It would not be expected that any agent is investing in customer accounts.
LO 14.1

Question 18

The regulators are concerned when a broker-dealer operates on the premises of a financial institution. However, the rules only apply when which of the following activities takes place on those premises?
A. Personal loans are made
B. Retail deposits are taken
C. Mortgage loan applications are accepted
D. Safe deposit boxes are available

Answer 18

B | Because of the potential for misunderstanding the difference between bank retail products (savings accounts, CDs, money market checking accounts) and brokerage accounts, the rules on BDs operating on the premises of a financial institution apply only when that location accepts retail deposits. In most cases, these other activities will take place, but it is the accepting of retail deposits that triggers the “on the premises” rule.
LO 14.j

Question 19

Which of the following employees of a publicly traded company would most likely have access to MNPI?
A. VP of Human Resources
B. Receptionist
C. Chief Financial Officer (CFO)
D. VP of Marketing

Answer 19

C. Although any of these employees could obtain access to MNPI because the CFO is the individual who sees the financial numbers first, it is part of the job to have access to earnings numbers before anyone else.

Question 20

A company leaks some inside information to crucial employees but not the public. One of those employees tells the agent servicing his brokerage account, and the agent tells another customer who trades on the information before it becomes public. In this situation, who would be guilty of insider trading?
I. The person at the company who leaked the information
Il. The employee who told the registered representative
III. The registered representative
IV. The customer who traded on the information
A. I only
B. I and IV
C. I, II, and III
D. I, II, III, and IV

Answer 20

D | It is illegal to trade on inside information, and it is also unlawful to disseminate the information if someone else trades on it.
LO 14.k

Question 21

An investor receives an unsolicited email about a startup company trading for pennies. The email notes that a patent for a new technology is forthcoming, and investors need to get in now. The next day, the investor sees lots of information on the same stock in an internet chat room. The hype seems similar to what they received in the email blast. Being cautious, the investor senses that this could be
A. an effort to spread market rumors to manipulate the stock.
B. a front-running scheme to get ahead of large buy orders.
C. an attempt to generate commissions by churning investors’ accounts.
D. a fraudster attempting to peg the price of the stock.

Answer 21

A | This is an example of potential market manipulation by spreading rumors. Regulators have issued alerts to warn investors about fraudsters who may attempt to manipulate share prices by spreading false or misleading information about stocks. This exploitation is often done through social media platforms where large numbers of people can be contacted.
LO 14.k

Question 22

A great concern to broker-dealers is the theft of a client’s identity. To reduce the possibility of a client’s assets being improperly taken, most firms would consider all of these to be red flags except
A. almost one year after your last contact with your client, you receive a phone call requesting that funds be wired to an offshore account.
B. a client regularly visits your office to pick up a check representing the proceeds of recently settled transactions.
C. when running a credit report on a new client’s application, there is a discrepancy between the home address listed on the report and the one on the new account form.
D. the photograph on the identification documents provided does not resemble the individual opening the account.

Answer 22

B. There is nothing wrong with a client picking up a check for the proceeds of a securities transaction, even if done regularly (some folks don’t trust the mail). Each of the other choices should raise a red flag as needing further investigation.

Question 23

Under Regulation S-P, if an investment adviser sends a customer an initial privacy notice that contains an opt-out provision, the firm may not disclose nonpublic personal information about that customer for how many days from the mailing?
A. 10
B. 15
C. 20
D. 30

Answer 23

D. An investment adviser (or broker-dealer) must give customers 30 days to implement any opt-out provision in the privacy notice.

Question 24

Protection of customer confidential information is an obligation of the
I. agent servicing the customer’s account.
II. broker-dealer maintaining the account.
III. customer.
IV. investment adviser in an advisory account.
A. I and II
B. II and IV
C. III and IV
D. I, II, III, and IV

Answer 24

D | Although any securities professional handling a customer account must follow all necessary procedures to protect client data, customers are also responsible. Customers ignoring the cybersecurity safeguards put not only their data at risk but also that of other customers by potentially opening the door to hackers.
LO 14.1

Question 25

A broker-dealer’s cybersecurity procedures should address all of the following except
A. the music played while customers are placed on hold.
B. office desktop computers.
C. agents’ smartphones used on occasion to communicate with clients.
D. remote access to servers or workstations via a virtual private network (VPN).

Answer 25

A | It is hard to imagine how the music on hold would present a security risk. All of the other choices offer potential for loss.
LO 14.1

Question 26

A BCP should be designed to protect the firm’s clients in the event of which of the following?
I. A natural disaster such as a hurricane or tornado
II. Acts of terrorism
III. Pregnancy of one of the firm’s lARs
IV. Climate change
A. I and II
B. I and IV
C. II and III
D. III and IV

Answer 26

A. Business continuity plans are designed to address sudden, unexpected events that can disrupt day-to-day business operations.

Question 27

The first step in developing a business continuity plan (BCP) is identifying the risks that could cause a service interruption. Such risks would include:
A. a natural disaster (such as storms, earthquakes, or flooding).
B. the death or disability of a key employee.
C. a service provider interruption (such as the internet going down).
D. all of these.

Answer 27

D | Each of these choices is an event that could interrupt an investment adviser’s ability to provide service to clients.
LO 14.m

Question 28

The death of an investment adviser’s key person would most likely have the most significant immediate effect when the firm is organized as
A. a C corporation.
B. an LLC.
C. an S corporation.
D. a sole proprietorship.

Answer 28

D | Although each business structure could consist of a single key individual, that would always be true with a sole proprietorship.
LO 14.m