This page of our SIE Study Guide covers customer accounts and compliance considerations. Specific topics reviewed here include types of customer accounts and registrations, anti-money laundering, and general requirements for member firm books and records, communications with the public, and suitability.
Account Types and Characteristics
Investors buy and sell securities through brokerage accounts held at firms such as Charles Schwab, Fidelity, Robinhood, and many others. The two main accounts types that can be opened are known as cash accounts and margin accounts and are governed under Federal Reserve Board Regulation T (Reg T).
Cash Account: In a cash account, all transactions must be paid in full with available cash or investments; no credit is permitted. When using an existing investment position to finance a transaction, the investor must be able to sell it that same day in order for the necessary cash to become available.
Margin Account: In a margin account, investors can borrow up to 50% of the cost of securities they wish to purchase from their brokerage firm in a process referred to as buying on margin. Investors are charged interest on the account loan which accrues on a monthly basis, and the loan must be paid off when the securities are sold. The idea behind margin accounts is to use increased purchasing power to purchase securities that will increase in value faster than the loan interest. However, there’s also a greater potential for large losses when using credit. Margin accounts are thus much riskier than cash accounts and come with additional requirements for both the investor and the FINRA member firm.
Options Account: Broker-dealers are required to formally approve investors for options trading by having them complete an options agreement, which will assess the investor’s general investing knowledge as well as their knowledge of options, trading strategies, and the risks associated with options transactions. They may also need to provide information such as investment objectives, trading experience, and personal financial details. In addition to the options agreement, broker-dealers are required to furnish all potential options investors with certain disclosures. Once approved, the broker-dealer will decide which option trading level the investor qualifies for (typically one of five levels varying in risk).
Educational Accounts: Families wishing to save up for qualified postsecondary educational expenses can open a 529 college savings plan account. These plans are popular with investors for their tax benefits.
Discretionary vs. Non-Discretionary: In discretionary accounts, brokers or advisors are authorized to trade securities on behalf of their clients without consent being required for each trade. The opposite is true of non-discretionary accounts in which clients make all the investment decisions.
Fee-Based vs. Commission-Based: Investment advisor compensation can typically be classified as fee-based (fee-only) or commission-based. There are significant differences between the two. Fee-based advisors charge their clients annual, hourly, or flat fees and are required to operate under a fiduciary duty, meaning they must always prioritize their clients’ best financial interests over their own. Commission-based advisors, on the other hand, earn their compensation from selling certain investment products or opening accounts. Fiduciary duties are optional for commission-based advisors.
Customer Account Registrations
Individual Account: An account opened in one person’s name that does not have any named beneficiaries. Examples of individual accounts are checking accounts, savings accounts, and money market deposit accounts.
Joint Account: An account opened by two or more persons. TIC (tenants in common) is more frequently used by friends or relative, other than spouses, where what’s mine is mine and what’s his is his. When I die or the co-tenant dies, his or her share of the account go to that person’s estate, not to me. JTWROS (joint tenants with rights of survivorship) is commonly used by spouses, where when one spouse dies, their share automatically goes to the surviving spouse.
Corporate/Institutional Account: Corporations often open brokerage accounts, as do large institutions such as banks, insurance companies, pension plans, etc.
Trust Account: Accounts that transfer assets to one or more beneficiaries upon the death of the owner(s). Revocable trusts can be revoked or modified by the creator—grantor—of the trust, whereas irrevocable trusts cannot be modified without beneficiary consent.
Custodial Account: When a gift of cash or securities is being given by a ‘donor’ to a minor child, it is typical for the account to be set up as a Uniform Gifts (or Uniform Transfers) to Minors Act account. An adult is appointed by the Donor to act as Custodian over the account and make all investment decisions for the benefit of the child. The parent is able to report UTMA income on either his/her own tax return, using his/her own tax ID, or else on the minor child’s tax return, using the minor child’s tax ID. In those instances where UTMA income exceeds $2,000, some or all of the income may need to be reported on the parent’s tax return.
Partnership Account: An account owned by two or more persons who are held equally liable. These accounts are similar to joint accounts but are different in that they’re mostly used by business partners rather than, for example, married couples.
Retirement Account: There are several different types of retirement accounts available to investors depending on certain factors such as age, employer, length of employment, and retirement objectives. Most retirement plans come with required minimum distributions, meaning account owners must start withdrawing annual minimum amounts from their accounts when they reach a predetermined age. Each type of account comes with different rules.
- Defined Benefit Plan: An employer-sponsored plan that provides a specified monthly benefit or lump-sum payment to the employee upon retirement. The employer, who guarantees this benefit, is responsible for all the investment decisions in the account and thus bears all the risk. While both the employee and the employer can make contributions, such is most typical of employers. Benefits are taxable as ordinary income to employees upon distribution.
- Defined Contribution Plan: A plan that generally permits an employee to make pre-tax contributions which can be partially matched by their employer. In traditional accounts, investment gains grow on a tax-deferred basis up until retirement, when they are then taxed as income withdrawals are made. The most common example of a defined contribution plan is a 401(k) which is only accessible through an employer. Unlike defined benefit plans, these plans are voluntary for employees and the retirement income is not guaranteed by employers. Required minimum distributions start for defined contribution plans at the age of 72.
- Individual Retirement Account (IRA): A tax-advantaged savings account available to any individual with earned income. There are several different types of IRAs including traditional IRAs, Roth IRAs, Payroll Deduction IRAs, SEP IRAs, and SIMPLE IRAs, with traditional and Roth IRAs being the most common. On an annual basis, individuals can contribute the lesser of: (1) $6,000, or $7,000 for those 50 years or older by the end of the year; or (2) taxable compensation for the year. Required minimum distributions for traditional IRAs start by April 1 following the year in which the account owner turns 72, but are not required for Roth IRAs if the individual is the original account owner.
- Simplified Employee Pension Plan (SEP): A cost-effective IRA that allows employers to make discretionary contributions towards their own retirement—as well as their employees’—and receive tax deductions for those contributions. SEP IRAs can be considered traditional IRAs with a few key differences, namely employers being able to contribute. Additionally, employers can often contribute significantly more to a SEP IRA than a traditional IRA but are still limited to the lesser of 25% of an employee’s compensation or $58,000 (as of 2021). Like traditional IRAs, account owners who turn 72 have until April 1 of the following year to take their first required minimum distribution.
- Employee Stock Ownership Plan (ESOP): An employee benefit plan that is set up as a trust fund and provides employees with the option to acquire ownership interests in the form of company stock. Both the company and the employees receive tax benefits for participating in the plan. Distributions are typically tied to a vesting schedule, meaning the longer an employee stays with the company the higher their proportion of shares increases. Once fully vested, an employee who leaves the company or retires will often sell the shares back to the company in exchange for a lump sum of cash or recurring payments.
Anti-Money Laundering (AML)
Alongside the Bank Secrecy Act (BSA), FINRA Rule 3310 requires all member firms to have a written compliance program in place to detect and prevent money laundering, which is the illegal process of disguising the source of money associated with criminal activity, such as drug trafficking, by making it appear legitimate. Money laundering typically follows three steps known as placement, layering, and integration. Placement is when the illegitimate money is entered into the legitimate financial system, layering is when the money source is disguised through a series of sophisticated transactions, and integration is when the now-legitimatized money is withdrawn by the criminal(s) to be used as they wish.
- At minimum, a written AML compliance program must satisfy the following conditions:
- Have policies, procedures, and internal controls reasonably designed to achieve compliance with the BSA;
- Appoint an AML Compliance Officer (AML Officer), with subsequent notification to FINRA;
- Provide ongoing training to personnel;
- Implement risk-based procedures for conducting ongoing customer due diligence;
- Conduct independent testing of the firm’s AML program (done annually for most firms).
Further, financial institutions such as broker-dealers are required to file a suspicious activity report (SAR) with the Financial Crimes Enforcement Network (FinCEN) whenever it knows, suspects, or has reason to suspect that a transaction—or a series of transactions—of at least $5,000 involving the firm or its client:
- involves funds related to illegal activity, or is hiding or disguising funds or assets derived from illegal activity;
- is designed, whether through structuring or other means, to evade requirements of BSA or other federal reporting requirement;
- has no business or apparent lawful purpose, or is not the sort in which this particular customer would normally be expected to engage;
- or involves use of broker-dealer to facilitate criminal activity.
Similarly, financial institutions such as banks are required to file a currency transaction report (CTR) with FinCEN whenever a customer completes a transaction (deposit, withdrawal, or other payment or transfer) in currency of more than $10,000. They may also file a CTR whenever a customer appears to be intentionally avoiding the $10,000 threshold by effecting a series of smaller transaction in a process known as structuring. Transactions of more than $10,000 are not required to be reported via a CTR for banks, government agencies, or public companies whose shares trade on the NYSE, Nasdaq, or American Stock Exchange as these are all considered exempt persons.
The Office of Foreign Asset Control (OFAC) is the U.S. Treasury Department agency tasked with enforcing sanctions against terrorists, narcotics traffickers, and other threats to national security. They keep the public informed in part by publishing the Specially Designated Nationals (SDNs) List, which contains individuals and companies owned or controlled by, or acting for or on behalf of, targeted countries, as well as those that are not country-specific. The assets of those found on the SDNs List are blocked—frozen—and U.S. persons are generally restricted from doing business with them.
Books and Records and Privacy Requirements
The SEC, the MSRB, and FINRA all have specific recordkeeping rules for registered broker-dealers and their associated persons so that effective examinations of broker-dealer records can be made, when necessary, among other reasons. These rules apply to both electronic communications and hard copy (paper) records relating to the firms’ business and require that firms maintain legible, true, accurate, and complete copies of these books and records throughout the applicable retention period, which can vary for each type of record. Firms must also preserve the integrity of these records.
At a minimum, broker-dealers must retain the following records:
- Communications with the Public: Retained for three years, the first two years in an easily accessible place;
- Organizational Documents: Retained for the life of the firm;
- Special Reports: Retained for three years after the date of the report;
- Compliance, Supervisory & Procedures Manuals: Retained for three years after the manual’s termination of use; and
- Exception Reports: Retained for eighteen months after the date the report was generated.
Brokerage account statements and trade confirmations are retained for six years and three years respectively. Firms generally send account statements to customers on a quarterly basis and written trade confirmations at—or prior to—transaction completion. In some cases, customers will receive these statements or confirmations from the brokerage firm’s clearing and carrying firms, which are responsible for actually settling the trades and which hold customer securities (or funds).
Member firms are permitted to hold customer mail for customers unable to receive mail at their usual address so long as certain requirements are met, such as the customer providing written instructions that include the time period for which they’re requesting the firm to hold their mail. If the specified time period is longer than three (consecutive) months, then the customer is also required to provide an acceptable reason for the request, such as security concerns.
FINRA Rule 4370 requires firms to create and maintain a written business continuity plan (BCP) that addresses an emergency or serious business disruption and how the firm plans to respond to such. The BCP must be reasonably designed to ensure the firm can meet its existing obligations to customers and should, at a minimum, include the following:
- Data backup and recovery (hard copy and electronic);
- All mission critical systems;
- Financial and operational assessments;
- Alternate communications between customers and the firm, and between the firm and employees;
- Alternate physical location of employees;
- Critical business constituent, bank, and counterparty impact;
- Regulatory reporting;
- Communications with regulators; and
- How the firm will assure customers’ prompt access to their funds and securities in the event that the firm determines that it is unable to continue its business.
Under Exchange Act Rule 15c3-3, firms are required to protect customer funds and securities by segregating these assets from the firm’s own business activities as well as promptly delivering these assets to their owner upon request. To satisfy this requirement, firms can either hold the customer’s assets (1) in the firm’s physical possession; or (2) in a location through which the firm can direct their movement, such as a clearing corporation.
Firms also must protect and keep confidential their customers’ personal and financial information under SEC Regulation S-P, which requires firms to have policies and procedures in place addressing this protection and safeguarding of customer information and records.
An additional requirement of the rule is that firms must provide their customers with initial and annual privacy notices that contain the firm policies as well as inform customers of their rights, such as opting out of their nonpublic personal information being shared with nonaffiliated third parties.
Communications with the Public and Telemarketing
Member firms and their associated persons are required to abide by FINRA Rule 2210 whenever they communicate with the public, which can take the form of correspondence, retail communications, or institutional communications. Correspondence is defined by FINRA as any written, including electronic, communication that is distributed (made available) to 25 or fewer retail investors within any 30 calendar-day period. Institutional communication is defined as any written, including electronic, communication that is distributed (made available) only to institutional investors.
Two specific communications rules related to telemarketing are described below.
- Cold Calling: Cold calling (making an outbound phone call) to prospects cannot be done before 8:00 AM or after 9:00 PM in the prospect’s time zone, unless (1) an established business relationship with the prospect exists, (2) the prospect has provided permission; or (3) the prospect is a broker or dealer. If the prospect requests that no further calls be made to them, then FINRA requires that the member firm place that person on a firm-specific do-not-call list.
- National Do-Not-Call List: No cold calls may be made to any person who has registered his or her telephone number on the Federal Trade Commission’s national do-not-call registry.
Best Interest Obligations and Suitability Requirements
Under the SEC’s Regulation Best Interest (Reg BI) rules, broker-dealers and associated persons must follow a “best interest” standard of conduct when making a recommendation of a certain type to a retail customer. For Reg BI purposes, a recommendation is defined as any securities transaction or investment strategy involving securities, including recommendations of types of accounts. One requirement of the rule is for broker-dealers and investment advisers to provide retail investors with a brief relationship summary known as Form CRS, which includes information such as types of services the firm can provide to retail investors, fees/costs, conflicts, and more.
Under FINRA Rule 2111, broker-dealers and associated persons are required to have a reasonable basis to believe a recommended securities transaction (or investment strategy involving securities) is suitable for the customer. In order to make this determination, the firm or associated person most conduct an appropriate level of diligence on the customer to understand their investment profile which will include their age, financial situation and needs, investment objectives, risk tolerance, and other important information. The broker must also demonstrate a firm understanding of both the product and the customer to avoid violating Rule 2111.
The three main suitability obligations of Rule 2111 are described below.
- Reasonable-basis Suitability: Based on reasonable diligence, the broker must have a reasonable basis to believe that the recommendation is suitable for at least some investors. The firm or associated person must also have an understanding of the potential risks and rewards of the recommended product.
- Customer-specific Suitability: Based on a customer’s investment profile, the broker must have a reasonable basis to believe that the recommendation is suitable for that specific customer. The broker must also be able to support this determination.
- Quantitative Suitability: A broker with actual (or de facto) control over a customer’s account must have a reasonable basis to believe that a series of recommended transactions is not excessive nor unsuitable for the customer in consideration of their investment profile. The rule applies even if the transactions are suitable when viewed in isolation (as separate transactions).
Suitability obligations also require firms to “know their customer” by conducting reasonable diligence on customers each time a new account is opened as well as to know, verify, and retain each customer’s essential facts. This obligation is referred to as Know-Your-Customer (KYC) and is governed FINRA Rule 2090.
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