An IAR of a state-registered investment adviser asks a client for a $20,000 personal loan to cover a temporary cash shortfall. The client is a physician and is not in the lending business, although she has occasionally made loans to friends. The client agrees to make the loan; the IAR signs a promissory note at a market rate of interest, and the client tells the IAR that the loan is being made because she trusts the adviser.
Under the NASAA Unethical Business Practices of Investment Advisers Model Rule, is the borrowing permitted? Answer: No, because borrowing from a client is barred unless the client is a broker-dealer, an adviser affiliate, or a lending institution.
Under the NASAA Unethical Business Practices of Investment Advisers Model Rule, borrowing money or securities from a client is unethical unless the client is a broker-dealer, an affiliate of the investment adviser, or a financial institution engaged in the business of loaning funds. The physician is none of these: she is not in the lending business, and occasional loans to friends do not make her a lending institution. The rule has no family, friend or firm-approval exception. A promissory note, market-rate interest and client sophistication do not create an exception; the client's voluntary agreement is not a defense; and the statement about the adviser's prior written approval and account-statement disclosure describes a firm-approval condition the NASAA rule does not contain, so neither step would make the borrowing permitted.
An IAR of a state-registered investment adviser manages separately managed accounts for two clients. Client A wants to sell 1,000 shares of a small-cap issuer, and Client B's investment objectives permit owning that stock. The IAR directs both orders to an affiliated broker-dealer, which executes them as a cross at the current market price and charges each client the same commission, a portion of which is shared with the adviser. Before the trade, the IAR telephones each client, explains that the adviser will act for both sides, and each client orally says the trade is acceptable. No written disclosure is sent before the trade.
Under the Uniform Securities Act, which statement is correct? Answer: The trade is prohibited because the required written disclosure was not provided before completion; oral notice alone does not satisfy the Act.
Governing authority: Uniform Securities Act § 102. An adviser acting as agent for both parties to a transaction may not complete the transaction unless, before completion, it discloses in writing to the client that it is acting in that capacity and obtains the client's consent. Here, the IAR gave only oral notice and obtained only oral approval; no written disclosure was provided before completion, so the cross is prohibited. Advance oral notice and equal price and commission do not satisfy the statutory writing requirement. Compliance-officer approval is an internal procedure and does not replace the required client disclosure and consent.
A federal covered adviser manages money for a state pension plan. One of the adviser's IARs regularly solicits state pension business on behalf of the adviser. The IAR personally contributes $200 to the re-election campaign of the state controller, who serves on the board that selects investment managers for the state pension plan. The IAR does not reside in that state and is not eligible to vote for the controller. The contribution has not been returned.
Which statement is correct? Answer: The adviser is barred for two years from providing advisory services to the state pension plan for compensation.
SEC Rule 206(4)-5 (the pay-to-play rule) imposes a two-year time-out when an investment adviser or a covered associate contributes to an official of a government entity the adviser serves or is seeking to serve. The IAR is a covered associate because he solicits government clients for the adviser, and the controller is an official because the controller sits on the board that selects the plan's investment managers. The de minimis exception is $350 per election only for a contributor entitled to vote for the official; for a contributor not entitled to vote, it is $150. The $200 contribution exceeds $150, and because it has not been returned the return exception is not available, so the adviser may not provide advisory services to the state pension plan for compensation for two years. The $350 statement applies the voting-contributor threshold to an IAR who cannot vote, the voter-ineligibility statement wrongly treats ineligibility as removing coverage, and the all-government-clients statement overstates the rule's scope, which reaches only the government entity whose official received the contribution.
An IAR of a state-registered adviser holds a written limited power of attorney from a client that permits the IAR to pay the client's bills from the client's brokerage account. The client asks the IAR to pay a $5,000 insurance premium. The IAR pays the premium with a personal check from his own bank account and then transfers $5,000 from the client's brokerage account into his personal account to reimburse himself. The transfer is made the same business day, is for the exact amount, and the client is told about it the next day.
Under the Uniform Securities Act, which statement is correct about the IAR's conduct? Answer: The IAR's conduct is prohibited because client funds were deposited into and commingled with the IAR's personal account, even temporarily.
Uniform Securities Act § 102 custody provisions and the NASAA custody rule (Model Rule 102(e)(1)-1) require client funds and securities to be held by a qualified custodian in a separate account for each client, so an adviser or IAR may not move client funds into, or commingle them with, the adviser's or IAR's personal funds, even temporarily. The written limited power of attorney allowed the premium to be paid from the client's brokerage account; it did not authorize the client's funds to pass through the IAR's personal account as reimbursement. The violation is complete when the client's funds are transferred into the IAR's personal account, so the statement relying on written authority and an exact, timely reimbursement is wrong, and the statement that later client ratification cures the conduct is wrong for the same reason. The statement that the conduct is prohibited only if the IAR earned interest or delayed the reimbursement is wrong because the temporary commingling itself is the prohibited act.
- An agent of a broker-dealer sells a customer an interest in a private real estate limited partnership sponsored by an unaffiliated developer, and the developer pays the agent a 2% fee. The agent disclosed the fee to the customer in writing before the sale. The sale is not recorded on the broker-dealer's books; the agent told the broker-dealer about it two days after execution, and the broker-dealer then approved it in writing. Under NASAA rules, the sale is:
Answer: A violation, because the broker-dealer did not authorize the sale in writing before the sale was executed.
NASAA Dishonest or Unethical Business Practices of Broker-Dealers and Agents Model Rule. An agent who effects a securities transaction that is not recorded on the regular books or records of the agent's broker-dealer engages in an unethical practice unless the broker-dealer authorized the transaction in writing before execution, whether or not the agent is paid. The broker-dealer's written approval here came after the sale, so the sale is a violation. The statement that the later written approval makes the sale permitted is wrong because the authorization must come before execution. The statement that written disclosure of the fee to the customer makes the sale permitted is wrong because disclosure to the customer does not replace the broker-dealer's prior written authorization. The statement that only a paid sale is a violation, and that an unpaid one would need only notice, imports the FINRA Rule 3280 distinction between paid and unpaid private securities transactions; the NASAA rule requires the broker-dealer's prior written authorization either way.
- A federal covered investment adviser manages the portfolio of a state employees' retirement system. The state comptroller, who is running for reelection, sits on the board that selects the retirement system's investment advisers. One of the adviser's covered associates, who resides in a neighboring state and is not entitled to vote for the comptroller, makes a $200 personal contribution to the comptroller's reelection campaign, and the contribution is not returned. Which statement is correct?
Answer: The adviser may not provide advisory services for compensation to the retirement system for a period of two years following the contribution.
Governing authority: SEC Rule 206(4)-5, the pay-to-play rule. The rule bars an adviser from providing compensatory advisory services to a government entity for two years after a contribution to an official of that entity is made by the adviser or any covered associate. The comptroller is an official of the system because the office can influence the system's hiring of an investment adviser. The de minimis exception permits contributions up to $350 per election only when the contributor is entitled to vote for the official; for a contributor who is not entitled to vote, the limit is $150. Because the associate's $200 contribution exceeds the $150 limit, the de minimis exception does not apply. The return exception (a covered associate's contribution of no more than $350, discovered within four months and returned within 60 calendar days of discovery) is also unavailable because the contribution was not returned, so the two-year time-out begins. The statement that the contribution falls within the $350 de minimis amount is wrong because that threshold applies only to contributors entitled to vote for the official. The statement that a personal contribution by the associate does not count is wrong because contributions by covered associates are imputed to the adviser. The statement that only the associate must be removed from the account is wrong because the time-out prohibits the adviser from providing services to the retirement system; the adviser cannot keep the business by reassigning the associate.
- An IAR of a state-registered investment adviser recommends that a client invest in a private partnership. The IAR's spouse is a general partner of the partnership, and the IAR will share in the general partner's carried interest. The IAR discloses this conflict in the adviser's Form ADV Part 2A brochure, which was delivered to the client when the account was opened, but the IAR does not discuss the relationship with the client. Under NASAA rules, the IAR's recommendation is:
Answer: Permitted because the conflict was adequately disclosed to the client in writing before the recommendation was made.
Governing authority: NASAA Unethical Business Practices of Investment Advisers Model Rule, which requires advisers to disclose material conflicts of interest to clients. The spouse's role as general partner, together with the IAR's share of the carried interest, is a material conflict. The Form ADV Part 2A brochure is the primary written disclosure document, and because it disclosed this conflict and was delivered to the client, the disclosure obligation was satisfied. The statement that a separate oral disclosure is required is wrong; the rule requires disclosure, not a particular oral presentation. The statement that the spouse's role creates no conflict because the IAR is not the general partner is wrong because the IAR's share of the carried interest is a direct economic interest. The statement that an IAR may never recommend an investment in which a spouse has an interest is wrong; such a recommendation is permitted when the conflict has been fully disclosed.
An SEC-registered investment adviser's portfolio manager, a covered associate of the adviser, contributes $200 to the re-election campaign of a city mayor. The mayor appoints the members of the city pension board that hires the plan's investment managers. The city pension plan is seeking an outside investment manager, and the adviser wants to be considered for the assignment. The portfolio manager lives outside the city and is not eligible to vote for the mayor. The contribution has not been returned.
Under federal law applicable to SEC-registered advisers, which statement is correct? Answer: The firm is barred for two years from providing compensated advisory services to the city plan because the contribution exceeds the $150 de minimis limit for a contributor not entitled to vote for the official.
Governing authority: SEC Rule 206(4)-5 under the Investment Advisers Act. A contribution by the adviser or any covered associate to an official of a government entity triggers a two-year prohibition on the adviser providing compensated advisory services to that government entity unless an exception applies. The mayor is an official because the mayor appoints the board that hires the plan's advisers. The de minimis amount is $350 per election when the contributor is entitled to vote for the official, but only $150 when the contributor is not entitled to vote. Because the portfolio manager could not vote for the mayor, the $200 contribution is not de minimis, and because it has not been returned the return exception does not apply, so the firm is barred for two years. The statement that only the portfolio manager is disqualified is wrong because the bar applies to the adviser's provision of services, not simply to the contributor's compensation. Removing the portfolio manager from the proposal or account does not cure the firm-level bar. The $350 threshold is inapplicable because the contributor was not entitled to vote for the official.
- An IAR of a state-registered investment adviser has discretionary authority over a client's $200,000 account. During the past year, the IAR produced a portfolio turnover rate of 400% and generated $18,000 in commissions for the adviser. The account appreciated 12% during the year, and the client's stated objective was long-term growth. Which statement is correct?
Answer: The IAR churned the account because the trading was excessive relative to the client's objectives and the trades served mainly to generate commissions.
Governing authority: NASAA Unethical Business Practices of Investment Advisers Model Rule, which prohibits churning. Churning requires control over the account, trading that is excessive in light of the client's objectives, and a primary purpose of generating commissions. The IAR had discretionary authority, produced a 400% turnover in an account with a long-term growth objective, and generated commissions equal to 9% of the account's value. The statement that appreciation or the absence of a client complaint defeats churning is wrong because the test is whether the trading was excessive and self-serving, not whether the account made money. The statement that discretionary authority is a defense is wrong; discretion satisfies the control element and supports a churning finding. The statement that churning requires commissions to exceed the account's return is wrong; the violation is the excessive turnover relative to the client's objectives, and a profitable account can still be churned.
An IAR of a state-registered adviser has written discretionary authority over a $200,000 account. The client's investment policy statement calls for long-term, buy-and-hold growth. Over the following four months, the IAR places 140 trades, producing transaction costs equal to about 16% of the account's average value and turning the portfolio over more than three times. Every trade, viewed alone, was consistent with the client's policy statement, and the account did not lose money during the period.
Under the Uniform Securities Act, which of the following is correct? Answer: The activity is a prohibited practice because the trading and costs are excessive for a buy-and-hold account even if no single trade was unsuitable.
Under the NASAA Unethical Business Practices of Investment Advisers Model Rule, churning—excessive trading in a client's account—is a prohibited practice. The IAR had written discretionary authority, and the facts show objectively excessive activity for a buy-and-hold account: 140 trades in four months, turnover above three times, and transaction costs of about 16% of average account value. The practice is prohibited even though no individual trade was unsuitable and the account did not lose money. Written discretionary authority and the client's failure to object do not cure churning, and there is no legal requirement that every discretionary trade be pre-approved by the adviser's compliance department.
- Under NASAA rules, which of the following statements is true regarding borrowing by an IAR of a state-registered investment adviser from an advisory client?
Answer: An IAR may borrow $20,000 from a client that is a commercial bank if the loan is at the bank's customary lending rate and is evidenced by a signed promissory note.
Governing authority: NASAA Unethical Business Practices of Investment Advisers Model Rule. An investment adviser or IAR may not borrow money or securities from a client unless the client is a broker-dealer, an affiliate of the investment adviser, or a financial institution engaged in the business of loaning funds. The rule has no family, friend or personal-relationship exception. The statement permitting a loan from a commercial bank at the bank's customary rate is correct because the bank is a financial institution engaged in the business of loaning funds. The statement permitting a loan from a wealthy retiree is wrong: the client's written consent, a market-rate note, and collateral do not substitute for one of the three exceptions, and a retiree is none of them. The statement permitting a loan from the business partner of the IAR's brother is wrong because that client is not a broker-dealer, an affiliate of the adviser or a lending institution, and documenting or disclosing the loan to the compliance officer does not create an exception; relationship-based exceptions exist only under FINRA Rule 3240, which does not govern this IAR. The statement permitting a loan from an insurance agent at a personal-loan rate is wrong because an individual insurance agent is not a financial institution engaged in the business of loaning funds.
A registered agent of a broker-dealer, acting outside the regular course of the firm's business, arranges for a friend to buy shares of a private company. The broker-dealer is not involved, the agent receives no compensation, and the agent does not notify the broker-dealer before or after arranging the purchase.
Under FINRA Rule 3280, which statement is correct? Answer: The agent's conduct is prohibited because a private securities transaction requires prior written notice to the broker-dealer even when the agent receives no compensation.
Governing authority: FINRA Rule 3280 (private securities transactions). A private securities transaction is a securities transaction outside the regular course or scope of an associated person's employment with the member. Before participating, the person must give the member prior written notice describing the transaction, the person's role, and whether he may receive selling compensation. If there is selling compensation, the member must approve or disapprove in writing and, if it approves, record and supervise the transaction as its own; if there is none, the member must give a prompt written acknowledgment and may impose conditions. Because the agent gave no notice, the conduct is prohibited. The statement that the conduct is permitted because the firm need not supervise a no-compensation transaction confuses what the firm must do after notice with the agent's duty to give notice in the first place. The friend's status as a non-customer does not bring the trade within an exclusion, and the absence of any use of the firm's name, premises or customer lists does not remove the notice requirement.
A federal covered investment adviser manages discretionary accounts for clients. The adviser's trading desk buys a block of ABC common stock for the adviser's own inventory. Later that day, a portfolio manager fills a client's buy order for ABC out of that inventory at the current market price plus $0.10 per share. The client is not told in advance. After execution, the confirmation states that the adviser acted as principal and shows the markup.
Which statement is correct under the Investment Advisers Act of 1940? Answer: The transaction is prohibited because the adviser acted as principal without disclosing that capacity in writing before completion and without obtaining the client's consent.
Section 206(3) of the Investment Advisers Act of 1940 allows an adviser to buy from or sell to a client as principal only if the adviser makes written disclosure of its capacity before completion and the client consents. The transaction described lacks both. The after-execution confirmation is too late, and the adviser's good faith or fair price does not substitute for the required prior disclosure and consent. The statement that principal transactions are never permitted is too broad; they are permitted when the required disclosure and consent are obtained.
- An SEC-registered investment adviser that is also a registered broker-dealer decides to sell a block of stock from a discretionary advisory client's account. Its brokerage desk finds a buyer among its brokerage customers, whom the firm does not advise and to whom it made no recommendation, and acts as broker for both sides, charging each a commission. When the account was opened, the advisory client signed a written consent prospectively authorizing agency cross transactions after receiving full written disclosure, and the consent has not been revoked. Under SEC Rule 206(3)-2, which statement regarding this trade is true?
Answer: The adviser may rely on the prospective consent but must send the client a written confirmation at or before completion of the trade.
SEC Rule 206(3)-2, under Investment Advisers Act § 206(3). An adviser acting as broker for both its advisory client and another person may rely on the client's prospective written consent, given after full written disclosure, instead of transaction-by-transaction consent, if it sends the client a written confirmation at or before completion of each trade (stating the nature of the transaction, its date, an offer to furnish the time of execution, and the source and amount of any other remuneration), sends at least an annual summary of the number of such trades and the commissions received, and states in each confirmation and summary that the consent may be revoked at any time by written notice. The rule is unavailable only when the adviser recommended the trade to both the seller and the buyer; here it advised only the seller. The statement that no confirmation is needed is wrong because the per-trade confirmation is a condition of the rule. The statement that a new written consent is required for this trade applies the bare § 206(3) per-transaction requirement, which the rule's prospective consent replaces for agency cross transactions. The statement that the rule is unavailable because the adviser decided the client's side misreads the exclusion, which applies only when the adviser recommended the transaction to both sides.
