Stock Advisor Regulatory Compliance and Ethics 2 — Questions and Answers
Question 1: What is the primary regulatory distinction between a registered investment adviser (RIA) and a broker-dealer?
- RIAs can only manage retirement accounts, while broker-dealers manage taxable accounts
- RIAs are held to a fiduciary standard, while broker-dealers traditionally follow a suitability standard (Correct answer)
- Broker-dealers are registered with the SEC, while RIAs are registered with FINRA
- RIAs earn commissions on trades, while broker-dealers charge flat advisory fees
Correct answer: RIAs are held to a fiduciary standard, while broker-dealers traditionally follow a suitability standard
RIAs owe clients a fiduciary duty to act in their best interest, while traditional broker-dealers were held to a lower suitability standard (though Regulation Best Interest has raised broker-dealer obligations).
Question 2: An advisor recommends a mutual fund that pays the advisor a higher commission than competing funds with similar performance. This situation is an example of:
- Churning
- A conflict of interest (Correct answer)
- Front-running
- Market manipulation
Correct answer: A conflict of interest
A conflict of interest arises when an advisor's personal financial incentive (higher commission) may influence their recommendation away from what is solely in the client's best interest.
Question 3: Under SEC rules, investment advisers must disclose all of the following in their Form ADV EXCEPT:
- Fee structures and compensation arrangements
- Types of investments and strategies used
- Names and contact details of every current client (Correct answer)
- Disciplinary history and legal proceedings
Correct answer: Names and contact details of every current client
Form ADV requires disclosure of fees, strategies, conflicts, and disciplinary history, but client names and personal contact details are confidential and are not disclosed on Form ADV.
Question 4: The Securities Exchange Act of 1934 is primarily focused on regulating:
- The initial issuance of new securities to the public
- The secondary trading of securities in organized markets (Correct answer)
- The registration of investment advisers managing large portfolios
- The oversight of futures and derivatives contracts
Correct answer: The secondary trading of securities in organized markets
The Securities Exchange Act of 1934 governs the secondary market trading of securities (i.e., stock exchanges and broker-dealers), while the Securities Act of 1933 covers new issuances.
Question 5: Churning in a client's investment account refers to:
- Holding securities for long-term capital appreciation
- Excessive trading to generate commissions for the advisor at the expense of the client (Correct answer)
- Reinvesting dividends automatically into additional shares
- Rebalancing a portfolio quarterly to maintain target allocations
Correct answer: Excessive trading to generate commissions for the advisor at the expense of the client
Churning is the unethical and illegal practice of excessively trading a client's account primarily to generate commissions, regardless of whether the trades benefit the client.
Question 6: A 'soft dollar' arrangement in the investment advisory industry refers to:
- Advisory fees paid in installments rather than as a lump sum
- An arrangement where advisers receive research or other services from broker-dealers in exchange for directing client trades to them (Correct answer)
- Discounts on brokerage commissions offered to high-net-worth clients
- Deferred compensation paid to advisers from fund management fees
Correct answer: An arrangement where advisers receive research or other services from broker-dealers in exchange for directing client trades to them
In a soft dollar arrangement, advisers direct client brokerage to a specific broker in exchange for research or services, which must be disclosed as it can create a conflict of interest.
Question 7: Anti-money laundering (AML) regulations in the securities industry primarily require broker-dealers and advisers to:
- Report all client transactions exceeding $1,000 to the IRS
- Establish programs to detect and report suspicious financial activity (Correct answer)
- Refuse to open accounts for any foreign nationals
- Obtain written consent from clients before executing any cash transactions
Correct answer: Establish programs to detect and report suspicious financial activity
AML regulations, under the Bank Secrecy Act and FinCEN rules, require financial firms to maintain compliance programs to identify, detect, and report suspicious activities that may indicate money laundering.
Stock Advisor Regulatory Compliance and Ethics 2
What is the primary regulatory distinction between a registered investment adviser (RIA) and a broker-dealer?