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Chapter 2: Ethics, Laws


Chapter 2: Ethics, Laws & Regulations AND the Plan, the Process & the Profession The Process of Financial Planning: Developing a Financial Plan – PowerPoint PPT presentation

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Title: Chapter 2: Ethics, Laws

Chapter 2 Ethics, Laws Regulations AND the
Plan, the Process the Profession
  • The Process of Financial Planning
  • Developing a Financial Plan Lytton, Grable
  • 2006

Building Blocks Financial
Planning Pyramid
This is a BIG Chapter!!
  • Part 1 Ethics and Regulations
  • Part 2 The F Word Fiduciary
  • Part 3 Rules Governing Communication
  • Part 4 Ethical Requirements for Financial
  • Part 5 Professional Practice Issues

  • Part 1 Ethics and Regulations
  • Sometimes, you just need a cop!
  • 1. Federal
  • 2. State
  • 3. Voluntary Professional Associations

Ethical, Illegal or Good Practice?
  • Selling-away
  • Violates FINRA (NASD) Rule 3040
  • May subject the broker-dealer to claims of
    unsuitability, unnecessary fees, and regulatory
  • Rebating
  • Unethical and in most states illegal
  • Violates FINRA (NASD) Rule 2470
  • Violates state insurance regulations

  • suggested standards of conduct based on an
    agreed-upon set of values
  • where values are preferred attitudes and behaviors

Western Moral Philosophical Basis
  • Teleological consequential approach or
    situational ethics
  • Deontological Absolutism, or universally
    accepted RIGHT and WRONG
  • Characterized by predetermination and prescribed
    proceedings BUT mitigating circumstances may

Practice Standard Acceptable Practice
  • Deontological (contd)
  • According to society (all or part)
  • Codified in a code of ethics or statement of
    standard practice
  • Practice standards reflect normative ethics, or
    standards, and define what should be done
  • Governing bodies, such as FINRA (NASD), or
    membership organizations, FPA, define these
  • Practice standards may be descriptive right
    or wrong is defined by the outcome

Stealing from Clients is Wrong
  • for a practice standard to come into existence
    and to be enforced, certain groups of people must
    agree on what is inherently right and wrong. This
    means that normative standards must be practiced.
    While it is not necessary for all practitioners
    and regulators to be in agreement with a
    standard, standards cannot be enforced if
    behaviors are evaluated solely on relative

Federal Regulations
  • Securities Act of 1933 Paper Act
  • Securities Exchange Act of 1934 Peoples Act
  • Created the SEC
  • Publicly traded companies required to provide
    quarterly and annual reports
  • Maloney Act of 1938
  • Registered securities associations to promote
    self-regulation, which lead to the NASD, now
    FINRA as of 2007

  • In July 2007, the Financial Industry Regulatory
    Authority (FINRA) was created from the merger of
    the National Association of Securities Dealers
    (NASD) and the self-regulatory functions of the
    New York Stock Exchange (NYSE).
  • FINRA is often referred to as the successor
    organization to the NASD

Federal Regulations (contd)
  • Investment Advisors Act of 1940 Fee Act
  • Registered Investment Advisor (RIA)
  • investment adviser is any person who, for
    compensation, engages in the business of advising
    others, either directly or through publications
    or writings, as to the value of securities or as
    to the advisability of investing in, purchasing,
    or selling securities, or who, for compensation
    and as part of a regular business, issues or
    promulgates analyses or reports concerning

SEC Definition of Registered Investment Advisor
  • Provides advice or issues reports, analyses or
    opinions regarding securities
  • Provides such services for compensation
  • Is in the regular business of providing such

Federal Regulations (contd)
  • Investment Advisors Act of 1940 Fee Act
  • Investment Advisor Representative (IAR)
    Performs services or works for an RIA
  • 1997 Amendment Advisors to register with the SEC
  • Managing assets gt25M rule
  • Service in more than 30 states
  • Advisors to investment companies under the 1940
    Act or anyone eligible for exemption under the
    1940 Act

Form ADV
  • 2001, Investment Advisor Registration Depository
    (IARD) electronic system for registering ADV
    with state(s) and SEC
  • Part I
  • Advisors business information
  • Persons who own or control the business
  • Any violations by the advisor or other personnel
    of securities laws or other laws

Form ADV (contd)
  • Part II Written disclosure or brochure
    describing business practices, fees, and
    conflicts of interest
  • Education
  • Certifications
  • Types of investments
  • Fees charged
  • Methods of analysis
  • Investment strategies
  • Descriptions of legal problems

Form ADV (contd)
  • Part I Filed with IARD Notification with 45
    days of status
  • Part II Investment Advisors Act of 1940
    requires delivery of Part II to all clients or
    potential clients, and then again annually
  • See Figures 2.1 and 2.2

SEC Definition of RIA Exceptions to Registration
  • Banks and bank holding companies
  • Lawyers, accountants, engineers, or teachers if
    solely incidental to their professions
  • Brokers or dealers ifsolely incidental to their
    business as brokers or dealers
  • Publishers of newspapers, magazines, or
    business/financial publications of general or
    regular circulation

SEC Definition of RIA Exceptions to Registration
Requirement (contd)
  • Persons whose advice relates only to securities
    that are direct obligations of or guaranteed by
    the U.S.
  • Advisors whose only clients are insurance
  • Advisors with fewer than 15 total clients who do
    not hold themselves out publicly as investment
  • Otherwise, advisors who receive compensation must
    register. Failure to register may result in a
    fine of 10,000 and 5 years in jail.

5-yr. Practice Management Records Rules
  • Receipts and disbursements journals
  • General ledger
  • Order memoranda
  • Bank records
  • Bills and statements
  • Financial statements
  • Written communications and agreements (including
    electronic transmissions)
  • List of discretionary accounts

5-yr. Practice Management Records Rules
  • Advertising
  • Personal transactions of representatives and
  • Powers granted by clients
  • Disclosure statements
  • Solicitors disclosure statements
  • Performance claims
  • Customer information forms and suitability
  • Written supervisory procedures

Advisor as Custodian
  • Custody Direct or indirect access to and
    responsibility for clients funds or securities
  • Advisor must prove that accounts are safeguarded
  • Advisor must submit to random audits by an
  • Must disclose this role to the client

Advisor as Custodian (contd)
  • Additional documents required
  • Journals of securities transactions and movements
  • Separate client ledgers
  • Copies of confirmations
  • Records showing each clients interest in a
  • Client purchases and sales history

Investment Discretion
  • authorized to determine the disposition of
    assets (e.g., what securities shall be purchased
    or sold) for the account of another person,
    whether or not another person may have
    responsibility for such investment decisions, or
    if they exercise such influence with respect to
    the purchase and sale of securities that they may
    as well have executed the transaction themselves

Custody vs. Investment Discretion
  • Advisor as custodian has physical possession of
    the asset, but must follow the clients
  • Advisor with discretion or trading authority
    can dictate the disposition of the asset but does
    not have possession

State Securities Regulators
  • Blue sky laws
  • North America Securities Administrators
    Association (NASAA), 1919
  • Generally, states require
  • Form ADV
  • Series 65 Uniform Investment Advisor Law Exam
  • Payment of fee
  • Posting of bond, especially if a custodian
  • File a U-4 for all IARs serving the advisors

State Insurance Regulators
  • National Association of Insurance Commissioners
    (NAIC), 1871
  • 8 licenses require examination
  • 6 licenses require registration only

Common Insurance Licenses
To Obtain an Insurance License
  • Be at least 18 years of age
  • Submit a NAIC Uniform Application to their state
    insurance regulator
  • Submit an application fee
  • Notify the state regulator if an insurance
    license is held in another state
  • Provide evidence of Series 6 or Series 7 FINRA
    (NASD) registration if selling variable contracts
  • Pass a licensing examination
  • Secure an insurance company certification showing
    where business will be transacted
  • Meet ongoing continuing education (CE)

SROs Maloney Act of 1938
  • Managed and funded by firms participating in a
    particular segment of the securities markets
  • provide consumers with protection against fraud
  • provide a means to enforce SRO rules and standards

FINRA (NASD until 2007)
  • Most powerful SRO in financial services
  • Oversees
  • 5,100 brokerage firms
  • 99,000 branch offices
  • 675,000 registered reps

  • Licenses individuals
  • Admits firms to the industry
  • Writes rules to govern stockbroker and firm
  • Conducts regulatory and ethical compliance
  • Disciplines those who fail to comply with rules
  • Oversees and regulates equity, corporate bond,
    futures, and options trading
  • Operates the largest securities dispute
    resolution forum

Common Securities Exams
RIA, Registered Rep or Both?
  • RIA Charge a fee for advice
  • Registered Reps Execute transactions for a
  • In some cases, an advisor can be registered with
    the SEC and licensed with the FINRA (NASD)
  • See Figure 2.3

Professional Financial Services Organizations
  • Credentialing organizations
  • Quasi-credentialing organizations
  • Designation organizations
  • Membership organizations
  • Jan. 2005 87 organizations in the U.S. and
    Canada offering almost 90 certifications and

Credentialing Organizations
  • Certification Minimum qualification and
    knowledge level
  • Experience
  • Knowledge competency exam(s)
  • Good standing with the certifying body
  • Continuing education requirements
  • Acceptable practice
  • Fees

Credentialing Organizations (contd)
  • Common examples
  • The American College CLU, ChFC
  • The CFP Board CFP
  • CFA Institute CFA
  • Quasi-credentialing organizations and their

Designation Organizations
  • No examination required, but other experience or
    education requirements apply
  • Accredited Business Accountant, ABA
  • Registered Financial Planner, RFP

Membership Organizations
  • Shared interest in financial services, practice
    management techniques and objectives
  • FPA
  • MDRT
  • NAPFA Hybrid that offers membership and a

  • Furthers fee-only advising
  • NAPFARegistered Financial Advisor
  • BS specialized study
  • 60 hours of CE every two years
  • Must offer comprehensive planning services
  • Submit a comprehensive financial plan for review
  • 36 months of experience providing comprehensive
    financial services

  • Part 2 The F Word
  • Enough said!

  • anyone who provides financial services and acts
    in a position of trust on behalf of, or for the
    benefit of, a third party
  • trustee, executor, administrator, registrar of
    stocks and bonds, transfer agent, guardian,
    assignee, receiver, or custodian

Financial Planning Fiduciary
  • Provides specific recommendations regarding
  • Is paid to provide ongoing financial advice
  • Works with unsophisticated clients that rely on
    the advisers advice
  • A financial planner becomes a fiduciary when the
    advice given to a client becomes comprehensive
    and continuous

History of Fiduciary Rules
  • 1803, Prudence standards
  • 1942, The Model Prudent Man Rule Statute
  • 1959, Prudent man rule
  • In making investments of trust funds the
    trustee is under a duty to the beneficiary to
    make such investments and only such investments
    as a prudent man would make of his own property
    having in view the preservation of the estate and
    the amount and regularity of the income to be
    derived .

History of Fiduciary Rules (contd)
  • 1974, Employee Retirement Income Security Act
  • Applies UPIA to investment professionals through
    the prudence standard of ERISA
  • 1994, Uniform Prudent Investor Act (UPIA)
  • Primarily focused on trust and foundation assets,
    most states apply much more broadly
  • Applies to
  • financial planners acting as fiduciaries
  • investment advisors for charities and pensions
  • executors, conservators, and guardians

UPIA Fiduciary Standards for Trustees
  • Standard of prudence
  • Risk/return tradeoff is a central consideration
  • No investment restrictions, IF consistent with
    risk/return objectives and prudence
  • Diversification is assumed within prudence
  • Delegation of investment/management allowed,
    subject to safeguards

UPIA Investment Standards
  • Prudence reasonable care, skill, and caution
  • Consider trust portfolio, overall investment
    strategy, and risk/return
  • Circumstances economy inflation/deflation
    taxes mix of assets total return
    beneficiaries resources, investment needs, and
    any special relationship with assets

UPIA Investment Standards (contd)
  • Reasonable effort to verify facts for
  • Investment choice consistent with the trust and
  • If trustee chosen for special skills or
    expertise, they must be used

UPIA Prudent Man Expectations for a Financial
  • Be objective
  • Monitor investments
  • Investigate investments
  • Diversify portfolios
  • Maintain loyalty to the client
  • Remain impartial
  • Reduce costs to maximize portfolio efficiency
  • Maintain regulatory compliance

1940 Act, UPIA, and RIAs
  • Hold the client's interest above all other
  • Use the highest standards of care when working
    with clients.
  • Avoid conflicts of interest.
  • If conflicts of interest cannot be avoided, be
    diligent in disclosing such information to all
    interested parties.
  • Disclose compensation methods.

1940 Act, UPIA, and RIAs (contd)
  • Ensure client confidentiality.
  • Select broker-dealers based on their ability to
    provide the best execution of trades for accounts
    where the adviser has authority to select the
  • Make recommendations based on a reasonable
    inquiry into a client's investment objectives,
    financial situation and other factors.

Legal Ramifications
  • Burden of proof is with the advisor
  • Both the planner and the firm can be held legally
    liable for a breach of fiduciary duty
  • In some cases, criminal charges may apply

Fiduciary Standards the SEC
  • Apply to SEC-registered RIAs and their
  • Rules are de facto universal, as most states
    follow the federal guidelines
  • Broker-dealers and registered reps are exempt
    from the fiduciary and ethics rules

Stockbroker Client Requirements per the FINRA
  • The brokers must
  • Know a clients investment goals and objectives.
  • Make investment recommendations suitable to meet
    the clients objectives.
  • Make trade accurately.
  • Based on these standards, stockbrokers currently
    are not considered to be fiduciaries.

Stockbroker Client Requirements per the SEC
  • The brokers
  • cannot call themselves financial planners. May
    use financial consultant, wealth manager, etc.
  • are exempt from most disclosure rules. Must only
    disclose that
  • brokerage accounts are different from managed
    advisory accounts
  • they may be paid incentive income from third

  • Part 3
  • Rules Governing Communication
  • Everybody wants a say about what you say and how
    you say it!

Communication Rules NAIC
  • Advertising Create product interest or induce
    the public to purchase, increase, modify,
    reinstate, borrow on, surrender, replace or
    retain a policy
  • Applies to any communication used to enhance
    sales business cards, brochures, ads, etc.
  • Clear, easily understood, not misleading message
  • States control maintenance schedule requirements
    for advertising files, which range from 3-4 years
    to 7-10 years

Communication Rules FINRA (NASD)
  • BROAD definition of advertising, but constrained
    by control over who receives it
  • Sales literature defined as for the general
    public or clients available upon request

Communication Rules FINRA (NASD) (contd)
  • Requirements include
  • Approval by registered principal
  • Filing with the FINRA (NASD) (including
    electronic advertising, but excluding any filed
    with SEC)
  • Written communication must be archived by the
    issuer for not less than 3 years from initial
    use, including names of those who prepared and
    approved its use

Communication Rules SEC
  • unlawful for any person to use the mail or any
    other form of interstate commerce (including
    telephone and email) to employ manipulative or
    deceptive practices in conjunction with the
    purchase or sale of any security

Communication Rules SROs FCC
  • Telephone Consumer Protection Act of 1991
  • Controls calls for business solicitation
  • Limits hours to 8 a.m. to 9 p.m., local time
  • Requires a Do Not Call list
  • Exceptions for
  • Established working relationship
  • Prior permission from call recipient

Communication Rules SEC, FCC FTC
  • Securities Exchange Act of 1934
  • 1997 amendment to paragraph (f) of Rule 17a-4
    allowed broker-dealers to store records
    electronically in a non-rewriteable, non-erasable
  • email communications between broker-dealers or
    other financial intermediaries and their clients
    or the general public must be archived for at
    least 3 years for possible review

Gramm-Leach-Bliley Act (GLBA) of 1999
  • Established the Financial Privacy Rule and the
    Safeguards Rule, regulated by 8 federal agencies
    and the states
  • Financial institutions banking, insurance,
    securities, lending, real estate settlements,
    taxes, financial advice, financial counseling,
    debt collection, etc.
  • Established notice requirements and restrictions
    on disclosing consumers nonpublic personal
    information without disclosure and consent

GLBA, SEC and Financial Advisors
  • SEC Regulation S-P
  • as a general rule, the initial privacy notice
    must be given to a customer or proposed customer
    no later than when a registered adviser provides
    each client with a written disclosure statement
    or investment advisory contract

  • Part 4
  • Ethical Requirements for Financial Planners
  • Can you trust what they say?

SEC, Rule 204A-1
  • Amendment to the Investment Advisors Act of 1940
  • Every adviser must have a code of ethics that
    sets forth standards of conduct expected of
    advisory personnel
  • Designed to reduce conflicts of interest,
    especially for advisor managed mutual funds

Code of Ethics Must Include
  • Appointment of a chief compliance officer
  • Written business conduct standards reflecting the
    firms fiduciary duty
  • Chief compliance officer and supervised persons
    must comply with federal securities laws
  • Reporting and review of an advisers personal
    investment transactions
  • Supervisors approval before an RIA
    representative invests in an IPO or private

Code of Ethics Must Include (contd)
  • Prompt internal reporting of any violation of the
  • Requirement that all employees receive subsequent
    code amendments
  • Adviser must keep copies of the code, records of
    code violations, and actions taken as a result of
    any violation
  • Copy of the receipt from all RIA representatives
    acknowledging receipt of the code

SEC Rules 206(4)-7 and 204-2
  • Identification of conflicts of interest and risks
    facing the RIA
  • Description of the portfolio management process
    used by the RIA
  • Description of trading practices
  • Description of the policies for proprietary
    trading of the RIA and RIA representatives
  • Policy on the accuracy of client disclosures,
    including account statements and advertisements

SEC Rules 206(4)-7 and 204-2 (contd)
  • Policy on safeguarding clients' assets
  • Description of, security of, and protection of
    books and records maintained by the RIA
  • Description of marketing policies, including the
    use of solicitors
  • Processes to value client holdings and
    calculation of fees
  • Description of safeguards for client privacy for
    records and information
  • Disaster recovery and business continuity plan

SEC Rules 206(4)-7 and 204-2 (contd)
  • Annual review is required and must be documented,
    as well as any actions required
  • Chief compliance officer requirements
  • Knowledgeable of Investment Advisors Act of 1940
  • Position of power to make, implement, and enforce
    necessary policies and procedures

Professional Association Codes of Ethics
  • CFP Board Code of Ethics Professional
    Responsibility (adopted by FPA)
  • Applicable to certificants and candidates
  • IARFC example
  • NAPFA example
  • NAPFA Fiduciary Oath
  • What do these codes have in common?

  • Part 5
  • Professional Practice Issues
  • 1. Continuing education
  • 2. Professional liability insurance
  • 3. Regulation, arbitration and litigation

CE Organization, State Regulator, and SRO
  • CFP Board, 30 hrs. every 2 years, of which 2 must
    be an approved Code of Ethics and Professional
    Standards program
  • NAPFA, 60 hrs. every even-year biennial
  • IARFC, 40 hrs. per year

CE Organization, State Regulator, and SRO
Requirements (contd)
  • NASD (now FINRA), 1995, Rule 1120
  • Regulatory element
  • Computer-based training on licensing and
    registration, communication, product suitability,
    and professional conduct
  • Completed with 120 days of registered reps 2nd
    anniversary of registration approval date, and
    every 3 years in the future
  • Firm element
  • Broker-dealer provided formal training programs

Failure to Comply?
  • CFP Board will not renew certification
  • NAPFA relinquish all benefits of and references
    to the organization

Failure to Comply? FINRA (formerly NASD)
  • Registration is inactive if the regulatory
    element is not satisfied, and remains so until
  • Employer subject to penalties
  • 1996, the NASD censured and fined Citicorp
    Securities, Inc. 25,000 and ordered it to
    disgorge 300,000 for violating NASD CE
    requirements involving only 19 employees

Professional Liability Insurance EO Insurance
  • Protects against claims for actual or alleged
    negligent acts, errors, or omissions of a
    planner, or others for whom the planner is
    legally liable, in the rendering of or failure to
    render services
  • Fiduciary liability insurance, sub-category for
    fiduciary breaches
  • No coverage for acts of fraud

Professional Liability Insurance EO Insurance
  • Before purchasing, ask
  • 1. Will the insurance cover prior acts?
  • 2. Will all legal expense be paid?
  • 3. Where is policy in force?
  • 4. What is covered? (exclusions apply)

Professional Liability InsuranceFidelity Bond
  • Dishonesty or fiduciary bond to cover negligent
    or dishonest actions (e.g., fraud, theft,
    forgery, and embezzlement)
  • Planners may be required by SEC or state
    regulators to post such a bond
  • Planners involved in business covered by ERISA
    must post a bond

Avoid Claims of Misconduct
  • Practice professional ethics
  • Use disclosure and commonly acceptable practice
    management standards as a fiduciary, regardless
    of role
  • Get clients written agreement prior to gathering
    data or making recommendations
  • Figure 2.6 Sample Client Disclosure Form
  • Figure 2.7 Sample Planning Agreement
  • Figure 2.8 Sample Investment Management Agreement

Avoid Claims of Misconduct (contd)
  • Know the laws and follow them
  • Disclose anything that might be considered a
    conflict of interest
  • Avoid anything that appears unethical, illegal,
    or below commonly accepted practice standards

Regulation, Arbitration, Litigation
  • U-4 Form Required to be filed upon employment
    with a FINRA (NASD) license requires resolution
    through arbitration but does not bind the client
    to the same process
  • Brokerage contracts and account applications
    require the client to pursue arbitration (See
    Figure 2.9)
  • Arbitration Resolution bilaterally binding
  • Mediation Solution is not binding

Regulation, Arbitration, Litigation (contd)
  • For violations of FINRA (NASD) rules, federal
    securities laws, rules, and/or regulations
  • censure
  • fines
  • suspension or barring of a professional or
  • Criminal offenses may be turned over to state or
    federal court system

  • Professions require ethical practice standards
  • Understand the ethical and legal requirements of
    the financial planning profession
  • Understand the ramifications of failing to follow
    those standards