FINRA Series 26 Investment Company and Variable Contracts Products Principal Exam Key Study Note

Registered Investment Advisers (RIAs) and Broker-Dealers operate under distinct regulatory frameworks. RIAs, governed by the Investment Advisers Act of 1940, provide advice about securities, while broker-dealers, regulated under the Securities Exchange Act of 1934, primarily execute transactions. Registration requirements differ significantly; RIAs register with the SEC or state securities authorities, depending on their assets under management, as outlined in Section 203 of the Investment Advisers Act. Broker-dealers must register with the SEC and become members of a Self-Regulatory Organization (SRO) like FINRA, as mandated by Section 15 of the Securities Exchange Act of 1934. Permissible activities also vary. RIAs have a fiduciary duty to act in their clients’ best interests, while broker-dealers are held to a suitability standard. FINRA By-Law Article IV outlines the membership application process, executive representative responsibilities, resignation procedures, and branch office registration, impacting broker-dealers directly. Understanding these differences is crucial for maintaining compliance and avoiding regulatory conflicts.

FINRA Rule 1240 establishes continuing education (CE) requirements for registered persons. The Regulatory Element, prescribed by FINRA, requires registered individuals to complete a computer-based training session within 120 days of their second registration anniversary date and every three years thereafter. This element focuses on regulatory changes and industry practices. The Firm Element, on the other hand, requires member firms to develop and administer an annual training plan tailored to their business and the specific roles of their registered representatives. This plan must cover topics related to investment products, services, and strategies offered by the firm, as well as compliance, regulatory, ethical, and sales practice standards. For representatives dealing with variable contracts and investment company products, the Firm Element should include in-depth training on product features, risk characteristics, suitability considerations (as per FINRA Rule 2111), and relevant regulations such as the Investment Company Act of 1940. Both elements are crucial for ensuring registered representatives remain competent and informed, thereby protecting investors.

FINRA Rule 3110(a) mandates that member firms establish and maintain a system to supervise the activities of its associated persons that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with FINRA rules. This supervisory system must include written procedures as detailed in Rule 3110(b). Supervisory responsibilities include, but are not limited to, the review of customer accounts, the approval of advertising and sales literature, and the monitoring of transactions to detect and prevent potential violations. Specifically, supervisors must monitor and document the sales activities of associated persons, providing feedback on product knowledge and performance. This involves reviewing correspondence, order tickets, and other relevant documentation to ensure recommendations are suitable (FINRA Rule 2111), disclosures are adequate, and transactions comply with applicable rules and regulations. The supervisory system must also address how the firm manages conflicts of interest and handles customer complaints, ensuring a robust compliance framework.

FINRA Rule 2210 governs communications with the public, categorizing them into retail communications, institutional communications, and correspondence. Retail communications are defined as any written or electronic communication distributed or made available to more than 25 retail investors within any 30 calendar-day period. These require prior principal approval and, in some cases, filing with FINRA’s Advertising Regulation Department. Institutional communications are communications distributed only to institutional investors, as defined by FINRA. These generally do not require pre-approval or filing, but firms must maintain records of their use. Correspondence includes written or electronic communications distributed to 25 or fewer retail investors within any 30 calendar-day period. Correspondence requires supervision and review, but not necessarily pre-approval. The rule outlines specific content standards, prohibiting misleading statements and requiring fair and balanced presentations. Investment company rankings in retail communications are subject to additional requirements under FINRA Rule 2212. Understanding these distinctions is critical for ensuring compliance and avoiding regulatory scrutiny.

FINRA Rule 2090, the “Know Your Customer” (KYC) rule, requires member firms to use reasonable diligence to know and retain the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. This includes understanding the customer’s financial situation, tax status, investment objectives, and other information needed to make suitable recommendations. FINRA Rule 2111, the suitability rule, builds upon the KYC rule by requiring that a member firm or associated person have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the KYC process. This involves three main obligations: reasonable-basis suitability (understanding the product), customer-specific suitability (matching the product to the customer’s needs), and quantitative suitability (ensuring the overall investment strategy is appropriate). Together, these rules ensure that recommendations are not only suitable but also aligned with the customer’s best interest, considering their individual circumstances and risk profile. The implementation of Regulation Best Interest (Reg BI) further reinforces this obligation.

FINRA Rules 2320(g) and 2341 address member compensation related to variable contracts and investment company securities, respectively. These rules aim to prevent conflicts of interest by restricting certain types of cash and non-cash compensation that could incentivize registered representatives to recommend products based on personal gain rather than the client’s best interest. Specifically, these rules limit or prohibit certain sales contests, gifts exceeding a nominal value, and other incentives that could unduly influence recommendations. While cash compensation is generally permitted, it must be disclosed and cannot be structured in a way that favors one product over another without a legitimate business justification. Non-cash compensation, such as extravagant trips or prizes, is often restricted to ensure that recommendations are based on the merits of the investment and the client’s needs, rather than the potential for personal enrichment. These regulations promote objectivity and integrity in the sales process.

FINRA Rule 3270 states that no registered person may be an employee, independent contractor, sole proprietor, officer, director, or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the registered person’s relationship with his or her member firm, unless he or she has provided prior written notice to the member firm. The rationale behind this rule is to allow the firm to assess potential conflicts of interest and ensure that the outside business activity does not compromise the registered person’s duties to customers or the firm. Potential conflicts include diverting business opportunities away from the firm, using confidential client information for personal gain, or engaging in activities that could impair the registered person’s objectivity or integrity. Firms can manage these risks by establishing clear policies and procedures for reviewing and approving outside business activities, conducting regular audits, and providing training to registered persons on ethical conduct and conflict management. The firm must also consider whether the outside activity would cause the registered person to violate securities laws or regulations.

FINRA Rule 3270 mandates that registered persons provide prior written notice to their member firm before participating in any outside business activity, particularly if that activity involves receiving compensation or the reasonable expectation of compensation. An “outside business activity” encompasses any business endeavor undertaken by the registered person away from their primary employment with the member firm. This includes, but is not limited to, serving as an officer, director, partner, employee, or consultant of another company. The rule aims to ensure that the member firm is aware of potential conflicts of interest or undue time commitments that could detract from the registered person’s ability to fulfill their responsibilities to the firm and its clients. Failure to disclose such activities can result in disciplinary action. The firm must assess the proposed activity to determine if it will interfere with or compromise the registered person’s duties or create regulatory concerns.

FINRA requires heightened supervision for registered representatives with a history of significant disciplinary events, such as regulatory sanctions, customer complaints, or arbitrations. The specific criteria triggering heightened supervision are outlined in FINRA Rule 3110. The supervising principal’s responsibilities include more frequent reviews of the representative’s transactions, correspondence, and customer interactions. The principal must also document these supervisory activities and maintain records demonstrating the firm’s efforts to mitigate the risks associated with the representative’s past conduct. Heightened supervision aims to protect investors by ensuring that representatives with a problematic history are closely monitored and prevented from engaging in further misconduct. The intensity and duration of heightened supervision depend on the severity and nature of the past disciplinary events.

FINRA Rule 2330 outlines specific responsibilities for member firms concerning deferred variable annuities. A crucial aspect is the suitability determination, requiring firms to have reasonable grounds for believing that a deferred variable annuity is suitable for a particular customer based on their financial situation, investment objectives, and risk tolerance. This includes considering factors like age, income, existing investments, and tax status. Principal review is also mandated, requiring a registered principal to review and approve each deferred variable annuity transaction before it is executed. Furthermore, firms must provide clear and comprehensive disclosure of surrender charges, fees, and other costs associated with the annuity, ensuring customers understand the financial implications of their investment. Compliance with Rule 2330 is essential to protect investors from unsuitable recommendations and ensure transparency in variable annuity transactions.

FINRA Rule 2010, which mandates adherence to high standards of commercial honor and just and equitable principles of trade, extends to a registered representative’s personal investment activities. Actions that could violate this rule in that context include engaging in insider trading, front-running, or any other manipulative or deceptive practices for personal gain. For example, if a representative uses non-public information obtained through their professional capacity to make investment decisions in their personal account, they would be in violation of Rule 2010. Similarly, if a representative places personal trades ahead of customer orders to benefit from anticipated price movements, this would also constitute a violation. The rule emphasizes that registered representatives must maintain the highest ethical standards in all their financial dealings, both professional and personal, to uphold the integrity of the securities industry.

FINRA Rule 2210 sets forth specific requirements for using investment company rankings in retail communications to prevent misleading investors. The rule mandates that any communication including such rankings must prominently disclose the ranking’s source, the ranking criteria, the period on which the ranking is based, and any fees or expenses that could affect the ranking. Furthermore, the communication must disclose the name of the category for the ranking (e.g., large-cap growth funds) and, if applicable, that the fund’s performance may not continue in the future. The rule also prohibits the use of rankings that are based on subjective criteria or that are not widely recognized and respected within the industry. The goal is to ensure that investors receive a balanced and objective presentation of investment company performance, rather than being swayed by potentially biased or incomplete information.

FINRA Rule 3110 outlines the supervisory responsibilities of a principal regarding discretionary accounts. Principals must establish and maintain a system to supervise the activities of registered representatives with discretionary authority. This includes regular reviews of account activity to detect and prevent potential abuses, such as churning or unsuitable trading. The rule requires frequent reviews, typically at least quarterly, of all discretionary accounts. During these reviews, the principal must consider factors such as the investment objectives and financial situation of the customer, the frequency and nature of the transactions, the level of commissions generated, and whether the trading activity is consistent with the customer’s stated goals. The principal must also document these reviews and take appropriate action if any irregularities or potential violations are detected. Effective supervision of discretionary accounts is crucial to protect investors from unauthorized or unsuitable trading practices.

FINRA Rule 3240 strictly regulates borrowing from or lending to customers by registered representatives. Generally, such activities are prohibited unless the member firm has written procedures allowing them and the arrangement meets specific conditions. These conditions typically include the customer being a member of the representative’s immediate family or the customer being a financial institution engaged in the business of lending. Even when permitted, the representative must provide written notification to the firm and obtain written approval before entering into the arrangement. The notification must disclose the nature of the relationship with the customer, the terms of the loan, and any potential conflicts of interest. The firm must then assess the proposed arrangement to determine if it is fair and reasonable and does not create undue risk for the customer or the firm. The rule aims to prevent representatives from exploiting their relationships with customers for personal financial gain and to ensure that any borrowing or lending activities are conducted in a transparent and ethical manner.