Customer Accounts & Compliance Considerations

The customer accounts and considerations are important topics from the perspective of the SIE exam. This page of the SIE study guide covers various types of customer accounts and account opening procedures.

Other topics like anti-money laundering, general requirements for member firm books and records, communications with the public, and suitability are also covered in this study material.

Types of Customer Accounts

If you’re an individual investor looking to invest in stocks, you must open a trading account with a brokerage firm like Charles Schwab, Robinhood, JP Morgan, Fidelity, or Vanguard. These firms are regulated by the Federal Reserve Board under Regulation T (Reg T). You can open two main types of accounts: a cash account and a margin account.

  • Cash Account: A cash account is a brokerage account where you must pay the total amount for the securities you purchase. You cannot borrow funds from your broker, making it straightforward and typically less risky than other account types.
  • Margin Account: A margin account allows you to borrow funds from your broker to purchase securities. This means you can buy more than you could with just your available cash. While it can amplify gains, it also increases risk since you must repay the borrowed amount with interest, and losses can exceed your initial investment.
  • Options Account: An options account allows investors to trade options contracts, which are financial derivatives giving the right, but not the obligation, to buy or sell an asset at a set price before a specific date. Opening an options account requires approval based on investment experience, financial situation, and risk tolerance. Due to the higher risk and complexity of options trading, brokerage firms ensure clients meet specific criteria before granting access to such accounts.
  • Educational Accounts: Educational accounts, such as 529 college savings plans and Coverdell Education Savings Accounts (ESAs), are designed to help save for future education expenses. These accounts offer tax advantages, such as tax-free growth and withdrawals for qualified education expenses.
  • Discretionary vs. Non-Discretionary: In a discretionary account, the broker-dealer or registered representative (RR) is authorized to trade securities on behalf of clients without the client’s consent for all trades. On the other hand, the client makes all trade decisions in the non-discretionary account.
  • Fee-Based vs. Commission-Based: Clients pay a flat fee, annual charges, or a percentage of assets under management (AUM) in a fee-based account. This model aligns the advisor’s interests with the clients’, as they earn more when the portfolio grows. In a commission-based account, clients pay fees based on the transactions made. Advisors earn a commission for each trade, sometimes leading to more frequent trading.

Customer Account Registrations

Customer account registration refers to the process of establishing ownership and control over a brokerage account. There are several types of registrations, each with unique features and implications for account management and inheritance.

  • Individual Account: An individual account is owned by one person who has sole authority over all transactions and decisions. This type of account is straightforward, providing clear control and ownership for the account holder.
  • Joint Account: A joint account is shared by two or more individuals, each having equal access and control. Typically, it includes JTWROS (joint tenants with rights of survivorship), meaning the account’s assets automatically transfer to the surviving owner(s) upon one owner’s death.
  • Corporate/Institutional Account: A corporate/institutional account is registered to a corporation or institution, allowing it to invest its funds. Authorized individuals within the organization manage the account and make investment decisions. This type of account is essential for companies such as banks, insurance companies, pension plans, etc., seeking to grow their assets and manage investments efficiently.
  • Trust Account: A trust account type ensures that assets are managed and distributed according to the trust’s specifications, providing control and protection for the beneficiaries’ interests. Trust accounts can be either revocable, allowing the grantor to modify or revoke the trust, or irrevocable, where the trust terms cannot be changed once established, providing greater asset protection and potential tax benefits.
  • Custodial Account: A custodial account is typically set up as a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account when a donor gives cash or securities to a minor child. An adult custodian, appointed by the donor, manages the account and makes investment decisions for the child’s benefit. UTMA income can be reported on either the parent’s or the minor’s tax return using the respective tax ID. If UTMA income exceeds $2,000, some or all of it may need to be reported on the parent’s tax return.
  • Partnership Account: A partnership account is registered to a partnership, allowing multiple partners to manage and invest the account’s assets jointly. Each partner has the authority to make transactions, and the account operates according to the partnership agreement. This type of account is essential for businesses structured as partnerships, providing collective management and investment opportunities.
  • Retirement Account: A retirement account is designed to help individuals save for retirement with tax advantages. Common types include 401(k)s, IRAs, and Roth IRAs. Contributions to these accounts may be tax-deductible, and the investments grow tax-deferred or tax-free. Retirement withdrawal is subject to specific rules and, in some cases, tax penalties if taken early.
  • Defined Benefit Plan: A Defined Benefit Plan is an employer-sponsored retirement plan that provides a specified monthly benefit or lump-sum payment to the employee upon retirement. The employer guarantees this benefit and is responsible for all investment decisions, bearing all the associated risks. While both the employee and employer can make contributions, the employer typically contributes. Benefits are taxable as ordinary income to employees upon distribution.
  • Defined Contribution Plan: A Defined Contribution Plan is an employer-sponsored retirement plan where contributions are made to individual employee accounts, typically by both the employee and employer. Common examples include 401(k) and 403(b) plans. The final benefit depends on the contributions made and the investment performance. Employees bear the investment risk, and contributions are often tax-deferred until withdrawal, taxed as ordinary income.
  • Individual Retirement Account (IRA): An Individual Retirement Account (IRA) is a tax-advantaged savings account available to anyone with earned income. Types of IRAs include Traditional IRAs, Roth IRAs, Payroll Deduction IRAs, SEP IRAs, and SIMPLE IRAs, with Traditional and Roth IRAs being the most common. Annually, individuals can contribute less than $6,000 ($7,000 for those 50 or older) or their taxable compensation for the year.
  • Simplified Employee Pension Plan (SEP): A Simplified Employee Pension Plan (SEP) is a cost-effective IRA allowing employers to make discretionary contributions towards their own and their employees’ retirement while receiving tax deductions. SEP IRAs operate similarly to traditional IRAs, but employers can contribute more, up to 25% of an employee’s compensation or $58,000 (as of 2021). Account owners must start taking required minimum distributions by April 1 of the year following the year they turn 72.
  • Employee Stock Ownership Plan (ESOP): An Employee Stock Ownership Plan (ESOP) is a trust fund-based employee benefit plan that enables employees to gain ownership in the company through company stock. Both the company and employees enjoy tax advantages from the plan. Employees earn shares according to a vesting schedule, with their ownership increasing the longer they remain with the company. Employees typically sell their shares back to the company on retirement and receive a lump sum payment or regular installments.

Account Opening Procedures

Required Documentation: When opening a new account, several key documents are necessary to ensure compliance with regulatory requirements and to establish the account correctly. These documents typically include:

  • New Account Application: Collects essential personal information such as name, address, Social Security number, date of birth, and employment status.
  • Government-Issued Identification: A driver’s license or passport to verify the client’s identity.
  • Financial Information: Details about the client’s income, net worth, investment experience, and risk tolerance.
  • Signed Agreements: Includes margin agreements for margin accounts and discretionary account agreements if applicable.

Customer Identification Program (CIP): It is a critical component of the USA PATRIOT Act to prevent money laundering and terrorist financing.

The CIP requires financial institutions to:

  • Verify Identity: Obtain, verify, and record information identifying each person who opens an account.
  • Maintain Records: Keep records of the information used to verify a customer’s identity, including name, address, date of birth, and identification number.
  • Check Against Lists: Compare customer information with government-provided lists of known or suspected terrorists.

Know Your Customer (KYC) Rules: These rules are designed to protect financial institutions and their clients by ensuring a clear understanding of the customer’s identity and financial activities.

The key elements of KYC include:

  • Customer Due Diligence (CDD): Collecting and analyzing information on a client’s identity, financial situation, and investment objectives.
  • Enhanced Due Diligence (EDD): Implementing additional scrutiny for high-risk customers, such as politically exposed persons (PEPs) or those from high-risk countries.
  • Ongoing Monitoring: Continuously reviewing and updating customer information and monitoring transactions to detect and report suspicious activities.

Anti-Money Laundering (AML)

Money laundering is the illegal process of disguising the origins of money obtained from criminal activities, such as drug trafficking, by making it appear legitimate. Alongside the Bank Secrecy Act (BSA), FINRA Rule 3310 mandates that all member firms have a written compliance program to detect and prevent money laundering.

The money laundering process typically involves placement, layering, and integration.

  • Placement: Illegitimate money is introduced into the financial system.
  • Layering: The money is moved through complex transactions to obscure its origins.
  • Integration: The now-legitimatized money is withdrawn and used by criminals.

A written AML compliance program must include the following:

  • Policies and Procedures: Designed to achieve compliance with the BSA.
  • AML Compliance Officer: Appoint an officer and notify FINRA.
  • Ongoing Training: Provide continuous training to personnel.
  • Risk-Based Procedures: For conducting ongoing customer due diligence.
  • Independent Testing: Conduct independent testing of the firm’s AML program annually.

Financial institutions, such as broker-dealers, must file a suspicious activity report (SAR) with the Financial Crimes Enforcement Network (FinCEN) if a transaction or series of transactions totaling at least $5,000.

Additionally, banks must file a currency transaction report (CTR) with FinCEN for any currency transaction over $10,000. They may also file a CTR if a customer appears to be intentionally avoiding the $10,000 threshold through smaller transactions, a practice known as structuring.

Exempt persons from CTRs include banks, government agencies, or public companies listed on the NYSE, Nasdaq, or American Stock Exchange and are not required to file CTR for transactions above $10,000.

The Office of Foreign Asset Control (OFAC) enforces sanctions against terrorists, narcotics traffickers, and other national security threats. OFAC publishes the Specially Designated Nationals (SDNs) List, which includes individuals and companies associated with targeted countries or specific threats.

Assets of those on the SDNs List are frozen, and U.S. persons are generally prohibited from conducting business with them.

Books and Records and Privacy Requirements

The SEC, MSRB, and FINRA have specific recordkeeping rules for registered broker-dealers and their associated persons. These rules ensure effective examinations of broker-dealer records when necessary. They apply to electronic communications and paper records related to the firm’s business.

The broker-dealer must retain the following customer information:

  • Communications with the Public: It must be retained for three years, the first two years, in an easily accessible place.
  • Organizational Documents: All organizational documents must be retained for the firm’s lifetime.
  • Special Reports: All special reports must be retained for three years from the report date.
  • Compliance, Supervisory & Procedures Manuals: It must be retained for three years after the manual terminates use.
  • Exception Reports: It must be retained for eighteen months after the date the report was generated

Brokerage account statements and trade confirmations are essential documents in the securities industry, serving as records of customer transactions and account activities. According to regulatory requirements, these documents must be retained for specific periods to ensure compliance and facilitate audits.

  • Brokerage Account Statements: Must be retained for six years.
  • Trade Confirmations: Must be retained for three years.

FINRA Rule 4370 mandates that firms create and maintain a written Business Continuity Plan (BCP) to address emergencies or serious business disruptions. The BCP must be reasonably designed to ensure the firm can meet its obligations to customers and should, at a minimum, include the following elements:

  • 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.
  • How the firm will assure customers’ prompt access to their funds and securities if the firm determines that it is unable to continue its business.

Exchange Act Rule 15c3-3 directs firms to keep the customer’s funds and securities separate from their business activities, and the firm should promptly deliver these assets to their owner upon request. The firms can hold their customer’s assets (1) in their physical possession or (2) in a location where the firm can direct their movement, such as a clearing corporation.

The firms should also be liable to protect their customer’s personal and financial information as per SEC Regulation S-P. Additionally, the firm must provide initial and annual privacy notices containing firm policies and customer rights.

Communications with the Public and Telemarketing

Member firms and their associated persons abide by FINRA Rule 2210 while communicating with the public. It categorizes communications into correspondence, retail, and institutional communications, each with specific approval, review, and recordkeeping requirements.

Retail communications require principal approval before use and must be filed with FINRA. The rule outlines content standards to ensure communications are fair, balanced, and not misleading, including prohibitions on false claims and requirements for appropriate disclosure. It also includes specific guidelines for filing, review procedures, and exemptions.

There are certain rules described by FINRA for communication and telemarketing:

  • Cold Calling: FINRA rule 3230 prevents firms and associated members from cold calling customers before 8:00 AM or after 9:00 PM. Unless an exception is available, Rule 3230 prohibits members and their associated persons from initiating any “outbound telephone call” during restricted periods or to individuals on the “firm-specific do-not-call list” or the “national do-not-call list.” Rule 3230(m)(16) defines “outbound telephone call” as a telephone call initiated by a telemarketer to induce the purchase of goods or services or to solicit a charitable contribution from a donor.
  • National Do-Not-Call List: Firms and associated members are prohibited from making cold calls to those customers who have registered their number in the Federal Trade Commission’s national do-not-call registry.

Best Interest Obligations and Suitability Requirements

SEC Regulation Best Interest (Reg BI) rule sets forth the standard of conduct broker-dealers must provide to their retail customers when they make recommendations of securities or investment strategies involving securities.

A rule requirement mandates that broker-dealers and investment advisers deliver a concise relationship summary, known as Form CRS, to retail investors. This summary encompasses details about the types of services the firm offers, associated fees and costs, potential conflicts of interest, and other pertinent information.

According to FINRA Rule 2111, broker-dealers and associated persons must have a reasonable basis to believe that a recommended securities transaction or investment strategy suits the customer.

To make recommendations, they must conduct appropriate due diligence to understand the customer’s investment profile, including age, financial situation, needs, investment objectives, and risk tolerance. Additionally, brokers must thoroughly understand the product and the customer to ensure compliance with the rules.

  • Reasonable-basis Suitability: Through reasonable diligence, the broker must believe that their recommendation is suitable for at least some investors. The firm or associated person must also comprehensively understand the recommended product’s potential risks and rewards.
  • Customer-specific Suitability: Based on a customer’s investment profile, a broker must have a reasonable basis to believe their recommendation suits that specific customer. The broker must also be able to substantiate this determination.
  • Quantitative Suitability: A broker with actual (or de facto) control over a customer’s account must ensure that a series of recommended transactions is neither excessive nor unsuitable for the customer, considering their investment profile. This rule applies even if the transactions appear suitable when evaluated individually.
Prohibited Activities >>

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