Ethical Obligations

The duty to seek the most favorable terms reasonably available when executing client transactions, considering all qualitative and quantitative factors beyond just price. Factors include speed of execution, certainty of settlement, commission costs, and market impact. Broker-dealers have explicit best execution obligations under FINRA rules. Investment advisers, while not subject to specific best execution rules, must seek favorable execution terms as part of their broader fiduciary duty to act in clients' best interests.

Example: An adviser executing a large block trade evaluates three broker-dealers: Broker A offers $0.01/share...

Per-transaction compensation paid to broker-dealers and agents based on each trade executed, creating potential conflicts of interest between generating transactions and serving client interests. Differs from fee-based advisory compensation (typically a percentage of AUM). Subject to suitability obligations and reasonableness standards.

Example: A broker-dealer agent earns a $200 commission on each stock trade executed for a client. This create...

The second prong of FINRA Rule 2111's three-part suitability test, requiring a broker or adviser to have a reasonable basis to believe a recommendation is suitable for a specific client based on their investment profile. Profile factors include age, financial situation, risk tolerance, investment objectives, time horizon, liquidity needs, tax status, and investment experience.

Example: An adviser conducting customer-specific suitability analysis determines that recommending tax-free m...

An account where the investment adviser or IAR has written authorization to make trading decisions without obtaining prior client approval for each transaction, including selecting the security, number of shares or units, and whether to buy or sell. Investment advisers may accept oral discretionary authorization but must obtain written authorization within 10 business days of the first discretionary trade. Broker-dealers must obtain written authorization before exercising any discretion. Time and price discretion (deciding when to execute within a day) is not considered discretion.

Example: An adviser with written discretionary authority can decide to sell 500 shares of Apple and buy 300 s...

A legal obligation to act in another party's best interest with utmost good faith. Investment advisers and IARs must put client interests ahead of their own and either eliminate or fully disclose all material conflicts of interest. This encompasses both duty of care (providing competent, diligent advice) and duty of loyalty (prioritizing client interests). Investment advisers owe fiduciary duty to all clients.

Example: An adviser must recommend the lowest-cost share class when two mutual fund options are otherwise ide...

A written document that establishes a client's investment objectives, risk tolerance, time horizon, constraints, strategic asset allocation, and rebalancing procedures. Serves as the roadmap for portfolio management, guiding all investment decisions and ensuring alignment with client goals. Must be reviewed and updated when client circumstances change (retirement, inheritance, marriage, job change).

Example: An IPS for a 45-year-old professional might specify: objective (retirement in 20 years), risk tolera...

The fundamental regulatory requirement for investment advisers and broker-dealers to gather and maintain essential information about each client to meet suitability obligations and Anti-Money Laundering (AML) requirements. Required information includes financial situation, investment objectives, tax status, risk tolerance, time horizon, liquidity needs, and investment experience. KYC is an ongoing obligation that begins at account opening and requires updates when client circumstances materially change.

Example: During account opening, an investment adviser gathers information showing a client is 45 years old, ...

A brokerage account that allows investors to borrow money from their broker-dealer to purchase securities, with the purchased securities serving as collateral. Federal Reserve Regulation T requires 50% initial margin (the investor must deposit at least 50% of the purchase price), while FINRA requires 25% minimum maintenance margin (the account equity must not fall below 25% of the current market value). Interest is charged on the borrowed amount, and investors face the risk of margin calls if account equity falls below maintenance requirements.

Example: An investor with $10,000 cash wants to buy stock worth $20,000. In a margin account, they can borrow...

A false or misleading statement or omission of fact that a reasonable investor would consider important in making an investment decision. Prohibited under Investment Advisers Act Section 206, materiality is judged by whether the misrepresentation would likely influence a reasonable investor's decision. Both affirmative false statements and material omissions violate anti-fraud provisions.

Example: An adviser tells a client that a mutual fund "has never had a down year" when the fund actually lost...

Compensation based on capital gains or appreciation of client assets, generally prohibited for investment advisers EXCEPT for qualified clients. Qualified client = At least $1.1M under management with this adviser OR in excess of $2.2M net worth (excluding primary residence). Creates conflict of interest by incentivizing excessive risk.

Example: An adviser managing a $1.5M portfolio can charge 1% base fee plus 20% of returns exceeding the S&P 5...

An investor classification that allows performance-based compensation under Investment Advisers Act Rule 205-3. Requires either at least $1.1 million in assets under management with the adviser OR net worth in excess of $2.2 million (excluding primary residence). A subset of accredited investors with higher thresholds, specifically for charging performance fees.

Example: A client with $1.2 million under management with an adviser qualifies for performance fees (meets th...

The third prong of FINRA Rule 2111 suitability obligations, requiring the broker-dealer to have a reasonable basis to believe that a series of recommended transactions is not excessive in light of the customer's investment profile. Addresses churning and over-trading concerns by evaluating the frequency and volume of transactions collectively, even when each individual trade may be suitable.

Example: A broker recommends five different suitable equity trades to a conservative retiree over two weeks, ...

The first prong of FINRA Rule 2111's three-part suitability test requiring the adviser or broker to have a reasonable basis to believe a security or strategy is suitable for at least SOME investors before recommending it to ANY client. Requires understanding the product's features, risks, potential returns, and costs through reasonable diligence and investigation.

Example: Before recommending a complex leveraged inverse ETF, a broker must research and understand the produ...

Compensation paid to third parties (solicitors or promoters) for referring clients to an investment adviser. Under the SEC Marketing Rule (compliance deadline November 4, 2022), all referral arrangements require written agreements disclosing the relationship, compensation structure, and conflicts of interest. Applies to both cash and non-cash compensation arrangements.

Example: An accountant refers a tax client to an investment adviser and receives 25% of the first year's advi...

The ability and willingness to withstand investment losses and volatility, comprising TWO components: (1) Risk CAPACITY - the financial ability to take risk based on time horizon, income needs, and net worth, and (2) Risk WILLINGNESS - the psychological comfort with volatility and potential losses. Suitability requires assessing BOTH, and the LOWER of capacity or willingness determines the appropriate risk level for investment recommendations.

Example: A 28-year-old software engineer earning $180,000 annually with 35+ years until retirement has HIGH r...

A standardized assessment tool used during account opening to evaluate a client's risk tolerance, measuring both financial capacity (time horizon, income, net worth, liquidity needs) and psychological willingness (comfort with volatility, emotional responses to losses) to take investment risk. Required as part of Know Your Customer (KYC) obligations under FINRA Rule 2090 and critical for fulfilling customer-specific suitability requirements under FINRA Rule 2111. Must be updated when material changes occur in client circumstances.

Example: A 45-year-old client completes a risk tolerance questionnaire indicating "aggressive growth" as an o...

An arrangement where investment advisers use client brokerage commissions to obtain research and brokerage services from broker-dealers. Section 28(e) of the Securities Exchange Act provides a safe harbor allowing advisers to pay higher commissions if the services provide lawful and appropriate assistance in investment decision-making. Permitted items include research reports, financial analysis, and portfolio management tools. Prohibited items include office rent, equipment, travel, marketing, and administrative expenses. Must be disclosed in Form ADV Part 2A.

Example: An investment adviser directs client trades to Broker XYZ, which charges $0.08 per share instead of ...

The obligation to recommend securities appropriate for a client's financial situation, investment objectives, risk tolerance, time horizon, liquidity needs, tax status, and investment experience. Includes three types: reasonable basis, customer-specific, and quantitative suitability.

Example: A broker recommending high-yield bonds to a 35-year-old aggressive investor with a long time horizon...