Series 27 Financial and Operations Principal Exam

Correct: SEC Rule 17h-1T (Risk Assessment Recordkeeping Requirements for Associated Persons) requires broker-dealers to maintain records concerning the financial and operational condition of Material Associated Persons (MAPs). A MAP is defined as any associated person whose business activities are reasonably likely to have a material impact on the financial or operational condition of the broker-dealer. The rule specifically requires the maintenance of organizational charts, consolidated financial statements, and descriptions of the policies and procedures the firm uses to monitor and manage the risks resulting from the activities of these associated persons. Incorrect: The approach of designating all entities within a holding company as MAPs is incorrect because the regulation requires a specific assessment of materiality rather than a blanket application to all affiliates. Limiting recordkeeping only to associated persons overseen by federal banking or foreign regulators is a misunderstanding of the rule; while there are special provisions for regulated entities, the core intent of 17h-1T is to capture risks from unregulated affiliates that could impact the broker-dealer. Using fixed numerical thresholds such as 20% of gross revenue or 50% of transaction volume is not a regulatory standard for determining MAP status, as the determination must be based on a qualitative and quantitative assessment of potential material impact on the broker-dealer’s stability. Takeaway: Under SEC Rule 17h-1T, broker-dealers must identify and maintain risk-related records for any associated person whose activities could materially affect the firm’s financial or operational stability.

Correct: Accredited investors are a specific category of investors defined under SEC Rule 501 of Regulation D. They are deemed to have the financial sophistication and resources to invest in private placements without the protections provided by a formal SEC registration. This includes individuals with high net worth or income, as well as certain institutional entities that meet specific asset thresholds. Incorrect: Retail investors are generally protected by registration requirements and do not automatically qualify for private placements based on tenure or questionnaires. Transfer agents are service providers for issuers that manage record-keeping, not the investors themselves. Clearing corporations are infrastructure entities that handle the settlement of trades, not the participants purchasing the private placement. Takeaway: Accredited investors are key participants in the primary market for private placements, defined by their ability to sustain risk and their financial sophistication without the need for full SEC registration protections.

Correct: A Bankers’ Acceptance (BA) is a money market instrument specifically designed to facilitate international trade. It functions as a time draft (a promise to pay at a future date) that is ‘accepted’ and guaranteed by a commercial bank. This guarantee makes the instrument highly liquid and tradable in the secondary market, as the credit risk is shifted from the importer/exporter to the bank. Incorrect: The description of an unsecured promissory note issued by a corporation refers to commercial paper, not a bankers’ acceptance. The receipt representing foreign shares describes an American Depositary Receipt (ADR), which is an equity-related instrument rather than a money market debt instrument. The debt instrument issued by a municipality to provide interim funding describes a municipal note, such as a Bond Anticipation Note (BAN). Takeaway: Bankers’ Acceptances are bank-guaranteed time drafts used to facilitate international trade and are considered liquid, short-term money market instruments.

Correct: Although ADRs trade in U.S. dollars on U.S. exchanges, the underlying security is a foreign stock denominated in a foreign currency. When the foreign company pays a dividend, it does so in its local currency. The U.S. depositary bank receives that dividend, converts it to U.S. dollars, and distributes it to the ADR holders. Consequently, if the foreign currency weakens against the U.S. dollar, the value of the dividend payment decreases, representing a clear currency risk for the investor. Incorrect: The claim that ADRs eliminate exchange rate risk is a common misconception; while the transaction is in dollars, the underlying value is tied to foreign currency performance. ADR holders typically do not have the same direct voting rights as common shareholders; instead, the depositary bank usually votes the shares on behalf of the holders or may pass through voting rights in a more limited capacity. ADRs are equity-proxy securities, not debt instruments, and they are not insured by the FDIC, which covers bank deposits rather than investment securities. Takeaway: ADRs facilitate the trading of foreign stocks in U.S. markets but do not shield investors from the currency risk associated with the foreign issuer’s home country.

Correct: Schedule A of the Securities Act of 1933 specifies the information that must be included in a registration statement for a new issue. This includes vital details such as the identities of the company’s leadership (directors and officers), their security holdings, a thorough description of the issuer’s business operations, and the ‘use of proceeds,’ which explains how the capital raised will be spent. Incorrect: The SEC does not certify the investment merit or safety of a security; it only ensures that the required disclosures are made. Schedule A pertains to the primary market and the initial registration of securities, not historical secondary market performance. Furthermore, the registration statement is a public document designed to provide transparency to all potential investors, not a private filing for underwriters. Takeaway: Schedule A requires issuers to provide comprehensive public disclosure regarding management, business operations, and the intended use of capital to ensure investors can make informed decisions in the primary market.

Correct: FINRA Rule 2090 (Know Your Customer) requires that every member use reasonable diligence, in regard to the opening and maintenance of every account, to know and retain the essential facts concerning every customer. These essential facts include those required to effectively service the account, understand the authority of each person acting on behalf of the customer, and comply with applicable laws and regulations. Incorrect: The suggestion that KYC is only required at account opening is incorrect because Rule 2090 applies to the maintenance of the account as well. Prioritizing suitability over legal authority is a regulatory failure, as understanding authority is a core component of knowing the customer. There is no exemption from KYC requirements based on the length of the relationship or the consistency of transaction history. Takeaway: FINRA Rule 2090 requires firms to maintain ongoing diligence regarding the essential facts of a customer, including the legal authority of any person acting on the customer’s behalf.

Correct: Under SEC Rule 10b-10, broker-dealers are required to provide customers with a written confirmation of a transaction at or before the completion of the trade (typically the settlement date). Regarding account statements, FINRA Rule 2231 requires firms to send statements to customers at least quarterly. However, if there is any activity in the account during a specific month, a statement must be sent for that month. Incorrect: The requirement for trade confirmations is that they be sent at or before the completion of the transaction, not within a generic three-day window or only upon request. Account statements must be sent at least quarterly, not annually. Reversing the roles of confirmations and statements is incorrect, as confirmations are transaction-specific and statements are periodic summaries. Takeaway: Broker-dealers must provide immediate trade confirmations for every transaction and periodic account statements at least once per quarter, or monthly if activity occurs.

Correct: A Unit Investment Trust (UIT) is an investment company organized under a trust indenture that does not have a board of directors. Instead, it is supervised by a trustee. UITs typically purchase a fixed portfolio of securities, such as bonds, and hold them until the trust’s termination date. They issue redeemable units (shares of beneficial interest) to investors, which means the trust will buy back the units at their current net asset value. Incorrect: Open-end management companies, commonly known as mutual funds, are actively managed and require a board of directors to oversee the fund’s operations. Closed-end management companies also have a board of directors and an investment adviser, but their shares trade on the secondary market rather than being redeemable. Face-amount certificate companies are a specific type of investment company that issues debt certificates promising a fixed sum of money at a future date, which does not match the description of a fixed portfolio of bonds held for unit holders. Takeaway: Unit Investment Trusts are characterized by a fixed, unmanaged portfolio of securities and the absence of a board of directors, issuing redeemable units to investors.

Correct: Under the Trust Indenture Act of 1939, corporate bond issuances exceeding a specific dollar threshold must be issued under a trust indenture. This legal document requires the appointment of a trustee, typically a large bank or trust company, which acts in a fiduciary capacity to protect the interests of the bondholders. The trustee is responsible for monitoring the issuer’s compliance with all bond covenants and taking appropriate legal action if the issuer defaults or fails to meet its obligations. Incorrect: The transfer agent is responsible for maintaining records of security ownership and the issuance or cancellation of certificates, but does not have a fiduciary role in enforcing bond covenants. The custodian is responsible for the safekeeping of the assets and securities but lacks the legal authority to monitor or enforce the terms of the bond’s indenture. The paying agent is a role focused on the administrative task of distributing interest and principal payments to investors and does not perform oversight of the issuer’s financial health. Takeaway: The trustee is the market participant legally mandated to represent and protect the interests of corporate bondholders by ensuring the issuer complies with the trust indenture.

Correct: In a firm commitment underwriting, the investment bank and the underwriting syndicate purchase the entire issue from the corporation and resell it to the public, thereby assuming the financial risk of any unsold shares. To handle the administrative aspects of share ownership, a transfer agent is employed to maintain records of who owns the shares and to handle the issuance and cancellation of certificates. Incorrect: Municipal advisors provide advice to state and local governments regarding municipal debt and are not authorized to underwrite corporate equity IPOs. Clearing corporations like the DTCC facilitate the settlement of trades but do not act as underwriters. Selling group members assist in the distribution of shares but do not assume financial liability for unsold inventory; that liability remains with the underwriting syndicate. Takeaway: The underwriting syndicate assumes financial risk in a firm commitment offering, while the transfer agent is responsible for the administrative maintenance of shareholder records.

Correct: Under Rule 15c3-1, broker-dealers must maintain a minimum level of net capital at all times. When a firm enters into a complex transaction like a total return swap with an affiliate to hedge proprietary positions, the haircut treatment depends on the creditworthiness of the counterparty and the specific regulatory approval of the hedging model. If the affiliate lacks sufficient liquidity or the arrangement has not received specific SEC approval or a no-action letter for offset treatment, the firm must apply the full haircut to the underlying securities. Furthermore, if this adjustment causes the firm to fall below its minimum requirement or triggers early warning thresholds, the firm must immediately notify the SEC and its designated examining authority (DEA) under Rule 17a-11. Incorrect: Increasing a general contingency reserve is an accounting entry that does not satisfy the specific liquidity-based requirements of the Net Capital Rule, as net capital is focused on the immediate convertibility of assets to cash. Seeking a retroactive subordination agreement is not permissible because all subordination agreements must be submitted to and approved by the firm’s regulator at least 30 days prior to their effective date to qualify as regulatory capital. Amortizing a haircut charge is strictly prohibited under the moment-to-moment compliance requirement of Rule 15c3-1, which mandates that the full impact of market risk be reflected in the net capital calculation immediately rather than over the life of the contract. Takeaway: Net capital compliance requires the immediate application of full haircuts on proprietary positions unless a hedge is executed with a qualified counterparty under a regulator-approved methodology.

Correct: According to FINRA Rule 2262, a member controlled by, controlling, or under common control with the issuer of any security must disclose the existence of such control to the customer. This disclosure must be made before any contract for purchase or sale is entered into (which can be oral), and if the initial disclosure was not in writing, it must be supplemented by written disclosure at or before the completion of the transaction (typically on the trade confirmation). Incorrect: The requirement for disclosure of a control relationship does not depend on a specific dollar threshold or the classification of the investor as retail. Obtaining a signed waiver 48 hours in advance is not a requirement of Rule 2262, as oral disclosure followed by written confirmation is sufficient. Furthermore, the rule applies to individual transactions and cannot be satisfied solely through a general disclosure in an annual report. Takeaway: Broker-dealers must disclose any control relationship with an issuer to customers both before the trade occurs and in writing at or before the completion of the transaction.

Correct: The Official Statement is the primary disclosure document for municipal securities, providing comprehensive information about the issuer and the specific bond issue. Under MSRB rules, broker-dealers are required to deliver the final Official Statement to customers at or before the settlement of the transaction.

Correct: FINRA Rule 5210 prohibits member firms from publishing, circulating, or causing to be published any report of a transaction or a quotation unless the member believes that the transaction was a bona fide purchase or sale, or that the quotation was a bona fide bid or offer. Transactions that do not involve a change in beneficial ownership (often referred to as wash sales) are generally not considered bona fide and reporting them would mislead the market regarding active trading volume. Incorrect: Reporting all transactions regardless of whether they are bona fide would violate the core principle of Rule 5210, which is to prevent the dissemination of misleading market information. The Securities Investor Protection Corporation (SIPC) provides insurance for customer accounts in the event of a broker-dealer failure and does not have a role in verifying or clearing daily market quotations. Implementing a time delay does not address the underlying requirement that the published data must represent genuine, bona fide trading interest. Takeaway: FINRA Rule 5210 requires that all published transactions and quotations represent bona fide trading activity to maintain market integrity and prevent misleading the public.

Correct: Direct Participation Programs (DPPs) are typically highly illiquid and carry significant risk, as there is no active secondary market. Regulatory standards require that a representative perform rigorous suitability checks to ensure the investor has a net worth and liquidity profile sufficient to handle the long-term commitment and the potential for a complete loss of the investment. Transparency regarding the lack of liquidity is a critical component of the disclosure process. Incorrect: SIPC does not protect investors against market losses or declines in the value of an investment; it only protects against the failure of a broker-dealer. Passive losses from a DPP can generally only be used to offset passive income, not active earned income like a salary. Finally, SEC registration does not imply that the commission approves of the investment, guarantees its safety, or verifies the accuracy of its financial projections. Takeaway: The primary regulatory concern with DPPs is their inherent illiquidity and the requirement that they only be recommended to investors who can financially withstand the lack of access to their capital.

Correct: A restrictive (or tight) monetary policy is implemented by the Federal Reserve to slow down an overheating economy and control inflation. This is achieved by increasing interest rates (such as the federal funds rate) and reducing the money supply through open market operations (selling securities). For a business like a REIT that relies on debt financing, this results in higher borrowing costs and potentially slower growth, which are critical factors in a risk assessment during onboarding. Incorrect: Purchasing government securities is a characteristic of expansionary (easy money) policy, which aims to increase the money supply, not restrict it. Reducing reserve requirements is also an expansionary tool that allows banks to lend more, which contradicts a restrictive policy stance. Finally, higher interest rates resulting from restrictive policy typically lead to a stronger U.S. dollar, not a weaker one, as international investors seek higher yields on dollar-denominated assets. Takeaway: The Federal Reserve utilizes restrictive monetary policy to curb inflation by increasing interest rates and reducing the money supply, which generally leads to higher borrowing costs for businesses and a slowdown in economic activity.

Correct: SIPC is a non-profit membership corporation that provides limited protection to customers in the event a broker-dealer fails. The coverage limit is $500,000 per separate customer, of which no more than $250,000 can be for cash. This is distinct from FDIC insurance, which covers traditional bank deposit accounts like savings and checking. Incorrect: SIPC does not protect against market loss or ‘bad’ investments; it only protects against the insolvency of the firm. The SEC is a regulatory body and does not provide insurance or guarantees on investment principal. The DTCC is a clearing and settlement facility and does not provide insurance coverage to individual retail investors for firm insolvency. Takeaway: SIPC provides limited protection against broker-dealer insolvency for both cash and securities, but it does not protect against market risk or investment losses.

Correct: MSRB Rule G-8 requires municipal securities dealers to maintain blotters or other records of original entry that contain an itemized daily record of all purchases and sales. These records must be kept chronologically and include specific details such as the transaction date, price, and par value. Ensuring these are recorded promptly and in order is the most critical preventive measure for maintaining the integrity of a firm’s financial and regulatory history. Incorrect: Retaining records for ten years is a storage policy that exceeds the standard three-to-six-year requirement but does not address the accuracy of the record-making process itself. Restricting ledger reviews to the CEO is an impractical internal control that ignores the role of the designated principal and does not ensure record accuracy. Limiting the recording of complaints based on a monetary threshold is a direct violation of Rule G-8, which requires a record of every written customer complaint regardless of the amount involved. Takeaway: MSRB Rule G-8 mandates the chronological and itemized recording of all municipal securities transactions in daily blotters to ensure a complete and transparent audit trail.

Correct: Exploratory programs, often referred to as wildcatting, involve drilling for oil or gas in areas where there is no proven record of production. These programs carry the highest level of risk because the likelihood of finding a commercially viable well is lower than in other programs. However, they offer the highest potential for capital appreciation and provide significant tax advantages through the immediate write-off of intangible drilling costs (IDCs) if the drilling is successful. Incorrect: Developmental programs are considered less risky than exploratory programs because they involve drilling in areas with proven reserves, typically near existing productive wells. Income programs are the most conservative oil and gas DPPs as they involve purchasing interests in already producing wells, focusing on immediate cash flow rather than drilling. Balanced programs attempt to mitigate risk by investing in a combination of both exploratory and developmental drilling projects. Takeaway: Exploratory oil and gas programs represent the highest risk and highest potential reward among drilling DPPs due to their focus on unproven territories.

Correct: Under the Bank Secrecy Act (BSA), financial institutions are required to file a Currency Transaction Report (CTR) for any currency transaction exceeding $10,000 in a single business day. This includes the aggregation of multiple smaller transactions if the bank has knowledge that they are by or on behalf of the same person and total more than $10,000. The report must be filed with the Financial Crimes Enforcement Network (FinCEN) within 15 calendar days of the transaction. Incorrect: The suggestion that only single transactions over $10,000 trigger a CTR is incorrect because the law requires aggregation of all cash transactions by the same individual in one business day. The claim that the SEC is the recipient of CTRs is incorrect, as they are filed with FinCEN. Furthermore, the 30-day and 60-day timeframes mentioned are incorrect for CTR filings, and branch location does not provide an exemption from the aggregation rule. Takeaway: Financial institutions must aggregate all cash transactions made by the same individual on a single business day and file a CTR with FinCEN within 15 days if the total exceeds $10,000.

Correct: Municipal fund securities, including 529 College Savings Plans, ABLE accounts, and Local Government Investment Pools (LGIPs), are issued by state or local government entities. While they function similarly to mutual funds, they are legally classified as municipal securities. As such, they are exempt from the Investment Company Act of 1940, but the MSRB establishes the rules for broker-dealers and municipal advisors who engage in transactions involving these securities. Incorrect: Classifying these as corporate equity is incorrect because they are issued by government entities, not private corporations. Treating them as municipal debt obligations like General Obligation bonds is incorrect because they represent an interest in a fund’s assets rather than a fixed debt promise backed by taxes or revenue. Stating they are exclusively regulated by FINRA is incorrect because the MSRB is the primary self-regulatory organization (SRO) that writes the rules for municipal securities, even though FINRA often handles the enforcement of those rules. Takeaway: Municipal fund securities are state-issued investment vehicles that are exempt from the Investment Company Act of 1940 but are regulated as municipal securities under MSRB jurisdiction.

Correct: The DTCC, through its subsidiaries like the National Securities Clearing Corporation (NSCC), provides clearing and netting services. Netting consolidates multiple buy and sell orders into a single net position for each participant. This process significantly reduces the volume of transactions and the amount of money that needs to be exchanged, which lowers operational risk and increases market efficiency. Incorrect: The DTCC does not guarantee investment performance, as market risk is borne by the investors. Auditing the financial statements of listed corporations is the responsibility of independent accounting firms under the oversight of the PCAOB and the SEC. Furthermore, the DTCC promotes the centralization of securities and the use of book-entry (electronic) records rather than maintaining a decentralized network of physical certificates in local vaults. Takeaway: The DTCC streamlines the settlement process by netting trades and providing centralized book-entry custody to mitigate systemic and operational risk.

Correct: The Options Clearing Corporation (OCC) is the issuer and guarantor of all listed options. By acting as the central counterparty to every trade, it effectively severs the direct link between the buyer and the seller. This ensures that if a holder chooses to exercise an option, the OCC guarantees the performance of the contract, even if the clearing member on the other side of the trade defaults. Incorrect: Market making is a function performed by participants on the exchange floor to provide liquidity, not by the clearing corporation. Suitability is a regulatory obligation of the broker-dealer and its registered representatives under FINRA rules. The registration of securities and oversight of the markets is the responsibility of the Securities and Exchange Commission (SEC), whereas the OCC is a clearing agency. Takeaway: The OCC provides market stability by acting as the common counterparty and guarantor for all standardized, listed options contracts.

Correct: To qualify as an accredited investor under SEC guidelines for private equity and other private placements, an individual must meet specific financial thresholds: an annual income of $200,000 (or $300,000 with a spouse) for the last two years with the expectation of the same in the current year, or a net worth exceeding $1 million, excluding the value of their primary residence. Incorrect: Professional certifications like a CPA or CFA do not automatically grant accredited status without meeting financial or specific professional role requirements. Frequent trading or a $500,000 account balance are not the legal standards for accreditation. A Qualified Institutional Buyer (QIB) refers to entities, not individuals, and requires a much higher asset threshold ($100 million) than the standard for an individual accredited investor. Takeaway: Accredited investor status for individuals is primarily determined by specific income or net worth thresholds defined by the SEC to ensure investors can bear the risk of private offerings.

Correct: Under FINRA Rule 3310, a broker-dealer’s AML program must include several core components, one of which is providing for independent testing of the program. This testing ensures the system is functioning as intended and must be conducted by personnel who are independent of the functions being tested or by a qualified third party. For most firms, this testing is required on an annual basis. Incorrect: Designating a Board member as the AML Compliance Officer is not a requirement; the firm must simply designate an individual to oversee the program and provide FINRA with their contact information. Firms are not required to submit their AML programs to the SEC or FINRA for prior approval, though the programs must be available for regulatory inspection. While ongoing training is required, there is no specific regulatory mandate that it must occur every six months; it is generally expected to be conducted annually or as needed based on changes in the law. Takeaway: A compliant AML program must include independent testing, a designated compliance officer, ongoing training, and internal controls to detect and report suspicious activity.

Correct: The ex-dividend date is the first date on which a security trades without the dividend attached. Under current T+1 settlement rules, the ex-dividend date is typically the same day as the record date. To be the owner of record and receive the dividend, an investor must purchase the stock at least one business day before the ex-dividend date. Since the client purchased the stock on the ex-dividend date, the trade will not settle until the day after the record date, meaning the seller remains the owner of record for that specific distribution. Incorrect: Option B is incorrect because the payable date is merely the date the company distributes the funds and does not determine eligibility. Option C is incorrect because it suggests a timeline that is logically reversed; purchasing after the record date never grants dividend rights for that period. Option D is incorrect because it relies on outdated T+2 settlement logic; under the current T+1 standard, the ex-dividend date and record date are generally the same day, and buying on that date does not grant the dividend. Takeaway: To receive a declared dividend, an investor must purchase the security before the ex-dividend date to ensure the trade settles by the record date.

Correct: 12b-1 fees are asset-based charges used to pay for marketing and distribution of mutual fund shares. Because these fees are deducted from fund assets, they represent a potential conflict of interest where the fund manager might prioritize asset growth over shareholder returns. To mitigate this, the Investment Company Act of 1940 requires that any 12b-1 plan be approved by the board of directors, specifically requiring a majority of the disinterested (independent) directors to conclude that the plan is likely to benefit the fund and its shareholders. Incorrect: The suggestion that 12b-1 fees are used for research is incorrect, as those are covered by investment management fees, not distribution fees. Waiving fees based on negative performance is not a regulatory requirement for 12b-1 plans. While Class C shares do have high 12b-1 fees, the law does not mandate their conversion to Class A shares as a mitigation strategy for the existence of a 12b-1 plan itself; rather, it focuses on board oversight and disclosure. Takeaway: 12b-1 fees are ongoing distribution costs that must be approved and monitored annually by a mutual fund’s independent directors to ensure they provide a legitimate benefit to the shareholders.

Correct: Exchange-Traded Notes (ETNs) are unsecured debt instruments issued by financial institutions. Unlike Exchange-Traded Funds (ETFs), which hold a basket of underlying assets (like stocks or commodities) in a separate trust, an ETN’s value is backed only by the creditworthiness of the issuer. Therefore, if the issuing bank’s credit rating is downgraded or the bank defaults, the investor may lose their principal even if the underlying index performs well. Incorrect: ETFs are typically registered under the Investment Company Act of 1940, while ETNs are debt securities and are not considered investment companies. Both ETFs and ETNs are traded on exchanges throughout the day, providing intraday liquidity, so end-of-day redemption is not a distinguishing factor. ETNs actually have a stated maturity date because they are debt obligations, whereas ETFs are generally open-ended and do not expire. Takeaway: The fundamental difference between an ETF and an ETN is that ETNs are debt instruments subject to the credit risk of the issuer, while ETFs represent an ownership interest in a pool of assets.