HOW THE FINANCIAL PLANNING INDUSTRY WORKS^©

Overview of Securities Side of the Financial Planning Industry:
Securities are investments which an investor purchases. Most do not have a guaranteed return (see the exception below with bonds). What the investor receives from the securities investment is completely subject to open market variables. Therefore the entire investment can potentially be lost. Securities for our purposes are: Publicly traded stocks, bonds and mutual funds. There are more exotic securities that this article will not detail such as: Puts, calls, options, futures, currencies, derivatives, commodities, etc.

Stocks.
Publicly traded stocks are fractional ownership interests in specific public, regulated companies. For example, an investor may purchase stock in a large public company like Microsoft or General Motors, or a much smaller public company like Zions Bank.

Mutual Funds.
Mutual fund companies are regulated organizations which purchase the stock of a number of different public companies. These stocks are pooled together in one fund. The mutual fund company, in turn, sells a fractional interest of the pool of stocks to investors. An example is Fidelity (the organization) Magellan Mutual Fund (the specific fund name). If an investor purchases Magellan, they buy an interest in the overall pool of stocks which the Magellan fund owns. The advantage of this investment approach is two fold: (i) Diversification, meaning the investor’s risk is spread among many companies, so that if one company goes bad the whole investment pool suffers only a fractional loss, usually only a few percent, and (ii) the fund is managed by professionals who are experts in picking stocks to buy and knowing when to sell a given stock.

Bonds.
Bonds are the sale of debt. A company or government (city, state or federal) sells a piece of paper to investors called a bond. The bonds are called either corporate or government, depending on whether they are sold by a corporation or a government agency. Bonds sold by the federal government are mostly sold by the U.S. Treasury Department, and are therefore called “treasury bonds” (also called T-bonds). The sale of a bond is actually a loan of money from the investor to the bond seller. The bond is a promise from the bond seller to repay the full investment principal, or loan, over a specified period of time, and to also pay a specified amount of interest at a fixed coupon rate. Bonds, then, differ from other securities in that their return, investment principal and interest, is usually guaranteed. Bonds are like other securities in that they are investments in a company or governmental unit which are sold by third party registered reps, working under a broker dealer.

Investors purchase securities because they have the highest potential to earn money. These earnings, called “returns”, while not at all guaranteed for stocks and mutual funds, over a period of decades have averaged significantly more than the investment returns which are guaranteed from life insurance or annuities, bonds, or from banking investments such as certificates of deposit and savings accounts.

Securities are sold by or through organizations known as “broker dealers”, which we will refer to as BD. BDs are regulated at the top by a federal agency known as the Securities and Exchange Commission, or SEC. Under that, BDs have their own regulatory association known as National Association of Securities Dealers, or NASD. The NASD is the BD industry’s own self policing organization. The NASD enforces upon the BDs the securities laws and rules created by Congress and the SEC. Normally the SEC doesn’t get involved with the internal workings of a BD, only the NASD does. But, if criminal or illegal activity is suspected, the SEC can step in at any time and investigate, punish, terminate, etc. any BD.

Every BD is required to be licensed before it may operate. The licenses are issued by the SEC first, and then additional licensing comes from the NASD. Further licensing is also required at the state level, for the state securities commission.

Some examples of BDs are: Merrill Lynch and Morgan Stanley for large BDs, and Brookstreet Securities Corporation and Securities America, Inc. for much smaller firms. Large BDs are often public corporations and their stock is publicly traded in one of the major stock market exchanges. The smaller firms are often referred to as “independent”. Their stock is privately held, not sold through a public stock exchange..

The individuals who actually make the sales for the BD are referred to by the public as brokers or stock brokers. Within the industry the sales people are referred to as: (i) Brokers, (ii) registered representatives or registered reps and, (iii) securities representatives or securities reps.

Registered reps must first obtain securities licensing, then they must affiliate with a BD (no college education is required to be a registered rep). This is much the same process as becoming a real estate agent and then affiliating with a real estate broker. To obtain a securities license requires taking an examination for the specific license being sought. The SEC doesn’t require any specific study process, but as a practical matter, study is required to become knowledgeable enough to pass an exam.

Registered reps must obtain different licenses to sell different types of securities and/or to perform certain specialized activities. For example, a series 6 license is required to sell mutual funds, and a series 7 is required to sell individual stocks.

Large BDs treat their reps much like the captive agents of the life insurance industry. These BDs will extensively limit and dictate what securities or investments the individual reps will sell, and the reps are severely limited in what non-BD activities they may engage in. As an example, a large BD might now allow its reps to use the NAFEP CEA® credential.

The smaller, independent BDs allow a much greater degree of flexibility among their reps. Generally speaking, the smaller, independent BDs do allow their reps the usage of the CEA®. In fact, many independent BDs actively encourage their reps to earn the CEA® designation. .

Registered reps, similar to life/annuity agents, are the BD’s network of independent sales agents. They are independent in the sense that they typically work on commissions only, and are not salaried employees of the BD. This independent relationship means that the reps can set their own hours, they work for themselves.

All broker dealers have a “compliance” department which is responsible for making sure the reps follow securities laws and rules. A great amount of a rep’s daily activity is subject to rules laid down in securities laws by Congress, the SEC, the NASD, state securities regulators and by the broker dealer. The broker dealer compliance department is the first line of defense in overseeing and regulating rep activities. Any serious violations which are not caught and appropriately handled by the compliance department are subject to investigation and punishment by the NASD, SEC or the state securities regulators. Broker dealers want to catch problems before they get to the regulators because the broker dealer can be punished and/or sued for failing to take action or failing to act appropriately.

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