Required Disclosures on Specific Transactions

Now that you understand the risks and returns of investments, the next question is: what must be disclosed to customers? Broker-dealers and representatives have an obligation to ensure customers have the information they need to make informed decisions.

Material Aspects of Investments

• Representatives must disclose all material facts about a security or transaction that could affect the customer's investment decision
• Material information includes:
  • Risks associated with the investment
  • Fees and expenses
  • Conflicts of interest
  • Liquidity limitations
  • Relevant financial condition of the issuer
• Failure to disclose material information can constitute fraud under the Securities Exchange Act of 1934 (Rule 10b-5)
• The standard is whether a reasonable investor would consider the information important in making a decision

Key Point: If a fact could influence an investor's decision, it is material and must be disclosed.

Statement of Additional Information (SAI)

• The SAI is Part B of the mutual fund registration statement (the prospectus is Part A)
• Contains detailed information not in the summary prospectus:
  • Financial statements
  • Portfolio holdings
  • Management details and compensation
  • Fund policies
  • Tax information
• Not automatically delivered to investors; must be provided upon request at no charge
• The prospectus must reference the SAI's availability

Exam Tip: Gotchas

• The SAI is NOT the prospectus. It supplements the prospectus with more detailed information. The key distinction: the prospectus IS delivered to investors; the SAI is only delivered upon request.

Material Events

• Issuers and broker-dealers must promptly disclose material events that could affect the value of a security
• Examples of material events:
  • Mergers and acquisitions
  • Changes in management
  • Restatement of financials
  • Default or credit downgrade
  • Regulatory actions
  • Bankruptcy or restructuring

Municipal Securities Continuing Disclosure

• For municipal securities, issuers must file continuing disclosure under SEC Rule 15c2-12
• Annual financial information and material event notices are filed via EMMA (Electronic Municipal Market Access), the MSRB's centralized disclosure system
• Material event notices include:
  • Principal and interest payment delinquencies
  • Rating changes
  • Defeasances
  • Unscheduled draws on reserves
  • Bond calls and tender offers

Exam Tip: Gotchas

• EMMA is the MSRB's system, not the SEC's. Municipal continuing disclosure filings go through EMMA.
• Failure to disclose material events can constitute fraud under Rule 10b-5.

Control Relationships

• A broker-dealer must disclose if it has a control relationship with the issuer of a security being recommended or sold
• Control means the power to direct or influence the management or policies of the issuer
• Examples:
  • The broker-dealer is an affiliate of the issuer
  • A principal of the firm sits on the issuer's board
  • The issuer and broker-dealer share common ownership
• This disclosure must be made before or at the time of the transaction
• Required under FINRA Rules to ensure the customer is aware of potential conflicts of interest

Exam Tip: Gotchas

• A broker-dealer selling securities of a company it controls (or is controlled by) must disclose this relationship. The timing is critical: disclose BEFORE or at the time of the transaction, not after.
• Material information is judged by the "reasonable investor" standard. If a reasonable investor would consider the information important, it must be disclosed.