The Traps in Section Four of the Exam: Definitions, Registration, Custody, Fees and Unethical Practices

Series 65 ethics questions come from the fourth section of the exam, Laws, Regulations and Guidelines, including Prohibition on Unethical Business Practices. It carries 30% of the exam, or 39 of the 130 scored questions, and it is where dense legal definitions catch candidates who read a general rule as an absolute one.

This guide covers the traps in that section, from the definitions in the Uniform Securities Act to registration, custody, fees and unethical practices, with practice questions at the end. It is part of FRC’s guide to Series 65 exam traps and common mistakes, which covers all four sections of the exam.

Preparing for your exam? Watch FRC’s Series 65 playlist on YouTube, with exam traps called out in every topic.

What Section Four Covers

The laws and ethics section tests the Uniform Securities Act, the model state law that most states have adopted in some form, alongside the federal securities laws. It also tests the ethical standards that apply to investment advisers, their representatives, broker-dealers and agents.

Questions fall into a few groups: who must register, how securities are registered or exempted, what the state Administrator can do, and which business practices are prohibited. Almost every trap in this section comes from mixing up two terms that sound alike or applying a rule to the wrong person.

Where to Start Your Preparation

This section rewards structured study more than any other, because the definitions build on each other. FRC’s Series 65 Exam Preparation course works through the Uniform Securities Act, registration and ethical practices in order, with the exam traps flagged as you go.

If you are also planning a broker-dealer career, the SIE Examination Preparation course covers the industry structure and federal laws that this section assumes you know. Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay your exam date.

The Four Persons Under the Uniform Securities Act

The Uniform Securities Act regulates four types of person: broker-dealers, agents, investment advisers and investment adviser representatives. A “person” in the law can be an individual or a business, which is the first trap, because agents and investment adviser representatives can only ever be individuals.

Trap 1: Exclusion Is Not Exemption

An exclusion means a person does not meet the legal definition at all, so the registration rules never apply to it. A bank, for example, is excluded from the definition of both a broker-dealer and an investment adviser.

An exemption means the person does meet the definition but is released from registration in certain circumstances. Questions often describe an excluded person and offer “exempt” as an answer, or the reverse, and the two words are not interchangeable on this exam.

Trap 2: The Incidental Advice Test

Lawyers, accountants, teachers and engineers are excluded from the definition of an investment adviser only when their advice is solely incidental to their profession. An accountant who mentions that a client could use a Roth IRA is not an adviser.

An accountant who charges a separate fee for portfolio recommendations, or holds themselves out as an investment adviser, has crossed the line. The trap is assuming the profession itself provides the exclusion, when it is the incidental nature of the advice that does.

Trap 3: Agents Are Always Individuals

Only an individual can be an agent or an investment adviser representative. A firm can be a broker-dealer or an investment adviser, but never an agent.

Clerical and administrative staff who do not take orders or give advice are not agents. Candidates who apply the agent label to a receptionist or a firm lose an easy mark.

Trap 4: State or SEC Registration for Advisers

An investment adviser with less than $100 million in assets under management generally registers with the states. Between $100 million and $110 million, it may choose SEC registration, and at $110 million it must register with the SEC as a federal covered adviser.

Once SEC-registered, an adviser does not have to switch back to the states unless its assets fall below $90 million. Federal covered advisers still file notice with the states where they do business and may pay state fees, but the states do not register them.

Trap 5: Representatives of Federal Covered Advisers

Even when the firm registers with the SEC, its investment adviser representatives register with the states. The test is where the representative has a place of business.

The trap is assuming that SEC registration of the firm covers its people. It does not, and this distinction is tested again and again.

Trap 6: The De Minimis Exemption

A state-registered investment adviser with no place of business in a state does not have to register there if, over the preceding 12 months, it has had fewer than six retail clients resident in that state. Advisers whose only clients in a state are institutions, such as banks and insurance companies, are also exempt.

Broker-dealers have no equivalent client-count exemption for retail customers. A broker-dealer with no place of business in a state can deal with institutions there, or with an existing client who is only temporarily in the state, but a new retail client requires registration.

Trap 7: Registration Rules Candidates Forget

Under the Uniform Securities Act, a registration generally becomes effective at noon on the 30th day after the application is filed, unless a proceeding is pending or the Administrator sets an earlier date. Registrations expire on December 31 each year unless renewed.

An agent’s registration is valid only while the agent is associated with a registered broker-dealer or issuer. When an agent leaves a firm, both the agent and the firm must notify the Administrator promptly.

Registering Securities

Trap 8: The Three Ways to Register a Security With a State

The Uniform Securities Act provides three methods of registering a security. Registration by coordination is used when the security is also being registered with the SEC under the Securities Act of 1933, and it becomes effective at the same time as the federal registration.

Registration by qualification is used when no other method is available, and it becomes effective when the Administrator orders it. Registration by notification, also called filing, is for established issuers with a record of operations and earnings.

The trap is mixing up coordination and qualification. If the question mentions a simultaneous SEC registration, the answer is coordination.

Trap 9: Federal Covered Securities

Federal covered securities, such as securities listed on major national exchanges, investment company securities registered under the Investment Company Act of 1940 and offerings under Rule 506 of Regulation D, do not register with the states. States may still require a notice filing and a fee.

Rule 504 offerings are not federal covered securities, which is a classic trap. FRC’s guide to Regulation D Rule 504 vs Rule 506 explains the difference.

Trap 10: Exempt Securities and Exempt Transactions

An exempt security is exempt because of what it is, such as a U.S. government or municipal security, a bank security or the stock of an insurance company. An exempt transaction is exempt because of how it is sold, such as an isolated nonissuer transaction, an unsolicited order or a sale to an institutional investor.

The insurance company exemption covers the company’s own stock, not the variable annuities it sells, which are securities. FRC’s guides to fixed vs variable annuities and control stock vs restricted stock cover two areas where the exam tests these exemptions.

Trap 11: Exempt Never Means Exempt From Fraud

An exempt security or transaction is excused from registration, never from the antifraud provisions. Fraud is prohibited in every securities transaction, whatever its registration status.

The same rule applies to federal covered advisers. The SEC registers them, but the state Administrator keeps the power to investigate and act against fraud within the state.

Running an Advisory Business

Trap 12: Custody and the Three-Business-Day Rule

An adviser has custody if it holds client funds or securities, or has the authority to obtain them, such as the power to withdraw money from a client’s account. Custody brings extra safeguards, including the use of qualified custodians, notice to the Administrator and higher financial requirements.

Under NASAA rules, an adviser that receives client funds or securities by mistake and returns them within three business days is generally not treated as having custody. The trap is assuming any contact with a client’s check creates custody, or that holding it for longer does not.

Trap 13: Net Worth and Bonding

Under NASAA’s model rules, a state-registered adviser with custody must generally maintain a minimum net worth of $35,000, and one with discretionary authority but no custody must maintain $10,000. An adviser with neither must keep a positive net worth.

An adviser that cannot meet these requirements may be able to post a surety bond instead. The trap is attaching these firm-level requirements to the individual representative.

Trap 14: Time and Price Discretion

When a client chooses the security, the quantity and whether to buy or sell, but leaves the timing and price to the professional, that is time and price discretion. It does not require written discretionary authority.

Full discretion over the asset, amount or action does require it. Under NASAA rules, an investment adviser must obtain written authority within 10 business days after the first discretionary transaction, while an agent of a broker-dealer needs written authority before exercising discretion.

Trap 15: Delivering the Brochure

State-registered advisers must deliver their disclosure brochure, Form ADV Part 2, before or at the time the advisory contract is signed. Under NASAA rules, if it is delivered less than 48 hours before signing, the client must be able to cancel the contract within five business days without penalty.

The trap is the timing. Remember 48 hours before signing, or five business days to cancel.

Trap 16: Advisory Contracts and Fees

Advisory contracts should be in writing and must not allow the adviser to assign the contract to another adviser without the client’s consent. If the adviser is a partnership, it must notify clients of any change in its membership.

Performance-based fees are generally prohibited, except with qualified clients who meet asset or net worth thresholds. The trap is an answer built on “never,” when the exception exists.

Ethical Duties and Unethical Practices

Trap 17: The Fiduciary Duty

Investment advisers owe their clients a fiduciary duty, meaning they must put the client’s interests first and disclose material conflicts of interest. Disclosure does not make an unsuitable recommendation acceptable.

FRC’s guides to what fiduciary means, fiduciary standard vs suitability standard and what conflicts of interest an investment adviser must disclose cover this duty in depth.

Trap 18: Which Hat Is the Professional Wearing?

Many professionals are dual registrants, acting as an agent of a broker-dealer in some transactions and as an investment adviser representative in others. The standard that applies depends on the capacity in which they are acting at the time.

When advice is given for an advisory fee, the fiduciary duty applies. FRC’s guide to FINRA Rule 2090 vs Rule 2111 covers the know-your-customer and suitability obligations on the broker-dealer side.

Trap 19: Prohibited Practices for Agents

Churning, which means excessive trading to generate commissions, is prohibited, and so is unauthorized trading. Selling away, where an agent sells securities that are not recorded on the firm’s books, is prohibited too.

An agent cannot guarantee a client against loss, though they can describe a security that carries an issuer or third-party guarantee of payment. Sharing in a client account’s profits or losses is prohibited unless the client consents in writing, the firm approves and the share is proportionate to the agent’s own contribution.

Trap 20: Borrowing From and Lending to Clients

Borrowing money or securities from clients is prohibited, except from clients in the business of lending, such as banks, or where the firm’s policies allow it for immediate family. The same applies to lending to clients, unless the firm is a broker-dealer making a margin loan.

The trap is an answer that allows a loan from a wealthy client who offers one. Wealth does not create an exception; being in the lending business does.

Trap 21: Fraud by Omission

Leaving out a material fact can be fraud, just as stating a false one can. Promoting a fund’s past performance without mentioning that the manager who produced it has left is a classic example.

Advertising that shows only winning recommendations while hiding losing ones is misleading for the same reason. On this exam, what a professional fails to say is judged as strictly as what they say.

The Administrator and Enforcement

Trap 22: What the Administrator Can and Cannot Do

The state Administrator can deny, suspend or revoke registrations, issue subpoenas, issue stop orders against securities registrations and issue cease-and-desist orders, in some cases without a prior hearing. It cannot issue an injunction or impose a prison sentence, because those powers belong to the courts.

Under the Uniform Securities Act of 1956, a willful violation can lead to criminal penalties of up to three years in prison, a $5,000 fine or both, but only a court can impose them. The trap is choosing an answer that gives the Administrator court powers.

Trap 23: Rescission Offers

A client who bought a security in violation of the Act may be able to recover what they paid, plus interest and legal costs, minus any income received. The seller can limit this liability by making a rescission offer.

If the buyer does not accept the offer within 30 days, they lose the right to sue. The trap is forgetting the 30-day window.

Trap 24: Form U4 and the Ten-Year Myth

Form U4 asks whether an individual has ever been convicted of, or charged with, a felony, so there is no time limit on disclosing a felony. The 10-year period candidates often remember is the look-back period for statutory disqualification, not for disclosure.

The trap is believing an old felony no longer needs to be reported. Failing to disclose it can itself lead to disciplinary action.

Practice Questions

Question one: a bank gives investment advice to its customers. Is the bank an investment adviser under the Uniform Securities Act? No, because banks are excluded from the definition.

Question two: an adviser with $105 million in assets under management wants to remain registered with its home state. Is that allowed? Yes, because advisers between $100 million and $110 million may choose either state or SEC registration.

Question three: a federal covered adviser opens an office in a new state, and one of its representatives works there. Who registers with the state? The representative registers with the state, while the firm makes a notice filing.

Question four: a client tells an adviser to buy 500 shares of a specific stock and leaves the timing to the adviser. Does the adviser need written discretionary authority? No, because this is time and price discretion.

Question five: an adviser receives a client’s stock certificate by mistake and returns it two business days later. Does the adviser have custody? Generally no, because it was returned within three business days.

Question six: can the state Administrator sentence an agent to prison for securities fraud? No, only a court can impose criminal penalties.

How to Study This Section

Learn the definitions first, because every other topic in the section depends on them. When you read a question, ask who the person is, what they are being asked to do and whether an exclusion or exemption applies, in that order.

Then build a short list of the numbers: $100 million, $110 million, $90 million, fewer than six clients, three business days, ten business days, 48 hours, five business days, 30 days and noon on the 30th day. Most near-miss answers in this section are built from those figures.

Where Section Four Fits With the Rest of the Exam

The laws and ethics section is one of four, and FRC’s main exam traps guide, linked at the top of this guide, covers the traps in economics, investment vehicles and client strategies too. Working through all four gives you a full picture of where marks are lost.

The FRC Series 65 playlist linked at the top of this guide pairs each topic with a video. The FRC dictionary is more than a dictionary, with explainer videos, written explanations and on-page quizzes covering the rules you are tested on.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65 alone or alongside the SIE and Series 7, structured preparation turns the law and ethics section from the one you fear into the one you rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply for roles, employers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

The laws and ethics section is 30% of the Series 65, and most of its traps come from a handful of definitions, thresholds and time limits. Learn who each rule applies to and the numbers behind it, and you take away the trap before the question is even written.

Pick the three traps in this guide you feel least sure about and test yourself on them today. Then move on to the next section, and repeat until every trap has become a mark you can count on.