Avoid Rigid Thinking

The other day a customer wrote an email asking about debit and credit spreads. He had been working with another vendor's material and had someone thought that memorizing "right to buy" and "obligation to sell" was about all he had to do to get through this whole options thing. In my book, I explain that if you buy the ABC Oct 50 call and sell the ABC Oct 55 call, you have created a debit spread. Why? The right to buy stock at $50 is worth more than the right to buy it for $55.
Whoah--slam the brakes, shut the system down, this guy was not happy with that explanation. He was convinced that there WAS no right to buy stock at $55 since this guy SOLD that call. This is why rigid thinking can be so detrimental on the Series 7 exam. The little options quadrant that everyone learns is helpful in some cases, but--like the T-chart--has its limitations, too. I need you to accept this statement, everyone: a call option is the RIGHT TO BUY stock at a set price.
Period.
You can buy that right, sell that right, or just take a pass on the whole thing. Okay? Whatever the premiums are, somebody paid more for the right to buy ABC for $50 than anyone paid for the right to buy it for $55. This guy bought the more valuable call and sold the less valuable call. Debit to his account. More money went out than came in. On the other hand, if he buys an ABC Dec 40 call and sells an ABC Dec 30 call, he sells the more valuable option and, therefore, starts with a credit. Whatever the premiums are, the right to buy stock for $30 is worth more than the right to buy it for $40. He took in more money than he spent. A credit to his account; credit spread.
I know it's hard to see this without the premiums provided, but you have to learn how to do that for your exam. What really helped me see this concept was pulling up real-world quotes on options. You'll see calls on the left, puts on the right. And, you'll see that as strike prices drop, call premiums rise and put premiums fall. Until you can see that and understand it fully, options questions will likely seem like a major challenge when, in fact, they should be among the easiest questions you encounter at the test center.

Real-World DPPs

One of the most frustrating aspects of studying for the Series 7 is that most of the information is presented as if totally divorced from the so-called "real world." The term "DPP" or "direct participation program," for example is not something most people actually say in the day-to-day world. Usually, these investments would be called "partnerships" or "limited partnerships." The business is established as a limited partnership, and what your investor buys is a limited partnership (LP) interest. The GP is also the sponsor of the program, the one who puts it together and oversees the management of the business. The LPs provide capital and stay out of day-to-day management. In exchange for staying out of the management decisions, the LPs maintain limited liability in terms of lawsuits against the partnership. For the Series 7 we seem to only talk about limited partnerships involved with oil & natural gas or real estate. But many of you are sports fans, so it might help to remember that many pro sports teams are also limited partnerships. Here in Chicago, the Chicago White Sox are owned by Chicago White Sox Ltd, a limited partnership. The LPs are all high-net-worth investors, and while they can vote through "partnership democracy," they can not get involved with day-to-day management of the business. If the Sox want to trade a left-handed reliever for two triple-A outfielders, the LPs would have no say over that, for example. The LPs would get to inspect the books of the business, just as a shareholder of a corporation would get to. The General Partner (GP) runs the business and happens to be Jerry Reinsdorf. Turns out, Reinsdorf is also the chairman of the limited partnership that owns the Chicago Blackhawks and co-owns the United Center. I wish I could sell enough Pass the 7 full packages to buy into either of these partnerships, but, so far, I don't find myself traveling in these circles.

Municipal Securities Terminology

The key to ace-ing the questions on municipal securities is to know the vocabulary terms inside out and use what you know to do process-of-elimination with the answer choices. Luckily, the terms used in connection with municipal securities always mean exactly what they seem to mean. Except when they mean something different.
Seriously, the terms are usually pretty much what they sound like. For example, what would a "debt service coverage ratio" be? If you know that debt service is the interest and the part of the principal to be paid this year on the revenue bonds, you're half-way home. What would an "agreement among underwriters" be? If you know what underwriters are (syndicate members) and understand what they would care about--and not care about--you can figure out the answer. They don't care about the bond counsel, right? They care about the terms of syndicate operation, the participation of the members, the order priority, the spread, and the deadline for taking orders, etc. If you know that "primary" market = new issues and "secondary" market = trading, you can get a lot of questions right just from that.
Use the bold-letter terms in your textbook and the glossary--if it has one. But to really take it up a notch, use the MSRB's excellent glossary at www.msrb.org.

Can I get registered with FINRA if I have a felony conviction?

So, the post called "felonies and FINRA registration" has now grown to about 215 comments (half of them mine, of course). Who knew it was such a hot topic? Let's see what FINRA has to say about some of the quesitons I've been receiving.

Q: if a registered person is arrested but not charged with a crime, is the arrest required to be reported?
A: No. An arrest without a charge is not required to be reported.

Q: if a registered person is convicted of a crime and later pardoned, must the conviction continue to be reported? What if the conviction is set aside?
A: A person convicted of a crime and subsequently pardoned must continue to report the conviction. A pardon releases an individual from the punishment of the crime, but does not remove the conviction.

So, that comes close--but not quite--to answering the questions I keep getting from guys (it's always guys) who want to know if a conviction that is 'expunged' must be reported. Above FINRA uses the word "pardoned," which I don't think is the same thing as "expungement." But whether a conviction were pardoned or expunged, it appears that the CHARGE still has to be reported. FINRA gives me that clue with this statement, "Even if the conviction is not reportable, the charge may still be reportable." Don't you love the shades of gray they use? They then write, "Registered persons have an obligation to determine whether a criminal event is required to be reported through one or more questions under Item 14A or 14B."

Hmm . . . so I plan to talk to some more attorneys, but it appears my assumption so far is correct: even if you get a felony conviction expunged from your record, your truthful answer to the question of whether you were ever CHARGED with a felony is . . . YES.

Series 7 Study Materials

There are all kinds of Series 7 study materials out there. Of course, I'm somewhat partial to the ones I write and produce. But, other companies have good questions, too, and if you have them, use them.
If you are on a budget, I recommend getting the Pass the 7 textbook and the Pass the 7 ExamCram Online at www.passthe7.com/exams.htm (hit continue shopping, etc.).
If you're not on quite as tight a budget, get the full package at www.passthe7.com/fullpackage.htm. This includes the audio lectures on CD and the DVD set that you can watch on your TV, with the ability to pause, review, fast-forward, etc.
Either way, make sure you learn as many vocabulary terms as possible, and focus on understanding concepts/how things work. You don't get to memorize a bunch of bullet points and merely spit them back at the testing center--the exam forces you to prove you can apply the information you've learned in some pretty creative ways.
So, study hard, everybody. The Series 7 doesn't play.

Churning and Defrauding the Sisters

In case it wasn't intuitive for you, please know that churning customer accounts is, like, bad. The SEC and FINRA consider it to be a prohibited and fraudulent practice. The practice of buying and selling, buying and selling, puts the customer's account at risk without affecting the broker in any way other than generating excessive commissions. Heads-he wins, tails-he wins, and either way, the customer loses. A broker will end up generating so much in commissions that the account can't possibly make money.
Which, again, is bad.
Here's a link to an SEC notice that will remind us that while churning is bad, churning and ripping off a convent of nuns is probably even worse. Notice how he not only (allegedly) traded too frequently, but also gouged the sisters (allegedly) with high markups/markdowns.
Wow. As a non-Catholic I can't even guess how many hail mary's this guy will need to say each day for the rest of his life . . . ?
http://sec.gov/news/press/2011/2011-2.htm

What is a "private" company?

While tutoring a young man recently, I realized that not everyone is clear what the terms "public company" and "private company" mean. When studying for questions on issuing securities and the Securities Act of 1933, it would probably help to understand the fundamental concepts, so let's say a few quick words. A "privately held company" is simply a company that has not yet raised money from public investors. Virtually all companies start as private companies--picture Mr. Jobs and Mr. Wozniak in the garage back in the day. Successful private companies start out using their own savings and credit cards to fund operations then move up to lines of credit from the local bank and, eventually, perhaps funding from rich "venture capitalists" or "private equity groups." These multimillion-dollar and billion-dollar private equity/VC funds become owners of major stakes in these growing private companies. For example, maybe they give the next Groupon $5 million in exchange for 30% ownership. Eventually, these backers are going to want to cash in their investment, either by selling to another private company with deeper pockets or doing an IPO through investment bankers like Goldman, Merrill, etc. When they access the public markets, they suddenly have to disclose all kinds of things they used to keep, yes, private. For example, a business magazine can look up exactly how much revenue and net income a public company like Microsoft took in last year. For a private company, they would often have to estimate, since the owners aren't likely to share their private business with outsiders.
While some public companies are massive--WalMart, Microsoft, Apple, American Express--that does not mean that all public companies are either large or even profitable. It also does not mean that private companies are necessarily small. While reading Crain's Chicago Business yesterday, I read a list of the largest private companies in the area. Check out some of the familiar names on this list:

• CDW Corp.
• Ace Hardware Corp.
• True Value Co.
• Follett Corp (college textbooks)
• Solo Cup Co.
• Crate & Barrel
• Culligan International
• Nuveen Investments (closed-end funds, e.g.)
• Mesirow Financial Holdings

How much revenue do these companies make? Mesirow has the lowest among that group, which is still about $467 million a year! Another way to look at is that my office is about 100 yards from a privately held company called Ferrara Pan Candy Co. They make Lemonheads and other famous candies. They also did $322 million in revenue last year, making them only the 89th largest in the Chicago area . . . bigger than the Chicago Bears Football Club Inc. or Safeway Insurance.

Will these companies ever go public? Maybe. Or, maybe they don't need to and/or don't find it worth the hassle of filing registration and listing statements, quarterly and annual reports, etc. In any case, when we talk about "public companies," we simply mean those companies that have accessed the public markets by selling securities to finance their expansion. To make things a littler trickier, many public companies later get taken private again. For example, the Tribune Co. used to be a public company but is now the 10th largest private company in the area after Sam Zell, real estate mogul, put together a complex leveraged buyout. A "buyout" occurs when a group of private investors figures out a way to purchase the shares of a public company, often at a premium to their market price. For example, Zell's Equity Office Properties was a publicly traded REIT of which I owned a few shares . . . but was then taken private in a leveraged buyout.

Oh, I could go on, but this is probably enough excitement for one blog post.