Conflicts, Criminal Activity and Other Prohibited Practices

Excessive trading, loans and sharing

Excessive trading. It is an unethical practice to induce trading in a customer's account which is excessive in size or frequency in view of the financial resources and character of the account. Note the test: excessive relative to this account, not excessive in the abstract. It is assessed with reference to turnover — purchases relative to average account equity — and the cost-to-equity ratio, the return the account would have to earn simply to cover its costs. Neither is a bright line; both are evidence. The federal counterpart is quantitative suitability under FINRA Rule 2111 and the care obligation under Regulation Best Interest, neither of which requires proving intent, and churning under the anti-fraud rules, which does.

Loans. For an agent, NASAA's statement of policy is categorical: engaging in the practice of lending or borrowing money or securities from a customer is a dishonest or unethical practice. The federal rule, FINRA Rule 3240, is narrower — it permits borrowing or lending where the firm has written procedures allowing it and the arrangement falls into a defined category, such as an immediate family member, a customer in the business of lending, or a personal relationship outside the broker-customer relationship, generally with notice and pre-approval. Where the two differ, the safe answer on this exam is the state one: an agent does not borrow from or lend to customers.

Sharing. It is unethical for an agent to share directly or indirectly in profits or losses in the account of any customer without the written authorization of the customer and the broker-dealer the agent represents. The state rule requires both authorizations and, unlike FINRA Rule 2150, does not by its terms require the sharing to be proportionate to the agent's financial contribution — the federal rule does. Know both, and note that guaranteeing a customer against loss is prohibited outright under either.

And the related prohibition: establishing or maintaining an account containing fictitious information in order to execute transactions that would otherwise be prohibited. A nominee account created to get around a restriction is a violation in itself.

Selling away and outside activity

It is an unethical practice for an agent to effect securities transactions not recorded on the regular books or records of the broker-dealer the agent represents, unless the transactions are authorized in writing by the broker-dealer prior to execution.

That is selling away, stated at the state level. The federal rule, FINRA Rule 3280, requires prior written notice of any securities transaction outside the regular course of employment, and where the agent will receive selling compensation, the firm's written approval, recording on its books and supervision as if the transaction were the firm's own.

Selling away is among the most common causes of an agent being barred, and it is frequently discovered only when the outside investment turns out to be a fraud. The customer's remedy then runs against the firm, which is why firms treat the notice requirement as absolute.

Outside business activities, under FINRA Rule 3270, require prior written notice before being employed by or accepting compensation from any other person, or acting as an independent contractor or sole proprietor. Notice, not permission — though the firm may impose conditions or prohibit the activity.

Outside securities accounts, under FINRA Rule 3210, require the employing member's prior written consent before establishing an account at another financial institution in which the associated person has a beneficial interest, and the executing firm must notify the employer and supply duplicate confirmations and statements on request. The reach extends to accounts held in another name in which the person has a beneficial interest.

All three exist for the same reason: a firm cannot supervise activity it does not know about.

Insider trading and manipulation

The elements of insider trading are on the study guide's testable list. There is no statutory definition; liability is built on the general anti-fraud provisions and two theories.

Under the classical theory, an insider — officer, director or employee — who trades on material non-public information breaches a duty to the shareholders on the other side of the trade.

Under the misappropriation theory, a person who takes confidential information from a source to whom they owe a duty and trades on it commits fraud on that source. This is the theory that reaches an agent who trades ahead of a client's order, or who uses information learned from an employer.

Tipping extends both: a tipper who discloses in breach of duty for a personal benefit is liable, and a tippee who trades knowing of the breach is liable too.

The three elements the exam looks for: material information, non-public information, and a breach of duty in trading on or communicating it. Material means a reasonable investor would consider it important; non-public means it has not been disseminated to the market generally.

Penalties under the Insider Trading and Securities Fraud Enforcement Act reach three times the profit gained or loss avoided, plus disgorgement, alongside criminal fines and imprisonment. Firms can be liable as controlling persons for failing to maintain and enforce adequate procedures.

Market manipulation is enumerated in the statement of policy as effecting any transaction in, or inducing the purchase or sale of, any security by means of a manipulative, deceptive or fraudulent device — including a wash trade involving no change in beneficial ownership; a matched order, entered knowing an offsetting order of substantially the same size, time and price has been or will be entered, for the purpose of creating a false appearance of active trading; and a series of transactions creating actual or apparent active trading or raising or depressing the price for the purpose of inducing others to buy or sell.

Spoofing and layering — entering orders with no intention of executing them to create a false impression of supply or demand — are the modern electronic forms of the same conduct and are named in NASAA's study guide.

Investment company shares and vulnerable adults

NASAA has a second statement of policy dealing specifically with dishonest or unethical business practices in connection with investment company shares, and it names the practices covered in the Series 7 course from the state side.

Breakpoint sales — recommending or effecting a purchase in an amount just below the point at which the sales charge is reduced, without disclosing the breakpoint.

Selling dividends — recommending a purchase shortly before an ex-dividend date on the basis that the customer will receive the distribution, when the effect is a taxable event and an equal drop in net asset value.

Switching — recommending a move between fund families that incurs a new sales charge without a documented basis for believing the new fund better suits the customer.

Misrepresenting a fund's charges, its performance, or the meaning of a rating or ranking.

And the model act on the other side of the relationship. NASAA's Model Act to Protect Vulnerable Adults from Financial Exploitation, adopted in 2016, allows a qualified individual at a firm who reasonably believes financial exploitation of an eligible adult has occurred, is occurring or is attempted to notify the state securities Administrator and adult protective services, to notify a third party previously designated by the customer, and to delay a disbursement from the account for a defined period subject to review and extension. Firms adopting it receive immunity for good-faith action taken under it.

The federal counterpart is FINRA Rule 2165, which permits a temporary hold on a disbursement from the account of a specified adult where financial exploitation is reasonably believed, and Rule 4512's trusted contact person is who the firm calls.

This is one of the few places in the whole regulatory scheme where a suspicion translates into a power to act rather than merely a duty to report, and it exists because financial exploitation of older customers is common, is usually committed by someone the customer knows, and is usually visible first to the person handling the account.

One closing point that ties the module together: the NASAA statement of policy ends by saying that the conduct set out in it is not inclusive, and that other conduct — forgery, embezzlement, nondisclosure, incomplete disclosure, misstatement of material facts, or manipulative or deceptive practices — is equally grounds for denial, suspension or revocation. The lists are illustrative, not exhaustive, and an exam question describing conduct that is plainly dishonest but not on any list is still describing a violation.