Business Practices & Prohibited Activities

Ethical Standards in the Securities Industry

The Uniform Securities Act establishes comprehensive ethical standards for all persons engaged in the securities business. These standards are designed to protect investors from fraud, deception, and unfair practices. The USA's anti-fraud provisions apply to every person involved in the offer, sale, or purchase of securities, regardless of whether the security or transaction is exempt from registration.

Section 101 of the USA states that it is unlawful for any person, in connection with the offer, sale, or purchase of any security, directly or indirectly, to:

1. Employ any device, scheme, or artifice to defraud
2. Make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading
3. Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person

These provisions mirror the federal anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. They are intentionally broad to capture any form of deceptive or manipulative conduct, whether the conduct involves outright lies, misleading half-truths, or sophisticated schemes designed to exploit investors.

Prohibited Practices for Broker-Dealers and Agents

Beyond the general anti-fraud provisions, the USA and NASAA model rules identify specific practices that are prohibited. These practices represent the most common and harmful forms of misconduct in the securities industry. Understanding them is critical for the Series 63 exam, which devotes approximately 20% of its questions to this topic.

Churning

Churning is the practice of excessive trading in a customer's account for the purpose of generating commissions for the broker-dealer or agent, rather than to benefit the customer. Churning is one of the most serious forms of broker misconduct because it directly harms the customer through unnecessary transaction costs while enriching the broker.

Factors considered in determining whether churning has occurred include:

• The turnover rate of the account (how frequently the entire portfolio is replaced through trading)
• The cost-to-equity ratio (the total commission and trading costs relative to the account's equity)
• The customer's investment objectives (conservative investors should not have high turnover)
• Whether the broker-dealer or agent has control over the account (churning typically requires that the broker exercises some degree of control over trading decisions)

Unauthorized Trading

Unauthorized trading occurs when an agent executes transactions in a customer's account without the customer's prior authorization. Unless the customer has granted the agent discretionary authority (the power to make trading decisions without consulting the customer for each trade), every transaction requires the customer's express consent before execution.

Discretionary authority must be granted in writing and must be accepted by the broker-dealer. Even with discretionary authority, the broker-dealer is still obligated to ensure that all transactions are suitable for the customer and are not excessive.

Selling Away

Selling away occurs when an agent conducts securities transactions outside the scope of the agent's employment with the broker-dealer, typically by selling private investments or unregistered securities without the knowledge or approval of the broker-dealer. This practice is prohibited because it deprives the customer of the protections provided by the broker-dealer's supervisory and compliance systems.

All securities activities by an agent must be conducted through the broker-dealer, on the broker-dealer's books, and under the broker-dealer's supervision. An agent who participates in a private securities transaction without notifying the broker-dealer is violating both state law and FINRA rules.

Commingling

Commingling is the practice of mixing a customer's funds or securities with the agent's, the broker-dealer's, or another customer's funds or securities. This is strictly prohibited because it makes it difficult to identify and protect individual customer property, and it creates opportunities for misappropriation.

Customer funds and securities must always be kept separate from the firm's proprietary assets. When a broker-dealer holds customer assets, they must be clearly identified and segregated. Commingling is a form of misuse of customer property and is grounds for disciplinary action.

Guaranteeing Against Loss

It is unlawful for a broker-dealer, agent, investment adviser, or IAR to guarantee a customer against loss in connection with any securities transaction. This prohibition exists because no one can eliminate investment risk, and a guarantee creates a false sense of security that may lead the customer to take on inappropriate risk.

Examples of prohibited guarantees include:

• Promising a customer that a specific investment will not lose value
• Agreeing to reimburse a customer for any losses in the account
• Promising a specific rate of return on an investment (unless the security itself guarantees a return, such as a government bond)

Sharing in Client Accounts

An agent may not share in the profits or losses of a customer's account unless all of the following conditions are met:

1. The customer has given prior written authorization
2. The broker-dealer has approved the arrangement in writing
3. The agent shares in proportion to the agent's financial contribution to the account

The proportional sharing requirement means that if an agent contributes 20% of the account's funds, the agent can only share in 20% of the profits or losses. An exception exists for accounts held by members of the agent's immediate family (spouse, parent, child), where disproportionate sharing is permitted with the customer's and firm's written consent.

Borrowing from or Lending to Clients

Agents and IARs generally may not borrow money from or lend money to clients. This prohibition prevents conflicts of interest and protects clients from exploitation. If the client is a lending institution (such as a bank), borrowing may be permissible under normal commercial terms. Some firms permit lending and borrowing between agents and clients under strictly defined circumstances, but this is highly regulated and requires firm approval.

Excessive Markups and Commissions

Broker-dealers and agents must not charge excessive markups, markdowns, or commissions on securities transactions. What constitutes "excessive" depends on the type of security, the size of the transaction, the market conditions, and the services provided. As a general guideline, FINRA considers a markup of more than 5% to be presumptively unfair (the "5% markup policy"), though this is a guideline, not a rigid rule.

The prohibition on excessive compensation applies to all types of transactions, including principal transactions (where the firm buys from or sells to the customer from its own inventory), agency transactions (where the firm acts as a middleman and charges a commission), and advisory fee arrangements.

Front-Running

Front-running occurs when a broker-dealer or agent places a personal or proprietary trade ahead of a known customer order that is likely to move the price of the security. For example, if an agent knows that a large customer is about to place a buy order for 100,000 shares of XYZ stock (which will likely push the price up), and the agent first buys XYZ for their own account, the agent has engaged in front-running.

Front-running is a form of market manipulation because the agent is exploiting advance knowledge of customer orders for personal gain. It is prohibited under both state and federal law and can result in severe penalties.

Insider Trading

Insider trading involves buying or selling securities based on material, non-public information (MNPI). Material information is any information that a reasonable investor would consider important in making an investment decision. Non-public information is information that has not been disseminated to the general public through normal channels.

Under the USA and federal securities law, it is illegal to:

• Trade securities while in possession of MNPI
• Communicate ("tip") MNPI to others who then trade on it
• Trade on information received from an insider (the "tippee" is also liable)

Fiduciary Duty for Investment Advisers

Investment advisers owe a fiduciary duty to their clients. This is the highest standard of care recognized in law. A fiduciary must act in the best interest of the client, placing the client's interests above the adviser's own interests at all times. This duty is derived from both the Uniform Securities Act and the federal Investment Advisers Act of 1940.

Components of Fiduciary Duty

The fiduciary duty encompasses several specific obligations:

1. Duty of Loyalty: The adviser must put the client's interests first. This means the adviser cannot favor its own interests (or those of the firm) over the client's interests. If a conflict of interest exists, the adviser must disclose it fully and manage it appropriately. The adviser should not engage in transactions that benefit the adviser at the client's expense.
2. Duty of Care: The adviser must provide advice that is suitable for the client's individual circumstances, including the client's financial situation, investment objectives, risk tolerance, time horizon, liquidity needs, and other relevant factors. The adviser must conduct a reasonable inquiry into these factors before making recommendations.
3. Duty of Good Faith: The adviser must act honestly and in good faith in all dealings with the client. This includes providing accurate information, not engaging in deceptive practices, and honoring commitments made to the client.
4. Duty to Disclose: The adviser must make full and fair disclosure of all material facts, including conflicts of interest, the adviser's compensation arrangements, any disciplinary history, and any other information that a reasonable client would want to know. Disclosure must be clear, specific, and delivered in a timely manner.
5. Duty to Seek Best Execution: When executing trades for clients, the adviser must seek the most favorable terms reasonably available under the circumstances. This does not necessarily mean the lowest commission; it includes factors such as execution speed, market access, reliability, and the overall value of the transaction.

Broker-Dealer Standard of Care

The standard of care for broker-dealers and their agents differs from the fiduciary standard applicable to investment advisers. Broker-dealers are generally held to a suitability standard: they must have a reasonable basis for believing that a recommended transaction or investment strategy is suitable for the customer based on the customer's investment profile.

Under FINRA's Regulation Best Interest (Reg BI), broker-dealers must also act in the customer's best interest at the time of the recommendation, but this standard is not identical to the full fiduciary duty that applies to investment advisers. Reg BI requires broker-dealers to disclose conflicts of interest, exercise reasonable diligence and care, and mitigate conflicts but does not impose the ongoing duty of loyalty that a fiduciary relationship requires.

Suitability Requirements and Disclosure Obligations

Suitability

Under the USA and NASAA model rules, broker-dealers, agents, investment advisers, and IARs must make suitable recommendations to their customers and clients. A recommendation is suitable if it is consistent with the customer's stated investment objectives, financial situation, risk tolerance, time horizon, liquidity needs, tax status, and any other relevant characteristics of the customer's investment profile.

There are three components of the suitability obligation:

1. Reasonable-basis suitability: The securities professional must have a reasonable basis for believing the recommendation is suitable for at least some investors, based on adequate research and due diligence.
2. Customer-specific suitability: The securities professional must have a reasonable basis for believing the recommendation is suitable for the specific customer, based on the customer's investment profile.
3. Quantitative suitability: Even if each individual transaction is suitable, the overall pattern of transactions must not be excessive in light of the customer's profile. This component addresses churning.

Disclosure Obligations

Securities professionals have extensive disclosure obligations to their customers and clients. These obligations include:

• Material facts about the security: All material information about the security being recommended, including risks, costs, and any limitations.
• Conflicts of interest: Any financial or personal interest the agent, BD, IA, or IAR has in the transaction, including whether the firm is acting as principal or agent, whether the firm has a market-making position, and any referral fees or revenue sharing arrangements.
• Compensation: How the securities professional is compensated, including commissions, markups, advisory fees, 12b-1 fees, revenue sharing, or any other form of compensation.
• Risks: The risks associated with the investment, including the risk of loss, liquidity risk, and any specific risks unique to the product (e.g., call risk for bonds, currency risk for international investments).
• Financial condition of the firm: If the broker-dealer's financial condition is precarious or could materially impair its ability to meet commitments to customers, this must be disclosed.

Compensation Disclosure

NASAA model rules require that all forms of compensation be clearly disclosed to clients. This includes:

• Direct compensation: Commissions, advisory fees, markups, and markdowns
• Indirect compensation: Soft-dollar arrangements (receiving research services in exchange for directing brokerage business), 12b-1 fees, revenue sharing payments from mutual fund companies, referral fees from other firms
• Third-party compensation: Any payments received from third parties in connection with transactions for the customer (e.g., a BD receiving payment for order flow from a market maker)