Ethical Practices & Fiduciary Obligations

Fraud Provisions Under the USA

The anti-fraud provisions of the Uniform Securities Act are among the most important and most tested topics on the Series 66 exam. These provisions apply to all persons, all securities, and all transactions, regardless of whether the security, transaction, or person is exempt from registration. There is no exemption from the anti-fraud rules.

Section 501 of the USA (modeled on the federal securities laws) makes it 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 to make the statements made, in light of the circumstances under which they were made, not misleading
3. Engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person

These three prongs cover virtually every conceivable form of fraudulent conduct in connection with securities. The first prong addresses intentional schemes to defraud. The second addresses misrepresentations and material omissions. The third serves as a catch-all for any other conduct that operates as a fraud, even if it does not fit neatly into the first two categories.

Fraud by Investment Advisers

The USA contains a separate anti-fraud provision specifically targeting investment advisers. It is unlawful for any investment adviser or investment adviser representative to employ any device, scheme, or artifice to defraud a client or prospective client. It is also unlawful to engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative. The Administrator may define by rule specific acts and practices that are considered fraudulent, deceptive, or manipulative.

Common examples of adviser fraud include cherry-picking (allocating profitable trades to favored accounts), front-running (trading ahead of client orders), misrepresenting performance results, charging undisclosed fees, commingling client assets with personal assets, and failing to disclose conflicts of interest.

Prohibited Practices for BDs, Agents, IAs, and IARs

Beyond the general anti-fraud provisions, the USA and NASAA model rules identify specific practices that are prohibited for broker-dealers, agents, investment advisers, and investment adviser representatives. These prohibited practices are heavily tested on the Series 66 exam.

Prohibited Practices for Broker-Dealers and Agents

• Churning: Excessive trading in a client's account for the purpose of generating commissions rather than benefiting the client. Churning is determined by looking at the turnover rate, the cost-to-equity ratio, and whether the trading is consistent with the client's objectives.
• Unauthorized trading: Effecting transactions in a client's account without the client's prior authorization (unless the account has been granted discretionary authority in writing).
• Selling away: An agent conducting securities transactions outside the scope of their employment with a broker-dealer, without the firm's knowledge and approval.
• Sharing in customer accounts: An agent sharing in the profits or losses of a customer's account, unless the agent has obtained prior written authorization from both the customer and the broker-dealer, and the sharing is proportional to the agent's financial contribution.
• Guaranteeing against loss: Promising a customer that they will not lose money on a securities transaction. No guarantee of profits or guarantee against losses is permitted.
• Making unsuitable recommendations: Recommending a security or investment strategy without reasonable grounds for believing it is suitable for the customer based on the customer's financial situation, needs, and objectives.
• Front-running: Trading in a security for the firm's own account or a personal account ahead of a known customer order in the same security.
• Commingling: Mixing customer funds or securities with the firm's own funds or securities.
• Borrowing from or lending to customers: Unless the customer is a financial institution in the business of lending.

Prohibited Practices for Investment Advisers and IARs

• Misrepresenting qualifications or services: Claiming expertise, credentials, or capabilities that the adviser does not possess.
• Failing to disclose conflicts of interest: Not informing clients about financial interests, affiliations, or arrangements that could bias the adviser's recommendations.
• Providing misleading performance data: Presenting investment performance results in a manner that is false, misleading, or does not reflect actual results.
• Cherry-picking: Allocating profitable trades to favored accounts (such as the adviser's own account) while allocating less profitable or losing trades to other client accounts.
• Charging unreasonable fees: Imposing advisory fees that are excessive or not clearly disclosed to the client.
• Exercising discretion without authorization: Making investment decisions on behalf of a client without obtaining proper written discretionary authority.
• Assigning advisory contracts without consent: Transferring the advisory relationship to another adviser without the client's written consent.
• Taking custody without compliance: Holding client assets without meeting the applicable custody rule requirements.

Market Manipulation

Market manipulation refers to any conduct designed to artificially influence the price of a security or create a false or misleading appearance of active trading. Market manipulation is prohibited under both federal and state securities laws.

Common forms of market manipulation include:

• Wash trading: Simultaneously buying and selling the same security to create the illusion of active trading volume without any actual change in beneficial ownership.
• Matched orders: Coordinating buy and sell orders with another person at the same price and quantity, creating the appearance of legitimate trading activity.
• Painting the tape: Executing a series of transactions to create the appearance of active trading and attract other investors to the security.
• Marking the close: Executing trades near the end of the trading day at artificially high or low prices to manipulate the closing price of a security.
• Pump and dump: Artificially inflating the price of a security through false or misleading positive statements, then selling the security at the inflated price before the price declines.
• Bear raids: Coordinating short sales to drive down the price of a security, then buying back at the depressed price.

Disclosure Requirements and Compensation

Full and fair disclosure is a cornerstone of securities regulation. Both broker-dealers and investment advisers are required to disclose material information to their clients, including conflicts of interest, compensation arrangements, disciplinary history, and material facts about recommended investments.

Compensation Disclosure

All forms of compensation must be disclosed to clients. This includes commissions, markups and markdowns, advisory fees (fixed, hourly, or asset-based), performance fees, 12b-1 fees received from mutual funds, soft-dollar arrangements, referral fees, and any other economic benefit received in connection with providing services to the client.

For investment advisers, the Form ADV Part 2 brochure must include a detailed description of the adviser's fee schedule and compensation methods. For broker-dealers, trade confirmations must disclose the commission charged on agency transactions, and the markup or markdown on principal transactions must be reasonable and disclosed.

Soft-Dollar Arrangements

A soft-dollar arrangement exists when an investment adviser directs client brokerage transactions to a particular broker-dealer in exchange for research or other services. Under SEC guidance (Section 28(e) safe harbor), advisers may use soft dollars to pay for research reports, financial databases, market data services, and other items that constitute "research" or "brokerage" services. However, the adviser must disclose the arrangement to clients and must ensure that the brokerage commissions paid are reasonable in relation to the value of the research received.

Soft dollars may NOT be used to pay for general overhead expenses such as office rent, travel, entertainment, employee salaries, or computer hardware used for non-research purposes. Using soft dollars for non-research expenses is a violation of the adviser's fiduciary duty and disclosure obligations.