Prohibited Activities

Insider Trading

Insider trading is one of the most heavily tested topics on the SIE exam and one of the most serious violations in the securities industry. It involves buying or selling securities based on material, nonpublic information (MNPI). The prohibition against insider trading is rooted in the principle that all investors should have equal access to information that could affect their investment decisions. When insiders use privileged information for personal gain, it undermines the integrity of the markets and erodes public confidence.

Material Nonpublic Information (MNPI)

To constitute insider trading, the information must be both material and nonpublic:

• Material: Information is considered material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. In other words, the information would likely affect the price of the security if it were made public. Examples of material information include earnings announcements (before release), merger and acquisition plans, significant changes in executive leadership, major new contracts or loss of clients, pending regulatory actions, changes in dividend policy, stock splits, FDA drug approvals or rejections, and significant litigation outcomes.
• Nonpublic: Information is nonpublic if it has not been disseminated to the general public through recognized channels such as press releases, SEC filings, or major news outlets. Information shared with a select group (such as analysts or institutional investors) before public release is still considered nonpublic. Information becomes public only after it has been broadly disseminated and the market has had sufficient time to absorb and react to it.

SEC Rule 10b-5

SEC Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934, is the primary anti-fraud provision used to prosecute insider trading. Rule 10b-5 makes it unlawful for any person, in connection with the purchase or sale of any security, to:

1. Employ any device, scheme, or artifice to defraud
2. Make any untrue statement of a material fact or omit a material fact necessary to make statements not misleading
3. Engage in any act, practice, or course of business that operates as a fraud or deceit upon any person

Rule 10b-5 is broad in scope and applies to all securities transactions, whether on exchanges or in OTC markets. It applies to any person, not just corporate insiders, officers, or directors. Anyone who trades on material nonpublic information can be prosecuted, including friends, family members, business associates, or even strangers who receive a tip.

Tipper / Tippee Liability

The tipper is the person who provides material nonpublic information to another person. The tippee is the person who receives the information. Both the tipper and the tippee can be liable for insider trading, even if the tipper does not personally trade on the information.

For tippee liability to attach, two conditions must generally be met: (1) the tipper must have breached a duty of trust or confidence by disclosing the information, and (2) the tipper must have received a personal benefit (which can be tangible, such as money, or intangible, such as maintaining a friendship or enhancing reputation) from the disclosure. Importantly, if the tippee passes the information to yet another person (a "remote tippee"), that chain of liability can extend indefinitely as long as the downstream tippee knows or should know that the information originated from a breach of duty.

Penalties for Insider Trading

The penalties for insider trading are severe and can be both civil and criminal:

• Civil Penalties: The SEC can seek disgorgement (return) of all profits gained or losses avoided, plus a civil penalty of up to three times the profit gained or loss avoided (the "treble damages" penalty under the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988).
• Criminal Penalties (Individuals): Up to $5,000,000 in fines and up to 20 years in federal prison.
• Criminal Penalties (Entities): Corporations and other entities face fines of up to $25,000,000.
• Supervisory Liability: Firms and supervisors who fail to establish, maintain, and enforce adequate policies and procedures to prevent insider trading may also face penalties under the "controlling person" provisions.

Information Barriers (Chinese Walls)

Broker-dealer firms implement information barriers (historically called "Chinese walls") to prevent the flow of material nonpublic information between departments. For example, the investment banking department may have knowledge of a pending merger (MNPI), while the trading desk and research analysts should not have access to that information. Information barriers include physical separation of departments, restricted access to files and computer systems, and compliance monitoring of employee trading. FINRA requires firms to establish and maintain written supervisory procedures that include information barrier policies.

Market Manipulation

Market manipulation refers to intentional conduct designed to artificially influence the price or trading volume of a security, thereby deceiving investors and distorting the normal functioning of the markets. Market manipulation is prohibited under Section 9(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The SIE exam tests your ability to identify various forms of manipulation.

Wash Trading

Wash trading involves simultaneously buying and selling the same security to create the appearance of active trading without any actual change in ownership. The purpose is to generate misleading volume and make the security appear more actively traded than it actually is, which can attract other investors. For example, a trader who simultaneously places a buy order and a sell order for the same stock at the same price through different accounts is engaged in wash trading. Wash trading creates no genuine economic activity and is illegal under Section 9(a)(1) of the Exchange Act.

Painting the Tape

Painting the tape occurs when two or more parties collude to execute a series of transactions in a security that are reported on the consolidated tape, creating the appearance of active trading. Unlike wash trading (which can be done by a single person using multiple accounts), painting the tape involves collusion between multiple parties. The goal is the same: to create a false impression of market interest and activity to lure other investors into trading the security.

Marking the Close

Marking the close involves executing trades near the end of the trading day to influence the closing price of a security. Because closing prices are used as benchmarks for portfolio valuations, derivative settlements, index calculations, and margin requirements, artificially inflating or deflating the closing price can benefit manipulators in various ways. For example, a fund manager might buy large quantities of a stock just before the market close to inflate the closing price and make their portfolio's performance appear better. This is especially harmful at quarter-end or year-end when performance reporting occurs.

Pump and Dump

Pump and dump is a scheme in which a person or group acquires shares of a stock (usually a thinly traded, low-priced security), then promotes the stock aggressively through false or misleading statements to inflate the price (the "pump"). Once the price has risen, the manipulators sell their shares at the inflated price (the "dump"), causing the price to collapse and leaving other investors with significant losses. Pump and dump schemes often target micro-cap and penny stocks and use channels such as online message boards, social media, spam emails, and bogus newsletters.

Spoofing and Layering

Spoofing (also called "phantom orders") involves placing large orders with the intent to cancel them before execution. The purpose is to create a false impression of supply or demand, tricking other traders into buying or selling at prices influenced by the deceptive orders. Layering is a more sophisticated form of spoofing where multiple orders are placed at various price levels on one side of the order book, then canceled after the manipulator's real order on the opposite side is filled. Spoofing was explicitly prohibited by the Dodd-Frank Act of 2010 and carries both civil and criminal penalties.

Front-Running

Front-running occurs when a broker-dealer or its associated person trades in a security ahead of a customer's large order to benefit from the anticipated price movement. For example, if a registered representative learns that a large institutional client is about to place an order to buy 500,000 shares of a stock (which would likely push the price up), and the rep buys the stock for their personal account before entering the client's order, that is front-running. Front-running is a violation of the broker-dealer's fiduciary duty to its client and is prohibited by FINRA rules.

Customer Account Violations

In addition to insider trading and market manipulation, the securities industry prohibits a range of conduct that violates the trust between broker-dealers and their customers. These violations involve the misuse of customer accounts, excessive activity, and inappropriate financial relationships with clients. The SIE exam frequently tests your ability to identify these prohibited practices.

Churning (Excessive Trading)

Churning occurs when a registered representative engages in excessive trading in a customer's account primarily to generate commissions, with little regard for the customer's investment objectives. Churning requires three elements: (1) the representative has control over the account (either express discretionary authority or de facto control through influence), (2) the trading is excessive in light of the customer's investment profile, and (3) the representative acted with intent to defraud or with reckless disregard for the customer's interests.

Regulators evaluate potential churning using quantitative measures such as the turnover ratio (how many times the account's assets are traded in a year) and the cost-to-equity ratio (the annualized cost of trading as a percentage of the account's average equity). A turnover ratio of 6 or more or a cost-to-equity ratio above 20% may suggest excessive trading, though these are not rigid thresholds.

Unauthorized Trading

Unauthorized trading occurs when a registered representative executes transactions in a customer's account without the customer's prior knowledge or approval. Every trade must be authorized by the customer unless the account has been granted discretionary authority through a written power of attorney on file with the firm. Even with discretionary authority, trades must be suitable for the customer and consistent with their investment objectives.

Merely having a close relationship with a customer does not constitute authorization. A verbal instruction to "do what you think is best" is insufficient for discretionary trading unless formal written authorization is in place. Without discretionary authority, the registered representative must contact the customer and receive approval before every trade.

Selling Away

Selling away (also called "private securities transactions") occurs when a registered representative participates in securities transactions outside the scope of their employment with their broker-dealer firm. FINRA Rule 3280 requires that all associated persons provide written notice to their firm before participating in any private securities transactions. If the representative will receive compensation (selling compensation), the firm must approve the activity and supervise it as if it were the firm's own business. Selling away without firm approval is a serious violation that can result in suspension or termination of registration.

Borrowing From or Lending to Customers

FINRA Rule 3240 restricts registered representatives from borrowing money from or lending money to customers. Such arrangements create conflicts of interest and can lead to exploitation of the customer relationship. Borrowing or lending is permitted only under specific circumstances:

• The customer is a member of the representative's immediate family
• The customer is a financial institution that makes loans in the ordinary course of business
• Both parties are registered persons with the same firm
• The arrangement is based on a personal relationship (outside the broker-customer relationship)
• The arrangement is based on a business relationship (outside the broker-customer relationship)

Even in permitted circumstances, the firm's written supervisory procedures must allow it, and pre-approval from the firm may be required.

Sharing in Customer Accounts

FINRA Rule 3110 restricts registered representatives from sharing in the profits or losses of a customer's account. Sharing is permitted only if: (1) the representative obtains written permission from the firm, (2) the customer provides written authorization, and (3) the representative shares in proportion to their financial contribution to the account. An exception exists for accounts of immediate family members, where disproportionate sharing may be permitted with firm approval.

Excessive Markups and Markdowns

When a broker-dealer acts as a principal (trading from its own inventory), it charges a markup (on sales to customers) or markdown (on purchases from customers) instead of a commission. FINRA's 5% Policy provides guidance that markups and markdowns should generally not exceed 5% of the prevailing market price. This is a guideline, not an absolute rule. Factors considered include the type of security, its availability, the size of the transaction, and prevailing market conditions. Charging excessive markups is considered a violation of fair dealing and can result in disciplinary action.

Anti-Money Laundering (AML)

Anti-money laundering (AML) regulations are a critical compliance area for all broker-dealer firms and a frequently tested topic on the SIE exam. Money laundering is the process of making illegally obtained money appear legitimate by passing it through complex financial transactions. The securities industry, with its high transaction volumes and complex products, is a potential target for money launderers.

The Bank Secrecy Act (BSA)

The Bank Secrecy Act (BSA) of 1970 is the foundational U.S. anti-money laundering law. It requires financial institutions to assist government agencies in detecting and preventing money laundering by maintaining records and filing reports on certain financial transactions. The BSA is administered by the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury.

The USA PATRIOT Act of 2001 significantly expanded the BSA's requirements following the September 11 attacks. It imposed additional obligations on financial institutions, including broker-dealers, to establish comprehensive AML programs and implement Customer Identification Programs (CIPs).

Customer Identification Program (CIP)

Every broker-dealer must establish a Customer Identification Program (CIP) as part of its AML program. The CIP requires the firm to collect and verify identifying information for each customer who opens an account. At a minimum, the following information must be obtained:

• Name
• Date of birth (for individuals)
• Address (residential or business)
• Identification number (Social Security Number for U.S. persons; passport number and country of issuance, or other government-issued ID for non-U.S. persons)

The firm must verify the customer's identity using documentary methods (government-issued photo ID, passport, driver's license) or non-documentary methods (checking credit bureaus, public databases) within a reasonable time after the account is opened. The firm must also check the customer's name against the OFAC (Office of Foreign Assets Control) list of Specially Designated Nationals and Blocked Persons.

Suspicious Activity Reports (SARs)

Broker-dealers must file a Suspicious Activity Report (SAR) with FinCEN when they detect transactions that they know, suspect, or have reason to suspect involve funds derived from illegal activity, are designed to evade BSA reporting requirements, lack a lawful purpose, or involve the use of the firm to facilitate criminal activity. Key SAR requirements include:

• SARs must be filed for transactions of $5,000 or more that the firm suspects are suspicious
• SARs must be filed within 30 calendar days of the initial detection of suspicious activity (may be extended to 60 days if no suspect is identified)
• The filing of a SAR is confidential: the firm must NOT notify the customer or any other person that a SAR has been filed (this is called "tipping off" and is itself a violation)
• SARs must be retained for 5 years from the date of filing

Currency Transaction Reports (CTRs)

A Currency Transaction Report (CTR) must be filed with FinCEN for any cash transaction exceeding $10,000 conducted in a single day. "Cash" refers to physical currency (coins and paper bills), not checks, wire transfers, or electronic payments. Multiple cash transactions by the same person totaling more than $10,000 in a single day must also be reported. CTRs are filed on FinCEN Form 104.

Structuring (also called "smurfing") is the deliberate breaking up of cash transactions into smaller amounts to avoid the $10,000 CTR threshold. For example, depositing $9,500 on Monday and $9,500 on Tuesday instead of $19,000 at once. Structuring is a federal crime, even if the underlying funds are from legitimate sources.

OFAC Compliance

The Office of Foreign Assets Control (OFAC), a division of the U.S. Department of the Treasury, administers economic sanctions programs against targeted countries, groups, and individuals. Broker-dealers must screen all customers and transactions against the OFAC list of Specially Designated Nationals (SDN) and blocked persons. If a match is found, the firm must block (freeze) the assets and report to OFAC within 10 business days. OFAC violations carry severe penalties, including fines of up to $20 million and criminal penalties of up to 30 years imprisonment for willful violations.

AML Program Requirements

FINRA Rule 3310 requires every member firm to develop and implement an AML compliance program that includes:

• Written policies and procedures reasonably designed to detect and report suspicious activity
• Designation of an AML Compliance Officer (AMLCO) responsible for day-to-day oversight
• Ongoing employee training on AML policies and red flags
• An independent audit (or testing) of the AML program to assess its effectiveness
• A Customer Identification Program (CIP) to verify the identity of new customers

The AML program must be approved in writing by a senior member of the firm's management and must be reviewed and updated regularly as regulatory requirements and risk factors evolve.