Estimated study time: 50 minutes
Content:
FINRA and the SEC have established a comprehensive set of rules prohibiting specific sales practices and market conduct that would harm investors or market integrity. Knowing which practices are prohibited — and why — is essential for the SIE exam and for ethical industry conduct.
Churning is one of the most commonly tested prohibited practices. It occurs when a registered rep excessively trades a customer's account for the purpose of generating commissions, without regard to the customer's investment objectives. The key elements are excessive trading frequency and the motivation of generating commissions rather than serving the customer. Even if each individual trade was otherwise suitable, the overall pattern of excessive trading constitutes churning.
Unauthorized trading occurs when a rep executes transactions in a customer's account without prior authorization. In a non-discretionary account, the rep must obtain specific authorization from the customer for each trade (the specific security, quantity, price, and buy/sell direction). In a discretionary account (where the customer has given written authority to the rep to make trading decisions), the rep may trade without consulting the customer each time, but must still act in the customer's best interest.
Front-running occurs when a broker-dealer or registered rep executes orders for the firm's own account (or personal account) ahead of a large customer order, knowing the large order will move the market price. This is a form of market manipulation that profits at the customer's expense.
Insider trading — trading on material, nonpublic information — is illegal and heavily prosecuted by the SEC. "Material" means the information would likely affect a reasonable investor's decision. "Nonpublic" means it has not been broadly disseminated to the general investing public. Tippees (people who receive inside information from insiders) can also be liable if they know or should have known the information was obtained improperly.
Selling away is prohibited conduct in which a registered rep conducts securities business outside the scope of their relationship with their broker-dealer — selling investments without the firm's knowledge or approval. Registered reps may only conduct securities business through their member firm.
Misrepresentation and omission — making false statements or failing to disclose material facts in connection with the purchase or sale of securities — violates SEC Rule 10b-5, which is the primary anti-fraud rule in federal securities law. Puffery (vague optimistic statements) may not rise to the level of fraud, but specific false claims about a security's performance, risk, or characteristics clearly do.
Guarantees against loss are flatly prohibited. No registered rep or broker-dealer may promise or guarantee that a customer will not lose money on an investment, or guarantee a specific return. Such guarantees create a false sense of security and misrepresent investment risk.
Key Terms:
Quiz Questions:
Q1. A registered rep notices his customer's account has been traded 40 times in the past year, generating $8,000 in commissions on a $50,000 account. The customer is a 72-year-old retiree with a stated income objective. Which prohibited practice is most likely occurring?
A) Front-running B) Insider trading C) Churning D) Selling away
Answer: C — Churning is characterized by excessive trading frequency relative to account size and customer objectives, motivated by commission generation. A retiree with an income objective who has generated $8,000 in commissions on a $50,000 account (16% in commissions alone) in a single year is a classic churning scenario.
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Q2. A registered rep tells a prospective customer: "I guarantee you won't lose a single dollar on this investment — it's completely safe." This statement:
A) Is acceptable as long as the rep believes it to be true B) Is only prohibited if the investment actually loses money C) Is a prohibited guarantee against loss regardless of the rep's belief or the investment's actual performance D) Is acceptable if it appears in a written confirmation
Answer: C — Guarantees against loss are unconditionally prohibited. It doesn't matter whether the rep sincerely believes the investment is safe, whether it actually performs well, or whether the guarantee is oral or written. Guaranteeing a customer against loss misrepresents investment risk and violates FINRA rules.
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