Prohibited Activities in Securities Trading: Understanding FINRA and SEC Regulations

19.3 Prohibited Activities

Understanding prohibited activities in the securities industry is crucial for maintaining ethical standards and compliance with regulatory requirements. The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) have established clear guidelines to prevent unethical and illegal practices. As an aspiring General Securities Representative, you must be familiar with these regulations to ensure you uphold the integrity of the financial markets and protect investors.

Overview of Prohibited Activities

Prohibited activities encompass a range of unethical and illegal actions that can harm investors and undermine the integrity of the financial markets. These activities are strictly regulated by FINRA and the SEC to ensure fair and transparent trading practices. Below, we will explore some of the most significant prohibited activities, providing detailed explanations and real-world scenarios to illustrate their impact.

19.3.1 Churning

Definition: Churning refers to the excessive trading of securities in a client’s account primarily to generate commissions for the broker, without regard to the client’s investment objectives or best interests.

Why It Is Unacceptable: Churning is unethical because it prioritizes the financial gain of the broker over the welfare of the client. It can lead to significant financial losses for the client due to unnecessary transaction fees and unfavorable tax consequences.

Scenario: Imagine a broker who frequently buys and sells stocks in a client’s account, even when the market conditions do not warrant such activity. The client notices a high volume of trades and questions the strategy, only to find that the account’s performance has not improved. Upon investigation, it is revealed that the broker was engaging in churning to increase their commission earnings.

Regulatory Framework: FINRA Rule 2111 requires brokers to have a reasonable basis for believing that a recommended transaction or investment strategy involving a security or securities is suitable for the customer. Excessive trading that disregards this rule constitutes churning.

19.3.2 Front Running

Definition: Front running occurs when a broker or trader executes orders on a security for their own account while taking advantage of advance knowledge of pending orders from their clients.

Why It Is Unacceptable: Front running is a violation of the duty of loyalty and fairness that brokers owe to their clients. It exploits nonpublic information for personal gain, undermining market integrity and client trust.

Scenario: A broker receives a large buy order from a client for a particular stock. Before executing the client’s order, the broker buys shares of the same stock for their personal account, anticipating that the client’s order will drive up the stock price. This practice is front running, as the broker uses insider knowledge to profit at the client’s expense.

Regulatory Framework: Front running is prohibited under SEC Rule 10b-5, which makes it unlawful for any person to engage in any act, practice, or course of business that operates as a fraud or deceit upon any person in connection with the purchase or sale of any security.

19.3.3 Insider Trading

Definition: Insider trading involves buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

Why It Is Unacceptable: Insider trading violates the principle of fair and equal access to information, giving an unfair advantage to those with privileged knowledge. It erodes investor confidence and can lead to significant legal penalties.

Scenario: A corporate executive learns about an upcoming merger that will significantly increase the company’s stock price. Before the information is made public, the executive buys a large number of shares, profiting once the merger is announced. This is a classic case of insider trading.

Regulatory Framework: The SEC enforces insider trading laws under the Securities Exchange Act of 1934, with severe penalties including fines and imprisonment for violators.

19.3.4 Misrepresentation and Omissions

Definition: Misrepresentation involves providing false or misleading information, while omissions refer to failing to disclose material facts that are necessary to make other statements not misleading.

Why It Is Unacceptable: Both practices deceive investors, leading them to make decisions based on incomplete or incorrect information. This undermines the trust necessary for efficient market functioning.

Scenario: A financial advisor recommends a high-risk investment to a client, claiming it is low-risk and guaranteed to yield high returns. The advisor omits the fact that the investment has a history of volatility and potential for loss. This misrepresentation and omission can result in significant financial harm to the client.

Regulatory Framework: FINRA Rule 2210 prohibits misleading communications with the public, requiring that all communications be fair, balanced, and not misleading.

19.3.5 Unauthorized Transactions

Definition: Unauthorized transactions occur when a broker executes trades in a client’s account without the client’s consent or authorization.

Why It Is Unacceptable: Unauthorized transactions violate the fiduciary duty brokers owe to their clients, breaching the trust and confidence placed in them to act in the client’s best interests.

Scenario: A broker decides to buy shares of a new technology company for a client’s account without consulting the client. The client, who has a conservative investment strategy, discovers the transaction and is upset by the unexpected risk exposure. This is an example of an unauthorized transaction.

Regulatory Framework: FINRA Rule 3260 requires brokers to obtain prior written authorization from the customer before exercising discretion in a customer’s account.

19.3.6 Market Manipulation

Definition: Market manipulation involves deliberate actions designed to deceive or defraud investors by controlling or artificially affecting the market for a security.

Why It Is Unacceptable: Market manipulation distorts the natural supply and demand dynamics, leading to artificial price movements that can harm investors and destabilize financial markets.

Scenario: A group of traders colludes to buy large quantities of a thinly traded stock, driving up the price to attract unsuspecting investors. Once the price is inflated, they sell their shares for a profit, leaving other investors with losses when the price collapses. This is a form of market manipulation known as a “pump and dump” scheme.

Regulatory Framework: The SEC and FINRA have strict rules against market manipulation, with penalties including fines, suspension, and criminal charges.

19.3.7 Selling Away

Definition: Selling away occurs when a broker sells or offers securities not approved by their firm, typically without the firm’s knowledge or consent.

Why It Is Unacceptable: Selling away exposes clients to unvetted and potentially risky investments, bypassing the firm’s compliance and due diligence procedures.

Scenario: A broker learns about a private investment opportunity and offers it to clients without informing their firm. The investment turns out to be fraudulent, resulting in significant losses for the clients. This is a case of selling away.

Regulatory Framework: FINRA Rule 3280 prohibits registered representatives from participating in private securities transactions without prior written notice to their firm.

19.3.8 Conflicts of Interest

Definition: Conflicts of interest arise when a broker’s personal interests or relationships interfere with their duty to act in the best interests of their clients.

Why It Is Unacceptable: Conflicts of interest can lead to biased advice or recommendations that do not align with the client’s needs or objectives.

Scenario: A broker receives a higher commission for selling a particular mutual fund and, as a result, recommends it to clients regardless of whether it suits their investment goals. This conflict of interest can compromise the broker’s objectivity and harm the client.

Regulatory Framework: FINRA and the SEC require firms to identify and manage conflicts of interest, ensuring that they do not adversely affect client outcomes.

19.3.9 Falsification of Records

Definition: Falsification of records involves altering or fabricating financial documents or records to mislead regulators or clients.

Why It Is Unacceptable: Accurate record-keeping is essential for regulatory compliance and investor protection. Falsification undermines the integrity of financial reporting and can lead to severe legal consequences.

Scenario: A broker alters trade confirmations to hide unauthorized transactions in a client’s account. When the client requests an account statement, the discrepancies are discovered, revealing the broker’s misconduct.

Regulatory Framework: The SEC and FINRA have strict requirements for accurate and truthful record-keeping, with severe penalties for violations.

19.3.10 Anti-Money Laundering Violations

Definition: Anti-money laundering (AML) violations occur when financial institutions fail to implement adequate procedures to prevent, detect, and report money laundering activities.

Why It Is Unacceptable: Money laundering facilitates criminal activities, including terrorism and drug trafficking, posing significant risks to financial stability and security.

Scenario: A brokerage firm fails to report suspicious transactions involving large cash deposits and withdrawals, allowing illicit funds to be laundered through the financial system. This oversight constitutes an AML violation.

Regulatory Framework: The Bank Secrecy Act and the USA PATRIOT Act require financial institutions to establish robust AML programs, including customer due diligence and suspicious activity reporting.

Conclusion

Understanding and adhering to the regulations governing prohibited activities is essential for maintaining ethical standards and protecting investors in the securities industry. By familiarizing yourself with these rules and scenarios, you will be better prepared to navigate complex ethical dilemmas and ensure compliance with FINRA and SEC requirements.

Series 7 Exam Practice Questions: Prohibited Activities

By understanding these prohibited activities and their implications, you can better prepare for the Series 7 Exam and ensure compliance in your professional practice. Familiarity with these concepts is essential for maintaining ethical standards and protecting investor interests in the securities industry.

In this section

• Churning and Excessive Trading: Understanding, Indicators, and Regulatory Consequences
  Explore the intricacies of churning and excessive trading in the securities industry. Learn about the definitions, indicators, regulatory consequences, and calculations involved in identifying these unethical practices.
• Unauthorized Transactions in Securities Trading: Understanding Compliance and Best Practices
  Explore the critical importance of obtaining client authorization before executing trades, exceptions for discretionary accounts, and the role of documentation in preventing unauthorized transactions in securities trading.
• Misrepresentation and Omissions in Securities Transactions
  Explore the critical concepts of misrepresentation and omissions in the securities industry, understand their impact, and learn how to ensure accurate communication with clients.