Chapter 7: Prohibited Activities

Testimonials

A specific concern of the SEC and the states is the use of testimonials on social media sites. The term testimonial means any statement by a current or former client that endorses the adviser or gives a favorable impression of that customer's experience with the adviser. Today, the Investment Advisers Act of 1940 permits investment advisers to use testimonials as long as the testimonials are not misleading and the following conditions are met: Disclosure - An investment adviser must disclose: ‒ Whether the person who's making the testimonial (i.e., the promoter) is a current client ‒ Whether the promoter is receiving cash or non-cash compensation and, if the promoter is being compensated, a description of the compensation ‒ Disclosure of conflicts of interest (e.g., whether the person promoting the IA is also an employee of the IA) Oversight - An investment adviser must supervise the publication of testimonials. In addition, a written contract between the IA and promoter must be created if compensation is being paid to the promoter. Disqualification - Certain "bad actors" are not permitted to make testimonials. An exception to the requirement to have a written contract with a person making a testimonial is available if the investment adviser is paying a person $1,000 or less during the preceding 12-month period (i.e., "de minimis compensation.").

Holdings Reports

Access persons are required to submit a report which shows their current securities holdings and includes the following: The title and type of security, and (as applicable) the exchange ticker symbol or CUSIP number, number of shares, and principal amount of each reportable security in which the access person has any direct or indirect beneficial ownership The name of any broker-dealer or bank with which the access person maintains an account in which any securities are held for the access person's direct or indirect benefit The date the access person submits the report Timing of Holdings Reports Access persons must submit their holdings reports: No later than 10 days after they become an access person and At least once every 12 months thereafter ‒ The holdings being reported on the form must be current as of a date no more than 45 days prior to the date on which the report is submitted.

Other Prohibited Practices

Although any financial professional may be accused of the following violations, these activities are more likely to involve broker-dealers and their agents.

Borrowing and Lending

As to be expected, borrowing money or securities from, and lending money to, a client is generally considered a conflict of interest. However, there are some limited exceptions which allow the practice. There are more exceptions available for broker-dealer agents than for investment adviser representatives.

Exercising Discretion without Written Authority

Broker-dealers and agents may not exercise any discretionary authority when placing an order for the purchase or sale of securities for a client without first obtaining written discretionary authority from the client. However, remember, discretionary authorization is different for investment advisers. Pursuant to oral discretionary authority from a client, IAs and IARs must obtain the client's written authorization within 10 business days after the date on which the first discretionary transaction is placed. If an individual wants to authorize a spouse or family member to have complete control of his account and investments, he must provide full power of attorney (also referred to as third-party authorization). Discretionary power doesn't include a power relating solely to the price and/or time at which an order involving a definite amount of a specified security is executed. An order in which a client determines the action, asset, and amount, but leaves the decision as to the price and/or time of execution to an agent, is referred to as a Not-Held order. Not-Held orders may be accepted and executed without obtaining written authorization, but are only able to be executed on the day on which the order was entered.

Failing to Notify a Supervisor of a Written Client Complaint

Broker-dealers are required to respond to all written customer complaints and must maintain a file with a copy of the complaints. Complaints maybe delivered in either a traditional medium (written letter) or an electronic medium (e-mail or text message). If a complaint is directed to an agent, the appropriate action is for the agent to forward it to his immediate supervisor. Ignoring or failing to respond to a complaint is a violation of the USA.

Conversion of Client Cash and Securities

Conversion occurs when an agent illegally takes possession of a client's assets for his own personal use. An agent receives a check from a client who wants to open a brokerage account. Since it's late in the day on Friday, the agent decides to deposit the client's check in his business account and write a check to the broker-dealer next week when he returns to the office. Is this practice acceptable? No. Regardless of the agent's good intentions, this is considered conversion. The agent may not deposit cash or securities that belong to a customer into his personal or business account. Remember, if an agent of a broker-dealer inadvertently receives a client's cash or securities, the assets must be promptly deposited with a qualified custodian or returned to the customer. Agents who inadvertently hold fund or securities that belong to clients for longer than three days are considered to have custody of clients' assets.

However, transactions involving the following securities are excluded from the reporting requirement:

Debt obligations of the U.S. government Money-market instruments and shares of money-market mutual funds Shares of other types of mutual funds, unless the adviser serves as the underwriter or investment adviser to the fund Shares of a unit investment trust

Failing to Disclose Control Relationships

If a broker-dealer is affiliated with or controlled by an issuer of a security, it must disclose this relationship to all of its clients before allowing them to buy or sell the security. If the firm discloses this relationship orally before the trade has been executed, it must provide a written disclosure by no later than the date on which the transaction is completed. Broker-dealers can also comply with the rule by providing written notice before the trade. Keith is a producing branch manager of a brokerage firm, but also sits on an advisory board for his local municipality. When the municipality needs to issue bonds, the deals usually are directed to and completed by Keith's firm. As Keith's firm sells these bonds to clients, what disclosure must be provided? Clients must receive a specific disclosure of the relationship that Keith and his firm have with the issuer. The disclosure must be made at least orally before the trade, followed by a written disclosure at or prior to the settlement of the transaction.

Record Maintenance

It's considered a violation of the USA for an adviser to fail to maintain and produce the required records for inspection by the Administrator.

Market Manipulation

No person may participate in any form of manipulation or effect any transaction that gives a misleading appearance of the trading activity in a security. The following information will provide a summary of some of the different prohibited trading practices.

An agent of a broker-dealer recently opened an account for a client. The agent's initial recommendation of Atlas Industries has appreciated in value by more than 20% in a short period. The agent thinks the time is right to take the profits and sell, but is unable to get in contact with the client. The agent sells the stock and decides to explain everything to the client later. Were the agent's actions justifiable since the result was a profit?

No. The profitability of the transaction doesn't make the agent's actions acceptable. The agent was not granted discretionary authorization; therefore, she's not permitted to effect transactions without the client's prior knowledge. Without proper trading authorization, every order placed in the client's account requires her specific approval prior to placement. If a broker-dealer doesn't have discretionary authorization over a client's account, but the client specifically states whether to buy or sell, the specific security, and the specific quantity, the client's agent may exercise judgment only as to the price and/or time of execution.

Selling Away

Selling away is a prohibited activity that involves an agent executing securities transactions without notifying his broker-dealer. In other words, the agent is selling away from the supervision of his firm. If an agent wants to sell securities outside the normal course of his employment (e.g., private placement), at minimum, he must notify his firm in advance. Once the broker-dealer is notified of the arrangement, the agent's activities must then be recorded on the books and records of the firm. If an agent will receive compensation for the execution of a private securities transaction, the agent must also receive permission from the broker-dealer, along with giving advance notice.

Fraudulent and Misleading Activities of Broker-Dealers and Agents

The following section will identify the practices that financial professionals should avoid for fear of violating the USA. Broker-dealers and agents must be careful not to engage in any of these actions since they may lead to a suspension or revocation of their registrations.

Withholding Sales of IPO Shares

When involved in an initial public offering (IPO), a broker-dealer must always make a genuine (bona fide) public offering of all securities to which it was allocated as an underwriter or member of a selling group. When presented with a customer order, it's considered an unethical sales practice to withhold the sale of these securities.

Executing Orders at Unfair Prices

When quoting prices in the marketplace, broker-dealers have an obligation to honor their quotes. Transactions must be executed at contemporaneous prices; in other words, at prices that are reasonably related to the current market price. Quoting prices that are better than the market and then adding an unreasonable commission or markup is considered a violation. Remember, if a firm states that a security is being offered at its current market price, it must have reasonable grounds for making this statement.

Some of the issues that need to be considered regarding a firm's cybersecurity risks include:

Whether the firm has written policies, procedures, or training programs in place in order to safeguard client information Whether the firm maintains insurance coverage for cybersecurity Whether the firm has experienced a cybersecurity incident where theft, loss, unauthorized exposure, use, or access to customer information occurred Whether the firm uses safeguards such as encryption, anti-virus, and anti-malware programs

Transaction Reports

Access persons are also required to submit quarterly securities transactions reports which include the following information about each transaction involving a reportable security in which the access person had, or as a result of the transaction acquired, any direct or indirect beneficial ownership: The date of the transaction, the title, and (as applicable) the exchange ticker symbol or CUSIP number, interest rate and maturity date, number of shares, and principal amount of each reportable security involved The nature of the transaction (purchase or sale) The price of the security at which the transaction was effected The name of the broker-dealer or bank through which the transaction was effected Timing of Transaction Reports persons must submit Access submit their transaction reports: No later than 30 days after the end of each calendar quarter

Making Unsuitable Recommendations

Agents should always have reasonable grounds for recommending a particular security and must ensure that the recommendation is suitable. When determining suitability, agents depend on the information obtained from clients, such as financial status, needs, objectives, and willingness to assume risk. Churning involves an agent engaging in excessive trading in a client's account, usually for the purpose of generating commissions. For example, let's assume an agent is recommending for a client to sell shares of a mutual fund and to use the proceeds to buy shares of a different mutual fund with similar investment objectives. Although the sale of most funds doesn't generate a sales charge, the purchase does. Agents who make this recommendation are not significantly changing the client's holdings because the funds have similar objectives. Instead, the agent is earning a sales charge on the purchase of the shares of the new mutual fund. When making recommendations to a client, an agent MAY NOT: Recommend transactions that are excessive in size in relation to the client's financial resources Omit details relating to the risks of a transaction Engage in churning of the client's account To determine whether churning has occurred, regulators typically examine the suitability of solicited trades (i.e., those recommended by agents of a broker-dealer) Broker-Dealers versus IAs ... Excessive trading (churning) is unlikely to be a concern in a fee-based advisory account since the client pays a single flat fee that covers all transaction costs. However, in a brokerage account, this may be of greater concern since agents are compensated by commissions.

Third-Party Research

An adviser that provides its clients with research reports or recommendations produced by third parties must disclose that the adviser is not the author of these materials. However, this disclosure requirement doesn't apply when advisers use various outside sources to formulate their own independent conclusions.

Agency Cross Trades

An agency cross trade occurs when an investment adviser acts as a broker for its client and for another person on the other side of the transaction. In order to effect such a trade, an investment adviser must act in the best interests of its advisory client with respect to the trade's price and execution. Agency cross trades are not permitted if the investment adviser recommends the trade to both the buyer and the seller—one side must be unsolicited. For cross trades to be effected, the adviser must: 1. Provide a prospective client with a written disclosure regarding the potential conflicts that may arise from agency cross trades 2. Obtain written, revocable client consent authorizing the adviser to effect agency cross trades 3. Send the client a written confirmation, no later than the completion of the transaction, that includes the nature of the transaction, the date of the transaction, an offer to provide (on request) the time of the transaction, and the source and amount of any other compensation received by the investment adviser in connection with the transaction 4. At least annually, send each client a written disclosure identifying the total number of agency cross trades effected during the period and the total amount of commissions received by the investment adviser for cross trades executed during the period

Confidentiality of Client Information

An investment advisory firm must keep all information concerning its clients confidential. However, firms may release the information if required to do so by law or with the client's approval. The Administrator, SEC, FINRA, and the IRS are regulatory organizations that have the authority to demand access to the information without the client's approval.

Sharing in the Profits or Losses in a Client's Account

Another practice that's generally prohibited is sharing in a client's account. However, an agent may share in the profits and losses in a client's account if: The sharing arrangement is approved in writing by the customer and the agent's broker-dealer The sharing is proportionate based on the funds invested by each party

Guaranteeing the Client a Profit

As mentioned earlier, agents must be careful to not use a definitive term, such as guarantee. Under the Uniform Securities Act, the only reference to a guarantee is in connection to a security whose payment of dividends, interest, and principal is guaranteed by an entity other than the issuer (a guaranteed security). In such cases, the guarantee is only as good as the guarantor. Agents are prohibited from guaranteeing their clients a minimum rate of return or a specific profit on an investment. Also, if clients lose money on their investments, agents are prohibited from reimbursing them for any portion of those losses.

Agency Cross Trades Cont...

As with principal trades, each written disclosure and confirmation must include a conspicuous statement that the client's consent which allows agency cross transactions may be revoked at any time by giving written notice to the investment adviser. Good to know ... The provisions of the USA and the Investment Advisers Act of 1940 regulate principal and agency cross trades in the same way. These requirements don't apply to broker-dealers who are not acting as investment advisers since principal and cross trades are a standard part of business for a broker-dealer. Keep in mind, all client confirmations will indicate the capacity in which a broker-dealer executes trades. A firm is registered as both a broker-dealer and an investment adviser. Jim, an advisory client of the firm, has just placed an order to sell 500 shares of XYZ. The firm knows another advisory client for whom XYZ is an appropriate purchase and will charge a small brokerage fee for arranging the trade. Is this permissible? Yes. Since the client solicited the trade, the firm is able to offer the stock to another advisory client in an agency cross trade. However, representing both sides of the transaction is generally a conflict of interest. Therefore, prior to the trade, the firm must obtain each client's written consent and must disclose the firm's capacity (as a dual agent) to each customer. By crossing the trade, the firm may be able to provide each client with a better price than what might be obtained in the open market.

Failing to Deliver a Final Prospectus

Broker-dealers are responsible for ensuring that every customer who purchases a new issue receives a copy of the final prospectus by the date the transaction is confirmed. This requirement may also be fulfilled by providing the client with a written or electronic copy of the preliminary prospectus together with an additional document that, when combined, discloses all of the information found in the final prospectus. When investors buy stock in the primary market directly from the issuer, broker-dealers are always required to provide them with a prospectus. However, if investors buy stock in the secondary market (after-market) shortly after a primary market issuance, they must also receive a prospectus. Listed below are the after-market prospectus delivery rules: For exchange-listed follow-on offerings - no requirement applies For initial public offerings (IPO) of exchange-listed stocks - 25 days For follow-on offerings for over-the-counter (non-listed) stocks - 40 days For initial public offerings of over-the-counter (non-listed) stocks - 90 days

Unnecessarily Delaying the Payment or Delivery of Securities

Broker-dealers generally require customers to pay for their securities purchases by the settlement date of the trade (typically by the second business day following the trade date, or T + 2). Customers may also demand the same level of prompt treatment by their broker-dealer. Therefore, firms are not allowed to delay the delivery of securities that were purchased by a client, delay the payment to a client for securities sold from their account, or delay the payment of funds that a client has available in his account (free credit balance). A customer free credit balance represents funds available in a client's account due to sales or the crediting of a dividend or interest payment.

Commingling Client and Firm Securities

Commingling is the practice of intermixing securities belonging to customers with those belonging to the broker-dealer. Client securities that are retained by the broker-dealer must be segregated (separated) from the securities owned by the broker-dealer. The purpose of segregation is to prevent the misuse of customer securities and to eliminate the potential risk of commingling. In order to avoid possible commingling, securities may be registered in a client's name and sent directly to the client. Another possibility is the securities may be held in safekeeping by the broker-dealer, with the firm charging the client a reasonable fee for the service. A broker-dealer owns 70,000 shares of XYZ Company in its inventory, and its clients own 15,000 shares of the same stock. In an effort to reduce bookkeeping expenses, the broker-dealer keeps all 85,000 shares together in one secure vault. Is this permitted? Yes. A broker-dealer may keep customer stock and its own stock in the same vault; however, the securities must be maintained in such a way that it's clear which certificates belong to the broker-dealer and which certificates belong to customers. When securities are separated appropriately, they're considered segregated. Separate client ledgers and journals of securities transactions are created to record where each security is located and help the firm satisfy its recordkeeping obligations.

Performance-Based Advertising Investment advisers are only permitted to use performance-based advertising in certain circumstances. The following conditions must be met:

Fees: If an adviser intends to put the gross rate of return in a social media post, the firm must also disclose performance net of advisory fees. For example, an investment adviser cannot simply advertise that it generated a 7% return for its managed accounts last year. Instead, it must also disclose that its clients' net return was actually 6% after the firm's 1% management fee was deducted. Time Frames: In order to include past returns, an adviser must include performance over one-, five-, and 10-year periods. If the adviser or the portfolio for which it's providing returns has not existed for five or 10 years, then the performance over the life of the account must be provided. The SEC wants to ensure that advisers don't cherry pick their best years and exclude any poor performance. An adviser also needs to be certain that it's comparing similar investment portfolios. For example, an adviser cannot compare the return of an equity portfolio with the return of a debt portfolio. No Approval: If an adviser still wants to include performance data, it cannot imply that the SEC has approved or reviewed its performance numbers. An adviser also needs to be careful with disclosures that are made regarding the personnel who generated the performance. For example, let's assume that an investment adviser representative of an advisory firm was managing a portfolio and earned 17% for her advisory clients. If that portfolio manager left her position, the firm is still permitted to use the 17% performance in marketing material; however, the firm must disclose the fact that the portfolio manager is no longer managing the portfolio. Also, the adviser must provide details regarding the manager's investment objectives to ensure that they match up with the objectives of the accounts being marketed. Hypo

Broker-Dealer Agents

For an agent to borrow money or securities from, or lend money to, a client, the agent's broker-dealer must have written procedures allowing the arrangement and: The customer must be a member of the agent's immediate family (i.e., parent, grandparent, husband or wife, brother or sister, child, mother or father-in-law, brother or sister-in-law, son or daughter-inlaw, grandchild, cousin, aunt or uncle, niece or nephew, or any other person whom the agent supports, directly or indirectly, to a material extent); The customer must be a financial institution that's regularly engaged in the business of providing credit, financing, or loans (the loan must be made on the same commercial terms that are available to the general public); The customer and the agent must both be registered persons of the same broker-dealer; and The customer and the agent must have either a personal or business relationship that exists outside of the brokerage relationship Unless the borrowing or lending arrangement is with an immediate family member or with a customer that's a financial institution in the business of extending credit, agents are required to provide notification to their member firms and obtain written approval prior to entering into such arrangements.

Fraudulent and Other Prohibited Activities

Fraud is often defined as intentional deception carried out for personal gain or to damage another person. However, under state law, fraud is not as clearly defined. Some states have held that it's necessary to prove willful intent for a person to be found guilty of fraud. The difficult part is that states don't consider willful intent to be the same as having an evil motive. For potential violations, willful intent is present if a person intended to perform the acts of which he's accused; it doesn't require any specific state of mind. In other words, if a person is charged with fraud for having sold unregistered, non-exempt securities, all that a state prosecutor must prove is that the person engaged in the act of selling the securities—not that the person knew the securities were unregistered and non-exempt. So, while some fraudulent activity is obvious and easily recognized, other cases at the state level have abandoned the greedy motive of the defendant and, instead, focused on a lack of reasonable care (negligence). The Uniform Securities Act states that it's unlawful for any person, in conjunction with the direct or indirect offer, sale, or purchase of any security, to directly or indirectly: 1. Employ any device, scheme, or artifice to defraud 2. Make an untrue statement of material fact or omit any material fact that's needed to make a statement 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 This language is broad enough to cover a number of practices, but the USA doesn't define which particular practices are permitted and which are not. Over the years, enforcement actions by Administrators, as well as court cases, have pointed out many specific actions that are violations of the Act. In addition

Front-Running

Front-running occurs when a brokerage firm enters into an equity trade, or options or futures contract, with advance knowledge of an impending block (large) transaction that will influence the price of an underlying security in an effort to capitalize on the trade. Because front-running relies on information that's not been made available to the general public, it's considered unethical. Another manipulative practice is referred to as shadowing. This action involves a broker-dealer executing a trade for its own account immediately after it executes a substantial client trade, but before the client's trade is reported. By waiting for the client trade to be executed, the firm may be hoping to avoid making it appear as though it's front-running.

Utilizing a Client's Username and Password

If a client engages in online trading, his username and password must be kept confidential. An agent who executes trades in the client's account should not have access to this information. For example, if an agent has discretionary authorization in the client's account and utilizes the client's credentials to access the system, the agent's employer wouldn't have the ability to discern whether the trade was entered by the agent or the client and whether it was fraudulent. Situations like this are a violation of the terms of service for a broker-dealer's online account access system.

Entanglement and Adoption

In some cases, an adviser is permitted to share or distribute content that's created by a blogger or social media influencer. If third-party content is created and posted without being requested by an investment adviser and the advisory firm then uses the content in its marketing campaign, the SEC considers the material to have been "adopted" by the adviser. According to the SEC, an investment adviser is considered to have adopted content when it implicitly or explicitly approves of information. An obvious example is when an adviser shares, retweets, or posts an article about its services. If the adviser commented in its reposting of the material, "what a great article!," the SEC would consider the adviser to have adopted the content. However, if the article is simply shared without comment, it will not be considered adopted. Additionally, advisory customers can also comment about an article that's shared on their adviser's social media page and the adviser will still not be considered to have adopted the content. However, if an adviser comments about a customer's comment, then the article is considered to have been adopted by the adviser.

Use of Inside Information

Inside information is any material information that has not yet been disseminated to the public. An agent who has access to material, non-public information may not make recommendations based on it and, with the exception of a supervisor, may not discuss it with anyone. Brian, an agent of a broker-dealer, learns from a client who sits on the board of directors of a Fortune 100 company that the company is going to be subject to an expensive lawsuit. The client asks that Brian keep the information confidential. If another client calls and expresses interest in buying that company's stock, does Brian have an obligation to provide this news to his client? No. This is inside information and Brian is prohibited from sharing it with the public. An insider trading violation occurs if a person uses material, non-public information either to make a profit or avoid a loss. Remember, it's using the information (i.e., trading on the information) that creates the problem. Situations may arise in which one person provides the information to another person who ultimately executes trades. If this is the case, the person providing the information (the tipper) and the person who receives and trades on the information (the tippee) are both considered to have engaged in insider trading.

Lists of Past Recommendations

Investment advisers may include a list of their previous investment recommendations in advertising and sales materials as long as the list includes all of the advisers' recommendations during the relevant period (which must be at least one year). The list must also state the name of each security, the date on which the recommendation was made, the type of recommendation (e.g., buy, sell, or hold), and the current market price of the security. Basically, the list needs to be an accurate reflection of the adviser's recommendations during that period. What advisers are prohibited from doing is including only recommendations that produced favorable results (i.e., cherry-picking).

Pay-to-Play

Investment advisers provide a wide variety of advisory services to state and local governments, including managing their public pension plans. Elected officials who allow political contributions to play a role in the management of these assets and who use these assets to reward contributors violate the public trust. For that reason, the SEC has established specific rules restricting these pay-to-play practices. The rule prohibits investment advisers from receiving compensation for advisory services for two years after the advisory firm or any covered employee makes a political contribution to a public official or candidate who is or would be in a position to influence the award of investment advisory business by public retirement funds. The contribution of any amount made by an investment adviser will trigger a violation of the rule. However, the rule allows for the following employee contributions: If the covered employee is able to vote for the candidate/official, he may contribute up to $350 per election If the covered employee is not able to vote for the candidate/official, he may contribute up to $150 per election

Advisers with custody must also maintain:

Journals of securities transactions and movements Separate client ledgers Copies of confirmations Records by security showing each client's interest and the security's location

Investment Advisory Activities

Many of the concepts previously discussed apply to all financial professionals. However, up to this point, we have concentrated on activities that are fraudulent and prohibited in connection with the purchase or sale of securities. Keep in mind, broker-dealers and agents are in the business of effecting securities transactions; therefore, when answering questions regarding the previous violations, remember to look for scenarios that involve agents and/or broker-dealers. However, it's necessary to understand that the Uniform Securities Act's antifraud provisions also apply to investment advisers. Let's take a look at some of the advisory practices that are regulated under state law.

False and Misleading Statements

No person may make false or misleading statements in connection with the purchase or sale of a security. Although these provisions apply to all securities professionals, many of the court cases and administrative actions that illuminate the unacceptable practices involve agents of broker-dealers. The following list is rather straightforward and generally requires little explanation. It's prohibited for any person to: Tell clients that the registration of broker-dealers or agents implies that their business practices, knowledge, or capabilities have been certified or approved by the SEC, the Administrator, or FINRA Promise to perform certain services without intending to do so Promise free services and then charge hidden fees Falsely state anticipated or current earnings Falsely state the amount of a commission or markup Overstate or misrepresent the status of a client's account We will expand on the next group of misleading statements and/or activities to ensure a more clear understanding of the violations.

Chapter 7 Summary

Now that you've completed this chapter, for the following commonly tested concepts, you should be able to: Understand the difference between fraudulent and unethical business practices and provide examples of each Identify statements which are considered misleading under the USA Recognize and provide examples of prohibited activities, including: ‒ Insider trading ‒ Unsuitable recommendations ‒ Mishandling of customer funds, including borrowing and lending with customers ‒ Providing guarantees against losses ‒ Investment adviser failing to provide disclosure of conflicts of interest ‒ Market manipulation in both the primary and secondary markets ‒ Executing trades in a client's account without discretionary authorization Understand NASAA's standards and prohibitions that apply to communications with clients Understand the pay-to play rule and the punishments for investment advisers that violate the rule Identify the records that must be maintained by both broker-dealers and investment advisers under the USA Compare and contrast principal and agency cross trades and recognize the required disclosures for investment advisers to engage in these trades Understand the requirements for cyber preparedness and how to comply with applicable rules Understand industry guidelines on the use of social media, including standards and approvals

Painting the Tape

Painting the Tape involves financial professionals buying and/or selling securities among themselves in order to create false trading volume. When the trades are reported, the appearance of increased trading activity is intended to attract investors. Mort and Mickey are friends who work on the trading desks of rival brokerage firms. The two traders decide to engage in high-frequency trading of a specific stock with each other at prearranged prices in an attempt to create a new single day-trading volume record for that stock. The next day, news of the trading circulates in the press and other investors start to bid up the stock's price. Mort and Mickey subsequently sell their shares at a nice profit and stop trading the stock. What form of market manipulation is being committed? Since Mort and Mickey prearranged their trading activity to created false volume in the security, they're guilty of Painting the Tape.

Pegging and Capping

Pegging involves buying large amounts of securities, often stock, to keep the price from falling. Pegging can be done by one party or, more commonly, by several market participants at a time. In many instances, pegging is performed to influence the stock price to make an option or futures position profitable. Capping is similar to pegging, but involves the sale of securities in order to keep the price from rising. Like pegging, capping is a manipulative activity.

Advisers must maintain specific client records, such as:

Powers granted by clients Disclosure statements: ‒ Solicitors' disclosure statements ‒ Performance claims ‒ Customer information forms and suitability information ‒ Written supervisory procedures Customer complaints

Knowingly Failing to Follow Client Instructions

Securities professionals are required to follow all lawful client requests when servicing their accounts. If a client indicates a desire to purchase, sell, transfer, or close an account, the agent has an obligation to properly execute the client's instructions in a timely manner. A client contacts his agent and enters a market order to sell his 1,000-share position in RST Corp. Rather than route the order for immediate execution, the agent holds the client's order because he feels as though RST stock is going to rally later in the day. Ultimately, the agent was right and the stock was later sold near the closing price which was the high for the day. Was the agent justified in holding the client's order? No. Although delaying the execution of the market order resulted in a benefit to the client, knowingly failing to follow client instructions is an unethical business practice. This rule applies even if the broker-dealer or agent has discretion over the account.

Social Media

Several years ago, keeping clients informed meant that financial professionals were required to communicate with them by phone, letter, or in person. Today, there are an extraordinary number of choices, including Twitter, Facebook, LinkedIn, Tumblr discussions, chat-room talk, and texting. To compete in an increasingly electronic, fast moving, and challenging prospecting environment, the use of social media is on the rise. More prospective and existing clients can be reached, more targeted information can be delivered, and more investment advice can be dispensed through technologies that were not imagined a few years ago. It's a new world for financial professionals, but also one that's filled with potential rule violations. Some broker-dealers ban the use of all social media. By doing so, the firms clearly reduce the risk that their personnel may inadvertently violate SEC requirements. However, the entire ban places significant restrictions on representatives prospecting, especially considering the advantages that current technology offers. On the other hand, many firms simply allow the limited use of social media. With this approach, firms are required to develop well-structured policies and procedures that including a supervisory review. If any social media is being used by a firm for business purposes, a principal is required to review the sites prior to use. The decision to approve the use of a particular site should include an analysis of whether it's designed in such a way that it allows associated persons to comply with regulatory requirements.

IAs and Investment Adviser Representatives

Since advisory relationships provide IAs and IARs with access to confidential information about their clients' income and assets, it's considered a breach of their fiduciary duty and generally prohibited to borrow money or securities from, or lend money to, their clients. Under NASAA's Unethical Business Practices Module Rule, IAs and IARs are prohibited from borrowing money or securities from a client or lending money to a client unless the client is: A broker-dealer An affiliate of the investment adviser, or A financial institution that's engaged in the business of loaning funds It's important to note that IAs and IARs are not permitted to borrow money from, or lend money to, an immediate family member who happens to be a client of the firm.

Identifying Conflicts of Interest

Since investment advisers have a fiduciary relationship with their clients, one of the most important issues facing fiduciaries in general, and investment advisers in particular, is the potential for conflicts of interest. The general rule regarding the handling of conflicts of interest may be referred to as the Disclose or Abstain Principle. At some point, advisers may be faced with choosing between what's in their best interests and what's in their clients' best interests. The ethical and legal choice in these types of situations is clear—advisers must always consider their clients' best interests. When an action involves a conflict of interest, an investment adviser should disclose the conflict to the client before providing any service. While disclosure of a conflict of interest will often satisfy a fiduciary's duty to a client, there are cases where disclosure is not enough. If a situation arises that results in an adviser putting its interests ahead of its clients, the adviser is required to abstain (refrain) from the activity.

Use of the Term Financial Planner

Some who claim to be financial planners may not actually be trained or educated in the discipline of financial planning. Under the USA, the use of the term financial planner by someone whose business is limited to selling products may be a deceptive practice, since financial planning goes beyond simply selling products.

Entanglement and Adoption Cont...

The SEC has also provided guidance on profane or offensive comments. Advisory firms are permitted to delete offensive comments on their social media pages, while also avoiding the implication of the content being edited. When adopting content, advisers are not specifically requesting the content or influencing its creation; instead, the interaction occurs after it's created. If an adviser pays for a social media post, it's a testimonial. However, since it was not created by the adviser directly, but was instead written by a third party and originally posted on a third-party site, the SEC considers the adviser to be "entangled" in the content. In other words, an adviser that's directly involved in the creation of third-party content or has influence over what's created is entangled in the third-party content. As another example, an adviser that pays a blogger to create a list of the most successful investment advisers is entangled in the article. The rules for both adopted and entangled material are very similar to advertisements that are created directly by an investment adviser. Both adopted and entangled content are permitted as long as they don't mislead the public. In addition, although adopted and entangled content has not been directly created by the investment adviser, the adviser is still responsible for the content's accuracy. The SEC wants advisers to investigate and verify third-party content before adopting and distributing it.

Summary

The underlying purpose of the Uniform Securities Act is to prevent fraud and to prohibit certain business practices from occurring in the securities industry. The information presented in this chapter is rudimentary and, in most cases, common sense will be your guide as to whether a practice is prohibited. Your examination may contain questions that will require you to determine if an action constitutes fraud or whether it's an unethical practice (both of which are considered violations of the USA). Also, we will focus on the differences in the activities of broker-dealers and investment advisers.

Spreading rumors in order to effect transactions

The violation: A broker-dealer has a bullish outlook for the common stock of The Green Company. Jenny, an agent of the broker-dealer, goes to a chat room on a financial market Web site and poses as an employee of The Green Company. Jenny begins discussing The Green Company's favorable sales outlook and new client acquisitions in an effort to make the company appear more successful. The rule: This type of activity is prohibited for all persons, not just agents. State and federal authorities have charged a number of individuals with fraud for circulating rumors on the Internet to pump up the price of a stock. Jenny's actions could lead to her registration being suspended or revoked, also ultimately, if prosecuted, she may be subject to an even more severe penalty

Providing inaccurate market quotations

The violation: A customer called a broker-dealer to inquire about the price of XYZ stock in her account. Knowing that the client will be upset by the fact that the stock's price dropped, the agent provided the previous day's price, which was significantly higher. The rule: Although it's never easy to give clients bad news, agents should never tell clients that everything is okay with their accounts when, in fact, a stock position has fallen in value. An agent who misrepresents the true market price of the stock by quoting the previous days' price has committed an unethical act.

Selling dividends

The violation: ABC Corporation has just announced a $1.00 dividend per share that's payable to shareholders of record on Thursday, May 12. Ted, an agent of a broker-dealer, calls Jane and encourages her to buy the stock by Monday, May 9, to lock in the $1.00 dividend; otherwise, she will miss receiving the dividend and lose the profit. Should Jane succumb to this high-pressure sales tactic? The rule: No. An investor who buys the stock in order to receive the dividend will be paying a price that includes the dividend. Jane is effectively receiving her money back in the form of a taxable dividend. If Jane waits to buy the stock on or after the ex-dividend date, she will be able to buy it at a reduced price. Ted acted unethically when he attempted to induce the sale of stock based on its impending dividend

Stating that a security is about to be listed without justification

The violation: An agent calls a client to announce that a company's stock is about to be listed on Nasdaq. The agent stresses that the client should place a buy order before the announcement is made. The agent's belief is that the stock's market price will rise due to the fact that index fund managers will begin buying large quantities of the stock for their portfolios. The rule: Unless the broker-dealer or agent has firm grounds (such as a press release) for believing that the security is about to be listed on the exchange, his statements are considered misleading. In this situation, the agent's statements are a violation since he stated that the order needed to be placed prior to the announcement.

Claiming that a security has been approved by a regulator

The violation: An agent of a broker-dealer calls a client and solicits the sale of an IPO. During his sales presentation, the agent states that the securities are a great investment opportunity, are legal, and have been approved by both the SEC and the state securities Administrator. The rule: The Administrator and the SEC don't provide approval for securities; they simply require that the securities be registered. When the agent stated that the security is legitimate or safe because it has been registered, he made a misleading and untrue statement.

Using inflated language

The violation: An agent of a broker-dealer has been analyzing the technology sector for several months, and although the market has been down, she feels that market conditions are improving. When speaking with a client about Xcel stock, she says, "As soon as the market corrects, Xcel is definitely going to rise to $40." The rule: Since using promissory language is a violation, agents must carefully consider their words when making recommendations to clients. Using definitive words such as always, only, never, will, and guarantee may be problematic when making statements to clients. In the above situation, when the agent used the word definitely, she violated the USA by using inflated language.

Omitting material facts

The violation: An agent of a broker-dealer has been selling a large quantity of stock that's on his firm's recommended list. The agent is on the phone with a client who places an order to buy the shares when he receives news that the issuing company's earnings will need to be restated. Fearing the news will cause the client to withdraw the trade, he decides to not disclose it to his client. What are the agent's actions considered? The rule: The agent's actions are fraudulent and deceitful since he withheld material facts from a client. Registered persons don't need to tell an outright lie to violate the USA's antifraud rule. While it's virtually impossible to relate all known facts, a reasonable person can determine if the information is a material fact—one that's important in order to decide whether to engage in a particular transaction. The agent withheld material facts when involved in a securities transaction. In this example, the agent is required to disclose the material information regarding the company's earnings to his client prior to entering the order.

Providing false information

The violation: An agent tells one of his clients that a specific fund is a no-load fund and that a sales charge will not be deducted from the purchase price. However, the agent fails to mention that the fund has a deferred (backend) sales charge that's assessed at redemption. The rule: A fund only may be described as a no-load fund if it has no front-end charge, no back-end (deferred) charge, and no 12b-1 fee that exceeds .25% of the fund's average net assets each year. In an effort to execute a trade, the agent has given false information by suggesting that the fund (which has a deferred charge) is a no-load fund. Once again, this practice is unethical. Consider this ... False information could potentially be presented to a client in many different ways. On your exam, look out for situations that range from trade confirmations to advertising. It's also considered an unethical business practice for a broker-dealer and its agents to publish or circulate an advertisement, report, notice, or other form of communication that reports a transaction without the reasonable belief that the transaction is a bona fide purchase or sale. If an agent provides an execution report to a customer without verifying the price, this is also an unethical business practice.

Cyber Preparedness

To establish the proper information security procedures, an investment advisory firm must first identify which threats and vulnerabilities pose the most risk to the firm. For example, given the frequency of email communication with clients, many RIA firms are at risk of being deceived by hackers who impersonate a client and make a fraudulent wire request via email. Once the firm has evaluated the greatest risk, it's important for the firm to establish an information security policy which includes employee training as part of its broader policies and procedures. More and more large firms are beginning to engage outside experts for assistance in developing the proper policies, monitoring, and safeguards. To properly protect sensitive client information, it's crucial for a firm to perform proper due diligence and establish confidentiality agreements with all third-party vendors that may have access to such information. Every RIA firm must install the proper anti-virus software on all firm computers. In addition, firms should consider implementing encryption and authentication capabilities to help protect against the theft of client information or client impersonation attempts.

Trading Ahead

Trading ahead occurs when a broker-dealer accepts and holds an order for a security from its own client, or a client of another firm, and trades that security on the same side of the market for its own account at a price that would satisfy the customer's order. For example, a broker-dealer is holding an order from a client who wants to buy ABC stock at $21. Rather than filling the client's order, the broker-dealer buys ABC stock for its own account at $21 or better. A trading ahead violation may also occur if a member firm or any of its associated persons execute trades in a security in advance of the publication of a research report on that security.

Advisers are generally required to maintain and keep current the following records:

U4 Forms of investment adviser representatives General ledgers as well as receipt and disbursement journals Order memoranda Bank records Bills and statements Financial statements Written communications and agreements (including electronic transmissions) A listing of discretionary accounts Advertising Personal transactions of representatives and principals

Personal Securities Transactions

Under both the Uniform Securities Act and Investment Advisers Act of 1940, an adviser's code of ethics must contain provisions which require "access persons" to report their personal securities transactions to their firm's chief compliance officer or other designated person. An access person includes an officer, director, partner, or other supervised person of the adviser who has access to non-public information, or who's in a position to exploit information that relates to client transactions or holdings in reportable securities. Both state and federal regulations require access persons of investment advisers to file two reports—the holdings report and the transaction report— in order to avoid conflicts of interest.

The use of social media is also of great interest for many investment advisers due to the possibility of attracting new clients. However, the SEC is concerned that an adviser's compliance programs that apply to advertisements and other forms of communication may fail to include social media. For that reason, firms must include the following provisions in their compliance programs:

Usage Guidelines Compliance procedures should address appropriate usage and restrictions on the use of social media, based on potential risks. Content Standards Content may violate a firm's fiduciary duty or other regulatory issues; therefore, procedures must address it. Monitoring Advisers should consider how to monitor the use of social media by employees, representatives, and solicitors, taking into consideration the lack of ability to monitor third-party sites. Approval of Content Advisers should consider requiring the preapproval of communications, rather than after-the-fact reviews. Training Advisers should consider implementing a training program that's related to social media, with a view toward promoting compliance. Personal/Professional Sites Advisers should consider whether to adopt policies to address the business being conducted on personal or third-party media sites. Information Security Advisers should consider whether permitting representatives to have access to social media sites poses information security risks, as well as how to protect the information.

Soliciting Orders for Unregistered, Non-Exempt Securities

When an agent solicits a buy order from a customer, the agent and her broker-dealer have an obligation to make sure that the recommended security is both suitable and in compliance with the provisions of the Uniform Securities Act. This includes making sure the security is either registered or exempt from registration. It's a prohibited sales practice for agents to solicit the sale of an unregistered, non-exempt security. However, if a client places an unsolicited order for unregistered, non-exempt securities, the transaction may be completed. In such a case, the Administrator may require a signed acknowledgement from the client confirming that the order was unsolicited.

Principal Trades

When an investment adviser buys or sells securities for its own account at its own risk, it has executed a principal trade. The Uniform Securities Act provides protection to advisory clients by requiring trade-by-trade disclosure and consent. However, the adviser is subject to several conditions including that it must: 1. Provide a prospective client with a written disclosure regarding the potential conflicts that may arise from principal trades 2. Obtain written, revocable client consent authorizing the adviser to enter into principal trades 3. Make certain disclosures, either orally or in writing, and obtain the client's consent before each principal trade 4. Send the client a confirmation statement disclosing the capacity in which the adviser acted and disclosing that the adviser informed the client that it may act in a principal capacity and received the client's authorization 5. Deliver to the client an annual report itemizing all principal trades As a general rule, each written disclosure or confirmation must include a conspicuous statement that the client's consent which allows principal trades may be revoked at any time by giving written notice to the investment adviser.

Communications with Clients

When investment advisers distribute information to the public, any communication that's sent to more than one person is considered advertising. All advertising by investment advisers must meet the standards contained in the Uniform Securities Act, including that it MAY NOT: State that a report, analysis, or other service will be furnished free, unless these items have no cost or obligation Contain untrue statements of material fact, be false, or misleading It's also a violation to represent rumors, opinions, or other unfounded statements as being factual either in advertisements or in other client communications. If hypothetical returns are used in an illustration, the assumptions used must be disclosed. An IAR should contact his compliance and/or legal department if he suspects that false or misleading information has been disseminated about a security or that material facts have been omitted.

Grace has a non-discretionary account with a brokerage firm. Grace contacts her agent and says, "At some point today, please buy 100 shares of YSP, Inc. whenever you think it's best." Is her agent allowed to execute this order without written power of attorney?

Yes. Grace indicated that she wanted to buy 100 shares of YSP, Inc. Since she specified the three important details—the action (buy), the amount (100 shares), and the asset (YSP)—the agent may use his judgment regarding the best price and/or time of execution without written authorization.