Securities Exam Prep – Prohibited Conduct

In this article we are going to take a look at employee conduct and the conduct of registered representatives.  Virtually all FINRA exams will test the rules and regulations relating to professional conduct in the Securities industry.   This article will highlight a number of prohibited practices that you are likely to see on your exam. It will also detail the reporting requirements for certain events for both broker-dealers and registered representatives.

Churning is a practice of doing transactions that are excessive in size or frequency in an effort to earn commissions for the registered representative. A representative may have churned a customer if they have engaged in numerous transactions to generate commission dollars if every transaction they execute for the customer is to the maximum capacity of that customer’s account, and if they have earned a significant amount of commission revenue in relation to the assets in the customer’s account.

Profitability will not mitigate the finding of whether or not a customer’s account has been churned. The only thing that will mitigate this is if the customer has a short-term trading objective. With a short-term trading objective, the customer does want to trade very frequently. So that may be an offsetting consideration to determine if their registered rep was engaging in a prohibited practice.

Capping—  Certain market participants with long put positions or short stock positions may have a vested interest in trying to keep the stock price down so that their other positions are profitable. So capping is trying to keep a stock price artificially low by entering a lot of sell orders, usually right around the close of the market.

Pegging-– pegging is trying to keep a stock price up. Certain market participants with long calls and long stock positions may want that stock to go higher. So they may enter a lot of buy orders as the market is closing to try and lift that stock price up.

Front running— front running is a prohibited practice whereby a registered rep with the knowledge that a large order is about to be entered enters an order for themselves to buy that stock prior to entering the customer’s order. So let’s say, for example, a large institution calls up a broker dealer, and wants to buy 200,000 shares of XYZ. Wow, that’s really going to cause that stock price to rise. The registered rep fills in an order ticket for their own account, and buys 1,000 for themselves, and then enters the order for the customer to buy 200,000, causing the stock price to rise. Once the large order is complete, the registered rep sells their own stock at a profit, and has committed a violation known as front running.

Trading ahead— trading ahead is entering an order with the knowledge that a research report is about to be released. Let’s say a registered rep walks into an elevator. And on this elevator are two research analysts from his firm. He overhears these two research analysts speaking about how XYZ really has turned the corner, and things are really looking up for this company. They say that they’re just about done with the analysis, and they’re going to put out a research report in the next week or two, and put up a stock price target that is significantly higher than it currently is.

The registered rep can’t believe his good luck overhearing this conversation. He goes to his desk, he buys some stock for himself. He calls all of his customers, and recommends they buy it too. A week or so later, that buy recommendation comes out, causing the stock price to rise, earning that registered a nice profit in their own account, and making him look like a hero to his customers. So trading ahead is the practice of entering an order with the knowledge that a research report is going to be released shortly.

Try not to confuse front running and trading ahead. People sometimes have a little bit of an issue with that. Front running, you have knowledge of an order that is about to be entered. Trading ahead, you have knowledge that a research report is about to be released.

Painting the tape— painting the tape, sometimes referred to as match purchases, match sales, or even wash sales. Let’s see if I can paint a picture for you, much the way someone may paint the tape. Let’s say the registered rep at broker dealer A has 100,000 shares of XYZ for their clients. And they have a colleague at another broker dealer, and they have about 100,000 shares for their clients as well. And this stock is just sitting here doing nothing.

The two  reps are talking about how this stock has been sideways for months and months and months, and how they can’t get their clients out of it. So one registered rep says to another, how about I buy all of your stock from you in the morning, and then I sell it back to you at the end of the day. Let’s do this for a few days. And well, it’s going to look really active, and people will start thinking something is up, something is going on.

This activity of seeing the stock ticker going across the tape, as they say, creates false activity and draws in new buyers. As the new buyers come in, and it causes the stock price to increase, the two registered representatives sell their stock out for their customers, and now they can move on to the next trade, so to speak.

So match purchases, match sales, wash sales, painting the tape– violations, trying to make a stock price look active without any real beneficial change in ownership.

Unauthorized trading— unauthorized trading is entered for the benefit of a customer’s account without their knowledge. Let me say that again. It’s entered for the benefit of a customer’s account, without their knowledge and without discretionary authority. That word, benefit, may be used on the exam, which means the account is having this trade credited to it. It doesn’t mean it’s profiting or benefiting from a trade. So be on the lookout for that. You can not transact business for a customer’s account without their approval or without written discretionary authority. And I think we did a pretty good job covering discretionary authority just a few minutes ago.

Fraud— if you’re trying to test you on fraud, you don’t have to go that far looking for it. You’ll know it when you see it. A fraudulent practice is trying to establish a material advantage over someone through the employment of any artifice, device, or scheme for someone’s financial benefit. You’ll understand fraud when you see it.

Blanket recommendations— there is no one-size-investment-fits-all in the financial services community. What is right for one person may not be right for another. Now a blanket recommendation could take place if a registered calls up all of their clients, and recommends XYZ to them. Well, XYZ may be appropriate for some, but not for all. Even if every single customer makes money on that it is a violation because it was probably too risky, or unsuitable for many of those customers.

Another style of blanket recommendation– a little bit of a subtlety here– would be if a registered rep was speaking at a seminar, and they started talking about a specific mutual fund, a specific stock, a specific annuity. That would constitute a blanket recommendation. And the registered representative probably doesn’t even know who’s in the audience, let alone what their investment objectives are. So blanket recommendations– always wrong.

Selling dividends— selling dividends is using the pending ex-dividend date as a way to create urgency to induce the client to buy the stock. Let’s say a registered representative has an investor as a client who likes to receive dividends on their common shares. And the registered representative calls up Mary and says, hey Mary, I know that you had some interest in XYZ a little while ago. And I know you like to receive that dividend income, and so I wanted to let you know that if you want to buy it, the time is now, because this stock goes ex-dividend in two days, and I think we should go ahead and pick up some stock for you.

Mary says,” wow, thanks for the call. Thanks for the tip”. And then she buys the stock. When the stock goes ex-dividend, that stock price goes down. And then Mary gets her dividend check, which is effectively a return of the capital she just put into the stock. And now she’s taxed on it. She has a tax liability on her own money. That’s one of the reasons it’s a violation. So, selling dividends, always a bad idea.

Misrepresentations-– you may never, ever, ever misrepresent yourself, your firm, an investment, a security, your research facilities. Don’t say you have one of the most extensive research departments if you have two guys in the back office looking on the internet for ideas. You can never ever misrepresent anything. Don’t tell someone you went to Harvard if you went to a local community college– pretty straightforward.

Omitting material facts— a material fact is one that would impact the company today or tomorrow. If there is a material fact, you must make it known to your investor prior to having them buy a security. You can’t tell your client to buy ABC, and then two days later, when you’re speaking to them, oh yeah, I forgot to tell you, the CFO resigned about three weeks ago. He wasn’t really happy with the financial reports. That seems like it’s material, and that seems like it should have been disclosed prior to the person buying those shares.

Guarantees— there are only three entities on the planet in the financial services world that can guarantee anything. It’s an insurance company, it’s the United States government, and a parent company could guarantee the obligations of a subsidiary, much the way a parent could guarantee their child’s car loan. Other than that, there are no guarantees– no guarantees by a broker dealer, by an investment advisor, by a registered rep– and under no circumstances. You can’t guarantee a profit. You can’t promise no loss– I promise you won’t lose money. No way. You can never say that. Certain things in the course of a registered representative’s career and life must be reported, and they must be reported to FINRA.

When certain events take place, the registered rep is going to have to disclose it. When in doubt, they must disclose it to FINRA within 30 days of the event. What the rep will do in most situations is, they will disclose information to FINRA through their form U4, which we’re going to discuss in just a few moments here.

But 30-day notifications are things like the rep moved, they changed their address, they changed their name. These are all 30-day disclosures. Certain things must be disclosed to FINRA within 10 days. FINRA considers immediate notification to be 10 days. Something that will require immediate notification is something that would cause the registered representative to become subject to statutory disqualification, or said another way, may cause them to lose their license– things like being charged with a felony.

A registered rep is charged with armed robbery. When must they notify FINRA? Well, the answer is immediately, and the definition is 10 business days. A registered has a customer alleging the registered representative forged their name– immediate notification, 10 business days. A registered rep’s customer calls in and alleges that their registered rep stole securities out of their account. Immediate notification to FINRA, again, 10 business days.

If another industry regulator takes action against a registered rep, FINRA must be notified within 10 days, immediately. So if the New York Stock Exchange, the Chicago Board Options Exchange, a state securities administrator, takes action against a registered representative, FINRA must be notified immediately, and that’s 10 business days.

It’s worth mentioning here an event that also requires immediate reporting to FINRA, and that is if the registered rep’s member firm sanctions, suspends, or takes action against the registered representative. Perhaps their regular representative has done something, and the firm is very unhappy about it. They’re not so unhappy about it that they’re going to fire them, but they are going to internally sanction or punish that person. That must be reported to FINRA immediately, and that’s within 10 days. 

One other thing that’s immediately reportable to FINRA is if the firm withholds commissions from a registered rep in excess of $2,500 in amount. So if the firm withholds commissions from the registered representative and the amount is more than $2,500, immediate notification to FINRA, and that is 10 business days.

Now we said the registered has to report serious customer complaints to FINRA within 10 business days, and that’s the definition of immediate. When a broker-dealer receives standard general customer complaints, things of that nature, the broker dealer is required to disclose those electronically to FINRA at the end of every calendar quarter, within 15 days of that quarter’s end. So most of the standard-style customer complaints will be disclosed or reported to FINRA within 15 days of the end of the quarter, those serious, allegations will be reported to FINRA within 10 days– forgery, theft, et cetera– charged with a felony. 

We hope this article has helped you better understand the different types of conduct that constitute violations in the Securities industry. Virtually all of you who are preparing for a finra exam will see this information tested in one form or another.  Be sure you are ready to pass your finra exam with our Greenlight money back pass guarantee

 good luck on your exam,

 The Securities Institute of America