NASAA Model Rule: IA Prohibited Practices
Now that you know what broker-dealers and agents cannot do, let's look at the parallel set of rules for investment advisers. The NASAA Model Rule on Unethical Business Practices of Investment Advisers (Model Rule 102(a)(4)-1) establishes the fiduciary standard and specific prohibited practices for investment advisers (IAs), investment adviser representatives (IARs), and federal covered advisers.
Fiduciary Duty
- An investment adviser, IAR, or federal covered adviser is a fiduciary and has a duty to act primarily for the benefit of its clients
- The extent and nature of this duty varies by the relationship and circumstances
- For federal covered advisers, the provisions apply to the extent the conduct is fraudulent or deceptive (as permitted by the National Securities Markets Improvement Act (NSMIA))
- The listed practices are not inclusive; other deceptive or nondisclosure conduct is also deemed unethical
Exam Tip: Gotchas
- An IA is ALWAYS a fiduciary. The fiduciary duty is not optional or contractual; it is imposed by law on every investment adviser, IAR, and federal covered adviser (to the extent of fraud for federal covered advisers).
Key IA Prohibited Practices
| Rule | Prohibited Practice | Key Details |
|---|---|---|
| (a) | Unsuitable recommendations | Cannot recommend without reasonable grounds based on inquiry into objectives, financial situation, and needs |
| (b) | Unauthorized discretion | Must obtain written authority within 10 business days after first trade under oral discretion |
| (c) | Churning | Excessive trading in size or frequency; IA can directly benefit from transaction volume |
| (d) | Unauthorized trading | Placing orders without authority |
| (e) | Third-party trading | Cannot trade on a third party's instruction without written authorization from the client |
| (e)/(f) | Borrowing from clients | Only permitted if client is a broker-dealer (BD), affiliate of the IA, or financial institution engaged in lending |
| (f)/(g) | Lending to clients | Only permitted if IA is a financial institution or client is an affiliate of the IA |
| (g)/(h) | Misrepresentation | Cannot misrepresent qualifications, services, or fees; cannot omit material facts |
| (h)/(i) | Undisclosed third-party reports | Must disclose that a report was prepared by someone else (exception: published research) |
| (i)/(j) | Unreasonable fees | Cannot charge an unreasonable advisory fee |
| (j)/(k) | Failing to disclose conflicts | Must disclose in writing before any advice all material conflicts of interest |
| (k)/(n) | Performance guarantees | Cannot guarantee a specific result (gain or no loss) |
| (m)/(r) | Breaching confidentiality | Cannot disclose client identity or affairs unless required by law or with consent |
| (o) | Deficient advisory contracts | Must be in writing and disclose: services, term, fee, formula, prepaid fee return policy, discretion, and no assignment without consent |
| (p)/(q) | No insider trading policies | Must establish written policies to prevent misuse of material nonpublic information |
| (q)/(r) | Improper performance fees | Cannot enter contracts contrary to Investment Advisers Act (IAA) Section 205 |
| (r) | Waiver of compliance | Cannot bind clients to waive compliance with the Act or IAA |
| (u)/(v) | Using client credentials | Cannot access client accounts with client's own username and password |
| (v)/(w) | Failing to maintain policies | Must establish and enforce all required policies and procedures |
| (w)/(x) | Failing to pay arbitration awards | Same as BD rule; must satisfy final judgments and awards |
| (x)/(y) | Avoiding arbitration awards | Cannot attempt to evade payment |
| (y)/(z) | Failing to pay penalties | Must pay regulatory fines, restitution, and disgorgement |
The 10-Business-Day Rule for Discretionary Authority
This is a critical distinction between BD and IA rules:
| Broker-Dealer | Investment Adviser | |
|---|---|---|
| When written authority is required | Before the first discretionary trade | Within 10 business days after the first trade under oral authority |
| Grace period | None | 10 business days |
| Time/price exception | Yes | Yes |
The time/price exception applies to both: if a customer says "buy 100 shares of XYZ at the best price today," the BD or IA may decide when and at what price to execute without written discretionary authority.
Exam Tip: Gotchas
- The 10-business-day grace period applies only to investment advisers. Broker-dealers must have written authority before the first discretionary trade with no grace period.
- A common wrong answer: applying the 10-day rule to BDs. It does not apply to BDs.
Advisory Contract Requirements
Every investment advisory contract must be in writing and disclose:
- Services to be provided
- Term of the contract
- Advisory fee amount
- Formula for computing the fee
- Policy on returning prepaid fees if the contract is terminated early
- Whether the IA is granted discretionary authority
- That no assignment may occur without client consent