Conflicts of Interest, Impermissible Activities, and Ethics
This is the largest topic in the ethics unit, covering 13 categories of prohibited conduct, conflicts of interest, and ethical obligations for investment advisers, broker-dealers, and their representatives.
Loans To and From Clients
Borrowing from Clients
Borrowing from clients is prohibited unless the client is:
- A broker-dealer
- An affiliate of the investment adviser
- A financial institution in the business of loaning funds (e.g., a bank)
Loaning to Clients
Loaning to clients is prohibited unless the adviser is:
- A financial institution in the business of loaning funds
- The client is an affiliate of the adviser
Exam Tip: Gotchas
- An investment adviser (IA) cannot borrow $50,000 from a wealthy client to cover a personal expense, even if the client willingly offers the loan. The prohibition is absolute unless the client is a broker-dealer (BD), affiliate, or bank.
Sharing in Profits and Losses
IAs and investment adviser representatives (IARs) generally cannot share in the profits or losses of a client's account.
Exception: Sharing is permitted if:
- The adviser contributes its own capital to the account
- Sharing is proportional to the adviser's contribution
- Written authorization from the client exists
Members of the adviser's immediate family may share disproportionately with client authorization.
Client Confidentiality
Advisers must not disclose the identity, affairs, or investments of any client unless:
- Required by law (court order, subpoena, regulatory investigation)
- Client consents to the disclosure
Confidentiality continues after the advisory relationship ends.
Insider Trading
Investment advisers must establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information (Investment Advisers Act (IAA) Section 204A).
Key Definitions
- Material - information a reasonable investor would consider important in making an investment decision
- Nonpublic - information not yet broadly disseminated to the investing public
Key Rules
- Trading on or tipping others to trade on material nonpublic information violates Section 10(b) of the Securities Exchange Act of 1934 (SEA) and Securities and Exchange Commission (SEC) Rule 10b-5
- Information barriers ("Chinese walls") are common compliance tools to prevent material nonpublic information (MNPI) from flowing between departments
Exam Tip: Gotchas
- An adviser who learns that a publicly traded company is about to be acquired (material, nonpublic) cannot trade on that information for personal accounts OR client accounts. Using insider information to benefit clients is still illegal.
Selling Away
Engaging in securities transactions outside the scope of the adviser's normal business activities without proper disclosure and authorization. Similar to private securities transactions for BDs.
Market Manipulation
Any conduct designed to artificially influence the price of a security is prohibited. This includes:
- Wash trades - buying and selling the same security to create appearance of activity
- Matched orders - two parties secretly coordinate prearranged trades
- Painting the tape - creating false volume to mislead investors about market activity
- Front-running - executing personal trades before a large client order that will move the price
Personal Securities Transactions (Code of Ethics)
Every registered investment adviser must adopt a code of ethics (SEC Rule 204A-1). The code must address personal securities transactions of access persons.
Access Persons Defined
Access persons - supervised persons who:
- Have access to nonpublic information about client trades or portfolio holdings
- Are involved in making securities recommendations
- If providing investment advice is the adviser's primary business, all directors, officers, and partners are presumed to be access persons
Reporting Requirements
| Report | Timing | Content |
|---|---|---|
| Initial holdings report | Within 10 days of becoming an access person (information current within prior 45 days) | All reportable securities holdings |
| Annual holdings report | At least once every 12 months (information current within prior 45 days) | All reportable securities holdings |
| Quarterly transaction report | Within 30 days after end of each quarter | All securities transactions during the quarter |
Pre-Clearance Required
Pre-clearance required before access persons acquire beneficial ownership in:
- Initial public offerings (IPOs)
- Limited offerings (private placements)
Sole Proprietor Exception
If the adviser has only one access person (the adviser itself), it does not need to submit reports to itself, but must maintain records of all holdings and transactions.
Exam Tip: Gotchas
- The initial holdings report must be filed within 10 days of becoming an access person, but the holdings information must be current as of no more than 45 days prior. The exam may test these specific time frames.
Outside Securities Accounts
- Access persons must report any brokerage accounts they hold or establish
- Advisers must receive duplicate confirmations and/or statements for access persons' outside accounts
Excessive Trading (Churning)
Churning - inducing trading in a client's account that is excessive in size or frequency in view of the client's financial resources, investment objectives, and account character. The adviser can directly benefit from excessive transactions, creating a conflict of interest.
Indicators of churning:
- High turnover ratio (annualized value of purchases divided by average account value)
- High cost-to-equity ratio (total costs divided by average equity)
- Frequent short-term trades inconsistent with stated objectives
Churning is both an unethical business practice and a violation of antifraud provisions.
Exploitation of Vulnerable Adults
The Model Act to Protect Vulnerable Adults from Financial Exploitation addresses financial exploitation of eligible adults (typically age 65+ or adults with impairments).
| Provision | Details |
|---|---|
| Delayed disbursement | Adviser may delay disbursements for up to 15 business days if reasonable belief that financial exploitation would result |
| Trusted contact person | Advisers may designate a trusted contact person (authorized by the client) who can be notified of suspected exploitation |
| Mandatory reporting | Must notify the state securities regulator and adult protective services when exploitation is suspected |
| Immunity | Good-faith compliance provides immunity from administrative and civil liability |
| Limitation on trusted contact | Disclosure may not be made to the trusted contact if that person is suspected of the exploitation |
Exam Tip: Gotchas
- The disbursement delay is up to 15 business days, not calendar days. The adviser must also conduct an internal review during this period. This is a protective measure, not a punishment; the adviser is shielding the vulnerable adult while the situation is investigated.
Other Prohibited Activities
Additional unethical business practices:
- Misrepresentation of qualifications, services, or fees; omitting material facts
- Using others' work without disclosure (presenting third-party reports as your own)
- Guaranteeing results - promising a specific gain or no-loss outcome
- Advertising violations - ads containing untrue statements, implying Administrator approval, or false "free" offers
- False transaction reports - publishing or circulating any report of a securities transaction the BD does not believe was bona fide (distinct from deceptive advertising; this protects the integrity of the public trade record)
- Advisory contract failures - contracts must be in writing and disclose services, term, fees, formula, refund policy, discretionary power, and assignment restrictions
- Assignment without consent - cannot assign an advisory contract without client consent
- Accessing client accounts using the client's own unique identifying information (e.g., username and password)
- Failing to satisfy arbitration awards or final judgments from client-initiated proceedings
- Failing to pay regulatory fines or penalties imposed by the SEC, state regulators, or self-regulatory organizations (SROs)
- The list is not exhaustive - other conduct involving non-disclosure, incomplete disclosure, or deceptive practices is also deemed unethical
Exam Tip: Gotchas
- An IA cannot state in advertisements that the state Administrator has "approved" the advertisement. Registration does not imply approval or endorsement of qualifications or business practices.
- An IA cannot include a waiver of compliance with securities laws in an advisory contract.