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.

When Can Advisers Borrow From or Lend to Clients?

Affiliate: a person or entity that controls, is controlled by, or is under common control with the investment adviser, whether directly or through one or more intermediaries. In practice, this means a corporate parent, a subsidiary, or a sister company under common ownership with the adviser, not an individual client who merely happens to have wealth, industry ties, or a personal relationship with the adviser.

When Can Advisers and IARs Borrow From Clients?

Investment advisers and IARs may not borrow from clients 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)

Agents (registered representatives of broker-dealers) face a stricter rule: they may never borrow from any client under any circumstances. There are no exceptions. The financial institution carve-out exists only in the IA rules, not in the BD/agent rules.

When Can Advisers Loan 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.
• The financial institution exception requires the client to be the institution itself, not merely an employee of one. A client who works at a bank (a loan officer, for example) is still an individual; the loan comes from that person, not the bank, so the exception does not apply.
• The affiliate exception hinges on a control relationship between entities, not on how close or trusted the client is. A wealthy individual investor, even one who sits on the adviser's advisory board or has known the adviser for years, is not an affiliate. A parent company, subsidiary, or sister entity under common ownership with the adviser is.
• An agent may never borrow from any client, full stop. The three exceptions above apply only to IAs and IARs. If a question asks whether an agent can borrow from a client who is a bank, the answer is no.

When Can Advisers Share in Client Profits and Losses?

Agents (broker-dealer representatives) may share in a customer's profits or losses only with:

• Prior written authorization from the firm, AND
• Prior written authorization from the customer, AND
• Sharing in proportion to the agent's own financial contribution to the account

The proportionality requirement is waived for accounts of the agent's immediate family (firm and customer authorization are still required).

Investment advisers and IARs generally cannot share in the profits or losses of a client's account. A separate exception applies: sharing is permitted if the adviser contributes its own capital to the account, the sharing is proportional to that contribution, and written authorization from the client exists. As with agents, members of the adviser's immediate family may share disproportionately with client authorization.

This capital-contribution exception is distinct from a performance-based fee, which is a compensation arrangement permitted only when the client is a qualified client (at least $1.4M under the adviser's management, more than $2.7M net worth, a qualified purchaser, or a knowledgeable employee of the adviser). See the compensation section for the qualified-client thresholds.

What Are the Client Confidentiality Rules?

Advisers must not disclose the identity, affairs, or investments of any client unless either of the following applies:

• Required by law (court order, subpoena, regulatory investigation)
• Client consents to the disclosure

Confidentiality continues after the advisory relationship ends.

Exam Tip: Gotchas

• The protection points outward: the rule prohibits sharing client information with third parties, not withholding it from the client. A client may always request information about their own accounts, even after the advisory relationship ends. Citing "client confidentiality" to refuse a client's own request for their own portfolio data is an improper application of the rule.
• The "unless consented to by the client" exception confirms the direction. Consent is only needed when sharing with someone other than the client; the client does not need to consent to receive their own information.

What Are the Insider Trading Rules?

Investment advisers must establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information (Investment Advisers Act insider-trading-policies requirement).

What Do Material and Nonpublic Mean?

• Material: information a reasonable investor would consider important in making an investment decision
• Nonpublic: information not yet broadly disseminated to the investing public

What Are the Key Rules?

• Trading on or tipping others to trade on material nonpublic information violates the Securities Exchange Act of 1934 antifraud provisions, including the general antifraud rule prohibiting any manipulative or deceptive device in connection with the purchase or sale of a security
• 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.

What Are Principal Transactions?

A principal transaction occurs when an adviser acting as principal for its own account buys a security from a client or sells one to a client out of its own inventory. Before the transaction is completed, the adviser must disclose that capacity to the client in writing and obtain the client's consent.

This is broader than the agency cross transaction covered in the Client Communication unit: an agency cross involves the adviser acting as broker for both sides, while a principal transaction is the adviser trading directly against the client's own account.

Exam Tip: Gotchas

Failing to make the written disclosure and obtain consent before completion of a principal transaction is a violation of the Investment Advisers Act's antifraud provisions. Consent given after the trade closes does not cure the violation.

What Is 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.

Exam Tip: Gotchas

Selling away involves a client or third party: the adviser or IAR sells securities to a client (or arranges a client's transaction) outside the firm's normal, disclosed business, off the firm's books. It is not about the representative trading in their own personal account.

An adviser or IAR trading their own account is governed by a separate set of rules covered elsewhere in this unit:

• The Personal Securities Transactions (Code of Ethics) section below requires pre-clearance before an access person buys into an IPO or limited offering, plus initial, annual, and quarterly holdings/transaction reports.
• The Outside Securities Accounts section below requires access persons to have duplicate confirmations and statements sent to the adviser for any personal brokerage account held elsewhere.

Both regimes require disclosure to the firm before or shortly after the trade; neither one is "selling away."

What Counts as 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
• Scalping: buying or holding a security, recommending it to clients so demand pushes the price up, then selling the adviser's position for a profit

What Does the Code of Ethics Require for Personal Trading?

Every registered investment adviser must adopt a code of ethics under the IA code-of-ethics rule. The code must address personal securities transactions of access persons.

Why this exists: access persons see client trades before the market does. Without oversight, an access person could front-run a client order in their own account, or trade ahead of a recommendation the firm is about to make to clients. The holdings and transaction reports below let the adviser's compliance staff compare an access person's personal trading against what clients were doing at the same time, so conflicts like that surface instead of staying hidden.

Who Is an Access Person?

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

What Are the Reporting Requirements?

Reportable securities covers almost everything an access person could hold or trade, including stocks, bonds, options, and most mutual funds the adviser itself doesn't manage. A short list is carved out because it presents little opportunity for the kind of trading these reports are meant to catch:

• Direct obligations of the U.S. government (e.g., Treasury securities)
• Bank CDs, commercial paper, repurchase agreements, and other high-quality short-term debt instruments
• Shares of an open-end mutual fund, unless the adviser (or an affiliate) acts as that fund's investment adviser or principal underwriter

When Is Pre-Clearance Required?

Pre-clearance required before access persons acquire beneficial ownership in:

• Initial public offerings (IPOs)
• Limited offerings (private placements)

What Is the 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.

What Are the Rules for Outside Securities Accounts?

Two separate rules govern outside accounts, and the exam tests them differently.

What Must Agents Disclose About Outside Accounts?

Agents must disclose brokerage accounts held at other firms to their employing broker-dealer under the outside-account disclosure requirement.

• New accounts (opened after joining): the agent must obtain prior written consent from the employer before opening the account. No grace period.
• Pre-existing accounts (opened before joining): the agent must notify the employer and the executing firm within 30 calendar days of becoming associated.

The employing firm may then request duplicate confirmations and statements from the executing firm to monitor the account.

What Must IA Access Persons Disclose About Outside Accounts?

Access persons at investment adviser firms must report outside brokerage accounts as part of the holdings-reporting regime. Advisers must receive duplicate confirmations and/or statements for access persons' outside accounts.

The initial holdings report (which covers outside accounts along with all reportable securities) must be filed within 10 days of becoming an access person.

Exam Tip: Gotchas

• The 10-day deadline and the 30-day deadline apply to different registrant types under different rules. The 10-day figure comes from the IA Code of Ethics access-person reporting requirement. The 30-day figure applies to agents disclosing pre-existing outside brokerage accounts to their new employing BD.
• New accounts always require prior consent from the employer. The 30-day grace period exists only for accounts that predated the agent's current employment.

What Is 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.

Three required elements (all three must be established to prove churning):

1. Control over the account by the agent or adviser. This is the threshold element: without it, the client (not the agent or adviser) is directing the trading, so there is no basis for a churning claim. Control can be actual (formal discretionary authority) or de facto (the client routinely follows every recommendation without independently evaluating it, even with no signed discretionary agreement).
2. Excessive trading, evaluated at the account level (the aggregate pattern), not trade by trade. A recommendation can be individually suitable and still be part of a churning pattern.
3. Scienter (intent): intent to defraud, or reckless disregard for the client's interests. Ordinary negligence does not satisfy this element.

Indicators used as evidence of the excessive-trading element (none is conclusive on its own, and none substitutes for proving control or intent):

• 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.

Exam Tip: Gotchas

• A high turnover ratio or cost-to-equity ratio is evidence toward the excessive-trading element only. It never conclusively establishes churning by itself, and it does not substitute for proving control or intent. If a question asks for the "threshold" or "required" element and lists a ratio alongside control, the ratio is a trap.
• Control does not require a signed discretionary agreement. De facto control (the client rubber-stamps every recommendation without independent judgment) satisfies the control element the same as formal discretionary authority does.
• A client authorizing every individual trade is not a complete defense. If the agent has de facto control and the pattern is excessive, churning can still be found even though the client technically approved each order.

How Are Vulnerable Adults Protected From Exploitation?

The Model Act to Protect Vulnerable Adults from Financial Exploitation addresses financial exploitation of eligible adults.

Who Is an Eligible Adult or Qualified Individual?

• Eligible adult: a person age 65 or older, OR an adult with a mental or physical impairment that affects the ability to protect their own financial interests
• Qualified individual: a broker-dealer agent, investment adviser representative, OR any associated person of a broker-dealer or investment adviser who serves in a supervisory, compliance, or legal capacity. Independent contractors fulfilling any of these roles also qualify. Qualified individuals carry the mandatory reporting obligations described below

What Are the Key Provisions?

Exam Tip: Gotchas

• The disbursement delay is up to 15 business days, not calendar days. The firm must conduct an internal review during the delay period.
• Immunity is not automatic. It requires good-faith compliance. A reckless or bad-faith disclosure or delay loses the safe harbor.
• Mandatory vs. permissive: reporting to APS and the Administrator is mandatory (shall). Notifying the trusted contact is permissive (may). Many exam stems hinge on this distinction.
• The suspected exploiter is never notified. This applies in both directions: a suspected-exploiter trusted contact must not be notified of suspected exploitation, and a suspected-exploiter authorized party must not be notified that a disbursement has been delayed.
• A "qualified individual" is defined by role at the firm (supervisory, compliance, or legal capacity), not by job title. Legal counsel for the firm qualifies; a back-office clerk does not.

What Other Activities Are Prohibited?

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

Source: NASAA Model Rule on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (April 2025)

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.

What Should You Check on Exam Day?

• IAs/IARs cannot borrow from clients except a BD, affiliate, or bank; agents can never borrow from any client, no exceptions
• IAs generally cannot share in client profits/losses, except by contributing their own capital proportionally with written client authorization (or via a qualified-client performance fee, a separate compensation arrangement); agents may share proportionally to their contribution with firm and client written authorization; both exceptions waive proportionality for immediate family
• Client confidentiality continues after the relationship ends; the rule restricts disclosure to third parties, not to the client's own request for their own data
• A principal transaction (adviser trading against its own inventory) requires written disclosure and client consent before the trade completes; consent after the fact does not cure it
• Churning requires all three of control, excessive trading (account-level), and scienter; a high turnover or cost-to-equity ratio alone never proves churning
• Access persons: initial holdings report within 10 days (data current within 45 days), annual holdings report every 12 months, quarterly transaction report within 30 days; pre-clearance required for IPOs and limited offerings
• Vulnerable-adult disbursement delay: up to 15 business days, extendable to 25 business days at APS's or the Administrator's request (measured from the original delay); notice of the delay to authorized parties and to APS/the Administrator within 2 business days, investigation results due to APS/the Administrator within 7 business days; immunity requires good-faith compliance
• The suspected exploiter must never be notified, whether as a trusted contact or an authorized party on a delayed disbursement
• The 10-day IA access-person deadline and the 30-day agent pre-existing-outside-account deadline apply to different registrants under different rules