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
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.
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.
- 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.
- 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.
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 insider-trading-policies requirement).
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 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.
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 under the IA code-of-ethics rule. 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
Two separate rules govern outside accounts, and the exam tests them differently.
Agents (BD Outside-Account Disclosure Requirement)
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.
IA Code of Ethics (Access Persons)
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.
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.
Key Definitions
- 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
Provisions
| Provision | Permissive or Mandatory | Details |
|---|---|---|
| Reporting to APS and Administrator | Mandatory | A qualified individual who reasonably believes an eligible adult is being financially exploited must notify both Adult Protective Services (APS) and the state securities administrator promptly |
| Trusted contact disclosure | Permissive | A firm may notify a previously designated trusted contact about suspected exploitation. Disclosure is not allowed if the trusted contact is the suspected exploiter |
| Delayed disbursement / temporary hold | Permissive | The firm may delay disbursements (or place a temporary hold) for up to 15 business days when financial exploitation is reasonably suspected. Applies to both broker-dealers and investment advisers |
| Notification of the delay | Mandatory (with exception) | When a disbursement is delayed, the firm must notify all parties authorized to transact on the account within 2 business days, except any party suspected of the exploitation |
| Immunity (safe harbor) | Two-prong test | Immunity from administrative and civil liability requires action be taken in good faith AND with reasonable care. The protection does not extend to criminal liability and does not apply to reckless or bad-faith conduct |
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 BOTH good faith AND reasonable care. 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.
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.