With custody and compensation rules in place, the next layer of protection focuses on preventing conflicts of interest and outright fraud. This section covers the broadest set of prohibited practices and ethical requirements.
Conflicts of Interest
Loans To and From Clients
Agents: may never borrow from or lend to any client. No exceptions.
Investment advisers and IARs: generally prohibited, with limited exceptions. An IA may borrow from a client only if the client is a broker-dealer, an affiliate of the IA, or a financial institution engaged in the business of loaning funds (e.g., a bank). An IA may lend to a client only if the IA is a financial institution or the client is an affiliate.
The financial institution carve-out applies to IAs only. An agent whose client is a bank still may not borrow from that client.
Sharing in Profits and Losses
An adviser or agent cannot share in the profits or losses of a client's account unless:
- The adviser/agent makes a proportionate contribution to the account
- The client provides written consent
Exception: Family members are exempt from the proportionate contribution requirement.
Exam Tip: Gotchas
- Two requirements for sharing in profits/losses: proportionate contribution AND written consent. Both are needed.
- Family members are only exempt from the proportionate contribution rule, not from the written consent requirement.
Client Confidentiality
- Client information must be kept confidential
- Cannot be disclosed without client consent
- Exceptions: Disclosure is required when compelled by law (subpoena, regulatory request)
Criminal Activities
Insider Trading (the federal antifraud authority for MNPI trading)
- Trading on material nonpublic information (MNPI) is prohibited
- Applies to anyone in possession of MNPI, not just corporate insiders
- Both the person who trades and the person who "tips" can be liable
- Penalties include disgorgement of profits, civil fines, and criminal prosecution
Selling Away
- An agent conducting securities transactions outside the scope of their employing broker-dealer
- Done without the firm's knowledge and approval
- Prohibited: all transactions must go through or be approved by the employing broker-dealer (BD)
Market Manipulation
Prohibited manipulative activities include:
| Practice | Description |
|---|---|
| Wash trading | Buying and selling the same security to create the appearance of trading activity |
| Matched orders | Prearranged buy and sell orders at approximately the same time to create artificial activity |
| Painting the tape | Executing transactions to make it appear that a security is being actively traded |
Exam Tip: Gotchas
- Insider trading applies to ANYONE with MNPI, not just corporate officers or directors. A friend, neighbor, or taxi driver who trades on a tip is equally liable.
- Both the tipper and the tippee are liable. The person who shares the information and the person who trades on it can both face penalties.
Personal Securities Transactions and Code of Ethics
The IA Code-of-Ethics Rule
Every registered investment adviser must adopt a code of ethics that includes:
- Standards of business conduct reflecting fiduciary obligations
- Compliance with federal securities laws
- Reporting of personal securities transactions by access persons
Access Person Reporting Requirements
Access persons are individuals who have access to nonpublic information about client trades or portfolio holdings. If providing investment advice is the firm's primary business, all directors, officers, and partners are presumed to be access persons.
| Report Type | Deadline | Content |
|---|---|---|
| Initial holdings | Within 10 days of becoming an access person | Current holdings (as of a date no more than 45 days prior) |
| Quarterly transactions | Within 30 days of quarter-end | All personal securities transactions during the quarter |
| Annual holdings | Annually | Complete holdings report |
- Supervised persons must promptly report violations of the code of ethics to the chief compliance officer
- Reports are exempt for securities held in accounts where the person has no direct or indirect influence, and for transactions under automatic investment plans
Exam Tip: Gotchas
- The three access person deadlines: 10 days (initial), 30 days (quarterly), annually (holdings). These specific timeframes are frequently tested.
- All directors, officers, and partners are presumed access persons if the firm's primary business is investment advice. The exam tests who qualifies.
Excessive Trading (Churning)
Churning is trading in a client's account that is excessive in frequency or size relative to the client's objectives and financial resources, done primarily to generate commissions or fees.
Factors considered:
- Turnover rate: how quickly the portfolio is being traded
- Cost-to-equity ratio: total costs relative to account equity
- Client's investment objectives
- Whether the trading was authorized
Churning is a violation of both fiduciary duty and securities laws.
Exam Tip: Gotchas
- Churning is measured by turnover rate and cost-to-equity ratio, not just the number of trades. A high number of trades alone is not sufficient to prove churning.
- Churning requires control by the adviser. If the client directed every trade, the adviser is not churning the account.
North American Securities Administrators Association (NASAA) Unethical Business Practices
For Investment Advisers and Investment Adviser Representatives (IARs)
The NASAA Unethical Business Practices Model Rule prohibits the following:
- Misrepresenting qualifications or credentials
- Guaranteeing results (promising no losses or specific returns)
- Recommending transactions without a reasonable basis
- Churning client accounts
- Borrowing money or securities from clients
- Misusing client funds or securities
For Broker-Dealers and Agents (the NASAA Unethical Business Practices for BDs and Agents)
Similar prohibitions apply, plus:
- Investment company share rules: Specific obligations around breakpoint discounts and suitability of share class recommendations
- Agents must ensure clients receive applicable breakpoint discounts on mutual fund purchases
Outside Securities Accounts
Two separate requirements apply, depending on registrant type:
Agents (BD-registered persons): must obtain written consent from their employing BD before opening a new outside account. For accounts that predated employment, the agent must notify the employer within 30 calendar days of becoming associated. The employing firm may then request duplicate confirmations and statements from the other firm to monitor activity.
IA access persons: must report outside brokerage accounts as part of the holdings-reporting regime. The initial holdings report (covering all outside accounts and reportable securities) must be filed within 10 days of becoming an access person. Advisers must receive duplicate confirmations and/or statements for access persons' outside accounts.
The 30-day and 10-day deadlines are frequently confused on the exam because they cover the same general topic (outside accounts) but apply to different registrant types under different rule frameworks.
Due Diligence
- Advisers and agents must conduct reasonable investigation before making recommendations
- Must understand the products and securities being recommended
- Cannot rely solely on issuer representations; independent verification is required
Protecting Vulnerable Adults (NASAA Model Act)
The NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation authorizes firms to act when financial exploitation of an eligible adult is reasonably suspected.
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. The act authorizes a hold on disbursements only, not a full account freeze |
| 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
- Temporary HOLDS on disbursements only (not freezing the entire account). The act does not authorize a full account freeze.
- 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. 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.
Political Contributions (pay-to-play recordkeeping)
- See the pay-to-play rules covered in the Compensation section
- Advisers must maintain records of all political contributions by the adviser and its covered associates
- The 2-year look-back applies to covered associates' contributions made before they joined the firm