Conflicts of Interest, Criminal Activities, and Fiduciary Considerations

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

• Generally prohibited for advisers
• Creates conflicts and potential for abuse
• An adviser who borrows from a client has a financial interest that may cloud their judgment

Sharing in Profits and Losses

An adviser or agent cannot share in the profits or losses of a client's account unless:

1. The adviser/agent makes a proportionate contribution to the account
2. 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 (Securities Exchange Act (SEA) Section 10(b), Rule 10b-5)

• 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:

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

Securities and Exchange Commission (SEC) Rule 204A-1 (Code of Ethics)

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.

• 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 (Model Rule 102(a)(4)-1)

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

• Supervised persons of advisory firms must report outside brokerage accounts
• Agents of broker-dealers typically must obtain employer approval for outside accounts
• This prevents hidden conflicts and undisclosed trading activity

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 covers:

• Who qualifies: Adults aged 65+ or those with mental/physical impairments
• Temporary holds: Broker-dealers and investment advisers may place temporary holds on disbursements when financial exploitation is suspected
• Notification: Must notify the state administrator and/or adult protective services
• Liability protection: Firms and advisers who act in good faith are protected from liability

Exam Tip: Gotchas

• Temporary HOLDS on disbursements only (not freezing the entire account). The act does not authorize a full account freeze.
• Notification to the state administrator and/or adult protective services is required. Firms cannot just place a hold and do nothing else.

Political Contributions (SEC Rule 206(4)-5)

• 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