Prohibited Activities is the last topic of the third section of FINRA’s SIE content outline. Approximately 23 questions come from the third section, and prohibited activities are the most important topic from the SIE exam perspective.
This page of the SIE study guide covers various market manipulation techniques and other prohibited activities to secure retail investors from big losses.
Market Manipulation
Market manipulation involves practices that artificially inflate or deflate the price of a security or otherwise influence market activity for personal gain. Common tactics include spreading false rumors, engaging in excessive trading, and manipulating opening or closing prices. These actions undermine market integrity and investor trust and are illegal under securities laws.
- Market Rumors: It involves spreading false or misleading information about a company or its stock to influence its price. These rumors can create artificial demand or panic, leading to abnormal price movements, which is illegal.
Example: Let’s assume Kevin holds 10,000 shares of an XYZ company at $5.00/share, and he manages to plant a rumor about XYZ company. Due to this false news, the XYZ share price increased to $20.00/share in a few days, and he sold all his 10,000 shares at a high price. Kevin made a $150,000 profit during a short period, an illegal and punishable offense.
- Pump and Dump: It is a fraudulent method where promoters or investors artificially hype a stock to inflate its price. Once the stock price peaks, they sell their shares for a profit. This leads to a significant drop in the stock price. This practice is illegal and unethical.
Example: Suppose Kevin holds 10,000 shares of XYZ company, and he recommends dozens of his clients and friends. Due to his recommendation, a huge demand is created, and XYZ’s share price increases. After a few days, Kevin sold all his holdings at a peak price, and the share price dropped drastically, and his client made losses.
- Front Running: It is an unethical practice where a broker executes orders on security for their account while taking advantage of advanced knowledge of pending client orders. This activity exploits confidential information for personal gain, violating fair trading principles and client trust.
Example: Assume Kevin is a broker, and his client Thomas asks to buy 500,000 shares of XZY company. Instead of purchasing shares for his client, Kevin first purchased a few shares in his own personal account, knowing that the large order quantity would boost the share price. He then executes his client’s order and sells his shares, earning himself a significant profit.
- Excessive Trading (Churning): A broker primarily purchases and sells securities in a client’s account to generate higher commissions. This practice is unethical as it prioritizes the broker’s profit over the client’s best interests, potentially leading to significant financial losses.
Example: Kevin has discretionary authorization for his client Andrew’s account, from which he earns a commission on every trade. Andrew is a risk-averse client, and he primarily invests for retirement. Kevin starts to trade excessively against Andrew’s best interests to generate more commission.
- Marking the Open: Marking the open involves manipulating a security’s price at the trading day’s opening by placing large orders to create a false impression of high demand or supply. This deceptive practice misleads other investors and disrupts market integrity.
Example: Kevin, his friends, and colleagues place several trade orders for XYZ company’s stock before the market opens. This creates a huge demand for shares, and their prices increase. Once the price is increased, they sell their shares for a profit, which is illegal.
- Marking the Close: It involves manipulating a security’s price at the end of the trading day by placing large orders to create a false impression of high demand or supply. This deceptive practice aims to influence the closing price, misleading investors and distorting market data.
Example: Kevin and his colleagues place several trade orders for XYZ company’s stock prior to market close to influence the stock’s closing price. This activity is known as marking the close, and it’s illegal.
- Freeriding: It occurs when an investor buys securities and sells them before fully paying for the initial purchase. This violates standard settlement rules, as the sale proceeds cover the initial purchase without proper funds. This practice is illegal, and freeriding accounts are frozen for 90 days.
Example: Kevin purchases stock in his account but does not pay for it before turning around and selling it.
Backing Away: Backing away occurs when a market maker fails to honor their quoted bid or ask for a price for security. This practice undermines market confidence and fairness. It is considered unprofessional and is prohibited by regulatory authorities.
Insider Trading
Insider trading involves buying or selling a security based on material, non-public information about the company. This can include knowledge of upcoming mergers, acquisitions, legal proceedings, financial reports, or significant corporate events.
Insider trading is illegal because it gives an unfair advantage to those accessing confidential information, undermining market integrity and investor trust. Violators can face severe penalties, including fines and imprisonment, as it breaches the principles of a fair and transparent market.
Regulatory bodies strictly monitor and enforce rules against insider trading to maintain market fairness. A person with access to non-public and confidential information about a company and trades in that stock is considered a violation of FINRA and SEC insider trading rules.
Penalty for insider trading rule violation:
- Twenty years imprisonment and/or a fine of up to $5 million for individuals.
- Up to $25 million fines for business entities.
Other Prohibited Activities
- Purchasing Initial Public Offerings: FINRA’s rules and SEC regulations restrict purchasing new equity security issues, such as initial public offerings (IPO), for registered representatives. They are also prohibited from selling a new issue of equity security to other broker-dealers and their affiliates.
- Use of Manipulative, Deceptive, or Other Fraudulent Devices: According to the SR-FINRA-2008-028 amendment, member firms are strictly prohibited from purchasing or selling security by any manipulative, deceptive, or fraudulent devices.
- Improper Use of Customers’ Securities or Funds: Broker-dealers, member firms, or registered representatives are restricted from improperly using customers’ securities or funds. There are various meanings of the term “improper use,” however, the most common are classified below:
- Borrowing From Customers: FINRA Rule 3240 prohibits registered representatives from borrowing money or securities from their clients unless the client is a family member or the client is a lending institution in the business of lending money. Even in these cases, representatives must follow their firm’s policies and obtain prior written approval.
- Sharing in Customer Accounts: FINRA Rule 2150 prohibits registered representatives from sharing in the profits or losses of a customer’s account unless certain conditions are met. The representative must obtain written authorization from the customer and the firm, and the sharing must be proportionate to the representative’s financial contribution.
- Financial Exploitation of Seniors: FINRA Rule 2165 allows firms to place a temporary hold on disbursements of funds or securities from the accounts of customers aged 65 or older or those who are mentally or physically impaired when there is a reasonable belief of financial exploitation. The rule requires notifying the trusted contact person and immediate internal review.
- Activities of Unregistered Persons: FINRA Rule 1031 prohibits individuals from performing activities that require registration, such as soliciting or executing trades and providing investment advice. Firms must ensure that all personnel engaging in these activities are appropriately registered and qualified.
- Falsifying or Withholding Documents: FINRA strictly prohibits the falsification or withholding of documents, including altering records, creating false entries, or failing to provide required information during investigations or audits. Registered representatives are also prohibited from creating blank template forms that contain signatures.
- Prohibited Activities Related to the Maintenance of Books and Records: The firms should maintain accurate and complete records of all transactions, communications, and other relevant data. Prohibited activities include falsifying records, failing to create required documentation, and improperly destroying documents. Accurate recordkeeping ensures transparency, regulatory compliance, and the protection of investor interests.
- Unsuitable Recommendations: When a broker advises a client to invest in securities that do not align with the client’s financial goals, risk tolerance, or investment profile. This violates the broker’s duty to act in the client’s best interest and can lead to significant financial losses for the client.
- Commingling: It occurs when a firm mixes client funds with its own assets. This practice is strictly prohibited as it can jeopardize the security of client assets and compromise financial integrity. Regulatory bodies require firms to separate client funds to ensure transparency and protect clients’ interests.
- Theft/Embezzlement/Similar Criminal Behavior: Theft, embezzlement, and similar criminal activities involve illegally appropriating client or firm assets. These actions are severe trust and fiduciary responsibility violations, leading to significant legal consequences, including heavy fines, imprisonment, and professional disqualification.
This is the end of the third section of the SIE study guide. We’ve covered all the topics mentioned in the SIE content outline. Now, let’s test your understanding with the below practice quiz.