Ch. 6 Prohibited and Ethical Business Practices Under the USA

Question 1

What is the issue?

An agent of a broker-dealer calls a client and solicits the sale of an IPO. During his sales presentation, the agent states that the securities are a great investment opportunity, are legal, and have been approved by both the SEC and the state securities Administrator.

Answer 1

Claiming that a security has been approved by a regulator

The Administrator and the SEC don’t provide approval for securities. They simply require that the securities be registered. When the agent stated that the securities are legitimate or safe because they have been approved, he made a misleading and untrue statement.

Question 2

What is the issue?

An agent calls a client to announce that a company’s stock is about to be listed on Nasdaq. The agent stresses that the client should place a buy order before the announcement is made. The agent’s belief is that the stock’s market price will rise due to the fact that index fund managers will begin buying large quantities of the stock for their portfolios.

Answer 2

Stating that a security is about to be listed without justification

Unless the broker-dealer or agent has firm grounds (such as a press release) for believing that the security is about to be listed on the exchange, his statements are considered misleading. In this situation, the agent’s statements are a violation since he stated that the order should be placed prior to the announcement.

Question 3

What is the issue?

An agent of a broker-dealer has been analyzing the technology sector for several months, and although the market has been down, she feels that market conditions are improving. When speaking with a client about Xcel stock, she says, “As soon as the market corrects, Xcel is definitely going to rise to $40.”

Answer 3

Using inflated language

Since using promissory language is a violation, agents must carefully consider their words when making recommendations to clients. Using definitive words such as always, only, never, will, and guarantee may be problematic when making statements to clients. In this situation, when the agent used the word definitely, she violated the USA by using inflated language.

Question 4

What is the issue?

A customer called a broker-dealer to inquire about the price of XYZ stock in her account. Knowing that the client will be upset by the fact that the stock’s price dropped, the agent provided the previous day’s price, which was significantly higher.

Answer 4

Providing inaccurate market quotations

Although it’s never easy to give clients bad news, agents should never tell clients that everything is okay with their accounts when, in fact, a stock position has fallen in value. An agent who misrepresents the true market price of the stock by quoting the previous day’s price has committed an unethical act.

Question 5

An agent tells one of his clients that a specific fund is a no-load fund and that a sales charge will not be deducted from the purchase price. However, the agent fails to mention that the fund has a deferred (back-end) sales charge that’s assessed at redemption.

Answer 5

Providing false information

As will be covered in more detail later, a fund may be described as a no-load fund only if it has no front-end sales charge, no back-end (deferred) sales charge, and no 12b-1 fee that exceeds .25% of the fund’s average net assets each year. In an effort to execute a trade, the agent has given false information by suggesting that the fund (which has a deferred charge) is a no-load fund. Once again, this practice is unethical.

Question 6

A broker-dealer has a bullish outlook for the common stock of The Green Company. Jenny, an agent of the broker-dealer, goes to a chat room on a financial market Web site and poses as an employee of The Green Company. Jenny begins discussing The Green Company’s favorable sales outlook and new client acquisitions in an effort to make the company appear more successful.

Answer 6

Spreading rumors in order to effect transactions

This type of activity is prohibited for all persons, not just agents. State and federal authorities have charged a number of individuals with fraud for circulating rumors on the Internet to pump up the price of a stock. Jenny’s actions could lead to her registration being suspended or revoked. She could also be subject to more severe penalties if prosecuted.

Question 7

ABC Corporation has just announced a $1.00 dividend per share that’s payable to shareholders of record on Thursday, May 12. Ted, an agent of a broker-dealer, calls Jane and encourages her to buy the stock by Monday, May 9, to lock in the $1.00 dividend. Otherwise, she will miss receiving the dividend and lose the profit. Should Jane succumb to this high-pressure sales tactic?

Answer 7

Selling dividends

No. An investor who buys the stock in order to receive the dividend will be paying a price that includes the dividend. Jane would effectively be receiving her money back in the form of a taxable dividend. If Jane waits to buy the stock on or after the ex-dividend date, she will be able to buy it at a reduced price. Ted acted unethically when he attempted to induce the sale of stock based on its impending dividend.

Question 8

What is the issue?

An agent of a broker-dealer has been selling a large quantity of stock that’s on his firm’s recommended list. The agent is on the phone with a client who places an order to buy the shares when he receives news that the issuing company’s earnings will need to be restated. Fearing the news will cause the client to withdraw the trade, he decides not to disclose it to his client. What actions has the agent taken?

Answer 8

Omitting material facts

The agent’s actions are fraudulent and deceitful since he withheld material facts from a client. Registered persons don’t need to tell an outright lie to violate the USA’s antifraud rule. While it’s virtually impossible to disclose all known facts, a reasonable person can determine if the information is a material fact—one that’s important in order to decide whether to engage in a particular transaction. The agent withheld material facts when involved in a securities transaction. In this example, the agent would be required to disclose the material information regarding the company’s earnings to his client prior to entering the order.

Question 9

Brian, an agent of a broker-dealer, learns from a client who sits on the board of directors of a Fortune 100 company that the company is going to be subject to an expensive lawsuit. The client asks that Brian keep the information confidential. If another client calls and expresses interest in buying that company’s stock, does Brian have an obligation to provide this news to his client?

Answer 9

No. This is insider information and Brian is prohibited from sharing it publicly.

Question 10

Donald is the CEO of a publicly traded corporation. He wants to sell some of his company’s stock to purchase his own private Caribbean Island, but his company is about to announce their quarterly earnings. What should Donald do?

Answer 10

Donald should wait until after his company releases its quarterly earnings to sell his shares.

Question 11

What is churning?

Answer 11

Engaging in excessive client trading in order to generate commissions

Question 12

A broker-dealer has 70,000 shares of XYZ Company in its inventory and its clients own 15,000 shares of the same stock. In an effort to reduce bookkeeping expenses, the broker-dealer keeps all 85,000 shares together in one secure vault. Is this permitted?

Answer 12

Yes. A broker-dealer may keep customer stock and its own stock in the same vault. However, the securities must be maintained in such a way that it’s clear which certificates belong to the broker-dealer and which certificates belong to customers. When securities are separated appropriately, they’re considered segregated. Separate client ledgers and journals of securities transactions are created to record where each security is located.

Question 13

What is Conversion?

Answer 13

agent illegally takes possession of a client’s assets for her own personal use.

Question 14

An agent receives a check from a client who wants to open a brokerage account. Since it’s late in the day on Friday, the agent decides to deposit the client’s check in her business account and write a check to the broker-dealer next week when she returns to the office. Is this practice acceptable?

Answer 14

No. Regardless of the agent’s good intentions, this is considered conversion. The agent may not deposit cash or securities that belong to a customer into her personal or business account.

Question 15

Under the Uniform Securities Act, the only reference to a guarantee is in connection with a security whose payment of dividends, interest, and principal is guaranteed by _____

Answer 15

an entity other than the issuer

Question 16

T/F Broker-dealers are required to respond to all written customer complaints and must maintain a file with a copy of the complaints

Answer 16

True

Question 17

What is front running?

Answer 17

a brokerage firm executes orders on a security for its own account to take advantage of advance knowledge of pending orders from its customers

Question 18

What is shadowing?

Answer 18

involves a broker-dealer executing a trade for its own account immediately after it executes a substantial client trade, but before the client’s trade is reported.

Question 19

What is painting the tape?

Answer 19

financial professionals buying and/or selling securities among themselves in order to create false trading volume.

Question 20

Mort and Mickey are friends who work on the trading desks of rival brokerage firms. The two traders decide to trade a certain low-priced stock with each other at agreed-upon prices in an attempt to create a new single-day trading volume record for that stock. The next day, news of the trading circulates in the press and other investors start to bid up the stock’s price. Mort and Mickey subsequently sell their shares at a nice profit and stop trading the stock. What form of market manipulation is being committed?

Answer 20

Since Mort and Mickey prearranged their trading activity to create false volume in the security, they’re guilty of Painting the Tape.

Question 21

What is Selling Away?

Answer 21

agent executes securities transactions without the knowledge of her broker-dealer

Question 22

A client contacts his agent and enters a market order to sell a 1,000-share position in RST Corp. Rather than route the order for immediate execution, the agent holds the client’s order because he feels as though RST stock is going to rally later in the day. Ultimately, the agent was right and the stock was later sold near the closing price which was the high for the day. Was the agent justified in holding the client’s order?

Answer 22

No. Although delaying the execution of the market order resulted in a benefit to the client, knowingly failing to follow client instructions is an unethical business practice. This rule applies even if the broker-dealer or agent has discretion over the account.

Question 23

Agents (may or may not) solicit the sale of an unregistered, non-exempt security.

Answer 23

MAY NOT

Question 24

T/F

When involved in an initial public offering (IPO), a broker-dealer must always make a genuine (bona fide) public offering of all securities to which it was allocated as an underwriter or member of a selling group.

Answer 24

TRUE

Question 25

Keith is a producing branch manager of a brokerage firm, but also sits on an advisory board for his local municipality. When the municipality needs to issue bonds, the deals usually are directed to and completed by Keith’s firm. As Keith’s firm sells these bonds to clients, what disclosure must be provided?

Answer 25

Clients must receive a specific disclosure of the relationship that Keith and his firm have with the issuer. The disclosure must be made at least orally before the trade, followed by a written disclosure at or prior to the settlement of the trade.

Question 26

An agent of a broker-dealer recently opened an account for a client. The agent’s initial recommendation of Atlas Industries has appreciated in value by more than 20% in a short period. The agent thinks the time is right to take the profits and sell, but is unable to get in contact with the client. The agent sells the stock and decides to explain everything to the client later. Were the agent’s actions justifiable since the result was a profit?

Answer 26

No. The profitability of the transaction doesn’t make the agent’s actions acceptable. The agent was not granted discretionary authorization; therefore, she’s not permitted to effect transactions without the client’s prior knowledge. Without proper trading authorization, every order that’s placed in the client’s account requires her specific approval prior to placement. If a broker-dealer doesn’t have discretionary authorization over a client’s account, but the client specifically states whether to buy or sell, the specific security, and the specific quantity, the client’s agent may exercise judgment only as to the price and/or time of execution.

Question 27

Grace has a non-discretionary account with a brokerage firm. Grace contacts her agent and says, “At some point today, buy 100 shares of ABC whenever you think it’s best.” Is her agent allowed to execute this order without written discretionary authority (power of attorney)?

Answer 27

Yes. Grace indicates that she wants to buy 100 shares of ABC. Since she specified the three important details—the action (buy), the amount (100 shares), and the asset (ABC)—the agent may use his judgment regarding the best price and/or time of execution without written authorization.

Question 28

TipTop Financial is registered as both a broker-dealer and an investment adviser. Jim, an advisory client of TipTop, has just placed an order to sell 500 shares of XYZ. TipTop knows another advisory client for whom XYZ would be an appropriate purchase. TipTop would charge a small brokerage fee for arranging the trade. Is this permissible?

Answer 28

Yes. By crossing the trade, TipTop may be able to provide each client with a better price than what might be obtained in the open market. Before the trade, TipTop must obtain each client’s written consent and must disclose the firm’s capacity (as a dual agent) to each customer. Representing both sides of the trade is generally a conflict of interest; however, the conflict may be resolved through disclosure.

Question 29

Which of the following actions are considered violations of the antifraud section of the USA?
(Check all that apply.)
a. Art, an agent of Rocksolid Brokerage, is speaking with a client about an initial public offering. As he hands the client the prospectus, Art states that the SEC has approved these securities by registering them, implying that the shares represent a rock-solid investment.
b. A research analyst tells her firm’s clients that she believes that a company’s earnings will grow at an above-average rate for the next two years.
c. Alice, an agent of Rocksolid Brokerage, is trying to convince one of her clients to buy shares in ZAP Wireless at its current price of $50. By afternoon it has increased to $55. Alice knows about the increase but encourages her client to place an order to buy the stock without revealing that the price has increased.
d. An agent’s client has purchased a large amount of Octopus Computer on margin. Over the course of one day, Octopus plummets 15 points based on rumors that the government is going to break up the company. Panicked, the client calls the agent who tells him that everything is fine.

Answer 29

(A, C, D) In choices (a), (c), and (d), the agent’s actions are considered misleading and are violations of the antifraud section of the USA. Note that in the scenario presented in choice (a), giving the client the prospectus, which states that the SEC has not approved the securities, doesn’t relieve Art of his responsibility for making a misleading statement.

Question 30

Stephanie, an agent, is recommending a biotech stock to a client. As Stephanie is speaking with the client on the phone, she reads a newsflash that the company’s patent on one of its key products has been declared invalid. Stephanie takes the client’s order without mentioning this news. Stephanie has:

a. Not violated the USA because the decision to purchase the security was made before Stephanie saw the newsflash
b. Violated the USA by reading the newsflash while conducting business with a client
c. Violated the USA by failing to state a material fact
d. Not violated the USA because the patent information doesn’t affect the company’s profits

Answer 30

(C) Failing to state something important (omitting a material fact) is also a violation of the antifraud provisions of the USA.

Question 31

According to the USA, churning is defined as:

a. Inflating the price of a stock by circulating false rumors
b. Executing transactions on a client’s behalf without written authority
c. Trading excessively in a client’s account solely to generate commissions
d. Active trading in a customer’s account resulting in substantial losses

Answer 31

(C) Churning is trading excessively in a client’s account in order to generate commissions. Choice (a) market manipulation, and (b) unauthorized trading, also violate the USA.

Question 32

An agent’s client is thinking of purchasing a 20-year Treasury bond. The agent tells the client that the principal is guaranteed by the U.S. government, making these bonds a very safe investment and, therefore, there’s almost no chance that the client will lose any of her principal. If the agent neglects to tell the client that the bonds will fluctuate in price prior to maturity, has the agent violated the USA?

a. Yes; although U.S. government bonds are very safe, they’re subject to interest-rate risk.
b. No, U.S. government bonds are the safest security and are not subject to fluctuation.
c. No, since the client is going to hold the bonds until maturity, the fluctuation in price doesn’t matter.
d. Yes, the agent should also point out that U.S. government bonds are subject to regulatory risk.

Answer 32

(A) Neglecting to inform clients of the risks associated with investments is a violation of the USA.

Question 33

An agent decides to open a joint account with his fiancé. The fiancé will supply the funds and the agent will make the trading decisions and take advantage of the fact the he receives discounted commissions. The agent wants to share equally in any profits and losses. He obtains his fiancé’s signature approving this arrangement. Is this arrangement appropriate under the USA?

a. Yes, since the agent obtained the client’s written consent.
b. Yes, since the two parties are to be married.
c. No, since they’re not sharing proportionally in the profits and losses based on the amount each invested.
d. No, since the agent didn’t obtain written trading authority from the client and approval from the Administrator.

Answer 33

(C) In order for an agent to share in the profits or losses in a client account, both of the following conditions must be satisfied. (1) The client must consent in writing and the agent’s employer must give written approval, and (2) the agent and the client must share in the losses or gains in proportion to the funds that each contributed. This arrangement would have caused disproportionate sharing and would not have satisfied the second requirement.

Question 34

Selling which of the following securities is a prohibited transaction under the USA?

a. Limited partnerships
b. Exempt securities
c. Unregistered, non-exempt securities
d. Registered, non-exempt securities

Answer 34

(C) Securities must be either registered in a state or exempt from registration in order to be sold legally in that state. Soliciting trades in unregistered, non-exempt securities is a violation of the antifraud provisions of the USA.

Question 35

When meeting prospective clients for the first time, an agent of a broker-dealer tells them that he’s a registered stockbroker who holds Series 7 and Series 63 registrations. He further explains that he had to pass rigorous examinations to obtain these registrations and has been certified to act as a stockbroker by FINRA and the Administrator. Based on these circumstances, has the agent violated the antifraud provisions of the USA?

a. No, since his behavior was not misleading or fraudulent in any way.
b. Yes, by implying that his registration signifies certification by a regulator.
c. Yes, since it’s illegal to mention FINRA and the Administrator in a client meeting.
d. No, since Series 7 and Series 63 are difficult examinations.

Answer 35

(B) The USA prohibits agents from stating or implying that being registered means that the authorities have approved their activities or judged them to be competent.

Question 36

A client writes a letter to her investment adviser telling the adviser that she’s pleased with the performance of her portfolio. The investment adviser asks the client for permission to use this testimonial on its website and obtains the client’s written consent. The investment adviser’s actions constitute a(n):

a. Conflict of interest with the client
b. Unethical practice, since testimonials may not be used by investment advisers
c. Acceptable business practice, since written client consent was obtained prior to using the testimonial
d. Unethical practice, since investment advisers may not use the Internet to advertise

Answer 36

(B) Investment advisers may not use testimonials in their advertising with or without written client consent. This activity is specifically prohibited. Investment advisers may advertise on the Internet as long as the advertising follows NASAA’s guidelines.

Question 37

Which of the following conditions must be met before an agent may describe a mutual fund as a no-load fund?
I. The fund must not have a front-end sales charge.
II. The fund must not have a contingent deferred sales charge.
III. The fund must not have a 12b-1 fee.
IV. The fund must not charge a 12b-1 fee greater than .25% of the fund’s average net asset value.
a. I and II only
b. I and III only
c. I, II, and III only
d. I, II, and IV only

Answer 37

(D) In order for a mutual fund to be described as a no-load fund, it must meet three conditions:

1. The fund must not have a front-end sales charge (load).
2. The fund may not have a contingent deferred sales charge (back-end load), and
3. The fund may not have a 12b-1 fee that’s greater than .25% of the fund’s average annual net asset value.

Question 38

An investment adviser that sells a security from its own inventory is acting as a(n):

a. Agent
b. Principal
c. Agent in an agency cross transaction
d. Financial intermediary in an unregistered capacity

Answer 38

(B) An adviser that sells a security from its own account is acting as a principal. Look out for terms that may sound official but are simply made up, such as financial intermediary in an unregistered capacity.