Key Takeaways
- Churning is excessive trading to generate commissions, measured by turnover ratio and cost-equity ratio.
- A turnover ratio of 6 or cost-equity ratio above 20% is generally indicative of churning.
- Front-running (trading ahead of client orders) is strictly prohibited.
- Scalping (recommending securities then selling own position) is prohibited.
- Guaranteeing against loss is ALWAYS prohibited, regardless of circumstances.
- Sharing in client profits/losses requires written consent AND proportionate sharing.
- Unauthorized trading and selling away are serious violations.
- Material misrepresentation and omission are forms of fraud.
Prohibited and Unethical Practices
Both investment advisers and broker-dealers must avoid prohibited practices that harm clients and violate securities laws.
Churning (Excessive Trading)
Churning is trading that is excessive in light of the account's objectives, conducted primarily to generate commissions rather than benefit the client.
Elements of Churning
To prove churning, three elements must be established:
| Element | Description |
|---|---|
| Control | Broker had control over the account (actual or de facto) |
| Excessive trading | Trading was excessive given account objectives |
| Scienter | Broker acted with intent or reckless disregard for client |
Quantitative Indicators
FINRA Rule 2111 (Quantitative Suitability) identifies these key metrics:
| Metric | Calculation | Warning Levels |
|---|---|---|
| Turnover Ratio | Total purchases ÷ Average equity (annualized) | 2 = suggestive, 4 = presumptive, 6+ = conclusive |
| Cost-Equity Ratio | Total annual costs ÷ Average equity | Above 20% indicative of excessive trading |
| In-and-Out Trading | Frequent buy/sell of same securities | "Hallmark" of churning |
Turnover Ratio Examples
| Account Type | Turnover Ratio | Interpretation |
|---|---|---|
| Conservative | 2 | Suggestive of churning |
| Moderate | 4 | Presumptive of churning |
| Any account | 6+ | Generally conclusive |
De Facto Control
Even in non-discretionary accounts, churning can occur if:
- Client routinely accepts all broker recommendations
- Client never makes independent decisions
- Broker dominates decision-making
Fraudulent Practices
| Practice | Description |
|---|---|
| Material Misrepresentation | Making false statements of material fact |
| Omission | Failing to disclose material information |
| Manipulation | Artificially affecting security prices |
| Front-Running | Trading ahead of known client orders |
| Scalping | Recommending securities then selling own position |
Front-Running
Trading in a security ahead of a client's order to profit from the expected price movement:
- Applies to advisers, BDs, and their employees
- Violates fiduciary duty
- Criminal penalties may apply
Scalping
Recommending securities to clients while secretly selling the adviser's own position:
- Deceives clients about adviser's true opinion
- Violates disclosure requirements
- May cause client losses while adviser profits
Trading Violations
Unauthorized Trading
Making trades without client consent:
- Even one unauthorized trade is a violation
- Discretionary authority requires written authorization
- Time/price discretion ≠ full discretion
Selling Away
Selling securities NOT approved by the employing firm:
- Private securities transactions
- Violates firm supervision requirements
- May involve undisclosed compensation
Best Execution
Advisers must seek the most favorable terms reasonably available:
| Factor | Consideration |
|---|---|
| Price | Best available price for the security |
| Commission | Reasonable commission rate |
| Speed | Timeliness of execution |
| Reliability | Broker's track record |
| Total cost | All-in cost to the client |
Sharing in Client Accounts
General Rule
Sharing in profits or losses is prohibited unless:
| Requirement | Details |
|---|---|
| Written consent | Client must agree in writing |
| Firm approval | Employing firm must approve |
| Proportionate sharing | Based on capital contribution |
Exception for Family Members
When sharing with immediate family members:
- Proportionate sharing NOT required
- Written consent still required
- Relationship must be genuine
Guarantees
Absolutely Prohibited
| Prohibited Practice | Example |
|---|---|
| Guaranteeing against loss | "I'll cover any losses you have" |
| Promising specific returns | "You'll definitely make 10%" |
| Making up losses | Reimbursing client from personal funds |
Allowed Practices
| Allowed | Example |
|---|---|
| Historical performance | "This fund returned 8% last year" (with disclosures) |
| Investment objectives | "We seek 7-9% annual returns" |
| Risk discussions | "Higher risk may mean higher returns" |
Other Prohibited Practices
| Practice | Description |
|---|---|
| Borrowing from clients | Unless client is a lending institution |
| Lending to clients | Generally prohibited |
| Excessive markups | Unreasonable profit on principal trades |
| Backdating documents | Falsifying dates on trades or contracts |
| Forging signatures | Creating or altering client signatures |
| Commingling | Mixing client and firm assets |
| Misappropriation | Using client assets for other purposes |
| False statements to regulators | Providing false information in exams |
Exam Tip: Churning indicators - turnover ratio of 6+ and cost-equity ratio above 20%. Guarantees against loss are ALWAYS prohibited. Sharing requires WRITTEN consent AND proportionate sharing (except family).
A broker's account has a turnover ratio of 6 and a cost-equity ratio of 22%. This suggests:
An investment adviser may share in a client's profits and losses if:
A broker tells a client, "If you lose any money on this trade, I'll personally reimburse you." This statement:
An adviser learns a large institutional client will purchase 100,000 shares of XYZ. Before executing the client's order, the adviser buys XYZ for their personal account. This is:
13.3 Custody and Safeguarding Client Assets
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