Prohibited Activities
Securities laws and FINRA rules prohibit various activities that harm investors or market integrity. Understanding these prohibitions is essential for ethical practice.
Insider Trading
Insider trading is trading securities based on material, non-public information.
What is Material Information?
Information is material if a reasonable investor would consider it important in making an investment decision:
| Material Information | Examples |
|---|---|
| Earnings | Upcoming earnings surprises |
| Mergers/Acquisitions | Pending deals |
| Management Changes | CEO resignation |
| Major Contracts | New significant customer |
| Regulatory Actions | FDA approval/rejection |
| Financial Issues | Fraud discovery, bankruptcy |
Who Can Violate Insider Trading Laws?
- Corporate insiders (officers, directors)
- Employees with access to information
- Tippees (people who receive tips)
- Tippers (people who provide tips)
- Anyone who misappropriates information
Penalties for Insider Trading
| Penalty Type | Amount |
|---|---|
| Civil Penalty | Up to 3x profits gained or losses avoided |
| Criminal Penalty | Up to $5 million fine, 20 years prison (individuals) |
| Criminal Penalty | Up to $25 million fine (firms) |
Key Point: Both the tipper and tippee can be held liable.
Market Manipulation
Market manipulation involves artificially affecting the price or volume of securities.
Types of Manipulation
| Type | Description |
|---|---|
| Pump and Dump | Inflate price with false info, then sell |
| Wash Sales | Trade with yourself to create fake volume |
| Matched Orders | Pre-arranged trades to mislead market |
| Marking the Close | Trade at close to influence price |
| Marking the Open | Trade at open to set artificial price |
| Spoofing/Layering | Enter orders you intend to cancel |
| Painting the Tape | Series of trades to suggest activity |
Stabilization (Legal Exception)
Stabilization is the ONLY legal form of market manipulation:
- Used by underwriters during new issue distribution
- Bids cannot exceed the public offering price
- Must be disclosed in the prospectus
Front-Running
Front-running is trading ahead of a customer order to profit from the expected market impact.
FINRA Rule 5270
Prohibits trading in a security when in possession of material, non-public market information about an imminent block transaction.
Example: Broker learns a large customer is about to buy 100,000 shares. Broker buys for personal account first, knowing the large order will push the price up.
Related Violation: Trading Ahead
Trading ahead is similar—executing orders for firm accounts before customer orders at the same or better prices.
Churning (Excessive Trading)
Churning is excessive trading to generate commissions without regard to the customer's best interest.
Indicators of Churning
| Indicator | Description |
|---|---|
| High Turnover Ratio | Excessive buying/selling vs. account size |
| Cost-to-Equity Ratio | Commissions as % of equity |
| In-and-Out Trading | Frequent short-term trades |
| Break-Even Analysis | Account must earn significant % just to break even |
Requirements for Churning Claim
- Control — Representative controlled trading activity
- Excessive Trading — Trading was excessive
- Intent — Trading was for commission generation, not customer benefit
Unauthorized Trading
Unauthorized trading is executing transactions without customer approval.
When Authorization is Required
- Every trade in a non-discretionary account
- Trades outside discretionary authority scope
- First trade after account opening
Unauthorized Trading Defenses
- Written discretionary authority existed
- Customer ratified the transaction
- Standing instructions covered the trade
Selling Away
Selling away involves selling securities not approved by or disclosed to the employing firm.
FINRA Rule 3280 (Private Securities Transactions)
Requires representatives to:
- Written Notice — Notify employer before participating
- Approval — Obtain employer approval
- Supervision — Allow employer to supervise if compensated
Key Point: Even if no compensation, written notice is required.
Other Prohibited Practices
Interpositioning
Interpositioning is inserting an unnecessary intermediary in a transaction, increasing costs to the customer.
Backing Away
Backing away is a market maker refusing to honor their published quote.
Unauthorized Borrowing
Representatives cannot borrow from or lend to customers (with limited exceptions for family members).
Sharing in Customer Accounts
Representatives generally cannot share in profits/losses of customer accounts except:
- With written firm approval
- In proportion to the representative's financial contribution
- Joint accounts with immediate family members
Guarantees Against Loss
Representatives cannot promise to protect customers from losses or guarantee investment performance.
On the Exam
The Series 7 exam frequently tests:
- Elements of insider trading (material, non-public)
- Types of market manipulation
- Front-running definition and prohibition
- Churning indicators
- Selling away and private securities transaction rules
An employee of a pharmaceutical company tells their friend about a pending FDA approval before the public announcement. The friend buys stock and profits. Who can be held liable for insider trading?
A trader places large buy orders with no intention of executing them, then cancels the orders after the price moves. This practice is called:
A broker learns that a large institutional customer is about to place a major buy order. Before executing the customer's order, the broker buys shares for their personal account. This is:
A registered representative wants to sell limited partnership interests to clients. The partnerships are not offered through their firm. What must they do?
Which of the following is the ONLY legal form of market manipulation?
12.5 Customer Protection Rules
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