Prohibited actions

While financial professionals generally strive to do their best, a number of “bad actors” in the past have demonstrated the need for regulation in our industry. We’ll discuss these prohibited actions in this chapter:

• Failure to disclose material facts
• Insider trading
• Market manipulation
• General unlawful actions

Failure to disclose material facts

Let’s first establish the definition of a material fact:

If a registered representative knowingly omits a material fact when discussing securities, they can be subject to penalties. This especially comes into play when recommendations are made. Financial professionals are required to act in a fiduciary capacity, meaning they must put the interests of their clients before their own. For example, a security sale may make a registered representative a great deal of compensation, but they should not recommend the security if it is not suitable for their client. Or, even worse, they cannot omit material information in the recommendation to make the investment sound better than it is. A clear omission of material fact is essentially viewed by securities regulators as a lie.

Insider trading

If you’ve paid any attention to the finance industry, you’ve heard of insider trading. By definition, insider trading involves trading on material, non-public information. Material information is any information that can drive someone to make an investment decision. Non-public information is not widely available or disseminated.

Insiders of publicly traded companies have access to significant amounts of material non-public information. For example, the executives at a large biotechnology company will know about a new medical product prior to releasing it publicly. If the product was groundbreaking, the executives could buy a bunch of stock prior to its release. Once the product is announced publicly, the demand and price of the stock would increase, creating a significant profit for the insiders.

This would be a big problem if the SEC found out. Insiders can discuss and obtain insider information, but cannot trade on it. As soon as a trade occurs, the person providing the insider information (the tipper) and the person receiving and trading on the insider information (the tippee) are subject to serious consequences.

Regardless of the size of the profit made or the loss avoided, the SEC takes insider trading very seriously. In civil court, perpetrators can be sued for up to three times the profit achieved or loss avoided. Known as “treble damages,” any investor in the security at the time of the trade (known as contemporaneous traders) can sue those responsible for insider trading for up to this amount.

Criminal charges and fines can also be levied against those found guilty of insider trading. If a person is caught, they could be fined up to $5 million and sent to jail for up to 20 years. When the problem is widespread across a financial firm, the firm can be fined up to $25 million. The SEC does not take insider trading lightly.

Market manipulation

Market manipulation comes in many shapes and forms, and is always prohibited. When a person engages in an activity that artificially influences the price of a security, they are manipulating the market. We’ll cover the following forms of manipulation in this section:

• Painting the tape
  • Matched orders
  • Wash trades
• Marking the open/close
• Pump and dump schemes

Painting the tape
Painting the tape sounds nice, but it involves creating a false appearance of market activity. This is normally done with thinly traded stocks, which are easier to manipulate due to their lack of trading.

Assume a group of financial professionals picks a rarely traded common stock to invest in. The stock is traded heavily between group members, which creates a significant amount of trading activity. The uptick in the stock’s trading activity grabs the market’s attention, driving some investors to make a speculative purchase. With more demand, the stock price rises. After the increase in price, the group sells and collects a profit. Painting the tape together in a group is commonly referred to as matched orders. If it’s done by one person through several of their own accounts, it’s called wash trades.

Marking the open or close
Marking the open or close is the act of placing trades prior to the market open or close solely to influence the price of the stock. A stock’s opening or closing price is very closely followed in the market. Think about it - how many times have you seen the news report on closing prices at the end of the trading day?

Assume a group of financial professionals place a bunch of orders to buy a thinly traded stock together right before the market opens in hopes of manipulating the price upward. If the stock were to open at a higher price than expected, other investors may notice and “jump on the bandwagon.” The increase in demand results in the price going up further, and the financial professionals sell the stock for a quick profit. The same could be done at towards the close of the market. Either way it’s done, marking the open or close is prohibited!

Pump and dump schemes
A similar tactic is known as a pump and dump scheme. Assume an investor* with a large following on social media “talks up” a thinly-traded stock in hopes their followers purchase the stock as well. The information shared with followers is misleading and overstates the prospects of the issuer’s business. Regardless, a number of followers purchase the stock, driving the market price upwards. The investor that “pumped up” the stock sells it after the price increase, resulting in a quick profit. This action is prohibited and subject to criminal penalties.

*While many of the prohibited actions we’ve discussed relate to registered representatives, anyone can manipulate the market. It doesn’t matter if it’s a financial professional or a retail investor. Criminal and regulatory penalties can apply to all types of persons.

General unlawful actions

Three general unlawful actions will be covered in this section, including:

• Backing away
• Frontrunning
• Trading ahead

Backing away
Backing away is the act of providing a firm quote on a security, but then failing to fulfill a trade request. A firm quote is a legitimate security quote provided by a financial firm. Assume a broker-dealer provides a quote for a stock in their inventory at $20 per share. If an investor requests a purchase at $20, the broker-dealer “backs away” if they subsequently refuse to fill the customer’s order.

Frontrunning
Frontrunning involves a financial professional placing an order for themselves prior to a customer’s order. When a large order is placed, it has the potential to “move the market.” For example, assume a wealthy investor requests a purchase of 100,000 shares of a rarely traded stock. Due to the size of the order and the demand it introduces to the market, the stock price could rise substantially after the trade is submitted. To personally benefit from the transaction, the agent handling the order places a smaller buy order for themselves first, then places the investor’s order. After the stock price rises, the agent sells their shares for a quick profit.

Trading ahead
There are two versions of ‘trading ahead.’ First, we’ll cover ‘trading ahead of research.’ While similar to frontrunning, this type of market manipulation involves a research report release. There are many security analysts in the industry, some of which are very popular and closely followed. When a prominent research analyst releases a report, the market tends to react. For example, assume Charmaine is a well-respected research analyst that plans on publishing a negative report on XYZ stock. Knowing many investors will sell their investment in XYZ stock (which will drive down the price of the stock), Charmaine short sells (bets against) XYZ stock prior to the report being released to make a profit.

‘Trading ahead’ may also refer to a market maker prioritizing its own trades over a public customer’s. Market makers are similar to used car dealerships, which buy used cars from the public at a marked down price, and resell those cars to the public at a marked up price. Replace the used cars with stocks trading in the market, and you have a market maker.

Market makers are under the obligation to prioritize public customer orders over their own. Assume an investor places a trade to buy stock from the market maker at $20. At the same time, another customer submits an order to sell the same stock at the market price. The market maker should “cross” the market order to sell against the other order to buy stock at $20 (if it’s the best price). However, let’s say the market maker buys the stock from the selling investor at $20 and leaves the other investor’s purchase request unexecuted. In this scenario, the market maker took part in trading ahead of the investor attempting to buy the stock at $20. They should’ve had the priority, but the market maker stepped in front.

It’s sometimes difficult to determine the difference between frontrunning and trading ahead. Frontrunning occurs when a financial professional places a personal trade prior to placing their customer’s trade in order to take advantage of a temporary price increase. On the other hand, trading ahead occurs when a market maker “jumps the line” and doesn’t prioritize public orders.