While most financial professionals try to act in their clients’ best interests, past misconduct has shown why regulation is necessary. This chapter covers four categories of prohibited behavior:
Let’s start by defining a material fact.
If a registered representative knowingly omits a material fact when discussing securities, they may be subject to penalties. This issue often arises when making recommendations.
Financial professionals are required to act in a fiduciary capacity, meaning they must put their clients’ interests ahead of their own. For example, a particular sale might generate substantial compensation for a registered representative, but they must not recommend that security if it isn’t suitable for the client.
Just as importantly, they can’t leave out material information to make an investment sound better than it is. Securities regulators generally treat a deliberate omission of a material fact as the equivalent of a lie.
You’ve likely heard of insider trading. Insider trading is trading based on material, non-public information.
Insiders of publicly traded companies often have access to large amounts of material non-public information. For example, executives at a biotechnology company may know about a new medical product before it’s announced publicly. If the product is groundbreaking, those executives could buy shares before the announcement. Once the product is announced, demand for the stock could increase, raising the price and creating a profit for the insiders.
This becomes a serious problem if the SEC discovers it. Insiders may possess and discuss insider information, but they can’t trade on it. Once a trade occurs, both:
may face serious consequences.
Regardless of the size of the profit made or the loss avoided, the SEC treats insider trading as a major violation. In civil court, perpetrators can be sued for up to three times the profit achieved or loss avoided. These are called “treble damages.” Investors who traded the security around the same time (called contemporaneous traders) may sue those responsible for insider trading for up to this amount.
Criminal charges and fines may also apply. An individual can be fined up to $5 million and sentenced to up to 20 years in prison. If the misconduct is widespread across a financial firm, the firm can be fined up to $25 million.
Market manipulation takes many forms, and it’s always prohibited. Any activity intended to artificially influence the price of a security is market manipulation. This section covers:
Painting the tape
Painting the tape involves creating a false appearance of market activity. This is often done with thinly traded stocks, which are easier to influence because there’s less normal trading volume.
Assume a group of financial professionals selects a rarely traded common stock. The group trades the stock heavily among its members, creating the appearance of strong market interest. That increased activity can attract attention and prompt other investors to buy speculatively. As demand increases, the stock price rises. After the price increases, the group sells and takes a profit.
When this is done by a group, it’s commonly called matched orders. When it’s done by one person using multiple accounts they control, it’s called wash trades.
Marking the open or close
Marking the open or close means placing trades right before the market opens or closes for the purpose of influencing the stock’s price. Opening and closing prices are closely watched and widely reported.
Assume a group of financial professionals places many buy orders for a thinly traded stock just before the market opens, intending to push the price upward. If the stock opens higher than expected, other investors may notice and buy as well. That additional demand can push the price up further, allowing the group to sell quickly for a profit.
The same tactic can be used near the market close. Either way, marking the open or close is prohibited.
Pump and dump schemes
A related tactic is a pump and dump scheme. Assume an investor* with a large social media following promotes a thinly traded stock to encourage followers to buy. The information shared is misleading and overstates the issuer’s prospects. Even so, followers buy the stock, pushing the market price upward. The investor who “pumped” the stock then sells after the price increase, generating a quick profit. This is prohibited and may lead to criminal penalties.
*While many prohibited actions discussed in this chapter involve registered representatives, anyone can manipulate the market. It doesn’t matter whether the person is a financial professional or a retail investor. Criminal and regulatory penalties can apply to all types of persons.
Three general unlawful actions are covered in this section:
Backing away
Backing away is providing a firm quote on a security and then failing to honor it when a customer attempts to trade at that price. A firm quote is a legitimate quote provided by a financial firm.
Assume a broker-dealer quotes a stock from its inventory at $20 per share. If an investor requests to buy at $20, the broker-dealer is backing away if it refuses to fill the order.
Frontrunning
Frontrunning occurs when a financial professional places an order for themselves before placing a customer’s order. This is especially problematic when the customer’s order is large enough to potentially “move the market.”
For example, assume a wealthy investor wants to buy 100,000 shares of a rarely traded stock. Because the order is so large, submitting it could increase demand and push the price up. To profit from that expected price increase, the agent handling the order places a smaller buy order for themselves first, then submits the customer’s order. After the price rises, the agent sells their shares for a quick profit.
Trading ahead
There are two versions of trading ahead.
First is trading ahead of research. This involves trading before a research report is released. Some analysts are closely followed, and their reports can move the market.
For example, assume Charmaine is a well-respected research analyst who plans to publish a negative report on XYZ stock. Expecting that many investors will sell (which could drive the price down), Charmaine short sells (bets against) XYZ stock before the report is released to profit.
Second, “trading ahead” can refer to a market maker placing its own trades ahead of a public customer’s order. Market makers are similar to used car dealerships: they buy from the public at a lower price and sell to the public at a higher price. Replace used cars with stocks, and you have a market maker.
Market makers are obligated to prioritize public customer orders over their own. Assume an investor places an order 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. If $20 is the best price, the market maker should “cross” the sell order against the buy order at $20.
However, suppose the market maker buys the stock from the selling customer at $20 and leaves the other customer’s buy order unfilled. In that case, the market maker has traded ahead of the customer who was trying to buy at $20. The public customer should have had priority, but the market maker stepped in front.
It can be difficult to distinguish frontrunning from trading ahead. The key difference is:
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