Both the Uniform Securities Act (USA), the Investment Advisers Act of 1940, and other securities laws make it clear that fraud won’t be tolerated. For example, here’s a direct quote from the USA:
It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly:
To employ any device, scheme, or artifice to defraud, or
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person
Series 66 exam questions will test your ability to recognize fraudulent activities, which are subject to criminal penalties. A criminal action occurs when a law or rule is broken willfully (knowingly). Fraud is generally treated as willful conduct, so it’s typically handled as a criminal matter.
Many of the criminal actions discussed in this chapter also appear on other licensing exams, including the SIE, Series 6, and Series 7. You’ll also see topics that are emphasized by the North American Securities Administrators Association (NASAA), including:
Although this was discussed in a previous chapter, it helps to revisit what a material fact is:
If a registered person knowingly omits a material fact when discussing securities, they may be subject to criminal penalties. This is especially important when making recommendations.
Because of the nature of their business and their fiduciary duty, the obligation to disclose all material facts most directly applies to investment advisers and investment adviser representatives (IARs).
If a broker-dealer and/or an agent receives an unsolicited order, they aren’t under the same obligation to disclose all material facts about the security. However, certain disclosures (for example, the price of the security or unusual market circumstances) are required when they’re pertinent to the transaction itself.
A registered person could omit a material fact unintentionally, although that should be rare. It’s part of the job to understand a security - especially when making a recommendation. If the omission was a legitimate mistake, the person wouldn’t be subject to criminal penalties. Civil liabilities could still apply.
Market manipulation takes many forms, and it’s always prohibited. Any activity that artificially influences the price of a security is market manipulation.
This section covers:
Painting the tape
Despite the name, painting the tape means creating a false appearance of market activity. It’s often done with thinly traded stocks, which are easier to influence because there’s less normal trading volume.
Assume a group of financial professionals chooses a rarely traded common stock. The group trades the stock heavily among themselves, creating the appearance of strong market interest. That activity attracts attention and can lead other investors to buy speculatively. As demand increases, the price rises. The group then sells at the higher price and takes a profit.
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 price. Opening and closing prices are widely reported and closely watched.
Assume a group of financial professionals places a large number of buy orders for a thinly traded stock right before the market opens, hoping to push the opening price higher. If the stock opens above expectations, other investors may notice and buy as well. Increased 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 “talks up” a thinly traded stock to encourage followers to buy. The information shared is misleading and overstates the prospects of the issuer’s business. As followers buy, the market price rises. The investor who promoted (or “pumped”) the stock then sells after the price increase, making a quick profit.
This is prohibited and subject to criminal penalties.
*While many prohibited actions involve registered persons (broker-dealers, agents, investment advisers, and IARs), anyone can manipulate the market. It doesn’t matter whether the person is a financial professional or a retail investor. Criminal penalties can apply to all types of persons.
This section covers three general unlawful actions:
Backing away
Backing away means providing a firm quote on a security and then failing to honor it. A firm quote is a bona fide quote provided by a financial firm.
Assume a broker-dealer quotes a stock from its inventory at $20 per share. If an investor accepts the quote and requests to buy at $20, the broker-dealer backs away if it then refuses to fill the order.
Frontrunning
Frontrunning occurs when a financial professional places an order for themselves before placing a customer’s order.
Large orders can move the market. For example, assume an institutional investor wants to buy 100,000 shares of a rarely traded stock. That demand could push the price up once the order hits the market. To profit from the expected price increase, the agent handling the order first places a smaller buy order for themselves, then submits the institution’s order. After the price rises, the agent sells their shares for a quick profit.
Trading ahead
There are two common uses of the term trading ahead.
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 (driving the price down), Charmaine short sells (bets against) XYZ stock before the report is released to profit from the expected decline.
Market makers must 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. The market maker should “cross” the sell order against the buy order at $20 (if it’s the best price). If instead the market maker buys the stock from the selling customer at $20 and leaves the other customer’s buy order unfilled, the market maker has traded ahead of the public customer.
It can be tricky to distinguish frontrunning from trading ahead:
All of these actions are prohibited and can result in criminal penalties. If an agent and/or IAR notices any of these actions, they’re obligated to inform their supervisor (a.k.a. principal).
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