Registered persons are always under an obligation to act ethically in the securities industry. In some circumstances, ethical actions exist in a “grey area.” Meaning, some actions could be considered unethical and wrong in one scenario, while completely fine in another. To ensure you’re aware of the details, we’ll cover the following in this chapter:
Failure to provide the necessary documentation to customers
Failure to respond to customer complaints*****
*Excessive trading is also known as churning. The best way to determine if an account is being churned is to compare the level of trading to the customer’s investment objective. For example, if the investment objective is conservative (safe) but a significant number of trades are taking place, it’s likely churning.
**Margin agreements must be signed and submitted promptly after the first margin trade.
***Broker-dealers must segregate fully paid (non-margin) securities, meaning they must be kept separate from the assets of the broker-dealer.
****A broker-dealer taking part in a public offering of a new issue (e.g. an initial public offering) must offer those securities to the general public. They may not “hold back” the securities by keeping them in inventory or giving them to employees.
*****A complaint is only required to be responded to if provided to the broker-dealer in writing (this includes electronic submissions). Agents must bring any received complaints to their supervisor (a.k.a. principal), who will then help them resolve the issue. Regardless of the outcome, the broker-dealer must respond to the customer’s complaint.
Let’s now cover the unethical practices of agents, some of which will be a repeat of the listed actions above:
Borrowing from or lending to customers*
Maintaining custody of customer assets**
Failing to record securities transactions***
Establishing a fake account in order to perform prohibited transactions
Sharing an account with a customer****
Splitting commissions with agents not affiliated with the same broker-dealer
Excessive trading in a customer’s account
Making unsuitable recommendations
Executing transactions without proper authority
Executing a margin trade without the margin agreement
Executing a transaction at a price unrelated to the current market value
Failing to deliver a prospectus in a new issue offering
Engaging in any form of market manipulation
Guaranteeing a customer against loss (performance guarantee)
Advertising a security without the intention of trading it
Engaging in dishonest or manipulative marketing
*Unlike FINRA rules, NASAA enforces stricter policies related to borrowing or lending to customers. In particular, there is no exception for family members. Agents generally cannot borrow from anyone, but there is one exception. If the client is in the business of lending money (e.g. banks and lending institutions), the agent may take a loan from the customer. Additionally, an arrangement may be made to set the customer up with a loan through a margin account at a broker-dealer. Last, loans may be made to clients that are affiliates of the broker-dealer (e.g. if the client is the Marketing Director at the firm).
**Broker-dealers maintain custody, not agents. Meaning, an agent should never personally take possession of a customer’s assets.
***Selling away occurs when a representative performs a securities transaction outside of their employing firm without disclosing the transaction and/or gaining written approval (from their firm) to perform the transaction. For example, an agent helps their friend sell the stock of their small business on the weekend, but does not inform their firm.
****While agents generally may not share accounts with customers, there is an exception. If the employing broker-dealer provides written approval and there’s a written agreement with the customer, the agent may share gains and losses (e.g. participate in a joint account) with a customer.
Unethical practices of investment advisers and IARs
NASAA rules also describe the various unethical practices of investment advisers and IARs. Unlike NASAA rules for broker-dealers and agents, the actions listed in the rule are not differentiated between investment advisers and IARs. It’s all one big category of unethical practices:
Making unsuitable recommendations
Executing transactions without proper authority*
Excessive trading in a customer’s account
Borrowing from or lending to clients**
Misrepresenting professional qualifications***
Providing a third-party analysis or report without proper disclosure****
Charging unreasonable fees
Failing to disclose conflicts of interest
Guaranteeing a customer against loss (performance guarantee)
Sharing an account with a client*****
*Investment advisers and IARs may execute discretionary transactions on 10 days of verbal authority, while broker-dealers and agents must have written authorization prior to any discretionary transaction.
**The same rule we discussed with agents (above) applies here. An investment adviser or IAR may borrow money from a client in the business of lending money. Otherwise, borrowing from or lending to clients is unethical and prohibited.
***The most common version of professional misrepresentation relates to registration designations. For example, an IAR may not infer their registration means they’re successful or are adequately qualified to handle any client account. Registration simply means a person may legally operate in a state, and has no bearing on their qualifications or abilities.
****When a third-party analysis or report is furnished to a client, the investment adviser or IAR must disclose it was the creation of the third party. Otherwise, the client may assume it was the creation of the adviser, which would be misleading.
*****While it’s possible an agent shares an account with a customer (if written approval from the broker-dealer and written agreement with the customer exists), IARs may never share accounts with clients. No matter the situation, it is considered unethical.
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