Unethical activities come in many forms. The prohibited activities in this section range from mildly unethical to seriously harmful. You’ll want to recognize what these activities look like in practice and know how to avoid them. These are the unethical actions covered here:
Interpositioning is creating an unnecessary middleman in a trade. Customers usually don’t see what happens behind the scenes when they place an order to buy or sell a security.
For example, suppose a financial firm takes a customer order to buy 100 shares of ABC and sends it to an associated broker-dealer. The broker-dealer then routes the order to a market maker, who fills it at $50 per share. The shares come back to the broker-dealer, who marks up the trade by $1 per share (to $51) and sends it to the original financial firm. The financial firm then charges a $1 per share commission on top.
The customer pays $52 per share, but only should have paid $51 per share. The broker-dealer in the middle added cost without adding value - the financial firm should have sent the order directly to the market maker.
Backing away is providing a firm quote on a security and then failing to honor it. A firm quote is a legitimate quote provided by a market maker.
Assume XYZ Market Maker quotes a stock at $20 per share. If an investor tries to buy at $20, the market maker is “backing away” if they refuse to fill the order at that price.
Frontrunning is when a financial professional places an order for their own account before placing a customer’s order. This is especially problematic when the customer’s order is large enough to “move the market.”
For example, a large hedge fund places an order to buy 100,000 shares of a thinly traded stock. Because the order is so large, the stock price rises. To personally benefit, the financial professional first places a smaller buy order for themselves, then places the hedge fund’s order. After the hedge fund’s order pushes the price up, the professional sells their shares for a quick profit.
Trading ahead of research is similar to frontrunning, but the trigger is a research report. Some research analysts are closely followed, and the market often reacts when they publish.
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 XYZ stock before the report is released to profit from the expected decline.
There are two prohibited actions involving the term “trading ahead.” In the secondary market chapter, we discussed how the DMM may not step ahead of public orders. If it occurs, the DMM is trading ahead. In most test questions involving this topic, there should be enough context in the question (or answers) to determine what version of trading ahead is being covered.
All of these actions are unethical and prohibited. If you see any of these activities in the real world, it’s your responsibility to report it to your principal (supervisor).
A guaranteed security is a security backed by a third party for interest, dividends, and/or principal. A security is considered guaranteed when a third party (usually an insurance company) pledges to cover any unpaid interest, dividends, and/or principal.
A guarantee does not mean an investor can’t lose money. The guarantee applies to the promised payments, not the security’s market value.
For example, assume an investor purchases a $1,000 principal (par) bond* for $1,200. If the bond defaults (meaning the issuer can’t repay the borrowed funds), the insurance would cover only the $1,000 principal and any unpaid interest up to that point. The $200 premium the investor paid above par would not be covered.
Outside of guaranteed securities, the word “guaranteed” is usually tied to unethical conduct. Financial professionals must never guarantee that a security will perform in a certain way. This includes:
A defining characteristic of a security is the possibility of loss, so performance guarantees and securities don’t mix. Even if a guarantee against loss sounds appealing, it isn’t feasible for broker-dealers, agents, investment advisers, or investment adviser representatives (IARs) to offer them. If a registered person guarantees more than they can cover, the guarantee can threaten the firm’s financial health - especially during a major bear market (e.g., the Great Recession). For that reason, financial professionals must avoid performance guarantees.
Churning is excessive trading done to generate commissions rather than to serve the client’s investment goals. It happens when a representative makes frequent or unnecessary trades that aren’t in the client’s best interest.
Common signs of churning include repeated transactions in the same securities, a high volume of trades, and using margin to increase trading activity. Churning is not unsolicited, and gain or loss is never used as a determinant of churning. Churning can lead to serious consequences, including loss of registration, penalties, and civil actions.
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