Prohibited Activities Related to Trading

Broker-dealers and their agents are not allowed to take advantage of customers through churning, excessive mark-ups, breakpoint sales, front-running, market ma­nipulation, and the improper sharing in profits and losses with customers.

Agents and their broker-dealers are paid to execute trades. Therefore, the more trad­ing a customer does, the better for the agent and the firm he represents.

However, frequent trading has not shown to benefit retail investors. As Professor Brad Barber and Terrence Odean found by studying the habits of U.S. retail investors, investors who were in the bottom 20% for trading activity had an average annual portfolio return of 18.5%, while those in the top 20°/o had an average annual return of just 11.4 %. (Source: Brad Barber and Terrence Odean (1999) 'The courage of misguided convictions' Financial Analysts Journal, November/December, p. 50.).

Recommending the customer engage in excessive trading is a violation known as churning. Based on the investment profile of the account, if the trading activity is excessive, both the agent and the broker-dealer risk being disciplined by FINRA. Not many investors are suitable candidates for frequent trading. If the firm determines an investor is interested in high-risk trading strategies, understands them, and can bear the risks associated, then frequent trading may be suitable.

But, when FINRA discovers that small IRA accounts with $20,000 balances experi­ence $200,000 worth of trading activity over the year, they tend to take disciplinary action. That would be a ''turnover rate'' of 10, while regulators typically see a rate of 6 or higher as a red flag.

Excessive Mark-Ups
Broker-dealers who make markets in securities trade with other institutional investors at their Bid and Ask prices. Some of these firms fill orders in the same securities for their retail investors at those prices, adjust ed by either markup or a markdown.

When the retail customer buys, the broker-dealer fills the order at the Ask plus a few cents per share. That net price is known as markup. When the retail customer sells, the broker-dealer fills the order at the Bid minus a few cents per share. That net price is known as a markdown.

Markups and markdowns are associated with principal transactions, while com­missions are associated with agency transactions. Firms either receive a markup/ markdown or a commission because they act in only one capacity in a trade. How­ ever they compensate themselves, the compensation must be reasonable. It is up to the firm to determine a fair and reasonable price to the customer based on factors including:
•    The size of the order
•    The price of the security
•    The liquidity of the security
•    The services provided by the firm

If a broker-dealer charges a per-share fee, FINRA expects the fee to go down on larger orders, not up. Volume in any industry tends to lead to better pricing for the customer, after all. If the security trades inactively, the customer does not receive as good a price as on actively traded securities. And, if the broker-dealer offers more ser­vices than a discount online broker, their charges are typically higher.

FINRA provides only guidelines for commissions and markups/markdowns. Member firms who charge excessively are disciplined by FINRA. And, FINRA tends to make the fines larger than any benefit the firm tried to make through excessive charges to customers.

Charges for Services
Member firms not only must be fair and equitable in securities transactions with their customers but also, if they charge for other services, those charges must also be reasonable and fair. FINRA states that ''Charges, if any, for services performed, including miscellaneous services such as collection of money due for principal, dividends, or interest; exchange or transfer of securities; appraisals, safe-keeping or custody of securities, and other services, shall be reasonable and not unfairly discriminatory between customers.''

Breakpoint Sales
Most open-end funds these days are no-load. However, many funds charge front-end sales charges. Let's say, a small investment into a stock fund involves a sales charge of 5 %. If so, a customer investing $10,000 only invests $9,500. The other $500 is taken out of his initial investment as a sales charge.

Funds with sales charges also have breakpoint schedules. For example, the Growth Fund of America™ by American Funds charges 5.75% on the front end for invest­ments up to $24,999. From $25,000 to $49,999, the sales charge drops to 5.0%. From $50,000 to $99,999, the sales charge is just 4.5%.nd, investments of $ 1 million or more are charged no sales charge at all.

These quantity discounts are illustrated in the prospectus, but the registered repre­sentative must not try to sell shares just below the next breakpoint. If the customer has close to $50,000 to invest in the Growth Fund of America™, the registered rep­resentative would commit the violation known as breakpoint selling if he didn't mention the breakpoint, or if he tried to talk the customer into investing just under that amount.

Let's see how a breakpoint sale would harm the customer. If he were to invest $50,000, the sales charge of 5.0% would equal $2,500. On the other hand, an invest­ment of $49,000 would involve a 5.75% charge, which is $2,817.50.

Not many customers would notice the difference, making it a tempting sales practice.
As we can see, it's manipulative and fraudulent.

If the agent informs the customer of the breakpoints, but the customer declines to utilize them, he should make notes of this. The firm might also request the customer's signature on an acknowledgement that he was made aware of  all quantity discounts before making the investment.

Sharing in Accounts
Agents and their broker-dealers execute trades for their customers. They make money to do so, whether the customer wins or loses on the investment. To show how confident he is in a recommendation, an agent might want to offer to go ''halvsies" on the trade. He'll put up as much as the client wants to, up to $5,000. If the stock goes up, they split the gain. If it drops, they split the loss.

How does that sound? To a lot of investors, it probably sounds great. To FINRA, however, it sounds like a violation. Agents and broker-dealers do not partner on a trade with the customer.
FINRA rules state:
 (1) (A) Except as provided in paragraph (f)(2) no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member provided, however; that a member or person associated with a member may share in the profits or losses in such an account if (i) such person associated with a member obtains prior written authorization from the member employing b the associated person; (ii) such member or person associated with a member obtains prior written authorization from the customer and (iii) such member or person associated with a member shares in the profits or losses in any account of such customer only in direct proportion to the financial contributions made to such account by either the member or person associated with a member.

Maybe the agent and the customer are married. Or the customer is the agent's mother. whatever the reason, both the customer and the broker-dealer must give their written authorization for the agent to share or participate in the account. And, the agent can only benefit in the same proportion that he invests. As usual, though, there is an exception:

(B) Exempt from the direct proportionate share limitation of paragraph (f)(l)(A)( iii) are accounts of the immediate family of such member or person associated with a member. For purpose es of this Rule) the term "immediate family " shall include parents, mother-in-law or father-in-law, husband or wife) children or any relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.

Borrowing front or Lending to Customers
Borrowing from or Lending to customers. Those words make the regulators a nervous... how, exactly, does that registered representative define "borrowing" from a customer? Is this like an actual loan from a bank that happens to be his customer? Or, is this like a little old lady who seldom monitors her account and, therefore, probably won't even notice that the $50,000 was missing for a few weeks?

FINRA has many concerns about registered representatives borrowing money from customers or lending money to them. The main point to know is, before doing either, the registered representative must check his firm 's written supervisory procedures to see what is allowed and what is required. As the rule states:

(a) No person associated with a member in any registered capacity may borrow money from or lend money to any customer of such person unless: (1) the member has written procedures allowing the borrowing and lending of money between such registered persons and customers of the member; and (2) the lending or borrowing arrangement meets one of the following conditions: (A) the customer is a member of such person 's immediate family· (B) the customer is a financial institution regularly engaged in the business of providing credit) financing or loan or other entity or person that regularly arranges or extends credit in the ordinary course of business)· (C) the customer and the registered person are both registered persons of the same member firm)· (D) the lending arrangement is based on a personal relationship with the customer; such that the loan would not have been solicited offered or given had the customer and the associated person not maintained a relationship outside of the broker/customer relationship)· or (E) the lending arrangement is based on a business relationship outside of the broker-custo1ner relationship.

How do they define "immediate family" here? Quite broadly:
(c) The term immediate family shall include parent, grandparent, mother-in-law or father-in-law, husband or wife, brother or  sister, brother-in-law or sister-in-law, son-in-law or daughter­ in-law, children, grandchildren, cousin, aunt or uncle or niece or nephew and shall also include any other person whom the registered person support directly or indirectly to a material extent.

As with sharing, the most important thing is to get your firm's permission before borrowing or lending with any customer. A registered representative who borrows money "under the table" from a customer will likely be suspended by FINRA.

Some trades are large enough to push the price of the stock up or down. If a buy order for 10,000 shares is entered by a customer, the agent might be tempted to first buy calls on the stock, and then enter the large purchase order. Or, he could buy shares of the stock himself That way, he makes an easy profit, while the customer pays more than he needed to.

This is a violation known as front-running. The firm itself would engage in front-running if they took advantage of large customer orders for their proprietary account.

As usual, the rules are stricter for transactions with retail customers than with institu­tional. Still, the rules apply in both situations.

Market Manipulation
Market manipulation is prohibited under the Securities Exchange Act of 1934 and various SEC and FINRA rules. If a few cheaters can manipulate the markets for their own advantage, the entire financial system suffers. Therefore, the exam might bring up terms such as painting the tape, a technique whereby individuals acting together repeatedly sell a security to one another without changing ownership of the securities. This is intended to give an impression of increased trading volume that can drive up the market price of their holdings.

FINRA has a specific rule that says, ''no member shall publish or circulate, or cause to be published or circulated, any communication of any kind which purports to report any transaction as a purchase or sale of any security unless such member believes that such a transaction was a bona fide purchase or sale of such security.'' So, if a member firm is publishing transactions designed to merely inflate the price of a security, such market manipulation would be a serious infraction that could get the member expelled from FINRA altogether.

However, these days firms have such sophisticated, rapid-fire, electronic trading desks generating orders based on algorithms that they sometimes end up accidentally com­pleting '' self-trades'' in which the firm or in which related firms end up as both the buyer and seller on the same transaction.

And, that of course violates the rule against reporting trades that did not involve an actual change in beneficial ownership. Therefore, FINRA states in a notice to members that ''firms must have policies and procedures in place that are reasonably designed to review trading activity for, and prevent, a pattern or practice of self­ trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks."

Other forms of market manipulation include capping and pegging. Capping is the illegal technique of trying to depress a stock price while pegging involves trying to move a stock up to a target price. A shady call option writer, for example, might want to help ensure that the calls expire by artificially conspiring to keep the price of the underlying stock from rising (capping). Or, the writer of a put might engage in pegging to push the put contracts out-of-the-money in his favor.

It's tough to manipulate a stock with billions of shares outstanding, but it's not so hard to do it with microcap stocks where the entire float is worth perhaps just $10 million. A few shady operators could easily manipulate the share price by forming secret joint accounts that allow them to drive up price and volume without any legitimate sales taking place. If all ten investors jointly own all 10 accounts, all the purchases and sales among these accounts would be bogus. That's a form of market manipulation that could end up being prosecuted in criminal court, apart from whatever the securities regulators do. that form of market manipulation  refer to ''engaging in securities transactions that involve no effective change in beneficial ownership .''

Another form of market manipulation occurs when traders spread rumors designed to move the stock price. Maybe they purchase put options on a stock trading on the OTC Bulletin Board and then start an ugly rumor about the company on social media to help push down the price. Or, they could buy call options on a small drug maker and then start a false rumor that the company has just developed the cure for ALS. The possibilities are endless, but if a registered representative were caught engaging in this type of activity, that would be the end of a career.

Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)
Although the Securities Exchange Act of 1934 talked about insider trading, appar­ently it didn't quite get the message across. So, in 1988 Congress passed the Insider Trading &  Securities Fraud  Enforcement Act of 1988 and raised the penalties for insider trading, making it a criminal offense with stiff civil penalties as well.

If you are married to an attorney working on an unannounced merger involving one or two public companies, you must pretend you know nothing about the deal. If you share that information, or if you use it to your advantage, you could face federal criminal charges. More likely, the SEC would merely sue you in federal court and try to extract a civil penalty of three times the amount of the profit made or loss avoided.

Any material information the public doesn't have is inside information. If you are the CFO of a large public company, you may know the numbers to be announced a few days before the rest of the world. It would be tempting to sell your stock if you knew the news was bad, or buy more shares if the news was good. But, the SEC has no sense of humor about such things. The CFO is a fiduciary to the shareholders. He or she cannot profit at the expense of shareholders, and is a position of trust where we expect him/her to put the interests of the shareholders first. Even though he or she is almost certainly a shareholder, too.

People who violate the act can be held liable to what they call ''contemporaneous traders.'' That means that if you're dumping your shares based on an inside tip, and that hurts me, we might need to have a little talk with our attorneys.

The investment banking arm of a broker-dealer has access to all kinds of material non-public information. To prevent that sensitive information from flowing to other areas of the firm, the broker-dealer is required to create a Chinese wall around departments that obtain such information. No, they don't build an actual wall. They just try to prevent the investment bankers working on a merger from revealing some good trading tips to the registered representatives working the telephones.


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