- The SEC, FINRA, and the exchanges have developed a series of trade practice rules to ensure that traders and market makers execute orders at the best prices and exercise market discretion in the interest of their customers.
These include:- Insider Trading (SEC Rule 10b-5) It is illegal to use or pass on to others material, nonpublic information or enter into transactions while in possession of such information.
- Backing away (NASD IM-3320 A market maker in a given security is obliged to honor the quoted bid and ask prices for a minimum quantity.
- Trading ahead of customer limit orders (NASD IM-2110-2) FINRA members acting as market makers are prohibited from trading ahead of customer limit orders and must ensure that such orders are executed at the most favorable price possible under prevailing market conditions.
- Front-running (NASD IM-2110-3) A broker/dealer is prohibited from buying or selling a security or an option on a security while in possession of material, non-public information concerning an imminent block transaction in the security or option on the security.
- Trading ahead of research reports (NASD IM-2110-4) FINRA member firms are prohibited from trading activity that changes the firm’s position in a Nasdaq® or exchange-listed security traded in the third market, or in any derivative security based on or related to the underlying security, in anticipation of the issuance of a research report in that security.
- Anti-Intimidation/Coordination (NASD IM-2110-5) A FINRA member firm may not coordinate its prices (including quotations), trades, or trade reports with any other member; direct or request another member to alter a price (including a quotation); or engage, directly or indirectly, in any conduct that threatens, harasses, coerces, intimidates, or otherwise attempts improperly to influence another member. This includes any attempt to influence another member to adjust or maintain a price or quotation and refusals to trade or other conduct that retaliates against or discourages the competitive activities of another market maker or market participants
Additional definitions:
- Commingling You are not permitted to place customers’ checks or money intended for transactions involving securities into your own bank account or your insurance business account, regardless of the amount of money or the length of time involved. Mishandling customer funds, such as money intended for insurance products, is a serious violation of FINRA rules and could result in prosecution by state or federal criminal agencies.
- Churning (NASD IM-2310-2) Frequent trading, or trading that is not consistent with the financial goals and risk tolerance of your customer, in a discretionary account (or an account over which you exercise de facto discretion) is an abuse of your control over the customer’s account. You can be found liable to your customer for damages and may be disciplined by FINRA.
- Suitability (NASD Rule 2310) You must have reasonable grounds for believing each recommendation to a customer is suitable on the basis of the customer’s other securities holdings and financial situation, among other factors.
- Free-riding and withholding (NASD Rule 2110-1) New issues of securities that immediately begin trading at a higher price than originally offered must be distributed to the public. They may not be placed in your account under any circumstances, and only under strict guidelines may they be placed in the accounts of financial services industry personnel or their immediate families.
- Selling away (NASD Rule 3040) Selling securities without processing the order through your firm and without your firm’s permission or knowledge is a violation of FINRA rules. Even products that you may not consider to be securities, such as leasing arrangements or promissory notes, may be securities under federal or state law. Check with your firm before engaging in any securities transactions for any purpose.
- Sharing in accounts The sharing of profits or losses in an account with a customer is generally prohibited. Before contemplating entering into such an arrangement, you should read and become familiar with the appropriate provisions of NASD Rule 2330.
- Conflicts of interest Avoid even the appearance of conflict, let alone any actual conflict of interest, in transactions with your customers. For instance, if you own shares of a thinly traded stock in your personal account, one has to question your true motivation in recommending large purchases of those shares to your customers when such a recommendation is likely to drive up the price of that stock.
Illegal activities:
- Switching and break-point sales for mutual funds (NASD Rule 2830) Mutual funds are typically long-term investments. Switching your customer among funds with similar investment objectives is usually a violation if it has no legitimate investment purpose and may needlessly impose another commission charge and increased tax liability on the customer. Recommending to a customer a mutual fund purchase for a quantity just beneath the point where the customer could save commission charges significantly by purchasing a few more shares may mean a bigger payment for you, but is not normally in the customer’s best interests and is usually a violation.
- Unauthorized trades No matter how noble your intentions may be, never enter an order without the expressed and detailed permission of the customer unless you and your firm have been granted written discretionary authority by the customer.
- Parking securities and maintaining fictitious accounts Holding or hiding securities in someone else’s or a fictitious account is misleading and strictly prohibited.
- Failure to cooperate If the FINRA staff asks you to provide information or testify in person, you must cooperate. Failure to cooperate or respond in a full, complete, and honest manner to any such request will normally result in a fine and a suspension or bar from the industry. In addition, under FINRA regulations, you must keep FINRA informed of your home address so that you may be reached in the event of a staff investigation; failure to do so may deny you the ability to provide input to the staff and have an impact on your registration status with FINRA.
- Cheating on exams (NASD Rule 1080) This rule prohibits an applicant from receiving assistance while taking a qualification examination. In instances where cheating or possession of unauthorized materials is demonstrated, the registered person or applicant found guilty of such behavior is normally barred from the securities industry.
The FINRA (Financial Industry Regulatory Authority) Conduct Rules provide guidelines to regulate the ethical and business practices of broker-dealers and their registered representatives. These rules ensure that firms operate with integrity and in the best interests of their clients. Below is a summary of the most important conduct rules:
Rule 2111 – Suitability:
- Overview: Firms and associated persons must have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for the customer based on the customer’s investment profile.
- Key Aspects:
- Customer’s Investment Profile: Includes factors such as age, financial situation, investment experience, risk tolerance, and financial objectives.
- Reasonable-Basis Suitability: The recommendation must make sense based on the characteristics of the security or strategy.
- Customer-Specific Suitability: The recommendation must fit the individual customer’s investment profile.
- Quantitative Suitability: Excessive trading (churning) for commissions is prohibited.
Rule 2210 – Communications with the Public:
- Overview: Firms must ensure that all communications with the public are fair, balanced, and not misleading. This rule governs advertisements, sales literature, and other public-facing communications.
- Key Aspects:
- Clarity and Accuracy: Communications must be clear, accurate, and provide a balanced view of the investment products or services being promoted.
- Disclosure Requirements: Certain risks, costs, and material facts must be disclosed to ensure transparency.
- Approval and Supervision: Communications must be approved by a registered principal before distribution, and firms must have procedures to supervise these communications.
Rule 3240 – Borrowing from or Lending to Customers:
- Overview: Registered persons are generally prohibited from borrowing money from or lending money to customers unless specific conditions are met.
- Key Aspects:
- Borrowing and lending are permitted if the customer is an immediate family member or if the lending arrangement is approved in writing by the firm.
- Firms must have written policies in place regarding borrowing and lending arrangements.
Rule 3270 – Outside Business Activities (OBA):
- Overview: Registered representatives must disclose and receive written approval from their firm before engaging in any outside business activities.
- Key Aspects:
- This rule helps prevent conflicts of interest and ensures that outside activities do not interfere with the individual’s responsibilities to the firm.
- Activities that must be reported include other employment, self-employment, or serving on a board of directors.
Rule 3220 – Gifts and Gratuities:
- Overview: This rule limits gifts and gratuities that associated persons may give or receive in connection with their securities business to a value of $100 per individual, per year.
- Key Aspects:
- The rule aims to prevent conflicts of interest that could arise from excessive gifts.
- Exclusions include promotional items of nominal value and gifts based on personal relationships (unrelated to the securities business).
Rule 4512 – Customer Account Information:
- Overview: Firms must maintain accurate and up-to-date records of customer account information, including the customer’s name, address, investment profile, and other essential details.
- Key Aspects:
- Firms are required to update customer account information periodically and must verify the accuracy of this information with the customer at least every 36 months.
- Any changes in customer profile information must be recorded promptly.
Rule 4330 – Customer Protection – Reserves and Custody of Securities:
- Overview: Firms must have procedures to safeguard customers’ securities and funds. They must comply with rules regarding the custody of customer assets and reserve requirements.
- Key Aspects:
- Firms must segregate customer securities from firm securities to prevent misuse.
- Firms are subject to reserve requirements to protect customer assets in case of firm insolvency.
Rule 3110 – Supervision:
- Overview: Firms must establish a system to supervise the activities of their registered representatives to ensure compliance with FINRA and SEC rules.
- Key Aspects:
- Firms must implement and maintain written supervisory procedures (WSPs).
- Supervisory activities must be tailored to the firm’s business model, and there must be oversight to ensure these procedures are being followed.
- Supervision includes monitoring communications, trades, and outside business activities.
Rule 4530 – Reporting Requirements:
- Overview: Firms are required to report certain events to FINRA, such as disciplinary actions, regulatory actions, and customer complaints.
- Key Aspects:
- Reports must be filed promptly, typically within 30 days of the event or action.
- Firms are required to keep accurate records of these filings and any related documents.
Rule 2040 – Payments to Unregistered Persons:
- Overview: Firms and registered representatives are prohibited from paying commissions or other compensation to unregistered individuals who are not registered with FINRA.
- Key Aspects:
- Ensures that only properly licensed individuals engage in securities transactions and receive compensation.
- Payments to unregistered foreign associates may be allowed under certain circumstances.
Key Principles of the FINRA Conduct Rules:
- Ethical Behavior: Registered representatives and firms must always act in the best interests of their clients and avoid conflicts of interest.
- Transparency and Fairness: All communications, recommendations, and transactions should be conducted in a manner that is fair, balanced, and understandable for clients.
- Supervision and Accountability: Firms must have systems in place to supervise the activities of their representatives to ensure compliance with rules and regulations.
These rules are designed to maintain the integrity of the securities industry, protect investors, and ensure that broker-dealers operate fairly and ethically.
Also, understand the following:
Fair Dealings with Customers: Treat clients honestly, disclose material facts, and ensure recommendations are suitable.
Recommending Speculative Securities: Only recommend high-risk investments to appropriate clients and fully disclose risks.
Fraudulent Activity: Prohibited actions include misrepresentation, insider trading, market manipulation, and churning.
Derivative Financial Products: High-risk instruments that require clear disclosure and are suitable for experienced investors.
Share Class Recommendations: Select the appropriate mutual fund share class based on the client’s financial objectives and time horizon.
Free Riding or Withholding: Prohibits practices that give unfair advantages in trading, such as failing to pay for securities or withholding IPO shares from the public.
New issues of securities that immediately begin trading at a higher price than originally offered must be distributed to the public. They may not be placed in your account under any circumstances, and only under strict guidelines may they be placed in the accounts of financial services industry personnel or their families.
A “hot issue” is an initial public offering (IPO) with overwhelming public demand that sells more than its initial offer price on the first day of the public price immediately after it starts trading
If the SEC declares an offering as a “Hot Issue”, it’s a violation to sell to any of the following:
- Underwriters of the issue
- FINRA member firm or associated person
- Supported family members of an associated member
- Person financially dependent upon an associated member