Prohibited Activities

This page of our SIE Study Guide covers market manipulation, insider trading, and other prohibited activities.

Market Manipulation

Thousands of companies are listed on the stock market and their share prices are determined by supply and demand. It’s typical for prices to fluctuate on a regular, sometimes frequent, basis. Sometimes a stock price is artificially changed for purposes of personal gain through an illegal process known as market manipulation.

There are several examples of market manipulation practices. Using a wealthy fictional broker named Jim, these examples are illustrated below.

Market Rumors: Jim personally holds 5,000 shares of Company ABC that he purchased at the price of $3.00 per share. He plants a rumor about Company ABC in order to drive its stock price up, and subsequently sells off his 5,000 shares a few days later when the price hits $14.00 per share. This earns him $55,000 in profit. The rumor is quickly proven to be false and the company’s stock price decreases.

‘Pump and Dump’ Schemes: Jim recommends Company XYZ’s stock to dozens of his clients which quickly creates excessive demand for the stock and raises its market price. At the peak price, Jim sells his shares of Company XYZ and makes a profit. What follows is a precipitous drop in the stock’s price and significant losses for his clients.

Front Running: Jim’s client Nancy calls and asks him to buy 600,000 shares of Company ABC. Knowing that a large purchase like this will drive the company’s stock price up in the short-term, he first decides to purchase some shares for his own personal account. He then executes his client’s order and sells off his own shares, earning himself a significant profit.

Excessive Trading (Churning): Jim has full discretionary trading authority over his client Terrell’s account and earns a commission on every trade. Terrell is risk-averse and his investment objective is to save for retirement. Jim begins to trade excessively in the account against Terrell’s best interests in order to inflate his commissions.

Marking the Open: Jim and a few colleagues place several trade orders for Company XYZ’s stock prior to market open, leading to an increase in the demand for the shares and a subsequent increase in price. Once the price is increased, they sell their shares for a profit, which is an illegal practice known as marking the open. If they did the same thing prior to market close to influence the closing price of the stock, then it would be known as marking the close.

Freeriding: In his personal trading account, Jim purchases a security that he does not pay for before turning around and selling.

  • Traders who engage in freeriding might be required to have their accounts frozen for 90 days.

Backing Away: A market maker in a security fails to honor the bid and ask prices that they quoted for the security.

  • Bid price indicates the maximum price of a security that a buyer is willing to pay.
  • Ask price indicates the minimum price of a security that a seller is willing to accept.

Insider Trading

Securities industry professionals have many obligations to their customers and to the capital markets. Like the prohibited activities described in the previous section, insider trading is another example of a violation of these obligations and occurs when someone trades on material non-public information. Under no circumstance is a person who comes into possession of non-public news or information about a publicly traded company allowed to use that information for personal gain before the information is released to the public. This would not include acting on views of the company that are held by outsiders.

Material nonpublic information is any information about a company that has not yet been made public but has the potential to affect their share price and influence investment decisions. Some examples might be information related to:

  • Impending mergers and acquisitions;
  • Legal proceedings;
  • Loan defaults; or
  • Development of patents

When a person who has possession of material nonpublic information trades in that company’s security, they are violating FINRA and SEC insider trading rules and other federal statutes. Civil and criminal penalties for insider trading charges vary between individuals and business entities.

  • Individuals

    • Up to 20 years imprisonment; and/or
    • Fines up to $5 million
  • Business Entities (i.e. Corporations)

    • Fines up to $25 million

For example, let’s say Company ABC is in the process of being acquired by a private equity firm. Two days prior to the announcement being made, the CFO of Company ABC purchases 3,000 additional shares of the company. The stock price rises significantly once the announcement of the acquisition has been made public, and the CFO subsequently sells off his shares for a large profit. He has committed securities fraud.

In another example, let’s say the CFO did not purchase any additional shares. He instead disclosed the impending acquisition to a friend of his prior to the public announcement. If the friend trades on the company’s stock based on this information, he and the CFO have both committed securities fraud.

Other Prohibited Activities

Purchasing Initial Public Offerings: Registered reps are prohibited from purchasing a new issue of an equity security (initial public offering or IPO). They are also prohibited from selling a new issue of an equity security to other broker-dealers and their affiliates.

Use of manipulative, deceptive or other fraudulent devices: Applied broadly, member firms are prohibited from effecting any transaction, purchase, or sale of a security by any manipulative, deceptive, or other fraudulent means.

Improper use of customers’ securities or funds: Applied broadly, member firms and registered reps are prohibited from making improper use of customers’ securities or funds. There are many examples of what “improper use” could mean, but the most common violation of this rule is theft.

  • Borrowing from customers: Member firms and associated persons are prohibited from lending money to or borrowing money from their customers unless the member firm has written policies in place that authorize their associated persons and customers to engage in borrowing or lending. Any agreement between an associated person and a customer must satisfy at least one of the following conditions:
    • The customer is an immediate family member of the associated person;
    • The customer is a financial institution that’s in the business of borrowing and lending;
    • The customer and the associated person are both employed by the member firm;
    • The customer and the associated person have a personal relationship that exists outside of the member firm; or
    • The customer and the associated person have a business relationship that exists outside of the member firm;
  • Sharing in customer accounts: Generally, member firms and associated persons are prohibited from sharing directly or indirectly in a customer’s gains or losses. However, they are able to do so if three conditions are met:
    • The associated person receives prior written authorization from their member firm;
    • The associated person receives prior written authorization from the customer; and
    • The associated person or member firm’s share in the customer’s gains or losses is directly proportional to their own financial contributions.

Financial exploitation of seniors: Seniors are one of FINRA’s top prioritized groups of investors due to the increasing problem of financial exploitation. A senior is defined as (1) a natural person age 65 and older or (2) a natural person age 18 and older with a reasonably believed mental or physical impairment that leaves them unable to protect their own interests.

  • Under FINRA rules, member firms are allowed to place a temporary hold on fund or security disbursements from a “specified adult” customer account if the firm believes that financial exploitation of the adult has occurred, is occurring, has been attempted, or will be attempted. By placing the hold, the firm has the opportunity to conduct further research and due diligence.

Activities of unregistered persons: Persons who provide investment banking services and perform functions such as supervision or solicitation of securities business are subject to certain registration and licensing requirements. Providing these services as an unregistered person can lead to a range of consequences.

  • Member firms and associated persons are prohibited from paying compensation, fees, concessions, discount, or commissions to unregistered persons.
  • Unregistered persons are prohibited from discussing firm investment products or services, pre-qualifying firm customers, or soliciting new customer accounts or orders.

Falsifying or withholding documents:

  • Signatures of convenience: Registered reps are prohibited from creating blank template forms that contain signatures.
  • Responding to regulatory requests: Regulatory requests should be responded to promptly.

Prohibited activities related to maintenance of books and records:

  • Registered reps and their firms are required to maintain accurate books and records. Falsifying these records is a serious violation.
  • Improper maintenance/retention of records: Books and records should be stored in paper form, micrographic media, or electronic storage media, for a period of time defined by the firm’s policies and procedures. Generally, records are kept for a period of six years.

Unsuitable recommendations: Making recommendations which do not match the client’s investment goals and needs is unsuitable and can lead to disciplinary action.

Commingling: Mixing client assets with registered rep or firm assets is called commingling. Customers’ money and securities are to be segregated from those of the brokerage firm and/or their rep.

Theft/Embezzlement/Similar Criminal Behavior: Stealing from clients is both unethical and illegal and can lead to incarceration and/or loss of career.

Section 3 Quiz >>