Unit 19 – Business Ethics

Market manipulation

manipulating the price or trading activity of a stock through artificial means creating a false or misleading appearance of market activity, an unethical and illegal practice under federal securities laws, can be very difficult and requires large amounts of cash (most attempts occur with smaller company stocks that are thinly traded)

Thinly traded

security with a low trading volume (very few shares are traded), usually traded in OTC market with a wide spread between quoted bid and ask prices or higher than usual commissions

Types of market manipulation

• market rumors

• pump and dump

• front running

• excessive trading (churning)

• marking the open and marking the close

• backing away

• freeriding

Market rumors

use misleading information or rumors to move the price of a stock up or down, industry personnel are prohibited from spreading false information and market rumors

Social media for rumors

one way to spread misinformation to a large audience with minimal effort and at a low cost while concealing identity or impersonating credible sources

Securities Exchange Act of 1934

puts a stop to manipulations by establishing that an individual would be in violation of federal law if they started rumors and could be held responsible by federal authorities for such rumors

Pump and dump

form of securities fraud (market rumors) through the act of inflating the price of an owner stock by spreading false and misleading positive rumors to sell the stock at a higher price later, shares owned are first accumulated at lower prices then dumped at overvalued prices in the open market – fraudster profits while the selling pressure with the dumping drives the price downward causing investors who purchased based off rumors to lose money

Front running

act of a BD or an RR placing orders for their own account ahead of other orders from a customer, taking advantage of the price movement that is likely to occur

Excessive trading (churning)

abuse of fiduciary responsibility by an excessive number of trades are made in a customer's account only to generate commissions rather than to help achieve the customer's stated investment objectives, frequent or large transaction that are not in keeping with the client’s history or financial ability is a sign – to prevent SROs require a principal to review all accounts (especially those where RR or IA has discretionary authority)

Marking the open

entering orders before the opening for a stock or falsely reporting trades that never occurred to influence the opening price of a stock

Marking the close

entering trades at or near the close of the trading day or falsely reporting trades that never occurred to influence the closing price of a stock

Backing away

market maker refuses to honor their quote, a serious rules violation as when they enter a quote they are committing to buying or selling the size listed at the price listed

Freeriding

when securities are purchased and then sold before payment is made and cash for the purchase is not delivered before settlement (customer must demonstrate that have the ability to pay for a trade), prohibited in both cash and margin accounts – penalty > acct frozen for 90 days and no new transactions unless cash or marginable securities in the account before purchase is made

Rule 5130

designed to protect the public offering process and public investors by preventing financial industry insiders from having advantages during IPOs of common stock, prohibiting member firms from selling shares of a new issue to any account in which restricted persons are beneficial owners

Rule 5130 ensures

1) RRs make true public offering at the POP

2) RRs don’t withhold securities in public offering for their own benefit or use securities to reward those in a position to direct future business to them

3) RRs and associated persons don’t take advantage of their insider status to gain access to new issues for their own benefit at the expense of customers

Restricted persons

under Rule 5130 those who are not permitted to buy shares of an IPO (i.e. purchase at POP), identified as

• FINRA member firms (whether or not they are involved in IPO) and their employees

• finders and fiduciaries acting on behalf of the managing underwriter (attorneys, accountants, consultants)

• portfolio managers

• IAs buying for their personal accts (i.e. any person owning 10% or more of a member firm)

• immediate family members of BDs employees

Before selling shares from an IPO reps must

get a letter from the account owner that the account is eligible to purchase a new common stock issue at the POP

Immediate family

any natural person of BDs employees that are also restricted persons under Rule 5130 including parents, in-laws, spouses, siblings, children, or any other individual to whom the person provides material support (aunts/uncles and grandparents are not considered unless living in same household)

De minimis exemption

exemption to Rule 5130 that if the ownership of restricted persons doesn't exceed 10% of an account, the account may purchase a new equity issue, restricted person may purchase new equity issues as long as no more than 10% of the account’s beneficial owners are restricted persons

Insider Trading and Securities Fraud Enforcement Act of 1988 (or Insider Trading Act or ITSFEA)

amended the Securities Exchange Act of 1934 by setting significant penalties for insider trading and securities fraud, prohibiting insiders from trading on or sharing inside information.

Insider

define under the Insider Trading Act defines as any person who has access to material nonpublic information about a company, doesn’t have to be an employee of the company

Inside information

any material nonpublic information, info that hasn't been given to or is not readily available to the general public – possession is not illegal but acting/sharing is

Material info

info important to know prior to making an investment decision

Insider trading

using inside information to make a gain or avoid a loss, don't have to be an insider to violate the law just using inside information is a violation of the law

ITSFEA liability

both tipper and tippee, as well as anyone who trades on information that they know or should know is not public or who has control over the misuse of this information

Tipper

individual responsible for disseminating material nonpublic information

Tippee

person receiving material nonpublic information from an insider or other tipper

Questions to ask to determine violation of ITSFEA

1) Is the information material and nonpublic?

2) Does the tipper owe a duty to a company or its stockholders? Did they breach that duty?

3) Does the tipper stand to gain? (including enhancing friendship or reputation gain)

4) Does the tippee know, or should the tippee have known, that the information was inside or confidential?

Insider trading penalties

SEC can investigate any person suspected of violating any of the provisions of the Insider Trading Act and if they determine violations occurred, there may be both civil and criminal penalties

Civil penalties

penalties of insider trading may be up to 3x the profits made or losses avoided, a controlling person (i.e. RR) may be fined $1M or 3x the profit made or loss avoided whichever is greater

Treble

legal term for triple

Criminal penalties

penalties of insider trading in which violators may face up to $5 million and up to 20 years in jail, if violator is employee of BD the firm could be fined up to 3x the damages or $25 million whichever is greater

Contemporaneous traders

people who enter trades at or near the same time (but on the other side of the market) in the same security as a person who has inside information, in addition to gov. imposed civil penalties they may sue those who violated insider trading regulations in which suits may be initiated up to 5 years after the violation has occurred

Dodd-Frank Act

amended payment provisions to informers so awards may now be paid for original info concerning any violations of securities law, including insider trading

Bounty

award paid in connection for original information concerning any violation of securities law that can range from 10% - 30% of amounts recovered, based on the information received

Financial exploitation

defined by FINRA as the wrongful taking, withholding, or use of funds or securities or any act or omission of an act taken by a person to obtain control, through deception, intimidation, or undue influence, over the specified adult's money, assets, or property (including any acts done through use of POA, guardianship, or any other authority)

Special concern adults

customers 65+ or 18+ that are unable to protect their own interest due to illness, injury, or disability (mental or physical impairment)

Rules for specified adults

1) member firms and associated persons make reasonable efforts to obtain the name and contact information for a TCP

2) permit but not require member firms to place temporary holds on disbursements from customer accounts when there is a reasonable belief of financial exploitation

Trusted contact person (TCP)

person designated to be contacted if suspicious activity arises in an account, reasonable effort to obtain must be made when opening a customer account or updating account info on an existing account - a resource for the firm in administering the customer's account, protecting assets, and responding to possible financial exploitation

Reasonable effort

asking customer to provide name and contact info for TCP, but if customer refuses or fails to provide TCP details it does not prohibit acct opening

TCP disclosure

member firm states in writing to customer that the member or an associated person is authorized to contact the TCP and disclose certain information about the customer's account

Reaching out to TCP when

1) unable to contact a customer after multiple attempts to inquire about the customer's current contact information

2) suspecting customer may be suffering from some form of diminished capacity

3) believing possible financial exploitation of the customer is occurring

Questionable disbursement

a temporary hold on a disbursement before that can be held up to 15 business days (applies to disbursing funds not holding up trades), not a requirement for firm to do but have power to do so and may reach out to TCP before placing hold

Temporary holds

placed by firm on disbursements of funds or securities if they reasonably believe financial exploitation has occurred, is occurring, has been attempted, or will be attempted – can be no longer than 15 biz days but state regulator or agency of jurisdiction can extern or terminate

Temporary hold rules

firm must immediately start internal review of facts and circumstances that caused the hold and provide notification of the hold and reasoning no later than 2 biz days after hold date begin to TCP and all parties authorized to transact business

Temporary hold notification exemption

1) TCP or authorized parties are unavailable

2) member believes that the TCP or party is the perpetrator of financial exploitation

Red flags

FINRA expects firms to detect and investigate actions that alert to improper use of customer funds

Red flag examples

• conflicting info on new account apps

• suspicious activity (i.e. transfers and disbursement of funds between unrelated accts)

• funds sent to third parties

• activity in deceased person’s acct

• excessive customer complaints

• exception reports showing discrepancies regarding more than one address (i.e. street address & city or zip code don’t match or phone area code & address don’t match)

BD expectations

put systems in place to enable review of customer accounts to prevent false new account apps & other record changes that take advantage of vulnerable customers

Borrowing/lending rules

borrowing a customer's funds for either the firm's or the representative's own use or lending customer's securities for the purpose of short sales when no loan consent agreement has been signed by the customer is prohibited, BD must have procedures in place allowing for either arrangement with customers (if none then it is not allowed in any circumstances…silence means activity is prohibited)

Permitted lending/borrowing

written agreements between RRs and customers for RRs who wish to borrow money from or lend money to customers, must provide prior written notice of the arrangement to the firm and the firm must approve arrangement in writing

Conduct Rules

permit the following five types of lending arrangements

• An immediate family relationship between the RR and the customer (no notice or approval is needed)

• Customer is in the business of lending money (e.g., a bank) (no approval is needed)

• Customer and RR are both registered persons with the same firm (firm approval required)

• Customer and RR have a personal relationship outside the broker-customer relationship (firm approval required)

• Customer and RR have a business relationship outside the broker-customer relationship (firm approval required)

Guarantees

BDs, IAs, and RRs may not guarantee against a loss or a gain and anything intended to convey so is prohibited, 3rd party guarantee (i.e. guaranteed bond) nature may be explained to customers

Sharing

BDs, IAs, and RRs are prohibited from sharing in profits or losses in a customer's account, but an arrangement is possible between RRs of BDs and customers under specific rules

Sharing arrangement

following rules that make sharing possible between RRs of BDs and customers (NOT between BD and customer)

• RR and customer open a joint account (must be approved by BD where acct will be opened), and the RR shares are proportionate to their financial contribution to the joint account ($s only, not measured in knowledge or expertise)

• Received member firm's prior written approval

Proportionate contribution rule

profits and losses must be proportionate to the direct financial investment made, contributions are only measured in dollars – exception to rule applies to RRs sharing a joint acct with immediate family members

Nonregistered permitted activities

the following activities for nonlicensed employees of BDs

• Responding to general noninvestment questions (i.e. hrs of operations)

• Providing literature on request

• Setting appointments

• Inviting prospects to a seminar

• Handle customer money and securities, must be fingerprinted to do so

Nonregistered persons may not

engage in investment banking or other securities business (opening an account, soliciting trades, etc.).

Outside Business Activities (OBAs)

employment by (or compensation from) any business other than an associated (RRs) member firm (except a passive investment) that require written notice (not permission) to the BD, but BD may reject or restrict activity if they believe conflict of interest exists – ex. serving as an officer or director of a company and owning any interest in another financial services company

Passive investments

not considered OBAs as no compensation involved, so no notification required to BD (i.e. purchase/investment of a limited partnership, MF, or an investment company share)

Private securities transaction (selling away)

any sale of securities outside an associated person's regular business and employing member (securities not offered by RR’s firm), does not include transactions done on behalf of immediate family members where there is no compensation for RR

Selling away

associated person engaging in private securities transactions without the knowledge and consent of the employing broker-dealer, violates FINRA/Conduct rules

Rules for private securities transaction

associated person (RR) must

• Provide prior written notice to employer

• Describe in detail proposed transaction and proposed role in the transaction

• Disclose whether they receive compensation for transaction

Private securities transactions w/ compensation

employing member may approve or disapprove the associated person's participation, if not approve the associated person may not participate in it and if approved BD must treat transaction as if done in house by entering the transaction on its books and supervising the RR during the transaction

Private securities transactions w/o compensation

associated person has not received or will not receive compensation the following rules apply

• Member firm must acknowledge that it has received written notification

• Member may require the RR to follow conditions the firm sets during participation

• Transactions done on behalf of immediate family members

• Employer BD may place restrictions they want on an associate's participation in a private securities transaction, including prohibiting participation

Giving/gratuities rule (FINRA Rule 3220)

BDs may only give business-related compensation (cash or noncash gifts or gratitude) to the employees of another firm if it is not excessive, not intended to influence business decisions, and is reasonable ($300/ person annual limit) – ensures fair/ethical practices remain within regulatory boundaries and are consistent within the industry, maintains integrity of professional relationship

Compensation

gifts from an employer to employee, not a gift so FINRA rules on giving do not apply

Exceptions to giving rule

1) compensation is not conditional on sales or promises of sales

2) recipient’s firm gives prior approval

3) compensation's total value doesn't exceed the annual limit set by the regulatory bodies (FINRA/SEC), currently $300 per year

Giving limit exceptions

BDs may exceed $300 limit for occasional noncash expenditures/standard or reasonable business entertainment (i.e. dinner, tickets, and seminars), promotional items/advertising (i.e. pens with firm’s logo), and life events (i.e. wedding or child)

MSRB pay to play rules

deals with the influence (special treatments) of political contributions on the selection of underwriters preventing pay to play, focusing on negotiated underwritings where a municipal issuer selects an underwriter and negotiates a deal (not underwritings in which underwriters bid on a proposed new issue) and financial advisory work where a municipal issuer selects a municipal firm to help it structure a new issue

Pay to play

using political contributions to get business from municipalities

MSRB Rule G-37

prohibits firms that handle municipal securities from engaging in municipal securities business (negotiated underwritings and financial advisory work) with an issuer for 2 years after a contribution is made to an official of that issuer by the municipal firm, a MFP associated with the firm, or any political action committee (PAC) controlled by the firm

Negotiated underwriter time frame

prohibited from doing business for a period of 2 years after the last political contribution made under MSRB Rule G-37

Municipal finance professional (MFP)

associated person of a FINRA member firm engaged in municipal securities underwriting, trading, sales, financial advisory, research, investment advice, or any other activities that involve communication with public investors (does not include those who are limited solely to sales with natural persons and clerical or ministerial functions)

MFP contribution rules

MFPs are permitted to make contributions of up to $250 per election to officials for whom they are eligible to vote, exception does not apply to contributions made by municipal firms (a firm is not a voter)