Study guide
This chapter covers the seventh and final topic of the official NASAA outline: ethical standards of conduct. It covers compensation, handling of customer assets, discretion, standards of care, and the long list of prohibited and unethical practices, including protections for vulnerable adults.
Compensation, Customer Funds, Discretion, and Standards of Care
Compensation must be fair and disclosed. Commissions on agency trades and markups or markdowns on principal trades (where the firm trades from its own inventory) must be reasonable and not hidden; charging both a commission and a markup on the same trade, or imposing excessive fees for routine services, is a dishonest practice. Fee schedules and material compensation arrangements, including compensation the firm receives from third parties, must be disclosed so the customer can see what a recommendation earns the person making it. Handling customer assets carries its own rules. Firms must safeguard customer funds and securities, never commingle them with firm assets, and promptly deliver securities and pay balances as instructed. Custody, meaning holding customer funds or securities, triggers heightened requirements such as notice to the Administrator, bonding or net capital, segregation, and account statements. Discretion means the agent chooses any of the three As, asset, amount, or action (buy or sell), without talking to the customer first. Exercising discretion requires written authorization from the customer before the first discretionary trade, and discretionary accounts require principal approval and closer review. The one exception: an order that specifies the security, the amount, and the action, leaving only time or price to the agent's judgment, is not discretionary, though such orders are good only for that trading day. Third-party trading authorizations must likewise be written. Standards of care differ by role: broker-dealer agents must have a reasonable basis to believe each recommendation is suitable, and federal Regulation Best Interest requires recommendations to retail customers to be in the customer's best interest, while investment advisers owe a full fiduciary duty at all times. An agent taking on advisory-style compensation or control edges into the higher standard.
Prohibited Practices and Protecting Vulnerable Adults
Most exam questions in this area describe conduct and ask you to name the violation. Churning, called excessive trading in the outline, is trading a customer's account primarily to generate commissions, measured against the customer's objectives and resources, and it can occur even in a profitable account. Unauthorized trading is executing any trade without required consent. Selling away is effecting securities transactions outside the agent's employing firm without the firm's knowledge and permission, even when the customer begs for the product. Insider trading, trading or tipping on material nonpublic information, exposes both tipper and tippee to liability. Market manipulation includes wash trades (trades with no change in beneficial ownership), matched orders between colluding parties to paint a false picture of activity, spreading rumors to move prices, and front running customer orders. Borrowing from or lending to customers is prohibited unless the customer is in the lending business, such as a bank, or another narrow exception under firm policy applies. Sharing in a customer's account is forbidden for advisers and their representatives, but a broker-dealer agent may share profits and losses with a customer if both the customer and the employing broker-dealer give written authorization. FINRA's separate rule also requires the sharing to be proportionate to the agent's contribution; NASAA's rule does not. Maintaining outside securities accounts without notifying the employer, backdating documents, commingling, and deliberately delaying transactions round out the list. The exploitation of vulnerable adults, meaning seniors and adults with impairments, gets special machinery under the NASAA model act: qualified employees who reasonably suspect financial exploitation must notify the Administrator and adult protective services, may contact the trusted contact person, and the firm may delay a suspicious disbursement for up to 15 business days, extendable by 10 more at the regulator's or agency's request, with immunity for good-faith reports. Consent is never a defense: a violation remains a violation even if the customer approved it or made money.
Key terms
- Markup / markdown
- — The price adjustment a dealer adds or subtracts when trading with customers from its own inventory; it must be fair and reasonable.
- Custody
- — Holding customer funds or securities, which triggers notice, bonding or net capital, segregation, and reporting requirements.
- Discretionary authority
- — Power to decide asset, amount, or action for a customer, requiring prior written authorization; time and price alone are not discretion.
- Churning
- — Excessive trading in a customer's account, relative to objectives and resources, done primarily to generate commissions.
- Selling away
- — Effecting securities transactions outside the employing broker-dealer without the firm's knowledge and approval.
- Disbursement hold
- — Under the NASAA model act, a firm suspecting exploitation of a vulnerable adult may delay a disbursement up to 15 business days, extendable by 10 more.
- Wash trade / matched orders
- — Manipulative trades with no real change in ownership, or coordinated buy-sell orders, designed to create a false appearance of market activity.
Exam tips
- The three As define discretion: if the customer fixes asset, amount, and action and leaves only time or price, no written authorization is needed, but the order is good only that day.
- Sharing in accounts splits by role: never permitted for IAs and IARs, but permitted for broker-dealer agents with written consent of both the customer and the firm. If a question adds "proportionate to contribution," that condition comes from FINRA's rule, not NASAA's.
- Customer consent and profitable outcomes never cure a violation; a question saying the client agreed or the account made money is testing whether you will excuse prohibited conduct.
- Know the vulnerable-adult numbers cold: a hold of up to 15 business days plus a 10 business day extension, with reports to the Administrator and adult protective services and immunity for good-faith reporting.
- Distinguish the standards of care: suitability and best interest for broker-dealer agents on recommendations, ongoing fiduciary duty for advisers; a question about who owes a continuous duty of loyalty points to the adviser side.