18.2 Prohibited Practices

Investment advisers and their representatives are prohibited from engaging in various unethical and illegal practices. NASAA has established model rules that define prohibited conduct, and violations can result in administrative sanctions, civil liability, and criminal penalties.

NASAA Model Rule on Prohibited Conduct

The NASAA Prohibited Conduct Model Rule defines practices that constitute dishonest or unethical conduct for investment advisers and IARs.

Categories of Prohibited Conduct

Misrepresentation: Guaranteeing against loss, false credentials, misleading performance

Fraud and Deceit: Material misstatements, manipulative devices, false documentation

Conflicts of Interest: Undisclosed compensation, improper borrowing/lending

Trading Abuses: Front-running, churning, unauthorized trading

Information Misuse: Insider trading, breach of confidentiality

Misrepresentation Violations

Guarantee Against Loss

Absolutely Prohibited: Advisers cannot guarantee that a client will not lose money.

- Cannot guarantee specific returns

- Cannot promise to make client whole after losses

- Cannot use language implying no risk of loss

Misrepresenting Qualifications

- Claiming credentials not actually held

- Misrepresenting experience or track record

- Falsely claiming regulatory approvals or licenses

- Misrepresenting registration status (SEC vs. state)

Performance Claims

- Showing only winning trades (cherry-picking)

- Using hypothetical results without disclosure

- Comparing to inappropriate benchmarks

- Omitting material facts about past performance

Trading Abuse Violations

Front-Running

Definition: Trading ahead of client orders based on advance knowledge

Violation: Using knowledge of pending client orders to profit

Example: Buying stock personally before executing client buy order

Why Prohibited: Violates duty of loyalty; takes opportunity from client

Churning

Definition: Excessive trading to generate commissions

Elements Required: (1) Excessive trading, (2) Control by adviser, (3) Intent or recklessness

Indicators: High turnover ratio, transactions inconsistent with objectives

Why Prohibited: Disregards client's interests for adviser's benefit

Churning Indicators

Turnover Ratio: Annualized trading volume divided by average account equity

Cost-to-Equity Ratio: Total costs divided by average equity (if over 2% monthly, suspicious)

In-and-Out Trading: Buying and selling same securities frequently

Unsuitable Trading: Active trading in conservative accounts

Unauthorized Trading

- Trading without client authorization

- Exceeding scope of discretionary authority

- Falsifying client consent

- Trading in accounts without written discretionary authorization

Compensation and Conflict Violations

Undisclosed Compensation

All compensation must be disclosed:

- Fees, commissions, markups

- Revenue sharing arrangements

- Soft dollar benefits

- Referral fees

- Any other economic benefit

Borrowing From/Lending to Clients

Generally Prohibited under the NASAA adviser model rule, with limited exceptions:

- Borrowing from a client is allowed only if the client is a broker-dealer, an affiliate of the adviser, or a financial institution in the business of lending money

- Lending to a client is allowed only if the adviser is a financial institution in the business of lending money or the client is an affiliate of the adviser

- There is no family-member exception in the adviser rule

- Creates conflicts of interest

- Impairs objectivity

Sharing in Client Gains (Performance Fees)

An adviser may be paid a share of a client's capital gains or capital appreciation only under SEC Rule 205-3: the client must be a "qualified client" (net worth over $2.7 million, or at least $1.4 million under management with the adviser, since June 29, 2026). The NASAA model rule applies the same Section 205 standard to state-registered advisers and their representatives.

Information Misuse

Insider Trading

Material Information: Information a reasonable investor would consider important

Non-Public: Not yet disclosed to the public

Prohibition: Cannot trade or tip others based on MNPI

Liability: Civil and criminal penalties

Tipping

Passing material non-public information to others who then trade is equally prohibited, whether or not the tipper trades personally.

Selling Away

Definition: Engaging in securities transactions outside the employing firm without firm knowledge or approval.

Elements:

- Private securities transactions

- Not through employing firm

- Without firm supervision

- May constitute fraud

Consequences:

- Disciplinary action

- Termination

- Regulatory sanctions

- Civil and criminal liability

Personal Trading Policies

Code of Ethics Requirements

All investment advisers must adopt a written code of ethics including:

Standards of Conduct: Ethical standards for advisory personnel

Compliance Obligation: Duty to comply with securities laws

Personal Trading Rules: Restrictions on personal securities transactions

Reporting Requirements: Holdings and transaction reporting

Violation Reporting: Procedures for reporting violations

Access Person Requirements

"Access persons" (those with access to nonpublic information about client trades or holdings) must:

- Report personal securities holdings initially and annually

- Report personal securities transactions quarterly

- Pre-clear trades in certain securities

- Follow restricted and watch lists

On the Exam: Guaranteeing against loss is ALWAYS prohibited - this is frequently tested. Know the elements of churning (excessive trading + control + intent) and front-running (trading ahead of client orders).

Key Takeaways

- Guaranteeing against loss is absolutely prohibited

- Front-running and churning are serious violations

- All compensation must be disclosed

- Borrowing from/lending to clients is generally prohibited

- Insider trading and tipping are federal offenses

- Code of ethics with personal trading policies required