The Securities Exchange Act of 1934:

• The act of 1934 prohibits manipulative and deceptive practices in the sale of securities. Rule 10b-5 of the Act includes specific anti-manipulation provisions and states:
  • It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange:
    • To employ any device, scheme, or artifice to defraud
    • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
    • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person
• In connection with the purchase or sale of any security
• Rule 10b-1 – stipulates that anti fraud rules also apply to exempt securities 
• Rule 10b-3 – stipulates that broker-dealers are prohibited from engaging in fraudulent practices

Prohibited Trading Practices

• Market Rumors
  • Spreading false or misleading information to influence the price of stocks and/or bonds
• Front–Running
  • Registered Reps (RRs) executing trades for proprietary accounts (or those for which they have discretion) ahead of a customer’s block order (a market-moving order)
• Market-the-Close/Opening
  • Affecting trades near the opening or close of trading in an attempt to influence a stock’s closing price up or down
• Churning
  • Excessive trading in a client’s account for the purpose of generating additional fees and commissions

Prohibited Trading Practices

• Interpositioning
  • Refers to the insertion of a third party between a customer and the best market
    • Prohibited if detrimental to the customer, but acceptable if advantageous 
• Trading Ahead of Customer Orders
  • Occurs when, after accepting and while holding a customer order, a dealer executes an order for the same security on the same side of the market for its own account
    • The obligation is to fill the customer’s order first
    • An exception exists if executed by a different department at the same firm if information barriers exist
• Quoting a Security in Multiple Mediums
  • Refers to displaying quotes on the same security in multiple markets
    • Permitted if the quotes are the same price

Regulation M – Overview

• Contains rules to prevent manipulation in the secondary market by persons with an interest in the outcome of an offering and prohibits activities that could artificially influence an offered security’s market
• Under Reg. M, some of the rules include:
• 1
  • Limits bids and purchases by distribution participants (underwriters and selling group members)
  • Prevents conditioning the market by restricting trading for a specific period 
• 2
  • Allows for passive market making
  • Permits distribution participants to execute unsolicited trades to maintain marketability of the security
    • They can bid, but they can’t bid higher than highest independent bid (bid by brokerage firm not involved in distribution)
• 3
  • Permits stabilization of the new issue to protect its price from falling substantially
  • If public offering price is $20/share, syndicate can bid $20/share to support the POP, but can’t bid higher than $20/share

Trading Ahead of a Research Report

• If a firm has knowledge of material, non-public information regarding the contents of a research report, it may NOT establish, increase, decrease, or liquidate an inventory position in a security or its derivative
  • Executing proprietary orders is prohibited until the information is released publicly
    • Applies to equity, debt, and derivatives
    • Covers exchange and non-exchange listed securities
  • Information barriers must exist between trading and research departments
    • Barriers prevent the flow of information between the departments 

A Market Maker’s Quote

• A market maker that publishes a quote is obligated to buy or sell at its stated bid or offer and up to the size quoted
• Bid: $10 | Ask $10.05
• The market maker must buy at $10 and sell at $10.05
• Failure to do so is considered backing away (a violation)

Matching

• Market rumors
  • Spreading false or misleading information to influence the price of stocks and/or bonds
• Front-running
  • Establishing, increasing, decreasing, or liquidating a position based on having knowledge of an unexecuted block order
• Churning
  • Excessive trading in a client’s account to generate additional fees and commissions
• Trading ahead
  • RRs executing orders for proprietary accounts (or those in which they have discretion) ahead of the release of a research report 
• Backingaway
  • A market maker’s failure to buy or sell at its stated bid or offer

Regulation T Payment Date

• The Reg. T payment must be obtained from customers or purchases that are made in either cash or margin accounts within two business days of settlement (S + 2) (so T + 4)
• Before settlement, a customer can request that the broker-dealer transfer a trade from a cash account to a margin account
• If no payment is made, the position is closed out (securities sold) on the third business day following settlement 
• The result of non-payment is that the account is frozen for 90 days (all payments must be made in advance)
• An investor who buys a stock and subsequently sells it, but fails to meet the Regulation T requirement, is guilty of FREERIDING!

Anti-Intimidation/Coordination Interpretation

• The following actions are prohibited:
  • Coordinating price quotes, transactions, or trade reports with other market makers
  • Threatening, harassing, or intimidating other market makers
  • Retaliating against or discouraging the competitive activities of another market maker

Trading Rules

• Best Execution
  • FINRA and MSRB rules require member firms to use reasonable diligence to obtain best execution for their customers. Factors include:
    • The character of the market for the security
    • The size and type of the transact and number of markets checked
    • The ease of obtaining a quote and the terms of the order
• MSRB Time of Trade Disclosures
  • According to the MSRB, dealers are required to provide customers with all material information that is known or reasonably available at or prior to time of trade
    • These requirements apply for both solicited and unsolicited trades, trades that occur in the primary or secondary market, or for agency or principal trades

Insider Trading

• Insider trading involves the purchase or sale of securities using material, non-public information about an issuer to make a profit or avoid a loss
• Tippers and Tippees
  • Refers to inside information passed from one party (tipper) to another (tippee) who then trades on that information
  • If trading occurs, both parties would be in violation
• Procedures
  • Broker-dealers must have written policies designed to prevent insider trading. These must include:
    • A system to monitor employee’s personal trading
    • The establishment of information barriers to prevent access to confidential information
    • Trading restrictions or monitoring of certain securities in which the firm has access to inside information
      • Restricted list – distributed to employees (can’t trade)
      • Watch list – available only to legal/compliance (trades on these securities being scrutinized / watched closely, but you can trade)
• Insider Trading Penalties
  • Civil – the SEC may demand disgorgement of profits and the payment of treble damages (three times the damage) – 3x the profit made/loss avoided
  • Criminal – an individual may be subject to a maximum fine of $5 million, and/or up to 20 years in prison (Justice Department)
• Bounties
  • Eligible whistleblowers are entitled to an award of between 10% and 30% of the monetary sanctions collected in actions brought by the SEC and other regulatory authorities

The New Issue Rule

• Only applies to equity IPOs

• FINRA prohibits member firms from selling equity IPOs to any account in which restricted persons have beneficial interest
• Restricted Persons
  • Member firms and any member firm employees
  • Immediate family members of member firm employees if:
    • There is material support (25% of the person’s income), or
      • Spouse / children
    • Sharing of a household, or
    • The purchase is made through the family member’s firm
  • Finders and fiduciaries
    • (e.g., lawyers, accountants)
  • Portfolio managers purchasing for their own account
• Preconditions for Sale
  • Verification that the account is eligible to purchase the IPO
    • May be a written statement or electronic communication
    • May not be an oral statement
  • Re-verification of eligibility every 12 months 
• General Exemptions
  • An account that includes restricted persons, provided their combined ownership does not exceed 10% (de minimis)
  • Issuer-directed sales that allow restricted persons to purchase if the associated person or associated person’s immediate family is an employee or director of the issuer
    • Your spouse, working at the firm IPOing, that spouse can buy into the own’s firm IPO
  • Portfolio managers purchasing for the fund
  • A broker-dealer purchasing for its own account after making a bona fide public offering
    • You did a firm commitment underwriting, you can’t sell these to the public 

Sharing in Accounts and Guarantees

• Sharing in profits and losses in a client’s account is prohibited unless a joint account is established with the client and:
  • The employee has the written permission of both the client and the broker-dealer, and
  • The sharing is proportionate to the employee’s investment
    • An arrangement with a family member is exempt from the proportionate sharing requirement
• Investment advisory accounts permits sharing in profits and losses if:
  • Prior written consent between the firm and customer
  • Firm is in compliance with SEC regulations
• Guarantees – employees may neither guarantee against losses nor reimburse a customer for losses in any way

Borrowing and Lending

• Without Notification
  • RRs borrowing from or lending to customers is acceptable without firm notification if the customer:
    • Is an immediate family member, or
    • Is a financial institution regularly engaged in the business or providing loans
• With Notification
  • RRs must provide written notifications to their firms and obtain prior written approval if:
    • The customer and RR are both registered with the same firm, or
    • A personal relationship exists, or
    • A business relationship exists outside of the brokerage firm

Financial Exploitation Rules

• Definition
  • Financial exploitation rules apply to specified adults who are most likely to be exploited, including:
    • Persons age 65 or older
    • Any persons age 18 or older who are believed to have a mental or physical impairment jeopardizing their ability to protect their own interests
• Procedures
  • If signs of diminished capacity or dementia are identified, the firm should place a temporary hold on the account
    • The customer’s designated trusted contact person should be notified
      • Information regarding the trusted contact persons should be obtained when an account is opened (although not required, a reasonable effort should be made)

Temporary Holds

• Temporary Hold
  • Apply to the:
    • Disbursement of funds or securities
    • Execution of securities transactions
    • Transfer of assets from one account to another at the same firm
• Internal review
  • When a hold is placed, an immediate internal review of the reasons must occur
• Oral or written notification
  • No later than two business days after the hold is placed, the firm must provide oral or written notification of the hold to all parties who are authorized to transact business in the account and the trusted contact person 

Fill in the blank

• Clients who buy or sell a stock without paying the Regulation T requirement commit a freeriding violation
• Coordinating price quotes and transactions, delaying reporting of trades,and sharing information but customer orders are violations of the anti-intimidation and coordination interpretation
• Interpositioning refers to the process of inserting a third party between a customer and the best market
• Insider trading involves the purchase of sale of securities using material, non-public information about an issuer to make a profit or avoid a loss
• The new Issue Rule prohibits member firms from selling equity IPOs to account in which a restricted person has a beneficial interest (more than 10%)
• Financial exploitation rules apply to specified adults who are most likely to be exploited 

Outside Brokerage Accounts

• Employee Requirements
  • Before a member firm employee can open an account with another firm, the employee must
    • Obtain employer’s prior written consent
    • Provide written notification of his association to the executing firm
    • Satisfy the previous two provisions within 30 days of employment if opened prior to employment 
• Executing Broker-Dealer Requirements
  • The executing firm must send duplicate confirmations and statements if requested by the employing firm
  • This applies to accounts for the employee’s spouse, dependent children, or an account in which the person controls or has a beneficial interest
• Exemptions
  • Requirements of this rule do NOT apply to transactions involving mutual funds, variable contracts, unit investment trusts, or 529 plans 

Compensation Rules and Forgery

• Payments to Unregistered Persons
  • Generally, firms and RRs are prohibited from paying compensation to any individual or firm who is not FINRA registered
    • This includes paying referral fees
    • Retiring representatives may continue to receive commissions on existing accounts if a bona fide contract is created
• Forgery
  • Signing another person’s name without authorization
  • May result in criminal prosecution

Broker-Dealers Books and Records

• Prior to utilizing any form of electronic storage media, a B/D must notify its self-regulatory organization (SRO)
• If the electronic storage media to be used is order than CD-ROM, the B/D must give its SRO 90-days’ advance notice
• Electronic storage media must have tamper-evident features or the ability to record all changes that are made to its contents