18.2 Prohibited Practices
Key Takeaways
Guaranteeing against loss is prohibited.
Front-running and churning are serious violations.
All compensation must be disclosed.
Borrowing from or lending to clients is generally prohibited.
Insider trading and tipping are federal offenses.
Advisers must adopt a code of ethics with personal trading rules.
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
| Category | Examples |
|---|---|
| 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
| Element | Description |
|---|---|
| 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
| Element | Description |
|---|---|
| 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
| Indicator | Description |
|---|---|
| Turnover Ratio | Annualized trading volume ÷ average account equity |
| Cost-to-Equity Ratio | Total costs ÷ average equity (if >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
| Element | Description |
|---|---|
| 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:
| Requirement | Description |
|---|---|
| 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
Front-running is:
Executing client orders as quickly as possible for best execution
Trading ahead of client orders based on advance knowledge of those orders
Placing orders at the front of the order queue
A legitimate trading strategy for improving execution prices
Churning is prohibited because it:
Always results in client losses
Involves excessive trading primarily to generate commissions for the adviser
Provides too much diversification for client portfolios
Violates margin requirements
An investment adviser guarantees a client that they will not lose money. This is:
Permitted if the guarantee is in writing
Permitted for clients over age 65
Absolutely prohibited under all circumstances
Permitted if the adviser has sufficient capital
Sections you finish are checked off in the contents.