12.4 Prohibited Activities

Insider Trading

Insider trading is buying or selling a security while in possession of material, non-public information (MNPI), in breach of a duty. Information is material if a reasonable investor would consider it important to a buy/sell/hold decision — think pending mergers, earnings surprises, FDA decisions, executive departures, or a fraud discovery.

Liability is broad. Tippers (who pass MNPI), tippees (who trade on it), corporate insiders, and misappropriators (people who steal information, like a printer or lawyer) can all be charged. The governing law is the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA), layered on the 1934 Act's Rule 10b-5.

Market Manipulation

Manipulation artificially distorts a security's price or volume. The exam wants you to recognize each named scheme:

Stabilization — The Only Legal "Manipulation"

During a new-issue distribution, an underwriter may place a stabilizing bid to support the price. It is the only lawful form of price support, and two limits define it: the stabilizing bid may not exceed the public offering price, and it must be disclosed in the prospectus. Any bid above the offering price is illegal manipulation.

Front-Running and Trading Ahead

Front-running (FINRA Rule 5270) is trading a security (or a related option) while holding MNPI about an imminent block transaction — for example, buying ahead of a customer's known 100,000-share order to profit from the expected price move. Trading ahead is the related sin of executing firm proprietary orders before holding customer limit orders at the same or a better price.

Churning and Unauthorized Trading

Churning is excessive trading to generate commissions; proving it requires control of the account, excessive activity, and intent to enrich the rep over the client. Unauthorized trading is executing in a non-discretionary account without the customer's prior consent for that specific trade. Verbal discretion as to time and price (a "market not held" order) is fine for a day; discretion as to asset, action, or amount requires prior written authorization.

Selling Away and Other Bans

Selling away is offering securities outside the employing firm. FINRA Rule 3280 (Private Securities Transactions) requires prior written notice to the firm; if the rep is compensated, the firm must approve and supervise the activity. Even with no compensation, written notice is still required. Other prohibitions: interpositioning (inserting a needless middleman that raises cost), backing away (a market maker refusing to honor a firm quote), borrowing from or lending to customers (narrow family exceptions), and guaranteeing customers against loss.

Sharing in Customer Accounts and Borrowing — Rules 2150 and 3240

Under FINRA Rule 2150, a representative generally may not share in the profits or losses of a customer account. The narrow exception requires prior written approval from the firm and that the rep share only in proportion to the rep's own capital contribution — except for a joint account with an immediate family member, where the proportionality rule is relaxed.

Rule 3240 restricts borrowing from or lending to customers: it is prohibited unless the firm permits it and the parties fall into a defined relationship (immediate family, a customer in the lending business such as a bank, a personal/business relationship outside the brokerage, or registered persons at the same firm). Commingling customer funds with the rep's own is always prohibited.

A Front-Running Worked Example

A rep learns at 9:50 a.m. that an institutional client will enter a market order to buy 250,000 shares of a thinly traded stock at the open of the next session. Before placing the client's order, the rep buys 2,000 shares for a personal account, then sells into the price spike the large order creates. This is textbook front-running under Rule 5270: the rep traded while holding material, non-public market information about an imminent block. The violation exists even if the personal trade is tiny — the breach is using the customer's order information for personal gain, not the size of the profit.

Manipulation vs. Legitimate Activity

Students confuse lawful trading with manipulation. Use this contrast:

The dividing line is intent and economic reality: a real change in beneficial ownership and a genuine purpose are lawful; deception about supply, demand, or price is not.

On the Exam

Know that both tipper and tippee are liable, the 3× civil and $5M/20-year criminal ceilings, the stabilization rules (at or below the offering price, disclosed), and that selling away always demands written notice even without pay.