Overview
Prohibited practices on the SIE exam cover a wide range of illegal and unethical behaviors by brokers, dealers, investment advisers, and investors. These rules exist to protect market integrity, ensure fair dealing, and safeguard investors from fraud and conflicts of interest. Mastery of these topics is essential, as violations can result in fines, suspension, or permanent bars from the securities industry.
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Market Manipulation
Summary
Market manipulation involves artificially influencing the price or perceived activity of a security to deceive other investors. These practices distort the true forces of supply and demand and undermine investor confidence in the markets.
Key Schemes to Know
• Painting the Tape: Traders execute transactions between themselves to create the illusion of active trading volume. No real change in ownership occurs — it's purely a deception tactic.
• Pump and Dump: Fraudsters spread false or misleading information to inflate a stock's price (the "pump"), sell their shares at the peak, then abandon the position as the price collapses (the "dump"), leaving unsuspecting investors with losses.
• Spoofing: Placing large orders with the intent to cancel before execution to create false impressions of supply or demand. Illegal under the Dodd-Frank Act.
• Marking the Close: Executing trades near market close to artificially move a security's closing price, which is used for portfolio valuations, derivatives settlement, and benchmarks.
• Wash Trading / Match Trading: Simultaneously buying and selling the same security with no real change in ownership, creating artificial volume. Violates Section 9 of the Securities Exchange Act of 1934.
Key Terms
• Artificial trading volume — Fake activity designed to mislead investors
• Supply and demand manipulation — Distorting the natural price discovery process
• Dodd-Frank Act — Federal law that explicitly prohibits spoofing
• Section 9, Securities Exchange Act of 1934 — Prohibits wash trading and other manipulation schemes
Watch Out For
> ⚠️ Painting the tape vs. wash trading: Both involve fake transactions, but painting the tape focuses on creating the appearance of volume, while wash trading emphasizes buying and selling the same security with no change in ownership. Know both definitions separately.
> ⚠️ Spoofing requires intent: Simply canceling an order is not illegal — the intent to deceive when placing the order is what makes it spoofing.
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Insider Trading
Summary
Insider trading involves trading on material, non-public information (MNPI) in breach of a duty of trust or confidence. Both those who share the information (tippers) and those who act on it (tippees) face civil and criminal liability.
Key Concepts
• Material Information: Information that a reasonable investor would consider important in making an investment decision, or that would likely affect the security's price. Examples:
- Unreported earnings
- Pending mergers or acquisitions
- Major contract wins or losses
- FDA approval or rejection decisions
• Non-Public Information: Information not yet disclosed to the general investing public through appropriate channels.
• Tipper/Tippee Liability: The original insider (tipper) who leaks MNPI and the individual (tippee) who trades based on it can both be held legally liable.
• Rule 10b-5 (SEC) — The primary anti-fraud rule in securities law. It prohibits three broad categories of conduct:
1. Employing any device or scheme to defraud
2. Making any untrue statement of material fact or omitting a material fact
3. Engaging in any act or practice that operates as a fraud or deceit
Key Terms
• MNPI — Material, Non-Public Information
• Fiduciary duty — Legal obligation to act in another's best interest; a breach is required for insider trading liability
• Tipper — The insider who discloses MNPI
• Tippee — The recipient of MNPI who trades on it
• Rule 10b-5 — SEC rule prohibiting fraud and insider trading in connection with securities transactions
Watch Out For
> ⚠️ Both tippers AND tippees can be liable: Even if you didn't work for the company, trading on a "hot tip" from an insider can result in prosecution.
> ⚠️ Materiality is objective: It doesn't matter if you thought the information was important — the standard is whether a reasonable investor would find it significant.
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Broker-Dealer Violations
Summary
Broker-dealers and their registered representatives owe duties of fair dealing and loyalty to their clients. Violations in this category typically involve self-dealing, deception, or unauthorized conduct that harms the customer.
Key Violations
• Churning: Excessive trading in a customer's account primarily to generate commissions rather than to serve the customer's investment objectives. Violates both FINRA rules and SEC regulations.
• Unauthorized Trading: Executing transactions in a customer's account without prior consent and without written discretionary authority. Every trade requires either prior customer approval or a valid discretionary agreement.
• Front-Running: A broker trades in their own account based on advance knowledge of pending client orders, profiting from the price movement the client's order will cause. Places the broker's interests above the client's — a clear breach of fiduciary duty.
• Selling Away: A registered representative sells or solicits investments outside the scope of their employment without the broker-dealer's knowledge or approval. Violates FINRA rules requiring all securities activities to be conducted through the employing firm.
• Misrepresentation: Making false or misleading statements about a security's risks, potential returns, or issuer background — or omitting material facts a reasonable investor would need to make an informed decision.
• Free-Riding (Regulation T Violation): Buying securities and selling them before paying for the purchase, using sale proceeds to fund the original purchase. Violates Regulation T, which mandates payment within the required settlement period.
Key Terms
• Churning — Excessive trading to generate commissions
• Discretionary authority — Written permission allowing a broker to trade on a client's behalf
• Selling away — Conducting securities business outside the employing firm
• Regulation T — Federal Reserve rule governing the extension of credit for securities purchases
• Misrepresentation — False or misleading statements, including material omissions
Watch Out For
> ⚠️ Churning requires a pattern: A single excessive trade is not churning — regulators look at the frequency and volume of trades relative to the account size and the customer's investment objectives.
> ⚠️ Unauthorized trading vs. discretionary trading: Having discretionary authority makes trading without prior approval legal. Without it, every trade needs prior customer consent.
> ⚠️ Free-riding is a Reg T issue: Don't confuse this with free-riding in an IPO context (withholding). Know the context of the question.
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Fraud and Deceptive Practices
Summary
These practices involve deliberate deception to profit at the expense of investors. They range from outright theft (Ponzi schemes) to subtle conflicts of interest (scalping). Most violate multiple federal securities laws simultaneously.
Key Schemes
• Ponzi Scheme: A fraudulent investment where earlier investors are paid using new investors' capital rather than legitimate business profits. The scheme collapses when new money stops coming in. Key difference from legitimate investments: no real underlying business activity generates returns.
• Scalping: An investment adviser buys securities for their own account, then recommends them to clients to artificially drive up the price, and sells personal holdings at a profit. Violates the Investment Advisers Act of 1940 due to an undisclosed conflict of interest.
• Wash Trading / Marking the Close: (See Market Manipulation section above — these practices apply here as well under fraud classifications.)
Key Terms
• Ponzi scheme — Returns paid from new investor capital, not business profits
• Scalping — Adviser self-dealing by recommending securities they already own
• Investment Advisers Act of 1940 — Governs the conduct of investment advisers, prohibiting undisclosed conflicts of interest
• Conflict of interest — When a professional's personal financial interest competes with their duty to a client
Watch Out For
> ⚠️ Ponzi vs. Pyramid schemes: In a Ponzi scheme, the operator controls the funds; in a pyramid scheme, participants recruit others and collect fees. Both are fraudulent, but the structures differ.
> ⚠️ Scalping requires disclosure: If an adviser discloses their position and the conflict of interest, it may not rise to the level of a violation. The lack of disclosure is the key element.
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Customer Account Violations
Summary
These violations occur within the broker-client relationship and involve improper handling of customer funds, assets, or account authority. Regulatory protections in this area are designed to ensure customers retain control over their assets.
Key Violations
• Discretionary Trading Without Authorization: Discretionary trading (making decisions without per-trade approval) is only legal when the customer has provided written authorization and the broker-dealer has approved the arrangement. Abuse through excessive trading is also a violation.
• Commingling: Mixing customer funds or securities with the firm's own assets. Prohibited under SEC Rule 15c3-3 (the Customer Protection Rule), because customers must be able to recover their assets if the firm fails.
• Excessive Markup (FINRA 5% Policy): Charging customers prices significantly above the prevailing market price when selling from inventory.
- The 5% policy is a guideline, not an absolute rule
- Appropriate markup depends on: security type, transaction size, dollar amount, and whether the firm acted as principal or agent
- Applies to markups (selling), markdowns (buying), and commissions
• Guaranteeing Against Loss: Promising a customer they won't lose money, or agreeing to share in losses. Prohibited because:
- All investments carry inherent risk
- Such promises are misleading
- Creates an undisclosed financial arrangement between the broker and client
Key Terms
• Discretionary authority — Written permission to trade on a customer's behalf without per-trade approval
• Commingling — Improperly mixing customer and firm assets
• SEC Rule 15c3-3 — Customer Protection Rule prohibiting commingling
• FINRA 5% Policy — Guideline for fair markups, markdowns, and commissions
• Guaranteeing against loss — Prohibited promise that a customer will not lose money
Watch Out For
> ⚠️ The 5% policy is a guideline, not a hard rule: Some securities (e.g., mutual funds, municipal securities) have their own markup standards. Don't assume 5.01% is automatically a violation — context matters.
> ⚠️ Commingling endangers customer assets: Even if no fraud is intended, mixing assets creates legal and financial risk for customers in the event of firm insolvency.
> ⚠️ Sharing in losses requires written consent AND supervisory approval: While a registered rep can share in a customer's gains or losses under specific conditions (proportional sharing in a joint account), guaranteeing against loss is always prohibited.
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Quick Review Checklist
Use this checklist to confirm mastery before your exam:
• [ ] Define painting the tape and distinguish it from wash trading
• [ ] Explain the two phases of a pump and dump scheme
• [ ] Identify what makes information material and non-public under insider trading rules
• [ ] Know all three prohibitions under Rule 10b-5
• [ ] Explain how both tippers and tippees can face insider trading liability
• [ ] Define churning and explain what distinguishes it from normal active trading
• [ ] Explain when discretionary trading is legal vs. a violation
• [ ] Distinguish front-running from other forms of self-dealing
• [ ] Define selling away and the FINRA rule it violates
• [ ] Explain free-riding and its connection to Regulation T
• [ ] Describe how a Ponzi scheme differs from a legitimate investment
• [ ] Identify what makes scalping a conflict of interest under the Investment Advisers Act
• [ ] Explain the purpose of SEC Rule 15c3-3 and why commingling is prohibited
• [ ] Apply FINRA's 5% policy and understand its limitations as a guideline
• [ ] Define guaranteeing against loss and explain why it is always prohibited
• [ ] Know that spoofing is prohibited under the Dodd-Frank Act
• [ ] Know that wash trading violates Section 9 of the Securities Exchange Act of 1934
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Study Tip: Many prohibited practices involve the same core principle — putting personal gain ahead of client interests. When in doubt, ask yourself: "Who benefits from this action, and at whose expense?" If the answer favors the broker/adviser over the client without proper disclosure and consent, it's likely a prohibited practice.