SkarpChapter 23 of 27
Prohibited Activities II: Communications, Conflicts, and Ethical Sales Practices
Round out your understanding of misconduct by examining misleading communications, conflicts of interest, and sales practice abuses that trigger regulatory action.
Big Picture: Why Communications and Sales Practices Matter
From Fraud to Everyday Misconduct
This module focuses on everyday danger zones: what you say to customers, how you handle conflicts, and how you trade in their accounts.
Regulatory Anchors
Key anchors: SEC antifraud rules (like Rule 10b‑5), FINRA communications and suitability rules, and MSRB rules for municipal securities firms.
What You Will Learn
You will learn to spot misleading statements, recognize conflicts of interest, define churning and excessive trading, and understand supervisory and reporting duties.
Exam Mindset
On SIE questions, scenarios often look almost okay but include trigger words like guaranteed, always, or no risk that push them over the line.
Standards for Communications with the Public
What Counts as a Communication?
Communications include ads, websites, social media, emails, research, form letters, and scripted presentations to the public.
Core Standard
They must be fair and balanced, provide a sound basis for evaluating facts, avoid material omissions, and not be exaggerated or promissory.
Key Categories
Retail communications go to more than 25 retail investors; correspondence goes to 25 or fewer; institutional communications go only to institutional investors.
Why Category Matters
Retail communications face tighter controls, often needing principal pre‑approval and sometimes filing with FINRA.
Exam Shortcut
If a message is widely distributed to non‑professionals, treat it as retail communication with heightened scrutiny.
Misleading Statements, Omissions, and Performance Claims
When True Facts Mislead
A statement can be misleading even if each fact is true, if the overall impression is exaggerated, one‑sided, or missing key context.
Promissory Language
Phrases like sure thing, cannot lose, or will earn at least X% suggest guarantees and are prohibited.
Performance Pitfalls
Cherry‑picking winners, using hypothetical or back‑tested results without clear labels, or implying past success will continue is misleading.
Material Omissions
Leaving out key facts, such as a bond’s below‑investment‑grade status or a product’s short‑term design, can make a statement deceptive.
Visual Example
A fair chart shows multiple periods, a benchmark, and a past performance disclaimer; a misleading one highlights only a single great year.
Spot the Misleading Communication
Scenario A: Social Media Hype
A post touts 22% last year and says proven strategy and lock in your future. This cherry‑picks and implies guarantees: it is misleading.
Scenario B: Honest Bond Brochure
A brochure notes higher yield but also greater credit risk, volatility, and below‑investment‑grade status. Benefits and risks are balanced: acceptable.
Scenario C: Seminar Overconfidence
A speaker says the market has always come back and you will recover. Words like always and will recover are promissory: misleading.
Exam Trigger Words
Always, never, guaranteed, safe, no risk, and proven are red flags that a communication likely violates fair and balanced standards.
Conflicts of Interest: Where They Come From and What to Do
What Is a Conflict of Interest?
A conflict exists when the firm’s or rep’s interests may not align with the customer’s best interest, creating bias in recommendations.
Compensation Conflicts
Higher commissions, sales contests, or bonuses tied to certain products can push reps toward what pays more, not what fits best.
Product and Relationship Conflicts
Proprietary products, revenue sharing, or personal stakes in a security can all bias recommendations.
Modern Expectations
Firms must identify, disclose, and mitigate conflicts; some high‑risk practices, like product‑specific sales contests, may be banned for retail.
Exam Lens
If a recommendation boosts the rep’s pay with no clear benefit to the client, and there’s no disclosure, expect that it violates standards.
Conflicts in Recommendations: Practical Scenarios
Scenario 1: Share Class Conflict
Pushing Class C shares for a large, long‑term investment mainly boosts rep pay; cheaper Class A shares exist. That is a conflict and likely unsuitable.
Scenario 2: Proprietary Notes
Firm pushes its own structured notes with higher fees while cheaper alternatives exist. This firm‑level conflict must be disclosed and controlled.
Scenario 3: Personal Stock Stake
A rep owning a big stake in a micro‑cap and recommending it without disclosure has a serious conflict and possible manipulation risk.
Client vs. Rep Benefit
Always ask: who benefits most? If it is the rep or firm and the conflict is not disclosed or mitigated, regulators will likely object.
Churning, Excessive Trading, and Unsuitable Recommendations
What Is Churning?
Churning is excessive trading in a customer’s account by a rep or firm to generate commissions, not to serve the customer’s needs.
Elements of Churning
It requires control over the account, trading that is excessive for the client’s profile, and a commission‑driven motive.
Excessive Trading Concepts
Regulators look at turnover rate and cost‑to‑equity ratio to see if trading volume and costs are unreasonable.
Unsuitable Recommendations
Even a single recommendation can be unsuitable, such as concentrating a retiree in one stock or using leveraged ETFs long term.
Customer Profile Lens
Suitability and churning are judged against the client’s age, goals, risk tolerance, time horizon, liquidity, tax status, and finances.
Churning and Unsuitability: Red Flag Patterns
Pattern 1: Day‑Traded Retiree
A low‑risk, income‑focused retiree’s account is traded multiple times per week in small‑cap stocks with high commissions: classic churning red flag.
Pattern 2: High Turnover
A buy‑and‑hold client’s $100k account has $600k in purchases in a year. A 6x turnover is excessive for that stated strategy.
Pattern 3: Wrong Product
A leveraged inverse ETF recommended as a long‑term hedge for a conservative, inexperienced 65‑year‑old is likely unsuitable.
Exam Heuristics
Frequent trades plus high commissions plus conservative profile suggest churning; complex, volatile products for cautious clients suggest unsuitability.
Supervision and Reporting: Who Must Do What
Firm‑Level Responsibility
Regulators hold broker‑dealers and supervisors responsible for preventing and detecting misconduct, not just individual reps.
Written Supervisory Procedures
Firms must maintain WSPs explaining how they supervise communications, suitability, account opening, trading, and complaints.
Principal Review
Principals approve new accounts and often pre‑approve retail communications and specialized products like options or municipals.
Surveillance and Complaints
Supervisors monitor accounts for high turnover and other red flags and must log and investigate written customer complaints.
Reporting Duties
Firms must report certain disciplinary and legal events to regulators, and reps must inform their firms about events affecting their registration.
Thought Exercise: Fix the Communication and the Recommendation
Part 1: Flawed Email
The email promises steady income and growth without volatility and says you can count on and lock in your future. Identify and remove these guarantees.
Improving the Email
Add context like time periods, benchmarks, and a past performance disclaimer. Mention that dividends and prices can fluctuate and that risks remain.
Part 2: Off‑Target Recommendation
A 30‑year‑old growth investor is put 70% in long‑term bonds and 30% cash to avoid stocks. This clashes with long‑term growth goals.
Designing a Better Fit
Mentally shift toward higher equity exposure and explain both growth potential and volatility risks in a balanced, non‑promissory way.
Key Terms Review: Communications and Sales Practices
Flip these cards to reinforce core concepts before you quiz yourself.
- Retail communication
- A written or electronic communication distributed or made available to more than 25 retail investors within any 30‑calendar‑day period; subject to stricter review and, in some cases, filing requirements.
- Correspondence
- Any written or electronic message sent to 25 or fewer retail investors within any 30‑calendar‑day period; generally supervised post‑use rather than pre‑approved.
- Fair and balanced communication
- A communication that presents benefits and risks, avoids exaggeration and guarantees, does not omit material facts, and provides a sound basis for evaluating an investment.
- Material omission
- Failure to state a fact that a reasonable investor would consider important, where the omission makes what is said misleading.
- Conflict of interest
- A situation in which a firm’s or representative’s interests may diverge from the customer’s interests, potentially biasing recommendations.
- Churning
- Excessive trading in a customer’s account by a broker‑dealer or rep for the purpose of generating commissions, rather than to serve the customer’s needs.
- Unsuitable recommendation
- A recommendation that does not fit the customer’s investment profile, considering factors such as age, objectives, risk tolerance, time horizon, liquidity needs, tax status, and financial situation.
- Turnover rate (concept)
- A measure of how frequently the assets in an account are traded over a period; very high turnover may signal excessive trading or churning.
- Cost‑to‑equity ratio (concept)
- An indicator of how much an account must earn, as a percentage of its value, just to cover commissions and expenses; high ratios suggest trading may be too costly.
- Written Supervisory Procedures (WSPs)
- A firm’s documented policies and procedures describing how it supervises its business, including communications, suitability, trading, and handling of complaints.
Checkpoint Quiz 1: Communications and Conflicts
Test your understanding of communications standards and conflicts of interest.
A registered representative runs a mass email campaign to 500 retail investors promoting a new proprietary mutual fund. The email highlights that the fund has outperformed its benchmark for three years, but does not mention that the rep and firm earn higher fees on this fund than on similar alternatives. Which statement is MOST accurate?
- The email is acceptable because the performance information is factually correct and past performance is allowed in retail communications.
- The email is misleading because it fails to disclose a material conflict of interest related to higher compensation on the proprietary fund.
- The email is acceptable as long as the rep verbally discloses the higher compensation if an investor calls for more information.
- The email is prohibited because retail communications may not include any performance data.
Show Answer
Answer: B) The email is misleading because it fails to disclose a material conflict of interest related to higher compensation on the proprietary fund.
This is a retail communication because it goes to more than 25 retail investors. While performance data can be used if presented fairly, the key issue is the undisclosed conflict: the rep and firm earn higher fees on the proprietary fund. That conflict is material and must be disclosed in a way the customer can understand. Option 1 ignores the conflict, option 3 relies only on later verbal disclosure (too late for the initial solicitation), and option 4 is wrong because performance data is allowed when properly presented.
Checkpoint Quiz 2: Churning and Supervision
Now test yourself on churning, unsuitability, and supervisory duties.
A 68‑year‑old client with limited investment experience has an account that averages $80,000 in value. Over the past year, the account generated $9,000 in commissions from frequent trading in speculative small‑cap stocks recommended by the rep. The client’s objective on file is “income and capital preservation.” Which statement best describes the situation?
- This is likely churning or excessive trading, and the firm’s supervision and exception reports should have flagged the activity.
- This is acceptable because speculative small‑cap stocks can provide higher income than conservative bonds.
- This is acceptable as long as the client signed a non‑discretionary agreement and placed each order personally.
- This is not churning because the account value is below $100,000 and the commissions are under $10,000.
Show Answer
Answer: A) This is likely churning or excessive trading, and the firm’s supervision and exception reports should have flagged the activity.
The trading pattern (frequent, speculative trades, high commissions relative to account size) conflicts with the stated objective of income and capital preservation, especially for a 68‑year‑old with limited experience. That is a strong red flag for churning or excessive trading. Even in non‑discretionary accounts, reps can be responsible for excessive trading driven by their recommendations. Supervisors should detect this via surveillance tools. The dollar thresholds in option 4 are made up and not part of the rules.
Key Terms
- churning
- Excessive trading in a customer’s account by a broker-dealer or rep for the purpose of generating commissions, rather than to serve the customer’s needs.
- common stock
- An equity security representing ownership in a corporation, typically providing voting rights and a residual claim on corporate earnings and assets after creditors and preferred shareholders.
- broker-dealer
- A firm in the business of buying and selling securities either for the accounts of others (broker) or for its own account (dealer), or both, and subject to registration and regulation under federal securities laws and SRO rules.
- margin account
- A customer account in which a broker-dealer lends the customer a portion of the purchase price of securities, with the securities and other assets in the account serving as collateral, subject to initial and maintenance margin requirements.
- primary market
- The market in which new securities are issued and sold for the first time, such as through public offerings and private placements, to raise capital for issuers.
- insider trading
- The illegal practice of trading securities while in possession of material nonpublic information in breach of a duty of trust or confidence.
- preferred stock
- An equity security that represents ownership in a corporation and typically pays a fixed dividend, with priority over common stock in dividend payments and liquidation, but usually with limited or no voting rights.
- secondary market
- The market in which previously issued securities are bought and sold among investors, including exchange and over-the-counter trading.
- municipal securities
- Debt securities issued by states, municipalities, or their agencies and authorities, including general obligation and revenue bonds, often offering interest that is exempt from federal income tax.
- retail communication
- A written or electronic communication distributed or made available to more than 25 retail investors within any 30-calendar-day period; subject to stricter review and, in some cases, filing requirements.
- unsuitable recommendation
- A recommendation that does not fit the customer’s investment profile, considering factors such as age, objectives, risk tolerance, time horizon, liquidity needs, tax status, and financial situation.
- self-regulatory organization
- A non-governmental entity, such as FINRA or a national securities exchange, that is registered with and overseen by the SEC and is responsible for regulating the practices of its members through the adoption and enforcement of rules.
- Written Supervisory Procedures (WSPs)
- A firm’s documented policies and procedures describing how it supervises its business, including communications, suitability, trading, and handling of complaints.
- Securities Industry Essentials (SIE) exam
- The Securities Industry Essentials (SIE) exam assesses a candidate’s basic knowledge of the securities industry, including industry terminology, securities products, the structure and function of the markets, regulatory agencies and their functions, and regulated and prohibited practices.