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Difficulty: MediumProhibited Market Manipulation and Fraudulent Practices

A compliance officer at a broker-dealer is auditing trading activities across several customer accounts. Which of the following scenarios describe prohibited market manipulation or fraudulent practices under SEC and FINRA rules? (Select ALL that apply.)

  1. A registered representative frequently executes trades in a customer's discretionary account primarily to generate commissions rather than to serve the client's financial goals.Answer
  2. B
    A market maker widens the published bid-ask spread on a thinly traded equity security during a period of extreme market volatility.
  3. An investor buys shares in a cash account and sells the position prior to making full cash payment for the initial purchase.Answer
  4. D
    FINRA compliance officers file criminal fraud charges in federal court against a registered representative suspected of manipulative order entry.

Answer

The prohibited practices are executing excessive trades to generate commissions (churning) and selling securities in a cash account prior to paying for the purchase (freeriding).
Executing transactions excessively to derive commission income (churning) and selling a position in a cash account prior to paying for the transaction (freeriding) are explicit regulatory violations. Conversely, adjusting bid-ask spreads during market volatility is a permitted market-maker function, and self-regulatory organizations maintain civil sanction power rather than criminal prosecutorial authority.

Step-by-Step Solution

1
Evaluate the practice of trading excessively for commission generation.
Identified as churning, which violates FINRA Rule 2111 (Suitability) and anti-fraud rules.
Registered representatives owe a duty of loyalty and suitability to clients; excessive trading solely for firm/agent compensation is fraudulent.
2
Evaluate selling securities in a cash account before settling the purchase.
Identified as freeriding, which violates Regulation T credit rules.
Investors must pay for securities before selling them when operating in a cash account.
3
Evaluate market maker spread widening and SRO criminal jurisdiction.
Market maker spread adjustments are legitimate dealer activities, and SROs maintain civil authority rather than criminal jurisdiction.
Distinguishes legitimate principal activities from manipulation and clarifies SRO regulatory boundaries.

Key Concept

Prohibited Practices (Churning & Freeriding) vs. SRO Authority Scope
Estimated Time:1m 30s
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Prohibited Market Manipulation and Fraudulent Practices