Ethical Practices

A is correct. All material conflicts of interest, including compensation arrangements with broker-dealers, must be disclosed to clients in writing before or at the time the advisory contract is signed. This allows clients to make informed decisions about the relationship. The disclosure must be clear and prominent, typically in Form ADV Part 2A.

B (Annual consent) is incorrect because while disclosure is required, obtaining separate written consent annually is not mandated for this type of arrangement. C (Below average commissions) is incorrect because the obligation is disclosure, not a specific commission level, though best execution still applies. D (Avoid entirely) is incorrect because conflicts can be managed through proper disclosure. Not all conflicts must be eliminated, but all material conflicts must be disclosed.

B is correct. Soft dollar arrangements are permissible when client commissions are used to obtain research and brokerage services that benefit clients. Third-party research reports that help with investment decision-making qualify as legitimate research under Section 28(e). The research must provide lawful and appropriate assistance in the investment decision-making process.

A (Computer hardware) is incorrect because hardware is not considered research or brokerage services under Section 28(e). Only the research component of products (not hardware, furniture, or facilities) qualifies. C (Office rent) is incorrect because rent is a general business expense that benefits the adviser, not specifically research that benefits clients. D (Marketing salaries) is incorrect because marketing staff compensation is an overhead expense, not a research or brokerage service.

C is correct. Best execution is a holistic standard requiring advisers to seek the most favorable terms reasonably available, considering multiple factors including price, speed, likelihood of execution and settlement, size of order, nature of the market, and overall cost. It's not simply about finding the lowest commission. The focus is on the overall quality and value of the execution.

A (Lowest commission) is incorrect because best execution considers total cost and quality, not just commission rates. Sometimes paying a slightly higher commission results in better execution and lower overall costs. B (Fastest speed) is incorrect because speed is only one factor. Other considerations like price improvement and market impact matter. D (Highest volume) is incorrect because trading volume alone doesn't ensure best execution. The venue must provide the best overall terms for that particular transaction.

D is correct. Front-running (also called trading ahead) occurs when an adviser or representative trades for their own account based on knowledge of pending client orders, particularly when the client order is likely to move the market price. This is a prohibited practice because it allows the adviser to profit from information that belongs to the client, effectively putting personal interests ahead of client interests.

A (Dollar-cost averaging) is incorrect because that refers to a systematic investment strategy of making regular purchases regardless of price. B (Portfolio rebalancing) is incorrect because that involves adjusting portfolio allocations back to target weights, unrelated to trading ahead of clients. C (Tactical asset allocation) is incorrect because that refers to short-term strategy adjustments based on market conditions, not trading ahead of client orders.

C is correct. Investment advisers have a fiduciary duty to disclose all material conflicts of interest that could affect the advisory relationship or investment advice. Materiality is determined by whether a reasonable client would want to know the information when deciding whether to enter into or continue the advisory relationship. This is a broad, principles-based obligation that goes beyond specific regulatory requirements.

A (Significant only) is incorrect because the standard is materiality to clients, not the adviser's own judgment of significance. B (Listed in regulations) is incorrect because the fiduciary duty to disclose conflicts extends beyond specifically enumerated items. It's a principles-based obligation. D ($10,000 threshold) is incorrect because there is no dollar threshold for disclosure. Even small conflicts must be disclosed if they could influence the advice given or the client's decision-making.

A is correct. Churning is the prohibited practice of excessive trading in a client's account for the primary purpose of generating commissions or fees rather than benefiting the client. To prove churning, three elements must be present: control over the account, excessive trading inconsistent with the client's objectives, and intent to defraud or willful disregard of the client's interests.

B (Market timing) is incorrect because market timing refers to attempting to predict market movements and adjust positions accordingly, which is a strategy (though often unsuccessful), not an ethical violation per se. C (Arbitrage) is incorrect because arbitrage involves simultaneously buying and selling securities to profit from price discrepancies, a legitimate trading strategy. D (Active management) is incorrect because active management involves frequent trading based on research and strategy, which is legitimate when serving client interests rather than generating fees.

B is correct. Custody is triggered when an adviser has authority to withdraw client funds or securities, physically holds client assets, or acts as trustee or has similar authority over client accounts. Having authorization to deduct fees directly from client accounts also creates custody. These arrangements require additional safeguards including surprise audits, qualified custodian relationships, and specific client notifications.

A (Advice only) is incorrect because providing advice without handling funds does not create custody. Most advisers provide advice without custody. C (Performance fees) is incorrect because performance-based compensation relates to fee structure, not custody. It has separate requirements but doesn't automatically trigger custody rules. D (Quarterly arrears) is incorrect because billing in arrears typically avoids the custody issue, though if the adviser can deduct fees directly from accounts, custody considerations apply.

B is correct. Under the SEC's Marketing Rule (adopted in 2020, effective 2021), testimonials are permitted in investment adviser advertising if certain conditions are met. The adviser must disclose that the testimonial was given by a current client, disclose any compensation paid for the testimonial, and have written policies reasonably designed to ensure testimonials are not misleading and address conflicts of interest.

A (Prohibited) is incorrect because the current Marketing Rule reversed the prior prohibition on testimonials. They are now allowed with appropriate safeguards. C (Institutional only) is incorrect because testimonials may come from retail or institutional clients, though additional disclosures apply when the person is a compensated promoter. D (FINRA approval) is incorrect because investment advisers are regulated by the SEC or states, not FINRA. FINRA regulates broker-dealers, not investment advisers.

B is correct. When an IAR has a personal financial interest in securities being recommended, this creates a material conflict of interest that must be disclosed to clients before or at the time of making the recommendation. The disclosure allows clients to evaluate whether the recommendation might be influenced by the IAR's personal interests. After disclosure, the recommendation can proceed if it's suitable and in the client's best interest.

A (Avoid entirely) is incorrect because disclosure and suitability analysis can allow the recommendation to proceed. The conflict doesn't automatically prohibit the recommendation. C (Outperformance requirement) is incorrect because while the security must be suitable, there's no specific performance threshold. The issue is disclosure, not performance. D (After recommendation) is incorrect because disclosure must occur before or at the time of recommendation, not afterward. Disclosing after-the-fact doesn't give clients the information they need to evaluate the advice.

C is correct. Account losses are not an element of churning. Churning can occur even in profitable accounts if trading is excessive and primarily intended to generate commissions. The three required elements are: (1) control over the account by the adviser/representative, (2) excessive trading inconsistent with the client's objectives (often measured by turnover ratio), and (3) intent to defraud or willful disregard of the client's interests.

A (Control), B (Excessive trading), and D (Intent) are all required elements. Control means the adviser makes trading decisions or has discretionary authority. Excessive trading is evaluated using turnover ratios, in-and-out trading patterns, and consistency with client objectives. Intent or scienter can be inferred from the pattern of conduct, such as repeatedly ignoring client objectives to generate commissions.