Common Mistakes to Avoid
Watch out for these exam traps that candidates frequently miss on Prohibited Practices questions:
Not recognizing churning indicators (excessive trading)
Forgetting front-running applies to all securities
Confusing material non-public information rules
Sample Practice Questions
An investment adviser representative manages a discretionary account for a conservative retired client seeking income. Over the past year, the account has experienced a turnover ratio of 8 and commission costs equal to 22% of the account's average equity. This activity most likely indicates:
B is correct. This scenario exhibits classic churning indicators. A turnover ratio of 8 (meaning the entire portfolio is replaced 8 times per year) is excessive, particularly for a conservative income-oriented retiree. Additionally, a cost-to-equity ratio of 22% is well above the typical 20% threshold that suggests excessive trading. When combined with control (discretionary authority), excessive trading inconsistent with objectives (conservative, income focus), and the pattern suggesting intent to generate fees, this meets all three elements of churning.
A (Appropriate active management) is incorrect because while active management may involve frequent trading, it must align with client objectives. An 8x turnover for a conservative income investor is inconsistent with stated goals. C (Tactical allocation) is incorrect because tactical strategies typically don't produce 8x annual turnover, and this level of activity doesn't match conservative income objectives. D (Acceptable due to discretionary status) is incorrect because discretionary authority doesn't permit churning. Discretion must still be exercised in the client's best interest.
This question directly addresses the #1 common mistake for this subtopic: "Not recognizing churning indicators (excessive trading)." Churning is one of the most frequently tested prohibited practices on the Series 65. The exam expects you to recognize red flags: turnover ratios of 6 or higher are generally excessive, and cost-to-equity ratios exceeding 20% raise serious concerns. Understanding churning is critical because it can occur in both commission-based and fee-based accounts. This concept frequently appears alongside questions about suitability, fiduciary duty, and supervision. Remember that even profitable accounts can be churned if trading is excessive and primarily benefits the adviser through fees.
An investment adviser representative learns that a large institutional client plans to purchase 100,000 shares of a thinly traded stock tomorrow morning. The IAR purchases 5,000 shares of the same stock for his personal account that afternoon, before the client order is placed. This practice is known as:
B is correct. Front-running (also called trading ahead) occurs when an adviser or representative trades in their own account based on advance knowledge of pending client orders, especially in securities where the client order is likely to affect the market price. The IAR is effectively profiting from information that belongs to the client by positioning himself to benefit from the anticipated price movement the client's large order will create. This is a prohibited practice that violates the fiduciary duty to put client interests first.
A (Scalping) is incorrect because scalping involves buying securities for personal accounts, then recommending those same securities to clients to drive up the price, and selling at a profit without disclosing the personal stake. While related, the sequence and intent differ from front-running. C (Churning) is incorrect because churning involves excessive trading in client accounts to generate fees, not personal trading ahead of client orders. D (Selling away) is incorrect because selling away refers to securities transactions conducted outside an adviser's or agent's registered firm.
Front-running is explicitly listed as one of the common mistakes for this subtopic ("Forgetting front-running applies to all securities") and appears frequently on the Series 65. The exam tests whether you can identify front-running in various scenarios, including both equity and fixed income securities. This prohibition exists because the adviser is essentially stealing a trading opportunity from clients. It connects to code of ethics requirements, personal securities transaction reporting, and preclearance policies. Firms must have procedures preventing employees from trading ahead of client orders. The violation occurs regardless of whether the adviser ultimately profits, it's the attempt to benefit from client information that matters.
An investment adviser representative receives material nonpublic information about an upcoming merger from a corporate executive who is a client. Under securities law, the IAR:
C is correct. Trading on material nonpublic information (MNPI) constitutes insider trading, which violates Section 10(b) and Rule 10b-5 of the Securities Exchange Act. The IAR cannot trade on this information personally, in client accounts, or tip others who might trade. Material information is information that a reasonable investor would consider important in making investment decisions. Nonpublic means it has not been disseminated to the general public. The prohibition applies regardless of the relationship with the source.
A (Benefits all clients equally) is incorrect because distributing illegal gains among clients doesn't legitimize insider trading. Trading on MNPI is prohibited regardless of who benefits. B (24-hour wait) is incorrect because there is no waiting period that makes trading on MNPI legal. The information must become public through appropriate disclosure channels. D (Share with clients) is incorrect because tipping others with MNPI, even clients, creates tippee liability. The IAR would be liable for their trading, and sharing the information breaches confidentiality owed to the source client.
This addresses common mistake #3: "Confusing material non-public information rules." Insider trading is heavily tested on the Series 65 because it represents a serious securities violation with criminal penalties. The exam frequently presents scenarios where advisers receive information through legitimate channels (client relationships, industry contacts) and tests whether you understand the prohibition still applies. Material means important to investment decisions (typically price-sensitive). Nonpublic means not yet released to the public through appropriate disclosure methods. This concept connects to tipping liability, where the tipper and tippee can both face charges. Recent Rule 10b5-1 amendments require 90-day cooling-off periods for executives adopting trading plans.
Which of the following activities would constitute market manipulation in violation of securities laws?
B is correct. This describes a wash sale used for manipulation (different from the tax-related wash sale rule). When an adviser places offsetting buy and sell orders for the same security with no real change in ownership, purely to create the appearance of trading activity or influence the price, this constitutes market manipulation. This is also called "painting the tape." Such practices artificially inflate trading volume or manipulate prices, misleading other market participants about supply, demand, or price.
A (Blue-chip recommendations) is incorrect because recommending established securities is a normal advisory activity, not market manipulation. C (Quarterly rebalancing) is incorrect because periodic rebalancing to maintain target allocations is a legitimate portfolio management technique. D (Block trading for clients) is incorrect because purchasing securities for multiple clients in a single transaction (block trading) is an efficient execution method that can benefit clients through better pricing, not a manipulative practice.
Market manipulation appears regularly on the Series 65 in various forms including wash sales, matched orders (prearranged trades between colluding parties), spoofing (placing orders intended to cancel to manipulate prices), and layering (multiple spoof orders). The exam wants you to distinguish legitimate trading activity from manipulative practices designed to deceive the market. These violations can result in significant penalties from the SEC and criminal prosecution. Understanding market manipulation connects to best execution obligations, trade reporting requirements, and maintaining fair and orderly markets. The key element is intent to deceive or create false impressions about trading activity, prices, or market conditions.
A registered agent recommends and sells variable annuities to clients through his broker-dealer firm. He also privately sells shares in a real estate limited partnership to several of the same clients without notifying or obtaining approval from his broker-dealer. This practice is called:
C is correct. Selling away refers to an agent or IAR conducting securities transactions outside the scope of their registered employment without notifying and receiving approval from their firm. This is prohibited because it prevents the firm from supervising the transaction, maintaining proper records, and ensuring compliance with securities laws. Even if the investment is suitable and legitimate, the failure to conduct it through proper channels or obtain firm approval constitutes selling away.
A (Diversification) is incorrect because while the agent may be diversifying clients across different products, the term doesn't address the compliance violation of conducting unapproved outside transactions. B (Cross-selling) is incorrect because cross-selling refers to offering multiple products to the same client through proper channels, not conducting unauthorized outside transactions. D (Churning) is incorrect because churning involves excessive trading to generate commissions, not conducting securities transactions outside the registered firm.
Selling away is a commonly tested prohibited practice because it represents a breakdown in supervisory systems. Broker-dealer firms and investment advisory firms are required to supervise their representatives' activities. When representatives conduct securities business outside the firm, supervision becomes impossible, creating significant compliance and investor protection risks. The exam frequently presents scenarios where representatives engage in side businesses or private transactions with clients. Understanding selling away is essential because it applies to both agents and IARs. Even well-intentioned transactions become violations if conducted outside proper registration and supervision. Firms must have policies requiring employees to disclose and obtain approval for outside securities activities.
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Access Free BetaAn investment adviser representative tells a prospective client that her recommended strategy "guarantees a minimum 12% annual return with no possibility of loss." This statement is:
C is correct. Guaranteeing specific investment results or promising returns is a prohibited misrepresentation. No investment adviser can guarantee performance because all securities investments involve some degree of risk. Making such statements is fraudulent and violates both federal and state securities laws. This prohibition exists to protect investors from false promises and ensure they understand the risks involved in investing. Even if past performance has been excellent, future results cannot be guaranteed.
A (Historical performance justifies guarantee) is incorrect because past performance never justifies guaranteeing future results. All securities involve risk, and "past performance is not indicative of future results" is a fundamental disclosure principle. B (Accredited investors) is incorrect because the prohibition on guaranteeing returns applies to all clients regardless of sophistication or wealth. D (Written disclosure) is incorrect because disclosing a fraudulent statement doesn't make it legal. You cannot cure misrepresentation simply through disclosure.
Guarantees and promises of specific returns appear frequently on the Series 65 as clear examples of fraudulent misrepresentation. The exam tests whether you understand that no amount of historical success, client sophistication, or disclosure can legitimize guaranteeing investment performance. This principle extends to "can't lose" statements, promises of specific outcomes, and predictions stated as certainties. The only legitimate guarantees in the securities industry come from issuers (like guaranteed bonds) or insurance features (like guaranteed minimum death benefits in variable annuities), never from advisers about investment performance. This connects to advertising rules, which prohibit false or misleading statements, and to requirements for balanced presentation of risks and potential rewards.
An investment adviser representative purchases shares of a small-cap stock for her personal account, then immediately recommends the same stock to multiple clients without disclosing her personal ownership. After clients purchase shares and the price rises, the IAR sells her shares at a profit. This practice is known as:
B is correct. Scalping occurs when an adviser buys securities for their personal account, then recommends those same securities to clients to drive up the price, and subsequently sells the personal shares at a profit, all without disclosing the personal ownership and trading to clients. This violates fiduciary duty by using client purchases to profit personally. The practice is prohibited because it creates a conflict of interest where the adviser's personal trading profits come at potential expense to clients who may be buying at artificially inflated prices.
A (Dollar-cost averaging) is incorrect because that refers to investing fixed amounts at regular intervals regardless of price, not buying before recommending to others. C (Value investing) is incorrect because value investing is a legitimate strategy of buying undervalued securities, not a scheme to profit from undisclosed personal positions. D (Portfolio rebalancing) is incorrect because rebalancing involves adjusting portfolio allocations back to targets, unrelated to personal trading ahead of client recommendations.
Scalping is a prohibited practice frequently tested alongside front-running because both involve misuse of the adviser's position for personal gain. The key distinction is that scalping involves buying first, then recommending to pump up the price, while front-running involves trading ahead of known client orders. Both require disclosure of personal positions when making recommendations, as required by codes of ethics. The exam often presents subtle scenarios to test whether you recognize the violation. This connects to requirements for personal securities transaction reporting, preclearance of trades, and mandatory disclosure of conflicts. Advisory firms must have policies preventing employees from profiting at client expense through coordinated personal trading and recommendations.
All of the following scenarios would generally constitute prohibited borrowing or lending between an adviser and client EXCEPT
C is correct. Borrowing from or lending to clients is generally prohibited because it creates conflicts of interest and potential exploitation. However, there are exceptions when the client is in the business of lending money (such as a bank or credit union) and the loan is made on the same terms available to the general public. In this case, a business loan from a bank client at normal commercial terms would not constitute a prohibited practice.
A (Borrowing from elderly client), B (Lending to client for margin call), and D (Personal loan from retired teacher) are all prohibited. A represents potential exploitation of a vulnerable client. B creates a conflict where the IAR has a financial stake in the client's trading activity and ability to meet margin requirements. D involves borrowing from a retail client who is not in the lending business, creating an inappropriate financial entanglement regardless of the client's willingness to lend.
The prohibition on borrowing from or lending to clients is tested regularly because it represents a significant fiduciary breach. The exam presents various scenarios to test whether you understand both the general prohibition and the limited exceptions. The borrowing/lending prohibition exists because such arrangements create divided loyalties, potential coercion, and exploitation risks. IARs must avoid financial entanglements with clients beyond the advisory relationship. This principle extends to accepting gifts above de minimis amounts, becoming personally involved in client business ventures, and other arrangements that compromise the arm's length advisory relationship. Understanding the bank exception is important, but remember it applies only when the institution is in the business of lending and provides the same terms offered to non-clients.
An investment adviser maintains client funds in the firm's operating account instead of with a qualified custodian. This practice is called:
A is correct. Commingling occurs when an adviser mixes client funds or securities with the firm's own assets. This is prohibited because it creates significant risks of misuse, makes accounting difficult, exposes client assets to the firm's creditors, and enables potential fraud. Client assets must be maintained separately with a qualified custodian (such as a bank, broker-dealer, or trust company). The prohibition protects client assets from being used to pay firm expenses or being subject to claims against the adviser.
B (Hypothecation) is incorrect because hypothecation refers to pledging securities as collateral for a loan, typically when clients pledge securities to borrow on margin. C (Rehypothecation) is incorrect because that refers to a broker-dealer re-pledging client margin securities as collateral for its own borrowing. D (Diversification) is incorrect because diversification is spreading investments across different assets to reduce risk, unrelated to custody arrangements.
Commingling is tested regularly because it represents a serious custody rule violation. The exam wants you to understand that client assets must be segregated and held by qualified custodians, not mixed with adviser assets. This protection prevents advisers from using client funds as working capital, ensures client assets are protected in the event of the adviser's bankruptcy, and facilitates accurate accounting and reconciliation. The prohibition connects to broader custody rule requirements including surprise examinations, qualified custodian relationships, and quarterly client statements. Understanding commingling is essential because many enforcement actions involve advisers who improperly mixed client and firm assets, often leading to misappropriation. This also relates to Ponzi scheme patterns where commingling facilitates paying returns to earlier investors from later investors' funds.
An investment adviser representative tells clients that she holds the CFA designation when she has only completed Level I of the CFA program. This is an example of:
B is correct. Falsely claiming professional designations or credentials constitutes misrepresentation of qualifications, a prohibited practice under securities laws. The CFA charter is awarded only after completing all three levels of the program, passing all exams, meeting work experience requirements, and being admitted to the CFA Institute. Claiming to hold the designation when only Level I is complete is materially false and misleading. Such misrepresentations violate federal and state securities laws and the adviser's fiduciary duty to deal honestly with clients.
A (Acceptable marketing) is incorrect because while discussing actual educational achievements is permissible, falsely claiming credentials you haven't earned is fraud. The IAR could accurately state she passed CFA Level I, but cannot claim the charter. C (Corrected within 30 days) is incorrect because there is no cure period for fraudulent statements. The misrepresentation is a violation when made. D (Allowable puffery) is incorrect because puffery refers to subjective claims ("best service"), not false factual statements about verifiable credentials.
Misrepresentation of qualifications appears frequently on the Series 65, especially given the proliferation of financial designations. The exam tests whether you understand that advisers must accurately represent their credentials, education, and experience. State securities regulators have increased scrutiny of potentially misleading designations, particularly those targeting seniors. This violation extends beyond fake designations to include exaggerating experience, falsely claiming specializations, and using confusingly similar titles to legitimate credentials. Form ADV Part 2 requires accurate disclosure of all professional designations. This connects to advertising rules, which prohibit false or misleading statements, and to heightened standards when using titles suggesting special expertise. Always verify you understand what credentials actually signify before using them in communications with clients.
Key Terms to Know
Churning
Excessive trading in a client's account to generate commissions without regard to the client's investment objectives. Re...
Front-Running
The prohibited practice of trading in a security ahead of a client's order to profit from the anticipated price movement...
Insider Trading
Trading securities based on material, non-public information (MNPI). Both elements must be present: information must be ...
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