CSLB General Building (B) — All Questions

An agent handles a conservative retiree's account and generates 60 round-trip trades in six months, producing commissions that consume a large share of the account's value. This practice is best described as:

• a.Churning, which is excessive trading in light of the customer's resources, objectives, and account character✓
• b.Front-running, because the agent traded ahead of the customer
• c.A permissible active management style since the customer never objected
• d.Selling away, because the trades were placed outside the firm

Churning is trading that is excessive in size or frequency given the customer's financial resources, investment objectives, and the nature of the account, and it is judged by the pattern rather than by any single trade. The customer's silence is not consent and does not cure the violation. Front-running involves trading ahead of a known block order, and selling away involves transactions outside the employing firm, neither of which is described here.NASAA Model Rule

A customer tells his agent, 'Buy 500 shares of a good technology company sometime this week.' The agent selects the issuer and buys the shares two days later. The agent has:

• a.Acted properly, because the customer authorized a technology purchase
• b.Acted properly under time and price discretion
• c.Committed no violation because the customer approved afterward
• d.Exercised discretion without prior written authorization, because choosing the security and the day requires a signed discretionary agreement✓

Discretion over the security, the number of shares, or whether to buy or sell requires prior written authorization from the customer and acceptance by the firm. Time and price discretion is narrower: the customer must specify the security, the action, and the amount, and that limited authority is generally good only for the day it is given. After-the-fact approval does not retroactively authorize a discretionary trade.NASAA Model Rule

An agent learns that his firm is about to execute a very large buy order for a thinly traded stock and immediately buys shares for his own account before entering the customer's order. This is:

• a.Permissible, because the agent's order was small
• b.Permissible if the agent later discloses it
• c.Front-running, a prohibited practice that misuses knowledge of a pending customer order✓
• d.Merely a suitability issue

Front-running is the use of advance knowledge of a pending block order to trade ahead of it for the agent's own benefit, and it is prohibited regardless of the size of the personal order. Later disclosure does not cure a violation that was complete when the order was entered. The problem is misuse of customer order information and market integrity, not the suitability of the security.NASAA Model Rule

An investment adviser deposits a client's advance advisory fee into the firm's general operating account and uses it to pay office rent. This conduct is:

• a.Acceptable because the fee had already been earned on paper
• b.Commingling of client funds with firm assets, a prohibited business practice✓
• c.Acceptable if the client is later refunded
• d.Permitted for any adviser with a surety bond

Client funds and securities must be kept separate from firm assets, and mixing them exposes clients to the firm's creditors and obscures the audit trail. Prepaid fees that have not yet been earned belong to the client and must be handled under the applicable custody and prepayment rules. Neither a later refund nor a surety bond makes commingling permissible.NASAA Model Rule

A hesitant client says she will invest only if she cannot lose money. Her agent replies, 'Don't worry, if the stock drops below your purchase price I'll personally cover the difference.' The agent has:

• a.Violated the prohibition on guaranteeing a customer against loss✓
• b.Acted properly because the promise was voluntary and personal
• c.Acted properly if the firm approves the arrangement in writing
• d.Merely made a puffing statement with no regulatory consequence

Guaranteeing a customer against loss, whether by the firm or personally by the agent, is an unethical practice under the NASAA model rules because it misrepresents the risk of the investment. No firm approval can authorize the guarantee. A statement that removes the client's perception of risk is a misrepresentation of a material fact rather than harmless puffery.NASAA Model Rule

An agent proposes to share in the profits and losses of a customer's account. Under NASAA rules, this arrangement:

• a.Is prohibited under all circumstances for every registered person
• b.Is permitted for an agent only with the written authorization of both the customer and the employing broker-dealer, and generally only in proportion to the agent's own capital contribution✓
• c.Is permitted whenever the customer requests it orally
• d.Requires only the branch manager's verbal approval

Sharing in a customer account is permitted for an agent only where both the customer and the employing broker-dealer give written authorization and the sharing is proportionate to the agent's financial contribution to the account. Oral requests and verbal approvals do not satisfy the rule. Investment adviser representatives face a stricter standard, but the flat 'never for anyone' answer overstates the rule for agents.NASAA Model Rule

An agent is short of cash and asks a wealthy retail client for a $20,000 personal loan, promising repayment with interest. Under NASAA rules this is:

• a.Permitted because the client is wealthy and the loan is documented
• b.Permitted because the loan is unrelated to securities
• c.Prohibited, because borrowing money or securities from a customer is an unethical practice unless the customer is a financial institution in the business of lending or a permitted family relationship and firm policy allows it✓
• d.Permitted if the agent discloses the loan at year end

Borrowing money or securities from a customer, or lending to one, is an unethical business practice because it creates a conflict of interest and a risk of exploitation. Narrow exceptions exist where the customer is in the business of lending, such as a bank, or is an immediate family member, and only where the firm's written procedures permit the arrangement. The client's wealth, the loan's unrelated purpose, and later disclosure do not cure the violation.NASAA Model Rule

An agent arranges private investments in a real estate partnership for several clients, collects a finder's fee directly from the sponsor, and never mentions the activity to his broker-dealer. This is:

• a.Selling away, a prohibited private securities transaction effected without the knowledge and consent of the employing broker-dealer✓
• b.Permitted because real estate is not a security
• c.Permitted because the fee came from the sponsor rather than the clients
• d.A suitability violation only

Effecting securities transactions away from the employing firm without providing prior written notice and obtaining the firm's approval is the prohibited practice known as selling away, and it deprives the firm of its supervisory responsibility. A limited partnership interest is a security, so the real estate label does not help. The source of the compensation is irrelevant, and the violation exists even if every investment turned out to be suitable.NASAA Model Rule

An agent tells a prospect, 'My state registration means the Administrator has reviewed my qualifications and approved the investments I recommend.' This statement is:

• a.Accurate, because registration requires an examination
• b.Accurate for exempt securities only
• c.Accurate if the firm is also registered
• d.Prohibited, because it is unlawful to represent that registration means the Administrator has approved the registrant's qualifications or the merits of any security✓

The act expressly makes it unlawful to represent that registration, or the effectiveness of a securities registration, means the Administrator has passed on the merits of a security or the qualifications of the person. Registration is a disclosure and compliance filing, not an endorsement. That is true whether or not an examination was required and regardless of the firm's status or the type of security.Uniform Securities Act

Two traders repeatedly buy and sell the same thinly traded security between themselves at rising prices to attract outside buyers. This conduct is:

• a.Legitimate market making
• b.Permitted because both parties consented
• c.Market manipulation through matched orders creating misleading activity, which is prohibited✓
• d.Permitted if the trades are reported to the tape

Wash sales and matched orders create the false appearance of trading volume and price movement and are prohibited manipulative practices. Consent between the participants is irrelevant because the deception targets the investing public. Reporting the trades does not legitimize them, and genuine market making involves bona fide two-sided quotations rather than prearranged trades with no change in beneficial ownership.Uniform Securities Act

Before recommending a security to a new customer, an agent must:

• a.Guarantee that the recommendation will meet the customer's return objective
• b.Make reasonable inquiry into the customer's financial situation, investment objectives, tax status, and needs, and have a reasonable basis for believing the recommendation is suitable✓
• c.Obtain the Administrator's prior approval of the recommendation
• d.Confirm only that the customer has enough cash to pay for the trade

Recommending securities without reasonable grounds to believe they suit the customer, based on information the agent has actually gathered about the customer's situation and objectives, is an unethical practice. A customer who refuses to provide information limits what the agent may reasonably recommend. Administrators do not pre-approve recommendations, and settlement ability alone says nothing about suitability.NASAA Model Rule

Which statement best distinguishes the duties of an investment adviser from those of a broker-dealer effecting transactions for a customer?

• a.An investment adviser is a fiduciary owing duties of loyalty and care, including full disclosure of material conflicts, while a broker-dealer's recommendations must at a minimum be suitable for the customer✓
• b.A broker-dealer is always a fiduciary and an adviser is not
• c.Neither owes any duty beyond executing orders accurately
• d.An adviser owes duties only to institutional clients

The advisory relationship rests on a fiduciary standard: the adviser must place the client's interests first, disclose material conflicts such as compensation arrangements and proprietary products, and seek best execution. A broker-dealer making recommendations must have reasonable grounds to believe they are suitable and must disclose material facts about the transaction. Both roles carry duties well beyond accurate order entry, and fiduciary status does not depend on the client being institutional.NASAA Model Rule

A broker-dealer sells a customer bonds out of the firm's own inventory. Which disclosure obligation applies?

• a.None, because the customer received a confirmation of the trade price
• b.The firm must disclose only the current market price of the bonds
• c.The firm must obtain the Administrator's approval before acting as principal
• d.The firm must disclose that it acted as a principal, and its compensation is a markup rather than a commission✓

A customer is entitled to know the capacity in which the firm acted, because a principal trade produces a markup embedded in the price while an agency trade produces a disclosed commission. Failing to state capacity or disguising a markup as something else is an unethical practice. No Administrator approval is required to act as principal in an ordinary customer trade.NASAA Model Rule

A broker-dealer decides to raise its account maintenance and transfer fees substantially. Under NASAA rules, the firm:

• a.Must give customers notice of the change and may not charge unreasonable or undisclosed fees✓
• b.May implement the change without notice because fees are a business decision
• c.Must obtain each customer's written consent to every fee
• d.May charge any amount as long as it appears on the confirmation

Charging unreasonable and inequitable fees for services, or failing to disclose a change in the firm's fee schedule, is an unethical business practice. Customers must receive notice so they can decide whether to keep the account. Written consent for every fee is not required, and simply printing an excessive charge on a confirmation does not make it reasonable.NASAA Model Rule

A broker-dealer publishes a market letter recommending a stock in which it holds a substantial proprietary position and for which it makes a market. The letter must:

• a.Say nothing about the firm's position, to avoid influencing readers
• b.Disclose the firm's position and its role as a market maker, and present projections as opinions rather than as fact✓
• c.Guarantee the accuracy of the price target
• d.Be filed with the SEC before publication

Publishing research or a market letter without disclosing that the firm makes a market in or holds a position in the security conceals a material conflict of interest. Forecasts must be identified as opinion, since presenting a projection as an assured fact is a misrepresentation. No firm can guarantee a price target, and routine market letters are not filed with the SEC for approval.NASAA Model Rule

Regarding advertising and sales literature used to offer securities in a state, the Administrator:

• a.Has no authority over advertising of any kind
• b.May prohibit only advertising that mentions past performance
• c.May require prior approval of advertising for federal covered securities
• d.May by rule require the filing of advertising and sales literature, except for federal covered securities and exempt securities and transactions✓

The act allows the Administrator to require that prospectuses, pamphlets, circulars, letters, and other sales literature used in the state be filed, and material that is false or misleading may be halted. That filing authority does not extend to federal covered securities, where federal law preempts, or to exempt securities and exempt transactions. Antifraud authority over misleading advertising remains in all cases.Uniform Securities Act

A customer receives a margin call and cannot meet it. The agent offers to lend the customer the money personally so the position need not be sold. This is:

• a.Permitted because it protects the customer from a forced sale
• b.Permitted with oral disclosure to the branch manager
• c.Prohibited, because lending money to a customer creates a conflict of interest and is an unethical practice outside narrow exceptions✓
• d.Permitted if the customer signs a promissory note

Lending money or securities to a customer, like borrowing from one, is prohibited except in narrow circumstances such as a lending relationship through the firm or an immediate family member, and only where the firm's written procedures permit it. Good intentions do not create an exception. Documentation such as a promissory note or an oral notification to a manager does not make the loan permissible.NASAA Model Rule

A customer instructs her agent to sell her entire position in a stock. The agent, believing the stock will rebound, sells only half. The agent has:

• a.Acted prudently in the customer's best interest
• b.Committed a prohibited practice by failing to follow the customer's instructions and effectively exercising unauthorized discretion✓
• c.Acted properly because a partial sale is less risky
• d.Acted properly if the stock later recovers

Failing to execute a customer's order as instructed is an unethical practice, and substituting the agent's own judgment for the customer's amounts to unauthorized discretion. The agent may voice a contrary opinion but must ultimately follow the instruction or decline the account. A favorable market outcome does not retroactively excuse the deviation.NASAA Model Rule

An agent realizes a new account form is missing a signature, so he signs the customer's name himself, reasoning that the customer had already agreed by telephone. This conduct is:

• a.Acceptable because the customer consented orally
• b.Acceptable if the customer later ratifies the signature
• c.Prohibited, because falsifying or forging records and signatures is an unethical practice regardless of intent✓
• d.Acceptable if no customer is harmed

Signing a customer's name, backdating documents, or otherwise falsifying firm records is prohibited because it destroys the integrity of the books and records regulators rely on. Neither an oral agreement nor a later ratification cures the falsified document. The absence of financial harm is not a defense; the recordkeeping violation is complete when the record is made.NASAA Model Rule

An agent urges a client to buy a mutual fund now because 'the fund pays a big distribution next week and you'll pick up extra income.' This sales tactic is:

• a.Sound advice, because the client receives cash sooner
• b.Acceptable if the fund is otherwise suitable
• c.Acceptable because the distribution is publicly announced
• d.Selling dividends, a prohibited practice, because the share price drops by the distribution amount and the investor gains nothing while incurring a tax liability✓

Selling dividends is prohibited because the net asset value falls by the amount of the distribution on the ex-date, so the investor simply converts principal into a taxable payment. Framing an imminent distribution as a reason to buy misrepresents the economics of the transaction. Public disclosure of the distribution and general suitability of the fund do not make the pitch acceptable.NASAA Model Rule

A client intends to invest $48,000 in a mutual fund whose sales charge drops at a $50,000 breakpoint. The agent processes the order at $48,000 without mentioning the breakpoint. This is:

• a.A breakpoint sale, a prohibited practice, because the agent failed to disclose that a slightly larger investment would reduce the sales charge✓
• b.Acceptable because the client chose the amount
• c.Acceptable because breakpoints apply only to accumulation over several years
• d.Acceptable if the agent's commission was standard

Failing to disclose an available breakpoint, or deliberately keeping an order just below one to preserve a higher sales charge, is an unethical practice. The agent must alert the client to quantity discounts, letters of intent, and rights of accumulation. The fact that the client named the dollar figure does not relieve the agent of the disclosure duty, and breakpoints apply to single purchases as well as to accumulated holdings.NASAA Model Rule

An agent regularly advises clients to redeem shares of one mutual fund family and buy a similar fund in another family, generating a new front-end sales charge each time. Absent a documented benefit to the client, this is:

• a.Proper diversification across fund sponsors
• b.Acceptable because each fund is individually suitable
• c.Acceptable because the client signs each order ticket
• d.Improper mutual fund switching, because inducing exchanges between fund families without reasonable grounds imposes needless sales charges✓

Recommending that a client move between fund families without reasonable grounds is an unethical practice, since the new sales charge is a real cost with no corresponding benefit when comparable objectives are available within the existing family. Suitability of each individual fund does not justify the repeated charges. Signed order tickets document the trade but do not supply the required reasonable basis.NASAA Model Rule

A customer emails an agent complaining that a trade was never authorized. The agent should:

• a.Resolve it privately with the customer and say nothing to the firm
• b.Delete the email since the matter is disputed
• c.Promptly forward the written complaint to the firm so it can be reviewed, acted on, and preserved in the firm's records✓
• d.Wait to see whether the customer follows up before reporting it

Written customer complaints must be routed promptly to the firm and retained, because the firm has supervisory and recordkeeping obligations and regulators may inspect complaint files. Handling a complaint privately or settling it without the firm's knowledge is itself an unethical practice. Destroying or delaying the record compounds the original problem.NASAA Model Rule

A state-registered investment adviser takes custody of client securities. Under the NASAA custody rule, the adviser generally must:

• a.Notify the Administrator that it has custody, segregate client assets with a qualified custodian, send account statements to clients, and arrange for an independent verification of the assets✓
• b.Hold the securities in the firm's own name to simplify administration
• c.Send statements only upon client request
• d.Avoid any recordkeeping beyond a summary ledger

The custody rule requires notice to the Administrator, use of a qualified custodian, segregation of client assets from firm assets, periodic account statements sent directly to clients, and an independent surprise verification of the funds and securities. Registering client assets in the firm's name defeats the segregation requirement. Custody also raises the adviser's recordkeeping and financial requirements rather than lowering them.NASAA Model Rule

An investment adviser wants to charge a fee based on a share of the capital gains in a client's account. Under NASAA rules, such a performance-based fee is:

• a.Prohibited for every client without exception
• b.Permitted only for clients who meet defined net worth or assets-under-management standards, with the arrangement and its risks disclosed in writing✓
• c.Permitted for any client who signs a waiver
• d.Permitted only if the adviser also guarantees against loss

Performance-based compensation is limited to clients who satisfy financial thresholds designed to identify investors able to bear the incentive risk, and the arrangement must be disclosed along with the conflicts it creates. A client waiver cannot substitute for the eligibility standards, and provisions purporting to waive compliance with the act are void. Guaranteeing against loss is itself prohibited, so it could never be a condition of a permitted fee.NASAA Model Rule

An investment adviser directs client brokerage to a firm that provides research reports and also pays the adviser's office rent. Regarding these soft dollar arrangements, the adviser:

• a.May accept research and brokerage services that benefit clients within the recognized safe harbor and must disclose the arrangement, but paying general overhead such as rent falls outside it✓
• b.May accept anything of value so long as commissions are competitive
• c.Need not disclose soft dollar arrangements because they cost the client nothing extra
• d.May accept overhead payments if the client's returns are positive

Soft dollar benefits are acceptable only when they consist of research or brokerage services that assist the adviser's investment decision-making for clients, and the arrangement must be disclosed because it creates a conflict in the choice of executing broker. Payments for ordinary business overhead such as rent, salaries, or travel are outside the safe harbor and amount to using client commissions for the adviser's benefit. Client commissions are a real cost, so the claim that nothing extra is paid is false.NASAA Model Rule

An investment adviser proposes to act as broker for a client on one side of a trade while representing the counterparty on the other. This agency cross transaction:

• a.Is flatly prohibited in every circumstance
• b.Requires disclosure of the adviser's role and the conflicts involved, and the client's consent, with the adviser never having recommended the trade to both parties✓
• c.Requires only that commissions be reasonable
• d.Requires approval from the Administrator before each trade

An agency cross transaction is permitted only with disclosure of the capacity in which the adviser acts, the compensation it will receive, and the conflict inherent in serving both sides, together with the client's consent and periodic reporting. The adviser may not have recommended the transaction to both the buyer and the seller. Reasonable commissions alone do not satisfy the rule, and there is no requirement of trade-by-trade approval by the Administrator.NASAA Model Rule

An investment adviser pays an accountant a fee for every client the accountant refers. Under NASAA rules, this arrangement requires that:

• a.Nothing be disclosed, because the client pays no additional fee
• b.The solicitor register as an investment adviser in every state
• c.The arrangement be in writing and disclosed to the client in writing, so the client knows the referral was compensated✓
• d.The referral fee be capped at five percent of the first year's advisory fee

Compensated solicitation arrangements must be documented in a written agreement and disclosed to the prospective client in writing so the client can weigh the referral's independence. Whether the client pays more is beside the point; the conflict itself is the material fact. The rules impose disclosure and documentation requirements rather than a universal percentage cap, and a solicitor is not automatically an investment adviser in every state.NASAA Model Rule

An agent's friend asks about the holdings and balance in a mutual acquaintance's brokerage account. The agent should:

• a.Share general information as long as no dollar figures are given
• b.Share the information if the friend is also a client of the firm
• c.Share the information because account data is not confidential
• d.Decline, because customer account information is confidential and may be released only with the customer's consent or under proper legal authority✓

Disclosing confidential customer information without the customer's consent is an unethical business practice; the recognized exceptions are limited to responses to subpoenas, court orders, and legitimate regulatory demands. Being a client of the same firm gives the friend no right to another customer's data. Withholding dollar amounts does not make the disclosure permissible, since holdings themselves are confidential.NASAA Model Rule

A client loses money on a trade the agent recommended. To keep the client from complaining, the agent quietly writes a personal check covering the loss and tells no one at the firm. The agent has:

• a.Resolved the matter appropriately at his own expense
• b.Acted properly because the client suffered no net loss
• c.Committed a prohibited practice by settling a complaint without the firm's knowledge and effectively guaranteeing the customer against loss✓
• d.Acted properly because no securities were involved in the payment

Reimbursing a customer for losses out of personal funds both conceals a potential complaint from the firm's supervisory system and operates as a guarantee against loss, each of which is an unethical practice. The firm must be able to review the underlying recommendation and record the complaint. Making the client whole financially does not cure the concealment.NASAA Model Rule