NASAA Series 63Ethical Practices and ObligationsEasy
An investment adviser representative (IAR) is managing a discretionary account for a client. The IAR executes 50 trades in the client's account over a three-month period, generating substantial commissions for the IAR's firm. The client's investment objectives are long-term growth, and the frequent trading has not significantly improved the portfolio's performance, but has instead led to high transaction costs. This practice is commonly known as:
- AFront-running
- BChurning
- CUnauthorized trading
- DMarket timing
Show answer & explanationAnswer & explanation
Correct answer: B. Churning
Churning is the practice of excessively trading in a client's account, primarily to generate commissions for the agent or firm, rather than to benefit the client. The scenario describes frequent trading that is inconsistent with the client's long-term objectives and generates high costs without commensurate performance improvement.
Why the other options are wrong
- A. Front-running involves an agent trading on their own account before executing a large client order to profit from the anticipated price movement.
- C. Unauthorized trading involves executing trades without permission; here, the IAR has discretionary authority, so permission is implied for individual trades.
- D. Market timing is an investment strategy of moving in and out of the market or specific sectors based on short-term predictions, not necessarily an unethical practice in itself, though excessive market timing can lead to churning.
Churning
Excessive trading in a client's account for the primary purpose of generating commissions, rather than benefiting the client.
- Prohibited under the Uniform Securities Act.
- Requires evidence of control over the account and excessive trading.
- Often results in high transaction costs and may not improve portfolio performance.
Memory trick: Churning is like a butter churn, always moving, but for fees.