What Is Prohibited Practices?
Prohibited practices are actions or behaviors within the financial industry that are illegal, unethical, or otherwise forbidden by regulatory bodies and laws, falling under the broad umbrella of financial regulation. These activities are deemed detrimental to market integrity, investor confidence, and fair competition. Such practices are typically established to prevent harm to investors, maintain orderly markets, and ensure transparency. They encompass a wide array of illicit activities, from forms of financial fraud to deceptive trading strategies and breaches of professional conduct by financial professionals. Both the Securities and Exchange Commission (SEC) and self-regulatory organizations like FINRA actively define, monitor, and enforce rules against prohibited practices to safeguard the financial system.
History and Origin
The concept of regulating and prohibiting certain financial practices evolved significantly in response to major financial crises and periods of widespread abuse. Before comprehensive federal oversight, state-level "blue sky laws" emerged in the early 20th century to protect investors from fraudulent investment schemes, often described as having no more backing than the "blue sky" itself. However, the stock market crash of 1929 and the subsequent Great Depression highlighted the inadequacy of fragmented state regulations in curbing rampant manipulative and deceptive practices across the national securities markets.18, 19 This period of severe economic hardship led to a significant expansion of the federal government's role in regulating the financial sector.17
In response, the Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted, establishing the foundational regulatory framework still largely in place today.15, 16 The Securities Exchange Act of 1934 specifically created the SEC with broad powers to oversee the securities industry.14 This landmark legislation explicitly prohibited manipulative practices and mandated rigorous disclosure standards, aiming to prevent the recurrence of financial abuses.13 Over time, as markets and financial instruments grew in complexity, new forms of prohibited practices emerged, leading to continuous updates in regulations and enforcement efforts by bodies like the SEC and FINRA.
Key Takeaways
- Prohibited practices are illegal or unethical activities in finance, enforced by regulatory bodies to protect investors and ensure market integrity.
- Examples include insider trading, market manipulation, fraud, and misrepresentation.
- Regulations against these practices evolved from early state laws to comprehensive federal legislation following major financial crises.
- Enforcement aims to maintain fair, orderly, and transparent financial markets.
- Adherence to rules preventing prohibited practices is a core component of compliance for financial firms and individuals.
Interpreting the Prohibited Practices
Understanding prohibited practices is crucial for all market participants, from individual investors to large financial institutions. For regulators, identifying and prosecuting prohibited practices involves interpreting laws and rules to determine if conduct meets the definition of, for instance, insider trading or market manipulation. This often requires evaluating intent, the materiality of information, and the impact of the actions on market prices or other investors. For financial professionals, interpreting these rules means understanding the boundaries of acceptable conduct, particularly concerning fiduciary duty to clients and the need for transparent communication. The interpretation of these rules is dynamic, adapting to new technologies and evolving financial products.
Hypothetical Example
Consider a scenario where an analyst at a brokerage firm discovers non-public information about an impending merger between two large companies. Before the merger is publicly announced, the analyst uses this information to purchase shares in the target company through a family member's account, anticipating a significant price jump.
This action constitutes insider trading, a clear prohibited practice. The analyst has acted on "material non-public information" to gain an unfair advantage. If detected, both the analyst and potentially the brokerage firm could face severe penalties from the SEC and FINRA, including fines, disgorgement of profits, and prohibitions from working in the securities industry. The hypothetical profit derived from this illicit trade would be considered ill-gotten gains.
Practical Applications
Prohibited practices appear across various facets of the financial world, leading to specific regulatory and enforcement measures. In investing, the SEC and FINRA actively pursue cases involving broker-dealer misconduct, such as excessive trading to generate commissions (churning) or making unsuitable investment recommendations.11, 12 For example, FINRA has issued disciplinary actions against firms for failing to supervise representatives' communications or for charging unfair markups and markdowns.9, 10
In the realm of market analysis, actions like "spoofing" (placing large orders with no intent to execute them to manipulate prices) or "front-running" (a broker trading on advance knowledge of a client's large order) are considered prohibited forms of market manipulation.7, 8 Regulation is also crucial in preventing deceptive advertising or misrepresentation in marketing materials for financial products.6 The Foreign Corrupt Practices Act (FCPA), enforced jointly by the SEC and the Department of Justice, prohibits U.S. companies and individuals from bribing foreign officials to obtain or retain business.5 This extends the scope of prohibited practices globally, reinforcing the importance of sound corporate governance and internal controls.
Limitations and Criticisms
While regulations against prohibited practices aim to create fair markets, their enforcement faces several limitations and criticisms. One challenge is proving intent, especially with the rise of complex algorithmic trading and high-frequency trading, where manipulative behavior might be a byproduct of automated systems rather than explicit human intent.3, 4 This difficulty can complicate legal actions, as traditional definitions of manipulation often focus on the actor's intent.2
Another limitation is the constant evolution of financial products and technologies, which can create new avenues for illicit activities faster than regulators can define and prohibit them. The dynamic nature of market manipulation schemes, including those leveraging social media for mass misinformation, presents ongoing challenges for detection and enforcement.1 Critics also point to the reactive nature of regulation; laws are often enacted only after significant financial scandals or crises reveal existing vulnerabilities, rather than proactively preventing them. Ensuring adequate due diligence and encouraging whistleblower reports remain critical, as regulatory bodies cannot police every transaction.
Prohibited Practices vs. Market Manipulation
While often used interchangeably or as overlapping concepts, "prohibited practices" is a broader term than "market manipulation." Prohibited practices encompass any activity forbidden by financial regulations due to its illegality, unethical nature, or detrimental effect on market integrity and consumer protection. This includes a wide range of actions such as insider trading, breaches of fiduciary duty, unauthorized trading, certain marketing misrepresentations, and even violations of anti-bribery laws like the FCPA.
Market manipulation, on the other hand, is a specific type of prohibited practice. It refers to intentional actions designed to artificially influence the supply or demand for a security, its price, or its perceived value. Examples include schemes like pump and dump, spoofing, layering, or spreading false information to create an artificial trading volume or price movement. While all market manipulation is a prohibited practice, not all prohibited practices involve market manipulation (e.g., a simple conflict of interest that isn't properly disclosed would be a prohibited practice but not market manipulation).
FAQs
What is the most common prohibited practice?
While it's difficult to pinpoint one "most common," unauthorized trading, suitability violations (recommending investments not appropriate for a client), and various forms of financial fraud are frequently cited in enforcement actions against broker-dealer firms and investment adviser representatives.
Who enforces prohibited practices?
In the United States, primary enforcement bodies include the Securities and Exchange Commission (SEC) and self-regulatory organizations like FINRA. Other government agencies, such as the Department of Justice, also prosecute criminal violations related to prohibited practices.
How can investors protect themselves from prohibited practices?
Investors can protect themselves by conducting due diligence on financial professionals and firms through tools like BrokerCheck, understanding the risks of their investments, and being wary of unsolicited offers or promises of unusually high returns. If they suspect misconduct, they should report it to the relevant regulatory authorities.
Do prohibited practices only apply to individuals?
No, prohibited practices apply to both individuals and financial institutions. Firms are held responsible for establishing and maintaining supervisory systems to prevent such conduct by their employees, and they can face significant penalties for failing to do so.