Naming market manipulation

One defining act each

These violations are easy to confuse because they all involve trading and all involve dishonesty. They are much easier to keep apart if each is reduced to the single act that defines it. Front running is trading ahead of a customer order you know about, for your own account or the firm’s, so as to benefit from the price effect that order will have.

Pump and dump is hyping a security to push the price up and then selling into the demand you created. Marking the close is entering trades near the end of the session to move the closing price, usually so that a position, a fund valuation or a performance figure looks better than it is. Both are attempts to make a price say something untrue.

Churning is excessive trading in a customer account for the purpose of generating commissions, judged against the customer’s objectives and resources rather than against any fixed number of trades. Freeriding is buying a security and selling it without ever paying for the purchase, so the customer takes a profit with none of their own money at risk.

Each has a lawful neighbor, and that neighbor is where the exam sets its trap. Acting on published research is not front running, because the information is public and no customer order is being anticipated. Active trading that suits an aggressive client is not churning. Marketing a security honestly is not a pump and dump. What converts the lawful activity into the violation is the specific act, not the enthusiasm behind it.

Behind the named schemes sits a general prohibition. FINRA Rule 2020 says no member shall effect any transaction in, or induce the purchase or sale of, any security by means of any manipulative, deceptive or other fraudulent device or contrivance. It reaches both making the trade and persuading someone else to trade, and it needs no specific named practice: a deceptive scheme that no other rule describes is still covered.

Several more named practices appear on the exam. Spreading a false or misleading rumor to move a price is manipulation: the Exchange Act prohibits a person selling or buying a security from circulating information that its price will rise or fall because of market operations, or from making a statement they know or have reason to believe is false or misleading, to induce others to trade. Marking the open works like marking the close at the other end of the day: trading at or near the opening to influence the opening price. FINRA names marking the open or close among the manipulative practices firms must supervise for. Backing away is failing to honor a firm quote: under FINRA Rule 5220 a member may not make an offer to buy or sell a security at a stated price unless it is prepared to trade at that price and under the conditions stated. Two older schemes fake the volume rather than the price. A wash trade is a trade with no change in who really owns the security. Matched orders are an order to buy or sell entered knowing that an opposite order of about the same size, at about the same time and price, has been or will be entered, by the same or another party. The Exchange Act bans both when they are used to create a false or misleading appearance of active trading.

Excessive trading is judged as a pattern

Churning charged as fraud needs three things: control of the account, trading that is excessive for the customer’s objectives, and intent to defraud or reckless disregard. The best-interest and suitability tests for excessive trading are wider and need neither control nor intent. Under Regulation Best Interest, a representative recommending to a retail customer needs a reasonable basis to believe that a series of recommended transactions is not excessive when taken together in light of the customer’s profile, even if each trade is in her interest on its own.

That reasonable basis has to be the representative’s, whatever the customer approves trade by trade, and FINRA has dropped control from its own test to match. For a customer outside Regulation Best Interest, such as a company, FINRA’s suitability rule generally applies the same series test. FINRA says no single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio and in-and-out trading may support a finding.

Keep the wash trade apart from the tax wash sale rule, which can disallow a loss when substantially identical stock is bought within 30 days before or after the sale. That rule decides a deduction, not whether trading was manipulative.

Exam terms

Front running

Trading ahead of a customer order you know is coming.

Pump and dump

Hyping a security to raise the price, then selling into the demand.

Scalping

Buying a security, recommending it without disclosing that position or the plan to sell, then selling into the rise.

Marking the close

Trading near the close to move the closing price.

Churning

Excessive trading in an account to generate commissions.

Freeriding

Selling a security without ever paying for the purchase.

Matched orders

Prearranged buying and selling that creates fake activity.

Wash trade

A trade with no change in beneficial ownership, used to fake trading activity.

Worked example

A representative receives a large institutional buy order, buys the same stock for a personal account, then releases a research note recommending it, without disclosing the position or the plan to sell, and sells into the rise.

1. Take the first act. Buying personally after learning of a pending customer order, and before that order is executed, is front running: the customer’s own order is expected to move the price.
2. The customer order should have gone first. Priority belongs to the customer, and the personal trade takes value that the customer’s execution would otherwise have retained.
3. Now take the second act. Recommending a stock you hold without disclosing that position or your plan to sell, and then selling into the demand the recommendation creates, is scalping. The Supreme Court held that an adviser who keeps those facts from clients commits a fraud on them, and FINRA Rule 2020 bars any deceptive device used to get someone to trade.
4. Note what would have been lawful. Publishing the research first, letting the market absorb it, and trading only within the firm’s personal-trading rules would have used no customer order and hidden nothing from readers.
5. Two separate violations arise from one sequence, which is why the exam asks you to name the act rather than to judge whether the person behaved badly overall.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Manipulation type identificationPractice this
• Excessive trading: the series test and its signalsPractice this