20 Ethics & Fiduciary Duty Practice Questions & Answers

1. 1. An investment adviser representative recommends a mutual fund that is suitable for the client. The fund's sponsor pays the adviser's firm an ongoing revenue-sharing fee that the client does not know about. What does the adviser's fiduciary duty require?

   • A.Obtain the Administrator's approval before recommending the fund
   • B.Nothing further, because the recommendation is suitable
   • C.Fully and fairly disclose the revenue-sharing arrangement so the client can give informed consent✓ Answer
   • D.Rebate the revenue-sharing payment to the client, as the law requires

   An adviser's fiduciary duty of loyalty requires it to eliminate, or make full and fair disclosure of, all material conflicts of interest so the client can provide informed consent. Suitability alone does not cure a conflict: third-party compensation gives the adviser a financial incentive that could reasonably impair unbiased advice, so it must be disclosed. The law does not require the payment to be rebated, and no regulator pre-approves recommendations.

   Source: NASAA Model Rule 102(a)(4)-1(k); SEC Commission Interpretation Regarding Standard of Conduct for Investment Advisers (Advisers Act Rel. IA-5248)Report a problem with this question

2. 2. An investment adviser's duty of care includes seeking best execution of client transactions. Best execution means the adviser must:

   • A.Seek the best qualitative execution overall, weighing price and total cost together with the full range and quality of the broker-dealer's services✓ Answer
   • B.Always route orders to the broker-dealer quoting the lowest commission rate
   • C.Execute every client order on a national securities exchange
   • D.Always route orders to the broker-dealer that supplies the most research

   Best execution is a qualitative standard, not a lowest-commission rule. Because the adviser is spending the client's money on brokerage, it must periodically and systematically evaluate execution quality — price, speed, likelihood of execution, and the range and quality of services — and conclude in good faith that the commission is reasonable for the value received. Choosing a broker purely for research or purely for the cheapest rate, without that analysis, breaches the duty of care.

   Source: SEC Commission Interpretation Regarding Standard of Conduct for Investment Advisers (duty of care — best execution); Investment Advisers Act Section 206Report a problem with this question

3. 3. An individual is registered both as an investment adviser representative and as an agent of an affiliated broker-dealer. He charges an advisory fee for a financial plan and will also earn commissions on the securities transactions the plan recommends. This conflict must be disclosed:

   • A.Orally, at the time each order is entered
   • B.In writing, on the trade confirmation the client receives
   • C.Only in the adviser's annual Form ADV update
   • D.In writing, before any advice is rendered✓ Answer

   NASAA's unethical practices rule for advisers requires written disclosure, before any advice is rendered, of any material conflict of interest that could reasonably be expected to impair unbiased and objective advice — and it expressly names charging an advisory fee while also receiving commissions on the resulting transactions. Disclosure at the time of the transaction is too late, because the client must be able to weigh the conflict while deciding whether to accept the advice.

   Source: NASAA Model Rule 102(a)(4)-1(k) (Unethical Business Practices of Investment Advisers)Report a problem with this question

4. 4. An investment adviser that also maintains a securities inventory wants to sell bonds out of that inventory to an advisory client. What must the adviser do?

   • A.Disclose the capacity in which it acted on the next quarterly account statement
   • B.Nothing, because principal trades need no disclosure if the price is fair
   • C.Nothing, because an adviser may never trade with a client as principal under any circumstances
   • D.Disclose in writing that it is acting as principal and obtain the client's consent before completion of the transaction✓ Answer

   Principal transactions are permitted but tightly conditioned: Advisers Act Section 206(3) makes it unlawful to sell to or buy from a client as principal without disclosing the capacity in writing and obtaining the client's consent before completion of the transaction. The consent must be transaction-by-transaction; blanket prospective consent and after-the-fact statement disclosure do not satisfy the section, because the point is to let the client evaluate the adviser's conflicting interest before being bound.

   Source: Investment Advisers Act Section 206(3)Report a problem with this question

5. 5. An investment adviser wants to feature a current client's video testimonial on its website. Under the advertising standards now applicable to advisers, this is:

   • A.Prohibited in all circumstances
   • B.Permitted if the advertisement clearly and prominently discloses that the speaker is a client, whether compensation was paid, and any material conflicts of interest✓ Answer
   • C.Permitted only if the client is uncompensated and the testimonial appears only in printed material
   • D.Permitted only after the Administrator reviews and approves the advertisement

   Testimonials and endorsements are no longer flatly banned; the adviser advertising standard now permits them subject to disclosure conditions — clear and prominent disclosure of client versus non-client status, of cash or non-cash compensation, and of material conflicts — plus a written agreement with any compensated promoter and a reasonable basis to believe the testimonial complies. Note also that no advertisement may state or imply that a regulator approved it, so option D describes something that is itself impermissible.

   Source: SEC Marketing Rule 206(4)-1(b) (testimonials and endorsements); NASAA Model Rule 102(a)(4)-1 (advertising)Report a problem with this question

6. 6. A client telephones her investment adviser representative and orally grants him discretion over her account. He places the first discretionary trade that same afternoon. This is:

   • A.Permitted, provided written authority is obtained within 30 calendar days of the first transaction
   • B.Permitted indefinitely on oral authority as long as the trades remain suitable
   • C.Permitted, provided the adviser obtains written discretionary authority within 10 business days of the first transaction✓ Answer
   • D.Prohibited, because an investment adviser must have written authority in hand before the first discretionary trade

   NASAA's model rule for advisers allows an adviser or IAR to begin exercising discretion on oral authority, but written discretionary authority must be obtained within 10 business days after the date of the first transaction placed under that oral grant. This is the key asymmetry with broker-dealers and their agents, who must have written authority before exercising any discretion at all.

   Source: NASAA Model Rule 102(a)(4)-1(b) (discretionary authority)Report a problem with this question

7. 7. A customer tells her broker-dealer agent, "Buy 500 shares of XYZ for me today — you pick the best moment and price." The agent executes the purchase in the afternoon without any written authorization on file. This is:

   • A.Not discretionary, because the customer specified the security, the amount and the action, leaving the agent only time and price✓ Answer
   • B.Discretionary unless the agent is also registered as an investment adviser representative
   • C.Permitted only if the order is executed at the opening price
   • D.Discretionary, so prior written discretionary authority was required

   Deciding only the time and/or price at which an order involving a definite amount of a specified security is executed is not the exercise of discretion, so no written authorization is needed and the order is good for that day only. Discretion exists when the agent chooses the security, the number of shares, or whether to buy or sell — and an agent of a broker-dealer must have written authority in hand before exercising any of that.

   Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (discretion; time and price exception)Report a problem with this question

8. 8. A client's adult son begins telephoning the client's investment adviser representative with buy and sell instructions for his mother's account. The IAR is confident the son is acting with his mother's blessing. Accepting the orders is:

   • A.Permitted because the caller is an immediate family member
   • B.Permitted if the client orally ratifies the orders afterward
   • C.Permitted as long as the agent verifies the caller's identity
   • D.Prohibited unless the client has given written third-party trading authorization✓ Answer

   Placing an order to purchase or sell a security on the instruction of a third party is an enumerated unethical practice unless the client has first given written third-party trading authorization. Family relationship, identity verification, and later oral ratification are irrelevant — the writing is what evidences that the account owner actually delegated authority and defines its scope.

   Source: NASAA Model Rule 102(a)(4)-1(e) (third-party trading authorization)Report a problem with this question

9. 9. A state-registered investment adviser that does not have custody unexpectedly receives a stock certificate belonging to a client in the day's mail. To avoid being deemed to have custody, the adviser should:

   • A.Hold it for 30 days and return it only if the client does not claim it
   • B.Deposit the certificate into the adviser's own account for safekeeping
   • C.Return it to the sender within 3 business days and keep the required record✓ Answer
   • D.Treat the receipt as custody at once and engage an independent CPA for a surprise examination

   Custody means holding client funds or securities, directly or indirectly, or having any authority to obtain possession of them — but the definition carves out securities received inadvertently if they are returned to the sender within 3 business days and the required records are kept. Depositing the certificate into the adviser's own account would be commingling and would trigger the full custody requirements, including a qualified custodian and an annual surprise verification by an independent CPA.

   Source: NASAA Custody Model Rule 102(e)(1)-1 (definition of custody; inadvertent receipt)Report a problem with this question

10. 10. An agent of a broker-dealer borrows money from a long-standing retail customer, signing a promissory note that bears a market rate of interest. Under the NASAA statement of policy, this is:

    • A.Permitted because the customer offered the loan without being asked
    • B.Permitted, because a written note bearing a market rate of interest was signed
    • C.Permitted if the agent notifies the broker-dealer within 10 business days
    • D.Prohibited — an agent may not borrow money or securities from a customer✓ Answer

    The NASAA statement of policy lists lending to or borrowing money or securities from a customer as a dishonest or unethical practice, with no exceptions and regardless of documentation or interest rate; the same provision bars an agent from acting as custodian for a customer's money, securities or an executed stock power. The rationale is that the debt gives the agent a personal financial stake that conflicts with the customer's interests. On a NASAA exam, apply this rule rather than the narrower FINRA loan exceptions.

    Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (loans to or from customers)Report a problem with this question

11. 11. A state-registered investment adviser borrows funds from one of its advisory clients, a commercial bank that is in the business of making loans. The loan is on the bank's standard commercial terms. This is:

    • A.Permitted, because the client is a financial institution engaged in the business of loaning funds✓ Answer
    • B.Permitted only if the adviser first notifies the Administrator of the loan
    • C.Prohibited — an adviser may never borrow from a client
    • D.Permitted only if the adviser has no discretionary authority over the client's account

    The adviser rule is narrower than the agent rule: an adviser may not borrow money or securities from a client unless the client is a broker-dealer, an affiliate of the adviser, or a financial institution engaged in the business of loaning funds. A bank lending on its ordinary commercial terms falls squarely in that exception because the transaction is the client's normal business rather than an exploitation of the advisory relationship. Note the lending and borrowing exception lists are not identical.

    Source: NASAA Model Rule 102(a)(4)-1(f)-(g) (borrowing from and lending to clients)Report a problem with this question

12. 12. An agent proposes to share in both the profits and the losses of a customer's account. Under the NASAA statement of policy, sharing is:

    • A.Permitted only if the agent's share of profits and losses is proportionate to the agent's capital contribution
    • B.Permitted with the customer's oral consent alone
    • C.Permitted only with the written authorization of both the customer and the broker-dealer✓ Answer
    • D.Prohibited under all circumstances

    This is a conditional prohibition, not an absolute one: the NASAA rule bars an agent from sharing directly or indirectly in the profits or losses in a customer's account unless the agent has written authorization from both the customer and the broker-dealer the agent represents. Requiring the firm's written consent lets it supervise the resulting conflict. The proportionate-contribution requirement is a FINRA rule concept and is not what the NASAA statement of policy imposes.

    Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (sharing in profits or losses)Report a problem with this question

13. 13. To close a sale, an agent tells a hesitant customer, "If this stock is below your purchase price a year from now, I will personally make up the difference." This promise is:

    • A.Permitted if the agent has enough net worth to make good on it
    • B.Prohibited — guaranteeing a customer against loss is unethical regardless of the agent's intent or ability to pay✓ Answer
    • C.Permitted if the customer is an accredited investor
    • D.Permitted if the promise is put in writing and the broker-dealer approves it

    Guaranteeing a customer against loss in any securities account or in any securities transaction is an enumerated prohibited practice with no exceptions, and the parallel adviser rule bars guaranteeing a client a specific result. The prohibition exists because such a promise misrepresents the nature of market risk and induces the customer to buy for a reason unrelated to the merits of the security; firm approval or personal wealth cannot cure it.

    Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (guaranteeing against loss); NASAA Model Rule 102(a)(4)-1(l)Report a problem with this question

14. 14. Which statement best describes churning?

    • A.Any account in which more than twelve trades occur in a calendar year
    • B.Recommending only the broker-dealer's proprietary products to every client
    • C.Buying and selling the same security on the same day with no change in beneficial ownership
    • D.Inducing trading that is excessive in size or frequency in light of the account's resources, character and the customer's objectives✓ Answer

    Churning is defined qualitatively, not by a trade count: it is inducing transactions excessive in size or frequency given the character of the account and the customer's resources and objectives, where the agent exercises control over the account and trades to generate commissions. Option D describes a wash sale, a separate manipulative practice. For an adviser the abuse is aggravated because the adviser is paid to advise yet benefits from transaction volume.

    Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (churning); NASAA Model Rule 102(a)(4)-1(c)Report a problem with this question

15. 15. A registered agent sells interests in a private real estate program to several of his brokerage customers. The transactions are never recorded on his firm's books. This practice is:

    • A.Permitted as long as the agent receives no compensation for the sales
    • B.Prohibited unless the broker-dealer authorized the transactions in writing before they were executed✓ Answer
    • C.Permitted because the interests themselves are exempt from registration
    • D.Permitted if the agent tells each customer that he is acting outside the firm

    This is selling away: effecting securities transactions not recorded on the regular books or records of the broker-dealer the agent represents is prohibited unless the firm authorizes the transactions in writing prior to execution. The rule protects customers by ensuring the firm can supervise the product and the recommendation; the exempt status of the security, the absence of compensation, and disclosure to the customer do not substitute for the firm's prior written authorization.

    Source: NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents (selling away / transactions not recorded on the firm's books)Report a problem with this question

16. 16. An agent sells a security in a transaction that qualifies as an exempt transaction, and the security itself is an exempt security. In making the sale the agent deliberately misstates a material fact about the issuer's finances. The agent has committed:

    • A.A violation only if the purchaser ultimately suffers a loss
    • B.A violation of federal law only; the state Administrator has no jurisdiction
    • C.A violation, because the antifraud provisions apply to every security and every transaction, including exempt ones✓ Answer
    • D.No violation, because both the security and the transaction are exempt from the Act

    Exemptions under the Uniform Securities Act relieve a person of registration requirements only; there is no exemption from the antifraud provisions, which make it unlawful in connection with the offer, sale or purchase of any security to make an untrue statement of a material fact or omit a material fact necessary to make statements not misleading. Liability turns on the misstatement itself, not on whether the buyer lost money, and the state Administrator has jurisdiction wherever the offer originated, was directed or was accepted.

    Source: Uniform Securities Act Section 101 (1956) / Section 501 (2002); SEC Rule 10b-5Report a problem with this question

17. 17. An attorney at a law firm learns from firm files that a client intends to launch a surprise tender offer for a public company. He buys the target's shares before the announcement. Under federal securities law he is:

    • A.Is liable under the misappropriation theory, because he traded on confidential information taken in breach of a duty owed to the source of that information✓ Answer
    • B.Is not liable, because he is not an insider of the target company
    • C.Is not liable, because he owes no fiduciary duty to the shareholders who sold him the stock
    • D.Is liable only if he also passed the information along to someone else

    Under the misappropriation theory, a person violates Section 10(b) and Rule 10b-5 by trading on material, nonpublic information in breach of a duty owed to the source of the information — here his law firm and its client — even though he owes no duty to the target's shareholders. The deception is against the information's source, so classic insider status and tipping are unnecessary elements.

    Source: Securities Exchange Act Section 10(b) and Rule 10b-5; misappropriation theory (United States v. O'Hagan)Report a problem with this question

18. 18. An agent learns that his firm is about to execute a very large customer buy order in a thinly traded stock. Before entering the customer's order he buys shares for his own account. This conduct is:

    • A.Permitted as long as the agent's own order is small
    • B.Permitted, because the information concerns a trade rather than the issuer's business
    • C.Permitted if a branch manager approves the agent's order in writing
    • D.Prohibited — trading ahead of a customer's large order on material, nonpublic market information is a deceptive practice✓ Answer

    Front running is a manipulative and deceptive device: the agent exploits material, nonpublic information about an imminent block order, taking for himself the price movement that belongs to the customer and subordinating the customer's interest to his own. Information about order flow counts as material nonpublic information, so neither the small size of his order nor supervisory approval makes the trade permissible.

    Source: Securities Exchange Act Section 10(b) / Rule 10b-5; NASAA Statement of Policy on Dishonest or Unethical Business Practices (manipulative or deceptive devices)Report a problem with this question

19. 19. An investment adviser wants to give its client list, including holdings information, to an unaffiliated insurance agency that will market annuities to those clients. This is:

    • A.Permitted if the adviser discloses the practice on its Form ADV
    • B.Permitted, because a firm may share customer information freely for marketing purposes
    • C.Not permitted without the client's consent unless required by law, and Regulation S-P separately requires a privacy notice and an opportunity to opt out of sharing with nonaffiliated third parties✓ Answer
    • D.Permitted as long as the insurance agency agrees in writing to keep the information confidential

    Disclosing the identity, affairs or investments of any client is an enumerated unethical practice unless the disclosure is required by law or the client consents. Regulation S-P adds a federal privacy layer: initial and annual privacy notices, a right to opt out before nonpublic personal information is shared with nonaffiliated third parties, and safeguards to protect client records. A confidentiality promise by the recipient does not replace the client's consent or the opt-out right.

    Source: NASAA Model Rule 102(a)(4)-1(n) (client confidentiality); SEC Regulation S-P (17 C.F.R. Part 248)Report a problem with this question

20. 20. An agent reasonably believes that a 78-year-old client is being financially exploited by her nephew — who is also the third party the client previously designated to be contacted about her account. Under the NASAA model act, the agent's firm must:

    • A.Take no action for 15 business days while the firm completes an internal investigation
    • B.Notify the nephew first, because he is the client's designated third party
    • C.Report the matter only to the firm's own compliance department, which has no obligation to notify outside agencies
    • D.Promptly notify Adult Protective Services and the state securities Administrator, and withhold notice from the nephew because he is suspected of the exploitation✓ Answer

    For an eligible adult — a person 65 or older or one covered by the state's adult protective services statute — notification to Adult Protective Services and to the state securities Administrator is mandatory once a qualified individual reasonably believes exploitation has occurred or is being attempted. Notifying a previously designated third party is only permissive, and is expressly barred where that person is suspected of the exploitation, since the notice would tip off the suspect. Good-faith compliance carries immunity from administrative and civil liability.

    Source: NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation, Sections 3-4 (governmental disclosures; third-party notification)Report a problem with this question

Practice questions based on the NASAA content outlines and the Uniform Securities Act. Not affiliated with NASAA or FINRA, and not investment or legal advice. About NASAA exams →