16 Ethics & Fiduciary Duty Practice Questions & Answers

Every Ethics & Fiduciary Duty practice question from the Series 63 / 65 / 66 Practice Test, with the correct answer and a short explanation.

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1. Under the Uniform Securities Act, an investment adviser owes its clients a fiduciary duty. Which pair of obligations best captures the core of that fiduciary standard?
- A.The duty of care and the duty of loyalty, requiring the adviser to act in the client's best interest✓ Answer
- B.The duty to maximize commissions and the duty to trade frequently
- C.The duty of confidentiality and the duty to guarantee returns
- D.The duty to follow only the firm's instructions and the duty to avoid all disclosure
An investment adviser is a fiduciary whose duty comprises the duty of care (giving suitable, competent advice) and the duty of loyalty (placing the client's interest ahead of the adviser's own). Guaranteeing returns and maximizing the adviser's commissions are themselves prohibited or conflicted practices, so they cannot define the standard.
Source: SEC v. Capital Gains Research Bureau (1963); Investment Advisers Act fiduciary duty as adopted under Uniform Securities ActReport a problem with this question
2. An investment adviser representative recommends a mutual fund whose sponsor pays the adviser's firm a marketing fee for selling it. What must the adviser do regarding this conflict of interest?
- A.Fully and fairly disclose the conflict to the client so the client can give informed consent✓ Answer
- B.Nothing, because marketing fees are never a conflict of interest
- C.Keep the arrangement confidential to avoid confusing the client
- D.Disclose it only if a client specifically asks about compensation
The duty of loyalty requires full and fair disclosure of all material conflicts of interest so the client can provide informed consent; a payment from a fund sponsor is a material conflict because it may bias the recommendation. Disclosure cannot be withheld or made contingent on the client asking.
Source: Uniform Securities Act; NASAA Model Rule on unethical business practices — disclosure of conflicts of interestReport a problem with this question
3. 'Churning' is a prohibited practice under NASAA rules. Which behavior does it describe?
- A.Excessive trading in a client's account primarily to generate commissions rather than to benefit the client✓ Answer
- B.Executing a client's order in the wrong security by mistake
- C.Refusing to trade until the client signs new paperwork
- D.Recommending a long-term buy-and-hold strategy
Churning is excessive trading in a customer's account that is inconsistent with the customer's objectives and is done mainly to generate commissions for the agent or firm. It breaches the duty to deal fairly because the frequency serves the agent's interest, not the client's.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices; FINRA Rule 2111 (quantitative suitability)Report a problem with this question
4. An agent buys shares of a stock for their own account immediately before entering a large client buy order they know will push the price up. What prohibited practice is this?
- A.Front-running✓ Answer
- B.Dollar-cost averaging
- C.Rebalancing
- D.Netting
Front-running is trading in one's own account ahead of a known, market-moving customer order to profit from the expected price impact. It is prohibited because the agent exploits confidential client order information for personal gain, breaching the duty of loyalty.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices; FINRA Rule 5270 (Front Running of Block Transactions)Report a problem with this question
5. An agent tells a client, 'This bond is guaranteed by the state, so you cannot lose your principal,' when no such guarantee exists. This is an example of which prohibited practice?
- A.Misrepresentation of a material fact✓ Answer
- B.Fair and balanced disclosure
- C.Authorized discretion
- D.Suitable diversification
Falsely stating that a security is guaranteed or that principal cannot be lost is a misrepresentation of a material fact, which is a fraudulent and prohibited practice. Investors could reasonably rely on such a statement, so its falsity is material to the investment decision.
Source: Uniform Securities Act §101 (fraud); NASAA Model Rule on Dishonest and Unethical Business Practices — misrepresentationsReport a problem with this question
6. Except for accounts with proper written discretionary authority, what must an agent obtain before executing a specific transaction in a client's account?
- A.Approval from a competing broker-dealer
- B.Written consent from the issuer of the security
- C.A signed guarantee of profit
- D.The client's authorization for that transaction✓ Answer
Effecting a transaction that a client did not authorize, in an account lacking discretionary authority, is 'unauthorized trading' and is prohibited. Without written discretionary authority, the agent must obtain the client's authorization for each specific transaction.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices — unauthorized transactionsReport a problem with this question
7. Under NASAA rules, what must a broker-dealer do with client funds and securities to avoid the prohibited practice of commingling?
- A.Hold client cash in the agent's personal bank account
- B.Pool all client accounts into one omnibus account without records
- C.Keep client assets segregated from the firm's own assets✓ Answer
- D.Combine client assets with firm assets for efficiency
Commingling client funds or securities with those of the firm or the agent is prohibited; client assets must be kept segregated. Segregation protects clients if the firm becomes insolvent and prevents the firm from using client property as its own.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices — prohibition on comminglingReport a problem with this question
8. In a securities transaction, what distinguishes a broker-dealer acting as an 'agent' from one acting as a 'principal'?
- A.There is no difference; the terms are interchangeable
- B.As agent it always loses money; as principal it always profits
- C.As agent it arranges the trade for a commission; as principal it trades from its own inventory, typically for a markup or markdown✓ Answer
- D.As agent it must guarantee the price; as principal it need not disclose anything
When acting as an agent (broker), the firm arranges a transaction between others and charges a commission; when acting as a principal (dealer), it buys or sells from its own inventory and is compensated by a markup or markdown. The capacity in which the firm acts and its compensation must be disclosed on the confirmation.
Source: Uniform Securities Act definitions of broker-dealer and agent; NASAA confirmation disclosure requirementsReport a problem with this question
9. Before making a recommendation, an agent must have a reasonable basis to believe the transaction is suitable for the client. This suitability obligation is based primarily on what?
- A.The security paying the highest commission that month
- B.The agent's need to meet a monthly sales quota
- C.The firm's inventory it most wants to sell
- D.The client's financial situation, needs, objectives, and risk tolerance✓ Answer
Suitability requires the agent to gather and rely on the client's financial situation, needs, investment objectives, and risk tolerance before recommending a transaction. Basing recommendations on the agent's or firm's own incentives instead is a breach of the duty to deal fairly with clients.
Source: FINRA Rule 2111 (Suitability); NASAA Model Rule on Dishonest and Unethical Business PracticesReport a problem with this question
10. For a nondiscretionary account, what characterizes a transaction where the agent decides the security, amount, and timing without the client's prior approval?
- A.It is required whenever the market is moving quickly
- B.It is a prohibited exercise of discretion without written authority✓ Answer
- C.It is permitted as long as the trade is profitable
- D.It is permitted if the agent informs the client afterward
Deciding the security, the amount, and the action (buy/sell) is exercising discretion; doing so without prior written discretionary authority is prohibited. The timing and price alone (a 'not-held' order for the same day) do not constitute discretion, but choosing what and how much does.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices — discretion requires prior written authorizationReport a problem with this question
11. When an investment adviser intends to act as a principal or agent in a transaction with an advisory client, what does the Investment Advisers Act require?
- A.Written disclosure to and consent from the client before completion of the transaction✓ Answer
- B.Only a verbal notice after the trade settles
- C.Nothing, since advisers are exempt from these rules
- D.Approval from the client's accountant instead of the client
Under Section 206(3), an adviser engaging in a principal or agency cross transaction with a client must disclose the capacity in writing and obtain the client's consent before the transaction is completed. This protects clients from the conflict of the adviser trading against or across their account.
Source: Investment Advisers Act of 1940 §206(3) (principal and agency cross transactions)Report a problem with this question
12. An investment adviser is compensated with a share of the profits in a client's account ('performance-based fee') but does not qualify for any exemption. Under NASAA rules, this arrangement is generally:
- A.Encouraged for retail clients of any net worth
- B.Always required for all advisory accounts
- C.Permitted only if the adviser guarantees no losses
- D.Prohibited, because it can incentivize the adviser to take excessive risk with the client's money✓ Answer
Performance-based fees are generally prohibited unless an exemption applies (e.g., qualified clients meeting net-worth or assets-under-management thresholds), because sharing in profits can incentivize the adviser to take on excessive risk to boost their own compensation. The default rule is prohibition, not encouragement.
Source: Investment Advisers Act §205(a)(1); NASAA rules on performance-based compensationReport a problem with this question
13. The duty of fair dealing requires an agent, when quoting a security to a retail client, to charge a price that is:
- A.Set to maximize the firm's markup regardless of market value
- B.Equal to the security's par value in every case
- C.Reasonably related to the current market price of the security✓ Answer
- D.Whatever the client is willing to pay, without limit
Fair dealing and the markup/markup policy require that the price charged, including any markup or markdown, be reasonably related to the prevailing market price of the security. Charging an excessive markup unrelated to market value is an unfair and prohibited practice.
Source: FINRA Rule 2121 (Fair Prices and Commissions); NASAA Model Rule on Dishonest and Unethical Business PracticesReport a problem with this question
14. An agent, without giving prior written notice to or receiving approval from the employing broker-dealer, arranges a private securities transaction for a client that is never recorded on the firm's books. This prohibited practice is known as:
- A.Selling away✓ Answer
- B.Backing away
- C.Arbitrage
- D.Interpositioning
Selling away is participating in a private securities transaction outside the scope of one's employment without first giving written notice to, and obtaining approval from, the employing broker-dealer. It is prohibited because it deprives the firm of its supervisory oversight and exposes clients to unsupervised, potentially fraudulent deals.
Source: NASAA Model Rule on Dishonest and Unethical Business Practices; FINRA Rule 3280 (Private Securities Transactions of an Associated Person)Report a problem with this question
15. An agent proposes to share directly in the profits and losses of a client's account. Under NASAA and FINRA rules, such sharing by the agent is permitted only when:
- A.The client's account exceeds a stated dollar value
- B.The agent guarantees the client against all losses
- C.The agent and client verbally agree to split any gains
- D.The agent obtains prior written authorization from both the client and the employing broker-dealer and shares only in proportion to the agent's own capital contributed to the account✓ Answer
Sharing in the profits or losses of a customer's account is prohibited unless the agent obtains prior written authorization from both the customer and the employing firm, and the agent's share is proportionate to the agent's own financial contribution to the account. Requiring proportional, capital-backed participation prevents the agent from speculating with the client's money without bearing genuine, matching risk.
Source: FINRA Rule 2150(c) (Sharing in Accounts); NASAA Model Rule on Dishonest and Unethical Business PracticesReport a problem with this question
16. As part of the duty of care owed to clients, when handling client orders an investment adviser or broker-dealer must seek 'best execution.' What does this obligation require?
- A.Delaying execution indefinitely until the price moves in the client's favor
- B.Executing each order in whatever way generates the largest commission for the firm
- C.Seeking the most favorable terms reasonably available under the circumstances for the client's transaction✓ Answer
- D.Always routing every order to the firm's own affiliated market maker
Best execution requires seeking the most favorable terms reasonably available for a client's order, weighing factors such as price, speed, and the likelihood of execution and settlement. It flows from the duty of care and loyalty: routing orders to benefit the firm (for example, for higher payment for order flow) rather than the client would place the firm's interest ahead of the client's.
Source: FINRA Rule 5310 (Best Execution and Interpositioning); Investment Advisers Act fiduciary duty of care (SEC Release IA-5248)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 →

1. Under the Uniform Securities Act, an investment adviser owes its clients a fiduciary duty. Which pair of obligations best captures the core of that fiduciary standard?

2. An investment adviser representative recommends a mutual fund whose sponsor pays the adviser's firm a marketing fee for selling it. What must the adviser do regarding this conflict of interest?

3. 'Churning' is a prohibited practice under NASAA rules. Which behavior does it describe?

4. An agent buys shares of a stock for their own account immediately before entering a large client buy order they know will push the price up. What prohibited practice is this?

5. An agent tells a client, 'This bond is guaranteed by the state, so you cannot lose your principal,' when no such guarantee exists. This is an example of which prohibited practice?

6. Except for accounts with proper written discretionary authority, what must an agent obtain before executing a specific transaction in a client's account?

7. Under NASAA rules, what must a broker-dealer do with client funds and securities to avoid the prohibited practice of commingling?

8. In a securities transaction, what distinguishes a broker-dealer acting as an 'agent' from one acting as a 'principal'?

9. Before making a recommendation, an agent must have a reasonable basis to believe the transaction is suitable for the client. This suitability obligation is based primarily on what?

10. For a nondiscretionary account, what characterizes a transaction where the agent decides the security, amount, and timing without the client's prior approval?

11. When an investment adviser intends to act as a principal or agent in a transaction with an advisory client, what does the Investment Advisers Act require?

12. An investment adviser is compensated with a share of the profits in a client's account ('performance-based fee') but does not qualify for any exemption. Under NASAA rules, this arrangement is generally:

13. The duty of fair dealing requires an agent, when quoting a security to a retail client, to charge a price that is:

14. An agent, without giving prior written notice to or receiving approval from the employing broker-dealer, arranges a private securities transaction for a client that is never recorded on the firm's books. This prohibited practice is known as:

15. An agent proposes to share directly in the profits and losses of a client's account. Under NASAA and FINRA rules, such sharing by the agent is permitted only when:

16. As part of the duty of care owed to clients, when handling client orders an investment adviser or broker-dealer must seek 'best execution.' What does this obligation require?