22 Regulations & Ethics Practice Questions & Answers

1. 1. A corporate issuer's registration statement for a new common stock offering was filed with the SEC eight days ago and has not yet become effective. A registered representative at a syndicate member is contacted by a customer who wants to participate in the offering. What may the representative do?

   • A.Send the customer a preliminary prospectus and record a non-binding indication of interest✓ Answer
   • B.Send the customer the research report the firm published on the issuer, together with the preliminary prospectus
   • C.Confirm a sale at the anticipated public offering price and deliver the final prospectus later
   • D.Accept the customer's order and hold the funds in escrow until the effective date

   During the cooling-off period no offers to sell and no sales may be made. The only permitted activities are distributing the preliminary prospectus (red herring), which omits the final public offering price and the effective date, and accepting non-binding indications of interest; no money and no orders may be accepted, and research on the issuer may not be pushed out as part of the selling effort. Sales and confirmations occur only after the registration is effective, accompanied by a final prospectus.

   Source: Securities Act of 1933, Section 5Report a problem with this question

2. 2. Which of the following is an exempt security under the Securities Act of 1933, rather than a security sold in an exempt transaction?

   • A.Restricted stock resold to qualified institutional buyers under Rule 144A
   • B.Common stock sold to accredited investors in a Regulation D private placement
   • C.Shares sold only to residents of the issuer's home state under Rule 147
   • D.A general obligation bond issued by a state✓ Answer

   With an exempt security the exemption attaches to the instrument itself: municipal and U.S. government securities never require registration, no matter who sells them or to whom. The other three are exempt transactions — ordinary registrable securities that escape registration only because of the manner of sale or the type of purchaser (private placement, resale to qualified institutional buyers, purely intrastate offering). In every case the exemption runs only to registration; the antifraud provisions still apply.

   Source: Securities Act of 1933, Section 3(a)(2) (exempt securities) and Section 4 (exempt transactions)Report a problem with this question

3. 3. An issuer wants to advertise a private placement on a public website and solicit investors generally. Under Regulation D, this is permitted only if which condition is met?

   • A.Every purchaser is an accredited investor and the issuer takes reasonable steps to verify accredited status✓ Answer
   • B.No more than 35 non-accredited but sophisticated investors purchase in the offering
   • C.Every purchaser agrees in writing to hold the securities for at least six months before reselling
   • D.The issuer first files a registration statement with the SEC and waits for it to become effective

   Rule 506(b) forbids general solicitation and advertising but tolerates a limited number of non-accredited sophisticated purchasers. Rule 506(c) makes the opposite trade: general solicitation and advertising are allowed, but every single purchaser must be an accredited investor and the issuer may not rely on a purchaser's self-certification alone — it must take reasonable steps to verify accredited status, such as reviewing income or asset documentation or obtaining a third-party confirmation.

   Source: SEC Regulation D, Rule 506(c)Report a problem with this question

4. 4. An affiliate of a reporting issuer has held restricted stock for more than one year and now wants to sell. The issuer has 6,000,000 shares outstanding, and reported trading volume for the four most recent calendar weeks was 70,000, 60,000, 50,000 and 40,000 shares. Under Rule 144, what is the maximum number of shares she may sell?

   • A.115,000 shares
   • B.40,000 shares
   • C.60,000 shares✓ Answer
   • D.55,000 shares

   Rule 144 limits an affiliate's sales in any 90-day period to the greater of 1% of the shares outstanding or the average weekly trading volume for the four calendar weeks preceding the notice of sale. One percent of 6,000,000 is 60,000 shares; the four-week average is (70,000 + 60,000 + 50,000 + 40,000) divided by 4, or 55,000 shares. The greater figure, 60,000 shares, controls. Satisfying the holding period does not free an affiliate from the volume limitation, which applies for as long as the seller remains an affiliate.

   Source: SEC Rule 144Report a problem with this question

5. 5. Which statement correctly describes an intrastate offering structured under Rule 147?

   • A.The issuer must be resident and doing business in the state, every purchaser must be a resident of that state, and resales to out-of-state persons are restricted for six months after the sale✓ Answer
   • B.The issuer need only be incorporated in one state; it may then sell to residents of any state
   • C.Because the offering is exempt from federal registration, it is automatically exempt from state registration as well
   • D.Only accredited investors residing in the state may purchase the securities

   The intrastate exemption rests on the offering being genuinely local. The issuer must both reside in and do business within the state, all offers and sales must go to residents of that state, and a resale limitation of six months preserves the local character of the distribution so the exemption is not used as a conduit to interstate investors. The federal exemption says nothing about state law: the offering must still be registered or exempted under the state's own blue-sky statute.

   Source: SEC Rule 147; Securities Act of 1933, Section 3(a)(11)Report a problem with this question

6. 6. A representative selling municipal revenue bonds knowingly misstates the issue's debt service coverage in order to close a sale. Municipal securities are exempt from registration under the Securities Act of 1933. Which statement is correct?

   • A.The antifraud provisions of the Securities Exchange Act of 1934, including Rule 10b-5, still apply; the exemption runs only to registration✓ Answer
   • B.Only the MSRB may act on the misstatement; the SEC has no authority over municipal securities
   • C.No federal securities law liability arises, because municipal securities are exempt securities
   • D.The antifraud provisions apply only to sales made in a primary offering, not in the secondary market

   An exemption from registration is not an exemption from fraud liability. Rule 10b-5 reaches any manipulative or deceptive device used in connection with the purchase or sale of any security, registered or exempt, in any market. That is why municipal and government securities dealers remain fully answerable to the SEC for misrepresentations. The MSRB, by contrast, writes rules but conducts no enforcement of its own.

   Source: Securities Exchange Act of 1934, Section 10(b) and SEC Rule 10b-5Report a problem with this question

7. 7. Representatives at two different firms agree to buy and sell the same thinly traded stock between themselves at successively higher prices, with no real change in beneficial ownership, in order to create the appearance of active trading. This conduct is best described as:

   • A.A permitted stabilizing bid entered by a syndicate manager
   • B.Interpositioning of a third party between the customer and the best market
   • C.A permitted riskless principal transaction
   • D.Matched orders used to paint the tape, a manipulative practice prohibited by the Securities Exchange Act of 1934✓ Answer

   Matched orders are prearranged trades that produce reported volume and rising prices without any genuine transfer of beneficial ownership; running a series of them to make a security look active is painting the tape. Both are manipulative devices expressly prohibited, because the price signal they create is fabricated rather than the product of real supply and demand. Riskless principal trades, stabilizing bids and interpositioning are separate concepts, and stabilization is permitted only within strict limits by a syndicate manager during a distribution.

   Source: Securities Exchange Act of 1934, Section 9(a)Report a problem with this question

8. 8. A representative learns that his firm is about to execute a large block purchase order for an institutional customer, information that is not yet public. Before the block is executed, he buys call options on that stock for his own account. This conduct is:

   • A.Permitted, because an option is a different security from the underlying stock
   • B.Permitted, so long as he discloses the personal trade to compliance afterward
   • C.Permitted, provided the block order was unsolicited by the firm
   • D.Prohibited front-running, because trading ahead of an imminent block transaction extends to related options and other derivatives, not just the underlying stock✓ Answer

   Front-running is trading for one's own or the firm's benefit while in possession of material, non-public information about an imminent block transaction that is likely to move the price. The prohibition deliberately covers options, convertibles and other derivatives of the subject security, so switching instruments does not cure the violation, and after-the-fact disclosure does not either. The customer's order information belongs to the customer, and using it first is a breach of that duty.

   Source: FINRA Rule 5270 (Front Running of Block Transactions)Report a problem with this question

9. 9. An attorney working on an unannounced merger tells his brother-in-law about it, and the brother-in-law buys the target company's stock before the announcement. The attorney is not an officer, director or shareholder of either company. Under federal insider trading law:

   • A.Only the brother-in-law is liable, because only he traded
   • B.Both may be liable: under the misappropriation theory the attorney breached a duty to the source of the information, and a tippee who knew or should have known of that breach is liable as well✓ Answer
   • C.Liability attaches only if the attorney received a cash payment for the information
   • D.Neither is liable, because the attorney owed no duty to the issuer's shareholders

   Insider trading liability does not require being a classic insider of the issuer. Under the misappropriation theory, a person who takes confidential information entrusted to him and uses or passes it on in breach of a duty owed to the source — here the law firm and its client — violates the antifraud provisions. The tipper is answerable for the tippee's trades, and the tippee is liable when he knew or had reason to know the information came from a breach of duty; a cash payment is not required, since a gift of information to a relative supplies the necessary personal benefit.

   Source: SEC Rule 10b-5; misappropriation theory, United States v. O'HaganReport a problem with this question

10. 10. A retail representative is told by a colleague in his firm's investment banking department that a corporate client will announce a takeover next week. What should the representative do?

    • A.Wait 24 hours and then buy the stock for his own account only
    • B.Recommend the stock, since he did not receive the information directly from the issuer
    • C.Recommend the stock only to his largest customers, who are sophisticated investors
    • D.Report to compliance that he received the information, and neither trade the security for any account nor recommend it✓ Answer

    Broker-dealers are required by law to maintain and enforce written policies reasonably designed to prevent the misuse of material, non-public information; information barriers, watch lists and restricted lists exist precisely to keep such information from crossing from the investment banking side to the sales side. A representative who nonetheless receives it must escalate to compliance and abstain entirely — the duty attaches to the information, so passing it to customers as a recommendation is itself tipping, and waiting a fixed period does not make the information public.

    Source: Securities Exchange Act of 1934, Section 15(g); FINRA Rule 3110Report a problem with this question

11. 11. A customer's broker-dealer fails and is placed in liquidation. Which statement best describes SIPC protection?

    • A.It insures the customer's principal against any decline in the value of the account
    • B.It is a federal government agency whose payments carry the full faith and credit of the United States
    • C.It covers every asset held at the firm, including commodity futures contracts
    • D.It replaces missing customer securities and cash held at the failed firm, up to statutory limits, but does not reimburse losses caused by a decline in market value✓ Answer

    SIPC addresses custody risk, not market risk: it steps in when a member broker-dealer fails and customer securities or cash are missing, restoring positions up to the statutory limits. It is a non-profit membership corporation created by Congress, not a government agency, and it carries no federal guarantee. Losses from a security simply falling in price, and commodity futures positions, fall outside its protection.

    Source: Securities Investor Protection Act of 1970Report a problem with this question

12. 12. Under the Investment Company Act of 1940, a registered open-end management investment company that wants to change its stated investment objective must:

    • A.Obtain the prior approval of the SEC
    • B.Simply notify shareholders in a prospectus supplement 30 days in advance
    • C.Obtain the approval of a majority of the fund's non-interested (independent) directors only
    • D.Obtain the approval of a majority of its outstanding voting securities✓ Answer

    A fund's stated investment objective is a fundamental policy on which shareholders relied when they invested, so the Act reserves the decision to them: it may be changed only by a vote of a majority of the outstanding voting securities. Directors, including independent directors, approve advisory contracts and distribution plans, but they cannot rewrite a fundamental policy on their own, and the SEC does not approve or endorse the merits of a fund's objective.

    Source: Investment Company Act of 1940, Section 13(a)Report a problem with this question

13. 13. A representative exercises de facto control over a retired customer's account whose stated objective is income. Over one year the account is turned over many times, generating commissions equal to a large share of the account's average equity, and positions are typically held only a few days. The most likely violation is:

    • A.No violation, because each individual trade was suitable when it was made
    • B.Failure to meet the reasonable-basis suitability obligation
    • C.A violation of the 5% policy on markups and commissions
    • D.Failure to meet the quantitative suitability obligation, that is, excessive trading in light of the customer's investment profile✓ Answer

    Quantitative suitability applies where a representative has actual or de facto control of an account and asks whether the series of transactions, taken together, is excessive given the customer's profile; turnover ratio, cost-to-equity ratio and in-and-out trading are the standard measures. Trades that each look defensible in isolation can still be excessive in the aggregate. Reasonable-basis suitability concerns whether a product is suitable for anyone at all, and the 5% policy is a guideline on the size of markups and commissions, not on how often an account is traded.

    Source: FINRA Rule 2111 (Suitability), quantitative suitability componentReport a problem with this question

14. 14. A representative is comparing two products for a retail customer. Both fit the customer's objective: one has a lower total cost, while the other's features better match the customer's stated liquidity needs and time horizon. Under Regulation Best Interest's Care Obligation, how should cost be treated?

    • A.Cost must always be considered but is never by itself decisive; the representative needs a reasonable basis to believe the recommendation is in the customer's best interest given the whole investment profile✓ Answer
    • B.The Care Obligation applies only to institutional customers, so cost is irrelevant here
    • C.Cost need not be weighed in the analysis as long as it is disclosed to the customer
    • D.The representative must always recommend the lower-cost product

    Regulation Best Interest applies to recommendations to retail customers, and its Care Obligation requires a reasonable basis to believe the recommendation is in that customer's best interest without placing the firm's interest ahead of the customer's. Cost is expressly a factor that must always be considered, but the rule is equally explicit that it is not the only relevant factor and is never automatically dispositive — liquidity needs, time horizon, risk tolerance and product features are weighed alongside it, so the cheaper product is not necessarily the right recommendation.

    Source: SEC Regulation Best Interest, Exchange Act Rule 15l-1 (Care Obligation)Report a problem with this question

15. 15. A broker-dealer runs a sales contest awarding a bonus to the representatives who sell the most of one specific proprietary product during a single quarter. Under Regulation Best Interest's Conflict of Interest Obligation, the firm must:

    • A.Eliminate the contest, because sales contests, quotas, bonuses and non-cash compensation based on the sale of specific securities within a limited period must be eliminated, not merely disclosed✓ Answer
    • B.Disclose the contest in the relationship summary and may then continue it
    • C.Do nothing, because Regulation Best Interest applies only to institutional accounts
    • D.Obtain written consent from each retail customer and may then continue it

    Most conflicts under Regulation Best Interest can be managed through disclosure or mitigation, but the rule singles out one category for outright elimination: sales contests, sales quotas, bonuses and non-cash compensation tied to the sale of specific securities or specific types of securities within a limited period. These create a direct incentive to put the firm's revenue ahead of the customer's interest, and the relationship summary is a disclosure document that cannot cure that conflict.

    Source: SEC Regulation Best Interest, Exchange Act Rule 15l-1 (Conflict of Interest Obligation)Report a problem with this question

16. 16. A firm prepares a piece describing a mutual fund and plans to send it to 400 retail investors over the coming month. Before the piece is used, the firm must:

    • A.File it with the SEC and wait for the SEC to approve it before first use
    • B.Do nothing, because a piece sent to individual investors is correspondence and needs no principal approval
    • C.Have an appropriately qualified registered principal approve it in writing before first use, and retain it with evidence of that approval✓ Answer
    • D.Obtain principal approval only if the piece contains performance figures or fund rankings

    A communication distributed or made available to more than 25 retail investors within any 30 calendar-day period is a retail communication; 25 or fewer is correspondence. Retail communications must be approved in writing by an appropriately qualified registered principal before first use, subject to narrow exceptions, and the firm must keep the piece together with the name of the approver and the dates of approval and use. Regulators review and can require changes to communications, but they never pre-approve or endorse them, and the approval requirement does not depend on whether performance data is included.

    Source: FINRA Rule 2210 (Communications with the Public)Report a problem with this question

17. 17. A representative agrees to raise money for a friend's real estate limited partnership offering away from his employing firm, and he will receive a finder's fee. Before participating, he must:

    • A.Give prior written notice to his firm and obtain the firm's written approval; if approved, the firm must record the transaction on its books and supervise it as if it were its own✓ Answer
    • B.Do nothing, because the partnership interests are not being sold through his firm
    • C.Notify the firm in writing after the first sale has been completed
    • D.Disclose it only as an outside business activity on his Form U4

    Participating in a securities transaction outside the regular course of employment is a private securities transaction — selling away — and requires prior written notice to the firm. Where the representative will receive compensation, the firm must approve or disapprove in writing, and if it approves it must record the transaction on its own books and records and supervise it as though it were a firm transaction. Notice of an outside business activity is a separate obligation and does not satisfy this requirement, and the fact that the offering does not run through the firm is precisely why the rule exists.

    Source: FINRA Rule 3280 (Private Securities Transactions); FINRA Rule 3270 (Outside Business Activities)Report a problem with this question

18. 18. Which of the following is permitted?

    • A.A representative borrows money from a retail customer who is neither an immediate family member nor in the business of lending, based on the customer's oral consent
    • B.A representative shares in the profits and losses of a joint account with a customer, with the firm's prior written authorization and in direct proportion to his own financial contribution✓ Answer
    • C.A representative guarantees a customer against loss on a recommended security, provided the guarantee is put in writing
    • D.A representative personally reimburses a customer for a trading loss to settle a complaint, without telling the firm

    Sharing in a customer's account is allowed only with the member's prior written authorization and only in direct proportion to the representative's own financial contribution, so he cannot take a disproportionate share of the gains. Guaranteeing a customer against loss is flatly prohibited because it misrepresents the risk of investing, borrowing from a customer is permitted only within narrow enumerated relationships and under the firm's written procedures and approval, and settling a complaint out of one's own pocket conceals the complaint from the firm's supervisory and reporting systems.

    Source: FINRA Rule 2150 (Improper Use of Customers' Securities or Funds; Sharing in Accounts); FINRA Rule 3240 (Borrowing From or Lending to Customers)Report a problem with this question

19. 19. A municipal finance professional at a dealer contributes $500 to the campaign of a mayor who appoints the officials that award municipal bond business. The professional is not entitled to vote for that mayor, and the contribution exceeds the de minimis amount the rule permits. Under MSRB rules, the consequence is:

    • A.A permanent bar on the dealer underwriting any municipal securities in that state
    • B.A ban that applies only to the individual professional, leaving the dealer's business unaffected
    • C.A two-year ban on the dealer engaging in negotiated municipal securities business with that issuer✓ Answer
    • D.No consequence, as long as the contribution is disclosed on the dealer's periodic filing

    The pay-to-play rule attributes the contribution to the dealer, not just to the individual, and triggers a two-year prohibition on negotiated municipal securities business with that issuer. The de minimis exception exists only for a modest contribution to an official for whom the professional is entitled to vote, which is not the case here. Competitively bid business is not captured, because a sealed-bid award cannot be influenced by the contribution, and disclosure on the quarterly filing records the contribution but does not cure the ban.

    Source: MSRB Rule G-37Report a problem with this question

20. 20. Which statement about the Municipal Securities Rulemaking Board (MSRB) is correct?

    • A.MSRB rules prohibit a dealer's personnel from giving anything of value to employees of another firm
    • B.The MSRB writes rules for municipal dealers and municipal advisors but has no enforcement authority; examination and enforcement are carried out by FINRA, the SEC and the bank regulators✓ Answer
    • C.The MSRB may fine, suspend or expel a dealer that violates its rules
    • D.MSRB rules apply directly to municipal issuers, requiring them to file audited financial statements

    The MSRB is a rulemaking body only. Its rules bind municipal securities dealers and municipal advisors, but examinations and disciplinary action are conducted by FINRA for broker-dealers, by the SEC, and by the federal bank regulators for bank dealers. The MSRB also has no direct authority over issuers, which is why continuing disclosure is imposed on issuers indirectly through the underwriters. And the gift rule does not ban gifts outright: occasional gifts and ordinary business entertainment are permitted, subject to the annual limit the rule sets on gifts related to the recipient's business.

    Source: Securities Exchange Act of 1934, Section 15B; MSRB Rule G-20Report a problem with this question

21. 21. When opening a new account for an individual, a firm's customer identification program requires the firm, at a minimum, to:

    • A.Obtain the customer's name, employer, net worth and a copy of the most recent tax return
    • B.Obtain only the customer's name and address, and complete verification within 24 hours before the first trade
    • C.Obtain a government-issued photo identification, because documentary evidence is the only permitted method of verification
    • D.Obtain the customer's name, date of birth, a physical street address (a post office box alone is not acceptable) and a taxpayer identification number, and verify identity within a reasonable time✓ Answer

    A customer identification program must collect four items for a natural person — name, date of birth, a residential or business street address, and a taxpayer identification number — because a post office box alone gives no verifiable location. Identity must be verified within a reasonable time before or after the account is opened, and the firm may use documentary methods, non-documentary methods such as database checks, or both. Net worth, objectives and employment details are suitability and know-your-customer information; they serve a different purpose and do not substitute for the identification items.

    Source: USA PATRIOT Act Section 326; 31 CFR Chapter X customer identification program rulesReport a problem with this question

22. 22. A customer makes a series of cash deposits on consecutive days, each just below the amount that would trigger a currency transaction report. The representative should:

    • A.File the suspicious activity report himself and give the customer a copy for his records
    • B.Escalate the pattern to the firm's anti-money-laundering compliance officer so a suspicious activity report can be evaluated and filed, and must not tell the customer that such a report is being considered or filed✓ Answer
    • C.Take no action, because each individual deposit is below the reporting threshold
    • D.Suggest that the customer combine the deposits into a single transaction to simplify the paperwork

    Deliberately breaking cash transactions into smaller amounts to stay under a reporting threshold is structuring, which is itself a federal offense, and the pattern — not the size of any single deposit — is what makes it suspicious. Every member firm must maintain an anti-money-laundering program, and reports of suspicious activity are filed by the firm through its designated compliance officer, not by the representative individually. Tipping off the customer that a report is being considered or has been filed is prohibited, because it would defeat the investigation, and helping the customer restructure the deposits would make the representative a participant.

    Source: Bank Secrecy Act; USA PATRIOT Act; FINRA Rule 3310 (Anti-Money Laundering Compliance Program)Report a problem with this question

Practice questions based on the FINRA Series 7 content outline and on named federal securities statutes and FINRA, MSRB and SEC rules. Not affiliated with or endorsed by FINRA, and not investment advice. Amounts that are re-set periodically — rates, fee schedules, contribution limits and penalty amounts — are deliberately kept out of the answers; where a computation needs such a figure, the question supplies it. Confirm current requirements with FINRA and your firm before testing. About the Series 7 exam (FINRA) →