Series 65 Prohibited Practices Practice Questions
Question 1
Which of the following fact patterns would MOST strongly support a regulatory finding that an investment adviser representative churned a client's advisory account?
- A. The account had high turnover, but the client had directed, in writing, an active short-term trading strategy consistent with that turnover
- B. The representative exercised de facto control over trading in the account and generated a volume of transactions excessive in light of the client's investment objectives, financial resources, and risk profile
- C. The account underperformed its benchmark during a broad market downturn despite low turnover
- D. The client paid an asset-based wrap fee rather than per-trade commissions
Show answer and explanation
Correct answer: B. The representative exercised de facto control over trading in the account and generated a volume of transactions excessive in light of the client's investment objectives, financial resources, and risk profile
Churning requires (1) control over the account by the adviser/representative (whether through discretion or de facto control over a non-discretionary account), and (2) trading that is excessive in size or frequency in light of the client's objectives, financial situation, and resources — generally undertaken to benefit the representative rather than the client. Choice B captures both required elements. High turnover consistent with the client's own directed strategy (A) is not churning; poor performance alone (C) does not establish churning without excessive/inappropriate trading; and a flat asset-based fee (D) removes much of the transaction-based financial incentive that typically motivates churning, making it a less (not more) supportive fact.
- A. Incorrect — trading consistent with the client's own written instructions is not churning, even if turnover is high.
- B. Correct — control plus trading excessive relative to the client's objectives/resources is the textbook definition of churning.
- C. Incorrect — poor performance during a downturn, without excessive trading, does not by itself establish churning.
- D. Incorrect — an asset-based wrap fee reduces the incentive to over-trade for commissions, making churning less likely to be supported by this fact, not more.
Question 2
An IAR recommends a highly leveraged, complex inverse exchange-traded note as a core, long-term buy-and-hold holding for a 78-year-old retired client whose stated primary objective is capital preservation and modest income. The IAR did not analyze how the product's daily-reset mechanics would perform over a multi-year holding period. This most clearly reflects:
- A. A reasonable-basis suitability violation, since the IAR lacked adequate grounds to believe the recommendation was appropriate for this client's objectives and the product's actual characteristics
- B. A permissible recommendation, since leveraged and inverse products are suitable for any client who seeks growth, including as a long-term core holding
- C. A customer-specific suitability issue, because the product is sound but its risk level does not match the client's profile; the IAR's product analysis is not at issue
- D. No violation, as long as the client signs a risk acknowledgment form and the IAR documents that the product's daily-reset features were disclosed
Show answer and explanation
Correct answer: A. A reasonable-basis suitability violation, since the IAR lacked adequate grounds to believe the recommendation was appropriate for this client's objectives and the product's actual characteristics
This scenario reflects a reasonable-basis problem — the IAR didn't understand the product's daily-reset/decay mechanics well enough to have a reasonable basis for recommending it as a long-term hold at all — layered on top of a customer-specific mismatch, since leveraged/inverse products are broadly unsuited to buy-and-hold retirees seeking capital preservation. A best captures the IAR's failure to have adequate grounds for the recommendation in the first place. B mischaracterizes leveraged products as universally suitable for growth-seekers, ignoring their structural unsuitability for long holds; C wrongly denies the clear reasonable-basis failure; D treats a signed disclosure form as a cure, which it is not.
- A. Because the IAR didn't understand or analyze how a daily-reset leveraged inverse product would behave over a multi-year hold — and recommended it as a core holding for a capital-preservation client — the IAR lacked adequate grounds to believe the recommendation was appropriate, which is a reasonable-basis suitability failure.
- B. Leveraged and inverse products are not suitable as long-term core holdings for just any growth seeker, and this client's objective was capital preservation and income.
- C. The IAR failed to analyze the product's daily-reset behavior over a multi-year hold, which is a reasonable-basis problem in addition to any client-specific mismatch.
- D. A signed acknowledgment and documented disclosure do not cure a recommendation made without adequate understanding of the product or fit for the client.
Question 3
A long-standing advisory client, out of the blue, asks the IAR to help wire a large sum to an overseas account the client has never used before, is evasive about the purpose of the transfer, and pressures the IAR to process it same-day. From an anti-money-laundering standpoint, the IAR's most appropriate response is to:
- A. Process the wire immediately since the client has an established, trusted relationship with the firm
- B. Recognize this as a red flag warranting additional due diligence and escalation per the firm's AML policies before proceeding
- C. Ignore it, since AML obligations never apply to advisory relationships
- D. Refuse to ever work with the client again without any further inquiry
Show answer and explanation
Correct answer: B. Recognize this as a red flag warranting additional due diligence and escalation per the firm's AML policies before proceeding
Red flags for potential money laundering or fraud — unusual urgency, a new unexplained destination, evasiveness about purpose — warrant heightened scrutiny and escalation under a firm's AML/suspicious activity policies, regardless of how long-standing the client relationship seems. A wrongly assumes tenure neutralizes red flags; C understates that firms maintain relevant AML-related policies; D overreacts without any investigative step.
- A. Processing the wire simply because of a long relationship ignores the classic AML red flags present (unusual destination, evasiveness, time pressure) and would be an inappropriate response.
- B. The unusual destination, evasiveness about purpose, and pressure for same-day processing are textbook AML red flags that call for additional due diligence and escalation under the firm's AML procedures before acting — the correct answer.
- C. AML obligations do apply to advisory relationships and firms handling client funds; this statement is factually wrong.
- D. Cutting off the client without any inquiry or escalation skips the required due-diligence and reporting steps and is an overreaction, not the appropriate first response.
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An IAR notices that an elderly client, previously very engaged and detail-oriented, has recently begun authorizing unusually large, rapid disbursements to a new acquaintance the client mentions only vaguely, and seems confused when asked routine questions about the transactions. Under provisions modeled on NASAA's protection of vulnerable adults, the firm may:
- A. Do nothing unless a court order is presented, because the firm must execute client disbursement instructions on receipt and has no authority to delay them
- B. Place a temporary hold on the disbursement while notifying a trusted contact person and, as appropriate, the relevant state agency (e.g., Adult Protective Services) and securities Administrator
- C. Liquidate the client's entire account at once and move the proceeds to a firm-controlled account for safekeeping, without notifying the client or any trusted contact
- D. Act when a family member submits a written request, after which it must obtain a court order before placing a hold on the disbursement
Show answer and explanation
Correct answer: B. Place a temporary hold on the disbursement while notifying a trusted contact person and, as appropriate, the relevant state agency (e.g., Adult Protective Services) and securities Administrator
Model provisions addressing financial exploitation of vulnerable adults permit a qualified individual at the firm to place a temporary hold on a suspicious disbursement, notify a previously designated trusted contact person, and report concerns to the appropriate state agency and/or securities Administrator — without waiting for a court order. A treats client instructions as absolute even facing exploitation red flags; C is an overreaction unsupported by the rule; D wrongly requires a family request as a precondition.
- A. Firms are not required to wait for a court order and do have authority to delay a disbursement temporarily when there is a reasonable belief of financial exploitation.
- B. Correct. Rules modeled on NASAA's vulnerable adult provisions permit a temporary hold on disbursements, notification of a trusted contact, and reporting to Adult Protective Services and the Administrator when exploitation is suspected.
- C. Liquidating the account and moving the proceeds without notice goes well beyond what is authorized and would itself be an inappropriate unilateral action.
- D. Action is not contingent on a family member's written request or on a court order; the firm may place a temporary hold based on its own reasonable belief of exploitation.