This is from Sample Exam 1, Morning Session, Schwesser 2006. I have cut out filler information. X is a retail stock broker … X notices that one client in particular, Y is particualrly adept at picking undervalued stocks. X decides to watch Y’s trades and mimic them in his own account. X: A) is in violation of Standard VI(B) - Priority of Transactions because he is front running the client’s account B) Clearly wrong C) is not in violation of any Standards D) Clearly wrong Correct answer is (A). Why is this? The problem formulation states ‘mimics’ and does not state anything close to ‘front running.’ Since I am new, I am very confused about this. Thank you, Daniel
Front running is a stock broker’s illegal action of executing an order for his own account before executing orders received from his clients. By mimicking his client’s investment decisions, he is buying the same stocks that his client is buying, most probably ahead of his client - otherwise a client’s buy order would drive the price of the security up which would make it unattractive for his own portfolio.
Thanks map1. But I just don’t see where in the problem formulation it stated the order of the trades. When do we assume information in the ethics problems?
Well, this is not indicated, but it does make sense. Would the analyst buy a security for his own portfolio when its price is higher or when it is lower? of course, when the price is lower. When does it happen? before the execution of the client’s order, because client’s buy order would drive the price of the security up. It makes no sense for the analyst to buy the security after, mimicking the client’s investment decisions, because the security would be priced higher.
I fully understand the concept of front running…but this isn’t it. By the very nature of the question it requires that X trades after Y. How do you mimic a trade if you don’t know what the security is? You don’t. Though if B and D are “clearly wrong” I would be forced to pick A on the basis of “best” answer.
The client investing in undervalued stock cannot trade by himself, he needs to place his order with the stock broker, and this is how the stock broker finds in what stocks his client wants to invest and acts on his own portfolio, by mimicking, before executing the client’s order.