FINRA, in Regulatory Notice 13-07, requested comment on a proposal to transfer and amend certain NASD and NYSE rules governing markups, commissions and fees as FINRA Rules 2121, 2122 and 2123 (“Markup Rules”). A version of the proposal was first published in Regulatory Notice 11-08. The amended text of the Markup Rules (which can be found here) reflects comments received on the original proposal.
Retention of the 5% Markup Policy
The current NASD markup rule generally requires member firms to charge fair fees, commissions, markups and markdowns in connection with securities transactions and related services. A long-time feature of the existing rule was the 5% markup policy, based on studies done in 1943 indicating that the large majority of customer transactions were executed at a price that reflected a markup of the price paid by the member firm of 5% or less. Following that study, it became the policy of the NASD that markups (and markdowns, where the member firm bought securities from its customer) in excess of 5% were considered unreasonable in the absence of special factors justifying a higher margin. However, transactions involving markups or markdowns of less than 5% could also be considered unreasonable depending on the circumstances.
In Regulatory Notice 11-08, FINRA proposed to delete the 5% policy and to provide a separate Regulatory Notice which would include quantitative guidance regarding markups, markdowns and commission thresholds that, if exceeded, would be subject to additional regulatory scrutiny. In response to comments, a majority of which opposed elimination of the 5% policy, FINRA determined to retain the policy in the revised proposal.
Amendments to Pricing Considerations and Factors
New Rule 2121 would contain the general considerations and factors applied in determining the fairness of prices currently found in NASD Rule 2440 and IM-2440-1 with some changes, including the following:
- Provisions that currently address factors to be considered in the case of markups (where the member sells securities to a customer) would be revised to address factors applying to markdowns as well.
- Rule 2121(b)(4) would provide that, “except in riskless principal trades or nearly contemporaneous trades in which a security is held in a member’s inventory very briefly, if a member sells a security to a customer from inventory, the amount of the markup would be determined on the basis of the markup over the bona fide representative current market price, and the profit or loss to the member from market appreciation or depreciation before, or after, the date of the transaction with the customer would not ordinarily enter into the determination of the amount or fairness of the markup.”
- Rule 2121(c)(2) would clarify that one of the factors to be considered in determining whether a higher markup is reasonable would be “if a security is difficult to locate or source, is inactive or infrequently traded, is subject to market liquidity restraints relative to the size of the transaction sought to be executed, or if there are any unusual circumstances connected with its acquisition or sale (e.g., the security was acquired through a foreign intermediary).”
- Rule 2121(c)(4) retains the guidance that a transaction involving a small amount of money may warrant a higher percentage markup, markdown or commission but adds that, conversely, a transaction that involves a large dollar amount may warrant a lower percentage markup, markdown or commission if the expenses of handling the transaction do not rise by virtue of the size of the transaction.
Transactions to Which the Policy is Not Applicable
Purchase of Securities with Proceeds of Sale. FINRA proposes to delete the list, in IM-2440-1, of transactions to which the policy is applicable. One of the categories of transactions on the deleted list is transactions where a customer sells securities to or through a member, the proceeds of which are used to pay for other securities purchased from or through the member. In those transactions, under IM-2440-1, the markup on the sale to the customer is computed as if the customer had paid in cash and the profits on the securities liquidated is added to the amount of the markup. In Regulatory Notice 13-07, FINRA states that the current provision should not be incorporated in the Markup Rules because “it includes a standard that is not susceptible to consistent and fair application.” Instead, FINRA considers that the more practical approach is to determine transaction remuneration on a fair basis for each transaction but to monitor customer accounts for churning.
Transaction with QIB in Non-Investment Grade Debt Security. The current policy excludes from its provisions the sale of securities in public offerings. FINRA proposes to add an additional exclusion for a transaction in a non-investment grade debt security with a qualified institutional buyer as defined in SEC Rule 144A (“QIB”) that meets the conditions in proposed Rule 2122(b)(9). Rule 2122(b)(9) would define “customer” as used in Rules 2121 and 2122 to exclude QIBs meeting certain conditions in transactions involving non-investment grade debt securities. Those conditions are similar to the suitability requirements for sales to institutional accounts under Rule 2111, requiring a reasonable basis to believe that the QIB is capable of evaluating investment risks independently, and an affirmative indication from the QIB that it is exercising independent judgment in deciding to enter into the transaction. Where the QIB has delegated decision-making authority to an agent, such as an investment adviser or bond trust department, these factors are applied to the agent.
Notice of “Missing the Market”
FINRA proposes to add a paragraph (e) to Rule 2121 to provide that “a member that accepts an order for execution as agent and, by reason of neglect to execute the order or otherwise, trades with the customer as principal, shall not charge the customer a commission, without the knowledge and consent of the customer.”
Schedules of Charges and Fees
New Rule 2123 (b) would require that members establish and make available to retail customers a schedule or schedules of charges and fees for services performed for retail customers, reflecting the standard charges and fees of the member for the services. If the member makes available more than one schedule, it would be required to disclose the manner in which the schedules apply to various types or classes of retail customers, accounts or services. If the member negotiates or intends to negotiate with any retail customer to reduce any charges or fees below those in the applicable schedule, it must disclose that it may charge some retail customers less than the amounts shown in the schedules. The Rule specifies that the schedules must be provided to customers (1) at the opening of the customer’s account, (2) at least once each calendar year and (3) in the event of changes, at least 30 days prior to the date such changes take effect. Alternatively, the member may make the schedules available on the member’s website, if it gives customers written notice that the schedules are available on its website at the times when it would have been required to provide schedules as described above.
In Regulatory Notice 11- 08, FINRA proposed to require member firms to establish and make available to retail customers schedules of standard commission charges for transactions in equity securities with retail customers. In response to comments received, FINRA has determined to delete that provision from the proposed Markup Rules. FINRA states that the charges and fees referred to in Rule 2123(b) are for services provided by a member firm that are not related to the execution of a transaction.
Application to Transactions in Government Securities
FINRA proposes to amend Rule 0150(c) to provide that Rules 2121, 2122 and 2123 apply to transactions in exempted securities, except that Rules 2121 and 2122 will apply only to government securities, excluding U.S. Treasury securities.
Request for Comments
FINRA has requested comments on the proposed Markup Rules. Comments are due on or before April 1, 2013.