FINRA is requesting comment on a new proposed rule that would govern the markups, markdowns, commissions and fees charged by its member brokers and dealers.1
While much of proposed FINRA Rule 2121 is consistent with NASD Rule 2440, NASD IM-2440-1 and NYSE Rule 375 (which Rule 2121 is proposed to replace), there are a number of significant proposed alterations. Among these are:
Elimination of the ‘5 Percent Policy.’ The current 5 percent policy (relating to the maximum markup or spread that can be charged by a FINRA member without special justification) is based on a 1943 survey of the FINRA (then NASD) membership. The NASD Board had determined that in most transactions, markups of 5 percent or less would fall within the “fair and reasonable” standard and adopted the “5 Percent Policy” as guidance. While the later NASD IM-2440-1(a)(4) stated that a markup pattern of 5 percent (or even less) could be considered unfair or unreasonable under applicable rules, in general, 5 percent was viewed as a sort of safe harbor in the investment community.
Regulatory Notice 11-08 notes that “[t]he ‘5 Percent Policy’ is viewed by many as establishing a presumption that markups, markdowns and commissions in excess of 5 percent are prohibited, or, at best, are subject to additional scrutiny, requiring the firm to provide more justification to prove that such remuneration is not ‘excessive.’ Conversely, the ‘5 Percent Policy’ is also viewed by many as establishing a specific ceiling or cap below which most markups, markdowns or commissions will not be viewed as excessive (or will not be questioned).” FINRA notes that, according to a recent study, the mean markup charged by brokers is 2.2 percent, the average markup is 2 percent, the mean markdown is 1.9 percent and the average markdown is 1.3 percent.
FINRA does not propose a new policy based upon a lower percentage. Instead, FINRA is proposing to require an analysis using the same basic factors previously set forth in IM-2440-1, which involve a consideration of:
- the type of security involved
- the availability of the security in the market
- the price of the security
- the amount of money involved in a transaction
- the disclosure made
- the pattern of markups, and
- the nature of the firm’s business.
The exact wording and analysis that must be applied to each of the seven factors would not be identical to what currently exists under IM-2440-1. For example, the statement “[a] member may not justify mark-ups on the basis of expenses which are excessive” would change to “[a] member may consider its expenses, but shall not justify markups, markdowns, or commissions on the basis of expenses that are excessive.”2
FINRA has stated that this analysis would “not allow a member to factor into such charges realized and unrealized market losses on securities that a member holds or has held in inventory” and proposes to substitute for the guidance in current NASD IM-2440-1(a)(3), which currently provides: “In the absence of other bona fide evidence of the prevailing market, a member’s own contemporaneous cost is the best indication of the prevailing market price of a security.” The proposal takes a slightly different approach using the following language: “For a markup, a member’s own contemporaneous cost is the best indication of the prevailing market price of a security, and for a markdown, a member’s own contemporaneous proceeds are the best indication of the prevailing market price of a security, unless other bona fide, more credible evidence of the prevailing market price can be evidenced.”
Additionally, the proposal would eliminate the “proceeds provision” of IM-2440-1(c)(5) concerning total remuneration in connection with a sale and related purchase. Currently, when a customer sells one security and buys a second security at the same time, using the proceeds of the securities position liquidated to pay for the second position, the “proceeds provision” requires that both trades be treated as a single transaction for markup, markdown or commission purposes. FINRA proposes to eliminate this interpretation as it has determined the policy is “confusing and raises concerns that it represents a standard that may not be susceptible to consistent application.” For example, it is not always clear if two transactions are actually related or how close in time transactions must be to be considered “proceeds” transactions.
Pepper Point: This proposed change may increase the maximum allowable commissions in certain instances.
Please note: As proposed, Rule 2121(d) is not applicable to all transactions (although, if adopted, the 5 percent “safe harbor” would be gone). A Rule 2121(d) analysis would not be required for sales of a security where a prospectus or offering circular must be delivered (not in optional situations where a prospectus may be delivered) and the securities are sold at the specific public offering price (NASD IM-2440-1(d)). Transactions “with a qualified institutional buyer (QIB) that meets the conditions of Rule 2122(b)(9)” are also exempt.3
Pepper Point: FINRA notes that “[i]n lieu of stating in proposed FINRA Rule 2121 that a markup, markdown or commission of less than a specified amount or percentage, such as 3 percent or 3.5 percent, may not be excessive, FINRA expects to provide guidance in a Regulatory Notice that markups, markdowns and commissions above certain specified percentages will be subject to additional regulatory scrutiny, requiring members to provide additional justification to establish that such markups, markdowns, and commissions are not excessive.” While it is unclear that such an action will actually be taken by FINRA, given that the 5 percent “rule of thumb” standard existed for more than 60 years, it is likely that a number of brokers may now adopt the 3 percent figure as a new “rule of thumb.”
Retail Customer Commission Schedules. The proposed rule would also require a member to establish and make available to retail customers the schedule(s) of standard commission charges for transactions in equity (but not debt) securities. Under FINRA standards,4 a “retail investor” would include any party other than an institutional investor.
A member would be allowed to establish and publish multiple schedules of standard commission charges, as long as the member discloses in or with the schedule(s) how the commissions are stratified among all retail customers.
Pepper Point: The proposed rule would not prevent a member from negotiating lower commission rates with retail customers provided that it discloses that it may do so from time to time.
A member would be required to provide in writing (which may be electronic) the schedule(s) of commissions to new retail customers at the opening of an account, and to ALL retail customers at least once every calendar year. In addition, a member would be required to provide in writing (which may be electronic) any amendments to the schedule(s) of commissions (including any new forms of commissions or new disclosures) to all retail customers at least 30 days prior to imposing any change in the commissions set forth in the schedules or any new forms of commission charges for retail customers. Alternatively, a member would be permitted to make available to retail customers its schedule(s) of standard commission charges applicable to retail customers by posting them on its Web site if the member provides written notice (which may be electronic) to new retail customers at the opening of an account, and all retail customers at least once every calendar year, of the manner in which they may access the commission schedules, and that, upon a retail customer’s request, the member will provide a copy of the commission schedules to the customer. In such case, a member also would be required to provide written notice (which may be electronic) to all retail customers at least 30 days prior to imposing any change in the commissions set forth in the schedules or any new forms of commission charges for retail customers.
‘Missing the Market’ and Consent to Commission Charge. FINRA proposes to incorporate the substantive requirements of NYSE Rule 375 into Rule 2121(f). If a member has accepted the order for execution in an agent capacity but ultimately fulfills the order from its own account as principal (whether due to neglect or for any other reason), no commission can be charged on that trade without the customer’s knowledge and consent.
1 FINRA Regulatory Notice 11-08 available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122918.pdf.
2 See http://www.finra.org/web/groups/industry/documents/industry/p122920.pdf for specific proposed textual changes.
3 The QIB exemption would not simply mean that a broker can operate outside Rule 2121(b) when dealing with a QIB as defined in Securities Act Rule 144A. The exemption is only available if the QIB is purchasing or selling a “non-investment grade debt security” when the dealer has determined, after considering certain factors, that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction. “[N]on-investment grade debt security” means a debt security that: (i) if rated by only one nationally recognized statistical rating organization (NRSRO), is rated lower than one of the four highest generic rating categories; (ii) if rated by more than one NRSRO, is rated lower than one of the four highest generic rating categories by any of the NRSROs; or (iii) if unrated, either was analyzed as a non-investment grade debt security by the dealer and the dealer retains credit evaluation documentation and demonstrates to FINRA (using credit evaluation or other demonstrable criteria) that the credit quality of the security is, in fact, equivalent to a non-investment grade debt security, or was initially offered and sold and continues to be offered and sold pursuant to an exemption from registration under the Securities Act [of 1933].”
4 FINRA generally considers the “retail customer” to mean a customer that does not qualify as an institutional account under NASD Rule 311(c)(4). The definition of “institutional account” under that rule consists of a bank, savings and loan, insurance company, registered investment company, registered investment adviser or any entity (which includes natural persons) with total assets of at least $50 million.
Gregory J. Nowak and Matthew R. Silver