In an unusual about face, FINRA issued Regulatory Notice 13-07 (“RN 13-07”) on January 31, 2013 requesting comment on whether it should retain the 5% markup policy in NASD IM-2440-1 (the “Markup Policy”) that it had just sought to eliminate in its Request for Comment in February 2011.1
While issuing a Request for Comment reversing a prior Request for Comment is remarkable on its face, it is even more remarkable that in issuing RN 13-07, FINRA is taking the position that even though the new FINRA Rule 2121 would retain the Markup Policy, firms should not believe that it is establishing a specific ceiling or cap below which most markups, markdowns or commissions will be viewed as not excessive (or will not otherwise be questioned by examination staff). Put another way, FINRA appears to be telling its members that despite the language of the rule itself, they are on notice that FINRA intends to target markups, markdowns and commissions charged on equity securities below the 5% “threshold” as excessive.
In addition to the Markup Policy, there are key differences in the Request for Comment and revised rule proposal that FINRA seeks approval for including their proposals to:
- Establish a rebuttable presumption that a markup, markdown or commission in excess of 5% is unfair and unreasonable;
- Modify the relevant factors that member firms should take into consideration in determining the fairness of a markup, markdown or commission to provide additional guidance and, in some instances, expand the scope of the factor;
- Delete previously proposed FINRA Rule 2121(e), a requirement that member firms provide commission schedule(s) for equity securities transactions to retail customers;
- Amend proposed FINRA Rule 2122 to update the criteria applicable to eligible qualified institutional buyers (“QIB”) purchasing or selling non-investment grade debt securities, whose transactions are excluded under the markup rules. The amendments would incorporate the standards regarding institutional suitability under FINRA Rule 2111;
- Amend proposed FINRA Rule 2123 to provide additional examples of charges and fees, including charges and fees for setting up a new account, research, customer portfolio analysis, tax advice, and calculation of required minimum distribution; and
- Amend FINRA Rule 0150 to extend the proposed markup rules to transactions in government securities as defined in Exchange Act Section 3(a)(42), but excluding U.S. Treasuries as defined in FINRA Rule 6710.
The 5 Percent Policy
In February 2011, FINRA proposed to eliminate the 5% policy.2 Under the 2011 proposal, FINRA sought to provide markup threshold guidance that would set forth quantitative guidance regarding markup, markdown and commission thresholds that would be subject to regulatory scrutiny. In a footnote in the 2011 proposal, FINRA suggested that in lieu of a policy specifying a specific percentage, perhaps 3 or 3.5 percent, FINRA expected to provide guidance through additional notices that markups/markdowns above certain percentages would be subject to additional scrutiny.
Apparently, FINRA interpreted comments from its initial proposal to mean that the industry wants the 5% policy to remain in effect. This, however, may be misguided. Industry participants may be accustomed to a 5% threshold under NASD IM-2440-1, because, other than being on the opposite side of an enforcement proceeding, it is the only concrete guidance that FINRA has issued.
FINRA, other than alleging that a Firm violated its own supervisory procedures on charging more than a certain percentage markup, has not brought enforcement actions against members for charging excessive markups of less than 5% for equity securities. The same is not true for markups in debt transactions. To this day, FINRA has not suggested thresholds that are acceptable in debt transactions other than to say it is a facts and circumstances test and that five percent is generally higher than average. In support of its position, FINRA routinely cites to a more than a quarter of a century old statement from the SEC that markups/markdowns in debt transactions are expected to be lower than in equity transactions. This view is outdated and does not consider changes in the debt markets over the last quarter century, nor the development of new debt products. More importantly, FINRA’s examination and enforcement program focuses on an arbitrary and non-transparent determination by the FINRA staff of what is an appropriate markup and presumes a violation for any markup that exceeds that amount.3 Unfortunately, this Staff-imposed ceiling can only be deduced when the member is on the other side of a potential enforcement action.4
The problem with eliminating the 5% guideline is that it removes certainty from a member’s supervisory procedures and it leaves the industry to an ever-changing and arbitrary determination of what appropriate markups should be. That being said, that standard was based on a study conducted in 1943. Technology, market structure and members’ costs have changed significantly since then, and 5% may not be an appropriate guideline for equity or debt transactions anymore. In fact, most equity transactions are effected with a markup of much less than 5%. Moreover, demands on FINRA have also increased and changed significantly, and its examiners must be provided with objective standards to conduct their reviews.
If FINRA is suggesting it may take actions for excessive markups below 5% in equity transactions, it would be a shame if FINRA provided this guidance only in the context of enforcement actions, as is currently the case for debt transactions.
Instead of flip-flopping between keeping or removing the 5% guideline, FINRA and the industry should work together in consideration of today’s market structure, fairness to customers, costs and regulatory demands to provide certainty and guidance to broker-dealers and their customers about what is an appropriate and fair charge for services. All relevant factors should be considered, including the accepted fact that the liquidity provided by broker-dealers is a valuable service and entitles them to make a reasonable profit.5
Expansion of Relevant Factors in NASD IM-2440-1(b)
In the initial proposal, FINRA proposed to transfer to FINRA Rule 2121(c) the non-exhaustive list of seven relevant factors in NASD IM-2440-1(b) that firms should take into consideration in determining if a markup, markdown or commission is fair and reasonable. Under the current proposal, FINRA seeks to modify three of these relevant factors. Notably, FINRA seeks to expand the guidance concerning the availability of the security in the market (NASD IM-2440-1(b)(2); the amount of money involved in a transaction (NASD IM-2440-1(b)(4); and the effect of disclosure (NASD -IM-2440-1(b)(5).
With respect to the availability of the security in the market (NASD IM-2440-1(b)(2)), FINRA seeks to expand this provision to provide that the effort and cost of buying or selling a security may be a factor in determining the amount of the markup if a security is: 1) difficult to locate; 2) is inactive or infrequently traded; 3) is subject to market liquidity restraints relative to the size of the transaction sought to be executed; or 4) if there are unusual circumstances connected with a security’s acquisition. With respect to the amount of money involved in a transaction provision (NASD IM-2440-1(b)(4)), FINRA seeks to add language that provides that a transaction that involves a large amount of money may warrant a lower percentage of markup, markdown, or commission if the expense of handling the transaction do not rise by virtue of the size of the transaction. However, in our experience, the qualitative factors listed in current IM-2440-1 and proposed Rule 2121(c) — in other words, the factors besides the raw percentage of the markup — have received little if any attention in the FINRA staff’s actual evaluation of markup cases. One hopes this disconnect between FINRA’s regulatory and enforcement staffs will be addressed once these new rules are in place.
As for the disclosure provision (NASD IM-2440-1(b)(4)), FINRA seeks to clarify that for disclosure to be considered in determining if a firm deals fairly with a customer, a firm must disclose the total dollar amount and percentage of the commission charged in an agency transaction, or the total dollar amount and percentage of markup or markdown made in a principal transaction to a customer before the transaction is affected. FINRA reiterates its prior position that disclosure itself does not justify a markup, markdown or commission that is unfair or unreasonable in light of all other relevant facts surrounding the transaction.
What is clear is that by returning to a 5% threshold, the FINRA Staff will continue to regulate markups by enforcement. What remains to be seen is whether, having abandoned any attempt at real guidance, they will actually entertain market-based arguments employing FINRA’s own proffered waterfall of relevant factors to be considered in determining a debt markup, or if they will continue to use TRACE and RTRS as if they were a tape reporting transactions in a two-sided market.6
Other Proposed Changes
As FINRA notes in the revised proposal, firms should carefully read all of the proposed revisions to the original proposal as well as the rule text; however, below are some other proposed changes that may be of particular interest to firms:
- FINRA continues to propose eliminating the “proceeds provision” in NASD IM-2440-1(c)(5) in the proposed markup rules.
- FINRA is deleting its request that firms establish and make available schedules of standard commission charges for transactions in equity securities.
- With respect to markups/markdowns for transactions in debt securities (except municipal securities) under proposed FINRA Rule 2122(b)(9), firms engaged in customer transactions that meeting certain conditions are not subject to the requirements governing markups and markdowns for such transactions. Those conditions are a) the transaction is effected with a QIB; b) the transaction involves a non-investment grade debt security; and c) the dealer has determined, after considering the factors aligned with the criterion with the standards regarding institutional suitability in FINRA Rule 2111.
- FINRA seeks to expand the examples of charges and fees for miscellaneous services performed as well as to modify the definition of retail customer that would require disclosure regarding charges and fees. Under the modified proposed definition, a retail customer would mean a customer that does not qualify as an “institutional account” under FINRA Rule 4512(c), except any natural person or any natural person advised by a registered investment adviser.
- FINRA seeks to amend FINRA Rule 0150 to extend the proposed markup rules to transactions in government securities, except U.S. Treasury securities (as defined in FINRA Rule 6710(p). Prior to this proposed amendment, FINRA Rule 0150 did not include the current markup rules resulting in FINRA having to enforce excessive markups, markdowns and commissions in transactions in exempted securities (other than municipal securities) under FINRA Rule 2010 (standards of commercial honor and principles of trade).
FINRA member firms should pay particular attention to this “about face” by FINRA on the 5% markup policy. The continued drumbeat from FINRA is that a threshold or benchmark for markups, markdowns and commissions may not be what it seems to firms; indeed, it might be a wolf in sheep’s clothing. The proposal signals to firms that retaining the 5% markup policy will not prevent FINRA from questioning markups, markdowns, and commissions that are far lower than that. Instead, FINRA and the industry should work together in consideration of today’s market structure, fairness to customers, costs and regulatory demands to provide guidance to broker-dealers and their customers about what is an appropriate and fair charge for services. Firms should consider filing comments, which are due on April Fools’ Day (April 1, 2013).
*This alert was co-authored by Elizabeth Baird, W. Hardy Callcott, Paul Tyrrell, Michael Wolk and Timothy Nagy.