Clearly Erroneous Transactions in OTC Equity Securities

The OTC equity clearly erroneous rule looks like the exchange-listed clearly erroneous rule and differs in several places that get tested: what the term covers, the missing Normal Market Hours gate, how long the officer has, the second ground's guidelines condition, which table applies, the single bar on appeal, the unconditioned factor list, the missing multi-market coordination provision, and how rarely FINRA uses the power.

Which Securities Does This Review Cover?

For purposes of this rule, the term "OTC Equity Security" has the same meaning as in the OTC equity definitions, except that the term shall not include any equity security that is traded on any national securities exchange.

Following that definition through takes two more steps:

• The OTC equity definitions say an OTC Equity Security is any equity security that is not an NMS stock, a national market system stock, as that term is defined in the Regulation NMS definitions; provided, however, that the term shall not include any Restricted Equity Security.
• Those same definitions say a Restricted Equity Security is any equity security that meets the definition of "restricted security" in the restricted securities resale safe harbor, and the Regulation NMS definitions say an NMS stock means any NMS security other than an option.

Exam Tip: Gotchas

• This rule narrows the borrowed definition rather than adopting it whole. The OTC equity definitions already exclude NMS stocks, and this rule adds that an equity security traded on any national securities exchange is out as well.
• A restricted equity security sits outside the term entirely. That exclusion comes from the borrowed definition's own proviso, which points at the restricted securities resale safe harbor.

Who Reviews, on What Grounds, How Fast, and With What Appeal?

The reviewer is the same officer: an Executive Vice President of FINRA's Market Regulation Department or Transparency Services Department, or any officer designated by such Executive Vice President, acting on his or her own motion.

The scope sentence is wider than the exchange-listed one in a way worth memorising. It reaches any transaction involving an OTC Equity Security arising out of or reported through a trade reporting system owned or operated by FINRA or FINRA Regulation and authorized by the SEC. There is no Normal Market Hours gate to pass first.

The two grounds read almost the same. The officer may declare the transaction null and void where the transaction is clearly erroneous, or where such actions are necessary for the maintenance of a fair and orderly market or the protection of investors and the public interest.

The one difference sits at the end of the second ground. The exchange-listed rule requires the action to be consistent with the guidelines that rule sets out, and this rule states no such condition on that ground.

The timing is different. The officer shall take action as soon as possible after becoming aware of the transaction, but in all cases no later than the start of trading on the day following the date of the transactions at issue. This rule states no thirty-minute window at all.

Notice follows the familiar shape. If the officer declares any transaction null and void, each party involved shall be notified as soon as practicable by FINRA, and the party aggrieved by the action may appeal. The appeal runs under the Uniform Practice Code Committee appeal rule, which does carry a thirty-minute clock: a written appeal must be received by FINRA within thirty minutes after notification.

One bar sits on that appeal. The appeal right disappears where the officer making the determination also determines that the number of the affected transactions is such that immediate finality is necessary to maintain a fair and orderly market and to protect investors and the public interest.

Exam Tip: Gotchas

• The officer has no thirty-minute clock on the OTC equity side. The officer acts as soon as possible after becoming aware, with an outer limit at the start of trading on the following day.
• The appeal bar here turns on a second, separate determination. The officer must also determine that the number of affected transactions makes immediate finality necessary before the appeal right disappears.
• The scope sentence has no hours gate. Any transaction in an OTC Equity Security arising out of or reported through a qualifying FINRA system is within reach, whenever it was executed.

What Are the OTC Numerical Guidelines?

A transaction in an OTC Equity Security may be found to be clearly erroneous under this rule only if the execution price of the transaction is away from the Reference Price by an amount that equals or exceeds the guideline below. That Reference Price will generally be the prevailing market price just prior to the time of the trade.

In some instances the guidelines are based on a range, where the maximum percentage difference applies to the lower execution price in the range and the minimum percentage difference applies to the higher execution price in the range.

The rule states its own purpose for that design: the range is intended to smooth the percentage changes from tier to tier and allow for more gradual deviations.

Exam Tip: Gotchas

• The words "only if" make this a necessary condition, not a sufficient one. Meeting the guideline opens the door to a finding of clearly erroneous; it does not compel one.
• Inside a range tier the larger percentage attaches to the cheaper execution. The maximum percentage difference applies to the lower execution price and the minimum to the higher.
• The OTC table has seven price tiers against the exchange-listed table's three price bands. The two tables are not interchangeable, and they are keyed to different Reference Prices.

When Can FINRA Use a Different Reference Price?

In unusual circumstances, which may include periods of extreme market volatility, sustained illiquidity, or widespread system issues, FINRA may use a Reference Price other than the prevailing market price just prior to the time of the trade.

That discretion carries a stated standard. FINRA exercises it in its discretion and with a view toward maintaining a fair and orderly market and the protection of investors and the public interest.

Other Reference Prices may include the consolidated inside price, the consolidated opening price, the consolidated prior close, or the consolidated last sale prior to a series of executions.

Exam Tip: Gotchas

• Both lists in this provision are open. The unusual circumstances "may include" the three named, and the alternative Reference Prices "may include" the four named.
• Nothing here mirrors the exchange-listed coordination machinery. This provision is FINRA's own discretion over the Reference Price, with no review period negotiated with other markets.

What Additional Factors Can the Officer Consider?

A FINRA officer may also consider additional factors to determine whether a transaction is clearly erroneous. The list is introduced as "including but not limited to," and it names the same twelve factors set out in this unit's lesson on reviewability and the two price yardsticks.

Two limits the exchange-listed version carries are missing here. This provision has no exception for a Multi-Stock Event involving five or more securities, and no proviso confining the factors to executions outside Normal Market Hours or eligible under a during-hours gateway.

Each additional factor shall be considered with a view toward maintaining a fair and orderly market and the protection of investors and the public interest.

Exam Tip: Gotchas

• The OTC equity factor list is unconditioned. The exchange-listed version switches off inside a Multi-Stock Event of five or more securities and is limited to outside-hours or gateway-one executions, and this one carries neither limit.
• The closing standard is identical in both rules. Each additional factor is considered with a view toward maintaining a fair and orderly market and the protection of investors and the public interest.

How Often Does FINRA Actually Use This Authority?

With respect to OTC Equity Securities in particular, FINRA historically has applied its clearly erroneous authority in only very limited circumstances. The example the rule gives is an extraordinary event that has had a material effect on the market for the security, where cancelling trades is necessary to protect investors and ensure a fair and orderly marketplace.

As a result, in the vast majority of situations relating to OTC Equity Securities, FINRA does not expect to use its clearly erroneous authority. It expects the parties to settle any dispute privately.

Exam Tip: Gotchas

• The default outcome on the OTC equity side is a private settlement. FINRA states that it expects the parties to settle any dispute privately in the vast majority of situations.

What Should You Check on Exam Day?

• Confirm the security qualifies: not an NMS stock, not a restricted equity security, and not traded on any national securities exchange.
• Drop the hours test here. This rule reaches any qualifying transaction, whenever executed, with an outer deadline at the start of trading the following day.
• Read a range tier correctly. The maximum percentage applies at the low end of the price range and the minimum percentage at the high end.
• Check whether the appeal bar applies. The officer must also determine that the number of affected transactions makes immediate finality necessary.
• Expect the answer that FINRA does not act in the vast majority of situations. It applies this authority in only very limited circumstances and expects private settlement.