Front Running of Block Transactions

The front-running rule is about market information rather than issuer information. Nothing about the company has changed; what the trader knows is that a large order is about to hit the book.

What Does the Front-Running Rule Prohibit?

No member or person associated with a member shall cause to be executed an order to buy or sell a security or a related financial instrument while that member or associated person has material, non-public market information concerning an imminent block transaction.

The information can concern the security itself, a related financial instrument, or a security underlying the related financial instrument. All three are named.

The prohibition runs only until one of two events happens. It ends when information concerning the block transaction has been made publicly available, or when it has otherwise become stale or obsolete.

Exam Tip: Gotchas

• Both actors are named. The rule binds a member or a person associated with a member, so an answer that limits it to the firm has dropped half the sentence.
• The information is market information, not issuer information. Knowing that a large order is coming is enough. No fact about the company's business needs to be involved.
• Two events end the prohibition, not one. Public availability is the first. Information that has otherwise become stale or obsolete is the second, and it stands on its own.
• The act is causing an order to be executed. Entering an order for someone else to execute is described as squarely as trading the position yourself.

Which Accounts Does the Front-Running Rule Reach?

The rule applies to orders caused to be executed for three categories of account, and the third carries a condition the first two do not.

Exam Tip: Gotchas

• A customer account is not covered merely because it is a customer account. The third category bites only where the firm or one of its associated persons passed the information to that customer or affiliate.
• The first two categories need no tip at all. An interest in the account, or discretion over it, is by itself enough to bring an order inside the rule.

What Is a Related Financial Instrument?

The rule defines the term across two limbs joined by "as well as", so both are inside it.

• The overlying instrument limb. Any option, derivative, security-based swap, or other financial instrument overlying a security, the value of which is materially related to, or otherwise acts as a substitute for, that security.
• The functional equivalent limb. Any contract that is the functional economic equivalent of a position in that security.

Exam Tip: Gotchas

• The value test is disjunctive. An instrument qualifies if its value is materially related to the security or if it otherwise acts as a substitute for it.

How Much Must a Trader Know Before the Prohibition Bites?

The violative practices may include transactions executed on knowledge of less than all of the terms of the block transaction, so long as there is knowledge that all of the material terms of the transaction have been or will be agreed upon imminently.

Exam Tip: Gotchas

• Partial knowledge of the terms can still be enough. The interpretive item opens with "may include", so it describes a set rather than closing one, and knowing every term is not the threshold.
• The proviso is the limit. Without knowledge that all the material terms have been or will be agreed upon imminently, the partial-knowledge branch is not satisfied.

When Does Block Information Become Publicly Available?

Information as to a block transaction is treated as publicly available when it has been disseminated through the channels the rule names.

• A last sale reporting system, or a high speed communications line of one of those systems
• A similar system of a national securities exchange
• An alternative trading system under Regulation ATS
• A third-party news wire service

The second sentence decides scenarios. The requirement that information concerning the block transaction be made publicly available will not be satisfied until the entire block transaction has been completed and publicly reported.

Exam Tip: Gotchas

• A partial print does not release a trader. Dissemination of one leg leaves the requirement unsatisfied, because the entire block must have been completed and publicly reported.
• A telephone call to a client is not one of the four channels. Selective disclosure to a customer does not make the information publicly available under this rule.
• Regulation ATS supplies the definition of an alternative trading system. Those definitions are covered in the unit on display, execution and trading systems.

What Size Makes a Transaction a Block?

In the context of equity securities, a transaction involving 10,000 shares or more of a security, an underlying security, or a related financial instrument overlying such number of shares is generally deemed to be a block transaction.

The same sentence keeps the other direction open: a transaction of fewer than 10,000 shares could be considered a block transaction.

A block transaction that has been agreed upon does not lose its identity as such by arranging for partial executions of the full transaction in portions which themselves are not of block size. That holds if the execution of the full transaction may have a material impact on the market.

Exam Tip: Gotchas

• The share figure is a benchmark rather than a floor. The rule says a smaller transaction could be a block, so it draws no bright line in either direction.
• Slicing an agreed block does not dissolve it. Partial executions below block size leave the block's identity intact where the full transaction may have a material impact on the market.
• The material-impact clause is a condition on that result. It is attached to the whole transaction, not to any single slice of it.

Which Transactions Does the Rule Permit?

The rule does not preclude transactions that the member can demonstrate are unrelated to the material, non-public market information received in connection with the customer order. The burden of demonstration sits on the member.

Its examples are opened by "may include", so the four named types are illustrations rather than a closed list.

• Transactions where the member has information barriers established to prevent internal disclosure of the information
• Transactions in the same security related to a prior customer order in that security
• Transactions to correct bona fide errors
• Transactions to offset odd-lot orders

A second permission covers transactions undertaken for the purpose of fulfilling, or facilitating the execution of, the customer block order. It comes with three duties that apply when the member engages in trading activity that could affect the market for the security that is the subject of the customer block order.

• The member must minimize any potential disadvantage or harm in the execution of the customer's order
• The member must not place the member's financial interests ahead of those of its customer
• The member must obtain the customer's consent to that trading activity

Consent can be obtained in three ways.

• Affirmative written consent. The customer agrees in writing.
• A negative consent letter. The letter must clearly disclose to the customer the terms and conditions for handling the customer's orders. If the customer does not object, the member may reasonably conclude that the customer has consented and may rely on the letter for all or a portion of the customer's orders.
• Oral disclosure and consent, order by order. The member may provide clear and comprehensive oral disclosure to the customer and obtain consent on an order-by-order basis, provided that the member documents who provided the consent and the consent evidences the customer's understanding of the terms and conditions for handling the order.

A third permission switches the prohibitions off entirely, and it has two conditions that must both hold. The member's trading activity must be undertaken in compliance with the marketplace rules of a national securities exchange, and at least one leg of the trading activity must be executed on that exchange.

Exam Tip: Gotchas

• The member carries the demonstration. The unrelated-transaction permission is available only where the member can demonstrate that the transaction is unrelated to the information received in connection with the customer order.
• The exchange permission needs both halves. Compliance with the marketplace rules alone is not enough, and neither is an execution on the exchange alone.
• A negative consent letter has its own content requirement. It must clearly disclose the terms and conditions for handling the customer's orders before silence can be read as consent.
• The facilitation permission is conditional, not free. The three duties attach whenever the trading activity could affect the market for the security that is the subject of the customer block order.

What Happens When the Order Is Not a Block?

The prohibitions in this rule are limited to imminent block transactions. The rule's own closing item says so and then names where a smaller order can still land a firm in trouble.

Front running of other types of orders that place the financial interests of the member or persons associated with a member ahead of those of its customer, or the misuse of knowledge of an imminent customer order, may violate other FINRA rules, including the standards of commercial honor rule and the trading ahead of customer orders rule, or provisions of the federal securities laws.

Exam Tip: Gotchas

• A non-block order is outside this rule and not outside the rulebook. The closing item is a signpost to other rules, so "no violation" is the wrong reading of a small-order scenario.
• The trading ahead of customer orders rule is taught separately. Its prohibition and its exceptions are covered in the unit on identifying and avoiding prohibited practices with customer orders.

What Should You Check on Exam Day?

• Confirm the block is imminent and the information is market information. Issuer news is a different rule.
• Check whether the entire block has been completed and publicly reported before treating the information as public.
• Identify the account. An interest in it or discretion over it is enough with no tip; a customer or affiliate account needs the information to have been provided by the firm or an associated person.
• Test the share size against 10,000 shares as a benchmark, then ask whether the facts still describe a block below it.
• For a permitted transaction, confirm both conditions where two are stated, and confirm the member can demonstrate the transaction was unrelated.