Quick Answer
Trading as principal with a customer, a member must buy or sell at a price which is fair, taking into account all relevant circumstances, including market conditions at the time, the expense involved, and its entitlement to a profit. Acting as agent, it may not charge more than a fair commission or service charge.
The fair prices and commissions rule is one sentence of duty followed by two interpretations. The duty splits by capacity, principal or agent; the first interpretation, known as the Mark-Up Policy, explains how fairness is measured, and a second one adds how the prevailing market price is found for a debt security other than a municipal security.
What Does the Rule Require of a Member as Principal and as Agent?
The rule applies in securities transactions whether in "listed" or "unlisted" securities.
- As principal. If a member buys for his own account from his customer, or sells for his own account to his customer, he shall buy or sell at a price which is fair, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that he is entitled to a profit.
- As agent. If he acts as agent for his customer, he shall not charge more than a fair commission or service charge, taking into consideration all relevant circumstances, including market conditions at the time of the transaction, the expense of executing the order, and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefor.
Exam Tip: Gotchas
- The rule builds the dealer's profit into the fairness test. Entitlement to a profit is one of the circumstances the principal branch names, so a mark-up is not unfair merely because it exists.
- The two branches weigh different things. The principal branch names the expense involved. The agency branch names the expense of executing the order and the value of any service the member may have rendered by reason of its experience in and knowledge of the security and its market.
- Listed securities are inside the rule. It opens by covering listed and unlisted securities alike, so an answer that limits it to over-the-counter trading is too narrow.
What Turns an Unfair Price Into a Violation?
The interpretation states the enforcement link directly. It shall be deemed a violation of the standards of commercial honor rule and of the fair prices and commissions rule for a member:
- To enter into any transaction with a customer in any security at any price not reasonably related to the current market price of the security, or
- To charge a commission which is not reasonable.
The standards of commercial honor rule requires a member, in the conduct of its business, to observe high standards of commercial honor and just and equitable principles of trade.
Exam Tip: Gotchas
- One bad price is two violations. The interpretation names both rules, so the pricing failure and the conduct standard are charged together.
Is the 5% Policy a Rule?
The Mark-Up Policy opens with five general considerations, and the first answers the question directly.
| Consideration | What it says |
|---|---|
| Status of the policy | The "5% Policy" is a guide, not a rule |
| Excessive expenses | A member may not justify mark-ups on the basis of expenses which are excessive |
| The measuring spread | The mark-up over the prevailing market price is the significant spread from the point of view of fairness of dealings with customers in principal transactions. 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 |
| Patterns | A mark-up pattern of 5% or even less may be considered unfair or unreasonable under the policy |
| All the factors | Fairness must be based on a consideration of all the relevant factors, of which the percentage of mark-up is only one |
Exam Tip: Gotchas
- A charge below 5% can still be a violation. The interpretation says a pattern of 5% or even less may be unfair or unreasonable, so the number is a guide rather than a safe harbor.
- Contemporaneous cost is a fallback with a condition. It is the best indication of the prevailing market price in the absence of other bona fide evidence of that market, not in every case.
Which Factors Bear on a Fair Mark-Up?
The interpretation introduces its factor list with the words "Some of the factors," so the list is open. It names seven.
| Factor | What the interpretation says about it |
|---|---|
| The type of security involved | Some securities customarily carry a higher mark-up than others. A higher percentage customarily applies to a common stock transaction than to a bond transaction of the same size, and a higher percentage applies to sales of units of direct participation programs and condominium securities than to sales of common stock |
| The availability of the security in the market | In the case of an inactive security, the effort and cost of buying or selling it, or any other unusual circumstances connected with its acquisition or sale, may bear on the amount of mark-up justified |
| The price of the security | While there is no direct correlation, the percentage of mark-up or rate of commission generally increases as the price of the security decreases. Even where the amount of money is substantial, transactions in lower priced securities may require more handling and expense and may warrant a wider spread |
| The amount of money involved in a transaction | A transaction involving a small amount of money may warrant a higher percentage of mark-up to cover the expenses of handling |
| Disclosure | Any disclosure to the customer, before the transaction is effected, of information indicating the amount of commission charged in an agency transaction or the mark-up made in a principal transaction, is a factor to be considered. Disclosure itself, however, does not justify a commission or mark-up which is unfair or excessive in light of all other relevant circumstances |
| The pattern of mark-ups | Each transaction must meet the test of fairness, and particular attention should be given to the pattern of a member's mark-ups |
| The nature of the member's business | If not excessive, the cost of providing the services and facilities needed by and provided for a member's customers, particularly when they are of a continuing nature, may properly be considered |
Exam Tip: Gotchas
- Disclosure is a factor, not a cure. Telling the customer the mark-up before the trade counts in the analysis and does not make an excessive charge fair.
- The price relationship is stated with a caveat. There is no direct correlation; the percentage generally rises as the price falls, which is a tendency the interpretation describes rather than a formula.
- The list is open by its own words. "Some of the factors" means a factor outside the seven can still bear on fairness.
Which Transactions Does the Mark-Up Policy Reach?
The policy applies to all securities, and the interpretation names five types of transaction.
| Transaction | How the mark-up is measured |
|---|---|
| Buying to fill a customer order already received | A member buys a security to fill an order for the same security previously received from a customer. This includes the so-called "riskless" or "simultaneous" transaction |
| Selling from inventory | The mark-up is determined on the basis of the mark-up over the bona fide representative current market. 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 |
| Purchasing from a customer | The price paid to the customer or the mark-down applied by the member must be reasonably related to the prevailing market price of the security |
| Acting as agent | In such a case, the commission charged the customer must be fair in light of all relevant circumstances |
| Proceeds transactions | A customer sells securities to, or through, a broker-dealer and the proceeds pay for other securities purchased from, or through, that broker-dealer at or about the same time. The mark-up is computed in the same way as if the customer had purchased for cash, and in computing it there shall be included any profit or commission realized by the dealer on the securities being liquidated |
Exam Tip: Gotchas
- A proceeds transaction is priced as one event. The dealer's profit or commission on the securities being sold is added into the mark-up on the securities being bought, so quoting the purchase side alone understates the charge.
- Inventory gains and losses are ordinarily irrelevant. The measure is the mark-up over the bona fide representative current market, not the dealer's profit or loss on the position.
When Does the Mark-Up Policy Not Apply?
The interpretation states one carve-out, and it is conjunctive. The Mark-Up Policy is not applicable to the sale of securities where a prospectus or offering circular is required to be delivered and the securities are sold at the specific public offering price.
Both conditions must hold. A required prospectus alone does not reach it, and a sale at the offering price alone does not either.
Exam Tip: Gotchas
- The carve-out switches off the Mark-Up Policy, not the rule. The duty to charge a fair price as principal and a fair commission as agent still binds, because the carve-out is written against the interpretation.
How Is the Prevailing Market Price Found for a Debt Security Other Than a Municipal Security?
A second interpretation supplements the first for debt securities, and its footnote sets its own limit: the interpretation does not apply to transactions in municipal securities.
A dealer acting in a principal capacity in a transaction with a customer and charging a mark-up or mark-down must mark up or mark down the transaction from the prevailing market price. Presumptively, the prevailing market price is established by referring to the dealer's contemporaneous cost as incurred, or contemporaneous proceeds as obtained.
Countervailing evidence of the prevailing market price may be considered only in two situations, stated separately for each side of the trade:
- When the dealer is selling to a customer: where the dealer made no contemporaneous purchases in the security, or can show that in the particular circumstances its contemporaneous cost is not indicative of the prevailing market price.
- When the dealer is buying from a customer: where the dealer made no contemporaneous sales in the security, or can show that in the particular circumstances its contemporaneous proceeds are not indicative of the prevailing market price.
A dealer's cost is contemporaneous if the transaction occurs close enough in time to the subject transaction that it would reasonably be expected to reflect the current market price for the security. Where a mark-down is being calculated, the same test is applied to the dealer's proceeds.
A dealer that identifies the prevailing market price using a measure other than its own contemporaneous cost, or in a mark-down its own proceeds, must be prepared to provide evidence sufficient to overcome the presumption that its own cost or proceeds provides the best measure. The interpretation names three instances in which a dealer may be able to do so:
- Interest rates changed after the dealer's contemporaneous transaction to a degree that such change would reasonably cause a change in debt securities pricing.
- The credit quality of the debt security changed significantly after the dealer's contemporaneous transaction.
- News was issued or otherwise distributed and known to the marketplace that had an effect on the perceived value of the debt security after that transaction.
Exam Tip: Gotchas
- The presumption has to be overcome, not merely questioned. The dealer carries the burden of evidence sufficient to displace its own contemporaneous cost or proceeds.
- The interest-rate instance carries a degree test. A rate move counts where it would reasonably cause a change in debt securities pricing, not because rates moved at all.
- Municipal securities sit outside this interpretation. The limit is in the interpretation's own footnote.
Which Pricing Information Comes Next, and in What Order?
Where the dealer has established that its cost or proceeds is no longer contemporaneous, or has presented evidence sufficient to overcome the presumption, the member must consider, in the order listed, three types of pricing information.
| Order | Pricing information |
|---|---|
| First | Prices of any contemporaneous inter-dealer transactions in the security in question |
| Second | In the absence of those transactions, prices of contemporaneous dealer purchases (sales) in the security in question from (to) institutional accounts with which any dealer regularly effects transactions in the same security |
| Third | In the absence of both of the above, for actively traded securities, contemporaneous bid (offer) quotations for the security in question made through an inter-dealer mechanism, through which transactions generally occur at the displayed quotations |
A member may consider a succeeding category only when the prior category does not generate relevant pricing information. Within a category, the relative weight of a particular transaction price or quotation depends on the facts and circumstances of the comparison transaction or quotation, such as whether the comparison dealer was on the same side of the market and the timeliness of the information.
Only in particular circumstances where the above factors are not available does the interpretation open a further list, which includes but is not limited to four items:
- Prices of contemporaneous inter-dealer transactions in a "similar" security, or prices of contemporaneous dealer purchase (sale) transactions in a "similar" security with institutional accounts with which any dealer regularly effects transactions in that similar security.
- Yields calculated from prices of contemporaneous inter-dealer transactions in "similar" securities.
- Yields calculated from prices of contemporaneous dealer purchase (sale) transactions with institutional accounts with which any dealer regularly effects transactions in "similar" securities.
- Yields calculated from validated contemporaneous inter-dealer bid (offer) quotations in "similar" securities.
The weight of information drawn from those factors again depends on the facts and circumstances of the comparison transaction: whether the comparison dealer was on the same side of the market, the timeliness of the information, and, with respect to the final factor listed above, the relative spread of the quotations in the similar security to the quotations in the subject security.
Two provisions close the sequence:
- Economic models come last. If no factor above yields information about the prevailing market price, FINRA or its members may consider prices or yields from economic models, discounted cash flow models for example. They take into account measures such as credit quality, interest rates, industry sector, time to maturity, call provisions and any other embedded options, coupon rate, and face value, and consider all applicable pricing terms and conventions.
- Isolated data counts for little. Because the ultimate evidentiary issue is the prevailing market price, isolated transactions or isolated quotations generally will have little or no weight or relevance. For example, in considering yields of "similar" securities, except in extraordinary circumstances, members may not rely exclusively on isolated transactions or a limited number of transactions not fairly representative of the yields of transactions in similar securities taken as a whole.
Exam Tip: Gotchas
- This is a hierarchy, not a menu. A member reaches the institutional-account category only after applying the inter-dealer category and finding nothing relevant, and reaches quotations only after both of the earlier categories come up empty.
- The third category has two limits the first two do not. It is available for actively traded securities, and only for quotations made through an inter-dealer mechanism through which transactions generally occur at the displayed quotations.
- The relative-spread test attaches to one factor only. It applies with respect to the final factor listed, the validated inter-dealer quotations in a similar security.
What Makes Another Bond a "Similar" Security?
A "similar" security should be sufficiently similar to the subject security that it would be a reasonable alternative investment to the investor. At a minimum, the securities should be sufficiently similar that a market yield for the subject security can be fairly estimated from the yields of the similar security or securities.
Where a security has several components, appropriate consideration may also be given to the prices or yields of the various components of the security.
The degree of similarity may be determined by factors that include but are not limited to four:
| Factor | What it looks at |
|---|---|
| Credit quality considerations | Whether the security is issued by the same or similar entity, bears the same or similar credit rating, or is supported by a similarly strong guarantee or collateral. Where securities of other issuers are designated as similar, significant recent information of either issuer that is not yet incorporated in credit ratings should be considered, changes to ratings outlooks for example |
| Spread | The extent to which the spread over U.S. Treasury securities of a similar duration at which the similar security trades is comparable to the spread at which the subject security trades |
| Structural characteristics | General structural characteristics and provisions of the issue, such as coupon, maturity, duration, complexity or uniqueness of the structure, callability, the likelihood that the security will be called, tendered or exchanged, and other embedded options |
| Technical factors | The size of the issue, the float and recent turnover of the issue, and legal restrictions on transferability |
One case closes the door. Where a debt security's value and pricing is based substantially on, and is highly dependent on, the particular circumstances of the issuer, including creditworthiness and the ability and willingness of the issuer to meet the specific obligations of the security, in most cases other securities will not be sufficiently similar and therefore may not be used to establish the prevailing market price.
Exam Tip: Gotchas
- Similarity is measured from the investor's side. The test is whether the other bond would be a reasonable alternative investment, with a fairly estimable market yield as the minimum.
- A ratings outlook can matter before the rating moves. Significant recent information not yet incorporated in credit ratings should be considered where another issuer's security is used as the comparison.
Which Institutional Buyer Is Not a Customer for These Purposes?
For the fair prices and commissions rule and both of its interpretations, "customer" does not include a qualified institutional buyer (QIB) that is purchasing or selling a non-investment grade debt security, when the dealer has determined, after considering the factors set out in the suitability rule's institutional-account provision, 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.
A "non-investment grade debt security" is defined in three branches. It is a debt security that:
- if rated by only one nationally recognized statistical rating organization, is rated lower than one of the four highest generic rating categories;
- if rated by more than one such organization, is rated lower than one of the four highest generic rating categories by any of them; or
- if unrated, satisfies either of two limbs:
- The security 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 is in fact equivalent to a non-investment grade debt security.
- Or the security was initially offered and sold and continues to be offered and sold under an exemption from registration under the Securities Act of 1933.
The factors the dealer must consider come from the suitability rule. A member or associated person fulfills the customer-specific suitability obligation for an institutional account where:
- the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities, and
- the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member's or associated person's recommendations.
Where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, those factors are applied to the agent.
Exam Tip: Gotchas
- Both halves of the determination are required. Capacity to evaluate the risk independently, and actually exercising independent judgment on this transaction.
- The narrowing is doubly limited. It reaches a qualified institutional buyer only, and only in a non-investment grade debt security. The same buyer trading an investment grade bond is still a customer here.
- An unrated bond can be non-investment grade two different ways. The dealer's own documented analysis, or a continuing sale under an exemption from registration.
- One low rating is enough. Where more than one rating agency has rated the bond, a rating below the four highest generic categories by any of them makes it non-investment grade.
Who Is a Qualified Institutional Buyer?
The definition sits in the qualified institutional buyer resale safe harbor and runs in six branches.
| Branch | Who qualifies |
|---|---|
| Listed entities | Any of the ten entity types below, acting for its own account or the accounts of other qualified institutional buyers, that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity |
| Registered dealers | Any dealer registered under the Securities Exchange Act, acting on that same basis, that in the aggregate owns and invests on a discretionary basis at least $10 million of securities of issuers not affiliated with the dealer. Provided that securities constituting the whole or a part of an unsold allotment to or subscription by a dealer as a participant in a public offering shall not be deemed to be owned by that dealer |
| Riskless principal dealers | Any registered dealer acting in a riskless principal transaction on behalf of a qualified institutional buyer |
| Fund families | Any registered investment company, acting on that same basis, that is part of a family of investment companies which own in the aggregate at least $100 million in securities of issuers other than issuers affiliated with the investment company or part of that family |
| All-qualified entities | Any entity, all of the equity owners of which are qualified institutional buyers, acting on that same basis |
| Banks and thrifts | Any bank, any savings and loan association or other institution, or any foreign bank or savings and loan association or equivalent institution, acting on that same basis, that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers and that has an audited net worth of at least $25 million as demonstrated in its latest annual financial statements, as of a date not more than 16 months preceding the date of sale for a bank or savings and loan association in the United States, and not more than 18 months preceding that date for a foreign institution |
The ten entity types inside the first branch are:
- Any insurance company. A purchase by an insurance company for one or more of its separate accounts that are neither registered under the Investment Company Act nor required to be registered is deemed a purchase for the account of the insurance company.
- Any investment company registered under the Investment Company Act, or any business development company as that Act defines it.
- Any Small Business Investment Company licensed by the U.S. Small Business Administration, or any Rural Business Investment Company.
- Any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees.
- Any employee benefit plan within the meaning of title I of the Employee Retirement Income Security Act of 1974.
- Any trust fund whose trustee is a bank or trust company and whose participants are exclusively state plans or employee benefit plans of the two types above, except trust funds that include as participants individual retirement accounts or Keogh plans.
- Any business development company as the Investment Advisers Act defines it.
- Any tax-exempt charitable organization described in the Internal Revenue Code, a corporation other than a bank, a savings and loan association or other institution of that kind, or a foreign equivalent, a partnership, a limited liability company, or a Massachusetts or similar business trust.
- Any investment adviser registered under the Investment Advisers Act.
- Any institutional accredited investor as Regulation D defines that term, of a type not listed in the other entity types or in the other five branches above.
An entity seeking qualified institutional buyer status under that last entity type may be formed for the purpose of acquiring the securities being offered.
A "family of investment companies" means any two or more investment companies registered under the Investment Company Act, except a unit investment trust whose assets consist solely of shares of one or more registered investment companies, that have the same investment adviser or, in the case of unit investment trusts, the same depositor.
Two provisos attach to that definition. Each series of a series company is deemed a separate investment company. And investment companies are deemed to have the same adviser or depositor where those advisers or depositors are majority-owned subsidiaries of the same parent, or where one company's adviser or depositor is a majority-owned subsidiary of the other's.
Exam Tip: Gotchas
- The dealer threshold is the odd one out. Registered dealers qualify at $10 million where the entity, fund-family and bank branches all use $100 million.
- A dealer's unsold allotment does not count. Securities that are the whole or part of an unsold allotment or subscription from a public offering are not deemed owned by the dealer for the threshold.
- The bank branch carries a second test. Banks and thrifts need the $100 million portfolio and an audited net worth of at least $25 million, dated within 16 months for a United States bank or savings and loan association and 18 months for a foreign one.
- A registered dealer acting as agent on a non-discretionary basis need not qualify itself. The riskless principal branch reaches a dealer trading on behalf of a qualified institutional buyer, and a dealer may act as agent on a non-discretionary basis with such a buyer without being one.
What Should You Check on Exam Day?
- Identify the capacity first. A principal trade is tested on the price; an agency trade is tested on the commission or service charge.
- Treat 5% as a guide. A smaller pattern can be unfair, and the percentage is one factor among all relevant circumstances.
- On a proceeds transaction, add the dealer's profit or commission on the liquidated securities into the mark-up computation.
- Apply the debt pricing hierarchy in order, and stop at the first category that generates relevant pricing information.
- Before excluding an institutional buyer from the customer definition, confirm three things: qualified institutional buyer status, a non-investment grade debt security, and the dealer's determination that the buyer can evaluate risk independently and is in fact exercising independent judgment.