Net Transactions

Three elements define the trade, and the consent rules then split by customer type. A non-institutional customer's own consent has exactly one route, and an institutional customer has three.

What Is a Net Transaction?

A "net" transaction means a principal transaction in which a market maker, after having received an order to buy (sell) an equity security, purchases (sells) the equity security at one price from (to) another broker-dealer or another customer, and then sells to (buys from) the customer at a different price.

Three elements sit inside that definition: the member acts as principal, it is a market maker, and the security is an equity security. The definition turns on two prices: one on the first leg and a different one on the customer's leg.

Exam Tip: Gotchas

• All three elements are part of the definition. An agency fill, a trade by a firm that is not a market maker, or a debt security is not a net transaction under this rule, whatever the pricing looks like.
• The other side can be a broker-dealer or another customer. The definition names both, so a principal purchase from (or sale to) a second customer, followed by a trade with the customer at a different price, still meets it.

What Must a Member Do Before Executing One?

Prior to executing a transaction for or with a customer on a net basis, a member must provide disclosure to and obtain consent from the customer as the rule provides.

Both acts come first. Disclosure after the fact, or consent obtained later in the day, does not satisfy a duty written as a precondition to execution.

Exam Tip: Gotchas

• The rule requires two things, not one. Disclosure to the customer and consent from the customer are separate acts, and both must happen before the execution.
• The disclosure duty applies to every customer. The manner of meeting the disclosure and consent requirements changes with the customer type; the requirement to disclose and obtain consent first does not.

How Does a Non-Institutional Customer Consent?

With respect to non-institutional customers, the member must obtain the customer's written consent on an order-by-order basis prior to executing the transaction on a net basis, and that consent must evidence the customer's understanding of the terms and conditions of the order.

Exam Tip: Gotchas

• A non-institutional customer's own consent has one route, and it is the strictest. Written, order by order, before execution, and evidencing the customer's understanding of the order's terms and conditions.
• Negative consent is not available here. The letter route belongs to institutional customers, so a retail customer's own silence never becomes consent. Only where a fiduciary with trading discretion meets the institutional customer definition do the institutional methods, the letter included, become available.

How Does an Institutional Customer Consent?

With respect to institutional customers, a member must obtain the customer's consent prior to executing the transaction in accordance with one of the following methods.

Exam Tip: Gotchas

• The negative consent letter is the only method that is not order by order. It can cover all of the customer's orders or a portion of them, as the customer instructs.
• The oral route carries a documentation duty the others do not spell out. The member must document the understanding and the consent on an order-by-order basis, which means the oral method still generates a record.
• A meaningful opportunity to object belongs to two methods. The negative consent letter and the oral route both require it; the written-consent route does not name it.

Who Is an Institutional Customer?

An "institutional customer" means a customer whose account qualifies as an "institutional account" under the customer account information rule. That rule defines an institutional account as the account of:

• a bank, savings and loan association, insurance company or registered investment company;
• an investment adviser registered either with the SEC under the Investment Advisers Act or with a state securities commission, or any agency or office performing like functions; or
• any other person, whether a natural person, corporation, partnership, trust or otherwise, with total assets of at least $50 million.

Exam Tip: Gotchas

• A natural person can hold an institutional account. The third category names a natural person expressly, so the test is the $50 million in total assets rather than the kind of person.
• The adviser category takes state registration too. An adviser registered with a state securities commission, or an agency performing like functions, qualifies alongside an SEC-registered adviser.

What Happens When a Fiduciary Holds Trading Discretion?

For customers that have granted trading discretion to a fiduciary, an investment adviser for example, a member is permitted to obtain the required consent from the fiduciary.

If that fiduciary meets the definition of institutional customer, the member may meet the disclosure and consent requirements in the same manner permitted for institutional customers.

Exam Tip: Gotchas

• The fiduciary's own status decides the method. Where the discretionary account belongs to a retail customer but the adviser qualifies as an institutional customer, the institutional methods become available.

How Long Must the Consent Documentation Be Kept?

Members must retain and preserve all documentation relating to consent obtained under the rule in accordance with the general recordkeeping rule.

That rule sets a default period: members shall preserve for a period of at least six years those FINRA books and records for which there is no specified period under the FINRA rules or applicable Exchange Act rules.

Exam Tip: Gotchas

• Six years is the default, not a rule written for net transactions. It applies because no other period is specified for this record.

What Should You Check on Exam Day?

• Test the three definition elements first: principal capacity, a market maker, and an equity security.
• Confirm the disclosure and the consent both came before execution. The duty is written as a precondition.
• Match the method to the customer. Non-institutional customers give written, order-by-order consent, unless a fiduciary with trading discretion qualifies as institutional.
• On an institutional account, check which of the three methods the facts describe, and whether the oral route was documented order by order.
• Where a fiduciary consents, ask whether the fiduciary itself meets the institutional customer definition.