Exceptions to the Trading Ahead Prohibition

Most of these exceptions carry a condition beyond the population, so read the proviso attached to the exception before you accept it in a fact pattern. The odd-lot branch is the one that carries none; the demonstrate-and-document duty beside it is written for the bona fide error branch.

When Do Large Orders and Institutional Accounts Fall Outside the Rule?

This exception reaches two order populations, joined by "or":

• An order for a customer account that meets the definition of an "institutional account" in the customer account information rule.
• An order of 10,000 shares or more, unless such orders are less than $100,000 in value.

The customer account information rule defines an institutional account as the account of one of three categories.

That definition is also set out in the unit on meeting obligations to customers regarding orders.

Where an order sits in either population, a member is permitted to trade a security on the same side of the market for its own account at a price that would satisfy such customer order, provided that it has given the customer clear and comprehensive written disclosure at account opening and annually thereafter that does two things.

• It discloses that the member may trade proprietarily at prices that would satisfy the customer order.
• It provides the customer with a meaningful opportunity to opt in to the rule's protections with respect to all or any portion of its order.

If the customer does not opt in to those protections with respect to all or any portion of its order, the member may reasonably conclude that the customer has consented to the member trading on the same side of the market for its own account at a price that would satisfy the customer's order.

In lieu of that written disclosure at account opening and annually thereafter, a member may provide clear and comprehensive oral disclosure to and obtain consent from the customer on an order-by-order basis. That route carries two conditions: the member documents who provided such consent, and the consent evidences the customer's understanding of the terms and conditions of the order.

Exam Tip: Gotchas

• The two figures measure different things. The $100,000 measures the order's value, so a 10,000-share order in a $5.00 stock is worth $50,000 and drops out of the size branch. The $50 million measures the customer's total assets.
• An account that meets the institutional definition qualifies on its own. The two populations are alternatives, so an order that falls out of the size branch is still reached where the account is institutional, with no size or value test applied to it.
• The customer opts in, not out. The disclosure has to offer a meaningful opportunity to opt in to the protections, and that opt-in can cover all or any portion of the order.
• The deemed-consent sentence is written as "may reasonably conclude." Silence lets the member draw a conclusion; the rule does not state that consent is automatic.
• The oral route is order-by-order and replaces the written disclosure entirely. It is offered in lieu of the account-opening and annual disclosure, and it carries its own documentation and understanding conditions.

What Does the No-Knowledge Exception Allow?

The no-knowledge exception splits by product, and the two halves are not written the same way. An NMS stock means any national market system (NMS) security other than an option.

An NMS security is any security or class of securities for which transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options. The wider set of definitions Regulation NMS runs on is covered in the unit on Regulation NMS.

An OTC equity security means any equity security that is not an NMS stock, except that the term does not include a restricted equity security. A restricted equity security is an equity security meeting the definition of a restricted security under the restricted securities resale safe harbor.

In both halves the condition is that the member implements and utilizes an effective system of internal controls, such as appropriate information barriers, that operate to prevent that knowledge from passing.

A member that structures its order handling practices in NMS stocks to permit its market-making desk to trade at prices that would satisfy customer orders held by a separate trading unit owes an extra disclosure. That disclosure runs in writing to its customers, at account opening and annually thereafter.

It carries two content limbs: a description of the manner in which customer orders are handled by the member, and the circumstances under which the member may trade proprietarily at its market-making desk at prices that would satisfy the customer order.

A member that implements and utilizes appropriate information barriers in reliance on this exception must uniquely identify those barriers as prescribed in the Consolidated Audit Trail (CAT) industry member data reporting rule.

That rule calls for the unique identification of any appropriate information barriers in place at the department within the industry member where the order was received or originated, and again where the order is routed internally, received after routing, or modified.

CAT reporting itself is covered in the unit on creating, retaining and reporting required records of orders and transactions.

Exam Tip: Gotchas

• The exception is not symmetrical across the two products. In an NMS stock the market-making desk can sit on the trading side of the barrier, at the price of the extra written disclosure. In an OTC equity security the exception reaches a non-market-making trading unit only.
• The extra disclosure names its recipient. It runs in writing to the member's customers, at account opening and annually thereafter, and it has two content limbs: how customer orders are handled, and when the market-making desk may trade proprietarily at satisfying prices.
• Information barriers are an example, not the requirement. The condition is an effective system of internal controls, "such as appropriate information barriers," so the controls must actually operate to prevent the knowledge passing, and a barrier that exists but does not work does not qualify.
• Relying on the exception creates a reporting duty. A barrier used in reliance on it must be uniquely identified in the audit trail data the firm reports.

When Is a Riskless Principal Trade Exempt?

The rule's obligations do not apply to a member's proprietary trade made for the purposes of facilitating the execution, on a riskless principal basis, of an order from a customer, whether its own customer or the customer of another broker-dealer. The rule names that order the facilitated order.

Two conditions attach:

• The member submits a report, contemporaneously with the execution of the facilitated order, identifying the trade as riskless principal to FINRA, or to another self-regulatory organization if not required under FINRA rules.
• The member has written policies and procedures to ensure that riskless principal transactions relying on the exception comply with applicable FINRA rules.

Those policies and procedures are floored rather than left open. At a minimum they must require the following.

Separately, members must have supervisory systems in place that produce records enabling the member and FINRA to reconstruct accurately, readily, and in a time-sequenced manner all facilitated orders for which the member relies on this exception.

Exam Tip: Gotchas

• "At a minimum" floors the policies rather than closing the list. A firm can require more than the three items, and a firm that requires fewer has not met the condition.
• The price floor is measured before the charge to the customer. The offsetting trade matches the customer order's price exclusive of any markup or markdown, commission equivalent or other fee.
• The report destination has an alternative. It goes to FINRA, or to another self-regulatory organization if the report is not required under FINRA rules.
• The supervisory-records duty stands on its own. It sits in a separate sentence from the two conditions, and it asks that the member and FINRA be able to reconstruct all facilitated orders accurately, readily, and in a time-sequenced manner.

What Does the Intermarket Sweep Order Exception Cover?

An intermarket sweep order (ISO) is a limit order for an NMS stock that meets two requirements set by Regulation NMS definitions.

• When routed to a trading center, the limit order is identified as an intermarket sweep order.
• Simultaneously with that routing, one or more additional limit orders, as necessary, are routed to execute against the full displayed size of any protected bid, for a limit order to sell, or of any protected offer, for a limit order to buy, in that same NMS stock, priced superior to the limit price of the identified order.

Those additional routed orders also must be marked as intermarket sweep orders, so the second prong is not satisfied by unmarked clean-up orders.

The exception then runs in two directions:

• A member is exempt from the obligation to execute a customer order consistent with the rule, as to trading for its own account that is the result of an ISO routed in compliance with Regulation NMS definitions, where the customer order is received after the member routed the ISO.
• Where a member routes an ISO to facilitate a customer order and that customer has consented to not receiving the better prices obtained by the ISO, the member is also exempt as to its own trading resulting from that ISO, with respect to the consenting customer's order.

The role sweep orders play in the order protection rule, and that rule's own list of exceptions, are covered in the unit on Regulation NMS.

Exam Tip: Gotchas

• The first branch turns on sequence. It reaches trading that results from an ISO where the customer order arrived after the member routed that ISO, so an order already in hand is not covered by it.
• The second branch is limited to the consenting customer. The exemption runs with respect to that customer's order, so it says nothing about other customers' orders resting at the same time.
• The definition names a limit order for an NMS stock. Both prongs describe limit orders, and the additional orders routed alongside the sweep must themselves be marked as intermarket sweep orders.

Which Odd Lot and Error Trades Are Exempt?

The rule's obligations do not apply to a member's proprietary trade that is either of two things:

• A trade to offset a customer order that is in an amount less than a normal unit of trading.
• A trade to correct a bona fide error.

Members are required to demonstrate and document the basis upon which a transaction meets the bona fide error exception.

A "normal unit of trading" for an NMS stock means the round lot assigned to that stock by Regulation NMS definitions. That assignment is made in tiers from the stock's average closing price on the primary listing exchange during the prior Evaluation Period.

A security that becomes an NMS stock during an operative period is assigned a round lot of 100 shares. The Evaluation Period and the operative periods that follow it are covered in the unit on Regulation NMS.

Exam Tip: Gotchas

• The odd-lot branch is keyed to the round lot assigned to that individual stock. It is not a flat 100 shares, so where the assigned round lot is 10 shares, a 40-share order is not below a normal unit of trading.
• The demonstrate-and-document duty attaches to the error branch only. The rule states it for the bona fide error exception, not for the odd-lot exception beside it.
• A high-priced stock has a small round lot. The tiers move down as the average closing price moves up, so the odd-lot branch shrinks in exactly the names where a single share is worth the most.

What Should You Check on Exam Day?

• Confirm which exception the scenario is claiming, then read its proviso; most carry a condition beyond the population, and the odd-lot branch is the one that does not.
• On a large-order fact pattern, price the order before applying the size branch, and check the account against the institutional definition separately.
• Ask whether the product is an NMS stock or an OTC equity security before applying the no-knowledge exception, because the trading unit it protects differs.
• On a riskless principal claim, check the sequence, the same-price test exclusive of any charge, and the 60-second allocation.
• Check whether the customer order arrived before or after the sweep order was routed, and whether the customer consented to giving up the better prices.