Quick Answer
A broker-dealer must buy and sell at fair prices reasonably related to current market value and charge fair commissions or markups, judged by seven factors, not a fixed percentage. The 5% policy is a guideline, not a ceiling, and it does not apply to securities sold under a prospectus at the specific public offering price.
Now that you understand the types of broker-dealer compensation, the next question is how much is too much. This section supplies the fair-pricing framework that answers it.
What Is the Core Fair-Pricing Rule?
- A broker-dealer must buy or sell securities at fair prices and charge fair commissions or markups, taking into account all relevant circumstances
- It is a violation to enter into any transaction with a customer at a price not reasonably related to the current market price of the security
- It is a violation to charge a commission that is not reasonable
- The standard applies to both agency transactions (commissions) and principal transactions (markups/markdowns)
Why Doesn't a Fixed Percentage Decide Fairness?
- There is no fixed percentage that automatically makes a charge fair or unfair
- A low markup can still be unfair, and a higher markup can be fair, depending on the circumstances
- What matters is whether the price is reasonably related to the security's current market value and whether the compensation is reasonable given all relevant facts
- The standard applies to all securities transactions with customers, including both listed and OTC securities
What Is the 5% Policy and When Doesn't It Apply?
The industry uses a 5% policy (a FINRA markup guideline) as a benchmark for judging whether a markup, markdown, or commission is fair. It is a guideline, not a ceiling:
- A charge at or below 5% is not automatically fair: a lower markup can still be unfair given the circumstances
- A charge above 5% is not automatically a violation: it may be justified when the circumstances support it, such as a thinly traded security that took real effort to locate
- The policy applies to both commissions (agency) and markups or markdowns (principal), and to both listed and OTC securities
- The policy does not apply to securities sold under a prospectus or offering circular at the specific public offering price. This carve-out is why a mutual fund's front-end sales load can exceed 5% without breaching the policy
What Are the Seven Factors That Determine Fairness?
| Factor | How It Affects a Fair Markup |
|---|---|
| Type of security | Common stocks customarily carry higher markups than bonds of the same dollar amount; government securities typically carry the lowest markups |
| Availability | Inactive or illiquid securities can justify wider spreads, since locating them takes more effort and cost |
| Price of the security | Lower-priced securities customarily carry higher percentage markups, since fixed handling costs are a larger share of the transaction |
| Dollar amount of the transaction | Smaller transactions may justify a higher percentage markup to cover handling costs |
| Disclosure | Advance disclosure of the markup is a factor, but it does not, by itself, justify an excessive charge |
| Pattern of markups | A firm's overall pattern draws scrutiny; a pattern that consistently runs near or above 5% attracts regulatory attention |
| Nature of the firm's business | The cost of the services and facilities the firm provides may also be considered |
Exam Tip: Gotchas
- Fairness is not decided by a fixed percentage. A low markup can be unfair; the test is the relationship to current market value and the reasonableness of the charge.
- Disclosure does not cure an excessive markup. Telling a customer in advance about a high markup does not make it fair.
- The fair-pricing standard applies to all securities, not just OTC or unlisted securities. The 5% policy itself, however, does not apply to securities sold under a prospectus or offering circular at the specific public offering price, which is why a mutual fund's front-end load can exceed 5% without breaching the policy.
What Should You Check on Exam Day?
- Fair pricing applies to agency and principal transactions on all securities, listed and OTC.
- The 5% policy is a guideline, not a ceiling: below 5% is not automatically fair, above 5% is not automatically a violation.
- The 5% policy does not apply to securities sold under a prospectus or offering circular at the public offering price.
- The seven factors (type, availability, price, dollar amount, disclosure, pattern, nature of business) determine fairness. Disclosure is only one factor and never cures an excessive charge on its own.