Now that you understand the types of broker-dealer compensation, the next question is: how much is too much? The fair-pricing standard provides the framework for evaluating fairness.
The Core 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)
Fairness Depends on the Circumstances
- 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
The 5% Policy: A Guideline, Not a Ceiling
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
Factors used to judge fairness (sometimes called the seven-factor analysis):
- The type of security involved
- The availability of the security in the market
- The price of the security
- The amount of money involved in the transaction
- Any disclosure made to the customer before the trade
- The pattern of markups by the firm
- The nature of the firm's business
Disclosure is only one of these factors. Telling a customer about a high markup in advance does not, by itself, make it fair.
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.