FINRA Rule 2121 - Fair Prices and Commissions
Now that you understand the types of broker-dealer compensation, the next question is: how much is too much? FINRA Rule 2121 provides the framework for evaluating fairness.
The Core Rule
- FINRA Rule 2121 requires that members 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 rule applies to both agency transactions (commissions) and principal transactions (markups/markdowns)
The 5% Policy - A Guideline, Not a Rule
- The "5% policy" originated in 1943 based on studies showing the large majority of customer transactions were executed at markups of 5% or less
- 5% is a guideline, not a firm ceiling
- A markup below 5% can still be unfair depending on the circumstances
- A markup above 5% may be acceptable in certain situations (though it requires strong justification)
- The policy applies to all securities transactions with customers, including both listed and OTC securities
Exam Tip: Gotchas
The exam frequently tests whether 5% is a hard rule or a guideline. The answer is always: guideline. A 3% markup can be unfair. A 6% markup can be fair. It depends on the circumstances.
Seven Factors for Determining Fairness
When evaluating whether a markup or commission is fair, FINRA considers seven factors:
| Factor | Explanation |
|---|---|
| Type of security | Higher markups are customary on common stocks than bonds of the same dollar amount; government securities carry the lowest markups |
| Availability in the market | Inactive or illiquid securities may justify wider spreads due to the effort and cost of acquiring them |
| Price of the security | Lower-priced securities customarily carry higher percentage markups because fixed handling costs represent a larger share of the transaction |
| Dollar amount of the transaction | Smaller transactions may warrant higher percentage markups to cover handling expenses |
| Disclosure | Advance disclosure is considered but does not justify an excessive charge |
| Pattern of markups | The member's overall pattern of markups is scrutinized - a consistent pattern near or above 5% draws regulatory attention |
| Nature of the member's business | The cost of services and facilities the member provides may be considered |
Key takeaway: No single factor determines fairness. All seven are weighed together.
Prevailing Market Price for Debt Securities
For bond transactions, FINRA uses a specific hierarchy to determine the prevailing market price:
- Contemporaneous cost (for sales to customers) or contemporaneous proceeds (for purchases from customers) - this is the presumptive prevailing market price
- If no contemporaneous transactions exist, reference (in priority order):
- Inter-dealer transactions
- Institutional account transactions
- Dealer quotations
Exam Tip: Gotchas
- Disclosure does not cure an excessive markup. Telling a customer in advance about a 7% markup does not make it fair.
- 5% is a guideline, not a hard limit. Both higher and lower markups may be appropriate depending on circumstances.
- The policy applies to all securities, not just OTC or unlisted securities.