FINRA Rule 2121 governs markups in securities transactions. The rule requires that a FINRA member buy or sell a security at a price which is fair after taking into account all relevant circumstances, including market conditions. FINRA, and before that NASD, has long provided guidance to broker-dealers suggesting that 5% is the most that can be charged as a markup, thus this policy has been named the “5% Policy’ or the “5% Rule’ by those who are familiar with it. Further, there are cases suggesting that a markup of 10% or more is fraudulent.
It is important to note that the “5% Policy’ was created at a time when spreads were wider and the markets were not as liquid and efficient as they are today. In fact, in FINRA’s Rule 2121.01, it states that the “5% Policy’ was adopted by the NASD Board in 1943.
Today, generally speaking, if a firm is charging a 5% markup on a listed equity transaction, they will receive a good deal of attention from FINRA. FINRA has long stated that the “5% Policy’ is a guideline and not a hard and fast rule.
In determining commission and markup policy, broker-dealers must take into account numerous factors such as: the type of security involved (listed common stocks versus bonds versus private placements), the availability of the security (thinly traded can justify a higher markup), the price of the security (higher markup/commission for lower priced securities), transaction size (again, smaller means more markup or commission), whether disclosure was made to the client in advance (can justify higher markup), the pattern of markups (regularly high markups get more addition than the one-off), and the nature of the broker-dealer’s business (the services being provided).
The key here is whether a particular markup or commission can be justified. For those charging higher markups and commissions, they should be able to substantiate the reasons as outlined above, and they should be able to show what work they did to earn the markup (e.g. research, inquiry, etc.). Also, it is important to keep good records about markup decisions or compliance inquiries. Firms should have a stated markup policy and deviations from the policy should be detected by firm compliance systems and investigations of these deviations should be documented.
Broker-dealers should have supervisory systems in place that track the amount of commissions, identify any outliers, and document decision-making and inquiries about deviations from standard policy. Also, firms should evaluate the commission activity in customer accounts over time, determining the cost/equity ratio and turnover ratios in customer accounts. Any exceptions should be documented and addressed through standard protocols for active accounts.
If you have questions about markup or commission issues, Mitch Atkins, FINRA’s former South Region Director has extensive experience in this area. Call Mitch Atkins, Principal at FirstMark Regulatory Solutions, at 561-948-6511.