The End of the 5 Percent Policy

February 14, 2011

FINRA Requests Comment on Proposed Consolidated FINRA Rules Governing Markups, Commissions and Fees

On February 11, 2011, FINRA requested comment on proposed consolidated FINRA Rules governing markups, commissions and fees. The proposed series of rules, one of the many in the litany of rule proposals to combine NASD and NYSE rules in the consolidated rulebook, represents the most significant changes with respect to markups in 70 years. Among the most significant proposals is the elimination of the 5 percent policy and the “proceeds provision” of NASD IM-2440-1. The proposed rule, however, only promises further guidance to firms about the acceptable level of markups, which, as historically true as related to transactions in debt securities, may suggest that FINRA will continue to provide guidance solely through enforcement action.

Elimination of the 5 Percent Policy

Proposed FINRA Rule 2121 would eliminate the existing 5 Percent Policy set forth in IM-2440-1. FINRA explains in detail that the 5 Percent Policy is based on the execution practices and market efficiencies of nearly 70 years ago and that in a current study of equity transactions, the average markup was significantly below 5 percent, or approximately 2 percent‚ for purchases. FINRA also states that markdowns are typically even lower than markups, and cites a study finding that the mean markdown for equity securities was 1.9 percent, and the median markdown was 1.3 percent. FINRA also reiterated that it believes that 5 percent is higher than the average markup or markdown currently charged for debt securities. In support of its conclusion, FINRA cites to an as yet uncompleted review of TRACE data for the first two quarters of 2008. FINRA also cites to competition, automation and market pricing efficiency, as support for its conclusion that markups and commissions have decreased materially below 5 percent.

The proposed rule does not include a new policy based on a lower percentage. Rather, FINRA proposes that firms apply the relevant factors currently set forth in IM-2440-1 to evaluate their remuneration in connection with a transaction. (FINRA’s proposed rule makes clear that it is focused on the fairness of remuneration, not the firm’s entitlement to a profit as it had previously stated.) FINRA also repeated its oft-promised, but yet to be delivered upon, expectation that it will provide guidance that markups, markdowns and commissions above certain specified ranges (e.g., 3 or 3.5 percent) will be subject to additional regulatory scrutiny.

Elimination of the “Proceeds Provision”

FINRA also proposes to eliminate the “proceeds provision” of IM-2440-1(c)(5), which addresses the total remuneration in connection with a sale and a corresponding purchase at or about the same time. FINRA recognizes that it may not always be clear when two transactions occurring close in time are related or how close in time the transactions must be to be considered “proceeds” transactions. As a result, FINRA concluded that the more rational approach is to assess the fairness of the remuneration for each transaction.

Commission Schedule Requirement

Under the proposal, FINRA will require that members establish and make available schedules of standard commission charges for transactions in equity securities. The schedules would be required to be made available to new and existing retail customers in writing or by posting them on the firm’s website. The proposed commission schedules would be limited to equity securities because, according to FINRA, such commissions are most easily compared by retail customers and more readily reduced to fixed amount or ranges than commissions applicable to other securities transactions.

Other Proposed Changes

Among the other proposed changes is the re-wording of IM-2440-1(a)(3) to clarify the presumption that a member’s contemporaneous cost is the best indication of the prevailing market price, unless other bona fide, more credible evidence of the prevailing market price can be evidenced. FINRA proposes to amend the current provisions of IM-2440-1(c)(2) to provide that any market appreciation or depreciation only applies to markdowns when a member purchases a security into inventory. FINRA also noted that the proposed markup rules do not address a market maker’s allowance, subject to limitations, to capture the trading spread between the bid and the ask prices.

Consistent with current IM-2440-2(b)(9), the new FINRA Rules will not apply to certain transactions in non-investment grade securities effected with certain Qualified Institutional Buyers (“QIBs”).   

Considerations for Firms

Firms are encouraged to read the entire discussion in Regulatory Notice 11-08, available at Comments to the proposed rule are due March 28, 2011. In reviewing the Notice and preparing Comments, firms may wish to consider the following:

  • Although FINRA proposes to eliminate the 5 Percent Policy, does the notice establish a de facto 2 percent guideline for markups and less than 2 percent for markdowns in equity securities transactions?
  • What is the implication for debt securities of the elimination of the 5 Percent Policy for equities? Does this call into question the merits of existing case law and guidance that holds that markups in debt securities generally are substantially lower?
  • FINRA examinations will establish a guideline which will require a review of markups and markdowns above a certain percentage. As in the past, this will be addressed by the Staff with the view that any transactions above the set percentages are presumptively violative. Should the examination process contain an undisclosed cap that is applied objectively but can be changed without notice? Does increased regulatory scrutiny mean a presumption of guilt?
  • How does a firm establish a standard commission schedule if it is required to consider the application of specific factors to each transaction?
  • Should proposed rules be allowed to go effective without promised guidance for equity and debt securities transactions?
  • Does the reference to the QIB exemption in proposed Rule 2121(d) extend the exemption for transactions with QIBs to equity securities transactions?
  • Should an additional factor to be considered in determining if a markup/markdown is fair and reasonable be the overall course of business between the member and the specific customer, including but not limited to specifically negotiated transactions and agreements?
  • Does FINRA recognize a market maker status with respect to debt securities? 


Although the views of the Staff can be gleaned from FINRA’s proposed rules, it does not provide clear guidance, particularly with respect to debt securities transactions. While it is clear that average markups, markdowns and commissions have declined over time, there is still uncertainty as to what is required of firms in order to avoid regulatory scrutiny and FINRA has historically been very hesitant to provide such guidance.



For additional information concerning this alert, please contact the following lawyers:

Amy Kroll, Partner, Broker-Dealer Group, 202.373.6118

David Boch, Partner, Broker-Dealer Group, 617.951.8485

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

This article was originally published by Bingham McCutchen LLP.