When your stockbroker sells you a security, whether it be a bond or a stock, you are typically charged a “commission” which is fully disclosed and appears on your confirmation. So for example, you may wish to purchase 200 shares of Apple Computer (AAPL) or an exchange traded stock, and your broker, or brokerage firm acting as “agent” goes to a market-maker in the case of Apple or to a “specialist” in the case of an exchange traded security, and purchases these securities for your account.

Many of the nation’s discount broker will execute a market order for this stock for less than $29. Many of the nation’s large firms or wire houses, that may also provide research, at their highest possible commission rate, would charge less than $500 for this same transaction.

The Dirty Stockbroker Secret

However, in many cases, or actually not many cases, instead of acting as “agent” and buying the Apple stock directly for your account, a broker-dealer may instead act as principal, and with your Apple order in hand, go to a market-maker, and purchase the stock not for your account, but for their own proprietary account, and then turn around and sell it to you, on a riskless basis (because they already had your order), with a “mark-up.” And of course, the same thing happens when you sell it, they can run the trade through their trading account or proprietary account, and charge you a mark-down.

Now of course, when your broker does sells you securities from its own account as principal, the broker has to disclose only that amount of the “mark-up” that is above the prevailing offer. So if a stock is offered at $25 per share, which is the price you have to pay if you want to but it as agent, but is bid at $24.75 per share, the price you would get if you wanted to sell it, the broker only has to disclose the mark-up it charged you over the prevailing offer. In the case of municipal bonds or thinly traded securities which may have large “spreads” between the bid and offer, a firm may purchase securities at the bid (as market-maker or from another customer), lets say in the case of a bond that is $95 bid (per bond), and sell it to you as principal at the offer, in this case $100 (per bond), and never have to tell you anything about the gross trading profit it made.

Back to our example involving Apple Computers, I can buy 200 shares of Apple Computers, and my broker, if the transaction is effected as “principal,” may tell me that I did not pay a “commission,” other than perhaps postage or handling (where some firms may charge as much as $50), “the average retail brokerage customer may believe it. However, when I get my confirmation in the mail, I may see an “executed price” that is different than the price I paid, and also may be followed by an obscure notation “m/u.”

Although technically true because a “mark-up” is not a “commission,” under present FINRA Rules on a $100,000 order of Apple my broker may charge me as much as $5,000 or 5% of the order, and unless I knew what “m/u” means or did the calculations, despite that the commission box on the confirmation is empty, I would never know I just paid $5,000 for a transaction I could do anywhere else for one tenth the price.

FINRA Regulates The Charges

FINRA (formerly the NASD) however, regulates the charges that I can be charged as a mark-ups or mark-down. NASD Rule 2440 (Fair Prices and Commissions), NASD IM-2440-1 (Mark-Up Policy) and NASD IM-2440-2 (Additional Mark-Up Policy For Transactions in Debt Securities, Except Municipal Securities) — collectively referred to as the “markup rules” — govern markups, markdowns and commissions in transactions with customers. Charges or fees that are not transaction-related, such as charges for safekeeping or collecting dividends or interest for a customer, are governed by NASD Rule 2430 (Charges for Services Performed).

Under current policy the is a “5% mark-up” guideline, which subject to certain exceptions, limits the amount of this mark-up or mark-down on riskless principal trades to 5%. The “5% Policy,” stating that the “5% Policy” is a guide and not a rule (NASD IM-2440-1(a)(1)). (Of course in the case where the firm is at risk or a market maker, all bets are off, the broker’s compensation may be almost unlimited (particularly where they dominate or control the price of a security or there are large spreads), and the broker only has to tell you what you paid in excess of the offer).

FINRA Proposed Policy Change

In any event, in March 2011, FINRA proposed to eliminate the “5% policy” and the “proceeds provision” in NASD Rule IM-2440-1.

FINRA believes that the “5% Policy” — which is based on the execution practices and market efficiencies of nearly 70 years ago — should not be transferred to proposed FINRA Rule 2121. The “5% Policy” is viewed by many as establishing a presumption that markups, markdowns and commissions in excess of 5 percent are prohibited, or, at best, are subject to additional scrutiny, requiring the firm to provide more justification to prove that such remuneration is not “excessive.” Conversely, the “5% Policy” is also viewed by many as establishing a specific ceiling or cap below which most markups, markdowns or commissions will not be viewed as excessive (or will not be questioned).

According to FINRA, five percent is significantly higher than the average markup, markdown or commission currently charged by most firms in equity transactions. In a recent study conducted by an independent consultant, based on a sample of more than 161,000 equity transactions with customers, the mean markup was 2.2 percent and the average or median markup was 2 percent.10 Markdowns were even lower: the mean markdown was 1.9 percent and the median markdown was 1.3 percent.

When FINRA first proposed this Rule change, many practitioners, at least according to their Comments were outraged. As one Commentor put it: “By removing any tether to a real percentage or standard, FINRA is proposing a further license to steal for its members. It will spell further disaster for individual investors.”

Investor Legal Clinics Opposed the Policy Changed

Investor Legal Clinics, such as at Cornell Law School and at St. John’s University in New York, who typically represent investors in smaller cases “opposed the deletion of the “5% Policy.” Instead of omitting the 5% cap entirely, we believe FINRA should consider instituting a lower cap, consistent with current data, for example, a cap of 3%. The “5% Policy” is likely outdated if the mean markup rate is 2.2%; however, we think that having a cap is an important factor in keeping the mean rate low. Otherwise, prices may tend to rise with the removal of the 5% cap. We believe that in order for any cap to be meaningful, the rule must be clear that all markups, markdowns and commissions should never the less be judged on a case-by-case basis at the same level of scrutiny to determine if they are “fair and reasonable.” Overall, we think that revising the “5% Policy” to a “3% Policy” would help keep markups, markdowns and commissions low, while preventing brokers from charging higher without challenge.

Cornell’s Clinic suggested, that: (a) FINRA should replace the 5% policy with a 3% policy based on existing standards of excessiveness in U.S. Securities and Exchange Commission (SEC) litigated cases and current industry practice; (b) FINRA should not eliminate the “proceeds provision” in NASD IM-2440-1 because the benefits of the rule outweigh the difficulties of enforcement; and (c) FINRA should require firms to provide commission schedules for equity securities transactions to retail customers.

FINRA’s Proposal Was Scrapped

However, yesterday, it appears that FINRA is seeking comment on proposed FINRA rules governing markups, markdowns, commissions and fees and is proposing several changes to the proposed rules. This time, although FINRA suggests it wants to retain the 5% markup policy in NASD IM-2440-1 (Mark-Up Policy) it now wants to eliminate the requirement to provide commission schedules for equity securities transactions to retail customers, meaning that your broker can still charge you the 5%, but in so doing does not have to tell you or make available to retail customers the schedule(s) of standard commission charges for transactions in equity securities with retail customers.

Guiliano Law Group

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