Broker-Dealer Settles Charges for "Unfair" Mark-Ups
Commentary by Glen Barrentine
A broker-dealer settled FINRA charges for failing to charge a "fair" markup in corporate and municipal bond transactions and for failing to have a reasonable supervisory system in place to achieve compliance with fair pricing rules.
According to the AWC, FINRA found that the broker-dealer "failed to consider the appropriate pricing information, ... to determine the prevailing market price" when trading corporate and municipal bonds. FINRA found that when selling to customers, the firm used its own costs to determine the prevailing market price, even when its cost was not "contemporaneous" (as required); but when purchasing from customers, the firm in all cases used inter-dealer bid or offer quotations to determine the prevailing market price. As a result, the firm charged unfair prices on 98 bond transactions, which caused customers to pay $112,932 in excess of what they should have paid costs.
FINRA determined that the firm failed to establish and enforce a supervisory system reasonably designed to achieve compliance with fair pricing rules. Further, FINRA found that the firm's supervisory reviews of prices focused only on the size of mark-up and mark-down percentages, and the firm did not have any system to determine the appropriateness of the prevailing market price to which those mark-up and mark-down percentages applied.
FINRA found violations of Rule 2010 ("Standards of Commercial Honor and Principles of Trade"), Rule 2121 ("Fair Prices and Commissions") and Rule 3110 ("Supervision"); and MSRB Rules G-30 ("Prices and Commissions") and G-17 ("Conduct of Municipal Securities and Municipal Advisory Activities").
To settle the charges, the broker-dealer agreed to (i) a censure, (ii) pay a $125,000 fine, (iii) pay restitution of $112,932.02, plus interest, and (iv) undertakings to update its supervisory controls to comply with FINRA rules.
Commentary
The calculation of mark-ups and mark-downs on bonds under FINRA and MSRB rules can be complicated and often requires the exercise of judgment.
Specifically, FINRA Rule 2121 (and MSRB Rule G-30(a)) requires member firms to buy from customers or sell to customers at a price that is fair. For this purpose, fairness is to be determined by "taking into consideration all relevant circumstances ... with respect to [the relevant] security at the time of the transaction..." FINRA Rule 2121 Supplementary Material .02 (and MSRB Rule G-30 Supplementary Material .06) further provides that a dealer acting in a principal capacity in a transaction must calculate the mark-up or mark-down from the prevailing market price. Typically, the prevailing market price is calculated by referring to the dealer's contemporaneous cost, in the event of a sale, or contemporaneous proceeds, in the event of a purchase. Pursuant to FINRA Rule 2121.02(b)(3) (and MSRB Rule G-30 Supplementary Material .06(a)(iii)) "a dealer's cost [or proceeds] is considered contemporaneous if the transaction occurs close enough in time to the subject transaction that it would reasonably be expected to reflect the current market price for the security." When the dealer's cost or proceeds is no longer considered contemporaneous, or the dealer is able to bear the burden of showing that the dealer's contemporaneous cost or proceeds is not indicative of the prevailing market price, the dealer should consider the pricing information, in the order listed, set forth at FINRA Rule 2121.02(b)(5)(A)–(C) (and MSRB Rule G-30 Supplementary Material .06(a)(v)).
Given these requirements, it is important that a dealer's corresponding supervisory program consider not only the actual market as calculated but whether the prevailing market price used to calculate the mark-up or mark-down was appropriately calculated.