SEC Approves Expanded SRO Front Running Rule (FINRA Reg. Notice) (Significant Rule Change)
FINRA Rule 5270, addressing the front running of transactions, will replace NASD IM-2110-3 in the Consolidated FINRA Rulebook. Changes introduced by Rule 5270 include its application to a broader range of securities than IM-2110-3, inclusion of new Supplementary Material regarding permitted transactions, potential extension of the time period in which the front running rules apply, and codification that the front running of a customer order may violate other FINRA rules or the federal securities laws.
Effective Date: June 1, 2013.
View Notice in full here (links externally to FINRA website).
See generally Lofchie's Guide to Broker-Dealer Regulation, Trading Chapter (Section X discusses front running).
Commentary
This is a fairly significant rule change that should cause firms not only to revisit their procedures, but really to reconsider how to apply the front running prohibition and how to interpret it in various circumstances. For example, in the case of an "imminent block transaction," the Rule applies not only to the relevant securities being traded, but also to related financial instruments, including instruments that may not be the subject of public trading (e.g., derivatives that are "materially related to, or otherwise act[] as a substitute for," the securities being traded). The Rule would also apply in the opposite situation, i.e., when the customer is trading in the derivative and the firm trades in related securities. Firms that are involved in, for example, swap transactions or security-based swap transactions, should consider how the new rule might apply to such transactions.
The Rule's prohibitions apply until, in the case of trading information that is not otherwise made public, the relevant information "becomes stale or obsolete." FINRA has said that this means, in the case of block transactions, that "the entire block transaction has been completed and publicly reported." In the case of markets which do not require reporting, FINRA has said that execution of the customer order would be sufficient to take related trading outside of the scope of Rule 5270.
From a policy standpoint, the new front running rule seems a material shift from the old rule. That is, the old rule was largely intended to prohibit a broker-dealer from taking advantage of a customer who had entrusted it with information. The new expanded rule seems intended also to prevent broker-dealers from obtaining any market benefit from knowledge of a customer's trades even where that benefit is not to the detriment of the customer who provided the information. Indeed, in its response to comments from SIFMA on the rule proposal, FINRA explicitly conceded that the rule is not solely about the protection of a customer's information, but also to prevent the misuse of material nonpublic information by the broker-dealer that harms the market in general.