Currently, U.S. broker-dealers are not required to disclose their compensation in respect of fixed-income transactions effected as principal. In November 2016, the SEC approved a rule proposal of the U.S. Financial Industry Regulatory Authority, or “FINRA,” that will require such disclosure for the first time for transactions conducted by FINRA members with non-institutional customers.[1] The revised rule’s mechanisms for determining, first, to which debt transactions the disclosure requirement applies, and second, how the mark-up/mark-down is to be calculated are detailed and in some respects complex.
The SEC simultaneously approved similar requirements for municipal securities.[2] The MSRB rule amendments will be effective May 14, 2018. FINRA has not yet announced an effective date for the amendments to Rule 2232, but it must be no later than May 23, 2018.
The Mark-Up/Mark-Down Disclosure Requirement
Covered Transactions: Overview
The disclosure requirement is limited to certain principal transactions with non-institutional customers[3] in corporate debt[4] or agency debt securities. The requirement is triggered only if the firm purchased (or sold) the same security in one or more offsetting transactions on the same trading day in an aggregate trading size meeting or exceeding the size of such customer sale (or purchase).
The disclosure requirement applies even if the customer transaction occurred earlier in the trading day than the offsetting marketplace transaction.
Covered Transactions: Affiliate Look-Through Requirement
If any such offsetting transaction is entered into with an affiliate, and if the affiliate transaction was not on an arms-length basis,[5] then the firm must look through to the time and terms of its affiliate’s purchase from or sale to a third party to determine whether the mark-up disclosure requirement is triggered.
One hypothetical scenario set forth by the SEC’s Investor Advocate illustrates how the affiliate look-through requirement would operate between two affiliated dealers:[6]
-
Dealer A1 purchases a bond from an unaffiliated third-party for $90 (“Transaction 1”)
-
Dealer A1 then displays the bond for sale for $93 on Dealer A2’s customer-facing platform
-
During the day, no other dealers display any price for the bond
-
Retail Investor sees the bond listed for $93 and places an order with Dealer A2 to purchase it at the displayed price
-
Dealer A2 purchases the bond from Dealer A1 at $93 (“Transaction 2”)
-
Dealer A2 sells the bond to Retail Investor for $93 + $1 trading fee
In this scenario, Transaction 2 would not in the SEC Investor Advocate’s view be an arms-length transaction for purposes of the rule, and as such, the Prevailing Market Price (the basis for the mark-up disclosure, as discussed below) would be determined based on Transaction 1’s price rather than Transaction 2’s price. Note that this analysis assumes that mark-up disclosure was required, which assumes that Dealer A2 purchased as much or more of the bond on the trading day than it sold in Transaction 2.
FINRA has provided guidance in Regulatory Notice 14-52 and in its response to comments as to whether the disclosure requirement is triggered in several scenarios.[7] For example, if a firm purchased 100 bonds from a dealer at 9:30 AM, and sold 50 of the same bonds to three customers on the same day without purchasing any more of the bonds, only two of the three customer confirmations would be required to have the mark-up/mark-down disclosure, as one of the customer trades would have been satisfied out of the firm’s prior inventory.
Firms will need to establish systems to determine for which of its principal transactions mark-up disclosure is required. For introducing firms, this will require coordinating with their clearing firm(s). FINRA noted that firms may voluntarily provide the mark-up/mark-down disclosure more broadly than Rule 2232 will require if they find it beneficial to do so.
Exceptions to Disclosure Requirement
The revised rule’s mark-up/mark-down disclosure requirement will not apply in the following scenarios:
-
Sales of securities acquired in fixed-price offering: The firm acquires the security in a fixed-price offering and sells the security to non-institutional customers at the fixed price offering price on the day the securities were acquired; or,
-
Transactions by separate trading desks: The non-institutional customer transaction is executed by a principal trading desk that is functionally separate from the principal trading desk within the same firm that executed the offsetting purchase, and the firm has in place policies and procedures reasonably designed to ensure that the trading desk through which the firm purchase/sale is executed had no knowledge of the customer transaction.[8]
Calculation of Prevailing Market Price
Under the revised rule, the mark-up/mark-down will be calculated with reference to the Prevailing Market Price as calculated pursuant to FINRA Rule 2121. The analysis required under Rule 2121 is outside the scope of this note, but several commenters noted the difficulty in automating processes to calculate Prevailing Market Price, given the subjective nature of some of Rule 2121’s analyses. FINRA in response noted that it recognized the potential challenges involved in implementing the rule changes, and that it will provide firms with interpretive guidance during the implementation process as necessary.[9]
Revised Rule 2232 will require disclosure of mark-ups/mark-downs both as a total dollar amount (the dollar difference between the customer’s price and the security’s Prevailing Market Price) and as a percentage amount (the mark-up/mark-down’s percentage of the security’s Prevailing Market Price).
Confirmation Disclosures
In response to commenters’ inquiries as to whether FINRA members may add explanatory or qualifying descriptions of the mark-up/mark-down figure, FINRA stated that it does not believe that members should be permitted to label the mark-up/mark-down disclosure as an estimate or approximate figure, but that firms would not be prohibited as a regulatory matter from including language that explains Prevailing Market Price as a concept or providing details regarding the firm’s methodology for determining Prevailing Market Price, provided that such disclosures are accurate.[10]
Introducing Firms
Introducing firms’ customer confirmations are generally prepared and sent by their clearing firms, and introducing and clearing firms will need to work to ensure availability of information regarding principal transactions necessary to comply with the rule.
Rule 2232(e): TRACE Link and Execution Time
Rule 2232(e) will also require that the firms provide on all confirmations for corporate or agency debt securities in transactions with non-institutional customers (i) a reference, and hyperlink if the confirmation is electronic, to a web page hosted by FINRA that contains TRACE publicly available trading data for the specific security that was traded, in a format specified by FINRA, along with a brief description of the type of information available on that page; and (ii) the execution time of the customer transaction, expressed to the second. The 2232(e) requirements apply regardless of whether the 2232(c) mark-up/mark-down disclosure requirement is triggered.
Conclusion
The revised rule will require substantial operational changes to existing broker-dealer systems. Firms will need to work quickly to establish processes that will permit compliance with the rule by its anticipated effective date.