FINRA Rule 2121, also known as the 5% rule or 5% policy, was adopted to ensure that the investing public receives fair treatment and is charged reasonable rates for brokerage services. The 5% rule is more of a guideline than a rule, as there is no set limit for the amount you can charge as a markup. While 5% was the suggested limit for markups in the past, with how liquid and efficient markets are today, charging around 5% will lead to greater scrutiny from regulators.
When Does Rule 2121 Apply?
Rule 2121 applies to non-exempt securities in both the OTC and the exchange markets. It does not apply to exempt securities, such as municipal bonds, or to prospectus offerings. If a member is required to give a customer a prospectus in any transaction, that transaction is outside the scope of the 5% policy. Some examples of prospectus offerings are new issues, mutual funds, variable annuities, and direct participation programs.
Exemptions
Broker-dealers may make transactions that are exempt from FINRA Rule 2121 if the customer is a Qualified Institutional Buyer (QIB) who can independently evaluate risks, and the security is non-investment grade.
A Qualified Institutional Buyer (QIB) is any entity acting for its own account or the accounts of other QIBs, that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity. If the institution is a bank, it must have a net worth of $25 million. If the institution is a broker-dealer trading for its own account, it must have a portfolio of at least $10 million of non-affiliated securities.
Considerations for Fairness of Markups
In assessing the fairness of a member’s commission and markup practices, FINRA considers the following factors.
Type of security
In general, there is more market risk associated with making markets and trading in common stocks than in bonds (assuming the bonds are nonconvertible). The more risk a member must assume, the greater the justification for higher markups.
Availability
An inactively traded stock would command a higher markup than an actively traded stock.
Price
The percentage markup should decrease as the selling price of a stock increases.
Dollar Amount
The greater the dollar amount, the lower the percentage markup.
Pattern of Markups
Although FINRA is concerned primarily with detecting cases where a member has established a pattern of excessive markups, a single incident would still be considered an unfair markup.
Disclosure
If there is a case involving unusual securities or special transactions where there is little or no precedent for determining the fairness of a commission or markup, the best practice would be for the firm to discloses its fee in advance of the transaction. While this does not relieve the firm of their obligation to keep their fees reasonable and fair, regulators may take the show of good faith into consideration.
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