Excessive Markups / Markdowns

Markups and markdowns are a silent issue that usually goes unnoticed by investors. Most investors when reviewing their account statements or trade confirmations usually overlook the “capacity” in which their brokerage firm acted when executing a transaction. This can be misleading for investors when they try to calculate the compensation being taken by the broker.

What is a Markup and Markdown?

Brokerage firms can act in one of two capacities when executing a securities transaction. They can be acting as an “agent” meaning on behalf of the customer or as a “principal” meaning for their own account. Each of these capacities has different disclosure requirements.

When a brokerage firm acts as an agent the compensation is called a commission and will appear on the statement and confirmation as such. But when acting as a principal there is a “markup” or “markdown” that is embedded in the price to the client that is usually not disclosed.

Markups/Markdowns are only required to be disclosed for exchange-traded stock transactions (Securities Exchange Act of 1934 (“SEA”) Rule 10b-10). All other over-the-counter transactions such as bond trades do not require disclosure of the markup/markdown. They only disclose the final price to the client.

Issues With Excessive Markups and Markdowns?

When a brokerage firm sells a customer a security from its inventory (acting in a principal capacity) the broker will mark up the price it sells the security to the customer in order to be compensated for the transaction. In the same way when it buys a security from a customer for its inventory it will mark down the price to the customer. The difference or “spread” between the price given to the customer and the price of the security in the market is the compensation to the broker.

Due to little transparency and few instances where disclosure is required, many investors are not aware of whether or not there is a markup or markdown in a transaction and much less if it is excessive. Over the last few years though, the public has increasingly become more aware of the issue as regulators have taken action.

Rules and Regulations Protecting Investors

FINRA Rule 2121 Fair Prices and Commissions addresses markups/markdowns and commissions but fails to specify what would be considered “excessive.” In 1943, the National Association of Securities Dealers (“NASD”) (FINRA’s predecessor) adopted an unofficial guide known as the “5% Policy” which is incorporated into FINRA Rule 2121 through the supplementary guidance that states that a markup or markdown pattern of 5% or greater could be unreasonable.

While FINRA has shored up the rule by stating any markup or markdown in excess of 5% creates a rebuttable presumption that it is excessive, each markup or markdown is still evaluated on a case-by-case basis based on a variety of factors including the type of security involved, liquidity, and price among others.

It should be noted that this rule does not apply to securities sold through the use of a prospectus, offering circular or an initial public offering. Transactions affected by the rule guidelines include:

• Riskless or simultaneous transactions;
• Orders filled from inventory, also known as principal transactions;
• Orders filled from another broker-dealer’s inventory, also known as agency transactions; and
• Orders filled from securities purchased from another customer.

Municipal bonds have slightly different rules and guidelines. Municipal bond pricing is covered by MSRB Rules G-17 and G-30.

New Amendments to FINRA Rule 2232 Customer Confirmations Effective May 2018

In response to the overwhelming need for transparency for retail investors, FINRA has amended Rule 2232, entitled “Customer Confirmations,” to include a required disclosure of the markup/markdown the retail customer paid for a corporate or agency bond trade on the trade confirmation.

This change would be effective beginning May 14, 2018 allowing investors to close the gap in disclosure requirements between exchange-traded and over-the-counter securities in the future.

Silver Law Group is Experienced in Identifying Excessive Markups and Markdowns and Can Help You Recover

Silver Law Group’s team of lawyers can help you determine whether an investment loss is the result of excessive markups and/or markdowns in a brokerage account. If you have suffered losses as a result of excessive markups and/or markdowns, you may be able to recover your losses through FINRA arbitration. We work on a contingency fee, meaning you pay nothing unless we recover. Contact our firm for a free consultation.

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