Introduction
In recent years, markups have become a growing concern for regulators,
and brokerage firm markup policies and procedures have come under
increasing scrunity from the SEC and the NASD.
Essentially, a markup, or markdown, is the amount of money above
(or below) the "inside" market that a broker dealer may charge
to its customer on a particular trade.
The inside market is the highest "bid" price (the price at which
a market maker will purchase the securities from a customer) and
the lowest "asked" price, the price at which the market maker
will sell the stock to a customer. The difference between the
bid and the ask is know as the "spread".
The NASD Policy
Charging excessive mark-up is a violation of both the NASD's markup
policy (Rules of Fair Practice, Article III, Section 4) and the
1934 Act's Rule 10b-5.
The NASD views markups in excess of 5% above the prevailing
market price to be a violation of the requirements that a broker-dealer
comply with the basic principles of fair and equitable trade.
There are unique circumstances where the relevant facts justify
a markup/down of over 5%. Such markups/downs should require Compliance
Department approval prior to such charges being made.
The SEC Rule
The SEC views mark-ups in excess of 10% above the prevailing market
price in equity securities without disclosure of same to be a per
se violation of the 1934 Act's Section 10b-5 and Rule 10b-5.
Mark-ups on the sale of debt securities generally are expected to
be lower.
The NASD Board of Governors has determined that:
- The "5% Policy" is a guide -- not a rule.
- A member may not justify mark-ups on the basis of expenses
which are excessive.
- The mark-up over the prevailing market price is the significant
element in determining fairness of dealing with customers in
principal transactions. In the absence of an independent market
(where a member dominates and controls the market) a member's
own contemporaneous cost is the best indication of the prevailing
market price of a security. (See NASD Notice to Members 92-16.)
- Determination of the fairness of mark-ups must be based on
a consideration of all the relevant factors, of which the percentage
of mark-ups is only one.
The following factors must also be considered:
- a) the type of security involved;
- b) the availability of the security in the market;
- c) the price of the security;
- d) the amount of money involved in a transaction;
- e) disclosure;
- f) the pattern of mark-ups; and
- g) the nature of the member's business.
Domination and Control
There is one particular circumstance where markups are causing particular
concern; when the broker-dealer "dominates" or "controls" the market
for a particular security. In such instances, the "inside" market
will be measured by the broker-dealers' contemporaneous cost of
the securities, NOT the published market quotes.
Since using contemporaneous cost can have a material effect
on the amount of a markup, brokerage firms have begun to carefully
monitor the firm's market making activities, to insure that the
traders are aware of when the firm can be said to dominate or
control a market.
In order to monitor the firm's trading activities, many brokerage
firms create and monitor in house "Domination" and "Control" charts.
A Brokerage Firm's "Domination" chart will typically set forth
on a weekly basis all those securities in which a brokerage firm
makes a market and a percentage will be determined for each such
security.
The "domination" percentage will be determined by a numerator
comprised of the total number of shares in the particular security
traded by a brokerage firm and its customers divided by a denominator
of the volume of shares traded as reported by NASDAQ.
A Brokerage Firm's "control" chart will set forth on a monthly
basis, each security in which a brokerage firm has made a market
during the month. A "control" percentage will be determined by
a numerator comprised of the total number of shares held at or
about the date being reviewed in a brokerage firm's trading accounts
and the accounts of its customers divided by a denominator of
the numberin the "public float" for the security, as reported
in the issuer's latest available SEC filing. Each chart will contain
a "flag" or mechanism to visually indicate when the percentage
is 70% or greater.
While use of these control and domination charts will not guarantee
a violation-free trading room, such documentation will help to
prevent a violation, and may provide a defense to a regulatory
action, premised upon the inadvertant nature of any violation
that does in fact occur. The SROs are looking for these types
of charts and procedures to monitor markup issues, and brokerage
firms and traders are well advised to insure that these procedures
are in place.
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