In recent years, markups have become a growing concern for regulators, and brokerage firm markup policies and procedures have come under increasing scrutiny 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 known as the “spread”.
The NASD Policy
Charging excessive markup 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 markups 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. Markups 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 markups on the basis of expenses which are excessive.
The markup over the prevailing market price is the significant element in determining the 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 markups must be based on a consideration of all the relevant factors, of which the percentage of markups 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;
f) the pattern of markups; 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 number in 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 the 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 inadvertent 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 ensure that these procedures are in place.
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Mark J. Astarita, Esq. represents investors, financial professionals and firms in litigation, arbitration and regulatory matters across the country. He is a partner in the national securities law firm of Sallah Astarita & Cox, LLC and can be reached by email at firstname.lastname@example.org or by phone at 212-509-6544.
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