On behalf of Mihalek Law posted in Securities Law on Friday, November 21, 2014.
In the last few years, FINRA (Financial Industry Regulatory Authority) has taken a number of actions against firms for charging excessive markups and markdowns on bond transactions. In the last three years, FINRA has fined several firms for charging their customers excessive markups and markdowns. A markup/markdown is charged to a customer, (as opposed to a commission), on a principal transaction. In an agency transaction, the commission must be disclosed to the customer on the confirmation. However, markups or markdowns charged in principal transactions need not be disclosed.
The difference between an agency trade versus a principal trade is: In an agency transaction, a broker-dealer finds a bond in the market and directs the sale to or from its customer. In a principal transaction, say a purchase, the broker-dealer sells a bond to its customer from its own account – even if the bond is bought by the broker-dealer and sold to the client just a few seconds or minutes apart. This is known as a riskless principal transaction.
Some of FINRA’s recent fines for excessive markups/markdowns include:
December 9, 2013: FINRA fines Oppenheimer $675,000 and orders restitution for charging excessive markups and markdowns of municipal securities.
June 26, 2013: FINRA fines State Trust Investments $1 Million for excessive markups and markdowns charged to customers.
April 4, 2012: FINRA fines David Lerner Associates $2.3 Million for excessive markups/markdowns and orders the firm to pay restitution of more than $1.4 Million.
March 19, 2012: FINRA fines Citi International Financial $600,000 for charging excessive markups and markdowns to more than 3,600 customers.
November 10, 2011: FINRA fines Morgan Stanley $1 Million and orders $371,000 in restitution and interest to customers for excessive markups and markdowns.
Since firms do not have to disclose markups and markdowns on principal transactions, firms may take advantage of the regulatory lapse and conduct bond trades in riskless (from the firm’s perspective) principal transactions. Rather than have the buyer and seller of the bond linked directly and the firm acting as an agent and disclosing its commission, the firm buys the bond from the seller, holds it in inventory for a few moments, marks the price up and then sells it to its customer without disclosing the markup.
FINRA and the MSRB (Municipal Securities Rulemaking Body) have proposed rules to change this procedure and require firms to disclose the markups and markdowns for retail-sized investments ($100,000 or less). Though this is a good start, we believe that institutional-sized investors need the same level of protection and transparency.