Additional FINRA, SEC, and NYSE rules
FINRA Rule 2165: Financial exploitation of specified adults
Certain clients may be at risk of financial exploitation. FINRA Rule 2165 applies only to adults: generally those aged 65 or older, but also adults 18 or older with certain medical conditions or other impairments that make it difficult or impossible to protect their own interests. A 16-year-old with autism would not qualify because they are a minor, but a 35-year-old with autism might. That depends on the firm’s reasonable belief, based on what it observes in its dealings with the customer - no court finding or diagnosis is needed.
For every non-institutional customer account, not just specified adults, the firm must make reasonable efforts to have a “trusted contact person” on file, both when the account is opened and when the account information is updated. That duty comes from FINRA Rule 4512. This does not mean pressuring the client until they provide a name - if they decline, the representative notes the request and asks again at a later meeting. Age alone doesn’t indicate impairment; many clients remain fully capable of managing their own affairs well into their 80s.
When a client who has been designated a “specified adult” makes a disbursement request that raises a reasonable belief of financial exploitation, the firm may place a 15-business-day temporary hold on the disbursement (or, since 2022, on a securities transaction in the account) to investigate. During this time, the firm reaches out to the trusted contact person, who then contacts the client to help verify whether the request is legitimate.
The firm also continues to investigate, and no later than 2 business days after the date that the member first placed the temporary hold, must notify all parties authorized to transact business in the account (excluding any party who might be responsible for the exploitation) and the trusted contact person (again, excluding any party that might be responsible for the exploitation).
If the internal review supports the belief in exploitation taking place, the 15-business-day hold can be extended for no longer than 10 business days following the first hold. After that, provided the review is still confirming the reasonable belief in some form of exploitation, and has reported it to the appropriate regulators, agency, or court, the firm can extend at most an additional 30 business days following the second hold. After that, the regulators, agencies, or courts would extend if needed.
Market access (SEC Rule 15c3-5)
Broker dealers are able to provide direct and sponsored market access to customers. Market access is defined as:
- Access to trading in securities on an exchange or alternative system as a result of being a member or subscriber of that exchange or system, or
- Access to trading in securities on an alternative system provided by a broker-dealer operator of an alternative system to a non-broker-dealer.
Providing market access allows both the broker-dealer’s proprietary accounts and their specified clients to trade using the broker-dealer’s market participant identifier (MPID). These customers are often institutional traders or high-frequency traders (HFT). Direct access means the customer uses the back office of the broker-dealer, and orders pass through the broker-dealer. Sponsored access means the customer uses their own back office or systems, and orders go directly to the exchange or alternative trading system without passing through the broker-dealer’s system.
The broker-dealer is ultimately responsible for both direct and sponsored access, so the SEC requires it to have financial and regulatory risk management controls and supervisory procedures that:
- Prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds.
- Prevent the entry of erroneous orders, by rejecting orders that exceed appropriate price or size parameters or that look like duplicates.
- Prevent the entry of orders that don’t meet the regulatory requirements that apply before an order is entered, and orders in securities a person is restricted from trading.
- Restrict access to the market access systems to persons and accounts the broker-dealer has pre-approved and authorized.
- Make sure appropriate surveillance personnel receive immediate post-trade execution reports.
These controls and procedures must be under the broker-dealer’s direct and exclusive control.
NYSE rules
Circuit breakers, also known as trading curbs, pause trading for a set period after a severe market decline, giving participants time to let conditions settle. They were introduced in October 1988, following the market crash of October 19, 1987, known as “Black Monday”, when the DJIA dropped 508 points - a 22.6% decline in a single day.
The original circuit breakers were measured on the DJIA. Today’s levels, measured on the S&P 500, date from 2012, when the exchanges and FINRA replaced the DJIA-based levels of 10%, 20%, and 30%.
Level 1 is a 7% drop, Level 2 is a 13% drop, and Level 3 is a 20% drop, each measured relative to the close of the preceding day. A Level 1 or Level 2 trigger halts trading across the markets for 15 minutes, unless it occurs after 3:25pm, in which case there is no halt. A Level 3 drop halts trading for the remainder of the day, no matter what time it happens.
Circuit breakers are market-wide. A similar, security-specific set of rules is known as the Limit Up-Limit Down Plan, or LULD. While circuit breakers only prevent dramatic losses, LULD prevents both dramatic losses and speculative gains. The thresholds for individual securities:
- 5% change in the value of the security if it is a Tier 1 security (included in the S&P 500 index, Russell 1000 index, or select exchange-traded products such as the Invesco QQQ ETF) with a price above $3.00
- 10% change in the value of the security if it is a Tier 2 security (any other NMS stock) with a price above $3.00
- 20% change in the value of the security if it has a price from $0.75 to $3.00
- The lesser of $0.15 or 75% of the security’s price, if it has a price of less than $0.75
The band is measured from the security’s average price over the preceding 5 minutes, and if trading can’t take place within the band for 15 seconds, trading pauses for 5 minutes. The previous day’s closing price is used to determine which price level (above $3.00, $0.75 to $3.00, or less than $0.75) applies the day the halt might occur.
Erroneous reports and transactions
Mistakes happen even in automated markets, and the rules treat a mistaken report of a trade differently from a trade executed at a clearly mistaken price.
Erroneous reports
Relatively small, but the idea is sometimes notifications, reports, are sent out by mistake, or with incorrect information. Maybe a client was notified they got one price on a trade, but it was actually executed at a different price, the report is not binding. If a report says a transaction occurred, when it in fact had not, that is not binding anymore than if the report had said the transaction had not occurred, when it in fact did. In that second case, the client is still bound by the transaction, even if the report said it didn’t happen.
Clearly erroneous transactions
Sometimes a trade happens at a price so far from the market that it is clearly erroneous, and it is broken as soon as possible, since it could create issues in other markets. An exchange, or FINRA for an over-the-counter trade in a listed stock, can break a trade whose price is away from the reference price, normally the last sale, by a set percentage or more.
Since October 2022, a regular-hours trade can’t be reviewed as clearly erroneous unless one of a few exceptions applies, such as the stock being outside the LULD Plan or its price bands not being available. The percentages below apply outside regular hours, and in regular hours only to stocks outside the Plan.
| Reference price | Outside regular hours | Regular hours, outside the LULD Plan |
|---|---|---|
| Over $0 up to $25.00 | 20% | 10% |
| Over $25.00 up to $50.00 | 10% | 5% |
| Over $50.00 | 6% | 3% |
Handling errors
Sometimes the broker-dealer or a representative makes a mistake when handling an order, and the firm will then use an error account to fix it. Errors could include things like buying the wrong security for the account, or the wrong number of a security for an account, to the detriment of the client. For example, the client places an order to buy 100 shares of a stock, but instead 1000 shares are placed, or 2 identical orders of 100 are placed. Either way, the client’s account will reflect the proper 100 shares, and the extras will be moved to the firm’s error account, and sold at its earliest convenience. Any use of error accounts will require a qualified principal designated by the firm to authorize.
An error is usually corrected with a cancel and rebill: the trade is canceled out of the account it was booked to and rebilled to the right account, or on the right terms, with corrected confirmations. Moving a trade from one account to another, including into or out of the firm’s error account, is a change of account designation, and FINRA Rule 4515 requires a qualified and registered principal designated by the firm to approve it in writing. The principal must be personally informed of the essential facts first, and those facts are documented and kept. A change made before the trade is executed must be approved before execution.
Principals watch cancel-and-rebill and error-account activity closely, because a “correction” can hide misconduct:
- Parking - selling securities to another party with an understanding that the seller will buy them back later at a price that leaves the economic risk with the seller, often to hide who really owns them.
- Unauthorized trades - a trade the customer never authorized, sometimes relabeled as an error once the customer objects. It violates FINRA Rule 2010’s just and equitable principles of trade.
- Unapproved discretion - choosing the security, the amount, or whether to buy or sell without the customer’s prior written authorization and the firm’s written acceptance of the account (FINRA Rule 3260). Discretion over only the time and price of a customer’s order is allowed without that paperwork, but it lasts only until the end of the business day it was granted, unless the customer signs and dates a written instruction saying otherwise.
A pattern of cancellations and corrections, especially many by the same person or with the same counterparty, is a red flag a principal should investigate.
Rules for research reports
Non-equivalent recommendations (SEC Rule 138)
Rule 138 is a safe harbor: research on one class of an issuer’s securities isn’t treated as an offer of a different class the firm is helping underwrite. Common stock and the securities convertible into it are one class; non-convertible debt and preferred stock are the other. If the firm is participating in a non-convertible offering of preferred stocks or bonds, it may publish research on the common stock and convertibles. If the firm instead is participating in a convertible offering, or an offering directly involving common stock, the safe harbor covers only research on the company’s non-convertible securities.
Publication of research reports by firms in the distribution (SEC Rule 139)
Simply put, if firms already publish research on a specific company, they can continue to do so if they are involved in the distribution. The specific company would have to be a large reporting company under the Securities Exchange Act of 1934. The firm has to publish research in the regular course of its business, and it can’t use this to start, or restart, coverage of the company.
Waiting periods (FINRA Rule 2241)
Waiting periods, or “quiet periods”, are when the publication of research reports and appearances by managers, co-managers, and underwriters cannot be done within time periods of an offering, to try and prevent influencing the price. Doing so would be “gun jumping” or “trading ahead of research reports” or other manipulatory act.
For an IPO, no underwriter or dealer that participated in the offering - including managers, co-managers, and syndicate and selling group members - may publish a research report for 10 days following the IPO date. For a subsequent offering, only the managers and co-managers are restricted, and only for 3 days following the offering date; syndicate and selling group members involved in a subsequent offering face no waiting period. None of these quiet periods apply after an IPO or secondary offering of an emerging growth company, the JOBS Act’s category for smaller, newer issuers.