This chapter covers customer order rules and regulations related to the secondary market:
Registered representatives must create an order ticket for each order they place. The order ticket creates a record (a “paper trail” - though most tickets are digital today) that can be reviewed if a problem arises.
An order ticket includes the key details of the trade, including:
Representatives placing trades for customers often run into situations where an order needs to be cancelled. This is especially common for unexecuted limit, stop, and stop limit orders.
For example, assume an investor places a buy limit at $50 for a stock currently trading at $52. If the market price is $75 a few weeks later, the investor may decide the order no longer makes sense and cancel it. (A buy limit executes at the limit price or lower, so it won’t execute at $75.)
If an investor places an order, it executes, and then the investor wants to cancel it, the outcome depends on whether the order was entered correctly.
If the representative truly enters the wrong order, the firm must correct the trade error.
For example, an investor requests a market order to purchase Apple Inc. stock (ticker: AAPL), but the representative instead places a market order to purchase Amazon.com Inc stock (ticker: AMZN).
In this situation:
*The brokerage firm could sell the AAPL stock out of their inventory if they owned it. Or, they could purchase shares from the market, then sell them back to the customer (at the price they should have received initially).
Trade errors can be costly, especially in volatile markets. Continuing the example, assume AAPL was trading at $125 when the trade error occurred. If it takes the customer a few days to notice and contact the firm, AAPL might be $150 by the time the error is corrected.
In that case, the firm must still give the customer the $125 execution they should have received. That creates a $25 per share loss for the firm ($150 current value minus $125 customer price). For 1,000 shares, that’s a $25,000 loss.
Regardless of the transaction type, broker-dealers must make customers whole when a representative incorrectly places a trade. The customer must receive the transaction that should have occurred, even if fixing the error is expensive.
After representatives submit order tickets, supervisors must review them “promptly,” usually by the end of the day. Supervisors are formally referred to as principals. Their job is to review customer orders and try to catch mistakes.
If an error is found:
Another situation that requires principal approval involves name changes. For example, assume a customer gets married and changes their last name. Shortly after, the customer asks the firm to update the name in the broker-dealer’s system and also submits a trade request. FINRA Rule 4515 requires the name change to be reviewed and approved by a securities principal before any trades can be executed.
If you place customer orders in your career, you may encounter a customer who insists on placing an unsuitable order. For example, a retired customer with limited resources may want to buy a very risky stock.
Representatives must explain the risks involved. However, if the customer refuses to change their mind and insists on placing the order, the representative must submit it. Ultimately, the customer controls what happens in their account.
In this situation, it’s best for the representative to document the interaction in writing. Firms maintain customer files that include transaction history, account positions, and notes from prior interactions. If the customer’s expectations don’t materialize and losses occur, these notes can help address liability questions. If the trade resulted from a recommendation, the firm may be liable if the transaction was unsuitable.
Order ticket rules require marking sales as long or short.
Regulation SHO is a Securities and Exchange Commission (SEC) rule that sets requirements for short sales, particularly for broker-dealers.
When an investor requests a short sale, firms must satisfy the locate requirement. That means the firm must locate and identify the security it plans to lend to the customer for short-selling purposes. If this doesn’t happen, the SEC can penalize firms for naked short selling.
There are two primary ways a broker-dealer can fulfill the locate requirement.
First, some broker-dealers use computer systems that quickly identify which shares will be lent. As you may remember from the SIE exam, most securities lent out by broker-dealers are customer-owned. Customers with margin accounts who previously signed the loan consent form may have their securities lent out for short sales. The locate requirement is met if the broker-dealer’s system can quickly identify the specific shares being lent.
Second, broker-dealers can use an easy-to-borrow list. This list is updated by broker-dealers at least once a day to reflect securities they reasonably expect to borrow without difficulty. Securities on the easy-to-borrow list are typically stocks of well-known, heavily traded companies.
If an investor wants to sell short a security on the easy-to-borrow list:
There’s also a hard-to-borrow list, which is the opposite. Some broker-dealers don’t allow short sales of securities on this list, while others allow them but charge higher fees. If a security is on the hard-to-borrow list, the firm must locate the shares before accepting the short sale order.
When a customer places a trade, broker-dealers must route the order to the best potential market to obtain the best execution (usually the best price) for the investor. A security may trade in several markets, such as the NYSE, NASDAQ, the third market, and the non-NASDAQ OTC markets, among others. One way or another, firms are compensated for routing orders on behalf of customers.
FINRA has a guideline known as the 5% rule, sometimes called the 5% policy, designed to prevent firms from overcharging customers. In general, firms should not charge more than 5% in transaction fees (fees could be commissions, markups, or markdowns).
To determine the fee charged to the customer, the inside market for the security is the basis. For example, assume this inside market:
Bid / Ask
40.00 x 40.50
If a firm sold this security to a customer at a marked-up price of $42, the markup would be $1.50. The ask is the basis for the markup; the bid would be the basis if the firm bought the security from the customer. A $1.50 markup compared to an overall sale price of $42 is roughly a 3.6% fee.
Although “rule” is in the name, it functions as a guideline. A charge above 5% may not automatically violate the policy. FINRA expects firms to consider several factors when deciding what fee* to charge:
*A fee could be a commission, markdown, or markup, depending on the trade.
Type of security involved
Availability of security
Price of security
Amount of money involved
Disclosure
Pattern of markups (fees)
Nature of the firm’s business
If a firm considers these factors and consistently charges fees below 5% for most trades, it’s more likely to avoid FINRA penalties. Some trades can justify a fee above 5%. For example, a firm might justify a 10% fee if it spent months trying to locate a thinly traded security held by very few investors.
The 5% rule also considers the type of trade when determining whether a fee is excessive. There are four general trade types, and you already have learned two of them (agency and principal trades). The two others are proceeds transactions and riskless transactions.
A proceeds transaction is when a customer sells a security and uses the proceeds to buy a new security. For example, a customer sells 100 shares of Walmart Inc. stock (ticker: WMT), and uses the proceeds to purchase as many shares of Target corp. stock (ticker: TGT) as possible.
While proceeds transactions involve two transactions, FINRA treats them as one trade for purposes of the 5% rule. The commission is compared only to the proceeds amount (the amount sold and reinvested), not the combined value of both transactions.
For example, assume an investor sells $2,000 of WMT stock to purchase $2,000 of TGT stock, and is charged a $200 commission. This represents a 10% charge based on $2,000 ($200 is 10% of $2,000), not a 5% charge based on $4,000. Although the total money involved was $4,000 ($2,000 sold and $2,000 purchased), FINRA views proceeds transactions as one transaction for the 5% rule.
A riskless transaction is a specific type of principal transaction. Assume a firm acting on a principal basis receives a request to buy a security from a customer, but the firm does not have the security in its inventory. A riskless principal transaction occurs if the firm goes to the market, buys the security into its inventory, and then immediately sells it to the customer.
Firms that trade on a principal basis risk being unable to sell securities they hold in inventory. That risk doesn’t exist in a riskless transaction because a customer is already waiting to buy the security. Because the firm takes on less risk, it should charge smaller transaction fees when facilitating these transactions.
Not all securities transactions are subject to the 5% rule. In particular, exempt securities and new issues (private or public offerings) avoid the rule.
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