This chapter covers these various customer order rules and regulations related to the secondary market:
Registered representatives must create an order ticket for each order they place, which leaves a “paper trail” (virtually all order tickets are digital today) in case something goes wrong. The order ticket involves all of the details of a trade, which includes:
Representatives placing trades for customers often encounter scenarios involving trade cancellations. This can be a reasonably common occurrence, especially 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 was $75 a few weeks later, it might make sense for the investor to cancel their order. Unless they think the price will come back to $50 (buy limits execute at the price specified or below), the investor should probably consider a different move.
What if an investor places an order, it executes, and they want to cancel the order? If the representative taking the order followed instructions correctly, the investor is stuck with the purchase or sale made on their behalf. Brokerage firms usually record their phone calls to provide an unbiased accounting of customer interactions. That way, a customer accusing a representative of placing the wrong order can be proven right or wrong.
But what if the representative truly messes up an order? 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 a scenario like this, the brokerage firm is responsible for fixing the representative’s trade error. In our example, the firm would place the incorrectly purchased AMZN shares in their error account. Subsequently, AAPL stock would be sold* to the customer at the market price they would have received if the representative had placed the order correctly.
*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 result in significant costs for brokerage firms, especially if market prices are volatile. In the previous example, assume AAPL stock was trading at $125 when the trade error occurred. It may take the customer a few days to notice the error and contact the firm. What if AAPL’s market price is $150 by the time the error is corrected? This scenario results in a $25 per share loss that must be absorbed by the firm (sell shares to the customer at $125 when they’re currently worth $150). If the trade was for 1,000 shares, a total $25,000 loss occurs. To reduce trade errors, brokerage firms typically require their representatives to follow rigorous checklists when placing orders.
Regardless of transaction type, broker-dealers must make their customers “whole” if a representative incorrectly places a trade. Firms must grant their customers the transactions that should have occurred, regardless of the cost of fixing the situation.
After representatives submit order tickets, supervisors must review their work “promptly,” usually by the end of the day. Formally referred to as principals, supervisors should do their best to spot mistakes after a representative submits a customer order. If an error is spotted, principals have the power to update the order. Even if the representative placing the trade notices the mistake first, they should not fix the error themselves. Instead, they should notify their assigned principal to remedy the situation.
Another example of a situation requiring principal approval relates to name changes. For example, let’s assume a customer gets married and changes their last name. Shortly after being married, the customer requests for their name to be changed within the broker-dealer’s system. At the same time, the customer submits a trade request. FINRA Rule 4515 requires the name change be reviewed and approved by a securities principal before any trades can be executed.
If you place customer orders in your career, you’re likely to encounter a customer requesting an unsuitable order. For example, a retired customer with limited resources may want to place a trade for a very risky stock. Representatives are responsible for informing their customers of the risk they’re encountering. However, if they refuse to listen and insist on placing the order, the representative must submit the order. Ultimately, the customer is in charge of their money and decides what occurs in their account.
In this situation, it’s always best for the representative to document their customer interaction in writing. Firms maintain files on every customer, including transaction history, account positions, and notes on previous interactions. The investor’s expectations may not materialize and could result in significant losses. Interaction notes could help cover the firm’s liability. If the trade resulted from a recommendation, the firm might be liable if the transaction was unsuitable.
Order ticket rules require marking sales as long or short. A long sale involves a sale of stock the investor owns and possesses. A short sale involves a sale of borrowed shares, typically to bet against the security.
Regulation SHO is a Securities and Exchange Commission (SEC) rule that enforces specific short sale requirements, particularly for financial firms like broker-dealers. When an investor requests a short sale trade, firms must perform the “locate requirement.” Essentially, the firm must locate and identify the security it plans on lending to its customer for short-selling purposes. The SEC can penalize firms for naked short selling if this does not occur.
There are two primary ways a broker-dealer can fulfill the locate requirement. First, some broker-dealers have sophisticated computer systems that quickly identify which shares they’re selling short. 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 they’re lending out
Broker-dealers can also meet the requirement by utilizing the easy-to-borrow list. This list is updated by broker-dealers at least once a day to reflect the securities they reasonably expect to borrow effortlessly. Securities on the easy-to-borrow list are stocks of well-known and heavily traded companies. Suppose an investor wants to sell short a security on the easy-to-borrow list. In this scenario, broker-dealers are not required to identify the shares before lending them out (although they will eventually identify them). Easy-to-borrow lists are usually available to broker-dealer customers who wish to short sell.
There’s also a hard-to-borrow list, which is the opposite. Some broker-dealers do not allow investors to sell short securities on this list, while others will charge higher fees if they allow it. 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 their investor. There are several markets where a security could be traded: the NYSE, NASDAQ, the third market, the non-NASDAQ OTC markets, etc. One way or another, financial firms are compensated for routing orders on behalf of their customers.
FINRA institutes a rule known as The 5% Rule, sometimes referred to as The 5% policy, which prevents firms from overcharging their customers. Generally speaking, firms should not be charging more than 5% for 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, let’s 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’s a guide for financial firms. A charge above 5% to complete a trade for a customer may not be breaking the rule. FINRA requires financial firms to consider several items when considering 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
Pattern of markups (fees)
Nature of the firm’s business
If a financial firm considers all these factors while consistently charging fees lower than 5% for most trades, they’re likely to avoid FINRA penalties. Of course, difficult trades could warrant a fee higher than 5%. For example, a firm could 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 if 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 what it sounds like. These occur when a customer requests a liquidation (sale) of a security, then uses the sale proceeds to purchase 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 considers it one trade to determine the fee percentage.
Let’s assume an investor sells $2,000 of WMT stock to purchase $2,000 of TGT stock, then is charged a $200 commission. This would represent 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 in the trade was $4,000 ($2,000 sold, the $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. However, the firm does not have the security in its inventory. A riskless principal transaction would occur if the firm went to the market, bought the security into their inventory, then immediately sold it to their customer. Firms that perform trades on a principal basis risk being unable to sell securities in their inventory. This danger does not exist with a riskless transaction as an investor is waiting to purchase the security. Because of the lack of risk, firms should charge smaller transaction fees when facilitating these transactions.
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