FINRA 5 Percent Policy – What Firms Actually Need to Know

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mitch atkins finraA practitioner’s guide to FINRA Rule 2121 — covering the rule text, the governing case law, how the 5% and 10% thresholds actually work, what FINRA is finding in current exams, and what your firm needs to do to stay compliant.

The Core Obligation

FINRA Rule 2121 — titled “Fair Prices and Commissions” — governs how broker-dealers price transactions with their customers. The rule’s language is deceptively simple: when a firm buys or sells a security for its own account (acting as principal), it must do so at a price that is fair, taking into account all relevant circumstances, including market conditions, expense, and the firm’s entitlement to a profit. When a firm acts as agent, it must not charge more than a fair commission or service charge. Importantly, the obligation runs in both directions. The rule applies equally to markups — when a firm sells to a customer above the prevailing market price — and to markdowns, when a firm buys from a customer below the prevailing market price. Both must meet the same standard of fairness.

“It shall be deemed a violation of Rule 2010 and Rule 2121 for a member to enter into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable.” FINRA Rule 2121, Supplementary Material .01 

Every markup and markdown analysis is anchored to the prevailing market price (PMP) — the price that reflects current market conditions at the time of the transaction. The markup or markdown is the difference between what the customer pays or receives and that PMP. Getting the PMP right is not a technicality; it is the foundation of the entire analysis, and it is where FINRA examiners focus first.

The 5 Percent Policy: What It Is and What It Isn’t

Alongside the rule text, FINRA maintains what is known as the “5 Percent Policy” — an interpretive guideline adopted by the NASD Board in 1943, based on studies showing that the large majority of customer transactions were executed at markups of 5% or less. The Policy has been reviewed and reaffirmed by the FINRA Board of Governors multiple times since then.

Understanding what the 5% figure actually means in practice requires reading it carefully:

What the rule actually says about 5 Percent

The 5 Percent Policy is explicitly a guide, not a rule. Critically, the rule states that a markup pattern of 5% or even less may be considered unfair or unreasonable — and that the percentage of markup is only one of several factors that determine fairness. There is no “safe harbor” at 5%. There never has been.

In today’s markets — far more liquid and transparent than 1943 — FINRA applies considerably more pressure well below the 5% threshold, particularly for listed equities where inter-dealer spreads are tight and execution costs are minimal. A 5% markup on a listed equity transaction will attract significant examiner attention.

The 10% Threshold: Per Se Fraud

While FINRA guidance frames the 5% figure as a guideline, the SEC has established a considerably harder legal line at 10%. This is not a soft regulatory expectation — it is stated explicitly by the SEC in Release No. 34-24368 (April 21, 1987), transmitted to the industry via NASD Notice to Members 87-31:

The Commission consistently has held that, at the least, undisclosed mark-ups of more than 10% above the prevailing market price are fraudulent in the sale of equity securities.”

SEC Release No. 34-24368 (April 21, 1987) — citing In re Alstead, Dempsey & Co.; In re Peter J. Kisch (Release No. 19005, 1982); In re Powell & Associates (Release No. 18577, 1982); James E. Ryan; In re Sherman Cleason (1944); Duker & Duker

This line of administrative decisions — running from Duker & Duker in 1939 through multiple SEC releases — establishes that an undisclosed markup exceeding 10% on an equity security is fraudulent under Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 17(a) of the Securities Act of 1933.

The standard is stricter for debt securities

For debt securities — corporate bonds, municipals, and government securities — the standard is stricter. The SEC has consistently held that markups on debt are expected to be lower than on equities. A markup that might be defensible on an equity may be clearly excessive on a bond of equivalent dollar value.

Disclosure does not cure an excessive markup under FINRA rules

Disclosing the amount of a markup to the customer before the transaction is a relevant factor under Rule 2121 — but it does not render an otherwise excessive or unfair markup permissible. The rule is explicit: disclosure itself does not justify a commission or markup that is unfair in light of all other circumstances. The disclosure defense is available only in the narrower federal fraud analysis — it may defeat the “undisclosed” element of a 10b-5 claim — but it carries no weight under the SRO fair pricing rules, where excessive markups are prohibited whether or not disclosed.

The Seven Factors: How Fairness Is Determined

Rule 2121’s Supplementary Material .01(b) sets out seven factors that firms and regulators must weigh in assessing whether a markup, markdown, or commission is fair. No single factor is determinative — the analysis is always holistic. All seven must be considered:

1. Type of security – Higher markups are more defensible on lower-grade, less liquid, or more complex instruments. Listed common stocks face the tightest standards. Bonds carry tighter standards than equities. Units of direct participation programs and condominium securities have historically carried higher acceptable markups than common stock.
2. Availability in the market – For inactive or thinly traded securities, the effort and cost of sourcing the security may justify a wider spread. The firm should document specifically what effort was required — dealer inquiries made, time spent, risk taken in positioning inventory.
3. Price of the security – Lower-priced securities generally support higher percentage markups. The rule acknowledges that low-price transactions may require more handling and expense. The key is whether the economics of the specific transaction actually bear this out.
4. Amount of money involved – Small-dollar transactions may justify a higher percentage to cover handling expenses. Larger transactions — particularly block trades — are expected to be more efficient. Sliding-scale grids tied to transaction size are common and appropriate when kept current.
5. Disclosure – Prior disclosure of the markup amount is one factor among seven — not a trump card. The rule is explicit that disclosure does not justify a charge that is otherwise unfair. It is relevant but limited in its protective effect under SRO rules.
6. Pattern of markups – Each transaction must individually meet the fairness standard. FINRA pays particular attention to patterns — a consistent pattern of elevated markups across a class of transactions or for a specific customer draws far more scrutiny than an isolated outlier that was promptly documented and addressed.
7. Nature of the firm’s business – Firms providing substantive, continuing services — research, market access, advisory capabilities — may have a stronger basis for higher charges than execution-only operations. Note: inventory losses or unrealized market losses the firm sustained are the firm’s risk and may not be passed through to the customer as a justification for a higher markup.

Determining the Prevailing Market Price

Every markup and markdown analysis begins with the prevailing market price. Rule 2121 and its Supplementary Material .02 (for debt securities) establish a clear hierarchy for determining PMP. Firms must follow this waterfall in order — they cannot skip levels or use a lower-tier source when a higher-tier source is available:

1. Contemporaneous cost (primary presumption) — For a firm selling to a customer, its own contemporaneous cost of acquiring the security is presumptively the best evidence of PMP. For markdowns, contemporaneous proceeds from the firm’s own sales control. This presumption is strong: a firm must produce actual evidence to overcome it — not just assert that market conditions changed.
2. Inter-dealer transaction prices — If no contemporaneous cost exists, or if the presumption is legitimately overcome (for example, due to a material interest rate change, a significant credit quality shift, or market-moving news after the firm’s acquisition), the next source is contemporaneous inter-dealer transactions in the same security.
3. Institutional transaction prices — Contemporaneous dealer purchases or sales to institutional accounts with which the dealer regularly transacts in the same security.
4. Inter-dealer bid/offer quotations — For actively traded securities only, validated contemporaneous inter-dealer quotations through a mechanism where transactions generally occur at displayed prices. Quotations for inactively traded securities are frequently subject to negotiation and may not reflect actual PMP.
5. Similar securities and economic models — Only when none of the above yield relevant pricing information. Economic models (such as discounted cash flow or credit spread analysis) may be used, but only at the bottom of this hierarchy — not as a shortcut past the earlier steps. Isolated transactions or a limited number of non-representative transactions have little or no weight.
Firms cannot skip levels in this hierarchy

Using quotations from a limited number of market participants when inter-dealer transaction prices are available, or relying on economic models when contemporaneous transactions exist, is itself a Rule 2121 violation — regardless of whether the markup ultimately charged would have been found fair under a correct PMP analysis.

Transactions Covered — and One Key Exemption

The 5% Policy and Rule 2121’s fair pricing obligation apply broadly across transaction types. Firms should not assume the rule is limited to straightforward principal sales from inventory.

Transactions the rule covers

  • Principal sales from inventory to customers
  • Principal purchases from customers (markdowns)
  • Riskless and simultaneous principal transactions
  • Agency transactions (commissions)
  • Proceeds transactions (see below)
  • All security types: equities, bonds, direct participation programs, oil royalties, and others

One key exemption

  • New issue / prospectus sales: the 5% Markup Policy does not apply where a prospectus or offering circular is required to be delivered and the securities are sold at the specific public offering price.

Note: municipal securities are subject to MSRB Rule G-30 for debt-specific pricing requirements. The general fair pricing obligation under Rule 2121 continues to apply.

Proceeds transactions require particular attention. When a customer liquidates a position and uses those proceeds to purchase another security at or about the same time, both legs are treated as a single transaction for markup purposes. Any profit the firm realized on the liquidation side must be included in calculating the total markup on the purchase. Firms that treat each leg as a separate, independent transaction — and calculate markups independently on each — are incorrectly applying the rule and likely charging the customer an aggregate amount that would not pass the fairness test if properly measured.

What FINRA Is Finding in Current Examinations

FINRA’s current examination priorities in this area focus heavily on fixed income and principal transactions. The following deficiencies are the most frequently cited:

  • Incorrect PMP determination. Firms not following the contemporaneous cost presumption, or bypassing the required waterfall by jumping to quotations or economic models when inter-dealer transaction prices are available. This is the most frequently cited deficiency in markup-related exam findings.
  • Inadequate oversight of third-party pricing software. Firms using vendor systems to determine PMP but lacking oversight of how the software establishes prices, not verifying that the firm’s own trade data feeds are complete and accurate, or allowing manual overrides without documented supervision and rationale for each override.
  • Stale markup and markdown grids. Relying on fixed pricing grids established years earlier and never updated to reflect changed market conditions, instrument characteristics, or current transaction economics.
  • No facts-and-circumstances analysis. Relying solely on grids or fixed thresholds to assess fair pricing — without conducting the actual multi-factor analysis required by the rule — is a supervisory deficiency even if no individual transaction is found to be priced excessively.
  • Yield impact not considered for short-term debt. Charging markups on short-maturity fixed income securities that materially reduce the investor’s yield to maturity — sometimes eliminating a significant fraction of available return — without accounting for that impact in the fairness analysis.
  • No PMP documentation. Firms are required to document the basis for PMP in each transaction, particularly when departing from the contemporaneous cost presumption. Without this documentation, the firm cannot meet its evidentiary burden if a transaction is challenged in an examination or enforcement proceeding.

Building a Compliant Markup and Commission Program

A sound compliance program in this area rests on three pillars: a written policy that accurately reflects the firm’s actual business and pricing practices; supervisory systems capable of detecting and investigating deviations; and documentation sufficient to support the firm’s positions under examination. Here is what each requires:

Written Policy

  • Standard markup and markdown ranges by security type — equities, investment-grade debt, high-yield, municipals, direct participation programs
  • An explicit PMP determination methodology that follows the Rule 2121 waterfall in the correct order
  • A documentation standard for transactions where contemporaneous cost is not used as PMP, including the specific basis for departing from the presumption
  • A proceeds transaction identification and calculation procedure
  • A grid review schedule — pricing grids must be reviewed and updated periodically to reflect current market conditions
  • Disclosure protocols for markups above standard policy thresholds

Supervisory Systems

  • Automated exception reports flagging transactions above defined markup and markdown thresholds by security type
  • Periodic recalibration of exception parameters — static exception reports become ineffective as market conditions shift and stop identifying genuine outliers
  • Oversight of any third-party PMP software, including verification that firm trading data feeds are complete, accurate, and current
  • Supervision of all manual PMP overrides, with documented rationale required for each
  • Account-level monitoring: cost-to-equity ratios and turnover ratios for active accounts, with a defined protocol for investigating outliers

Documentation

  • PMP determination record for each principal transaction, particularly where the contemporaneous cost presumption is departed from
  • Written rationale for exception transactions identifying which of the seven factors apply and what specific work was performed to justify the charge
  • Investigation records for all exceptions flagged by supervisory systems, including disposition and any follow-up action taken
  • Records of periodic grid and procedure reviews, including what was reviewed, who conducted the review, and what changes were made
The practical test

If a FINRA examiner asks two questions — “how did you determine the prevailing market price for this transaction?” and “what specific factors justify this particular charge?” — can every person who prices transactions at your firm answer both clearly and consistently, with supporting documentation? If not, the compliance program has gaps worth addressing before the next examination cycle.