NASD Reminds Members of the Requirement for Fairness Of Agency Commissions And Applicability of the 5% Policy

Executive Summary

Members are reminded that commission charges to customers in agency transactions are fully subject to all provisions of Article III, Section 4 of the NASD Rules of Fair Practice. As such, the NASD 5% Policy applies as equally to commissions on agency trades as it does to markups or markdowns on principal transactions. Members are urged to review the level of their agency commissions to ensure that they are fair and reasonable and fully comply with all aspects of Section 4.

Background

The fairness of members' charges to customers both in regard to markups or markdowns on principal transactions and commissions in agency transactions has been the subject of close examination by the NASD across the country. As is evident by the number of disciplinary actions taken in recent years by the NASD involving egregious markup practices that have resulted in the imposition of serious sanctions on members and their associated persons, the NASD has been an aggressive enforcer in ensuring fair dealing with customers. Concerns are now being raised with the level of commissions being charged to customers that in some instances are not fair and reasonable in light of the requirements of Article III, Section 4 of the NASD's Rules of Fair Practice. In addition, members have raised questions about the applicability of various aspects of Section 4 to agency commissions. This Notice is being issued to assist members in adopting policies and procedures designed to achieve compliance with Section 4, and in resolving questions of fairness in agency commission transactions.

Application of Article III, Section 4 and 5% Policy to Agency Commissions

Article III, Section 4 of the Rules of Fair Practice states in part that, if a member acts as agent for a customer in any transaction, the customer shall not be charged more than a fair commission or service charge, taking into consideration all relevant circumstances.

To provide direction in this area, the NASD Board of Governors adopted its 5% Policy as an Interpretation of the Board under Section 4. It indicates that it may be conduct inconsistent with just and equitable principles of trade for a member to charge a commission that is not reasonable. The policy further states that it applies to all transactions in which the member acts as agent and charges its customer a commission. Therefore, the NASD 5% Policy and Article III, Section 4 of the Rules clearly apply to commissions charged in agency transactions and are not limited to markups in principal transactions.¹

Regardless of product or type of transaction, members should ensure that customers are receiving fair prices and not being charged unfair or unreasonable commissions. The issue of fairness relative to agency commission charges as well as markups is determined by considering all relevant factors to the transactions. Article III, Section 4 requires any NASD member that acts as an agent for its customer to charge only a "fair commission or service charge, taking into consideration all relevant circumstances including market conditions with respect to such security at the time of the transaction, the expense of executing the order and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefore."² Disclosure does not justify a commission or markup that is unfair or excessive in light of all other relevant circumstances.

In addition, other relevant factors include the price of the security and the amount of money involved in the transaction. In this regard, members should pay particular attention to commissions charged on agency transactions involving low-priced securities, including consideration of minimum commission charges.

The NASD 5% Policy, which has been revalidated on various occasions since it was originally adopted in 1943, provides guidance to members in determining the fairness of markups, markdowns, and commissions. Consistent regulatory policy requires that agency transactions come under the same guidelines as principal transactions. Indeed, that approach was affirmed in 1943 in a letter from the NASD Board of Governors to the membership that discussed the NASD 5% Policy.

Where consummated on an agency basis, the commission charged the customer must not be unfair and should not exceed the amount which, were the member to act as a principal, would be in accord with the standards of practices discussed above.³

It expressly states that the 5% Policy is a guide, not a rule, and is applicable to commissions as well as markups and markdowns.⁴ Thus, if a member undertakes an agency transaction, a commission should generally not exceed 5 percent of the total transaction amount unless the member can show or document factors under the policy that justify a higher amount. The NASD has, since 1943, deemed it inconsistent with Article III, Sections 1 and 4 and just and equitable principles of trade for a member to charge a customer a commission or a markup/markdown that is not reasonable or fair in light of the 5% Policy.⁵

The 5% Policy does not define specifically what constitutes a fair or reasonable commission, since "what might be considered fair in one transaction could be unfair in another transaction because of different circumstances."⁶ Instead, the 5% Policy requires that a determination of the fairness of a commission is based on "a consideration of all the relevant factors," of which the percentage of commission on the transaction is only one.⁷ Indeed, as with a markup/markdown, the 5% Policy says that commissions at 5 percent, or even less, may be deter-mined to be unfair or unreasonable when the other relevant factors have been carefully considered.

Market Conditions

When the market conditions for a security reflect active and competitive trading, the security typically will be readily available for the member to buy or sell on behalf of its customer. Thus, active, competitive market conditions would not usually justify a higher commission. However, in the case of an inactive security, the member's effort and cost of buying or selling the security for the customer may have a bearing on the amount of commission. Any special or unusual effort or cost should be documented if a higher commission is to be justified. The member bears the burden of adequately documenting any such claim.

Expense of Execution

The cost of actual execution of the customer's transaction may be taken into account. Normal overhead expenses, including commissions or other compensation to be paid to registered representatives, should not be taken into consideration in determining whether commissions to be charged customers are reasonable.⁸

As the SEC has stated:

The fact that a member is entitled to a profit is merely one of the circumstances to be considered in determining whether a price is fair, and excessive expenses cannot justify an excessive markup.⁹

Value of Services Rendered

In most instances, a member's service to its customer in executing a buy or sell transaction as agent for that customer is not extraordinary and therefore not sufficient to justify a commission greater than 5 percent. For example, a member's efforts to promote the stock and stimulate its sales cannot be viewed as a service for which customers can be charged by raising the com-missions.¹⁰

Many of these factors were considered in a recent NASD disciplinary proceeding that involved a member, the sole market maker in the particular security at issue, who regularly charged its customers commissions ranging from 7 percent to 9 percent when acting as its customers' agent in the purchase or sale of securities.

In its decision, the National Business Conduct Committee found that the member failed to demonstrate any "extraordinary" expense, service, or market condition that would justify a commission in excess of 5 percent.¹¹

Members are also reminded of their obligation under Section 27 of the NASD Rules of Fair Practice to have in place adequate written supervisory procedures to monitor employee conduct in customer transactions, including the fairness of commissions.

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The NASD hopes that this Notice, which embodies longstanding NASD policies and principles, will aid members in their compliance efforts, and thereby enhance customer protection and help preserve the integrity of the marketplace.

Questions concerning this Notice may be directed to your local NASD District Office, or to William R. Schief (Vice President) or Daniel M. Sibears (Director), NASD Regulation, 1735 K Street, NW, Washington, DC 20006-1500.

¹NASD Manual, paragraph 2154.

²Ibid.

³ In re: National Association of Securities Dealers, Inc., 17 S.E.C. 459 at Appendix A (1944).

⁴ In a recent case, Kevin B. Waide, Securities Exchange Act Release No. 30561, footnote 12 (April 7, 1992), the SEC agreed that the NASD's 5% Policy applied to commissions in agency transactions. See Notice to Members 92-16 (April 1, 1992) for details concerning the application of the 5% Policy to markups and markdowns.

⁵NASD Manual, paragraph 2154.

⁶Ibid.

⁷Ibid.

⁸ See Osborne, Stern and Co., Inc., Sec. Exch. Act Rel. No. 31211 (1992), at footnote 13, and Boren & Co., 40 S.E.C. 217 (1960).

⁹Boren & Co., 40 S.E.C. 217 (1960). See also Kenneth B. Stucker, 42 S.E.C. 910 (1966) (Excessive expenses in effecting sales—such as studies of the companies involved, attendance at the companies' stockholder meetings, political activity to further the companies' interests, and compliance with recordkeeping requirements— didn't justify excessive charges to customers.).

¹⁰ See Kenneth B. Stucker, 42 S.E.C. 910 (1966).

¹¹ See Van Clemens & Company, Inc., CO4920012 (April 22, 1993).