[ by Howard Haykin ]

FINRA announced on Monday the adoption of new FINRA Rule 5270, to address the front running of block transactions.  Rule 5270 will replace NASD IM-2110-3 in the Consolidated FINRA Rulebook and is scheduled to become effective 6/1/13. 

As differentiated from its predecessor rule, new FINRA Rule 5270: (i) applies to a broader range of securities than IM-2110-3;  (ii) includes new Supplementary Material regarding permitted transactions;  and, (iii) codifies that front running of a customer order may violate other FINRA rules or the federal securities laws.

FINRA Staff Contacts.   Direct questions to Brant Brown, Office of General Counsel = (202) 728-6927.

Background & Discussion.   In September, the SEC approved FINRA’s request to adopt FINRA Rule 5270, that is based principally on NASD IM-2110-3.   Among other things, Rule 5270 provides that:

• no member or person associated with a member shall cause to be executed an order to buy or sell a security or a related financial instrument when the member or person associated with the member causing the order to be executed has material, non-public market information concerning an imminent block transaction in that security, a related financial instrument or a security underlying the related financial instrument prior to the time information concerning the block transaction has been made publicly available or has otherwise become stale or obsolete.

The rule applies to orders caused to be executed for:

• any account in which the member or person associated with the member has an interest; 
• any account with respect to which the member or person associated with the member exercises investment discretion;  and,
• any account of customers or affiliates of the member when the customer or affiliate has been provided such material, non-public market information by the member or any person associated with the member.

How Rule 5270 differs from IM-2110-3.    The new rule differs in several important respects:

• The trading restrictions in Rule 5270 apply to a broader range of securities than IM-2110-3.
• Rule 5270 includes new Supplementary Material .04 re: permitted transactions that replaces the exceptions in IM-2110-3.
• New Supplementary Material .05 codifies that front running of any customer order, not just imminent block transactions, that places the financial interests of the firm ahead of those of its customer or the misuse of knowledge of an imminent customer order may violate other FINRA rules, including FINRA Rules 2010 and 5320, or the federal securities laws. Each of these changes is discussed below.

Expansion of Transactions.  Front running now will be prohibited for significantly more types of securities under new Rule 5270b, covering trading in an option, derivative or other financial instrument overlying a security that is the subject of an imminent block transaction:

• if the value of the underlying security is materially related to, or otherwise acts as a substitute for, such security, as well as any contract that is the functional economic equivalent of a position in such security (individually or collectively a “related financial instrument”).

The reverse is also true: When the imminent block transaction involves a related financial instrument, Rule 5270 prohibits trading in the underlying security.  Rule 5270 also applies to trading in the same security or related financial instrument that is the subject of an imminent block transaction.

Like IM-2110-3, the trading restrictions imposed by Rule 5270 generally apply until information about the imminent customer block transaction “has been made publicly available,” which the rule defines as having been disseminated to the public in trade reporting data.  However, because Rule 5270 includes related financial instruments that may not result in publicly available trading information being made available, the prohibitions in the rule are in place until the material, non-public market information is either publicly available or “otherwise becomes stale or obsolete.”

Permitted Transactions.   Supplementary Material .04 sets forth three broad categories of permitted transactions:

1. transactions that a firm can demonstrate are unrelated to the customer block order;
2. transactions that are undertaken to fulfill or facilitate the execution of the customer block order;  and,
3. transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange.

For the first category, Supplementary Material .04(a) ...  permits transactions that a firm can demonstrate are unrelated to the material, non-public market information received in connection with the customer block order. The Supplementary Material provides examples of transactions that, depending upon the circumstances, may be considered to be unrelated to the customer block order and, therefore, permitted under the rule.  Examples:

• transactions where firm has effective information barriers established to prevent internal disclosure of customer order information;
• transactions in a security that's the subject of the customer block order that are related to a prior customer order in that security;
• transactions to correct bona fide errors and transactions to offset odd-lot orders.

Firm must be able to demonstrate that the transaction at issue was unrelated to the customer block order. 

- e.g.,  a firm trading desk order coincides with an imminment customer block order, each involves the same security (or a related financial instrument);  the firm must demonstrate that its desk had no knowledge of customer order because it's adequately segregated or walled off, and that the timing of their respective orders was merely coincidental. 

The second category of permitted transactions involves ...  transactions undertaken to fulfill or facilitate the execution of the customer block order.  FINRA has acknowledged that firms are permitted to trade ahead of a customer’s block order when the purpose of the trading is to fulfill the customer order and when the customer has authorized the trading, including that the firm has disclosed to the customer that it may trade ahead of, or alongside, the customer’s order.  Supplementary Material .04(b) states that Rule 5270 does not preclude transactions undertaken for the purpose of fulfilling, or facilitating the execution of, a customer’s block order.

However, when engaging in trading activity that could affect the market for the security that is the subject of the customer block order, the firm must minimize any potential disadvantage or harm in the execution of the customer’s order, must not place the firm’s financial interests ahead of those of its customer and must obtain the customer’s consent to the trading activity.

The third, and final, category of permitted transactions is addressed in ... Supplementary Material .04(c) and concerns transactions executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange.  This provision states  that the prohibitions in Rule 5270 shall not apply if the firm’s trading activity is undertaken in compliance with the marketplace rules of a national securities exchange and at least one leg of the trading activity is executed on that exchange.

For further details, go to:  [FINRA RegNote 12-52, December 2012].

FINRA offers the following info:

Suggested Routing:  Compliance;  Legal;  Operations;  Senior Management;  Systems;  Trading.
Key Topics:  Customer Order Protection;  Front Running.
Referenced Rules & Notices.   FINRA Rules 0150 ...  FINRA Rule 2010  ...  FINRA Rule 5270  ...  FINRA Rule 5320  ...  FINRA Rule 6730  ...  NASD IM-2110-3  ...  NTM 05-51  ...  NTM 97-57  ...  NTM 96-66  ...  NTM 87-69  ...  RegNote 10-24.