[ By Howard Haykin ] FINRA has proposed a new FINRA rule for governing Front Running of Block Transactions.  It will be adopted in principal from NASD Interpretive Material IM 2110-3, Front Running Policy, which will be amended to broaden its scope and provide further clarity into activity that FINRA believes is inconsistent with just and equitable principles of trade. FINRA submitted on Thursday a rule filing with the SEC;  implementation of the new rule will take place within 180 days of the Commission's approval.  The implementation date will be announced in a Regulatory Notice within 90 days of the Commission's approval, and it will be implemented within 90 days of the RegNote publication. Background Information. The Front Running Policy, adopted in 1987 as an interpretation to Article III Section 1 of the NASD Rules of Fair Practice, states that it's inconsistent with just and equitable principles of trade for a member or an associated person of a member to buy or sell security futures or certain options for accounts in which the member or associated person has an interest when the member or associated person is in possession of material, non-public market information regarding an imminent block transaction in the underlying security. That same prohibition applies in the underlying security when the material, non-public market information regarding a block transaction concerns an option or security future on that underlying security.  The Front Running Policy also prohibits providing material, non-public market information re: an imminent block transaction to customers who then trade on the basis of the information. Such front running policy is limited to transactions in equity securities and options that are required to be reported on a last sale reporting system and to any transaction involving a security future, regardless of whether the transaction is reported. The prohibitions apply until the information concerning the block transaction has been made publicly available -i.e., "when [the information] has been disseminated via the tape or high speed communications line of one of those systems, a similar system of a national securities exchange under Section 6 of the Act, an alternative trading system under Regulation ATS, or by a third-party news wire service". Exceptions from the General Prohibitions. The Front Running Policy includes exceptions for "transactions executed by member participants in automatic execution systems in those instances where participants must accept automatic executions" as well as situations where a member receives a customer’s block order relating to both an option or security future and the underlying security and the member, in furtherance of facilitating the customer’s block order, positions the other side of one or both components of the order.  In the latter case, a member is still prohibited from covering any resulting proprietary position by entering an offsetting order until information concerning the block transaction has been made publicly available. Proposed Revisions to the Rule Interpretation. First, FINRA would ... extend the prohibitions in the rule to apply explicitly to all securities and other financial instruments and contracts - i.e., not only options and security futures - that overlay the security that is the subject of an imminent block transaction and that have a value that is materially related to, or otherwise acts as a substitute for, the underlying security.

Specifically, the extended prohibitions would cover 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 would also be true: when the imminent block transaction itself involves a related financial instrument, the proposed rule would prevent trading in the underlying security. The proposed rule change also extends the trading provisions in the rule to include explicitly trading in the same security or related financial instrument that is the subject of an imminent block transaction.

Although the proposed rule change would broaden the scope of trading covered by the front running rule, FINRA believes that the type of trading prohibited by the proposed rule change would generally already violate other existing FINRA rules, such as FINRA Rule 2010, Standards of Commercial Honor and Principles of Trade.  As FINRA noted when it first adopted the Front Running Policy, the adoption of the rule was never intended to imply that other forms of trading activity not explicitly covered by the Front Running Policy could not violate FINRA rules. Because FINRA believes the Front Running Policy is unduly narrow in capturing the types of front running activity that are inconsistent with just and equitable principles of trade, FINRA is proposing to broaden the language of the Front Running Policy to apply equally to all related financial instruments - e.g., stock options and futures, options futures, other derivatives, and security-based swaps - rather than be limited to equity securities, security futures, and certain options. Second, FINRA would ... propose that prohibitions of the rule be in place until the material, non-public market information is either publicly available or "otherwise becomes stale or obsolete."  Otherwise, the current trading restrictions, which 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, would remain largely unchanged. FINRA also would replace several existing provisions in the Front Running Policy with Supplementary Material to FINRA Rule 5270 - specifically replacing the existing exceptions in the Front Running Policy for certain transactions in automatic execution systems and for positioning the other side of certain orders when a member receives a customer’s block order relating to both an option and the underlying security or a security future and the underlying security with new Supplementary Material that identifies types of transactions that are permitted under the rule.

Under the Supplementary Material, there are three broad categories of permitted transactions: transactions that the member can demonstrate are unrelated to the customer block order, transactions that are undertaken to fulfill or facilitate the execution of the customer block order, and transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange.

The first category of permitted transactions are those that the member can demonstrate are unrelated to the customer block order.  Supplementary Material .04(a) recognizes that members may engage in such transactions provided that the member can demonstrate that the transactions are unrelated to the material, non-public market information received in connection with the customer order. The Supplementary Material includes an illustrative list of potentially permitted transactions as examples of transactions that, depending upon the circumstances, may be unrelated to the customer block order. These types of transactions could include transactions where the member has effective information barriers established to prevent internal disclosure of customer order information, transactions in the security that is 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.

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

The third, and final, category of permitted transactions is addressed in Supplementary Material .04(c) and concerns transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange. This provision, which is being proposed in response to comments received from exchanges, states that the prohibitions in Rule 5270 shall not apply if the member’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. This provision recognizes that it is not FINRA’s intent to introduce conflicts with other existing SRO rules. Finally, FINRA is proposing to adopt Supplementary Material .05 to the rule to reiterate that the front running of any customer order, not just imminent blockt transactions, that places the financial interests of the member 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.

For further details, go to:  [FINRA Rule Filing 12-25, 5/17/12].