FINRA Rule 2121

FINRA Rule 2121 was adopted via SR-FINRA-2014-023 effective May 28, 2014, transferring NASD Rule 2440 (Fair Prices and Commissions) and NASD Interpretive Materials IM-2440-1 (Mark-Up Policy) and IM-2440-2 (Additional Mark-Up Policy for Transactions in Debt Securities, Except Municipal Securities) into the Consolidated FINRA Rulebook without substantive change.

FINRA Rule 2121 sits within FINRA Rule 2120's Commissions, Mark Ups and Charges sub-grouping of FINRA Rule 2100's Transactions with Customers subsection, immediately following FINRA Rule 2120's series marker and immediately preceding FINRA Rule 2122's Charges for Services Performed provisions.

The Core Operative Provision: Principal and Agency Transactions

FINRA Rule 2121's core operative text addresses two fundamental transaction types. For principal transactions — where the member buys for its own account from its customer or sells for its own account to its customer — the member shall buy or sell at a price which is fair and reasonable, taking into consideration all relevant facts and circumstances, including: (1) the best judgment of the member as to the fair market value of the security at the time of the transaction; (2) the expense involved in effecting the transaction; (3) the fact that the member is entitled to a profit; and (4) the total dollar amount of the transaction.

For agency transactions — where the member acts as an agent for its customer — the member shall not charge its customer more than a fair commission or service charge, taking into consideration all relevant facts and circumstances, including: (1) the best judgment of the member as to the fair market value of the security at the time of the transaction; (2) the expense of executing the order; and (3) the value of any service rendered by reason of the member's experience in and knowledge of the security and the market therefor.

The distinction between principal and agency transaction standards is fundamental to understanding Rule 2121's operation. In a principal transaction, the member is the counterparty — it holds inventory and sells securities to the customer, or buys securities from the customer, at a price that includes the member's markup (on sales) or markdown (on purchases) embedded in the transaction price itself. In an agency transaction, the member acts as the customer's agent — it executes the customer's order in the market and charges a separately disclosed commission for that service. FINRA Rule 2121 applies to both, requiring fairness and reasonableness in each context, but the analytical framework differs because the economic structure differs.

The Violation Formulation: Rule 2010 and Rule 2121 as Co-Violated

FINRA Rule 2121 contains an explicit violation formulation — 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.

This formulation confirms that FINRA Rule 2121 violations simultaneously constitute FINRA Rule 2010 violations — precisely the co-violation structure this dictionary has observed in other contexts (FINRA Rule 11721's and FINRA Rule 11891's cross-references to Rule 2010 as the ethical backstop for specific Uniform Practice Code obligations). The 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 formulation establishes the principal-transaction standard in its most concrete form — the markup embedded in the principal transaction price must produce a price that is reasonably related to the current market price of the security, with unreasonably high prices (excessive markups) or unreasonably low prices (excessive markdowns on customer sales) both violating this standard.

Supplementary Material .01: The Mark-Up Policy (The 5% Policy)

Supplementary Material .01 houses FINRA Rule 2121's Mark-Up Policy — the provision derived from NASD IM-2440-1, known colloquially throughout the securities industry as the 5% Policy since the NASD Board's 1943 adoption.

The Policy's foundational statement establishes its character: it shall be deemed a violation of Rule 2010 and Rule 2121 for a member to enter into any transaction with a customer at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable. The 5% Policy is then presented as a general guide — not a rule — that a markup of more than 5% may be considered unfair or unreasonable. Several specific aspects of the Policy require careful understanding:

The 5% as Guide, Not Rule. The Policy explicitly states that 5% is not a rule. The question of fair markups is one for which no definitive answer can be given, because what might be fair in one transaction could be unfair in another because of different circumstances. A markup of 5% or even less may be considered unfair or unreasonable — the Policy emphasizes that even below-5% markups can be excessive, and that above-5% markups are not automatically per se violations.

Relevant Factors. Determination of the fairness of markups must be based on a consideration of all relevant factors, of which the percentage of markup is only one. The specifically identified relevant factors include: (1) the type of security; (2) the availability of the security in the market; (3) the price of the security — while there is no direct correlation, the percentage of markup generally increases as the price of the security decreases; (4) the amount of money involved in the transaction — small-dollar transactions may warrant higher percentage markups to cover handling expenses; (5) disclosure to the customer before the transaction; (6) the pattern of a member's markups; (7) the nature of the member's business; and (8) any other relevant circumstances.

The Prevailing Market Price in Equity Securities. In the absence of other bona fide evidence of the prevailing market, a member's own contemporaneous cost is the best indication of the prevailing market price of a security. This contemporaneous cost standard for equity securities parallels — and predates — the more detailed waterfall Supplementary Material .02 establishes for debt securities, confirming that the contemporaneous cost principle applies across both equity and debt transaction contexts as the starting presumption for prevailing market price determination.

Transactions to Which the Policy Applies. The Policy applies to all securities in transactions where a member buys to fill a previously received customer order, where a member sells from inventory or purchases for its own account in connection with a customer transaction, and in riskless principal transactions. However, the Policy does not apply to the sale of securities where a prospectus or offering circular is required to be delivered and the securities are sold at the specific public offering price — such sales are subject to the fixed public offering price established by the underwriter rather than a market-based markup.

Supplementary Material .02: The Additional Mark-Up Policy for Debt Securities

Supplementary Material .02 establishes the Additional Mark-Up Policy for transactions in debt securities other than municipal securities — derived from NASD IM-2440-2, which itself was developed in response to the historically lower transparency of the over-the-counter debt securities market relative to equity markets.

The Prevailing Market Price Waterfall. Supplementary Material .02's most consequential provision is the waterfall for determining the prevailing market price (PMP) in debt securities principal transactions. The PMP is presumptively established by referring to the dealer's contemporaneous cost as incurred (when selling to the customer) or contemporaneous proceeds as obtained (when buying from the customer).

Where the dealer has no contemporaneous cost or proceeds — or where the contemporaneous cost presumption has been overcome by countervailing evidence — the firm proceeds down the waterfall to: (1) bona fide third-party transactions in the security at or near the time of the customer transaction; (2) contemporaneous quotations for the security provided by dealers who are not affiliates of the member; (3) if no such third-party transactions or quotations are available, prices derived from a pricing model or from comparable securities — with the firm bearing a higher burden of demonstrating the resulting price reflects the prevailing market.

When the Contemporaneous Cost Presumption Can Be Overcome. The dealer may overcome the contemporaneous cost presumption by showing: (A) that it made no contemporaneous purchases or can demonstrate that in the exercise of prudent judgment the dealer could reasonably have expected to obtain from third parties the same security at a lower cost or to sell the security to third parties at a higher price than the dealer's cost; or (B) that the cost is not representative of the prevailing market price because of a material change in market conditions between the time of the dealer's cost and the time of the customer transaction.

The QIB Exclusion. Supplementary Material .02 establishes an important scope exclusion — the customer fair pricing obligation under Rule 2121 and Supplementary Materials .01 and .02 does not apply to a qualified institutional buyer (QIB) as defined in Securities Act Rule 144A that is purchasing or selling a non-investment grade debt security when the dealer has determined, after considering the factors set forth in Rule 2111(b), that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction. This QIB exclusion reflects a regulatory determination that large, sophisticated institutional investors capable of independently evaluating non-investment grade debt security transactions do not require the same customer protection as retail and smaller institutional customers — a determination that connects to the suitability framework's institutional-investor accommodation under FINRA Rule 2111(b).

Definition of Non-Investment Grade Debt Security. For purposes of the QIB exclusion, non-investment grade debt security means a debt security that: (i) if rated by only one NRSRO, is rated lower than one of the four highest generic rating categories; (ii) if rated by more than one NRSRO, is rated lower than one of the four highest generic rating categories by any of the NRSROs rating it; or (iii) if unrated, was analyzed as non-investment grade by the dealer with documentation retained, or was initially offered and sold pursuant to a Securities Act registration exemption.

The Rule 2232 Markup Disclosure Connection

The SEC's approval of FINRA's amendments to FINRA Rule 2232 (Customer Confirmations), effective May 14, 2018 and described in Regulatory Notice 17-08, created a direct connection between FINRA Rule 2121's markup determination framework and customer confirmation disclosure. The amended Rule 2232 requires member firms effecting transactions in certain corporate and agency debt securities with retail customers on a principal basis to disclose on the customer confirmation both the markup or markdown charged (expressed as a dollar amount and as a percentage of the prevailing market price) and the time of the execution.

This markup disclosure requirement makes FINRA Rule 2121's PMP determination directly visible to retail customers in their confirmations — the disclosed markup percentage is calculated from the same PMP the firm determined under Supplementary Material .02's waterfall, creating a direct accountability mechanism for the firm's fair pricing compliance. FINRA's examination findings have noted that firms using third-party software for markup disclosure must nonetheless understand and oversee the PMP determination methodology the software employs — the firm's compliance responsibility cannot be outsourced to the vendor.

Proceeds Transactions and Cumulative Customer Impact

FINRA guidance and examination findings have consistently addressed proceeds transactions — transactions where the proceeds from a customer's sale of a bond are used to purchase different bonds for the customer in close proximity. Under FINRA Rule 2121, a dealer effecting a proceeds transaction must consider the cumulative impact on the customer of both the markdown on the sale and the markup on the purchase in assessing total charges. Excessive cumulative charges across both legs of a proceeds transaction violate Rule 2121 even where each individual leg, considered in isolation, might appear to be within an acceptable range — a principle this dictionary has now confirmed from both FINRA's Annual Regulatory Oversight Reports and the fixed income fair pricing guidance those reports provide.

Connection to FINRA Rules 2010, 2090, 2111, 2120, 2122, 2124, 2232, 3110, 5310, and MSRB Rule G-30

FINRA Rule 2121 connects directly and explicitly to FINRA Rule 2010 — via the violation formulation in both the core operative provision and Supplementary Material .01, which expressly identifies violations of Rule 2121 as simultaneous violations of Rule 2010. It connects to FINRA Rule 2090 — whose know-your-customer obligations provide context for the relevant facts and circumstances analysis Rule 2121 requires, particularly the customer's sophistication and the appropriateness of the pricing structure for that specific customer. It connects to FINRA Rule 2111(b) — whose institutional investor assessment factors Supplementary Material .02 specifically cross-references in the QIB exclusion determination. It connects to FINRA Rules 2120, 2122, and 2124 — as co-residents of the Commissions, Mark Ups and Charges sub-grouping, with the sub-grouping addressing principal/agency pricing (Rule 2121), service charges (Rule 2122), and net transaction disclosure (Rule 2124) as a unified framework for the economic dimension of customer transactions. It connects to FINRA Rule 2232 — whose markup disclosure requirement makes the Rule 2121 PMP determination directly visible in customer confirmations for retail customers in corporate and agency debt securities transactions. It connects to FINRA Rule 3110 — whose supervisory requirements must specifically address markup and commission fairness, including the PMP waterfall, the facts-and-circumstances analysis, and exception report monitoring. It connects to FINRA Rule 5310 — whose best execution standard is explicitly referenced in Supplementary Material .02 as governing contemporaneous cost determination. And it connects to MSRB Rule G-30 — the parallel fair pricing standard for municipal securities transactions that FINRA examination findings consistently address alongside Rule 2121.

Examination Relevance and Key Takeaways

FINRA Rule 2121 is one of the most heavily tested pricing rules across the Series 7 and Series 24 examinations — the foundational fair-and-reasonable pricing standard applicable to all customer securities transactions.

The key points to retain are these: FINRA Rule 2121's core operative provision requires that principal transactions with customers be effected at fair and reasonable prices and agency transactions be subject only to fair and reasonable commissions, taking into consideration all relevant facts and circumstances including fair market value, transaction expense, the member's entitlement to a profit, and the total dollar amount; violations of Rule 2121 simultaneously constitute violations of Rule 2010 — it shall be deemed a violation of both rules for a member to enter into a transaction at a price not reasonably related to the current market price or to charge an unreasonable commission; Supplementary Material .01's 5% Policy is a guide, not a rule — a markup of 5% or less may be unfair and one above 5% is not per se a violation, with fairness determined by a multi-factor facts-and-circumstances analysis including security type, availability, price, transaction amount, disclosure, markup pattern, business nature, and other circumstances; in the absence of other bona fide evidence, a member's own contemporaneous cost is the best indication of the prevailing market price for equity securities; Supplementary Material .02 establishes the PMP waterfall for debt securities principal transactions — starting with contemporaneous cost (presumptive), then bona fide third-party transactions, contemporaneous dealer quotations, and pricing models — with the contemporaneous cost presumption overcomeable only by showing no contemporaneous purchases or a material change in market conditions; the QIB exclusion removes sophisticated institutional buyers of non-investment grade debt securities from the rule's customer fair pricing protections when the QIB is independently evaluating the investment risk; proceeds transactions require consideration of the cumulative markup on the purchase and markdown on the sale; and FINRA Rule 2232's markup disclosure requirement (effective May 14, 2018) makes the PMP determination directly visible on customer confirmations for retail customers in corporate and agency debt securities transactions. The rule was adopted via SR-FINRA-2014-023, transferring NASD Rule 2440 and IM-2440-1 and IM-2440-2 without substantive change.