The respective proposals would require disclosure of price differentials in certain same-day fixed-income transactions that involve retail customers and go beyond existing price differential disclosure requirements in equity transactions.
In coordinated regulatory notices to their respective members, the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) are seeking comment on proposed rules that would require firms for same-day, retail-size fixed-income principal transactions to disclose on customer confirmations (1) the price to the customer, (2) the price to the firm of a transaction in the same security, and (3) the difference between those two prices.[1] As explained in the notices, FINRA and MSRB developed the proposed disclosure requirements in response to recommendations in the U.S. Securities and Exchange Commission’s (SEC’s) 2012 Report on the Municipal Securities Market regarding enhanced pricing and markup disclosures to customers in municipal bond transactions.[2] However, as explained below, the proposed disclosure requirements go significantly beyond what firms currently have to disclose on confirmations for equity riskless principal transactions and also appear to go beyond the recommendations in the municipal securities report. In addition, the proposed disclosure requirements will likely require firms to make significant and costly changes to their order management and other back-office systems used to generate transaction confirmations.
Comments on the respective notices are due on or before January 20, 2015.
Proposed Disclosure Requirements
The FINRA RN 14-52 and the MSRB RN 2014-20 described proposed amendments to FINRA Rule 2332 (Customer Confirmations) and MSRB Rule G-15 (Confirmation, Clearance, Settlement and Other Uniform Practice Requirements with Respect to Transactions with Customer) to provide for enhanced disclosure requirements with respect to certain fixed-income securities transactions. More specifically, the proposal amendments would require a firm that executes a fixed-income transaction for a customer at or below a certain threshold size to disclose to customers on a transaction confirmation the difference in price to the customer against any other transaction effected by the firm in the same security on the same side as the customer (i.e., if both the customer and the firm bought or sold the same security on the same day). The following chart outlines the requirements of the proposed amendments.
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Proposed FINRA Rule 2232(b)(3) and (c) Amendments |
Proposed MSRB Rule G-15(a)(i)(F) and (I) Amendments |
Security Type |
Corporate debt securities and agency debt-securities[3] |
Municipal securities |
Customer Transaction Size |
Qualifying Size—Transactions for the purchase or sale of 100 bonds or less or bonds with a face amount of $100,000 or less, based on reported quantities |
Transactions where the broker, dealer, or municipal securities dealer is effecting a transaction as principal for 100 bonds or fewer or bonds in a par amount of $100,000 or less |
Transaction Types |
A sale to (purchase from) a customer of a Qualifying Size (see above) involving a corporate or agency debt security, where the member also executes a buy (sell) transaction(s) as principal with one party or multiple parties in the same security within the same trading day, where the size of the principal transaction(s) executed on the same trading day would meet or exceed the size of the customer transaction |
Reference Transaction—A transaction in which the broker, dealer, or municipal securities dealer transacts
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Disclosure Requirement |
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Disclosure Requirements in Practice
In its notice, FINRA provided 13 examples to illustrate how its proposed disclosure requirement would work in practice. We organized these examples as follows:
Observations
Equity Principal Transactions
As an initial matter, it is worth mentioning that the proposed fixed-income disclosure requirements surpass the price differential disclosures currently required for equity securities under Rule 10b-10 of the Securities Exchange Act of 1934. More specifically, under Rule 10b-10(a)(2)(ii)(A), a broker-dealer only has to disclose a price differential to the customer on a transaction confirmation for an equity security if the transaction was effected on a riskless principal basis and the broker-dealer is not a market marker in the subject security.[13] For all other principal transactions in National Market System (NMS) stock (as defined in Rule 600 of Regulation NMS), Rule 10b-10(a)(2)(ii)(B) requires a broker-dealer to disclose a price differential if the price to the customer is different than the reported trade price. The proposed disclosure requirements go significantly beyond what is required under Rule 10b-10 in that the proposed price differential disclosures would apply to transactions in debt securities and could be triggered by any same-day transaction.
Recommendations in Municipal Securities Report
Although FINRA and the MSRB refer to the municipal securities report as a basis for proceeding with the proposed disclosure requirement, the municipal securities report does not appear to be a recommendation of the sort that would necessitate the proposed disclosure requirements. Rather, with respect to price differentials on customer confirmations, the report only recommends that firms be required to disclose spreads on riskless principal transactions similar to the way that such spreads are disclosed for equity transactions under Rule 10b-10, as mentioned above.
Costs to Change Confirmation Production and Delivery Systems
Perhaps the most significant impact that the proposed disclosure requirements will have is on the changes that firms will have to make to their front- and back-office systems. In this connection, firm systems will have to be reprogrammed to account for the different scenarios under which a price differential obligation could arise while taking into account the differences in disclosure obligations under Rule 10b-10. These system changes and related testing can be costly. For example, the last time the SEC evaluated the costs of changes to firms’ systems in connection with transaction confirmations, it estimated that the industry costs of including additional disclosures on confirmations with respect to certain mutual fund distribution fees to be at about $285 million.[14] Although the costs of making back-office system changes to accommodate the proposed disclosure requirements would most likely be immediately borne by clearing firms that generate and send confirmations, these costs could be passed on to introducing firms that could, in turn, also pass these costs on to customers through account servicing and other related fees. Finally, it would appear that significant lead time would need to be provided to broker-dealers to permit them to meet these new requirements operationally.
Conclusion
FINRA and the MSRB developed the proposed disclosure requirements to address concerns that fixed-income securities investors have limited information to assess and compare transaction costs and to increase transparency in the pricing of fixed-income securities transactions. Although FINRA and the MSRB take the view that additional pricing disclosures would provide investors with key information for each transaction and allow them to analyze the quality of services received by the firms, both organizations acknowledge the likelihood of financial and compliance burdens associated with system changes and data reporting to customers if the proposed disclosures are approved. As mentioned above, if approved, the proposed disclosure requirements could result in significant costs to firms as they make changes to their front- and back-office operations to account for the new disclosure requirements. In this connection, firms that would be affected by the proposed disclosure requirements may have a strong incentive to submit comments, and supporting data as appropriate, to FINRA and the MSRB in connection with firms’ costs and associated compliance burdens. We will continue to review for developments in this area, especially in light of the interest in the municipal securities markets expressed by come SEC commissioners.[15]
Contacts
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Washington, D.C.
Amy Natterson Kroll
Steven W. Stone
Boston
David C. Boch
[1]. FINRA, Pricing Disclosure in the Fixed Income Markets, Regulatory Notice 14-52 (Nov. 2014) (FINRA RN 14-52), available here, and MSRB, Request for Comment on Draft Rule Amendments to Require Dealers to Provide Pricing Reference Information on Retail Customer Confirmations, Regulatory Notice 2014-20 (Nov. 17, 2014) (MSRB RN 2017-20, collectively with the FINRA RN 14-52, the Notices).
[2]. SEC, Report on the Municipal Securities Market (July 31, 2012) (Municipal Securities Report), available here.
[3]. See proposed FINRA Rule 2232(c)(1) and (2). Under the proposed rule, a “corporate debt security” would be defined as a “debt security that is United States (U.S.) dollar-denominated and issued by a U.S. or foreign private issuer and, if a ‘restricted security’ as defined in Securities Act Rule 144(a)(3), sold pursuant to Securities Act Rule 144A, but does not include a Money Market instrument as defined in [FINRA] Rule 6710(o) or an Asset-Backed Security as defined in [FINRA] Rule 6710(m).” An “agency debt security” would have the same meaning as a FINRA Rule 6710(m).
[4]. See Examples 1 through 4, FINRA RN 14-52 at 4.
[5]. See Example 5, FINRA RN 14-52 at 5.
[6]. See Example 6, FINRA RN 14-52 at 5.
[7]. See Example 7, FINRA RN 14-52 at 5.
[8]. See Example 8, FINRA RN 14-52 at 6.
[9]. See Example 9, FINRA RN 14-52 at 6.
[10]. See Example 10, FINRA RN 14-52 at 6.
[11]. See Examples 11 and 12, FINRA RN 14-52 at 7.
[12]. See Example 13, FINRA RN 14-52 at 7.
[13]. Under Exchange Act Rule 10b-10, a riskless principal transaction is described as a transaction in which a broker-dealer, after having received an order to buy from a customer, purchases the equity security from another person to offset a contemporaneous sale to such customer or, after having received an order to sell from a customer, sells the security to another person to offset a contemporaneous purchase from such customer.
[14]. Mutual Fund Distribution Fees; Confirmations, Exchange Act Release No. 62544 (July 21, 2010), 75 Fed. Reg. 47064, 47126 (Aug. 4, 2010).