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Bars Against Reps For Excessive Markups Upheld

Andrew P. Gonchar, Polyvios T. Polyviou, Exchange Act Rel. 60506, August 14, 2009

Time since appeal filed - 10 months 19 days
Time since last brief filed - 1 month 29 days


Finra found respondents charged excessive markups in 142 sales to 71 customers over an 18 month period. They were also charged with violation a Finra rule that prohibits interpositioning a third party between the firm and the best available market price. They were barred and fined $114,000 each. The Commission upheld the findings and sanctions on appeal.

So boys and girls, we enter the arcane area of excessive markups. For the uninitiated, the trick in markup cases is to determine the "prevailing market price" that is the basis for any markup charged the customer. In riskless principal trades (where the dealer acquires the securities to fulfill the customer order), the seller must calculate its markup based on its contemporaneous cost unless other evidence shows some other price is more appropriate. Excessive markups are a violation of the anti-fraud provisions.

The securities involved here were 142 sales to retail customers of convertible bonds that included a right to exchange them for common stock at a predetermined price. Hence the price of the bond is directly related to the price of the underlying stock. None of the bonds involved were listed on exchanges and transactions in them were not reported - there was no price transparency. Respondents' firm did not make a market in the bonds (did not keep a trading inventory).

Unfortunately for respondents' customers the trades were structured with an intermediary in the following manner. First, they had a trading account at their firm buy bonds. This account did not maintain overnight positions. Second, they sold the bonds to the intermediary, which in turn sold the bonds back to the trading account. On each leg of the transactions with the intermediary a markup or markdown was charged. The trading account then sold the bonds to respondents' retail customers. It appears that the sole purpose of interpositioning the intermediary was to increase the price that retail customers were charged as customers were charged based on the price the trading account paid to the intermediary, rather than the price the account had originally paid for the bonds.

The appropriate contemporaneous cost for calculating markups was the initial acquisition price paid by the firm trading account before the bonds were sold and repurchased to the intermediary. Respondents failed to show that there was any change in the market price between the time the trading account acquired the bonds and when it sold the bonds to its customers.

Here respondents marked up bonds by up to 23.9%. Once markups of more than 5% are established, the burden shifts to respondents to justify a markup higher than that. As to bonds, the Commission has consistently held that markups greater than 5% are "acceptable in only the most exceptional cases."

Respondents' primary defense was that they relied on the firm's trading desk to alert them if they were charging excessive markups. The Commission rejected this claim, noting that there was no apparent purpose for the interpositioning other than raising the price to retail customers. It further noted that respondents knew that the firm's trading desk was using the high price for the day of the bonds rather than contemporaneous cost to calculate markups.

Finally, in the never-say-die category, respondents argued that the standard of proof should be "clear and convincing" rather than "preponderance." Needless to say, the Commission rejected this claim as the Supreme Court in Steadman v SEC, 450 U.S. 91 (1981) ruled in favor of a preponderance standard.


The footnotes in this decision give a fairly thorough summary of the law of markups. Most of the significant cases are cited and discussed. So for those of you who are mad enough to want to learn the this area of the law, this case is a good place to start. The key issues usually involve determining whether a firm is a market maker holding inventory or it is engaging in riskless principal transactions. The Commission decided this case in a few days less than two months after the final briefs were filed. Bravo!