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New rule against front-running block trades includes derivatives

Friday, December 14, 2012
Opalesque Industry Update: FINRA's new rule prohibiting front-running of customer block transactions was approved by the SEC and takes effect on June 1, 2013. The new rule prohibits a FINRA member firm (generally a registered broker-dealer) from placing trades when it has information about an imminent block transaction of more than 10,000 shares.

New Rule Replaces and Expands Previous Rule

New FINRA Rule 5270 ("Rule 5270") addresses the front-running of block transactions and will replace NASD IM-2110-3 ("NASD 2110"). Rule 5270 significantly expands the prohibitions applicable to block transactions; it applies to a broader range of securities than NASD 2110, includes new supplementary material regarding permitted transactions, and states that front-running of a customer order may violate other FINRA rules or the federal securities laws.

Front-Running Prohibitions Expanded to Include Block Trading in All Securities Including Fixed Income Securities and Related Financial Instruments

Rule 5270 will apply to all securities and "related financial instruments"[1] that are the subject of an imminent block transaction. As a result, the prohibitions will apply to purchasing or selling a security or related financial instrument when a member firm has material, nonpublic market information concerning an imminent block transaction in that security, a related financial instrument, or a security underlying the related financial instrument (subject to the exemptions discussed below). The front-running prohibition remains applicable until the block transaction has been "made publicly available" or "has otherwise become stale or obsolete."

Permitted Transactions: New Exemptions from Front-Running Restrictions

Rule 5270 includes "Supplementary Material" that sets forth three broad categories of permitted transactions:

  1. Transactions that a firm can demonstrate are unrelated to the customer block order. These could include transactions where the firm has established effective information barriers 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. For each of these, the firm must be able to demonstrate that the transaction at issue was unrelated to the customer block order. For example, if the firm can demonstrate that transactions occurring in a security or a related financial instrument that is the subject of an imminent customer block order were undertaken by a desk that is walled off from the desk handling the customer block order through effective information barriers, the trading activity would be unrelated to the customer block order and would not violate the rule.

  2. Transactions that are undertaken to fulfill or facilitate the execution of the customer block order. 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. Rule 5270 does not preclude transactions undertaken for the purpose of fulfilling, or facilitating the execution of, a customer's block order. However, when a trade 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.

  3. Transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange. Rule 5270 will 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.


Please bear in mind that Rule 5270 does not provide an exhaustive list of prohibited front-running activity. [1] "Related financial instruments" include derivatives and other financial contracts, e.g., any option, derivative, security-based swap, or other financial instrument overlying a security, the value of which 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.

Sadis & Goldburg LLP

Press Release

BM

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