What it means
The NASD was the self-regulatory body that oversaw broker-dealers in the United States before 2007, when it merged with the regulation arm of the New York Stock Exchange to form FINRA (the Financial Industry Regulatory Authority). Its Rules of Fair Practice set the standard for how member firms and their salespeople should behave.
Many of the ideas were later reorganised into the FINRA rulebook. At the heart of the rules was a simple principle: a member firm must observe high standards of commercial honour and just and equitable principles of trade.
That broad statement was backed by more specific requirements, including a duty to recommend only suitable investments, to disclose important facts, to avoid manipulative practices and to keep fair records. One of the best-known parts dealt with pricing.
The NASD's "5% policy" was a guideline suggesting that markups, markdowns and commissions on securities should generally be reasonable and not much above 5% of the price. It was a guideline rather than a fixed cap, because a fair price depends on factors such as the size of the trade, how hard the security is to sell and the services provided.
For people outside the securities industry, the rules matter because they explain why an investment professional must act within defined limits. If a salesperson pushes an unsuitable product or a firm charges an excessive markup, the customer has a regulatory complaint route and the firm can face discipline, fines or suspension.
Business owners meet these ideas when they raise capital through a broker-dealer or invest company cash in securities. Knowing that the broker is bound by conduct rules helps you ask the right questions about fees, conflicts and suitability.
Fair practice standards also shape how firms keep records and handle complaints. A firm is expected to supervise its staff, keep accurate books and respond properly when a customer raises a concern, so a clear paper trail is part of compliance as much as good intentions.
In practice
Real-world examples.
Example
A small business owner asks a broker to invest $200,000 of surplus cash. The broker recommends a high-risk, illiquid product that is wrong for a company needing money within a year, which would raise a suitability concern under fair practice standards.
Example
A regional dealer sells a customer a bond with a 12% markup over its cost on a routine, easy-to-trade issue. The customer complains, and a regulator reviews whether that markup is fair for a simple, quickly resold security.
Example
A founder planning a funding round hires a broker-dealer to place shares with investors. The firm's duty to deal fairly, disclose material facts and avoid misleading statements shapes how it markets the offering.
Formula
Calculation
Markup percentage = (Price charged to customer - Dealer's cost) / Dealer's cost x 100.
Suppose a dealer buys a thinly traded bond for $40 per $100 of face value and sells it to a customer at $41.20. The markup is $41.20 - $40.00 = $1.20, and $1.20 / $40.00 = 0.03, or 3%. That sits below the 5% guideline, but a regulator would still look at whether it is reasonable given the dealer's costs and the difficulty of the trade. Remember that the dealer's costs, the size of the trade and the effort needed to find the security all feed into whether a given percentage is acceptable. The figure is a starting point for review rather than a pass or fail line.Case study
Seen in the real world.
Tidewater Securities is an entirely fictional broker-dealer used here only to illustrate how conduct rules work in practice. A junior salesperson at the firm sells a $50,000 position in a speculative fund to a retired customer who has told the firm that she needs stable income.
The customer complains after the fund drops 20%, and the firm's compliance officer in this illustrative story reviews the file. The account notes show the customer's stated goals, and no one at the firm documented why the fund was suitable.
The firm offers compensation, retrains its salespeople on suitability and adds a second-person approval for any recommendation outside a customer's stated risk level. The illustrative lesson is that fair practice depends on documenting why a recommendation fits the person receiving it. Because the firm's records showed it had acted promptly and cooperated fully, the matter was settled quietly and the firm avoided a larger penalty.
Watch out
Common mistakes.
- Thinking the 5% policy was a hard limit, when it was a guideline and fairness depended on the circumstances of each trade.
- Assuming the Rules of Fair Practice still exist under that name, when their principles have been carried into the FINRA rulebook.
- Believing fair practice duties only apply to large firms, when they apply to member firms and their staff of any size.
Questions
People also ask.
Who enforced the Rules of Fair Practice?
The NASD did, and its enforcement role passed to FINRA, which oversees broker-dealers in the United States.
What does suitability mean?
It means an investment recommendation must fit the customer's circumstances, such as their goals, time horizon, experience and ability to bear loss.
Do these rules apply to every investment adviser?
No, broker-dealers and investment advisers are regulated under different frameworks, so the correct rules depend on the type of firm.
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