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Question

Difficulty: HardSettlement Dates, Trade Confirmations, and Corporate Actions

An investor places a market order to purchase 1,000 shares of a Nasdaq-listed equity security through a FINRA member broker-dealer. The firm fills the order directly from its own inventory rather than matching the customer with a third-party seller. Under SEC and FINRA rules regarding trade confirmations, which of the following correctly describes the capacity in which the broker-dealer acted and the required compensation disclosure?

  1. The firm acted as a principal (dealer) and must disclose its capacity along with the markup charged on the transaction.Answer
  2. B
    The firm acted as an agent (broker) and must disclose its capacity along with the commission charged on the transaction.
  3. C
    The firm acted as an agent (broker) and is required to disclose a markdown subtracted from the prevailing market price.
  4. D
    The firm acted as a clearing depository and is exempt from providing capacity disclosures directly to retail investors.

Answer

The broker-dealer acted as a principal (dealer) trading from its own inventory and must disclose this capacity along with the markup on the customer trade confirmation.
When a broker-dealer executes a customer trade out of its proprietary inventory, it acts in a principal (dealer) capacity. Under SEC Rule 10b-10 and FINRA rules, the confirmation delivered to the customer at or before transaction completion must disclose that the firm acted as principal and state the markup charged.

Step-by-Step Solution

1
Determine the broker-dealer's execution capacity.
The firm filled the customer's buy order directly out of its proprietary inventory, operating as a principal (dealer).
Trading against a customer using firm inventory defines a principal transaction, whereas matching two independent parties without inventory involvement defines an agency transaction.
2
Identify the required form of transaction compensation.
Principal transactions involve adding a markup when selling to a customer (or subtracting a markdown when buying from a customer).
Commissions are charged strictly on agency trades, while principal trades incorporate markups or markdowns into the net execution price.
3
Apply SEC Rule 10b-10 trade confirmation delivery rules.
The confirmation delivered at or before completion of the transaction must explicitly state the firm's principal capacity and disclose the amount of the markup.
Federal securities laws mandate transparency regarding broker-dealer capacity and remuneration on all customer confirmations.

Key Concept

Broker-Dealer Capacity and Trade Confirmation Disclosure Requirements
Estimated Time:1m 30s
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Topics

Settlement Dates, Trade Confirmations, and Corporate Actions