FINRA's Focus on Compliance With Market Integrity Rules

FINRA's new enforcement head, Bill St. Louis, recently appeared on FINRA Unscripted, a FINRA podcast where he discussed his vision for FINRA's Enforcement Department as well as certain key regulatory issues that are under consideration at the regulator. The podcast follows FINRA's 2024 FINRA Annual Regulatory Oversight Report ("Oversight Report"), which was disseminated earlier this year to provide member firms with direction about what to expect from the regulator in the coming year.

Davis Wright Tremaine LLP previously provided Select Observations about the Oversight Report as an entry point into the larger set of issues that FINRA raised. FINRA's podcast is yet another access point into the Oversight Report as there were multiple references in the podcast to pending market integrity cases, and specifically best execution and Regulation SHO cases.[1] The podcast, therefore, serves as a reminder for member firms to evaluate their compliance in these areas.

Best Execution – Payment for Order Flow Arrangements and Exception Reports

FINRA Rule 5310 and MSRB Rule G-18 are complimentary and require member firms to use reasonable diligence in trades for or with a customer to ascertain the best market for the subject security and to buy and sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. MSRB Rule G-18, unlike its FINRA counterpart, provides an exemption from the best execution obligation for "Sophisticated Municipal Market Professionals" (SMMP).[2] As a result, it is important to consider both retail and institutional customers when assessing best execution obligations under FINRA and MSRB Rules, both to comply with the substantive requirements for such customers and to determine whether any exception applies to trades with or for SMMPs in municipal securities.[3]

FINRA's guidance, nonetheless, continues to emphasize the importance of considering payment for order flow (PFOF) arrangements, and therefore it remains important to establish and document at least quarterly "regular and rigorous" reviews of the execution quality for impacted trades.[4] Of course, regular and rigorous reviews are important outside of PFOF arrangements as well. For example, having a member firm's best execution committee evaluate and document execution quality in competing markets against the prices obtained for customers is an important exercise. In the past, regulators have pursued disciplinary actions and restitution for customers where it was determined that better prices were available in a subject security in a competing market and those prices were not considered when executing a trade for or with a customer. As part of this process, it also is important to have robust policies and procedures that describe the exception reports used to identify potential trades executed at inferior prices, to review such trades, and to document any corrective action taken or the rationale for not taking any further steps, as applicable. Implementing these considerations, and others, will put member firms on a better footing with the regulators when they ask for explanations about prices on trades for or with customers.

Regulation SHO – Bona Fide Market Making and the Reuse of Locates

FINRA's cases under Regulation SHO tend to involve order marking issues under Rule 200(g); locate issues under Rule 203(b); and/or close out issues under Rule 204. Rules 203(b) and 204, in particular, provide an exemption for bona fide market making activity, which FINRA highlighted in its 2024 Annual Regulatory Oversight Report.[5] The SEC Staff has provided guidance on what constitutes bona fide market making activity, explaining that, "Indicia of bona-fide market making activity include where a market maker's quotes are generally accessible to the public and the market maker holds itself out as being willing to buy and sell a security for its own account on a regular or continuous basis."[6] It should be expected that FINRA will seek to distinguish such bona fide market making activity from other proprietary trading activity that is ineligible for exemptions from the locate and close out requirements, respectively. Member firms, therefore, should be able to demonstrate to FINRA (and other regulators) that they qualify for the bona fide marking making exemption if it is being claimed. As a result, it will be important for a firm to have policies and procedures addressing compliance with the locate and close out requirements, in addition to the Rule requirements for order marking.

It also is worth noting that in past years, FINRA directed firms to consider the SEC Staff's guidance on the reuse of locates.[7] While FINRA did not emphasize this issue in the 2024 FINRA Annual Regulatory Report, locate compliance is a perennial issue and the FINRA Staff is still likely to be evaluating the reuse of locates through its exam and surveillance programs. According to the SEC Staff's guidance in this area, a locate for a security can be re-applied for an intra-day buy to cover trade if the source of the located shares indicates that the original locate is good for the entire day and the subsequent sale does not exceed the size of the original locate.[8] The SEC Staff's position is that "hard to borrow" and threshold securities, on the other hand, require a new locate prior to effecting short sales in such securities.[9] One of the keys for all locates is to memorialize the source and the quantity of shares – whether a firm is relying on the SEC Staff guidance for intra-day buy-to-cover trades or whether a firm is conducting a locate in the normal course. Not only is "documented compliance" required in Regulation SHO, but this step also serves to evidence a firm's permissible basis for executing a short sale in the first instance.

The lawyers on Davis Wright Tremaine's financial services team look forward to answering your questions about these market integrity issues and others.