Co-authored by Michelle S. McIntosh.

The Financial Industry Regulatory Authority has filed a proposed rule change with the Securities and Exchange Commission to adopt NASD Interpretive Material 2110-3 (the Front Running Policy) as FINRA Rule 5270. In connection therewith, FINRA proposes to amend FINRA Rule 5270 in several ways to “broaden its scope and provide further clarity into activity that FINRA believes is inconsistent with just and equitable principles of trade.”

The Front Running Policy prohibits the following activity by a member or associated person, subject to certain exceptions:

  1. buying or selling security futures or certain options for accounts in which such member or associated person has an interest when such member or associated person has material, non-public market information concerning an imminent block transaction in the underlying security;
  2. the activities prohibited in (1) above, in respect of the underlying security when the material, non-public market information regarding a block transaction concerns an option or security future on that underlying security; and
  3. providing material, non-public market information concerning an imminent block transaction to customers who then trade on the basis of such information.

The Front Running Policy applies (1) to transactions in equity securities and options that are required to be reported on a last sale reporting system, (2) to any transaction involving a security future, regardless of whether the transaction is reported and (3) only until the information concerning the block transaction has been made publicly available.

FINRA proposes to extend the Front Running Policy’s prohibitions to apply (1) to all securities and other financial instruments and contracts that overlay the security that is the subject of an imminent block transaction and “that have a value that is materially related to, or otherwise acts as a substitute for, the underlying security” and (2) until the material, non-public market information is either publicly available or “otherwise becomes stale or obsolete.”

Lastly, the proposed rule change would replace several provisions of the Front Running Policy, including the existing exceptions for certain transactions in automatic executions systems and for positioning the other side of certain orders when a member receives a customer’s block order relating to both an option and the underlying security or a security future and the underlying security. These provisions would be replaced with new “Supplementary Material” that would identify certain permitted transactions, as follows:

  • transactions that the member can demonstrate are unrelated to the customer block order;
  • transactions that are undertaken to fulfill or facilitate the execution of the customer block order; and
  • transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange.

Click here to read the full text of the Proposed Rule Change.