Codifying FINRA’s Front-Running Policy

The following post comes to us from Robert Buckholz, partner and co-coordinator of the Corporate and Finance Group at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication.

FINRA has proposed to codify its front-running policy, originally adopted by the NASD in 1987, as new FINRA Rule 5270. [1] The new rule would expand the policy to prohibit member firms and their associated persons from engaging in a broader range of front-running transactions ahead of a customer block order in securities. The rule would apply to most derivative transactions, not just those in futures and options, when the block involves the underlying security, as well as to transactions in the block security itself. In addition, block orders subject to the rule would include those in most derivatives, not only futures and options. FINRA believes that the additional trading activity that would now be covered by the broader prohibition would already violate other FINRA rules. The new provisions would also state that front-running activity ahead of non-block orders may violate other FINRA rules or the federal securities laws. FINRA originally proposed these changes in 2008 and expects to announce an implementation date within 90 days after SEC approval.


The front-running policy was originally adopted as interpretive material to Article III, Section 1 of the NASD’s Rules of Fair Practice in 1987 and is currently set forth as IM-2110-3 under Section 2100 (General Standards) of the NASD Conduct Rules. The policy currently states that it is considered conduct inconsistent with just and equitable principles of trade for a member or an associated person of a member to buy or sell securities futures or certain options for accounts in which the member or associated person has an interest (or over which the member or person exercises investment discretion) when the member or associated person has material, non-public market information concerning an imminent block transaction [2] in the underlying security. When the block transaction involves an option or securities future, the same prohibition applies with regard to trading in the underlying security. The policy also prohibits providing material, non-public market information concerning an imminent block transaction to customers who then trade on the basis of the information. Only reportable transactions in equity securities and options, and transactions in security futures, whether or not reportable, are subject to the policy. The prohibitions apply until the information concerning the block transaction has been made publically available (i.e., when it has been disseminated via a last-sale reporting system or high-speed communications line of one of those systems, a similar system of a national securities exchange or an alternative trading system under Regulation ATS, or by a third-party news wire service).

The policy includes two exceptions from the general prohibitions. One exception permits transactions executed by member participants in automatic execution systems in those instances where the participants must accept automatic executions. The other exception applies when a member receives a customer order of block size relating to both an option (or a security future) and the underlying security and permits the member to position the other side of one or both components of the order, although the member would not be permitted to cover any resulting proprietary position by entering an offsetting order until the information about the block trade has been made publicly available.

FINRA believes the current policy is unduly narrow in capturing the types of front-running activity that are inconsistent with just and equitable principles of trade. As described below, FINRA proposes to broaden the policy language to apply explicitly to front-running activity in a wide range of financial instruments (not only options and securities futures) relating to the security that is the subject of the block transaction, and to cover blocks involving such instruments (in addition to options and security futures). The expanded language would also explicitly prohibit front-running activity in the same security or instrument that is the subject of the block transaction. FINRA believes that the type of trading that would now be covered by the new rule would already violate other FINRA rules, such as Rule 2010 (Standards of Commercial Honor and Principles of Trade).

Proposed New Rule 5270

Under Rule 5270 as proposed, no member or associated person may execute for a covered account any order in a security or related financial instrument when the member or associated person has material, non-public market information about an imminent block transaction in that security, a related financial instrument or a security underlying the related financial instrument. A “block transaction” would continue to include a transaction involving at least 10,000 shares but would also include a transaction involving any related financial instrument overlying such number of shares. For this purpose, a “related financial instrument” would mean 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. The rule would apply to orders executed for any account in which the member or associated person has an interest or over which the member or associated person exercises investment discretion, or for accounts of customers or affiliates of the member when the customer or affiliate has been provided the material, non-public market information by the member or any associated person. The prohibitions of the new rule would continue until the market information about the block has been made publicly available or has become stale or obsolete. [3] Unlike the current policy, the new rule would not be limited to transactions that are reportable or involve futures.

The proposal also includes supplementary material covering various aspects of the existing policy, including the definition of a block transaction, which would be modified as noted above, and when information is deemed to be publicly available, which would not change. As described below, the supplemental material also includes three new exceptions, for transactions that are unrelated to the customer block order, are undertaken to facilitate execution of the block order or are executed on an exchange in accordance with exchange rules. These would replace the two exceptions in the current policy described above, relating to automatic execution and positioning blocks involving both securities and derivatives.

Proposed New Exceptions

Proposed paragraph .04(a) of the new supplemental material would permit transactions that the member can demonstrate are unrelated to the material, non-public market information received in connection with the customer block order. This paragraph includes an illustrative list of potentially permitted transactions that, depending upon the circumstances, may be unrelated to the customer block order:

  • Transactions where the member 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 but 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 types of transactions, the member must be able to demonstrate that the transaction at issue is unrelated to the customer block order.

Proposed paragraph .04(b) reflects FINRA’s current view that firms are permitted to trade ahead of a customer’s block order when the purpose of the trade is to fulfill the customer’s order and the customer has authorized such trading after disclosure by the firm that it may trade ahead or alongside of the customer’s order. This new paragraph would permit a member to undertake transactions for the purpose of fulfilling or facilitating the execution of a customer’s block order. However, the member must minimize any potential disadvantage or harm in the execution of the customer’s order, must not place the member’s financial interests ahead of its customer’s and must obtain the customer’s consent to such trading activity. The member may obtain this consent by means of an affirmative written consent or a negative consent letter. [4] A member may also obtain consent orally on an order-by-order basis. [5]

Proposed paragraph .04(c) would permit transactions that are executed, in whole or in part, [6] on a national securities exchange and comply with the marketplace rules of that exchange. According to FINRA, it does not intend to introduce conflicts with other SRO rules and added this exception in response to comments received from exchanges.

Front-Running Non-Block Orders

The new supplemental material would also state that, although the prohibitions in Rule 5270 are limited to activity in advance of imminent block transactions, the front-running of other types of orders that places the financial interests of the member or an associated person ahead of those of a customer, or the misuse of knowledge of an imminent customer order, may violate other FINRA rules or the federal securities laws. As examples of the former, the material cites FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade) and Rule 5320 (Prohibition Against Trading Ahead of Customer Orders). [7]

Effective Date

The SEC has until July 21, 2012 to approve or disapprove the proposal or institute proceedings to determine whether to do so. It may extend this deadline an additional 45 days if it finds the extension to be appropriate, or for any other period with FINRA’s consent (although FINRA has stated that it has not yet consented to any extension). If the SEC approves the proposal, FINRA will announce the implementation date in a regulatory notice to be published within 90 days thereafter. The implementation date will be no later than 90 days after publication of the regulatory notice. Written comments on the proposal may be submitted to the SEC no later than June 27, 2012.


[1] The proposal is another step in FINRA’s ongoing effort to develop a consolidated rulebook combining NASD (and some NYSE) rules with its own rules. The text of the proposed rule change can be found at under File No. SR-FINRA-2012-025.
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[2] The policy states that “[a] transaction involving 10,000 shares or more of an underlying security, or option or securities futures covering such a number is generally deemed to be a block transaction, although a transaction of less than 10,000 shares could be considered a block transaction in appropriate cases.” Executing such a transaction in non-block pieces does not avoid the policy if execution of the full transaction may have a material impact on the market.
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[3] The additional clause is intended to address situations in which the block transaction involves a financial instrument that may not be subject to public reporting, and thus information about the block may not become publicly available.
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[4] The negative consent letter must clearly disclose to the customer the terms and conditions for handling the customer’s orders. If the customer does not object to the letter, the member may reasonably conclude that the customer has consented and may rely on the letter for all or a portion of the customer’s orders.
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[5] To do so, the member must provide clear, comprehensive disclosure to, and obtain consent from, the customer orally in connection with a particular order and must keep a written record of who provided the consent and that the consent evidences the customer’s understanding of the terms and conditions for handling the order.
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[6] At least one leg of the trading activity must be executed on the exchange.
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[7] Under Rule 5320, a member that holds a customer order in an equity security without immediately executing the order may not trade the security on the same side of the market for its own account at a price that would satisfy the order, unless it immediately executes the order up to the size of its own trade and at the same or a better price.
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  1. By FINRA to Codify its Front-Running Policy | ValueWalk on Monday, July 16, 2012 at 11:37 am

    […] According to Robert Buckholz, in an article, published on theHarvard Law School blog, the proposed policy, which was originally adopted by NASD (National Association of Securities Dealers) in 1987 will now […]