FINRA finds broker-dealer firm charged excessive markups
J.W. Korth & Co. violated Municipal Securities Rulemaking Board rules when it charged excessive markups in 38 sales of municipal securities, an appellate panel of the Financial Industry Regulatory Authority found.
On Wednesday, FINRA’s National Adjudicatory Council agreed with a 2017 FINRA hearing panel that the Lansing, Michigan firm violated MSRB Rules G-30 on prices and commissions and G-17 on fair dealing. For those violations, FINRA ordered the firm to pay restitution of approximately $29,268, subject to final calculation, to its customers and appeal costs of $1,681.52. The regulatory group also censured the firm and ordered the firm to retain an independent consultant to establish pricing procedures for sales and purchases of debt securities.
Korth announced in April 2017 that it would appeal the lower panel's decision. The firm raised several issues on appeal, arguing that FINRA’s hearing panel used the wrong methodology to calculate the firm’s markups and markdowns. Korth also argued that the prices it charged customers were justified by the time and expense it dedicated to each bond transaction and the “complex, specialized services it provided to its customers.”
The firm said its markup and markdown procedures were designed to “balance the need for fair treatment of customers with the commission levels to representatives and the costs of maintaining all the support services, compliance, accounting, advertising and professional fees that both customers and representatives receive the benefit of."
The firm told The Bond Buyer it hopes the Securities and Exchange Commission will overturn FINRA's decision. It believes it acted properly in every circumstance and was operating within the written markup rules at the time.
"(The firm) deeply regrets FINRA’s findings and plans to appeal the decision to the SEC," the firm said. "J.W. Korth feels this is an important case for the industry because there are a lot of municipal bond issues that are obscure and come to market infrequently that may require extensive research to determine their value."
Before February 2009, the firm’s policy stated markups had a maximum of 3.5% internal markup/markdown limit on bond transactions. It then revised its policy, raising it to 3.9%.
Under MSRB and FINRA Rules, finding out whether a pricing markup is excessive is a two-step analysis, the first step being to determine the appropriate prevailing market price. After that, it has to be found whether the markups or markdowns calculated based on prevailing market price were fair and reasonable.
“Unlike FINRA's markup rule, MSRB Rule G-30 provides no threshold percentage for determining what constitutes a reasonable markup,” FINRA wrote. “However, the SEC and FINRA both have stated that markups on municipal securities should fall below five percent absent extraordinary circumstances.”
The hearing panel also conducted its own independent review of the trade data and agreed with FINRA Enforcement's assessment of 38 municipal transactions and 13 corporate transactions.
The panel found that with its municipal bond transactions, most of Korth’s purchases occurred one to two days prior to its sales to customers and that no intervening interdealer trades occurred. The panel also found that a markup or markdown for munis should not have exceeded 3.5%.
Originally the firm was found to have unfair practices on sales of municipal securities in 44 transactions but in April 2017, FINRA overturned six of them.
“J.W. Korth also researched and recommended smaller, more obscure bond issues with ratings below investment grade and bonds with complicated structures that a general, less-specialized firm may not have recommended,” FINRA found.
The firm gave clients access to a proprietary web-based system Shop4Bonds that enabled them to see the interdealer prices of bonds, without markups, for about 90% of U.S. bond offerings.
In 2017, the firm argued that it was entitled to make a reasonable profit based on its business model and its costs were high because of its particularized services. The FINRA panel rejected that argument, saying “if a firm cannot be profitable by charging fair and reasonable markups, the solution is not to charge excessive markups, but rather to revise the firm’s pricing practices.”
From April 2009 through December 2011, J.W. Worth generated revenues of about $3.2 million in 2009, $3.7 million in 2010, and $2.8 million in 2011.
The firm, headquartered in Lansing, Michigan, was founded in 1982.Its focus is on fixed-income products and generates the majority of its revenue from servicing financial advisers, institutions and wealthy individuals.
Unless FINRA's Board of Governors decides to review the NAC's appellate decision, the NAC's decision represents FINRA's final action. A firm or individual can appeal FINRA's decision to the SEC.
"We hope the SEC will overturn the FINRA finding and allow dealers to charge reasonable mark-ups to pay for research on smaller obscure issues thereby adding liquidity to the municipal market," the firm wrote in an email. "While at the same time, adhering to the written regulatory rules which govern the transactions."