Anti-Reciprocal Rule

What Is the Anti-Reciprocal Rule?

The Anti-Reciprocal Rule refers to a regulation designed to protect individual investors from conflicts of interest that may arise from the collaboration of certain brokerage firms and mutual funds. The rule was created by the Financial Industry Regulatory Authority (FINRA).

Any brokerage companies and mutual fund companies found violating the rule may be fined.

How the Anti-Reciprocal Rule Works

All financial professionals are bound by ethics that put their clients' needs ahead of their own financial gains. As such, they're expected to act professionally and dispense advice that is beneficial to their investors. This is where the Anti-Reciprocal Rule comes into play. First adopted by FINRA in 1973, the rule aims to prevent arrangements between brokerage firms and mutual funds that may be—or may appear to be—mutually beneficial to them rather than to their investors.

For instance, a brokerage firm may direct its clients to a mutual fund company that it has an established relationship with, thereby generating sales. The mutual fund, in turn, may send its trades through the brokerage firm to generate commissions. In this case, both the brokerage firm and mutual fund are taking advantage of the client and only thinking of their own financial benefit. Situations like this are a gross violation of financial ethics.

In its definition, FINRA also offers a list of scenarios that are meant to clarify specific situations that are inconsistent with the regulation. Some of these situations include requests made by dealers, or offers or agreements by primary underwriters:

• When it relates to a certain amount of brokerage commissions in relation to the sale of fund shares by the dealer
• When business is used to finance any part of a dealer's sales

As noted above, firms and fund companies that are found violating the agency's rule may face fines—often amounting to millions of dollars—that must be paid to the agency. Violators may also face additional penalties.

Special Considerations

As mentioned above, FINRA created the rule in 1973. According to the agency's website, the rule "prohibited members from seeking orders for the execution of portfolio transactions on the basis of their sales of investment company shares" when it was created.

FINRA amended the rule in 1981 "to specify that subject to certain restrictions it does not prohibit members from seeking or granting brokerage commissions in connections with the sale of investment company shares, and that it does not prohibit members from selling shares of investment companies which follow a disclosed policy of considering sales of their shares as a factor in the selection of broker-dealers to execute portfolio transactions, subject to best execution."

Examples of Anti-Reciprocal Rule Enforcement

In 2008, FINRA announced that a $5 million fine levied two years previously against American Fund Distributors for directed brokerage would stand after the fund company appealed the original decision to the National Adjudicatory Council, FINRA's appeals body.

The NAC upheld a decision that found that AFD violated the rule when by directing more than $98 million in brokerage commissions to almost 50 securities firms that sold its mutual funds between 2001 and 2003:

AFD is the principal underwriter and distributor of American Funds, a family of 29 mutual funds. In ruling on AFD's appeal of the Hearing Panel decision, the NAC concluded that AFD arranged for the direction of a specific amount or percentage of brokerage commissions to other securities firms conditioned upon those firms' sales of American Funds shares, an "outright" violation of FINRA's Anti-Reciprocal Rule.

The NAC also determined that the fund company's "requests and arrangements for the direction of brokerage, conditioned upon sales, was directly at odds with the goal of the Anti-Reciprocal Rule, which is "to curb conflicts of interest that might cause retail firms to recommend investment company shares based upon the receipt of commissions from that investment company."