Five Percent Rule

What Is the Five Percent Rule?

The five percent rule is a stipulation of the Financial Industry Regulatory Authority (FINRA), which oversees brokers and brokerage firms in the U.S. Dating back to 1943, it stipulates that a broker shouldn’t charge commissions, markups, or markdowns of more than 5% on standard trades, both stock exchange listings and over-the-counter transactions, along with proceeds sales and riskless transactions.

Although also known as the FINRA 5% markup policy or 5% policy, the five percent rule is more of a guideline than an actual regulation. The aim is to require brokers to use fair and ethical practices when setting commission rates, so that the prices investors pay are reasonably related to the market for the securities they buy.

Key Takeaways

  • The five percent rule, aka the 5% markup policy, is FINRA guidance that suggests brokers should not charge commissions on transactions that exceed 5%.
  • The five percent rule is more of a guideline than an actual regulation, aiming to ensure that investors pay reasonable commissions and that brokers are ethical in setting their fees.
  • Certain individuals or securities may be exempt from FINRA regulation and therefore the 5% rule.
  • In the context of investing, the five percent rule may also refer to the practice of not letting any single security or asset comprise more than 5% of a portfolio.

How the Five Percent Rule Works

The five percent rule itself does not set forth any criterion for calculating commissions or fees. Instead, it indicates that the broker should follow guidelines. The rule is applied to various transactions, including the following:

  • Principal transactions: A broker-dealer buys or sells securities from its own holdings and, based on that, charges a markup or markdown.
  • Agency transactions: A brokerage firm, acting as a middleman, charges a commission on a transaction.
  • Proceeds transactions: A broker-dealer sells a security for a client and uses those proceeds to purchase other securities. This constitutes one transaction, not two.
  • Riskless transactions: Such simultaneous transactions see a firm buy a security from its own holdings and immediately sell it to a customer.

The rule itself has several exceptions. For example, it does not apply to securities sold through a prospectus—such as in an initial public offering.

According to FINRA, "the policy has been reviewed by the Board of Governors on numerous occasions and each time the Board has reaffirmed the philosophy expressed in 1943".

What Determines a Fair Commission?

If the five percent rule aims to establish a reasonable fee, it's natural to wonder: How do firms determine what's fair? Elements that are considered when determining what is fair and reasonable include:

  • The price of the security in question 
  • The total value of the transaction (larger transactions may qualify for discounted pricing)
  • What kind of security it is (options and stocks transactions have higher costs than bonds, for example)
  • The overall value of the members' services
  • What it cost to execute the transaction (some firms impose a minimum transaction)

It should be noted that each factor may contribute to a higher or lower commission than 5%; a large equity transaction that was simple to execute may be done so for far less than 5%, while a small, complicated transaction of a more lightly traded security could be far more than 5%.

Five Percent Rule Example

If a client wanted to buy 100 shares of Hypothetical Co. at $10 a share, the total value of that transaction would be $1,000. If the broker's minimum transaction cost was $100, the total fee would be 10% of the trade—far more than the five percent rule. However, as long as the client knew of the transaction minimum in advance, the rule would not apply. 

Special Considerations

The five percent rule also has another meaning. In the context of investing, it may also refer to the practice of not allocating more than 5% of a portfolio to any single security—in other words, of not letting any one mutual fund, company stock, or even industrial sector to accumulate to comprise more than 5% of the investor's overall holdings. This rule is not codified by any investing agency; it is simply a rule of thumb to guide investment decisions.

This sort of five percent rule is a yardstick to help investors with diversification and risk management. Using this strategy, no more than 1/20th of an investor's portfolio would be tied to any single security. This protects against material losses should that single company perform poorly or become insolvent.

What Is Exempt From the 5% Markup Policy?

Anything that is being offered under a prospectus is exempt from the 5% markup policy. This is because all of the commissions and charges are all detailed in the prospectus. This extends to open end mutual funds or offering of securities.

Who Is Exempt from FINRA?

Certain individuals are exempt from from FINRA requirements. Employees exempt from FINRA registration include individuals whose functions are clerical/ministerial in nature, limited partners, or related exclusively to transactions executed on a securities exchange.

How Was the 5% Policy Created?

FINRA's Association Board adopted the policy in 1943 in exchange for feedback from customers who executed transactions. In general, studies based on a majority of transactions were effected with a mark-up of 5% or less.

The Bottom Line

The Financial Industry Regulatory Authority, which is in charge of regulating brokers and brokerage companies in the US, has a requirement known as the five percent rule. It dates back to 1943 and states that commissions, markups, and markdowns of more than 5% are prohibited on standard trades, including over-the-counter and stock exchange listings, cash sales, and riskless transactions.

Article Sources
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  1. Financial Industry Regulatory Authority (FINRA). "2121. Fair Prices and Commissions."

  2. FINRA. "Registration Requirements."

  3. FINRA. "2121. Fair Prices and Commissions."

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