Interpositioning

What Is Interpositioning?

Interpositioning refers to the illegal practice of using an unneeded third party, usually another broker-dealer, between the customer and the best available market price, with the sole purpose being to generate extra commissions at the cost of the customer.

Understanding Interpositioning

Interpositioning, in a securities transaction, refers to the illegal practice of employing a second broker in order to generate an additional commission. This extra broker collects a commission even though they provide no service.

As such, interpositioning is typically done as part of a mutual benefit strategy, sending commissions to the broker-dealer in exchange for referrals or other cash considerations. This type of behavior occurs at the upper levels of trade between specialists and broker-dealers, hedge funds, or other institutional investor accounts.

Interpositioning may also be described as when a specialist or broker-dealer positions themselves as a middle man in a transaction (between a buyer and a seller) and charges a commission without providing a service.

For example, Broker A convinces a customer to buy a security from Broker Z. After acquiring the security from a market maker, Broker Z adds a markup to the security and transfers it to Broker A, who then adds their own markup and provides the security to the customer. In all, the customer has paid two levels of fees, one each to Broker A and Broker Z, which cuts into their profit or adds to their loss.

Such commissions may not be worth much individually but can add up quickly, especially within institutional trading accounts. As such, interpositioning is illegal under the Investment Company Act of 1940, which states that a money manager cannot do anything that intentionally defrauds or deceives a client.

A wide-ranging case of interpositioning was found to have occurred among various specialists of the New York Stock Exchange (NYSE) in the 1999-2003 period. Both the NYSE and the Securities and Exchange Commission (SEC) initiated a settlement in the amount of $241.8 million against five firms that engaged in this behavior.

Interpositioning Rules

The guidelines governing interpositioning are spelled out in Financial Industry Regulatory Authority (FINRA) Rule 5310, which specifies that broker-dealers must use reasonable due diligence to ensure the best execution.

The rule (5310: Best Execution and Interpositioning) clearly states in part (a)(1) the minimum standards that brokers must follow to ensure the best execution:

"In any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Among the factors that will be considered in determining whether a member has used 'reasonable diligence' are:

1. The character of the market for the security (e.g., price, volatility, relative liquidity, and pressure on available communications);
2. The size and type of transaction;
3. The number of markets checked;
4. Accessibility of the quotation; and
5. The terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member."

5310 (a)(2) addresses interpositioning directly in stating: "In any transaction for or with a customer or a customer of another broker-dealer, no member or person associated with a member shall interject a third party between the member and the best market for the subject security in a manner inconsistent with paragraph (a)(1) of this Rule".