What is interpositioning?

Interpositioning means assigning an unnecessary third party, generally another broker, to act as a go-between with a customer and the best attainable market. Interpositioning is prohibited if the sole goal is to generate additional commissions at the customer’s expense.

Understanding interpositioning

In a securities transaction, interposition is when broker-dealers stand between a buyer and a seller as a middle man. This second broker does not provide any service, but they collect commission from the transaction, making the practice illegal.

This sort of trading generally occurs between specialists and broker-dealers, hedge funds or other institutional investor accounts at the highest levels of the market. It is usually done as part of a strategy to obtain mutual benefit by generating extra commissions for referrals or offering other financial incentives.

An example of interposition is when Broker A persuades a customer to buy a security from Broker B, who marks up its price after purchasing it from the market. Broker B transfers the security to Broker A, who also adds their own commission and then provides the security to the customer. As a result, the customer has paid fees on two levels: one to Broker A and one to Broker B. The practice reduces or increases the customer’s profit or loss.

These extra commissions may not seem like much on their own, but they can soon pile up, particularly in institutional trading accounts. Therefore, the practice is considered illegal according to the Investment Company Act of 1940, which stipulates that a money manager cannot defraud or deceive a client on purpose.

The interposition rule is also stipulated in Financial Industry Regulatory Authority (FINRA) Rule 5310. 

Additionally, the rule specifies a minimum standard that brokers must follow:

“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 favourable as possible under prevailing market conditions.”

To address the interposition, the rule clearly states: “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.”