[Federal Register Volume 59, Number 45 (Tuesday, March 8, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-5205]


[[Page Unknown]]

[Federal Register: March 8, 1994]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33697; File No. SR-NASD-93-58]

 

Self-Regulatory Organizations; Proposed Rule Change by National 
Association of Securities Dealers, Inc. Relating to Handling of 
Customer Limit Orders

March 1, 1994.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on October 
13, 1993 the National Association of Securities Dealers, Inc. (``NASD'' 
or ``Association'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the NASD. 
The Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Association is proposing an Interpretation to the Rules of Fair 
Practice to require that member firms not trade ahead of their 
customers' limit orders in their market making capacity. The 
Interpretation would make it a violation of just and equitable 
principles of trade for member firms to hold unexecuted customer limit 
orders and trade ahead of those orders in the firm's market making 
capacity without filling the orders under the specific terms and 
conditions with which the orders had been accepted.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The Association is proposing an Interpretation to the Rules of Fair 
Practice that would make it a violation of just and equitable 
principles of trade for member firms that hold unexecuted customer 
limit orders to trade ahead of those orders in the firm's market making 
capacity. In July 1993, the NASD solicited member comment on 
eliminating a disclosure safe harbor for members trading ahead of 
customer limit orders.\1\ In September 1993, the Board reviewed 
comments received from members and others and took action to eliminate 
the disclosure safe harbor and to replace it with a prohibition against 
members' trading ahead of their own customer limit orders.
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    \1\See Notice to Members 93-49 (July 23, 1993).
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    The issue of limit order protection in the NASDAQ market was 
brought to the forefront in 1985 when a customer alleged that a member 
firm had accepted his limit order, failed to execute it, and failed to 
discharge its fiduciary duties by trading ahead of the customer's 
order. In the Manning decision, the NASD found that upon acceptance of 
a customer's limit order, a member undertakes a fiduciary duty and 
cannot trade for its own account at prices more favorable than the 
customer's limit order unless clear disclosure is provided and there is 
an understanding by the customer as to the priorities that will govern 
the order. The SEC affirmed the NASD decision.\2\ After input from a 
number of members, the NASD proposed a ``safe harbor'' for members to 
fulfill their fiduciary obligations with disclosure when the customer's 
account was first opened and periodically thereafter.\3\ The language 
set out in the proposed safe harbor put customers on notice that the 
firm accepting a limit order would execute that order only when the 
inside bid or offer on Nasdaq reached the limit price and that the 
member might, in its market making capacity, trade ahead of that order. 
The membership approved the proposed language, and the NASD submitted 
the rule to the SEC.\4\
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    \2\In the Matter of E.F. Hutton & Co., Securities Exchange Act 
Release No. 25887 (July 6, 1988), 41 SEC Doc. 473.
    \3\See Notice to Members 90-37 (June 1990).
    \4\SR-NASD-89-10 (March 16, 1989). With submission of this rule 
proposal, the NASD, under separate cover, is withdrawing SR-NASD-89-
10.
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    In July 1993, the NASD Board of Governors reviewed the handling of 
limit orders in NASDAQ securities and concluded that the continuation 
of the disclosure exception appeared inappropriate. Because of the 
significance of this change to The NASDAQ Stock Market, a notice was 
issued soliciting input on how elimination of the safe harbor would 
impact the operation of member firms and the treatment of investors' 
orders. The NASD also solicited comment on what if any unintended 
effects or unacceptable consequences would ensue if rules prohibiting 
trading ahead of customer limit orders were imposed on member firms. 
Specifically, comment was requested on the impact of applying the 
requirements on integrated broker-dealers handling their own customer 
order flow; on customer limit orders received from other member firms 
(so-called member-to-member trades); and on market liquidity.
    In response to the notice, the NASD received 29 comment letters 
from members and trade associations, including the Security Traders 
Association (``STA''), STA of New York (``STANY''), and Securities 
Industry Association (``SIA''). The vast majority of comments supported 
elimination of the disclosure safe harbor for market makers trading 
ahead of their own retail, or ``commission paying,'' clientele. 
Commenters noted that elimination of the safe harbor would level the 
playing field for investors, enhance the image of The NASDAQ Stock 
Market, and instill greater confidence with investors that their NASDAQ 
limit orders would be handled fairly. Some commenters noted that the 
NASD should distinguish between retail and institutional customer limit 
orders, so that a market maker's ability to commit capital to large 
institutional orders would not be impaired by a narrow reading of 
``trading ahead.'' Members believed that the new rule language might 
interfere with a market maker's ability to commit capital to large 
institutional orders as filling these orders might necessarily involve 
a trading strategy to cover short positions or to buy stock along with 
the institution that on its face might appear to be trading in front of 
those or other customer limit orders. Other commenters believed that 
distinguishing between institutional and retail customers was not 
necessary because the proposed rule language that allows members to 
establish specific terms and conditions on each order adequately covers 
handling of institutional orders.
    Many commenters, including STA, SIA and STANY, argued that the NASD 
should draw a distinction between orders from a member's own customers 
and orders from another broker/dealer. They pointed out that unlike an 
integrated firm which may charge a mark-up or commission to its 
customers, the only profit potential for orders received from other 
members lies in trading revenues derived from the spread. If the effect 
of the NASD's proposed rule were to require a market maker to satisfy a 
limit order sent from another broker/dealer when the market maker 
traded at the same price, these commenters agreed that the NASD would 
be in effect forcing the market makers to handle the order at no profit 
or indeed at a loss net of processing costs. These commenters also 
argued that alternative means of compensating market makers, such as 
sharing the order entry firm's commission, were infeasible given the 
structure of the NASDAQ market. As a result, these commenters argued 
that extension of the Interpretation to member-to-member orders would 
dramatically reduce market maker commitment. Further, several members 
argued that by extending the requirements to other members' customer 
limit orders, the NASD would be inappropriately expanding the 
requirements of a fiduciary in the securities markets.
    Many also commented on the new rule's potential for unintended 
consequences on market liquidity, including a significant increase in 
limit orders as opposed to market orders, loss of market maker 
commitment, wider spreads and increased volatility. Members pointed out 
that the NASD had not yet fully explored the economic ramifications of 
the new requirements and noted that further economic analysis should be 
undertaken prior to rulemaking.\5\
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    \5\Some members also argued that procedural due process was 
being by-passed by framing the new requirement as an Interpretation 
to the just and equitable principles of trade standards of Article 
III, Section 1 of the NASD Rules of Fair Practice. The NASD notes 
that these comments misconstrue the regulatory process involved with 
NASD Interpretations. All NASD Interpretations are submitted to the 
SEC for review, publication in the Federal Register and public 
comment prior to SEC action.
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    After full consideration of the concerns articulated in the comment 
process, the NASD is proposing to eliminate the disclosure safe harbor 
for member firms that hold their own customer limit orders and trade 
ahead of those orders and to make such actions a violation of just and 
equitable principles of trade. The language of the Interpretation 
establishes that a member holding its customers' limit order may not 
continue to trade its market making position without executing that 
limit order under the specific terms and conditions that the customer 
understands and accepts. If the member does trade ahead of its 
customer, it will be in violation of article III, section 1 of the 
Rules of Fair Practice regarding just and equitable principles of 
trade.
    The NASD believes that it is inappropriate to distinguish between 
the limit order protection provided fee-paying, or retail customers, 
and non-fee paying, institutional clientele. The NASD recognizes, 
however, that filling institutional-sized orders generally involves 
best-effort commitments and trading strategies other than a straight 
acceptance of a limit order. Firms accepting institutional orders on a 
best-efforts basis, that may involve trading to a cover short position 
or buying stock along with the institution, would not be in violation 
of the rule as long as the firm maintains a clear understanding with 
its institutional clientele of the terms under which the order is being 
executed. Accordingly, the NASD does not distinguish between 
institutional and retail customers in the Interpretation because the 
proposed language that allows members to establish specific terms and 
conditions on each order clearly encompasses institutional orders. This 
language recognizes that institutions generally do not leave standard 
limit orders with market makers. Instead, in return for the willingness 
of member firms to put up substantial capital to provide liquidity for 
large orders, institutions generally only hold market makers to a best-
efforts standard in attempting to execute their order at a specific 
price. The ability of the member firm and the institution to reach 
agreement on the terms and conditions of the order would allow them to 
negotiate these arrangements without subjecting the member firm to the 
requirements of the proposed rule.
    Further, the NASD has determined to temporarily defer application 
of the Interpretation to member-to-member orders in order to avoid any 
unintended consequences from a broader application of the rule. The 
NASD will form a special task force to examine ramifications of 
extending limit order protections to include member-to-member 
transactions. The task force will analyze the effect of the proposal on 
market liquidity, volume of limit orders, market maker commitment, 
spreads and volatility. The NASD believes that the issues raised by 
customer limit orders passed from one member firm to a second member 
firm are very complex. Dealers that trade as ``wholesale'' market 
makers, whether exclusively or as a part of an integrated firms' 
business, have profit potential only in the trading revenues received--
they do not rely on commissions or commission equivalents as revenue to 
support their trading activities. Relying on pure trading profit and 
loses is unique to a dealer market and cannot be compared to a 
specialist that executes transactions for members on an exchange while 
charging a fee for that service. Accordingly, requiring a market maker 
to execute such limit orders any time it trades for its own account at 
the same price effectively eliminates any opportunity for that market 
maker to profit on that trade. The NASD is concerned that the economic 
implications for market makers and the potential impact on liquidity 
and spreads in the NASDAQ stock market have not fully been reviewed. 
For these reasons, the NASD will form a task force composed of diverse 
industry and investor interests to review the issues raised by limit 
orders passed from one member to another.
    In the Interpretation, the NASD also emphasizes that brokers 
forwarding orders to dealers for execution continue to be subject to 
their duties of best execution. Firms owe fiduciary duties of best 
execution to their customers and the NASD emphasizes that order entry 
firms should continue to routinely monitor the handling of their 
customer limit orders for quality of execution.
    The NASD believes that elimination of the safe harbor for a broker/
dealer's own customer orders is squarely in line with the original 
Manning decision which was premised on a firm's fiduciary duty not to 
trade ahead of its own customer order.\6\ Feedback from members 
commenting on the new rules indicates that integrated market makers on 
the whole do not trade ahead of their own customer orders, and 
accordingly, eliminating the safe harbor would not materially or 
adversely affect the way these market makers conduct their business 
today.
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    \6\In this regard, the NASD Interpretation on the obligation to 
protect the firm's customer limit orders will also apply to firms 
that control or are controlled by another member firm, e.g., where 
the order entry firm is a broker that owns or controls the executing 
dealer.
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    Finally, as the handling of customer limit orders entails duties 
that are not subject to a disclosure safe harbor, nothing in the rule 
compels market makers to accept limit orders from their customers or 
from other broker/dealers.
    The NASD believes the proposed rule change is consistent with 
section 15A(b)(6) of the Act. Section 15A(b)(6) requires that the rules 
of a national securities association be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and in general to 
protect investors and the public interest. The new requirement ensures 
protection of investor's limit orders when placed with market making 
firms and enhances the quality of the marketplace. The affirmative 
obligation for firms to protect their customer limit orders and to give 
them standing over their own market making activity also enhances 
opportunities for price improvement which is a benefit for public 
investors.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were solicited in Notice To Members 93-49 and the content 
of those comments are summarized in the description of the rule 
proposal in part II(A) above.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the NASD consents, the Commission will: A. By order approve such 
proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. In this regard, the Commission 
notes that in the recently issued Market 2000 study, the Division of 
Market Regulation recommends that the NASD revise its proposal to 
prohibit broker-dealers from trading ahead of all customer limit orders 
for NASDAQ/NMS securities.
    Persons making written submissions should file six copies thereof 
with the Secretary, Securities and Exchange Commission, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of the submission, all 
subsequent amendments, all written statements with respect to the 
proposed rule change that are filed with the Commission, and all 
written communication relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the file number in the caption above and 
should be submitted by March 29, 1994.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority, 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-5205 Filed 3-7-94; 8:45 am]
BILLING CODE 8010-01-M