[Federal Register Volume 59, Number 129 (Thursday, July 7, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16369]


[[Page Unknown]]

[Federal Register: July 7, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34279; File No. SR-NASD-93-58]

 

Self Regulatory Organizations; Order Approving Proposed Rule 
Change by the National Association of Securities Dealers Relating to 
Handling of Customer Limit Orders

June 29, 1994.
    On October 13, 1993, the National Association of Securities Dealers 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ a proposed rule 
change consisting of an Interpretation to the NASD's Rules of Fair 
Practice relating to the handling of customer limit orders. The 
proposed rule change was published for comment in the Federal 
Register.\2\ Two comment letters were received. For the reasons 
discussed below, the Commission is approving the proposed rule change.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\Securities Exchange Act Release No. 33697 (March 1, 1994), 59 
FR 45 (March 8, 1994).
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I. Background

    Over the past several years, limit order practices involving NASDAQ 
stocks have become the subject of investor complaints and Commission 
scrutiny. Current NASDAQ limit order handling practice often results in 
a market maker's delaying execution of the customer's sell (or buy) 
order until the highest bid (offer) from among competing market makers 
equals the customer's limit price. Moreover, firms that accept limit 
orders often trade for their own accounts at prices better than the 
customer's limit order price without executing the customer's order.
    The priority accorded a customer limit order today is different 
depending on the structure of the marketplace of execution, a 
distinction customers do not always understand. The rules of national 
securities exchanges require specialists to yield to a customer's limit 
order; the specialist cannot trade for its own account at prices better 
than the limit order until the limit order is executed.
    In 1988, the Commission expressed its views on the issue of limit 
order protection in the NASDAQ market when it ruled that broker-dealers 
owe a fiduciary duty to their limit order customers not to trade ahead 
of these orders unless the customer is first informed of the firm's 
limit order policy.\3\ As a result of the Manning decision, the NASD 
filed a proposed rule change with the Commission that states that a 
member firm will be deemed not to have violated NASD Rules of Fair 
Practice if it provides to customers a statement setting forth the 
circumstances in which the firm accepts limit orders and the policies 
and procedures that the firm follows in handling these orders.\4\
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    \3\See In re E.F. Hutton & Co. (the ``Manning'' decision), 
Securities Exchange Act Release No. 25887 (July 6, 1988), 41 SEC 
Doc. 473, appeal filed, Hutton & Co. Inc. v.  SEC, Dec. No. 88-1649 
(D.C. Cir. Sept. 2, 1988), (Stipulation of Dismissal Filed, Jan. 11, 
1989).
    \4\Securities Exchange Act Release No. 26824 (May 15, 1989), 54 
FR 22046 (May 22, 1989). The proposal included model disclosure 
language to be used by firms whose policy is not to grant priority 
to customer limit orders over the member's own proprietary trading.
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    In July of 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.''\5\ 
The NASD solicited member comment on eliminating the disclosure safe 
harbor for members trading ahead of customer limit orders and the 
effect a rule prohibiting trading ahead might have on integrated 
broker-dealers, on limit orders received from other firms (``member-to-
member'' trades) and on market liquidity.\6\
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    \5\See File No. SR-NASD-93-58, p. 6.
    \6\See Notice to Members 93-49 (July 23, 1993).
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    After full consideration of the concerns articulated in the comment 
process, the NASD withdrew the rule filing containing the disclosure 
approach,\7\ and submitted this proposed Interpretation to its Rules of 
Fair Practice, prohibiting member firms from trading ahead of their 
customers' limit orders in their market making capacity.
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    \7\See Letter from Robert E. Aber, Vice President and General 
Counsel, National Association of Securities Dealers, to Selwyn 
Notelovitz, Branch Chief, Division of Market Regulation, SEC (Oct. 
13, 1993).
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II. Description

    The NASD is proposing to adopt an Interpretation to its Rules of 
Fair Practice that would prohibit member firms that hold their own 
customer limit orders from trading ahead of those orders, regardless of 
whether the practice has been disclosed, and would make trading in 
disregard of the prohibition a violation of just and equitable 
principles of trade. The Interpretation establishes that a member 
holding its customers' limit order may not continue to trade for its 
own 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 deemed a violation 
of Article III, Section 1 of the Rules of Fair Practice regarding just 
and equitable principles of trade.\8\
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    \8\The Interpretation does not distinguish between the limit 
order protection provided retail and institutional customers.
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    The Interpretation also states that a member that ``controls or is 
controlled by''\9\ another member will be considered affiliated in a 
single entity for purposes of determining the application of the rule. 
Thus, if a member firm accepts a customer's limit order and forwards 
that limit order for execution to a market making unit that it 
controls, the firms will be considered affiliated and the prohibition 
against trading ahead of the customer's limit order will apply to the 
firm as a whole.
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    \9\Amendment No. 1 to File No. SR-NASD-93-58. See Letter from T. 
Grant Callery, Vice President and General Counsel, to Mark Barracca, 
Branch Chief, Division, Commission (June 14, 1994).
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    The Interpretation will not apply to limit orders accepted by 
market makers from unaffiliated members. For example, a firm's customer 
limit orders that are sent to an unrelated market making firm for 
execution would not be covered by the Interpretation. The NASD has 
decided to defer temporarily application of the Interpretation to these 
trades so that a task force may complete its examination of the 
potential consequences of a broader application of the rule. The 
Interpretation emphasizes that all members accepting customer limit 
orders owe those customers duties of ``best execution'' regardless of 
whether the orders are executed through the member's market making 
capacity or sent to another member for execution.\10\
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    \10\The best execution Interpretation requires members to use 
reasonable diligence to ascertain the best inter-dealer market for 
the security and buy or sell in such a market so that the price to 
the customer is as favorable as possible under prevailing market 
conditions. NASD Rules of Fair Practice, Art. III, Section 1, NASD 
Manual (CCH) 2151.03
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III. Summary of Comments

    As noted above, the Commission received two comment letters on the 
proposal.\11\ Merrill Lynch, a registered broker dealer, supports the 
proposal, noting that it will increase investor confidence in the 
NASDAQ market by improving the quality of executions they receive. The 
other commenter, STANY, supports the principle that the limit order of 
a commission-paying customer is entitled to priority over the order of 
the customer's broker-dealer. Both Merrill Lynch and STANY believe that 
the proposed interpretation should not apply to member-to-member 
transactions. Merrill Lynch believes that requiring leaders to provide 
limit order protection to other broker-dealers might have a serious 
deleterious effect on dealers' willingness and ability to make markets 
in these stocks. STANY offers three reasons why dealers that receive 
the limit orders of other firms' customers should not be subject to the 
restriction: (1) Agency dealers could be acting for their own 
customers, for themselves or for other dealers, thereby creating the 
possibility that some dealers could make markets within the spread 
without a capital commitment; (2) it would force a dealer to assume a 
fiduciary responsibility to customers of another firm with whom the 
dealer has no preexisting relationship; and (3) it may require dealers 
to execute certain limit orders at prices which do not provide an 
opportunity for any profit.
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    \11\Letter from Frank Masi, President, Security Traders 
Association of New York (``STANY''), to Jonathan G. Katz, Secretary, 
Commission (March 29, 1994). Letter from Hugh Quigley, Managing 
Director, Merrill Lynch. Pierce, Fenner & Smith (``Merrill Lynch'') 
to Jonathan G. Katz, Secretary, Commission (April 20, 1994).
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IV. Discussion

    The Commission believes that the proposed rule change is consistent 
with the Act and the rules and regulations thereunder applicable to the 
NASD and, in particular, Sections 15A(b)(6), 15A(b)(9) and 11A(a)(1)(C) 
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 and processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect he mechanism of a free 
and open market and a national market systems and in general to protect 
investors and the public interest. Section 15A(b)(9) requires that the 
rules of the association not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act. 
Section 11A(a)(1)(C) (i) and (iv) set forth the objectives of assuring 
economically efficient execution of securities transactions and the 
practicability of brokers executing investors' orders in the best 
market.\12\
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    \12\Although the proposed rule change is adopted pursuant to 
Section 15A of the Act, the Commission believes the goals of Section 
11A are equally served by this proposed rule change.
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    The NASD's proposal seeks to address the practice of NASDAQ market 
makers trading ahead of their customers' limit orders. That practice, 
its origins and implications for investors was recently discussed in 
the Division of Market Regulation's Market 2000 Report.\13\ That study 
concluded that the adverse effects of trading ahead exist whether the 
customer's limit order is handled by the customer's firm or by another 
market maker. The study recommended that the NASD revise its proposal 
to prohibit broker-dealers from trading ahead of all customer limit 
orders for NASDAQ National Market securities.
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    \13\Division of Market Regulation, SEC, Market 2000: An 
Examination of Current Equity Market Developemnts V-5 (1993).
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    The Commission believes that the rule change will enhance investor 
confidence by improving the quality of executions for customers. By 
giving a customer's limit order priority over the market maker's 
proprietary trading, more trade volume will be available to be matched 
with the customer's order, resulting in quicker and more frequent 
executions for customers.
    The NASD's proposal will also improve the price discovery process 
in NASDAQ securities. Limit orders aid price discovery by adding 
liquidity to the market and by tightening the spread between the bid 
and ask price of a security. In the past, customers may have refrained 
from placing limit orders because of the uncertainty of and difficulty 
in obtaining an execution at a price between the spread. The new rule 
will encourage dealers to execute customer limit orders in a timely 
fashion so that they may resume their proprietary trading activities. 
The practice of delaying executions until the inside price reaches the 
customer's limit order also impedes price discovery by shielding those 
orders from the rest of the investing public. More expeditious handling 
of customer limit orders under the proposed Interpretation will provide 
investors with a more accurate indication of the buy and sell interest 
at a given moment.
    The NASD proposal seeks to prevent a market maker from trading 
ahead of its own customer's limit order, but will not prevent the same 
market maker from trading ahead of the limit orders of other firms' 
customers that are sent to the market maker for handling.\14\ The NASD 
has determined to defer temporarily application of the Interpretation 
to member-to-member orders in order to avoid any unintended 
consequences from a broader application of the rule and to permit a 
special NASD task force to complete its examination of the 
ramifications of extending limit order protection to these limit 
orders. The Market 2000 study concluded that the adverse effects of 
trading ahead of a customer exist whether the customer's limit order is 
handled by a customer's firm or by another market maker. The 
Commission, at this time, strongly believes that the ban on trading 
ahead should be applied to these member-to-member trades. The NASD has 
requested the opportunity to examine and report the potential impact of 
the ban on market liquidity and market maker capital commitment. While 
such a report could be helpful to a future determination of the issue 
if it offers specific data regarding the potential consequences for 
market liquidity and market maker capital commitment rather than the 
anecdotal observations of NASD members, the Commission continues to 
believe that member-to-member trades raise significant concerns that 
should be addressed, and if necessary, the Commission would consider 
instituting its own rulemaking proceeding for that purpose. The 
Commission has expressed to the NASD its view that expanded limit order 
protection is desirable and will be expecting their response soon after 
the approval of this rule filing.
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    \14\The Commission would consider any order swapping 
arrangements between firms for the purpose of evading the 
Interpretation to constitute a violation of NASD rules. The NASD has 
stated that, while it is not aware of any instances of this 
practice, it would likewise consider it to be a violation of Article 
III, Section 1 of the NASD's Rules of Fair Practice. See Letter from 
Richard Ketchum, Executive Vice President and Chief Operating 
Officer, NASD, to Katherine England, Assistant Director, Division, 
Commission (June 29, 1994).
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    As reflected in the Market 2000 study, the Commission agrees that 
institutional orders may qualify for special treatment. Because most 
market makers cannot typically fill institution-size orders out of 
inventory, institutions generally only hold market makers to a ``best 
efforts'' standard in return for the willingness of the market maker to 
put up substantial capital to provide liquidity for large orders. In 
order to permit a member firm to employ the necessary trading strategy 
without being subjected to the requirements of the proposed ban, the 
Interpretation allows the parties to set the specific ``terms and 
conditions'' for acceptance of institutional orders.
    Finally, the Commission believes that the proposal does not impose 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act. Because the rule will apply to 
all NASD members, individual brokers and dealers will not be 
disparately affected by the rule change.

V. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change is consistent with the Act and the rules and regulations 
thereunder applicable to the NASD and, in particular, Sections 
15A(b)(6), 15A(b)(9) and 11A(a)(1)(C) of the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-NASD-93-58) be and hereby is 
approved, effective July 7, 1994.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 94-16369 Filed 7-6-94; 8:45 am]
BILLING CODE 8010-01-M