[Federal Register Volume 59, Number 193 (Thursday, October 6, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-24690]


[[Page Unknown]]

[Federal Register: October 6, 1994]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-34753; File No. S7-28-94]
RIN 3235-AG21

 

Customer Limit Orders

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission proposes a rule setting 
standards for market makers in handling customer limit orders in NASDAQ 
National Market System securities. The rule would prohibit a market 
maker from trading for its own account, directly, or indirectly, at a 
price at which the market maker could execute a customer limit order it 
is holding, without executing the customer's limit order at the limit 
price or a price more favorable to the customer under the specific 
terms and conditions by which the order is accepted by the market 
maker.

DATES: Comments should be submitted on or before December 5, 1994.

ADDRESSES: Interested persons should submit three copies of their 
written data, views and opinions to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549, and should refer to File No. S7-28-94. All submissions will 
be made available for public inspection and copying at the Commission's 
Public Reference Room, Room 1024, 450 Fifth Street, N.W., Washington 
D.C. 20549.

FOR FURTHER INFORMATION CONTACT: Scott C. Kursman, (202) 942-3197, 
Attorney, Office of Market Supervision, Division of Market Regulation, 
Securities and Exchange Commission, Mail Stop 5-1, 450 Fifth Street, 
N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction and Background

    The Securities and Exchange Commission (``SEC'' or ``Commission'') 
today is proposing a rule (17 CFR 240.15c5-1) to prohibit market makers 
in NASDAQ National Market System (``NASDAQ/NMS'') securities from 
trading ahead of customer orders that they are holding at the same or 
better price. The Commission is proposing to change existing practices 
because it believes this will enhance broker-dealer competition, 
promote efficient pricing of securities, facilitate best execution of 
customer orders and better reflect investor expectations in the NASDAQ/
NMS market. The growth of the NASDAQ market and the concomitant 
visibility of and investor interest in its companies has changed 
investors' expectations.
    In designing the proposed rule, the Commission has been mindful of 
the special role of NASDAQ market makers in discovering prices and 
providing liquidity in NASDAQ/NMS stocks. The proposal seeks comment on 
specific trading standards that would govern individual market makers. 
The proposed rule is intended to have the effect of giving priority to 
orders that improve the market (i.e., narrow the bid-ask spread) being 
made by a specific market maker.
    Generally, an order to buy or sell a security at a specified price 
(``limit order'') is first received by the customer's broker, who 
either routes the order to an affiliated or non-affiliated market maker 
for execution or, if the firm is itself a market maker in the security, 
to the firm's market making desk. The combination of limit order 
execution and market maker functions can lead to the market maker 
competing with a customer for executions. While the past few years have 
seen several positive efforts at improving limit order handling 
practices in the NASDAQ market, the Commission believes that it should 
consider a limit order priority rule to ensure protection for all 
customer orders in this market.
    The priority accorded a customer limit order today is different 
depending on the structure of the marketplace of execution. The rules 
of national securities exchanges generally require specialists and 
other market professionals to yield to a customer's limit order; the 
specialist cannot trade for its own account at prices equal to or 
better than the limit order until the limit order is executed.1 
The rules of the National Association of Securities Dealers (``NASD'') 
similarly prohibit third market makers (over-the-counter market makers 
in listed securities) from trading ahead of customer limit orders in 
the third market.2
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    \1\See, e.g., New York Stock Exchange (``NYSE'') Rule 92, 2 NYSE 
Guide (CCH) 2092. The priority rules of the New York Stock Exchange 
do permit an exception to this general principle for pre-arranged 
crosses of 25,000 shares or more. Such a cross may be executed on 
the floor without interacting with pre-existing limit orders at the 
same price. A preexisting limit order, however, may interact with 
the buyer or seller in the cross if it provides a price that is 
better than the proposed cross price. See Securities Exchange Act 
Release No. 31343 (October 21, 1992), 57 FR 48645 (October 27, 
1992).
    \2\NASD Bylaws, Schedule G, Section 4(f), NASD Manual (CCH) 
1921. Third market dealers account for more than 9% of listed stock 
trades.
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    In 1988, the Commission addressed the issue of customer limit order 
protection in the NASDAQ market.3 In the Manning decision, the 
Commission affirmed, based on principles of agency law, an NASD 
determination that it is inconsistent with just and equitable 
principles of trade for a market maker to trade ahead of a customer 
limit order unless the customer is first informed of the firm's limit 
order policy. As a result of the Manning decision, the NASD filed a 
proposed rule change with the Commission stating that a member firm 
will not be deemed to have violated NASD Rules of Fair Practice if it 
provides customers with a statement setting forth the circumstances in 
which the member 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 so-called ``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, 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'' 
approach 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, and on 
market liquidity.6
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    \5\See File No. SR-NASD-93-58, p.6.
    \6\See NASD 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 its rule filing proposing the disclosure 
safe harbor approach,7 and submitted a proposed Interpretation to 
its Rules of Fair Practice, prohibiting member firms from trading ahead 
of their customers' limit orders in their market making capacity.8 
The Division of Market Regulation's Market 2000 study examined this 
practice and recommended that a ban apply to trading ahead of all 
customer limit orders, not just those of a firm's own customer.9 
The study noted that the adverse effects of trading ahead exist whether 
the customer's order is handled by the customer's firm or by another 
market maker.10
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    \7\See Letter from Robert E. Aber, Vice President and General 
Counsel, NASD, to Selwyn Notelovitz, Branch Chief, Over-the-Counter 
Regulation, Division of Market Regulation, SEC (October 13, 1993).
    \8\Securities Exchange Act Release No. 33697 (March 1, 1994), 59 
FR 10842 (March 8, 1994).
    \9\Division of Market Regulation, SEC, Market 2000: An 
Examination of Current Equity Market Developments (``Market 2000 
Study''), V-5 (1994).
    \1\0Id.
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    The Commission approved the NASD Interpretation on June 29, 1994, 
but expressed concern that the prohibition did not extend to trading 
ahead of limit orders of other firms' customers that have been sent to 
the market maker for execution.\11\ The NASD also convened a special 
task force to study the potential effect of expanded limit order 
protection on market liquidity and market maker capital commitment and 
to report back to the Board in September. The Commission stated that 
while such a study could be helpful to a future consideration of this 
issue, the Commission believed 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.\12\
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    \11\Securities Exchange Act Release No. 34279 (June 29, 1994), 
59 FR 34883 (July 7, 1994).
    \12\Id..
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    The task force has now submitted its report to the NASD Board of 
Directors and the Board has proposed for member comment market maker 
standards that would restrict market makers from trading ahead of 
certain member-to-member trades, keyed in part on the size of the 
customer limit order.13 Under the NASD proposal, market makers 
would be prohibited from trading at prices equal to or better than the 
price of a customer limit order they hold if the size of that order was 
1,000 shares or less and from trading at prices better than a 
customer's limit order if the size of that order was greater than 1,000 
shares.
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    \1\3See Special NASD Notice to Members 94-79 (September 23, 
1994).
    11Securities Exchange Act Release No. 34279 (June 29, 
1994), 59 FR 34883 (July 7, 1994).
    12Id.
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    The Commission believes that the NASD's proposal is an instructive 
step and will provide useful comment from the member firm community. 
The Commission, however, believes that comment from the broader 
constituency of the investing public and other non-NASD members will be 
critical in formulating adequate limit order protection for the NASDAQ 
market. In addition, the Commission believes that alternatives which 
provide more extensive limit order protection for public customers also 
should be the subject of public comment. Therefore, the Commission has 
determined to propose its own rule. Publication of the proposal will 
complement the efforts of the NASD and enable the Commission to act on 
its own initiative if it deems such action appropriate.

II. Discussion

    The Commission proposes to adopt Rule 15c5-1 pursuant to Section 
15(c)(5) of the Securities Exchange Act of 1934 (``Exchange 
Act''),14 among other provisions.15 Section 15(c)(5) grants 
the Commission authority over dealers acting in the capacity of market 
makers by permitting the Commission to impose standards with respect to 
dealing as the Commission, by rule, shall prescribe as necessary or 
appropriate in the public interest and for the protection of investors, 
to maintain fair and orderly markets, or to remove impediments to and 
perfect the mechanism of a national market system.16
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    \1\4Section 15(c)(5), 15 U.S.C. 78o.
    \1\5Section 11A, 15 U.S.C. 78k-1; Section 23, 15 U.S.C. 78w.
    \1\6See Exchange Act Section 15(c)(5), supra note 14.
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    The legislative history of the Securities Acts Amendments of 1975, 
under which Section 15(c)(5) was adopted, endorsed priority for 
customer limit orders in national market system securities and stated 
that the Commission should have discretion to achieve this protection. 
Congress noted that for suitable securities, every effort should be 
made to ensure that public investors in these securities would receive 
the benefits and protections that would result from the placing of 
public orders ahead of dealers' orders in determining the sequence in 
which orders entering the market are executed.17
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    \1\7S. Rep. No. 75, 94th Cong., 1st Sess. 16 (1975) (``Senate 
Report'').
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    NASDAQ has evolved from a market of thinly traded companies in 1975 
to one that today accounts for 42% of share volume and 29.2% of dollar 
volume in the U.S. equity markets.18 During that time, the 
Commission, together with the NASD, has attempted to implement rules 
that reflect increased investor interest in this market. The events 
which gave rise to the Manning case date back to 1984 and the 
Commission has been pressing for improved limit order priority since 
then.
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    \1\8See supra note 9, at 9.
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    In its order approving the recent NASD Interpretation, the 
Commission indicated that a further Commission rule might be necessary 
to ensure protection for all public limit orders in NASDAQ/NMS 
securities, should the NASD fail to do so. The NASD's Interpretation 
prevents a market maker from trading ahead of its own customers' limit 
orders, but does 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 execution.19 The Commission believes that it is 
reasonable for customers to expect that the quality of the execution 
received will not vary from trade to trade. Under current NASD rules, 
the quality of the execution received could vary depending on whether 
the customer's firm or an affiliate makes a market in a security or 
whether that firm sends the order to another market maker for 
execution. Customers choose their brokers for a variety of reasons, 
including cost and integrity; whether the broker also makes a market in 
a security in which the customer may be interested should not affect 
the quality of the execution.
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    \1\9See supra note 11.
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    The Commission agrees with the conclusion of the Division of Market 
Regulation's Market 2000 Study that the adverse effects of trading 
ahead exist whether the customer's order is handled by the customer's 
firm or by another market maker.20 Rule 15c5-1 would apply to 
customer limit orders, regardless of where the order is ultimately 
routed for execution.
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    \2\0See supra note 9, at V-8.
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    The Commission believes that the principles of investor protection 
and market integrity would be advanced by a limit order priority rule. 
The lack of limit order protection results in inferior executions for 
customers and adversely affects the price discovery process for these 
securities.21
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    \2\1Id. at V-7.
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    By providing 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 limit order customers. 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. A customer limit order rule will encourage dealers that accept 
customer limit orders to execute them in a timely fashion so that they 
may resume their proprietary trading activities. With the improvement 
in the quality of these executions, investors will have greater 
confidence in this market and trade volume from retail investors could 
increase.22
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    \2\2Id.
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    In addition, customer limit order priority would improve the price 
discovery process in NASDAQ/NMS securities. Limit orders aid price 
discovery by adding liquidity to the market and by tightening the 
effective spread between the bid and ask price of a security, even 
though these limit orders would not be displayed in the market maker's 
quote. The practice of not executing a limit order until the inside 
quotation price reaches the customer's limit order price also impedes 
the price discovery process by preventing those orders from interacting 
with other orders. More expeditious handling of customer limit orders 
under the proposed rule could provide investors with a more accurate 
indication of the buy and sell interest at a given moment.23
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    \2\3Id.
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    One of the problems with not giving customer limit orders priority 
is the cost to public customers in terms of inferior or missed 
executions for limit orders. It is currently impossible for customers 
to monitor these costs. The ability of a customer to monitor the cost 
of the transaction and choose a broker-dealer on that basis imposes a 
competitive discipline on the market maker to achieve the best possible 
execution for the customer or risk losing the business. Unlike 
institutional clients who are in a better position to negotiate their 
own protection with market makers, public customers have less viable 
alternatives in determining where their orders are ultimately sent for 
execution. Under these circumstances, market makers lack the same 
incentive to provide superior executions to public customers.
    Market makers who oppose a comprehensive rule mandating limit order 
priority for customers do so in part on the ground that such a rule 
would reduce their return from market making.24 Market makers are, 
of course, entitled to earn a profit from their service; A limit order 
rule could force market makers to recoup the cost of the transaction in 
ways more apparent to the customer, such as by charging a commission 
for handling the limit order. The Commission requests comment in the 
form of specific data regarding the potential consequences of the 
proposed rule for market liquidity and market maker capital commitment.
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    \2\4See letter from Frank Masi, President, Securities Traders 
Association of New York (``STANY''), to Jonathan G. Katz, Secretary, 
SEC (March 29, 1994).
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III. Description of the Proposed Rule

    Limit order protection in the NASDAQ market is now required only of 
firms that execute their own customers' limit orders. Market makers 
still may trade ahead of the limit orders entered by customers of other 
firms that are sent to them for execution. Proposed Rule 15c5-1 would 
provide limit order protection to all customers in NASDAQ/NMS 
securities, regardless of where the order is ultimately sent for 
execution.

A. General Prohibition on Trading Ahead

    Paragraph (a) of the proposed rule establishes the general 
prohibition on trading ahead of limit orders: a market maker shall not 
effect a transaction involving a covered security for its own account, 
directly or indirectly, at a price at which the market maker could 
execute a customer limit order it is holding without executing the 
customer limit order at the limit price or a price more favorable to 
the customer, under the specific terms and conditions by which the 
order was accepted by the market maker.
    The rule applies once a market maker has accepted a customer limit 
order for execution.25 The rule applies to all market makers, 
whether they are handling orders for their firm's clients or orders 
sent from another firm. Finally, the rule applies to all accounts of 
the market maker in which the market maker or any person associated 
with the market maker is directly or indirectly interested.
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    \2\5NASD rules do not require a market maker to accept a 
customer limit order.
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    The application of the rule can best be illustrated through the 
following example. Firm A is a retail brokerage firm. Firm B is a 
market making firm with no customers of its own. Firm C is an 
integrated firm with both brokerage and market making units. The 
present NASD Interpretation applies only to orders received and 
executed internally by firm C.26 The proposed rule would cover 
these orders as well as orders sent from firm A to firm B or C, and 
orders sent from firm C to firm B.
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    \2\6The Interpretation also applies to firm A if it forwards 
limit orders to an affiliated firm (e.g., Firm D, a firm that it 
controls) for execution.
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    For instance, firm A may send firm B a customer limit order to buy 
1,000 shares of stock at $20\1/4\. Firm B, a market maker in that 
security, is quoting a bid of $20 and an offer of $20\1/2\. Under the 
proposed rule, a purchase of a certain number of shares by firm B at 
$20\1/4\ or lower would trigger an obligation to fill the same number 
of shares in the customer's order at $20\1/4\. A failure to execute the 
customer's limit order either before or immediately after the market 
maker's purchase would constitute a violation of the rule. The 
Commission is requesting comment on whether it should exclude from the 
protection of the rule limit orders to buy at the bid or limit orders 
to sell at the offer.

B. ``Covered Security''

    The rule would apply to NASDAQ securities that have been designated 
National Market System securities. A NASDAQ security is a registered 
equity security for which quotation information is disseminated in the 
National Association of Securities Dealers Automated Quotation system. 
A NASDAQ National Market System security is a NASDAQ security as 
defined above for which transaction reports are required to be made on 
a real-time basis pursuant to an effective transaction reporting 
plan.27 The Commission requests comments on the feasibility of 
extending the limit order protection measures incorporated herein to 
other NASDAQ securities, such as NASDAQ SmallCap securities and over-
the-counter (``OTC'') Bulletin Board-eligible securities.28
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    \2\7See 17 CFR 240.11Aa3-1.
    \2\8A NASDAQ SmallCap security is one which (1) satisfies all 
applicable requirements for qualification as a NASDAQ security and 
is not a NASDAQ National Market System security; (2) is a right to 
purchase such security; or (3) is a warrant to subscribe to such 
security. See File No. SR-NASD-94-48.
    The OTC Bulletin Board provides an electronic quotation medium 
for subscribing members to reflect market making interest in 
eligible securities, which are generally domestic or foreign equity 
securities or American Depository Receipts not listed on NASDAQ or 
the New York or American Stock Exchanges. See NASD Over-the-Counter 
Bulletin Board Service Rules, Sec. 3, NASD Manual (CCH) 2573.
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C. Definition of ``Customer Limit Order''

    Paragraph (c)(3) of the proposed rule defines the term ``limit 
order'' as an order to buy or sell shares of a security at a specified 
price or other price more favorable to the customer. In the example 
above, the customer placed a limit order to buy 1,000 shares of stock 
at $20\1/4\, indicating that the customer wishes to pay no more than 
$20.25 for the security. The market maker may fill the order at a lower 
price, but not at a price higher than the limit the customer has set.
    The Commission proposes to limit the class of persons who would be 
protected by the rule to public customers only. To this end, the term 
``customer'' in paragraph (c)(3) is defined as a person who is not a 
registered broker or dealer. Nevertheless, because customer limit 
orders often are sent to a market maker by a broker or another market 
maker that originally received the order, the definition of 
``customer'' would encompass such orders as customer orders entitled to 
protection under the rule. Orders for registered brokers or dealers 
that are sent to a market maker by another broker or market maker would 
not be entitled to this protection. The Commission requests comment on 
the necessity of restricting limit order protection to customers and 
the effectiveness of the definition in carrying out that purpose.

D. ``Terms and Conditions''

    While the proposed rule does not distinguish institutional from 
retail orders, the Commission believes that larger-sized orders may 
qualify for special treatment. The language of the proposed rule that 
would allow the parties to set the specific terms and conditions for 
acceptance of limit orders is intended to permit market makers to 
employ the appropriate strategy in filling a larger sized order without 
being subjected to the requirements of the proposed ban.
    By distinguishing the protection afforded a limit order by its size 
or dollar value, the rule would recognize the greater significance of 
larger size orders to market makers seeking to establish or liquidate a 
position and the ability of larger sized customers to negotiate 
specific order handling procedures. Market makers actively compete for 
customer order flow. A customer dealing in greater size or amount 
generally can better monitor the market for the security and negotiate 
alternative execution procedures with another market maker.\29\
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    \29\There are an average of 11.9 market makers for every NASDAQ/
NMS security. See NASD, 1994 NASDAQ Fact Book and Company Directory 
(1994).
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    The Commission preliminarily believes that larger sized orders 
should be distinguished by measurable characteristics such as number of 
shares or dollar amount. To this end, comment is requested on the 
appropriate level of a size limit, i.e. 5,000 or 10,000 shares, and/or 
a dollar value limit, i.e. $50,000, $100,000 or $200,000, that would 
determine market maker obligations with respect to these two types of 
orders in the final rule. This will insure that the rule ultimately 
adopted includes limit order protection for retail investors while 
maintaining the ability of market makers to negotiate order handling 
arrangements with their institutional clients.

E. Exceptions

    The rule proposal also establishes exceptions for all-or-none and 
odd-lot orders as well as a general exemptive provision [paragraph 
(d)]. The specific exceptions to the rule [paragraph (b)] are discussed 
below. The Commission requests comment on the need for an all-or-none 
or odd-lot order exception and a general exemptive provision.
Exception for All-or-None Orders
    The proposed rule includes an exception for all-or-none customer 
limit orders [paragraph (b)(2)]. An all-or-none customer limit order is 
defined in paragraph (c)(1) as one that carries a condition that 
instructs the market maker to execute all of the shares in the order 
only if it can be done all at once. The purpose of this exception is to 
prevent delays in executing other orders that a market maker may be 
receiving at the time the market maker is handling the all-or-none 
order. In the example above, the customer's limit order for 1,000 
shares of stock could be filled in several separate transactions. With 
an all-or-none order, a market maker must execute all the shares of the 
order in a single trade. The market maker may not have immediate access 
to that number of shares. In the meantime, other orders may be received 
that require the market maker to purchase shares from other market 
makers or their customers. Without this exception, the market maker 
would not be able to buy any stock at less than the all-or-none limit 
order price and, ultimately, the execution quality of other customer 
orders would suffer. Thus, using the above example, the exception would 
permit a market maker handling an all-or-none order to purchase shares 
in the security for its own account at $20 \1/4\ or lower without 
filling the customer's limit order, but only for amounts smaller than 
the 1,000 shares in the all-or-none order. The market maker could not, 
however, purchase 1,000 shares or more at $20 \1/4\ or lower for its 
own account without satisfying the customer limit order.

IV. Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed 
Rule 15c5-1. The IRFA uses certain definitions of small entities 
adopted by the Commission for purposes of the Regulatory Flexibility 
Act. The IRFA indicates that regulatory action is required in order to 
ensure that market makers in NASDAQ/NMS securities adhere to certain 
minimum standards of fair treatment of customers. Specifically, by 
prohibiting a market maker from trading ahead of a customer limit order 
that it holds, the rule would improve the quality of executions for 
customers and the price discovery process in the market for these 
securities.
    In 1993, there were 492 active NASDAQ market makers.\30\ Data on 
the number of market makers meeting the definition of small entity that 
make markets in NASDAQ/NMS securities and execute customer limit orders 
is unavailable. The Commission is unable to quantify reasonably the 
impact that the proposed rule would have on small market makers or 
small issuers. The Commission does not believe it would be practicable 
to exempt small market makers from the proposed rule because to do so 
would be inconsistent with the Commission's statutory mandate to 
protect investors.
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    \30\See supra note 29.
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    A copy of the Initial Regulatory Flexibility Analysis may be 
obtained by contacting Scott C. Kursman, Attorney, Office of Market 
Supervision, Division of Market Regulation, Securities and Exchange 
Commission, Washington, D.C. 20549 (202) 942-3197.

V. Effects on Competition

    Section 23(a)(2) of the Exchange Act\31\ requires the Commission, 
in adopting rules under the Act, to consider any anti-competitive 
effects of such rules and to balance these effects against the 
regulatory benefits gained in furthering the purposes of the Act. As 
previously noted, comment letters received prior to the adoption of the 
NASD Interpretation suggested that such a rule would deny market makers 
an opportunity to earn a profit in some situations. If true, this may 
result in less market maker commitment in the NASDAQ/NMS market which 
may in turn effect competition in this market. The Commission is 
soliciting comment on the effect the rule may have on market maker 
capital commitment and small issuers.
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    \31\15 U.S.C. 78w(a)(2).
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    The Commission preliminarily views Rule 15c5-1 as causing no burden 
on competition unnecessary or inappropriate in furtherance of the 
purposes of the Exchange Act. The Commission believes that the 
principles of customer protection that Congress envisioned and that 
would be advanced by this rule justify the burdens that the rule will 
impose on market makers. The Commission, however, requests comment on 
any competitive burdens that might result from adoption of the proposed 
rule described in this release.

List of Subjects in 17 CFR Part 240

    Reporting and recordkeeping requirements, Securities.

Text of Proposed Rule

    For the reasons set out in the preamble, part 240 of Chapter II of 
Title 17 of the Code of Federal Regulations is amended to read as 
follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for Part 240 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 
77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p, 
788s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 
80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
    2. Section 240.15c5-1 is added to read as follows:


Sec. 240.15c5-1.  Prohibition on Market Makers Trading Ahead of 
Customer Limit Orders.

    (a) General Prohibition--A market maker shall not effect a 
transaction involving a covered security for its own account, directly 
or indirectly, at a price at which the market maker could execute a 
customer limit order it is holding without executing the customer limit 
order at the limit price or a price more favorable to the customer, 
under the specific terms and conditions by which the order is accepted 
by the market maker.
    (b) Exceptions. The prohibition in paragraph (a) of this section 
shall not apply to the following customer limit orders:
    (1) ``all-or-none'' customer limit orders, provided that the number 
of shares executed by the market maker is less than the number of 
shares in the customer's all-or-none order; or
    (2) odd-lot customer limit orders.
    (c) Definitions. For purposes of this section:
    (1) The term all-or-none refers to a condition placed upon a 
customer limit order that instructs the market maker to either execute 
all of the shares in the order at the specified price or execute none.
    (2) The term covered security shall mean a NASDAQ security that has 
been designated a National Market System security pursuant to 
Sec. 240.11Aa2-1.
    (3) The term customer limit order shall mean an order to buy or 
sell a security at a specified price or a price more favorable to the 
customer, that is not for the account of either a broker or dealer; 
provided, however, that the term customer limit order shall include an 
order transmitted by a broker or dealer on behalf of a customer.
    (4) The term market maker shall have the meaning provided in 
Section 3(a)(38) of the Act (15 U.S.C. 78c(a)(38)).
    (d) Exemptions. The Commission, upon request or upon its own 
motion, may exempt, by rule or by order, any market maker or any class 
of market makers from the requirements of paragraph (a) of this section 
with respect to any limit order or class of limit orders, either 
unconditionally or on specified terms and conditions, if the Commission 
determines that such exemption is consistent with the public interest 
and the protection of investors.

    Dated: September 29, 1994.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-24690 Filed 10-5-94; 8:45 am]
BILLING CODE 8010-01-P