[Federal Register Volume 59, Number 246 (Friday, December 23, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31658]


[[Page Unknown]]

[Federal Register: December 23, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35122; File No. SR-NASD-94-62]

 

Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
Limit Order Protection for Member to Member Limit Order Handling on 
Nasdaq

December 20, 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 November 
22, 1994, the National Association of Securities Dealers, Inc. 
(``NASDA'' or ``Association'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') 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

    Pursuant to the provisions of Section 19(b)(1) of the Act, the NASD 
is filing a proposed rule change regarding the protection of limit 
orders to expand the scope of limit order protection beyond that 
presently afforded by member firms to their customers in the Nasdaq 
Stock Market. Currently, the NASD's Interpretation to the Rules of Fair 
Practice makes it a violation of just and equitable principles of trade 
for a member firm to trade ahead of its own customer's limit orders. 
The new proposal would extend this protection to the customer of a firm 
that sends a limit order to another member for execution (so-called 
member-to-member trades), with a proviso that until July 1, 1995, limit 
order protection for member-to-member customer limit orders greater 
than 1,000 shares in size will be protected at prices that are 
superior, but not equal to the limit order price. Below is the text of 
the proposed rule change. Proposed new language is italicized; language 
to be deleted is bracketed.

Limit Order Protection Interpretation to Article III, Section 1 of the 
NASD Rules of Fair Practice

    To continue to ensure investor protection and enhance market 
quality, the NASD Board of Governors is issuing an Interpretation to 
the Rules of Fair Practice dealing with member firm treatment of 
[their] customer limit orders in Nasdaq securities. This Interpretation 
will require members acting as market makers to handle [their] customer 
limit orders with all due care so that market makers do not ``trade 
ahead'' of those limit orders. Thus, members acting as market makers 
that handle customer limit orders, whether received from their own 
customers or from another member, are prohibited from trading at prices 
equal to or superior to that of the limit order without executing the 
limit order provided that, prior to July 1, 1995, this prohibition 
shall not apply to customer limit orders that a member firm receives 
from another member firm and that are greater than 1,000 shares. Such 
orders shall be protected from executions at prices that are superior 
but not equal to that of the limit order. In the interests of investor 
protection, the NASD is eliminating the so-called disclosure ``safe 
harbor'' previously established for members that fully disclosed to 
their customers the practice of trading ahead of a customer limit order 
by a market-making firm.
Interpretation
    Article III, Section 1 of the Rules of Fair Practice states that:
    A member, in the conduct of his business, shall observe high 
standards of commercial honor and just and equitable principles of 
trade.
    The Best Execution Interpretation states that: In any transaction 
for or with a customer, a member and persons associated with a member 
shall use reasonable diligence to ascertain the best inter-dealer 
market for the subject security and buy or sell in such a market so 
that the resultant price to the customer is as favorable as possible to 
the customer under prevailing market conditions. Failure to exercise 
such diligence shall constitute conduct inconsistent with just and 
equitable principles of trade in violation of Article III, Section 1 of 
the Rules of Fair Practice.
    In accordance with Article VII, Section 1(a)(2) of the NASD By-
Laws, the following interpretation under Article III, Section 1 of the 
Rules of Fair Practice has been approved by the Board:
    A member firm that accepts and holds an unexecuted limit order from 
a customer (whether its own customer or a customer of another member) 
in a Nasdaq security and that continues to trade the subject security 
for its own market-making account at prices that would satisfy the 
customer's limit order, without executing that limit order under the 
specific terms and conditions by which the order was accepted by the 
firm, shall be deemed to have acted in a manner inconsistent with just 
and equitable principles of trade, in violation of Article III, Section 
1 of the Rules of Fair Practice, provided that, until July 1, 1995, 
customer limit orders in excess of 1,000 shares received from another 
member firm shall be protected from the market maker's executions at 
prices that are superior but not equal to that of the limit order. 
Nothing in this section, however, requires members to accept limit 
orders from any customers[s].
    By rescinding the safe harbor position and adopting this 
Interpretation of the Rules of Fair Practice, the NASD Board wishes to 
emphasize that members may not trade ahead of customer limit orders in 
their market-making capacity even if the member had in the past fully 
disclosed the practice to its customers prior to accepting limit 
orders. The NASD believes that, pursuant to Article III, Section 1 of 
the Rules of Fair Practice, members accepting and holding unexecuted 
customer limit orders owe certain duties to their customers and the 
customers of other member firms that may not be overcome or cured with 
disclosure of trading practices that include trading ahead of the 
customer's order. The terms and conditions under which customer limit 
orders are accepted must be made clear to customers at the time the 
order is accepted by the firm so that trading ahead in the firms' 
market making capacity does not occur. For purposes of this 
Interpretation, a member that controls or is controlled by another 
member shall be considered a single entity so that if a customer's 
limit order is accepted by one affiliate and forwarded to another 
affiliate for execution, the firms are considered a single entity and 
the market making unit may not trade ahead of that customer's limit 
order.
    The Board also wishes to emphasize 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. As set 
out above, 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. The NASD emphasizes that order entry firms should continue 
to routinely monitor the handling of their customers' limit orders 
regarding the quality of the execution received.

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 purpose of the proposed rule change is to expand the scope of 
the current Interpretation from protecting only limit orders received 
from a market maker's own customers to protecting limit orders that a 
market maker receives from other member firms for execution, the so-
called ``member-to-member'' limit orders. The background and rationale 
for adoption of this proposed rule change are discussed below.

I. Background

    A. The Existing Interpretation. In July 1994, a limit order 
protection rule became effective for NASD members accepting limit 
orders in Nasdaq securities.\1\ Under the existing Limit order 
Interpretation to the Rules of Fair Practice, a member firm cannot 
accept and hold its customer's limit order in a Nasdaq security and 
continue to trade that security for its own account at prices that 
would satisfy the customer's limit order without filling that order at 
the limit order price or a price more favorable to the customer. The 
rule renders trading ahead of the customer's order a violation of just 
and equitable principles of trade. When the NASD initially proposed the 
limit order rule, it solicited comment from members on the advisability 
of implementing restrictions on trading ahead for all customer limit 
orders, including those passed from one member firm to another for 
execution.\2\ The vast majority of members commented that limit order 
protection for a firm's own customer was appropriate and beneficial to 
the market, but several cautioned against the potential adverse impact 
that could result from application of the rule to member-to-member 
orders. In recognition of the concerns raised, the Board deferred 
broader application of the rule and commissioned a special Limit Order 
Task Force to review the issue. The Task Force devoted considerable 
attention to discussions of the impact such additional rulemaking would 
have upon the financial viability of the competing dealer system and 
the potential adverse impacts upon the quality and efficiency of that 
market structure. Accordingly, the Task Force recommended limit order 
protection for member-to-member trades that would make it a violation 
to trade ahead of customer limit orders when the market makers traded 
at a price superior to the limit order price. The NASD Board thereafter 
carefully considered the Task Force's recommendation and determined 
that for member-to-member trades, the membership should consider 
whether limit order protection should be extended beyond the Task Force 
recommendation to include protection for customer orders of 1,000 
shares or less from member trading at the limit order price and prices 
superior to that price. The NASD solicited comment on this proposal.
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    \1\See Notice to Members 94-58 and Securities Exchange Act 
Release No. 34279 (June 29, 1994
    \2\See Notice to Members 93-49 (July 23, 1993).
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B. Comments Regarding NASD Notice To Members 94-79).

    The NASD received 33 letters in response to its proposal to deal 
with member-to-member limit orders. Twelve member firms supported the 
proposal as outlined in NTM 94-79.\3\ Two members opposed the proposal 
adopted by the Board, but suggested that the Board adopt the Limit 
Order Task Force recommendation.\4\ Seventeen commenters opposed the 
proposal for various reasons outlined below.\5\ One person expressed no 
opinion, except that more study should be done.\6\ Among the 
supporters, the commenters generally stated that the proposal would 
have a positive effect on investor perception of Nasdaq. In particular, 
two comment letters strongly recommended the expansion of limit order 
protection to all customer orders regardless of size. For example, 
Charles Schwab noted that limit order protection should be extended to 
all orders, regardless of size, and noted that it has already extended 
limit order protection to all orders that its market making unit, Mayer 
& Schweitzer, receives, regardless of order origin. According to the 
Schwab letter, if a limit order protection rule were to be uniformly 
applied, there would be increased trade volume, quicker executions, and 
tighter spreads. Schwab also stated the belief that expansion of limit 
order protection is consistent with just and equitable principles of 
trade and should promote investor confidence in the Nasdaq market. In 
addition, Lehman Brothers was equally strong in recommending that the 
Board's proposal in NTM 94-79 should extend the benefits of limit order 
protection to all customers without any order size limitations. Lehman 
noted that the proposal should not have a ``significant overall impact 
on market makers,'' nor should it have an effect on a market maker's 
willingness to commit capital. Lehman also noted that a broadened rule 
would be easier to comply with, and ultimately, would provide strong 
investor protection benefits.
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    \3\See letters from: (1) Santa Barbara Securities, Inc.; (2) 
Southwest Securities; (3) Wilshire Capital Management; (4) Freeman 
Welwood & Co., Inc.; (5) The Advest Group, Inc.; (6) R.A. Mackie & 
Co., LP; (7) Mericor Financial Services; (8) Absolute Investments; 
(9) Charles Schwab; (10) Lehman Brothers; (11) Merrill Lynch; and 
(12) A.G. Edwards & Sons, Inc. Merrill and A.G. Edwards qualified 
their support for the proposal, essentially agreeing with the 
details of the proposal, but urged that staff examine several 
additional issues that could arise with the adoption of the rule as 
proposed.
    \4\Letters from: (1) Sherwood Securities Group; and (2) Security 
Traders Association.
    \5\Two comment letters from the same organization, Herzog Heine 
Geduld, were received which accounts for the discrepancy in the 
number totals. A number of the negative letters made reference to 
the Herzog/Shearman & Sterline Letters. Five of the negative comment 
letters are form letters form traders within two firms, one of 
which, Southwest Securities, submitted a comment letter supporting 
the Board's proposal.
    \6\Letter from Andrew Peck Associates, Inc.
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    The firms opposed to any limit order action on member-to-member 
trades believed that the proposal would adversely affect the dealer 
market structure. In particular, many of those opposed to the concepts 
contained in NTM 94-79 concurred in the formulation of the issues as 
set forth in the Shearman & Sterling letter on behalf of Herzog Heine 
Geduld. Specifically, that letter stated that the proposal posed the 
following problems:
    (1) The costs of handling limit orders would be cross-subsidized by 
other market participants;
    (2) Illiquid stocks could be adversely affected;
    (3) Increased concentration among market making firms could occur, 
favoring vertically integrated firms;
    (4) The resulting concentration could lead to reduced competition;
    (5) The proposal could harm liquidity, market maker profits, and 
spreads; and
    (6) The proposal could allow for undetectable ``smurfing'' (the 
breaking up of larger orders to fit within the 1,000 share limit order 
protection).
    C. SEC Action. Shortly after the Board's publication of its 
original proposal, on September 29, 1994, the Securities and Exchange 
Commission proposed a new rule, Rule 15c5-1,\7\ that would prohibit a 
market maker in Nasdaq National Market Securities 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. Although the rule as 
proposed would apply only to Nasdaq National Market securities, the SEC 
solicitated comment on the feasibility of extending the limit order 
protection to other securities, including SmallCap and OTC Bulletin 
Board securities. The Commission also solicited comment on the terms 
and conditions provisions in its rule, which would allow the parties to 
a trade to set special conditions to order handling parties to allow a 
market maker to employ the appropriate strategy in filling a larger 
sized order without being subjected to the requirements of the proposed 
rule. In particular, the Commission solicited comment on whether the 
rule should specifically distinguish orders by measurable 
characteristics, such as number of shares or dollar amount.
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    \7\Securities Exchange Act Release No. 34753 (September 29, 
1994); 59 FR 50866 (October 6, 1994).
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II. Expanded Limit Order Protection

    After carefully weighing the ramifications of its actions on the 
liquidity in the Nasdaq Stock Market and after reviewing the comments 
it received on this proposal, the NASD determined that it should 
further expand limit order protection for all customer orders. The NASD 
has determined that all customer limit orders for Nasdaq securities--
whether originating within the firm or at another member firm--should 
be protected from trading ahead by the market maker holding the order. 
Thus, under the NASD's new Limit Order Interpretation to the Rules of 
Fair Practice Article III, Section 1, a member firm cannot accept and 
hold a customer's limit order in a Nasdaq security and continue to 
trade that security for its own account at prices that would satisfy 
the customer's limit order without filling that order at the limit 
order price or a price more favorable to the customer. Such ``trading 
ahead'' activity would be a violation of just and equitable principles 
of trade. Of course, the expansion of the Interpretation continues to 
permit a member to establish with its customers specific terms and 
conditions with regard to the acceptance of limit orders, provided that 
the member makes those terms and conditions clear to the customer at 
the time the order is accepted by the firm so that trading ahead in the 
firm's market making capacity does not occur. Similarly, the 
Interpretation continues in place the understanding that nothing in the 
Interpretation would obligate a market maker to accept limit orders 
from any or all customers or member firms. However, in recognition that 
the expansion of the Interpretation represents a significant change in 
the operation of a dealer market, the new Interpretation contains a 
phase-in period to expire on July 1, 1995, during which time, the NASD 
will permit member firms to handle member-to-member limit orders that 
are larger than 1,000 shares in size differently. Such orders during 
this phase-in period must be protected when the member firm accepting 
the order trades for its own account at prices that are superior to the 
limit order but not equal to the limit order price. The NASD believes 
that this measured implementation of the Interpretation is wholly 
prudent given the nature of the adjustment being made by certain firms 
in their order handling procedures and the potential need for 
reassessment of the existing revenue structure. During this period, the 
NASD will evaluate carefully any adverse impact the new Interpretation 
may be having on market maker participation or market quality.
    The NASD believes that the expansion of its own Rule will enhance 
investor confidence in the Nasdaq Stock Market by providing customers 
with the opportunity to improve the quality of executions of their 
orders. When a customer limit order is given priority over a market 
maker's own trading activity, it is likely that the customer's order 
will be executed more quickly and efficiently than before. Price 
discovery may also be improved in that limit orders may contribute to 
the tightening of spreads between the bid and ask prices of a security.
    Expansion of limit order protection to so-called member-to-member 
limit orders eliminates any adverse effect on customer protection that 
may have arisen depending on whether the customer's broker was also a 
market maker in a particular security. The NASD carefully considered 
the potential negative effects on the Nasdaq market (loss of market 
liquidity, concentration of market making firms and lack of sponsorship 
for smaller capitalized companies) that could occur with the expansion 
of limit order protection. The NASD has determined that in the long 
term, any such negative effects should be outweighed by the increased 
benefits to customers receiving the expanded protection and 
accordingly, there should be an increase in investor confidence and 
participation in the Nasdaq Stock Market. In this connection, the NASD 
notes that Nasdaq market makers are free to negotiate additional 
compensation from order routing firms to the extent that such 
compensation is economically and competitively justified.
    However, because a requirement that market makers yield priority to 
the execution of customer interest could have a short-term, temporary 
effect on the market maker' ability to offer liquidity at the limit 
order price, the NASD has proposed in its rule to delay the complete 
effectiveness of the rule for six months. Therefore, until July 1, 
1995, market makers would be allowed to trade at the same price as the 
limit order price for orders over 1,000 shares. Accordingly, the NASD 
has determined that it is appropriate to propose limit order protection 
standards which appropriately differentiate between small-sized and 
large-sized customer limit orders for the first six months that the 
rule is in effect. For small limit orders (1,000 shares or less), the 
NASD proposes to implement the same limit order protection that is 
currently in place for a market maker's own customers--that a market 
maker may not trade ahead for its own account at a price that would 
satisfy the limit order price. For larger-sized orders, however, the 
NASD believes it is appropriate to impose a different standard. When a 
member accepts and holds a customer limit order greater than 1,000 
shares from another member firm, the dealer's obligation to fill that 
limit order would be triggered when the market maker trades at a price 
that is superior to the limit order price.
    Thus, during the next six months, if the inside market in a Nasdaq 
issue were 20--20\1/4\ and the market maker accepted a customer buy 
order from another broker/dealer priced at 20 for 2,000 shares, when 
the firm buys at any price superior to 20 (that is, purchases at a 
price lower than a buy limit order, in this example, purchasing at 
19\7/8\ or 19\15/16\, it would be required to sell to the customer at 
20 or better. Using the same example, if the customer limit order were 
for 500 shares at 20, the rule would prohibit members from trading 
ahead at 20 without filling the customer order at 20. Accordingly, the 
proposal would require protection for orders greater than 1,000 shares 
when the dealer trades at a superior price, and protection for orders 
of 1,000 shares or less when the dealer trades at the limit order price 
or a price more favorable to the customer.
    Consequently, the NASD believes that the proposed rule change is 
consistent with Section 15A(b)(6) in that these proposed changes are 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to facilitate 
transactions in these securities, to remove impediments to and to 
perfect the mechanism of free and open market and a national market 
system, and in general to protect investors and the public interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended, The NASD has looked 
carefully at the suggestions by some commentators that smaller and non-
integrated firms will be unable to compete with large integrated firms 
under the new requirement, but can find no substantive support for the 
position advanced. First, the proposed Interpretation does not 
eliminate the ability of any firm to compete with respect to service, 
cost, investment recommendations or other executive parameters. For 
example, the NASD notes that at least one firm has already announced a 
new price improvement mechanism for Nasdaq securities. Accordingly, 
while the NASD will monitor carefully for an adverse competitive 
effects of the Interpretation, the NASD believes that any speculation 
on potential adverse effects is far outweighed by the enhanced 
execution opportunities that will be provided to public investors.

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

    Written comments were neither solicited nor received.

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 its 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. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 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 communications 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 January 13, 1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\8\
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    \8\17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-31658 Filed 12-22-94; 8:45 am]
BILLING CODE 8010-01-M