[Federal Register Volume 65, Number 117 (Friday, June 16, 2000)]
[Notices]
[Pages 37808-37811]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-15242]


=======================================================================
-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42908; File No. SR-NASD-00-22]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Limit Order Protection for OTC Bulletin Board Securities

June 7, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and rule 19b-4 thereunder,\2\ notice is hereby given that 
on April 19, 2000, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association''), through its wholly owned subsidiary, the 
Nasdaq Stock

[[Page 37809]]

Market, Inc. (``Nasdaq'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by Nasdaq. 
The Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1)
    \2\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

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

    Nasdaq is proposing a new Rule 6541 to implement a pilot program 
specifically prohibiting member firms from trading ahead of customer 
limit orders in designated OTC Bulletin Board (``OTCBB'') securities. 
Below is the text of the proposed rule change. Proposed new language is 
in italics.

6541. Limit Order Protection

    (a) Members shall be prohibited from ``trading ahead'' of customer 
limit orders that a member accepts in securities quoted on the OTCBB. 
Members handling customer limit orders, whether received from their own 
customers or from another member, are prohibited from trading at prices 
equal or superior to that of the customer limit order without executing 
the limit order. Members are under no obligation to accept limit orders 
from any customer.
    (b) Notwithstanding subparagraph (a) of this rule, a member may 
negotiate specific terms and conditions applicable to the acceptance of 
limit orders only with respect to such orders that are:
    (1) for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in Rule 3110(c)(4); 
or
    (2) for 10,000 shares or more, and greater than $20,000 in value.

(c) Contemporaneous trades

    A member that trades through a held limit order must execute such 
limit order contemporaneously, or as soon as practicable, but in no 
case later than five minutes after the member has traded at a price 
more favorable than the customer's price.

(d) Application

    (1) This rule shall apply only to OTCBB securities specifically 
identified as such through the Nasdaq Workstation service.
    (2) This rule shall apply, regardless of whether the subject 
security is additionally quoted in a separate quotation medium.
    (3) This rule shall apply from 9:30 a.m. to 4:00 p.m. Eastern Time.
    (4) This rule shall be in effect until [12 months from date of 
Commission approval].

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

    In its filing with the Commission, Nasdaq 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. Nasdaq 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

1. Purpose
    Background. NASD IM-2110-2 (commonly known as the ``Manning Rule'') 
was adopted in 1994 \3\ and further amended in 1995 \4\ to prohibit 
NASD member firms from trading ahead of customer limit orders in Nasdaq 
securities. The impetus for this rule was a case brought several years 
earlier by a customer of a member firm, William Manning, who alleged 
that the firm had accepted his limit order, failed to execute it, and 
violated its fiduciary duties to him by trading ahead of the order. In 
the Manning decision, the NASD found and the SEC affirmed that a member 
firm, upon acceptance of a customer's limit order, undertakes a 
fiduciary duty and cannot trade for its own account at prices more 
favorable than the customer's order.\5\ In the wake of this decision, 
however, members continued to trade ahead of customer limit order 
provided the practice was fully disclosed to the customer.
---------------------------------------------------------------------------

    \3\ See Exchange Act Release No. 34279 (June 29, 1994), 59 FR 
34883 (July 7, 1994).
    \4\ See Exchange Act Release No. 35751 (May 22, 1995), 60 FR 
27997 (May 26, 1995).
    \5\ See In re E.F. Hutton & Co., Exchange Act Release No. 25887 
(July 6, 1998).
---------------------------------------------------------------------------

    Through adoption of IM-2110-2, the NASD effectively eliminated the 
disclosure ``safe-harbor'' that developed after the Manning decision 
for all securities listed on Nasdaq. In proposing the interpretation, 
the Nasdaq recognized the growing importance of Nasdaq as a major 
equity market and noted that such a rule would enhance the image of the 
market by creating a more equitable, fair, and accessible market for 
all investors. Indeed, although the Manning Rule does not explicitly 
apply to OTCBB issues, it has always been the position of NASD and 
Nasdaq that a member owes a duty of best execution to all accepted 
customer orders.
    Nasdaq now believes that it is appropriate to employ this same 
rationale in applying limit order protection to the OTCBB.\6\ Over the 
past six years, the OTCBB has evolved into a marketplace for numerous 
securities, with market makers providing real-time quotations available 
for reviewing by other market participants.\7\ In 1994, the average 
daily volume in all OTCBB securities was approximately 28.5 million 
shares, a number that grew to more than 300 million shares per day in 
1999. OTCBB trading volume in February 2000 averaged more than 1.2 
billion shares per day.\8\
---------------------------------------------------------------------------

    \6\ The OTCBB, unlike Nasdaq, is a quotation medium for 
subscribing NASD members, not an issuer listing service. OTCBB 
securities are traded by market makers that enter quotes and trade 
reports through a sophisticated, closed computer network, which is 
accessed through the Nasdaq Workstation II. The OTCBB differs from 
Nasdaq in several ways; for example, the OTCBB does not maintain 
relationships with quoted issuers or impose quantitative listing 
standards. Also, the OTCBB also has different quotation obligations 
and does not currently provide a method for automated trade 
executions.
    \7\ All priced market maker quotations entered into the service 
are required to be firm up to a minimum size. However, market makers 
may still enter unpriced indications of interest in the OTCBB. See 
NASD Rules 6540 and 6750.
    \8\ By comparison, during the same month, Nasdaq averaged over 
1.8 billion shares per day, while the New York Stock Exchange 
averaged 1.06 billion share per day.
---------------------------------------------------------------------------

    As a result of this increase in trading volume, the OTCBB has 
become a more open and transparent market in which investors can obtain 
considerable information regarding the quoted issuers. For instance, by 
July 2000, all issuers quoted on the OTCBB will be required to provide 
updated financial information to the Commission, or to banking or 
insurance regulators, on a periodic basis.\9\ The accessibility of this 
disclosure information, along with last-sale information available 
through the Internet, has provided the retail investor with additional 
tools to make educated investment decisions regarding many formerly 
obscure OTCBB issuers.
---------------------------------------------------------------------------

    \9\ This requirement was effective immediately for all issuers 
initiating quotation on the OTCBB after January 4, 1999. All issuers 
quoted on the OTCBB as of that date were required to comply with the 
rule on a phased-in basis, beginning in July 1999 and ending in June 
2000. See Exchange Act Release No. 40878 (Jan. 4, 1999), 64 FR 1255 
(Jan. 8, 1999).
---------------------------------------------------------------------------

    In short, the OCTBB is far different today than it was at its 
inception ten years ago. In light of these notable changes, the 
increased retail participation, and the continuous efforts by Nasdaq 
and the NASD to provide fair

[[Page 37810]]

and efficient markets for all investors, Nasdaq now proposes to extend 
limit order protection to investors of OTCBB securities.
    Proposed Pilot Program. Nasdaq proposes to institute a 12-month 
pilot program that will apply limit order protection to a select subset 
of OTCBB securities.\10\ Nasdaq will monitor the progress of this rule 
and its effect on the market throughout the entire period. Prior to the 
completion of this pilot, Nasdaq will evaluate the impact of the 
proposed rule and report its findings to the Commission and, 
thereafter, determine the appropriate course of action.
---------------------------------------------------------------------------

    \10\ Although the proposed rule will specifically apply only to 
selected securities during the pilot program, general duties of best 
execution will continue to apply to all customer orders in all 
securities.
---------------------------------------------------------------------------

    Nasdaq intends to examine the effects of the proposed rule by 
applying it to approximately 325 OTCBB securities.\11\ Securities 
subject to the proposed rule will be positively designated as such 
through the Nasdaq Workstation II.\12\ Nasdaq will select as one sample 
set the 200 most actively traded OTCBB securities, which will be 
selected on the basis of specific price and volume parameters. An 
additional 100 securities will be selected as a representative cross-
section of all remaining OTCBB securities, therein providing an 
opportunity to test the effects of this rule upon the wide variety of 
securities quoted on the OTCBB. The implementation of the proposed rule 
upon these 300 securities would be phased in over a period of several 
weeks, beginning with the top 200 actively traded securities, then 
proceeding to the 100 representative cross-section securities. This 
phase-in process is intended to protect against any unanticipated or 
deleterious effect that could occur through an immediate application to 
all securities.
---------------------------------------------------------------------------

    \11\ This number represents roughly 10 percent of the total 
number of securities expected to remain on the OTCBB upon the 
completed implementation of Rule 6530. See supra note 10. For OTCBB 
securities that are not included in the pilot, members may trade 
ahead of customer limit orders if full and clear disclosure 
regarding this practice is provided to the customer.
    \12\ Nasdaq currently intends to display the identifier ``##'' 
following the security name denoting it as among the securities to 
which the proposed rule would be applicable. This same method of 
identification was utilized successfully by Nasdaq in designating 
securities subject to the SEC Order Handling Rules during their 
initial phase-in period.
---------------------------------------------------------------------------

    The remaining 25 securities would consist of selected securities 
added to the OTCBB after the initial phase-in period had been 
completed. This additional allowance is intended to provide Nasdaq with 
the flexibility to impose the proposed rule upon securities that 
necessitate its protections. It is expected that these securities, 
which would be selected by Nasdaq on a case-by-case basis, would be 
those that are highly liquid and widely held by retail investors. The 
securities expected to be included in this category are those that have 
been delisted from Nasdaq or an exchange and start trading on the 
OTCBB.
    Application of the proposed rule is intended to substantially 
mirror IM-2110-2, although some minor modifications, discussed below, 
have been afforded due to the distinction between Nasdaq and the OTCBB. 
While members will be under no obligation to accept limit orders, those 
willing to do so would be prohibited from trading at prices equal or 
superior to any held customer limit orders, regardless of whether those 
orders are from their own customers or from customers of firms who have 
routed those orders to the member for execution.\13\ This rule would 
apply even to those members who, in the past, have fully disclosed to 
their customers that they may trade ahead of customer limit orders.
---------------------------------------------------------------------------

    \13\ Order entry firms that forward customer orders to dealers 
for execution would continue to be subject to their duties of best 
execution and would owe a fiduciary duty to those orders. 
Accordingly, firms should routinely monitor the handling of their 
customer limit orders to ensure that the executing broker is 
complying with the provisions of this rule.
---------------------------------------------------------------------------

    As with IM-2110-2, Nasdaq recognizes that filling institutional-
sized orders involves differing trading strategies and risks, and that 
an application of limit order protection to all orders could prove 
unduly burdensome to those members willing to accept institutional 
orders. For that reason, Nasdaq has determined that the member may 
apply terms and conditions concerning limit order protection when 
accepting an institutional-sized order \14\ or an order from an 
institutional account.\15\
---------------------------------------------------------------------------

    \14\ Member firms may impose terms and conditions in the case of 
limit orders involving at least 10,000 shares and having a value 
greater than $20,000. The corresponding thresholds for IM-2110-2 are 
10,00 shares and $100,000. The distinction in price is due to the 
relatively lower share prices of OTCBB securities. Nasdaq will study 
this limit as part of the pilot period analysis and adjust it as 
appropriate if deemed necessary.
    \15\ This term is defined in NASD Rule 3110(c)(4).
---------------------------------------------------------------------------

    An additional distinction in the application of limit order 
protection to OTCBB securities will be the time interval allocated for 
``contemporaneous'' executions. In Nasdaq securities, a member is not 
deemed to have traded ahead of a customer limit order if the member 
provides a contemporaneous execution of the customer's order. 
``Contemporaneous'' has been interpreted by Nasdaq to require an 
execution as quickly as possible, but absent reasonable and documental 
justification, within one minute.\16\ This interpretation recognizes 
that additional time beyond the one minute provision may be necessary 
during unusual market conditions (e.g., at the opening or upon the 
commencement of trading following a trading halt or an initial public 
offering), provided that the member has taken all reasonable steps to 
execute the trade as soon as possible.\17\
---------------------------------------------------------------------------

    \16\ See NASD Notice to Members 95-67.
    \17\ See NASD Notice to Members 98-78.
---------------------------------------------------------------------------

    Unlike Nasdaq, in which trades may be executed or delivered through 
automated means, the OTCBB service provides no means of automated 
communication. Participants in OTCBB securities are generally required 
to contact each other via telephone, a time consuming process that can 
prove especially burdensome during periods of high trade volume. 
Recognizing this distinction, Nasdaq proposes to require a 
``contemporaneous'' trade to be executed as quickly as possible, but no 
later than five minutes after becoming marketable. If market conditions 
or other circumstances cause the member to exceed this five-minute 
requirement, the member should continue to attempt to execute the order 
as quickly as possible, while sufficiently documenting the particular 
conditions or circumstances causing this delay. Nasdaq will study this 
provision and modify it as appropriate at the conclusion of this pilot.
    This rule will apply only during normal market hours of 9:30 a.m. 
to 4:00 p.m. Although the OTCBB service is available from 7:30 a.m. to 
6:30 p.m., prices on the OTCBB are required to be firm only during the 
normal market hours. The hours of application of this rule would adjust 
accordingly on days in which normal market hours are shortened due to 
holidays or other events.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act \18\ which requires, 
among other things, that the Association's rules be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and, in general, to protest investors 
and the public interest. The new rule would ensure the protection of 
investor's limit orders, enhance the

[[Page 37811]]

quality of trading on the OTCBB, and significantly reduce the potential 
for unfair discrimination, real or perceived, of customer orders.
---------------------------------------------------------------------------

    \18\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

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

    Nasdaq does not believe that the proposed rule change would result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

(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 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, including whether the proposed rule 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. 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 File No. SR-NASD-00-22 and should 
be submitted by July 7, 2000.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority. \19\
---------------------------------------------------------------------------

    \19\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-15242 Filed 6-15-00; 8:45 am]
BILLING CODE 8010-01-M