[Federal Register Volume 66, Number 149 (Thursday, August 2, 2001)]
[Notices]
[Pages 40304-40306]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-19283]



[[Page 40304]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44593; File No. SR-NASD-2001-39]


Self-Regulatory Organizations; Notice of Filing and Immediate 
Effectiveness of Proposed Rule Change by the National Association of 
Securities Dealers, Inc. Relating to the Manning Pilot on the OTC 
Bulletin Board

July 26, 2001.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 \2\ thereunder, notice is hereby given 
that on June 7, 2001, the National Association of Securities Dealers, 
Inc. (``NASD''), through its subsidiary, The Nasdaq Stock 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. Nasdaq has 
designated the proposed rule change as constituting a ``non-
controversial'' rule change under Paragraph (f)(6) of Rule 19b-4 under 
the Act,\3\ which renders the proposal effective upon receipt of this 
filing by the Commission. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ 17 CFR 240.19b-4(f)(6).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq is herewith filing a proposal to amend NASD Rule 6541 which, 
for a pilot period ending February 8, 2002, prohibits member firms from 
trading ahead of customer limit orders in designated OTC Bulletin Board 
(``OTCBB'') securities. Specifically, Nasdaq proposes to amend 
Subsection (b) of NASD Rule 6541 for a three-month pilot period to 
reduce the minimum price improvement increment establishment therein 
from five cents to one cent, as explained in more detail below. Nasdaq 
believes that this change is non-controversial and, therefore, will 
implement the change immediately upon filing, pursuant to Rule 19b-
4(f)(6) under the Act. The three-month pilot change to NASD Rule 
6541(b) will operate from August 1, 2001, to November 1, 2001.
    The text of this rule change is provided below. Proposed new 
language is in italics; proposed deletions are in brackets.
* * * * *
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) Members may not avoid such obligation specified in paragraph 
(a) through the provision of price improvement, unless: [such price 
improvement is for a minimum of the lesser of $.05 or one-half (\1/2\) 
of the current inside spread.]:
    (1) for customer limit orders priced at or inside the current 
inside spread, the price improvement is for a minimum of the lesser of 
$.01 or one-half (\1/2\) of the current inside spread; or
    (2) for customer limit orders priced outside the current inside 
spread by $.01 or less, the market maker executes the incoming order at 
or better than the inside bid (for held buy orders) or offer (for held 
sell orders).
    (3) for customer limit orders priced more than $.01 outside the 
current inside spread, no obligation is imposed under subsection (a) 
above.
For purposes of this rule, the inside spread shall be defined as the 
difference between the best reasonably available bid and offer in the 
subject security.
    (c)-(e) No change.

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
    On February 8, 2001, the Commission approved new NASD Rule 6541 
which, on a pilot basis, applies the basic customer limit order 
protection principles that presently apply to Nasdaq securities to 
certain designated securities that are traded on the OTCBB. NASD Rule 
6541(a), in general, prohibits member firms that accept customer limit 
orders in these securities from trading ``ahead'' of their customers 
for their own account at prices equal or superior to the limit orders, 
without executing them at the limit price. NASD Rule 6541(b) requires 
member firms to provide a minimum level of price improvement to 
incoming orders in OTCBB securities if the firm chooses to trade as 
principal with those incoming orders at prices superior to customer 
limit orders they currently hold. Specifically, NASD Rule 6541(b) 
states that members may not avoid their obligations under the Rule 
``through the provision of price improvement, unless such price 
improvement is for a minimum of the lesser of $0.05 or one-half (\1/2\) 
of the current inside spread.'' If a firm fails to provide the minimum 
level of price improvement to the incoming order, the firm must execute 
its held customer limit orders. Generally, if a firm fails to provide 
the requisite amount of price improvement and also fails to execute its 
held customer limit orders, it is in violation of the rule.
    On March 2, 2001, the Commission approved on a pilot basis a Nasdaq 
proposal that established a different price improvement increment for 
the tradining of Nasdaq issues than that established in NASD Rule 6541 
with respect to the OTCBB.\4\ Nasdaq's proposal established a uniform 
$0.01 price improvement standard for Nasdaq market makers who elect to 
execute proprietary transactions in decimalized securities while 
holding customer limit orders on the same side of the market in those 
securities without triggering an obligation to ``protect'' (i.e., 
execute, up to the amount of shares traded proprietarily by the market 
maker) those customer orders. After that approval, Nasdaq became aware 
of certain anomalies that occur under its then-existing Manning rule 
when market makers elect to provide their customers the ability to 
enter orders into the firms' proprietary system in price increments 
smaller than a penny. Accordingly, on April 6, 2001, the Commission 
approved, on an expedited basis, modifications to NASD IM-2110-2.\5\
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    \4\ See Securities Exchange Act Release No. 44030 (March 2, 
2001), 66 FR 14235 (March 9, 2001).
    \5\ See Securities Exchange Act Release No. 44165 (April 6, 
2001), 66 FR 19268 (April 13, 2001) (approving proposal to establish 
new trading-ahead increment on Nasdaq, on a pilot basis, until July 
9, 2001); see also Securities Exchange Act Release No. 44529 (July 
9, 2001), 66 FR 37082 (July 16, 2001) (extending pilot program until 
November 5, 2001.)

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[[Page 40305]]

    As noted in the original filing to extend trading-ahead 
probhibitions to OTCBB securities on a pilot basis, the limit order 
protection embodied in NASD Rule 6541 is an investor protection tool 
based on NASD IM-2110-2 (commonly known as the ``Manning Rule''). In 
Manning, the NASD found and the Commission affirmed that a member firm 
that accepts a customer limit order has a fiduciary duty not to trade 
for its own account at prices more favorable than the customer 
order.\6\ NASD Rule 6541 expands, to securities traded on the OTCBB, 
the protections that NASD IM-2110-2 currently provides only to 
securities traded on the Nasdaq National Market and SmallCap Market. In 
fact, when Nasdaq proposed to the Commission that the price improvement 
increment be set at five cents, it indicated that ``this increment is 
based upon, and consistent with, Nasdaq's guidance on Members' Manning 
obligations when trading Nasdaq National Market and SmallCap 
securities.''\7\
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    \6\ See In re E.F. Hutton & Co., Securities Exchange Act Release 
No. 25887 (July 6, 1988) (``Manning'')
    \7\ See Letter from Jeffrey S. Davis, Assistant General Counsel, 
Nasdaq, to Nancy Sanow, Assistant Director, Division of Market 
Regulation, Commission, dated January 24, 2001 (Amendment No. 2 to 
SR-NASD-00-22).
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    Nasdaq believes that the cost for stepping ahead of a customer's 
limit order should not be higher in the OTCB, where stock prices are 
significantly lower, than in Nasdaq. Accordingly, Nasdaq is amending 
NASD Rule 6541(b) to resemble the relevant language of NASD IM-2110-2, 
including the amendments approved by the Commission on April 6, 2001. 
Nasdaq will implement this rule change for three months from the date 
that NASD Rule 6541 takes effect. Nasdaq has stated that it will give 
effect to NASD Rule 6541 30 days following the publication of a Notice 
to Members that explains the operation of NASD Rule 6541, including the 
operation of the price improvement increment.
    Under the proposal, Nasdaq would implement on the OTCBB a price 
improvement requirement of $0.01 or one-half the inside spread 
(whichever is less) for a market maker wishing to trade on a 
proprietary basis in front of a held customer limit order that is 
priced at or inside the current inside spread for an OTCBB security. 
For customer limit orders priced outside the inside spread, however, 
Nasdaq proposes to adopt a different standard. This standard would 
require a market maker seeking to trade in front of such a limit order, 
without triggering a Manning obligation, to execute its trade at a 
price at least equal to the inside bid (with respect to held customer 
limit orders to buy) or inside offer (for held orders to sell \8\). 
Market makers will be required to protect only customer limit orders 
that fall within $0.01 outside the current inside spread.
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    \8\ In the filing submitted by the NASD, this phrase originally 
appeared as ``* * * or inside offer (for held orders to buy)'' but 
has been corrected in the manner that appears above. Telephone 
Conservation between Jeffrey S. Davis, Assistant General Counsel, 
Nasdaq, and Michael Gaw, Special Counsel, Division of Market 
Regulation, Commission, on July 16, 2001.
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    The following examples illustrate how the proposed rule would 
operate:

Example #1

    Market is 5.00 to 5.01 with MMA's posted bid and offer at the 
inside
    MM receives and accepts Customer #1's limit order to buy priced at 
5.004 for 2000 shares
    MM receives a market sell order directed to its posted bid of 5.00 
for 1000 shares and immediately executes that order on a proprietary 
basis
    Here, since MMA has executed within $0.01 of Customer #1's inside-
the-spread buy limit order of 5.004, MMA would be obligated to protect 
that order and execute 1000 shares of Customer #1's order at a price of 
5.004. if MMA wished to avoid a Manning obligation with respect to 
Customer #1's 5.004 buy limit order, MMA would have to execute its 
proprietary trade at a price at least $0.005 better than that limit 
order and execute at 5.009.

Example #2

    Market is 10.00 to 10.01 with MMA's posted bid and offer at the 
inside
    MM receives and accepts Customer #2's limit order to buy priced at 
9.993 for 500 shares
    MM receives a market sell order directed to its posted bid of 10.00 
for 700 shares and immediately executes that order on a proprietary 
basis
    Under the Manning changes proposed here, since the market maker's 
700 share proprietary order was executed at a price (10.00) that is at 
least equal to the inside bid, it would not be obligated to execute 
that limit order. Similarly, if the market remained at 10.00 to 10.01 
and MMA held a customer limit order to sell priced at 10.016, MMA could 
trade proprietarily with an incoming buy order without triggering a 
Manning obligation with respect to the 10.016 outside-the-spread limit 
order if the market maker executes its proprietary trade at a price of 
at least 10.01.\9\
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    \9\ A third example that was provided in the draft notice has 
not been published at the request of Nasdaq. Telephone conversation 
between Jeffrey Davis, Assistant General Counsel, Nasdaq, and 
Michael Gaw, Special Counsel, Division of Market Regulation, 
Commission, on July 24, 2001.
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    Nasdaq believes that the proposed rule change draws an appropriate 
balance between providing effective limit order protection for 
customers who aggressively seek to participate in trading at the inside 
market while reducing the incidence of forced trading losses to market 
makers who, in meeting their firm quote and best-execution obligations 
to other market participants, trade near customer limit orders priced 
outside the spread.
    Nasdaq has stated that both Nasdaq and NASD Regulation will closely 
monitor the protection of customer limit orders and analyze and 
evaluate trading activity to determine if future changes to the NASD 
Rule 6541 price improvement standard are warranted. One goal of this 
pilot program is to bring NASD Rule 6541 into closer conformity with 
NASD IM-2110-2, and to permit Nasdaq to analyze the extent to which the 
two rules should differ.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act \10\ in that it is 
designed to: (1) Promote just and equitable principles of trade; (2) 
foster cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to and 
facilitating transactions in securities; (3) perfect the mechanism of a 
free and open market and a national market system; and (4) protect 
investors and the public interest.
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    \10\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    Nasdaq 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.

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

    The proposed rule change has been filed by Nasdaq as a ``non-
controversial''

[[Page 40306]]

rule change pursuant to Rule 19b-4(f)(6) under the Act.\11\ Nasdaq has 
stated that, because the foregoing proposed rule change: (1) Does not 
significantly affect the protection of investors or the public 
interest; (2) does not impose any significant burden on competition; 
and (3) does not become operative until more than 30 days from the date 
on which it was filed, and Nasdaq provided the Commission with written 
notice of its intent to file the proposed rule change at least five 
days prior to the filing date, the proposed rule change has become 
immediately effective. In addition, the establishment of this pilot 
program will permit Nasdaq to monitor the operation of NASD Rule 6541 
on the OTCBB, and to analyze the extent to which NASD Rule 6541 and 
NASD IM-2110-2 should differ.
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    \11\ 17 CFR 240.19b-4(f)(6)
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    At any time within 60 days of this filing, the Commission may 
summarily abrogate this proposal if it appears to the Commission that 
such action is necessary or appropriate in the public interest, for the 
protection of investors, or otherwise in furtherance of the purposes of 
the Act.
    Nasdaq has stated that it would implement the new trading-ahead 
provisions of NASD Rule 6541(b) for a three-month period from the date 
that NASD Rule 6541 takes effect. Nasdaq also has stated that it would 
give effect to NASD Rule 6541 30 days following publication of a Notice 
to Members that will explain the operation of NASD Rule 6541, including 
the operation of the new price improvement provisions. This Notice to 
Members was published in July 2001 and indicates that NASD Rule 6541 
will become effective on August 1, 2001, and that the price improvement 
provisions of NASD Rule 6541(b) will be effective until November 1, 
2001.\12\ The overall pilot program for Manning protection of selected 
OTCBB securities will be effective until February 8, 2002.
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    \12\ See NASD Notice to Members 01-46.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW, Washington, DC 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-2001-39 and 
should be submitted by August 23, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-19283 Filed 8-1-01; 8:45 am]
BILLING CODE 8010-01-M