[Federal Register Volume 66, Number 217 (Thursday, November 8, 2001)]
[Notices]
[Pages 56587-56590]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-28082]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45011; File No. SR-NASD-2001-78]


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 for Limit Order 
Protection on the OTC Bulletin Board

November 1, 2001.
    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 November 1, 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 29b-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

    This is 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. Portions of NASD Rule 6541 were previously 
amended for a three-month pilot period running from August 1, 2001, to 
November 1, 2001.\4\ The amendment effected by this filing

[[Page 56588]]

revises the rule text of the three-month pilot.
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    \4\ See Securities Exchange Act Release No. 44593 (July 26, 
2001), 66 FR 40304 (August 2, 2001).
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    Pursuant to Rule 19b-4(f) under the Act, Nasdaq has designated this 
proposal as non-controversial and requests that the Commission waive 
both the five-day notice and the 30-day pre-operative requirement 
contained in Rule 19b-4(f)(6)(iii).\5\ If such waiver is granted by the 
Commission, the rule change will be effective on November 1, 2001, and 
will remain in effect for a pilot period ending on January 14, 2002, 
the date when a similar pilot rule relating to Nasdaq securities will 
expire.
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    \5\ 17 CFR 240.19b-4(f)(6)(iii).
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    The text of the proposed rule change is provided below. New 
language is in italics; 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] the obligation specified in 
paragraph (a) through the provision of price improvement[, unless:]. If 
a customer limit order is priced at or inside the current inside 
spread, however, the price improvement must be for a minimum of the 
lesser of $0.01 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 
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 
designated securities that are traded on the OTCBB.\6\ 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 while holding customer limit 
orders. 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.
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    \6\ See Securities Exchange Act Release No. 43944 (February 8, 
2001), 66 FR 10541 (February 15, 2001) (approving SR-NASD-00-22).
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    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 SEC 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.\7\ NASD Rule 6541 expands to the trading of OTCBB the 
protections that NASD IM-2110-2 provides to the trading of Nasdaq 
National Market and SmallCap securities.
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    \7\ See In re E.F. Hutton & Co., Securities Exchange Act Release 
No. 25887 (July 6, 1988) (``Manning'').
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    On March 2, 2001 and April 6, 2001, the Commission approved 
modifications to NASD IM-2110-2.\8\ In general, these modifications 
narrowed the amount of price improvement required to avoid the 
obligation to fill a customer limit order, in recognition of the 
introduction of decimal pricing of Nasdaq securities. On July 26, 2001, 
Nasdaq filed and implemented an amendment to NASD Rule 6541(b) (SR-
NASD-2001-39) that likewise narrowed the amount of required price 
improvement for trading of OTCBB securities.\9\ As originally drafted, 
NASD Rule 6541(b) required price improvement of at least the lesser of 
$0.05 or one-half of the current inside spread. Under SR-NASD-2001-39, 
the price improvement requirement was narrowed to $0.01 or one-half the 
inside spread (whichever is less) for a market maker wishing to trade 
in front of a held customer limit order that is priced at or inside the 
current inside spread for an OTCBB security. For a customer limit order 
priced less than $0.01 outside the inside spread, however, SR-NASD-
2001-39 required a market maker seeking to trade in front of such limit 
order to execute its trades at a price at least equal to the inside bid 
(with respect to a held customer limit order to buy) or inside offer 
(for a held order to sell). Moreover, SR-NASD-2001-39 provided that 
limit order protection would not apply to a customer limit order that 
was priced more than $0.01 outside the current inside spread. The 
amendment to NASD Rule 6541(b) adopted by SR-NASD-2001-39 has been 
effective for a three-month pilot period that ends on November 1, 2001.
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    \8\ See Securities Exchange Act Release No. 44030 (March 2, 
2001), 66 FR 14235 (March 9, 2001) (approving SR-NASD-2001-09); 
Securities Exchange Act Release No. 44165 (April 6, 2001), 66 FR 
19268 (April 13, 2001) (approving SR-NASD-2001-27). See also 
Securities Exchange Act Release No. 44529 (July 9, 2001), 66 FR 
37082 (July 16, 2001) (SR-NASD-2001-43).
    \9\ See Securities Exchange Act Release No. 44593 (July 26, 
2001), 66 FR 40304 (August 2, 2001).
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    Nasdaq is amending NASD Rule 6541 (b) to eliminate the minimum 
price improvement requirement for limit orders outside the inside 
spread. Accordingly, any degree of price improvement would relieve a 
market maker from the obligation to fill a limit order that is outside 
of the inside spread. However, Nasdaq is also eliminating the provision 
of the pilot that provided no limit order protection to customer limit 
orders that are priced more than $0.01 outside the current inside 
spread. Thus, the basic prohibition on trading ahead of a customer 
limit order at a price equal or superior to the limit order without 
filing the limit order would apply to all limit orders in OTCBB 
securities covered by

[[Page 56589]]

NASD Rule 6541. The amount of required price improvement for limit 
orders priced inside the current inside spread would remain the lesser 
of $0.01 or one-half of the current inside spread.
    Nasdaq proposes to make this change because the degree of price 
improvement required under both the original rule and SR-NASD-2001-39 
is quite large in comparison to the share price of many OTCBB 
securities. In contrast to Nasdaq securities, many OTCBB securities 
trade at prices of a few cents or less and may be quoted out to four 
decimal places.\10\ Accordingly, OTCBB market makers may be required to 
fill limit orders at prices that are quite divergent, in percentage 
terms, from the price of the order that was traded ahead. An example 
will illustrate the concern addressed by this rule change:
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    \10\ In the draft notice provided to the Commission, Nasdaq 
incorrectly stated that OTCBB securities could be quoted to five 
decimal places. Telephone conversation between John Yetter, 
Assistant General Counsel, Nasdaq, and Michael Gaw, Special Counsel, 
Commission, on November 1, 2001.
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    Market is $0.0165 to $0.0167.
    MM receives and holds customer's limit order to buy priced at 
$0.0065.
    MM receives a sell order priced at $0.0164 and immediately executes 
that order on a proprietary basis.
    Under the current pilot, since MM held a limit order to buy priced 
within $0.01 of the inside spread and bought on a proprietary basis at 
a price less than the inside bid, MM would be required to fill the 
customer's limit order. In this example, however, the price of the 
proprietary trade is over 150% higher than the price of the limit order 
that MM must fill. Thus, the operation of the rule may significantly 
affect the profitability of market making in the low-priced and thinly 
traded securities that are traded on the OTCBB. Under the proposed rule 
change, MM would be required to fill the limit order only if its 
proprietary trade was at or below the price of the limit order.
    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. In doing so, Nasdaq believes that the proposed rule 
change will help to promote the liquidity of the OTCBB by encouraging 
greater market maker participation in the market. Nasdaq represents 
that it and NASD Regulation will closely monitor the protection of 
customer limit orders and analyze and evaluate trading activity to 
determine if future changes to price improvement standard of NASD Rule 
6541 are warranted.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of section 15A(b)(6) of the Act \11\ 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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    \11\ 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 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

    The proposed rule change has been filed by Nasdaq as a non-
controversial rule change pursuant to Rule 19b-4(f)(6) under the Act. 
Nasdaq represents that 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 for 30 days from the date on which it 
was filed, or such shorter time as the Commission may designate, if 
consistent with the protection of investors and the public interest; 
therefore, it has become effective pursuant to section 19(b)(3)(A) of 
the Act \12\ and Rule 19b-4(f)(6) thereunder. At any time within 60 
days of the filing of the proposed rule change, the Commission may 
summarily abrogate such rule change 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.
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    \12\ 15 U.S.C. 78s(b)(3)(A).
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    Nasdaq has requested that the Commission waive the 30-day pre-
operative period required by Rule 19b-4(f)(6), which would allow the 
proposal to become operative on November 1, 2001. The Commission finds 
that granting this request is consistent with the protection of 
investors and the public interest, as price improvement standards under 
NASD Rule 6541 will remain in effect on an uninterrupted basis.\13\ The 
Commission finds, moreover, that it is consistent with the protection 
of investors and the public interest to allow Nasdaq to eliminate NASD 
Rule 6541(b)(3) as of November 1, 2001, as this provision withholds 
limit order protection from customer limit orders in OTCBB securities 
that are priced more than $0.01 outside the current inside spread.
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    \13\ For purposes only of accelerating the operative date of 
this proposal, the Commission has considered the proposed rule's 
impact on efficiency, competition, and capital formation. See 15 
U.S.C. 78c(f).
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    Rule 19b-4(f)(6) also requires the self-regulatory organization to 
give the Commission written notice of its intent to file a proposed 
rule change at least five business days prior to the date of filing of 
the proposed rule change, or such shorter time as designated by the 
Commission. Nasdaq has requested that the Commission waive this five-
day period. For the same reasons that the Commission has determined to 
waive the 30-day pre-operative period, the Commission also waives the 
five-day notice period.

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

[[Page 56590]]

the principal office of the NASD. All submissions should refer to File 
No. SR-NASD-2001-78 and should be submitted by November 29, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-28082 Filed 11-7-01; 8:45 am]
BILLING CODE 8010-01-M