[Federal Register Volume 67, Number 110 (Friday, June 7, 2002)]
[Notices]
[Pages 39455-39457]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-14299]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46006; File No. SR-NASD-2002-66]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc., 
Relating to Limit Order Protection and the Facilitation of Other 
Customer Orders on a Riskless Principal Basis

May 30, 2002.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'' or ``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ notice 
is hereby given that on May 28, 2002, the National Association of 
Securities Dealers, Inc. (``NASD'' or ``Association''), 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. 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.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    Nasdaq proposes to establish a riskless principal customer 
facilitation exemption to NASD Interpretative Material 2110-2-Trading 
Ahead of Customer Limit Order (``Manning Interpretation'' or 
``Manning''). Proposed additions are italicized.

IM-2110-2. Trading Ahead of Customer Limit Order

    (a)-(b) No Change.

(c) Exemption for the Facilitation on a Riskless Principal Basis of 
Other Customer Orders

    A member shall be exempt from the obligation to execute a customer 
limit order in a manner consistent with this interpretation if such 
member engages in trading activity to facilitate the execution, on a 
riskless principal basis, of another order from its customer (whether 
its own customer or the customer of another member) (the ``facilitated 
order''), provided that all of the following requirements are 
satisfied:
    (1) The handling and execution of the facilitated order must 
satisfy the definition of a ``riskless'' principal transaction, as that 
term is defined in NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 
4652(d)(3)(B);
    (2) A member that relies on this exemption to this interpretation 
must give the facilitated order the same per-share price at which the 
member accumulated or sold shares to satisfy the facilitated order, 
exclusive of any markup or markdown, commission equivalent or other 
fee;
    (3) A member must submit, contemporaneously with the execution of 
the facilitated order, a report as defined in NASD Rules 
4632(d)(3)(B)(ii), 4642(d)(3)(B)(ii) and 4652(d)(3)(B)(ii) to the 
Automated Confirmation Transaction Service;
    (4) Members must have written policies and procedures to assure 
that riskless principal transactions relied upon for this exemption 
comply with NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 4652(d)(3)(B). 
At a minimum these policies and procedures must require that the 
customer order was received prior to the offsetting transactions, and 
that the offsetting transactions are allocated to a riskless principal 
account in a consistent manner and within 60 seconds of execution. 
Members must have supervisory systems in place that produce records 
that enable the member and NASD Regulation to accurately and readily 
reconstruct, in a time-sequenced manner, all orders which a member 
relies in claiming this exemption.
    Any transaction handled by a member on other than an agency basis 
that does not satisfy all of the above requirements remains a 
transaction that, where required by this interpretation, gives rise to 
the obligation to protect and execute customer limit order(s). This 
exemption applies only to the actual number of shares that are required 
to satisfy the facilitated order.

[[Page 39456]]

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 its proposal and discussed any 
comments it received regarding the proposal. 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
    NASD's current Manning Interpretation prohibits market makers from 
trading at prices equal or superior to customer limit orders they hold 
without executing those limit orders. In addition, Nasdaq has adopted 
price-improvement standards that obligate market makers to execute held 
customer limit orders unless the market maker either buys at a price 
sufficiently higher than a customer's buy order, or sells at a price 
sufficiently lower than a customer's sell order.
    Nasdaq has determined to adopt a customer facilitation exemption to 
Manning that would exempt from Manning single-priced riskless principal 
transactions done by market makers who are buying or selling securities 
to satisfy the order(s) of other customers. In these situations, since 
the true beneficiary of the market maker's activity is another 
customer, and not the firm's proprietary account, Manning will be 
interpreted to exempt such trading from being considered triggering 
trades obligating the market maker to protect other held customer limit 
orders.\3\ Additionally, this proposed exemption addresses some of the 
consequences created by Manning's minimum price improvement standard in 
a decimal environment.
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    \3\ In this sense, the exemption is similar in purpose and 
effect to the treatment of agency executions in IM-2110-2. 
Specifically, if a broker-dealer executes a customer order on an 
agency basis, the firm is not required to protect (execute) other 
customer limit orders.
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    To ensure that market maker transactions that will not trigger 
Manning obligations are being done for the ultimate benefit of other 
customers, the customer facilitation exemption will be strictly 
construed. As such, only those market maker trades meeting all of the 
following requirements would be eligible for an exemption from Manning:

    (1) The handling and execution of the facilitated order must 
satisfy the definition of a ``riskless'' principal transaction, as 
that term is defined in NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 
4652(d)(3)(B);
    (2) A member that relies on this exemption to this 
interpretation must give the facilitated order the same per-share 
price at which the member accumulated or sold shares to satisfy the 
facilitated order, exclusive of any markup or markdown, commission 
equivalent or other fee;
    (3) A member must submit, contemporaneously with the execution 
of the facilitated order, a report as defined in NASD Rules 
4632(d)(3)(B)(ii), 4642(d)(3)(B)(ii) and 4652(d)(3)(B)(ii) to the 
Automated Confirmation Transaction Service;
    (4) Members must have written policies and procedures to assure 
that riskless principal transactions relied upon for this exemption 
comply with NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 
4652(d)(3)(B). At a minimum these policies and procedures must 
require that the customer order was received prior to the offsetting 
transactions, and that the offsetting transactions are allocated to 
a riskless principal account within 60 seconds of execution. Members 
must have supervisory systems in place that produce records that 
enable the member and NASD Regulation to accurately and readily 
reconstruct, in a time-sequenced manner, all orders on which a 
member relies in claiming this exemption.

    Non-agency trades not meeting all of these standards would remain 
subject to Manning and require, upon execution, the protection and 
execution of appropriate limit orders in full conformity with the 
Interpretation. This exemption would apply only to the actual number of 
shares executed by the member necessary to fill the customer order(s).
    In Nasdaq's view, a transaction meeting these requirements is 
closely akin to an agency trade and does not materially implicate a 
market maker's proprietary trading. Nasdaq notes that the Commission in 
its recent release concerning the availability of the Section 28(e) 
safe harbor also highlighted the similarities in compensation 
transparency provided by agency and riskless principal trade reporting 
pursuant to NASD Rules 4632(d)(3)(B), 4642(d)(3)(B), and 6420(d)(3)(B), 
coupled with the requirements of Exchange Act Rule 10b-10.\4\ As such, 
Nasdaq will not consider riskless principal trades meeting the 
requirements of the exemption as triggering trades for the market 
maker's own market-making account for purposes of Manning. This view 
rests primarily on the requirement that only trades where a market 
maker gives the customer a trade price that reflects the market maker's 
actual cost in acquiring the stock be eligible for the exemption. This 
obligation to trade flat effectively removes concerns about a member 
breaching its fiduciary duty to customer limit orders that it holds 
that underlie the Manning protections in other trading contexts. Nasdaq 
believes that the above exemption draws an appropriate balance between 
the important customer protections afforded by Manning and the 
practical needs of market participants to assist other customers.
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    \4\ See Securities Exchange Act Release No. 45194 (January 2, 
2002), 67 FR 6 (January 2, 2002).
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    As to the Manning/price improvement issue, the Manning rule 
currently dictates that a market maker does not have an obligation to 
execute customer limit orders if it trades for its own account for at 
least a minimum amount more than the customer order. The amount that a 
market maker must better a customer's order depends on whether the 
customer limit order is priced at or inside the best bid and best 
offer, or outside of it. For limit orders that are priced at or inside 
the best inside market displayed in Nasdaq, a market maker must execute 
its trade at a price at least $0.01 better than the customer limit 
order. For limit orders priced outside the best inside market displayed 
in Nasdaq, the market maker must trade at a price at least equal to the 
next rounded penny increment better than that customer limit order.\5\ 
Some market participants assert that the operation of Manning's price 
improvement standards in a market where spreads are at a penny, forces 
them to accept losses if they choose to both accept sub-penny orders 
and facilitate the execution of other customer orders. The following 
example illustrates the issue:
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    \5\ See Securities Exchange Act Release No. 44164 (April 6, 
2001), 66 FR 19268 (April 13, 2001).

    Market is 10.01 (bid) to 10.02 (offer) with 1,000 shares on each 
side.
    Market Maker A (``MMA'') receives limit order from Customer 
1 to buy 1,000 shares @ 10.0101 and, after rounding, 
displays it in its market maker quote @10.01.
    MMA subsequently receives a market order to buy from Customer 
2.
    To facilitate the execution of Customer 2 market order, 
MMA sends a SuperSOES order to the market maker or ECN at the inside 
offer price of 10.02 for 1,000 shares
    MMA receives an execution of its SuperSOES order, thus buying 
1,000 shares at 10.02. MMA then sells to Customer 2 at 10.02, and 
reports the trade consistent with riskless principal trade reporting 
requirements.

    Under the current interpretation of Manning, MMA owes Customer 
1's resting 10.0101 limit order a fill since

[[Page 39457]]

MMA sold at 10.02 and did not meet the minimum price improvement 
required by the Manning rule (i.e., .01 over Customer 1's 
order to buy at 10.0101). In effect, MMA has just bought stock at 10.02 
and must sell that same amount of stock to Customer 1 at 
10.0101 and thus lose .0099 cents per share on the interactions between 
these transactions. Under the proposed interpretation, MMA would no 
longer be required to fill both Customer orders since MMA acted as 
riskless principal for Customer 2.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act \6\ 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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    \6\ 15 U.S.C. 78o-3.
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B. Self-Regulatory Organization's Statement on Burden on Competition

    Nasdaq does not believe that the proposed rule change will impose 
any inappropriate burden on competition.

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

    Written comments relating to the proposed rule change have not yet 
been solicited or received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within thirty-five 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 ninety 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 self-regulatory organization 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 proposal 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 Nasdaq. All 
submissions should refer to file number SR-NASD-2002-66 and should be 
submitted by June 28, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-14299 Filed 6-6-02; 8:45 am]
BILLING CODE 8010-01-P