[Federal Register Volume 67, Number 245 (Friday, December 20, 2002)]
[Notices]
[Pages 78033-78035]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32073]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46994; File No. SR-NASD-2002-66]


Self-Regulatory Organizations; Order Granting Approval of 
Proposed Rule Change by the National Association of Securities Dealers, 
Inc., and Notice of Filing and Order Granting Accelerated Approval of 
Amendment No. 1 to Proposed Rule Change Relating to Limit Order 
Protection and the Facilitation of Other Customer Orders on a Riskless 
Principal Basis

December 13, 2002.

I. Introduction

    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''), pursuant to section 19(b)(1) of the 
Securities Exchange Act of 1934 (Act) \1\ and Rule 19b-4 thereunder,\2\ 
a proposed rule change that would modify NASD Interpretative Material 
2110-2 to establish a riskless principal customer facilitation 
exemption. Notice of the proposed rule change appeared in the Federal 
Register

[[Page 78034]]

on June 7, 2002.\3\ The Commission received two comment letters in 
response to the proposed rule change.\4\ On November 26, 2002, Nasdaq 
submitted Amendment No. 1 to the proposed rule change.\5\ For the 
reasons discussed below, the Commission is approving the proposed rule 
change and granting accelerated approval to Amendment No 1.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 46006 (May 30, 
2002), 67 FR 39455 (June 7, 2002).
    \4\ Letters from Michael T. Dorsey, Senior Vice President, 
Director of Legislative and Regulatory Affairs, Knight Trading 
Group, Inc. (June 28, 2002); Michael Corrao, Vice President and 
Chief Compliance officer, Schwab Capital Markets L.P. (July 9, 
2002).
    \5\ See Letter from Thomas P. Moran, Associate General Counsel, 
Nasdaq (November 26, 2002). NASD's Amendment seeks to add the 
language ``or customer account'' to the proposed rule language for 
subparagraph (c) (4) of Interpretative Material 2110-2 as an 
alternative account to which a riskless principal offsetting 
transaction may be allocated in addition to the ``riskless principal 
account'' referenced in the original rule filing.
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II. Description of the Proposed Rule Change

    The proposed rule change seeks Commission approval of Nasdaq's 
proposal to establish a riskless principal customer facilitation 
exemption to NASD Interpretative Material 2110-2-Trading Ahead of 
Customer Limit Order (``Manning Interpretation'' or ``Manning''). 
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.\6\
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    \6\ 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.
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    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.\7\ Additionally, this proposed exemption is intended to 
addresses some of the consequences created by Manning's minimum price 
improvement standard in a decimal environment.
    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:
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    \7\ 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.

    (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 or customer 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 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.\8\ 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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    \8\ See Securities Exchange Act Release No. 45194 (January 2, 
2002), 67 FR 6 (January 2, 2002). ?
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III. Comment Letters

    The Commission received two comment letters in response to the 
proposed rule change. Knight Trading Group, Inc. (``Knight'') supported 
the proposed rule change but expressed concern about the conditions 
included in the exemption. In particular, Knight objected to the 
requirements that an offsetting riskless principal transaction must be 
allocated within 60 seconds of execution and that the transaction be 
allocated to a separate ``allocation account.'' Knight contended that 
these requirements were redundant in light of the proposed condition 
that members must have systems in place that enable a member to 
accurately and readily reconstruct, in a time sequenced manner, all 
orders upon which a member relies in claiming the exemption.
    Another commenter, Schwab Capital Markets L.P. (``Schwab''), 
expressed a broader concern about the application of the Manning 
Interpretation in a decimals environment where subpenny quotes are 
rounded to the nearest penny. Schwab stated that under certain market 
conditions, a member may attempt to execute a trade at least $0.01 
ahead of a customer limit order it holds pursuant to Manning but 
because a quote was rounded to the nearest penny the execution may 
trigger a fill of a customer limit order held by the member. Schwab 
suggested several solutions to the problem, including requiring an 
asterisk identifier to a rounded quote and the elimination of a penny 
price improvement standard

[[Page 78035]]

where the spread in a security is a penny.
    Nasdaq submitted Amendment No. 1 in response to one of the concerns 
raised by Knight. As discussed, Amendment No. 1 seeks to provide an 
alternative allocation account for those members for whom it may be 
cumbersome to establish a separate ``riskless principal account.'' With 
regards to Knight's concern about the requirement that an offsetting 
transaction be allocated to either a riskless principal or customer 
account within 60 seconds, Nasdaq has not sought to make any changes to 
the proposed rule in response to this concern as this condition is 
consistent with previously stated Nasdaq policy regarding the handling 
of mixed capacity trades and compliance with the Manning 
Interpretation.\9\
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    \9\ See NASD Notice to Members 01-85, at Question 7 and Notice 
to Members 95-67, at Question 5.
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    Further, Nasdaq has not sought any changes to the rule proposal in 
response to the concerns raised by Schwab. The issues raised by Schwab 
largely relate to the operation of Manning relative to the rounding of 
quotes to the nearest penny due to subpenny trading that are beyond the 
scope of the proposed rule change.

IV. Discussion

    The Commission has reviewed carefully the proposed rule change and 
the two comment letters and finds that the proposed rule change is 
consistent with the Act and the rules and regulations promulgated 
thereunder.\10\ Specifically, the Commission finds that approval of the 
proposed rule change is consistent with section 15A(b)(6) of the 
Act.\11\
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    \10\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition and capital 
formation. 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78o-3(b)(6).
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    The Commission finds that proposed rule change is consistent with 
section 15A(b)(6) of the Act \12\ in that it is designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and to remove impediments to and perfect 
the mechanism of a free and open market and a national market system, 
and, in general, to protect investors and the public interest. The 
Commission finds the proposed rule change promotes the just and 
equitable principles of trade by continuing to provide protection to 
customer limit orders while removing possible impediments to filling 
customer orders on a riskless principal basis. In particular, the 
Commission finds that an exemption from Manning for single-priced 
riskless principal transactions done by market makers who are buying or 
selling securities to satisfy the order(s) of other customers is 
consistent with the goals of Manning since the true beneficiary of the 
market maker's activity is another customer and not the firm's 
proprietary account. Additionally, we believe the proposed exemption 
will appropriately address some of the concerns raised by members 
regarding the consequences created by Manning's minimum price 
improvement standard in a decimal environment.
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    \12\ Id.
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    The Commission also finds good cause for approving proposed 
Amendment No. 1 prior to the 30th day after the date of publication of 
notice of the filing in the Federal Register. The Amendment provides an 
alternative allocation account, other than a riskless principal 
account, as a more efficient means of complying with the conditions of 
the exemption for some members for whom establishing a separate 
riskless principal account may be cumbersome. Approving the Amendment 
on an accelerated basis will allow some members to implement the 
exemption without having to unnecessarily establish a separate riskless 
principal account. For this reason, the Commission finds good cause for 
accelerating approval of the proposed rule change, as amended.
    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether the Amendment 
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 January 10, 2003.

V. Conclusion

    For the above reasons, the Commission finds that the proposed rule 
change is consistent with the provisions of the Act, in general, and 
with section 15A(b)(6),\13\ in particular.
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    \13\ 15 U.S.C. 78o-3(b)(6).
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\14\ that the proposed rule change (SR-NASD-2002-66), as amended, 
be and hereby is approved.
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    \14\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-32073 Filed 12-19-02; 8:45 am]
BILLING CODE 8010-01-P