[Federal Register Volume 70, Number 37 (Friday, February 25, 2005)]
[Notices]
[Pages 9402-9404]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-3678]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51231; File No. SR-NASD-2004-089]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment 
No. 1 Thereto Relating to Proposed Amendments To Require Limit Order 
Protection and To Expand the Application of Manning Obligations to 
Exchange-Listed Securities

February 18, 2005.
    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 
June 9, 2004, the National Association of Securities Dealers, Inc. 
(``NASD'') 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 the NASD. On November 
2, 2004, the NASD filed Amendment No. 1 to the proposed rule change.\3\ 
The Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 to SR-NASD-2004-089 replaces and supercedes 
the NASD's original 19b-4 filing in its entirety.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is proposing to require providing price improvement to 
customer limit orders under certain circumstances and to expand the 
application of NASD IM-2110-2 to exchange-listed securities.
    Below is the text of the proposed rule change. Proposed new 
language is italicized; proposed deletions are in brackets.
* * * * *

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

(a) General Applications
    To continue to ensure investor protection and enhance market 
quality, NASD's [the Association's] Board of Governors is issuing an 
interpretation to NASD [the] Rules [of the Association] dealing with 
member firms' treatment of their customer limit orders in Nasdaq and 
exchange-listed securities. This interpretation, which is applicable 
from 9:30 to 6:30 p.m. Eastern Time, will require members acting as 
market makers to handle their customer limit orders with all due care 
so that market makers do not ``trade ahead'' of those limit orders. 
Thus, members acting as market makers that handle 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 limit order without executing the limit order. [Such orders 
shall be protected from executions at prices that are superior but not 
equal to that of the limit order.] In the interests of investor 
protection, NASD [the Association] is eliminating the so-called 
disclosure ``safe harbor'' previously established for members that 
fully disclosed to their customers the practice of trading ahead of a 
customer limit order by a market-making firm (1).
    (1) For purposes of [the pilot program expanding] the operation of 
certain Nasdaq transaction and quotation reporting systems and 
facilities [in SR-NASD-99-57] during the period from 4 p.m. to 6:30 
p.m. Eastern Time. If a customer does not formally assent (``opt-in'') 
to processing of [their]the customer's limit order(s) during the 
extended hours period commencing after the normal close of the Nasdaq 
market, limit order protection will not apply to that customer's 
order(s).
Interpretation
    The following interpretation of Rule 2110 has been approved by the 
Board:
    A member firm that accepts and holds an unexecuted limit order from 
its customer (whether its own customer or a customer of another member) 
in a Nasdaq or exchange-listed security and that continues to trade the 
subject security for its own market-making account at prices that would 
satisfy the customer's limit order, without executing that limit order, 
shall be deemed to have acted in a manner inconsistent with just and 
equitable principles of trade, in violation of Rule 2110, provided 
that[, until September 1, 1995, customer limit orders in excess of 
1,000 shares received from another member firm shall be protected from 
the market maker's executions at prices that are superior but not equal 
to that of the limit order, and provided further, that] a member firm 
may negotiate specific terms and conditions applicable to the 
acceptance of limit orders only with respect to limit orders that are: 
(a) for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in Rule 3110(c)(4); 
or (b) 10,000 shares or more, unless such orders are less than $100,000 
in value. In the event that a member acting as market maker trades 
ahead of an unexecuted customer limit order at a price that is better 
than the unexecuted limit order, such member is required to execute the 
limit order at the price received by the member or better. Nothing in 
this interpretation, however, requires members to accept limit orders 
from any customer.
    By rescinding the safe harbor position and adopting this 
interpretation, NASD [the Association] wishes to emphasize that members 
may not trade ahead of their customer limit orders in their market-
making capacity even if the member had in the past fully disclosed the 
practice to its customers prior to accepting limit orders. NASD [The 
Association] believes that, pursuant to Rule 2110, members accepting 
and holding unexecuted customer limit orders owe certain duties to 
their customers and the customers of other member firms that may not be 
overcome or cured with disclosure of trading practices that include 
trading ahead of the customer's order. The terms and conditions under 
which institutional account or appropriately sized customer limit 
orders are accepted must be made clear to customers at the time the 
order is accepted by the firm so that trading ahead in the firm's 
market-making capacity does not occur. [For purposes of this 
interpretation, a member that controls or is controlled by another 
member shall be considered a single entity so that if a customer's 
limit order is accepted by one affiliate and forwarded to another 
affiliate for execution, the firms are considered a single entity and 
the market-making unit may not trade ahead of that customer's limit 
order.]
    As outlined in NASD Notice to Members 97-57, the minimum amount of 
price improvement necessary in order for a market maker to execute an 
incoming order on a proprietary basis when holding an unexecuted limit 
order for a Nasdaq security trading in fractions, and not be required 
to execute the held limit order, is as follows:
     If actual spread is greater than \1/16\ of a point, a firm 
must price improve an incoming order by at least a \1/16\. For stocks 
priced under $10[,] (which are quoted in \1/32\ increments), the firm 
must price improve by at least \1/64\.
     If actual spread is the minimum quotation increment, a 
firm must price

[[Page 9403]]

improve an incoming order by one-half the minimum quotation increment.
    For Nasdaq securities authorized for trading in decimals pursuant 
to the Decimals Implementation Plan for the Equities and Options 
markets, the minimum amount of price improvement necessary in order for 
a market maker to execute an incoming order on a proprietary basis in a 
security trading in decimals when holding an unexecuted limit order in 
that same security, and not be required to execute the held limit 
order, is as follows:
    (1) For customer limit orders priced at or inside the best inside 
market displayed in Nasdaq, the minimum amount of price improvement 
required is $0.01; and
    (2) For customer limit orders priced outside the best inside market 
displayed in Nasdaq, the market maker must price improve the incoming 
order by executing the incoming order at a price at least equal to the 
next superior minimum quotation increment in Nasdaq (currently $0.01).
    NASD [The Association] also wishes to emphasize that all members 
accepting customer limit orders owe those customers duties of ``best 
execution'' regardless of whether the orders are executed through the 
member's market-making capacity or sent to another member for 
execution. As set out above, the Best Execution Rule requires members 
to use reasonable diligence to ascertain the best inter-dealer market 
for the security and buy or sell in such a market so that the price to 
the customer is as favorable as possible under prevailing market 
conditions. NASD [The Association] emphasizes that order entry firms 
should continue to routinely monitor the handling of their customers' 
limit orders regarding the quality of the execution received.
    (b) and (c) 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, NASD 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. NASD 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 Interpretive Material (IM) 2110-2, Trading Ahead of Customer 
Limit Order (commonly referred to as the ``Manning Interpretation'') 
generally prohibits a member from trading for its own account at prices 
that would satisfy a customer's limit order, unless the member 
immediately thereafter executes the customer limit order.\4\ The legal 
underpinnings for the Manning Interpretation are a member's basic 
fiduciary obligations and the requirement that it must, in the conduct 
of its business, ``observe high standards of commercial honor and just 
and equitable principles of trade.'' \5\
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    \4\ For example, if a member bought 100 shares at $10 when 
holding customer limit orders in the same security to buy at $10 
equaling, in aggregate, 1000 shares, the member is required to fill 
100 shares of the customer limit orders. NASD Rule 6440(f)(2) 
imposes similar requirements with respect to the receipt of customer 
limit orders in exchange-listed securities traded over-the-counter.
    \5\ See NASD rule 2110. See also NASD Rule 232(a) (the ``Best 
Execution Rule''). Note: NASD has proposed changes to the Best 
Execution Rule in SR-NASD-2004-026. See Securities Exchange Act 
Release No. 51229 (February 18, 2005). See also related filing, File 
No. SR-NASD-2004-045. See Securities Exchange Act Release No. 51230 
(February 18, 2005).
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    The Manning Interpretation is designed to ensure that customer 
limit orders are executed in a fair manner by prohibiting a member firm 
from trading ahead of customers' limit orders in its principal capacity 
without executing the customer limit order. The Interpretation 
currently, however, only requires that a member that ``trades ahead'' 
of a customer limit order execute the customer limit order at its limit 
price. If the member trades ahead of a customer limit order and 
receives a better price than the unexpected customer limit order, the 
Manning Interpretation currently would not obligate the member to pass 
along the better price if received; it need only fill the customer 
limit order at the limit price.
    NASD believes that where a member trades at a price better than an 
unexpected customer limit order, the member should be required to pass 
along such price improvement to the unexecuted customer limit order. 
Accordingly, NASD is proposing to prohibit a member from trading for 
its own account in a Nasdaq or exchange-listed security \6\ at a price 
that is better than an unexpected customer limit order in that 
security, unless the member immediately thereafter executes the 
customer limit order at the price at which it traded for its own 
account or better.
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    \6\ NASD Rule 6440(f)(2) currently prohibits members from 
trading ahead of their customer limit orders in exchange-listed 
securities traded over-the-counter. To ensure consistency in the 
application of limit order protection to Nasdaq and exchange-listed 
securities, NASD also is proposing to apply explicitly its Manning 
Interpretation to exchange-listed securities. NASD will recommend to 
Nasdaq that it consider deleting NASD Rule 6440(f)(2), in light of 
the proposed application of NASD IM-1210-2 to exchange-listed 
securities.
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    In recognition that the proposed rule change may alter the way that 
many members handle customer orders, NASD believes that it is important 
to provide members with adequate time to develop and implement systems 
to comply with the proposed rule change. Therefore, NASD will announce 
the effective date of the proposed rule change in a Notice to Members 
to be published no later than 60 days following SEC approval. The 
implementation date will be 90 days after the issuance of such Notice 
to Members announcing SEC approval of the proposed rule change.
    NASD also is proposing several technical changes to the Manning 
Interpretation to delete language contained in the rule text that is no 
longer necessary. Specifically, as part of a proposed expansion of the 
Manning Interpretation in 1994 to include all member-to-member customer 
limit orders, the Manning Interpretation included a phase-in period 
that expired on September 1, 1995.\7\ Prior to that time period, the 
Manning Interpretation permitted member firms to handle member-to-
member limit orders that were larger than 1,000 shares more liberally 
(such limit orders were only required to be protected from executions 
at prices that were superior but not equal to that of the limit order). 
Given that the phase-in period has expired, NASD is proposing to delete 
the rule text related to the phase-in period.
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    \7\ See Securities Exchange Act Release No. 35751 (May 22, 
1995), 60 FR 27997 (May 26, 1995) (File No. SR-NASD-94-62).
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    NASD also proposes to delete the rule text relating to the 
application of the Manning Interpretation to affiliates as it also is 
no longer necessary. The rule text relating to affiliates was necessary 
when the Manning Interpretation did not apply to member-to-member limit 
orders to ensure that limit orders routed between affiliates were 
protected. However, because the Manning Interpretation has since been 
expanded to apply to member-to-member customer limit orders, if a 
member accepts a customer limit order and forwards that order to 
another member

[[Page 9404]]

(regardless of whether or not such member is an affiliate) for 
execution, the Manning Interpretation would apply.
    In addition, NASD is proposing to delete certain unnecessary rule 
text contained in footnote one relating to a Nasdaq pilot program 
expanding the operation of certain Nasdaq transaction and quotation 
reporting systems and facilities during the period from 4 p.m. to 6:30 
p.m. eastern time. This Nasdaq pilot program became a permanent program 
in 2003 and this footnote text inadvertently was not deleted as part of 
the rule filing making the pilot permanent.\8\ Finally, NASD no longer 
refers to itself or its subsidiary, NASD Regulation, Inc., using its 
full corporate name, ``the Association,'' ``the NASD'' or ``NASD 
Regulation, Inc.'' Instead, NASD uses ``NASD'' unless otherwise 
appropriate for corporate or regulatory reasons. Accordingly, the 
proposed rule change replaces several references to ``Association'' in 
the text of the proposed rule change with ``NASD.''
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    \8\ See Securities Exchange Act No. 47308 (February 4, 2003), 68 
FR 6976 (February 11, 2003) (File No. SR-NASD-2003-14).
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2. Statutory Basis
    NASD believes that the proposed rule change, as amended, is 
consistent with the provisions of section 15A(b)(6) of the Act,\9\ 
which requires, among other things, that NASD's rules must be designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, and, in general, to protect 
investors and the public interest. NASD believes that the proposed rule 
change, as amended, will improve treatment of customer limit orders and 
enhance the integrity of the market.
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    \9\ 15 U.S.C. 78o-3(b)(6)
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD 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

    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 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 proposed rule 
change, as amended, is consistent with the Act. Comments may be 
submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-NASD-2004-089 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-NASD-2004-089. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of NASD. 
All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-NASD-2004-089 
and should be submitted on or before March 18, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 05-3678 Filed 2-24-05; 8:45 am]
BILLING CODE 8010-01-M