[Federal Register Volume 70, Number 37 (Friday, February 25, 2005)]
[Notices]
[Pages 9408-9411]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-773]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51230; File No. SR-NASD-2004-045]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment 
No. 1 Thereto To Adopt NASD Rule 2111 To Prohibit Members From Trading 
Ahead of Customer Market Orders

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 
on March 12, 2004, the National Association of Securities Dealers, Inc. 
(``NASD''), filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') the proposed rule change as described in Items I, 
II, and III below, which Items have been prepared by NASD. On February 
16, 2005, NASD amended the proposed rule change.\3\ The Commission is 
publishing this notice to solicit comments on the proposed rule change, 
as amended, from interested persons.\4\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Amendment No. 1 to SR-NASD-2004-045 filed on February 
16, 2005. Amendment No. 1 made clarifying changes to the proposed 
rule text.
    \4\ NASD notes that related to this proposed rule filing it has 
also filed SR-NASD-2004-026, a proposed rule change that would amend 
NASD Rule 2320(a), known as the ``Best Execution Rule.'' See 
Securities Exchange Act Release No. 51229 (February 18, 2005) (SR-
NASD-2004-026). NASD has also filed SR-NASD-2004-089, a proposed 
rule change that would provide price improvement to customer limit 
orders under certain circumstances. See Securities Exchange Act 
Release No. 51231 (February 18, 2005) (SR-NASD-2004-089).

---------------------------------------------------------------------------

[[Page 9409]]

I. Self-Regulatory Organization's Statement of the Terms of the 
Substance of the Proposed Rule Change

    NASD is proposing to prohibit members from trading ahead of a 
customer market order under the circumstances described herein. Below 
is the text of the proposed rule change. Proposed new language is in 
italics.

2111. Trading Ahead of Customer Market Orders

    (a) A member must make every effort to execute a customer market 
order that it receives fully and promptly.
    (b) A member that accepts and holds a market order of its own 
customer or a customer of another broker-dealer in a Nasdaq or 
exchange-listed security without immediately executing the order is 
prohibited from trading that security on the same side of the market 
for its own account, unless it immediately thereafter executes the 
customer market order up to the size and at the same price at which it 
traded for its own account or at a better price.
    (c) A member that is holding a customer market order that has not 
been immediately executed must make every effort to cross such order 
with any market order, marketable limit order, or non-marketable limit 
order priced better than the best bid or offer, received by the member 
on the other side of the market up to the size of such order at a price 
that is no less than the best bid and no greater than the best offer at 
the time that the subsequent market order, marketable limit order or 
non-marketable limit order is received by the member and that is 
consistent with the terms of the orders. In the event that a member is 
holding multiple orders on both sides of the market that have not been 
executed, the member must make every effort to cross or otherwise 
execute such orders in a manner that is reasonable, and is consistent 
with the objectives of this rule and with the terms of the orders. The 
member must have a written methodology in place governing the execution 
and priority of all such pending orders and must ensure that such 
methodology is consistently applied.
    (d) A member may negotiate specific terms and conditions applicable 
to the acceptance of a market order only with respect to market orders 
that are: (1) for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in Rule 3110(c)(4), 
or (2) 10,000 shares or more, unless such orders are less than $100,000 
in value.
    (e) This rule applies to limit orders that are marketable at the 
time they are received by the member or become marketable at a later 
time. Such limit orders shall be treated as market orders for purposes 
of this rule, however, these orders must continue to be executed at 
their limit price or better. If a customer limit order is not 
marketable when received, the limit order must be provided the full 
protections of IM-2110-2 or Rule 6440(f)(2), as applicable. In 
addition, if the limit order was marketable when received and then 
becomes non-marketable, once the limit order becomes non-marketable, it 
must be provided the full protections of IM-2110-2 or Rule 6440(f)(2), 
as applicable.
    (f) The obligations under this rule shall not apply to a member's 
proprietary trade if such proprietary trade is for the purposes of 
facilitating the execution, on a riskless principal basis, of another 
order from a 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), 
4652(d)(3)(B), 4632A(e)(1)(C) or 6420(d)(3)(B);
    (2) A member that relies on this exclusion to the rule 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), 4652(d)(3)(B)(ii), 
6420(d)(3)(B)(ii) and 4632A(e)(1)(C)(ii), or a substantially similar 
report to another trade reporting system; and
    (4) Members must have written policies and procedures to assure 
that riskless principal transactions relied upon for this exclusion 
comply with applicable NASD rules. 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 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 to reconstruct accurately, readily, and in a time-
sequenced manner all orders on which a member relies in claiming this 
exception.
    (g) Nothing in this rule changes the application of Rule 2320 with 
respect to a member's obligations to customer orders.
* * * * *

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
    Background. NASD Interpretive Material 2110-2, Trading Ahead of 
Customer Limit Order (commonly referred to as the ``Manning Rule'') 
generally prohibits members from trading for their own account at 
prices that would satisfy a customer's limit order, unless the member 
immediately thereafter executes the customer limit order.\5\ The legal 
underpinnings for the Manning Rule 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.'' \6\
---------------------------------------------------------------------------

    \5\ For example, if the 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.
    \6\ See NASD Rule 2110.
---------------------------------------------------------------------------

    NASD believes that the same principles on which the Manning Rule is 
based should apply to the treatment of customer market orders. As such, 
on March 12, 2004, NASD filed the instant proposed rule change, 
proposing amendments to require market order protection. The proposed 
rule change sought to adopt new NASD Rule 2111 that would prohibit a 
member from trading ahead of a customer market order under the 
circumstances described therein. NASD proposed certain changes to 
proposed NASD Rule 2111 with Amendment No. 1.
    Proposal. NASD is proposing that a member be prohibited from 
trading for

[[Page 9410]]

its proprietary account on the same side of the market as a customer 
market order, if that customer market order has not been executed fully 
and promptly. Specifically, the proposed rule change would prohibit a 
member from trading for its own account on the same side of the market 
as a customer market order in a Nasdaq or exchange-listed security \7\ 
if the member accepts and holds a customer market order in that 
security without immediately executing the order, unless such member 
immediately thereafter executes the customer market order up to the 
size and at the same price at which it traded for its own account or a 
better price.\8\ Similar to the application of the Manning Rule, 
customer market orders would include orders received from the member's 
own customers or customer orders of another broker-dealer. In addition, 
if a member is holding a customer market order that has not been 
immediately executed, such member would be required to make every 
effort to match the pending market order against any market orders, 
marketable limit orders or non-marketable limit orders priced better 
than the best bid or offer received by the member on the other side of 
the market up to the size of the pending market order and at a price 
that is no less than the best bid and no greater than the best offer at 
the time such subsequent market order, marketable limit order or non-
marketable limit order is received by such member and is consistent 
with the terms of the pending order.
---------------------------------------------------------------------------

    \7\ NASD Rule 6440(f)(1) currently prohibits a member from 
personally buying (selling) an exchange-listed security for its own 
account while such member holds an unexecuted market order to buy 
(sell) such security for a customer. The proposed rule change would 
prohibit a broad range of conduct, including conduct prohibited by 
NASD Rule 6440(f)(1) and therefore, NASD staff will recommend to 
Nasdaq that it consider deleting NASD Rule 6440(f)(1), in light of 
the proposal described herein.
    \8\ The agency obligation of a broker-dealer with respect to a 
customer order is defined by the customer's expectation of the 
treatment of the order. A customer's market order generally 
represents the expectation that the order will be executed fully and 
promptly at the current best bid, for a sell order, or best offer, 
for a buy order, regardless of the impact on market price. In 
attempting to meet this expectation, there is some reasonable period 
of time in which market orders may queue while the broker-dealer is 
executing orders ahead on both sides of the market. This proposed 
rule change represents NASD's view that, when that reasonable time 
period has expired, the member shall not be permitted to trade that 
security for its own account on the same side of the market as its 
customer market order without giving the customer market order an 
execution at that same price or better.
---------------------------------------------------------------------------

    In the event that a member is holding multiple orders on both sides 
of the market that have not been executed, the member must make every 
effort to cross or otherwise execute such orders in a manner that is 
reasonable and is consistent with the objectives of the proposed rule 
change and with the terms of the orders. The member also must have a 
written methodology in place governing the execution priority of all 
such pending orders and must ensure that such methodology is 
consistently applied.
    For example, assume the inside market for security ABCD is 10 to 
10.05 and Firm A receives a market order to buy 1,000 shares of ABCD 
from Customer C1, which Firm A has not immediately executed. If Firm A 
buys 1,000 shares of ABCD at 10 from Firm B (or from any other source), 
Firm A would be required to sell 1,000 shares of ABCD to C1 at 10 or 
better. Similarly, if Firm A bought shares for its own account below 
the best bid of 10, it would be required to sell stock to C1 at that 
same price below the bid or better.
    If a member does not execute an order fully and promptly, but has 
not bought or sold securities for its own account on the same side of 
the market as the customer order or has not received a market order, 
marketable limit order or non-marketable limit order priced better than 
the best bid or offer from another customer on the contra-side of the 
market, the proposed rule change would not impose any specific 
obligations on the member above and beyond the member's current 
obligations to market orders, such as a member's best execution 
requirements under NASD Rule 2320.\9\
---------------------------------------------------------------------------

    \9\ See NASD Rule 2320(a) (the ``Best Execution Rule''). NASD 
has proposed changes to the Best Execution Rule in SR-NASD-2004-026 
(February 12, 2004), See footnote 4, supra.
---------------------------------------------------------------------------

    The proposed rule change also would incorporate several of the same 
types of exclusions that apply to the Manning Rule. First, the proposed 
rule change would permit members to negotiate specific terms and 
conditions applicable to the acceptance of a market order with respect 
to a market order for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in NASD Rule 
3110(c)(4) or a market order that is for 10,000 shares or more, unless 
such order is less than $100,000 in value.
    Second, the proposal would provide an exception for member 
proprietary trades that are part of an execution, on a riskless 
principal basis, of another order from a customer (whether its own 
customer or the customer of another member) (the ``facilitated 
order''). This exclusion would apply only if the following requirements 
are met: (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; (2) the member 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), 
4652(d)(3)(B)(ii), 6420(d)(3)(B)(ii) or 4632A(e)(1)(C)(ii), or a 
substantially similar report; and (4) members must have written 
policies and procedures to assure that riskless principal transactions 
relied upon for this exclusion comply with applicable NASD rules.\10\
---------------------------------------------------------------------------

    \10\ With respect to requirement (4), the member's policies and 
procedures, at a minimum, 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 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 to reconstruct 
accurately, readily, and in a time-sequenced manner, all orders on 
which a member relies in claiming this exemption.
---------------------------------------------------------------------------

    For example, assume that the inside market for security ABCD is 10 
to 10.05 and Firm A receives a market order to buy 1,000 shares of ABCD 
from Customer C1 and immediately thereafter, receives a market order to 
buy 500 shares of ABCD from Customer C2. Firm A has not immediately 
executed the orders from C1 and C2. If Firm A purchases 1,000 shares at 
10 to fill C1's order on a riskless principal basis and otherwise meets 
the requirements of the riskless principal exception to the proposed 
rule change, the riskless principal trade would not trigger an 
execution of C2's order under the proposed rule change. Under the same 
facts noted above, alternatively if Firm A were to execute C2's order 
for 500 shares on a riskless principal basis prior to executing C1's 
order, the riskless principal trade would not trigger the execution (or 
partial execution) of C1's order.\11\
---------------------------------------------------------------------------

    \11\ Except as specifically provided in the proposed rule 
change, NASD has not mandated any particular order handling and 
execution priority procedures among market orders. Thus, a member 
may choose any reasonable methodology for the way in which it 
executes multiple orders that it holds, but the member must ensure 
that such methodology is applied consistently. For example, a member 
could use a first in first out (FIFO) methodology or some other 
objective methodology or formula. It would be inappropriate, 
however, for a member's methodology to give priority, for example, 
to orders of certain ``preferred accounts'' or preference 
institutional orders over retail orders. To the extent a member 
elects a specific methodology, the member must document that 
methodology and have written supervisory procedures and systems in 
place to ensure that the methodology it has chosen is consistent 
with the duty of best execution. Further, simply because a member 
employs a methodology for execution of orders and that methodology 
is followed in a particular circumstance does not automatically mean 
that any or all customer orders executed pursuant to such a 
methodology have received best execution under NASD Rule 2320.

---------------------------------------------------------------------------

[[Page 9411]]

    The proposed rule change also applies to limit orders that are 
marketable at the time they are received by the member or that become 
marketable at a later time. Such limit orders would be treated as 
market orders for purposes of the proposed rule change; however, these 
orders must continue to be executed at their limit price or better. If 
a customer limit order is not marketable when received, the limit order 
must be provided the full protections of IM-2110-2 for Nasdaq 
securities of NASDRule 6440(f)(2) for exchange-listed securities. In 
addition, if the limit order was marketable when received and then 
becomes non-marketable, once the limit order becomes non-marketable, it 
must be provided the full protections of IM-2110-2 or NASD Rule 
6440(f)(2).
    The proposed rule change applies to NASD members irrespective of 
upon which market they trade. If a member were to execute a proprietary 
trade on an exchange while holding a customer market order on the same 
side of the market that the member has not fully and promptly executed, 
then the member would be deemed to have violated the proposed rule 
change unless (1) the member immediately provides an execution to that 
market order at a price equal to or better than the proprietary trade; 
or (2) the member's proprietary trade was in accordance with a 
functional role, recognized within the rules of that exchange, of 
acting as a liquidity provider, such as acting in the role of a 
specialist or some other substantially similar capacity.
    NASD is emphasizing that nothing in the proposed rule change 
modifies the application of NASD Rule 2320 with respect to a member's 
obligations to customer orders. For example, to the extent a member 
does not execute a market order fully and promptly, compliance with the 
proposed rule change would not safeguard the member from potential 
liability due to non-compliance with its best execution 
responsibilities.
    Finally, in recognition that the proposed rule change may alter the 
way that many members handle customer orders, NASD believes it is 
important to provide members with adequate time to develop and 
implement systems to comply with the proposed rule change. Therefore, 
should the Commission approve the proposed rule change NASD is 
proposing an implementation date of 90 days after the issuance of a 
Notice to Members announcing SEC approval of the proposed rule change.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A of the Act,\12\ in general, and with Section 
15A(b)(6) of the Act,\13\ in particular, which requires that NASD rules 
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 will improve the treatment of market orders and 
enhance the integrity of the market.
---------------------------------------------------------------------------

    \12\ 15 U.S.C. 78o-3.
    \13\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

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, as amended.

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

    Written comments were neither solicited or 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-2004-045 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-2004-045. 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 Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of the 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-2004-045 and should be submitted on or before March 
18, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
---------------------------------------------------------------------------

    \14\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
 [FR Doc. E5-773 Filed 2-24-05; 8:45 am]
BILLING CODE 8010-01-P