[Federal Register Volume 70, Number 37 (Friday, February 25, 2005)]
[Notices]
[Pages 9416-9419]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-776]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51229; File No. SR-NASD-2004-026]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment 
Nos. 1 and 2 Thereto To Amend NASD Rule 2320(a) Governing Best 
Execution

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 February 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 
May 11, 2004, NASD amended the proposed rule change.\3\ On February 14, 
2005, NASD amended the proposed rule change a second time.\4\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Amendment No. 1 to SR-NASD-2004-026 filed on May 11, 
2004. See infra discussion accompanying notes 6-7.
    \4\ See Amendment No. 2 to SR-NASD-2004-026 filed on February 
14, 2005. See infra discussion accompanying note 7.
    \5\ NASD notes that related to amending NASD Rule 2320(a) it has 
also filed SR-NASD-2004-045, a proposed rule change that would 
require market order protection by prohibiting members from trading 
ahead of a customer market order. See Securities Exchange Act 
Release No. 51230 (February 18, 2005) (SR-NASD-2004-045). NASD has 
also filed SR-NASD-2004-089, a proposed rule change that would 
require limit order protection by requiring members to provide price 
improvement under certain circumstances. See Securities Exchange Act 
Release No. 51231 (February 18, 2005)(SR-NASD-2004-089).
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I. Self-Regulatory Organization's Statement of the Terms of the 
Substance of the Proposed Rule Change

    NASD is proposing to amend Rule 2320(a) (``Best Execution Rule''). 
Below is the text of the proposed rule change. Proposed new language is 
in italics; proposed deletions are in brackets.
2300. TRANSACTIONS WITH CUSTOMERS
2320. Best Execution and Interpositioning
    (a) In any transaction for or with a customer or a customer of 
another broker-dealer, a member and persons associated with a member 
shall use reasonable diligence to ascertain the best [inter-dealer] 
market center for the subject security and buy or sell in such market 
center so that the resultant price to the customer is as favorable as 
possible under prevailing market conditions. Among the factors that 
will be considered in determining whether a member has used 
``reasonable diligence'' are:
    (1) [T]the character of the market for the security, e.g., price, 
volatility, relative liquidity, and pressure on available 
communications;
    (2) the size and type of transaction;
    (3) the number of [primary] market[s] centers checked;
    (4) accessibility of the quotation [location and accessibility to 
the customer's broker/dealer of primary markets and quotations 
sources.]; and
    (5) the terms and conditions of the order which result in the 
transaction, as communicated to the member and persons associated with 
the member.
    (b) through (g) 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
    Background. The Best Execution Rule currently requires a member, in 
any transaction for or with a customer, to use reasonable diligence to 
ascertain the best inter-dealer market for a security and to buy or 
sell in such a market so that the price to the customer is as favorable 
as possible under the prevailing market conditions. NASD has received a 
number of questions regarding the application of the term ``customer,'' 
in the context of best execution. NASD Rule 0120(g) defines 
``customer'' to exclude a broker or dealer, unless the context 
otherwise requires. For example, if a firm that receives an order from 
a customer (``originating broker-dealer'') routes the order to a member 
firm (``recipient member'') and the recipient member executes the order 
in a manner inconsistent with the Best Execution Rule, the recipient 
member could argue that it has not violated the Best Execution Rule 
because the transaction was not ``for or with a customer,'' but rather 
for or with a broker-dealer.
    NASD believes that not applying the Best Execution Rule to 
recipient members is contrary to the interests of the investing public 
as well as the general intent of the Best Execution Rule. To determine 
whether the scope of the Best Execution Rule requires further 
clarification to include customer orders received by a member from 
another broker-dealer, NASD issued Notice to Members 02-40 in July 2002 
seeking comment on this issue. NASD received eleven comment letters in 
response to NASD Notice to Members 02-40.\6\ The

[[Page 9417]]

majority of the commenters asserted that the Best Execution Rule should 
be amended to clarify the scope of the duty with respect to customer 
orders received from another broker-dealer.
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    \6\ See letter from Dan Jamieson dated July 18, 2002; letter 
from Seidel & Shaw, LLC dated July 29, 2002; letter from 
Consolidated Financial Investments, Inc. dated Aug. 1, 2002; letter 
from the Law Offices of Steve A. Buchwalter, P.C. dated Aug. 6, 
2002; letter from A.G. Edwards & Sons, Inc. dated Aug. 8, 2002; 
letter from Raymond James & Associates, Inc. dated Aug. 8, 2002; 
letter from T. Rowe Price Investment Services, Inc. dated Aug. 8, 
2002; letter from Security Traders Association dated Aug. 22, 2002; 
letter from The Island ECN, Inc. dated Aug. 22, 2002; letter from 
the Trading Committee and the Self-Regulation and Supervisory 
Practices Committee of the Securities Industry Association dated 
Sept. 9, 2002; and letter from the Subcommittee on Market Regulation 
of the Committee on Federal Regulation of Securities, Section of 
Business Law of the American Bar Association dated Oct. 2, 2002.
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    On February 11, 2004, NASD filed the instant proposed rule change, 
proposing that a recipient member provide best execution to customer 
orders routed to it when there was either a written agreement between 
the originating broker-dealer and the recipient member or written 
representations from the recipient member that it would provide best 
execution to the originating broker-dealer's customer orders. The 
proposal also sought to clarify that the recipient member was not 
required to enter into any such written agreements with the originating 
broker-dealer, and that the originating broker-dealer (to the extent it 
is was a member) would remain obligated to comply with the Best 
Execution Rule, irrespective of whether such an agreement existed.
    On May 11, 2004, NASD filed Amendment No. 1 to SR-NASD-2004-026. 
Amendment No. 1 continued to require that a recipient member provide 
best execution to customer orders routed to it when there was either a 
written agreement between the originating broker-dealer and the 
recipient member or written representations from the recipient member 
that it would provide best execution to the originating broker-dealer's 
customer orders. In addition, Amendment No. 1 added a new reasonable 
diligence factor to the text of the Best Execution Rule that required 
consideration of the existence of a written agreement or written 
representations when a customer order is routed to another broker-
dealer. Also, the amendment modified the text of new proposed paragraph 
(a)(2) of the Best Execution Rule. Lastly, the amendment provided 
proposed interpretive guidance concerning Rule 2320, as amended.
    Proposal. With Amendment No. 2, NASD proposes to amend the Best 
Execution Rule to require that a recipient member provide best 
execution to all transactions for or with a customer of another broker-
dealer. Specifically, NASD is proposing to amend the Best Execution 
Rule to state that the rule governs ``any transaction for or with a 
customer or a customer of another broker-dealer.'' NASD believes this 
proposed rule change will better ensure customer orders receive the 
equivalent best execution protections. This will occur without regard 
to whether a customer order is executed by the originating broker-
dealer or routed to another broker-dealer.\7\ Moreover, best execution 
protection will apply whether the originating or recipient member 
executes the order as principal or routes it as agent to another market 
center. The recipient firm's duty under the rule is owed only to orders 
accepted by the recipient firm. The proposed rule change should enhance 
NASD's regulatory program and create a more uniform and consistent 
standard of best execution than currently exists.\8\
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    \7\ NASD believes that this approach is preferable to that 
specified in the original rule proposal and Amendment No. 1 because 
customer orders will receive best execution protections without 
regard to whether there is a written agreement or written 
representations from a recipient member.
    \8\ NASD notes that by extending the scope of the Best Execution 
Rule to customer orders of another broker-dealer, the proposed rule 
change does not alter the obligation of an originating broker-dealer 
member to examine regularly and rigorously execution quality likely 
to be obtained from different market centers trading a security. See 
Notice to Members 01-22 (April 2001), which reiterates the best 
execution obligations that apply to member firms when they receive, 
handle, route for execution, or execute customer orders, and that 
also provides guidance to members concerning a broker-dealer's 
obligation, as articulated on numerous occasions by the SEC, to 
examine regularly and rigorously execution quality likely to be 
obtained from the different markets or market makers trading a 
security.
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    Furthermore, NASD proposes amending the Best Execution Rule to 
modernize the text of the rule. The Best Execution Rule currently 
requires a member to ascertain the best ``inter-dealer'' market for a 
security and to buy or sell in such a market so that the price to the 
customer is as favorable as possible under the prevailing market 
conditions. As a result of changes in market structure, NASD is 
proposing to delete the term ``inter-dealer'' from NASD Rule 2320(a). 
This modification will clarify that member requirements to ascertain 
the best market for a security are not limited to ``inter-dealer'' 
markets, but may include all ``market centers'' in which a security is 
traded. NASD also proposes amending the reasonable diligence factors to 
reflect current market structure and to delete terms that are outdated. 
Specifically, NASD is recommending that the reference to the ``number 
of primary markets checked'' be updated to instead refer to ``the 
number of market centers checked'' and that the reference to the 
``location and accessibility to the customer's broker-dealer of primary 
markets and quotation sources'' be updated to emphasize the importance 
of ``accessibility of the quotation.'' Lastly, NASD proposes adding a 
new factor that examines the ``terms and conditions of the order'' in 
determining whether a member has used due diligence. This will allow 
NASD staff to consider the communication of a customer's instructions 
to assess whether a member and persons associated with a member have 
used ``reasonable diligence.''
    Should the Commission approve the proposed rule change, 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 Commission 
approval. Also in this Notice to Members, NASD will issue interpretive 
guidance consistent with the interpretive positions specified in this 
rule filing. The implementation date of the proposed changes will be 30 
days following publication of the Notice to Members announcing 
Commission approval.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A of the Act,\9\ in general, and with Section 
15A(b)(6) of the Act,\10\ 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. The obligation of a member 
firm to provide best execution to its customers has long been an 
important investor protection rule, characteristic of fair and orderly 
markets and a central focus of NASD's examination, customer complaint, 
and automated surveillance programs. NASD believes that the proposed 
rule change will expand customer protection under the Best Execution 
Rule, provide better clarity to members, and enhance NASD's ability to 
pursue actions for failure to provide best execution.
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    \9\ 15 U.S.C. 78o-3.
    \10\ 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, as amended.

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

    As discussed in the Section 2A above, NASD published Notice to 
Members 02-40 (July 2002) seeking comment on whether the scope of the 
duty of best execution should be clarified to include customer orders 
received by a member

[[Page 9418]]

from another broker-dealer. A copy of the Notice to Members 02-40 and 
copies of the comment letters received in response to the Notice to 
Members 02-40 are on file with the Commission.
    Specifically, NASD solicited comment on several approaches, 
including whether the scope of the duty of best execution should be: 
(1) Limited to customer orders where there is an agreement or 
arrangement between the two broker-dealers that the recipient broker-
dealer would comply with the duty of best execution; (2) limited to 
customer orders routed pursuant to an arrangement or an agreement noted 
in NASD Notice to Members 02-40 (i.e., where a broker-dealer agrees to 
provide automated executions to a routing broker-dealer's customer 
orders or there is another arrangement between the two broker-dealers 
such as a payment for order flow, reciprocal, or correspondent 
arrangement); (3) limited to customer orders routed pursuant to an 
arrangement or an agreement where the recipient broker-dealer assesses 
a fee or charge to execute the order; (4) defined more broadly to 
include all orders that are identified by the routing broker-dealer as 
customer orders; or (5) clarified or amended in some other fashion. 
NASD also solicited comment on whether the Best Execution Rule should 
distinguish, if at all, between customer orders received by a member 
from a foreign affiliate or foreign broker-dealer (as opposed to 
customer orders received by a member from a domestic affiliate or 
domestic broker-dealer that is subject to SEC, NASD, or other legal 
obligations concerning best execution).
    NASD received eleven comments in response to the Notice to Members 
02-40.\11\ Seven commenters asserted that the Best Execution Rule 
should be amended to clarify the scope of the duty with respect to 
customer orders received from another broker-dealer.\12\ Three of the 
seven commenters asserting that the Best Execution Rule should be 
amended, believed that all routed orders should be treated by the 
receiving member as customer orders and, therefore, provided best 
execution. Two commenters thought that the Best Execution Rule should 
be amended to provide best execution protections specified by the Rule 
to all orders that are identified by the originating broker-dealer as 
customer orders. Lastly, two commenters articulated that the receiving 
broker-dealer should only have a duty of best execution under NASD Rule 
2320 when the receiving broker-dealer has explicitly agreed to handle 
orders received from the originating broker-dealer as customer orders.
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    \11\ See footnote 6, supra.
    \12\ See letters from Dan Jamieson; Consolidated Financial 
Investments, Inc.; the Law Offices of Steve A. Buchwalter, P.C.; 
Raymond James & Associates, Inc.; T. Rowe Price Investment Services, 
Inc.; Security Traders Association; and The Island ECN, Inc.
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    Four commenters asserted that the Best Execution Rule should not be 
amended at all.\13\ In general, commenters that opposed amending the 
Best Execution Rule asserted that an amendment was unnecessary. Some of 
the reasons given for advocating for no change to the Best Execution 
Rule included assertions that a change could stifle competition, the 
costs associated with amending the Rule outweigh the benefits, and that 
such a proposal would raise concerns regarding customers' privacy 
interests. After considering the comments received in response to the 
Notice to Members 02-40, NASD proposed amending the Best Execution 
Rule. On February 11, 2004, NASD filed SR-NASD-2004-026. On May 11, 
2004, NASD filed Amendment No. 1 to SR-NASD-2004-026.
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    \13\ See letters from Seidel & Shaw, LLC; A.G. Edwards & Sons, 
Inc.; the Securities Industry Association, Trading Committee and 
Self-Regulation and Supervisory Practices Committee; and the 
American Bar Association, Section of Business Law, Subcommittee on 
Market Regulation of the Committee on Federal Regulation of 
Securities.
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    In a letter dated August 17, 2004, the Securities Industry 
Association (``SIA'') through its Ad Hoc Best Execution Committee 
(``SIA Committee'') submitted comments to NASD in response to NASD's 
filing of Amendment No. 1.\14\ In this letter, the SIA Committee 
asserted that the proposal pending at the SEC is unnecessary in light 
of the effective safeguards already in place as a result of interplay 
between the current regulatory framework imposed on originating broker-
dealers and competitive forces requiring recipient members to provide 
high-quality executions to orders routed to them. NASD staff did not 
agree with the SIA Committee's position that the current regulatory 
framework sufficiently addresses best execution obligations of 
recipient members. In addition, the SIA Committee urged NASD, to the 
extent that NASD is determined to amend the Best Execution Rule, to 
consider an alternative approach that would focus on extending the 
scope of the Rule to include transactions for or with a ``customer of 
another broker-dealer.'' NASD believes the SIA Committee's alternative 
approach is consistent with the approach NASD proposed in Amendment No. 
2.
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    \14\ Letter from Amal Aly and Ann Vlcek, on behalf of the Ad Hoc 
Best Execution Committee of the Securities Industry Association, to 
Barbara Z. Sweeney, NASD, dated Aug. 17, 2004.
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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-2004-026 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-2004-026. 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

[[Page 9419]]

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-2004-026 and should be submitted on or before March 18, 2005.

    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. E5-776 Filed 2-24-05; 8:45 am]
BILLING CODE 8010-01-P