[Federal Register Volume 70, Number 65 (Wednesday, April 6, 2005)]
[Notices]
[Pages 17489-17491]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-1554]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51457; File No. SR-NASD-2004-135]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Disclosure and Consent Requirements When Trading on a Net Basis With 
Customers

March 31, 2005.
    Pursuant to section 19(b)(1) \1\ of the Securities Exchange Act of 
1934 (``Act'' \2\ and Rule 19b-4 thereunder,\3\ notice is hereby given 
that on September 1, 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 filed Amendment No. 1 to the 
proposed rule change.\4\ On February 25, 2005, NASD filed Amendment No. 
2 to the proposed rule change.\5\ On March 21, 2005, NASD filed 
Amendment No. 3 to the proposed rule change.\6\ 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\ 15 U.S.C. 78a et seq.
    \3\ 17 CFR 240.19b-4.
    \4\ In Amendment No. 1, among other things, NASD deleted each 
instance of the words ``or similar'' in the phrase ``on a `net' or 
similar basis'' in proposed new Rule 2441.
    \5\ In Amendment No. 2, NASD removed underlining that 
inadvertently had been applied to paragraph (e) of proposed new Rule 
2441 as it appeared in Exhibit 4 to Amendment No. 1.
    \6\ In Amendment No. 3, among other things, NASD modified 
proposed new Rule 2441 by substituting ``adviser'' for ``advisor'' 
in paragraph (b) and substituting ``customer whose account 
qualifies'' for ``customer that qualifies'' in paragraph (d).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is filing a proposed rule to require disclosure and consent 
when trading on a net basis with customers. Proposed new language is in 
italics.
* * * * *

2441. Net Transactions With Customers

    (a) Prior to executing a transaction with a customer on a ``net'' 
basis as defined in paragraph (d) below, a member must provide 
disclosure to and obtain consent from the customer as provided in this 
Rule.

[[Page 17490]]

    (b) With respect to non-institutional customers, the member must 
obtain the customer's written consent on an order-by-order basis prior 
to executing a transaction for or with the customer on a ``net'' basis 
and such consent must evidence the customer's understanding of the 
terms and conditions of the order. For those non-institutional 
customers that have granted trading discretion to a fiduciary (e.g. an 
investment adviser), a member is permitted to obtain such consent from 
the fiduciary.
    (c) With respect to institutional customers, a member may obtain 
customer consent through the use of a negative consent letter prior to 
executing a transaction for or with the customer on a ``net'' basis. If 
evidencing the consent of an institutional customer through the use of 
a negative consent letter, before obtaining such consent, a member must 
clearly disclose to the institutional customer in writing the terms and 
conditions for handling the customer order(s) and provide the 
institutional customer with a meaningful opportunity to object to the 
execution of transactions on a net basis. If no objection from the 
customer is received, then the member may reasonably conclude that the 
institutional customer has consented to the member trading on a ``net'' 
basis with the customer and the member may rely on such letter for all 
of the customer's orders (unless instructed otherwise) pursuant to this 
Rule.
    (d) For purposes of this Rule, (1) ``institutional customer'' shall 
mean a customer whose account qualifies as an ``institutional account'' 
under Rule 3110(c)(4); and (2) ``net'' transaction shall mean a 
principal transaction in which a market maker, after having received an 
order to buy (sell) an equity security, purchases (sells) the equity 
security at one price (from (to) another broker-dealer or another 
customer) and then sells to (buys from) the customer at a different 
price.
    (e) Members must retain and preserve all documentation relating to 
consent obtained pursuant to this Rule in accordance with Rule 3110(a).
* * * * *

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
    A riskless principal transaction is a transaction in which a 
member, after having received a customer order executes an offsetting 
transaction, as principal, with another customer or broker-dealer to 
fill that customer order and both transactions are executed at the same 
price. NASD announced amendments to the trade reporting rules that 
required qualifying riskless principal transactions of market makers to 
be the subject of a single trade report.\7\ Prior to these amendments, 
both legs of a riskless principal transaction were reported. The 
amendments stipulated that a riskless principal transaction qualified 
for a single trade report where each side of the trade was executed at 
the same price, exclusive of any mark-up, mark-down, commission 
equivalent or other fee. The trade reporting amendments in connection 
with riskless principal transactions were important for several reasons 
including the accuracy of the order audit trail and the transactional 
integrity of the volume of last sales reported to the consolidated 
tape.
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    \7\ See Notice to Members 99-65 (August 1999).
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    In view of the purpose and importance of these amendments, NASD 
also addressed the treatment of net trading.\8\ Net trading is 
generally defined as a principal transaction in which a market maker, 
after having received an order to buy (sell) an equity security, 
purchases (sells) the equity security at one price (from (to) another 
broker-dealer or another customer) and then sells to (buys from) the 
customer at a different price. The difference between the execution 
price given to the customer in a net transaction and the price of the 
offsetting transaction to the contra-side (other customer or broker-
dealer) is in effect the market maker's compensation.\9\ In sum, net 
trading is the transactional equivalent of a riskless principal 
transaction with the exception that the prices reported on both sides 
of the transactions are not the same. Consequently, each side of a net 
transaction is trade reported at its respective price.
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    \8\ Id. See also Notice to Members 01-85 (December 2001) 
(Question & Answer No. 4).
    \9\ Exchange Act Rule 10b-10(a)(2)(ii)(B) does not require such 
compensation to be separately disclosed on the customer confirmation 
by market makers.
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    In view of the regulatory interest in fostering a single trade 
report for riskless principal transactions, NASD announced that a 
member ``working an order'' (that is, finding an offsetting execution 
or series of executions for a customer order that the member holds) for 
an institutional account or in connection with a block-size order, 
would be presumed to be handling the worked order on a qualifying 
riskless principal basis with the order matched off on each side at the 
same price (exclusive of any mark-up or mark-down, commission 
equivalent or other fee) unless the customer has specifically requested 
that the order be traded on a net basis, at a different price.\10\ 
Accordingly, NASD and Nasdaq recognized that there are times when a 
market maker will trade on a net basis with an institution and that 
such market maker is not precluded from accumulating a position at one 
price and executing the offsetting trade with the customer at another 
price, provided that the customer has requested that the order be 
traded on a net basis and such arrangement satisfies the member's best 
execution obligation and is consistent with SEC and NASD statements 
regarding the matching of limit and market orders.
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    \10\ Id.
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    In response to this guidance provided by NASD and Nasdaq, members 
were concerned that the presumption to trade at the same price did not 
reflect the fact that institutional customers have historically 
expected firms to trade with them on a net basis. Members also were 
concerned that such a presumption would place them in the difficult 
position of having to rebut it on nearly every institutional trade. 
Members requested guidance on how to document this understanding, and 
asked for permission to use ``negative consent'' letters, citing 
logistical difficulties with obtaining affirmative consent from 
customers. In response, Nasdaq, after consultation with both the SEC 
and NASD regulatory staff, stated that members may use negative consent 
letters to evidence a customer's request to trade on a net basis, as 
long as the letter met specified conditions, including that the letter 
clearly disclosed the terms and conditions for handling the order and 
the customer was provided a meaningful opportunity to object to the 
letter.\11\
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    \11\ See SEC Release No. 34-43103 (August 1, 2000); 65 FR 48774 
(August 9, 2000). See also Notice to Members 00-79 (November 2000).

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[[Page 17491]]

    Because it has been the NASD staff's understanding that net trading 
typically only occurs at the request of institutional customers, NASD 
has not addressed specifically in prior Notices to Members a member's 
obligations when trading on a net basis with respect to non-
institutional customers. However, given that there is a presumption 
that a member cannot trade on a net basis with a customer unless the 
customer has specifically requested it, NASD staff has taken the 
position that members may only trade with non-institutional customers 
on a net basis after obtaining their informed consent on an order-by-
order basis.
    To clarify and codify the NASD staff's positions, both with respect 
to institutional and non-institutional customers, the proposed rule 
change would require a member to obtain consent from a customer prior 
to executing a transaction with a customer on a ``net'' basis. Members 
would be required to retain and preserve all documentation relating to 
the consent obtained pursuant to the proposed rule in accordance with 
Rule 3110(a).
    With respect to non-institutional customers,\12\ the member must 
obtain the customer's written consent on an order-by-order basis prior 
to executing a transaction for or with the customer on a ``net'' basis 
and such consent must evidence the customer's understanding of the 
terms and conditions of the order. For those non-institutional 
customers that have granted trading discretion to a fiduciary, such as 
an investment adviser, a member would be permitted to obtain such 
consent from the fiduciary.
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    \12\ For purposes of the proposed rule, ``institutional 
customer'' shall mean a customer whose account qualifies as an 
``institutional account'' under Rule 3110(c)(4). A non-institutional 
customer, therefore, would be a customer whose account does not 
qualify as an institutional account under Rule 3110(c)(4).
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    With respect to institutional customers, a member also must obtain 
consent, but it may be evidenced through the use of a negative consent 
letter. If using a negative consent letter, the member must clearly 
disclose to the institutional customer in the letter the terms and 
conditions for handling the customer order(s) and provide the 
institutional customer with a meaningful opportunity to object to the 
execution of transactions on a net basis in the letter. If no objection 
is received, then the member may reasonably conclude that the 
institutional customer has consented to the terms and conditions in the 
letter and requested that the member trade on a net basis and the 
member may rely on such letter for all of the customer's orders (unless 
instructed otherwise).
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act, 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 will promote 
investor protection by codifying the requirement that members provide 
disclosure and obtain customer consent when trading on a net basis.

(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 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 No. SR-NASD-2004-135 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 No. SR-NASD-2004-135. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review comments more efficiently, 
please use only one method. 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 will also 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 No. SR-NASD-2004-135 and should be submitted on or before April 
27, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-1554 Filed 4-5-05; 8:45 am]
BILLING CODE 8010-01-P