[Federal Register Volume 71, Number 59 (Tuesday, March 28, 2006)]
[Notices]
[Pages 15503-15506]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-4434]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53527; File No. SR-NASD-2006-035]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change Relating to 
Proposed Amendments to IM-2110-2 to Codify NASD's Existing Position 
that the Manning Rule Applies to All Members, Whether Acting as a 
Market Maker or Not

March 21, 2006.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on March 6, 2006, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by NASD. 
NASD has asked the Commission to grant accelerated approval to the 
proposed rule change. The Commission is not granting accelerated 
approval to the proposed rule change at this time, but is considering 
doing so at the close of a 15-day comment period. 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\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD proposes to amend NASD Interpretive Material (``IM'') 2110-2, 
Trading Ahead of Customer Limit Order (commonly referred to as the 
``Manning Rule''), to codify NASD's existing position that the Manning 
Rule applies to all members, whether acting as a market maker or not. 
The text of the proposed rule change is below. Proposed new language is 
in italics; proposed deletions are in brackets.
IM-2110-2. Trading Ahead of Customer Limit Order
(a) General Application
    To continue to ensure investor protection and enhance market 
quality, NASD's Board of Governors is issuing an interpretation to NASD 
Rules dealing with member firms' treatment of their customer limit 
orders in Nasdaq and exchange-listed securities. This interpretation, 
which is applicable from 9:30 a.m. 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 members[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. In the interests of investor protection, NASD 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\
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    \1\ 15 U.S.C. 78s(b)(1).
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    Rule 2110 states that:
    A member, in the conduct of his business, shall observe high 
standards

[[Page 15504]]

of commercial honor and just and equitable principles of trade.
    Rule 2320, the Best Execution Rule, states that:
    In any transaction for or with a customer, a member and persons 
associated with a member shall use reasonable diligence to ascertain 
the best inter-dealer market for the subject security and buy or sell 
in such a market so that the resultant price to the customer is as 
favorable as possible to the customer under prevailing market 
conditions.
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 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 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 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.
    As outlined in NASD Notice to Members 97-57, the minimum amount of 
price improvement necessary in order for a member[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 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 member[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 member[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 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 
emphasizes that order entry firms should continue to [routinely] 
monitor routinely the handling of their customers' limit orders 
regarding the quality of the execution received.
(b) Exclusion for Limit Orders that are Marketable at Time of Receipt
    NASD[The Association] has previously recognized the functional 
equivalency of marketable limit orders and market orders. Accordingly, 
it has adopted the following interpretation. IM-2110-2 shall not apply 
to a customer limit order if the limit order is marketable at the time 
it is received by a member[market maker]. These orders shall be treated 
as market orders for purposes of determining execution priority; 
however, these orders must continue to be executed at their limit price 
or better.
    The exclusion for marketable customer limit orders from the general 
application of IM-2110-2 is limited solely to customer limit orders 
that are marketable when received by a member[market maker]. If a 
customer limit order is not marketable when received by a member[market 
maker], the limit order must be accorded the full protections of IM-
2110-2. 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 accorded the full protections of IM-2110-2.
    The following scenario illustrates the application of the 
exclusion. The market in XYZ stock is 25 bid--25\1/16\ ask, the volume 
of trading in XYZ stock is extremely active, and Market Maker A 
(``MMA'') has a queue of market orders to buy and sell. Assume the 
following order receipt scenario. Each sell market order in the queue 
is for 1,000 shares and there are no special conditions attached to the 
orders. MMA then receives a customer limit order to sell 1,000 shares 
at 25. The customer limit order is marketable at the time it is 
received by MMA. MMA hits another market maker's bid at 25 for 1,000 
shares. Normally, IM-2110-2 would require that the customer limit order 
be executed before the market orders in the queue. However, because the 
marketable limit order and the market orders should be treated as 
functionally equivalent in determining execution priority, the 
marketable customer limit order shall not be given execution priority 
over the market orders that were already in the queue. When the limit 
order is executed, however, it must be executed at the limit price or 
better.
    In addition, if in the scenario just described the limit order does 
not get executed and the inside market in XYZ becomes 24\7/16\ bid, the 
member[market maker] would have to protect the limit order as required 
by IM 2110-2 if the

[[Page 15505]]

member[market maker] trades at the limit order price or better.
(c) Exemption for the Facilitation on a Riskless Principal Basis of 
Other Customer Orders
    A member shall be exempt from the obligation to execute a customer 
limit order in a manner consistent with this interpretation if such 
member engages in trading activity to facilitate the execution, on a 
riskless principal basis, of another order from its customer (whether 
its own customer or the customer of another member) (the ``facilitated 
order''), provided that all of the following requirements are 
satisfied:
    (1) through (3) No change.
    (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 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 [Regulation] to accurately and 
readily reconstruct, in a time-sequenced manner, all orders on which a 
member relies in claiming this exemption.

     1 No change to text of footnote 1.
* * * * *

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. 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
    The Manning Rule generally prohibits a member from trading for its 
own account in a Nasdaq or exchange-listed security at a price that is 
equal or better than an unexecuted 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.\3\ 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.'' \4\
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    \3\ 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.
    \4\ See NASD Rule 2110. See also NASD Rule 2320(a) (the ``Best 
Execution Rule''). Note: NASD has proposed changes to the Best 
Execution Rule in SR-NASD-2004-026, which is currently pending at 
the SEC.
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    The Manning Rule 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. Currently, IM-2110-2 generally 
provides that members acting as a market makers are prohibited from 
trading for their own accounts at prices equal or superior to an 
unexecuted customer's limit order in that security without executing 
the customer limit order. Further, if the member acting as a market 
maker trades ahead of a customer limit order and receives a better 
price than the unexecuted customer limit order, the member acting as a 
market maker must fill the customer limit order at the price at which 
it traded for its own account or better. While the text of the Manning 
Rule is written specifically to cover trading by market makers in their 
market-making capacity, NASD's longstanding position has been that the 
Manning Rule applies to all members (whether they are trading in a 
market making capacity or not) based on a member's best execution 
obligations.
    For example, in Notices to Members 94-58 (July 15, 1994) and 95-43 
(June 5, 1995), NASD provided guidance to member firms on the 
application of the Manning Rule to members not acting in a market 
making capacity. In the context of questions about whether a non-market 
maker holding a customer order can trade ahead of that limit order, 
NASD staff stated that it would be inconsistent with a member's best 
execution obligation for members to trade ahead of a customer's limit 
order even when not acting as a market maker.
    In addition, the Manning Rule specifically states 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 
and emphasizes that order entry firms should continue to monitor 
routinely the handling of their customers' limit orders regarding the 
quality of the execution received.
    Accordingly, NASD is proposing to amend the Manning Rule to codify 
NASD's existing position and to state explicitly that all members are 
prohibited from trading for their own accounts at prices that would 
satisfy a customer's limit order, whether acting as a market maker or 
not. NASD believes that the proposed amendments will provide better 
clarity to members as to the application of the Manning Rule to trading 
by non-market makers.\5\
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    \5\ It is important to note that the proposed clarification does 
not change the application of the Manning Rule to multiple trading 
desks within a member firm as described in Notice to Members 95-43 
(June 5, 1995) and Notice to Members 03-74 (November 26, 2003).
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    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 references to 
``Association'' and ``NASD Regulation'' in the text of the proposed 
rule change with ``NASD.''
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 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 will 
improve treatment of customer limit orders and clarify the application 
of the Manning Rule to non-market makers.

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.

[[Page 15506]]

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 NASD 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 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-2006-035 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-NASD-2006-035. 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 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-2006-035 and should be submitted on or before April 12, 2006.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E6-4434 Filed 3-27-06; 8:45 am]
BILLING CODE 8010-01-P