Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices 27997

7 17 CFR 200.30–3(a)(12) (1994).

1On February 15, 1995, the NASD filed

Amendment No. 1 with the Commission on March

7, 1995 the NASD filed Amendment No. 2 with the

Commission. See infra notes 6–7 and accompanying

text.

2 15 U.S.C. 78s(b)(1).

3 17 CFR 240.19b–4.

4NASD Manual, Rules of Fair Practice, Art. III,

Sec. 1 (CCH) ¶ 2151.07.

5See Letter from James T. Halverson, Esq.,

Shearman & Sterling, on behalf of Herzog, Heine,

Geduld, Inc. (‘‘Herzog’’) to Jonathan G. Katz,

Secretary, SEC, dated January 12, 1995 (‘‘January

Herzog Letter’’); and Letter from James F. Duffy,

Executive Vice President and General Counsel,

Legal & Regulatory Policy, American Stock

Exchange (‘‘Amex’’) to Jonathan G. Klatz, Secretary

SEC, dated January 18, 1995 (‘‘Amex Letter’’).

6NASD Manual, Rules of Fair Practice, Art. III,

Sec. 21 (CCH) ¶ 2171.

7See Letter from James T. Halverson, Esq.,

Shearman & Sterling, on behalf of Herzog, to

Jonathan G. Katz, Secretary, SEC, dated March 27,

1995 (‘‘March Herzog Letter’’) (the January Herzog

Letter and the March Herzog Letter are referred to

collectively as ‘‘Herzog Letters’’).

8Securities Exchange Act Release No. 33697

(March 1, 1994), 59 FR 10842 (March 8, 1994).

The Commission first addressed the issue of

customer limit order protection in the Nasdaq

market in the co-called Manning decision in 1988.

In that decision, the Commission affirmed, based on

principles of agency law, an NASD determination

that it is inconsistent with just and equitable

principles of trade for a market maker to trade

ahead of a customer limit order unless the

customers is first informed of the firm’s limit order

policy. See In re E.F. Hutton & Co. (the so-called

‘‘Manning decision’’), Securities Exchange Act

Release No. 25887 (July 6, 1988), 41 SEC Doc. 473,

appeal filed sub nom Hutton & Co. Inc. v. SEC, Dec.

No. 88–1649 (D.C. Cir. Sept. 2, 1988), (Stipulation

of Dismissal Filed, Jan. 11, 1989).

9Securities Exchange Act Release No. 34279

(June 29, 1994), 59 FR 34883 (July 7, 1994)

(‘‘Release 34–34279’’).

10 Division of Market Regulation, SEC, Market

2000: An Examination of Current Equity Market

Developments (‘‘Market 2000 Study’’), V–8 (1994).

11 Id.

IV. Solicitation of Comments

Interested persons are invited to

submit written data, views, and

arguments concerning the foregoing.

Persons making written submission

should file six copies thereof with the

Secretary, Securities and Exchange

Commission, 450 Fifth Street, NW.,

Washington DC 20549. Copies of the

submissions, 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 5th Street, NW.,

Washington, DC 20549. Copies of such

filings will also be available for

inspection and copying at the principal

office of PSE. All submissions should

refer to file number SR–PSE–95–14 and

should be submitted by June 15, 1995.

For the Commission by the Division of

Market Regulation, pursuant to delegated

authority.7

Jonathan G. Katz,

Secretary.

[FR Doc. 95–12925 Filed 5–25–95; 8:45 am]

BILLING CODE 8010–01–M

[Release No. 34–35751; File No. SR–NASD–

94–62]

Self-Regulatory Organizations; Order

Approving Proposed Rule Change by

National Association of Securities

Dealers, Inc. Relating to Limit Order

Protection and Nasdaq

May 22, 1995.

On November 22, 1994, the National

Association of Securities Dealers, Inc.

(‘‘NASD’’ or ‘‘Association’’) filed a

proposed rule change with the

Securities and Exchange Commission

(‘‘SEC’’ or ‘‘Commission’’) 1 pursuant to

Section 19(b)(1) of the Securities

Exchange Act of 1934 (‘‘Act’’),2 and

Rule 19b–4 thereunder.3 The proposed

rule change amends the NASD’s

Interpretation to Article III, Section 1 of

the NASD Rules of Fair Practice

(‘‘Interpretation’’) 4 to prohibit a member

firm that accepts and holds an

unexecuted limit order from its own

customer or from a customer of another

member in a Nasdaq security from

trading ahead of the customer’s limit

order—that is to trade the subject

security for its own market-making

account at prices that would satisfy the

customer’s limit order—unless it also

executes that limit order.

Notice of the proposed rule change,

together with the substance of the

proposal as initially filed, was provided

by issuance of a Commission release

(Securities Exchange Act Release No.

35122, Dec. 20, 1994) and by

publication in the Federal Register (59

FR 66389, Dec. 23, 1994, ‘‘Release 34–

35122’’). Two comment letters were

received.5

On February 15, 1995, the NASD filed

Amendment No. 1 with the

Commission. Amendment No. 1

clarified that the ‘‘terms and

conditions’’ exception to the

Interpretation applies only to limit

orders from institutional accounts, as

defined in Article III, Section 21(c)(4) of

the NASD Rules of Fair Practice,6

whether such limit orders originate with

a firm’s own customers or are sent to it

for execution by another member firm.

Notice of the proposed rule change, as

amended, together with the substance of

the proposal, was provided by issuance

of a Commission release (Securities

Exchange Act Release No. 35391, Feb.

16, 1995) and by publication in the

Federal Register (60 FR 9878, Feb. 22,

1995, ‘‘Release 34–35391’’). No

comment letters were received in

response to Amendment No. 1.

On March 7, 1995, the NASD filed

Amendment No. 2 with the

Commission. Amendment No. 2

amended the proposed rule change to

extend the ‘‘terms and conditions’’

exception to the Interpretation to limit

orders for 10,000 shares or more, unless

such orders are less than $100,000 in

value, as well as to limit orders from

institutional accounts.

Notice of the proposed rule change, as

amended, together with the substance of

the proposal, was provided by issuance

of a Commission release (Securities

Exchange Act Release No. 35454, Mar.

8, 1995) and by publication in the

Federal Register (60 FR 13199, Mar. 10,

1995, ‘‘Release 34–35454’’). One

comment letter was received in

response to Amendment No. 2.7 This

order approves the proposed rule

change.

I. Introduction and Background

Last year, the NASD submitted to the

Commission a proposed Interpretation

to its Rules of Fair Practice to prohibit

member firms from trading ahead of

their customers’ limit orders in their

market making capacity.8 The

Commission approved the NASD

Interpretation on June 29, 1994, but

expressed concern that the prohibition

did not extent to trading ahead of limit

orders of other firm’s customers that

have been sent to the market maker for

execution.9 In fact, the Commission’s

Division of Market Regulation, in its

Market 2000 Study, previously had

examined this practice and

recommended that a ban apply to

trading of all customer limit orders, not

just those of a firm’s own customer.10

The Study noted that the adverse effects

of trading ahead exist whether the

customer’s order is handled by the

customer’s firm or by another market

maker.11

Upon Commission approval the

NASD Interpretation, the NASD

convened a special task force (‘‘Task

Force’’) to study the potential effect of

expanded limit order protection on

market liquidity and market maker

capital commitment and to report to the

NASD Board of Directors in September

1994. At the time, the Commission
27998 Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices

12Release 34–34279, supra n. 9.

13See Special NASD Notice to Members 94–79

(September 23, 1994).

14Securities Exchange Act Release No. 34753

(Sept. 29, 1994), 59 FR 50867 (Oct. 6, 1994)

(‘‘Release 34–34753’’) (proposing 17 CFR 240.15c5–

1).

15Article II, Section 1(f) of the NASD Rules of

Fair Practice defines ‘‘customer’’ to exclude a

broker or dealer. See NASD Manual, Rules of Fair

Practice, Art. II, Sec. I (CCH) ¶2101.

16An ‘‘institutional account’’ is defined as an

account of: (1) a bank, savings and loan association,

insurance company, or registered investment

company; (2) an investment company; (2) an

investment adviser registered under Section 203 of

the Investment Advisers Act of 1940, 15 U.S.C. §

80b–3; or (3) any other entity (whether a natural

person, corporation, partnership, trust, or

otherwise) with total assets of at least $50 million.

NASD Manual, Rules of Fair Practice, Art. III, Sec.

21 (CCH § 2171.

17The value of a limit order is calculated by

multiplying the price per share specified in that

order by the number of shares specified in the

order. Thus, the value of a limit order does not

include any markup, markdown, commission,

commission equivalent, sales credit or other

internal credit.

18See Release 34–35391. Article III, Section 4 of

the NASD Rules of Fair Practice states in part that,

if a member acts as agent for a customer in any

transaction, the customer shall not be charged more

than a fair commission or service charge, taking into

consideration all relevant circumstances. See also

NASD Regulatory & Compliance Alert, Vol. 7, no.

4 (December 1993) at 1.

19See Release 34–34279, supra n. 9; Market 2000

Study, supra n. 10, at V–8–9.

The Commission notes that Sections 15A(b)(6)

and 19(b)(2) of the Act, 15 U.S.C. §§ 78o–3(b)(6),

78s(b)(2), together require, among other things, that

a rule change approved by the Commission not be

designed to permit unfair discrimination between

customers. The Commission expects that the NASD

will exercise its oversight authority to ensure that

market makers do not refuse to accept certain limit

orders in a manner that unfairly discriminates

among customers.

20Broker-dealers are not deemed to be customers

for purposes of the NASD Rules of Fair Practice. See

supra n. 15.

stated that while such a study could be

helpful to future consideration of this

issue, the Commission believed that

member-to-member trades raise

significant concerns that should be

addressed and, if necessary, the

Commission would consider instituting

its own rulemaking proceeding for that

purpose.12

The Task Force’s report (‘‘Task Force

proposal’’) recommended that market

makers be prohibited from trading

ahead to customer limit orders only

when such trades occurred at prices

superior to the limit order price. The

NASD Board of Directors reviewed the

Task Force Proposal and proposed for

member comment on amended proposal

that would have restricted a market

maker from trading ahead of a customer

limit order at a price equal to or better

than the price of the customer limit

order if the size of that order was 1,000

shares or less, and from trading to prices

better than a customer’s limit order if

the size of that order was greater than

1,000 shares (‘‘Board Proposal’’).13

The Commission then published for

comment its own proposed rule to

prohibit any market maker in Nasdaq

National Market securities from trading

ahead of the orders of other firms’

customers sent to it for execution

without regard to the size of the order

(‘‘Commission Proposal’’).14 The

Commission wished to solicit public

comment on alternatives that would

provide more extensive limit order

protection for public customers than

those alternatives that the NASD had

then proposed. The Commission also

was motivated in part by a desire to

solicit comment from public investors

and non-NASD members.

II. Description and Scope of the

Proposed Rule Change

The rule change we are considering

today provides that a member firm

cannot accept a customer15 limit order

in a Nasdaq security and continue to

trade that security for its own account

at prices that would satisfy the customer

limit order without filing that order at

the limit order price or a price more

favorable to the customer. The

Interpretation no longer distinguishes

between customer limit orders accepted

from a member’s own customer and

customer limit orders sent to it for

execution from another member (socalled ‘‘member-to-member’’ limit

orders). In either situation, such

‘‘trading ahead’’ activity would

constitute a violation of just and

equitable principles of trade.

The NASD requested that the

Commission allow the rule change to be

implemented on a phased-in-basis.

During the time period between the

rule’s adoption and September 1, 1995,

member-to-member limit orders that are

greater than 1,000 shares would be

protected when the member firm

accepting the order trades for its own

account at prices that are superior to the

limit order price, but not at prices equal

to the limit order price. The NASD

requested the phase-in-period to

provide NASD member firms an

opportunity to adjust their order

handling procedures for orders over

1,000 shares to the requirements of the

Interpretation and to reassess their

existing revenue structure.

The rule change also amends the

Interpretation by limiting the ‘‘terms

and conditions’’ exception of the

Interpretation to: (a) limit orders from

‘‘institutional accounts’’ as that term is

defined in Article III, Section 21(c)(4) of

the Rules of Fair Practice (‘‘institutional

orders’’),16 regardless of whether such

institutional orders come from a firm’s

own customers or are member-tomember limit orders; and (b) limit

orders from accounts other than

institutional accounts (‘‘retail orders’’) if

the order is for: (i) 10,000 shares or

more; and (ii) has a value of $100,000

or greater (‘‘institution-sized retail

orders.’’).17 The rule change does not

permit a market maker to accept and

hold other retail orders subject to terms

and conditions, but does permit a

market maker to accept and hold an

institutional order subject to terms and

conditions even if that order is for less

than 10,000 shares or is less than

$100,000 in value.

The NASD’s rule would continue to

permit a market maker to charge its

customers or an order entry firm

commissions or commission equivalents

for handling a limit order, provided

those charges previously are disclosed

in a clear fashion to the customer, and

provided those charges otherwise

comply with applicable law.18

Furthermore, an individual Nasdaq

market maker is not obligated to accept

any limit orders and is not required to

accept limit orders from any particular

customer.19

III. Summary of Comments

As noted above, the Commission

received three comment letters (one

commenter two letters) concerning the

rule change. These comment letters

raised the same types of arguments that

were raised in comment letters received

on the Commission Proposal.

A. Amex Letter

The Amex Letter addressed three

aspects of the rule proposal. First, Amex

stated that broker-dealers should be

included within the universe of

customers entitled to the benefits of

limit order protection in the Nasdaq

market.20 Amex reasoned that options

market makers, for example, would not

be able to hedge their positions in listed

options on Nasdaq stocks efficiently if

broker-dealers are not protected by the

Interpretation.

Second, the Amex Letter requested

that the NASD elaborate on the terms

and conditions that a market maker is

permitted to impose, with a view to

guarding against discrimination among

customers. As noted above, the rule

change was amended after the

Commission received the Amex Letter

to permit a market maker to negotiate

limit order terms and conditions only

with respect to institutional orders and

institution-sized retail orders, and the

rule change specifies that any terms and

conditions under which institutional
Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices 27999

21Herzog claims that the rule change would

violate, inter alia, Section 6(b)(5) of the Act, 15

U.S.C. § 78f(b)(5) (requiring that the rules of

national securities exchanges not be designed to

permit unfair discrimination between customers,

issuers, brokers, or dealers); and Section 15A(b)(9)

of the Act, 15 U.S.C. § 78o–3(b)(9) (requiring that

the rules of registered securities associations not

impose any burden on competition not necessary or

appropriate in furtherance of the purposes of the

Act).

The Commission notes that Section 6(b) of the

Act is inapplicable to the rules of the NASD, which

is not a national securities exchange. However,

Section 15A(b)(6) of the Act, 15 U.S.C. § 78o–

3(b)(6), imposes requirements upon NASD rules

that are virtually identical to those imposed upon

the rules of national securities exchanges by Section

6(b)(5).

22Herzog did not address whether a rule

establishing a minimum spread would violate

Section 15A(b)(6) of the Act, which requires, inter

alia, that NASD rules not be designed to fix

minimum profits or to impose any schedule or fix

rates of commission, allowances, discounts or other

fees to be charged by NASD members.

23See March Herzog Letter.

24Although the Commission is required to

evaluate the proposed rule change for consistency

with Section 15A of the Act, the Commission

believes the goals of Section 11A are equally served

by this proposed rule change.

orders or institution-sized retail orders

are accepted must be made clear to

customers at the time an order is

accepted.

Third, Amex expressed a concern

regarding the scope of the limit order

protection proposed, stating that the

protection afforded by the Interpretation

was not an extensive as that provided by

exchange markets. Amex recommended

that the Interpretation be extended to

trigger limit order protection whenever

a Nasdaq market making firm executed

a trade in any firm account or for any

person associated with the firm, rather

than limiting the Interpretation to trades

executed in a market making account.

The Amex Letter also noted that the rule

change would entitle a customer only to

an execution at the limit price, and not

to a better price that a market maker

might have obtained by trading ahead.

Amex recommended amending the rule

change to require market makers to

execute a limit order at a price better

than the limit price if obtainable, in

accordance with principles of agency

law.

B. Herzog Letters

Herzog opposed the rule change,

asserting that it is wholly unsuited to

the nature of the Nasdaq market. Herzog

stated that much market making activity

on Nasdaq is carried out by wholesale

firms, who do not conduct a retail

business. The sole source of revenue for

these firms is the ‘‘spread’’ between

their bid and their ask. Herzog noted

that wholesale firms must provide the

capital to maintain inventories in each

stock in which they make markets.

Herzog asserted that if the rule change

is approved, market makers would be

required to fill limit orders to sell (or

buy) stocks at the same price at which

they buy (or sell) for their own account.

Sophisticated traders would use limit

orders to buy and sell stocks at the same

price as market makers, without

incurring the obligations of market

makers. Herzog asserted that market

makers would be able to recover their

costs only if they widened spreads or

increased fees for traders who do not

enter limit orders. The impact of the

increased fees and widened spreads

would fall disproportionately on less

sophisticated investors who continue to

use market orders and who would

continue to pay the spread.

Although Herzog stated that the rule

would cause spreads to widen, it also

asserted that the rule change would

artificially restrict dealers from

recovering a competitive ‘‘spread’’ in

relatively illiquid stock, causing

reduced liquidity for those stocks. This,

in turn, would disproportionately harm

small issuers. Herzog also predicted

reduced liquidity for more liquid stocks,

because dealers would be less willing to

commit capital when institutions wish

to move blocks of stock that the market

cannot accommodate. Herzog asserted

that by imposing limit order obligations

on market makers, the rule change

would restrict market makers’ ability to

dispose of the stock acquired in such

transactions. The January Herzog Letter

also claimed that the rule change would

reduce liquidity by reducing a market

maker’s ability to charge different prices

for different transactions—market

makers would be less willing to trade in

between the spread for certain

customers because the transactions

would impose costly limit order

obligations upon those market makers.

Herzog also forecasted that the rule

change would lead to increased

concentration of market makers, because

vertically integrated firms, unlike

wholesale firms, possess the greatest

ability to directly charge customers

higher commissions, markups or other

fees to compensate for the loss of spread

income. It stated that less sophisticated

customers would be adversely affected

by these changes. Herzog predicted that

those market makers who cease making

markets would continue to trade for

their own account without incurring the

obligations that a market maker must

undertake.

Herzog also asserted that the rule

change violated the statutory criteria

imposed under the Act.21 It asserted that

the rule change would undermine

competition and harm customers

because it would reduce competition

among different types of markets to

obtain listings from companies and

among market makers to fill orders, and

would reduce the ability of small issuers

of stock to raise capital by having their

less liquid shares trade at competitive

prices on Nasdaq. As an alternative,

Herzog recommended that the NASD

permit market makers to establish a

minimum spread and fully disclose to

customers a suitable net price at which

they would execute limit orders.22

Herzog stated that the terms and

conditions exceptions were unduly

limited.23 It stated that many

professional investment funds do not

qualify as institutional accounts as

defined in Article III, Section 21(c)(4).

Herzog stated that these funds are no

less sophisticated or in need of

protection than are accounts that meet

the terms of the definition. Herzog also

believes that the exception for

institution-sized retail orders will

protect parties beyond the small retail

investors that the NASD wishes to

protect. Herzog stated that the NASD

will need to monitor carefully to ensure

that a single large order is not broken up

into multiple orders that qualify for

limit order protection.

IV. Discussion

The Commission believes that the

proposed rule change is consistent with

the Act and the rules and regulations

thereunder applicable to the NASD and,

in particular, Sections 15A(b)(6),

15A(b)(9) and 11A(a)(1)(C) of the Act.

Section 15A(b)(6) requires that the rules

of a national securities association be

designed to prevent fraudulent and

manipulative acts and practices, to

promote just and equitable principles of

trade, to foster cooperation and

coordination with persons engaged in

regulating, clearing, settling and

processing information with respect to,

and facilitating transactions in

securities, to remove impediments to

and perfect the mechanism of a free and

open market and a national market

system and in general to protect

investors and the public interest.

Section 15A(b)(9) requires that the rules

of the association not impose any

burden on competition not necessary or

appropriate in furtherance of the

purposes of the Act. Section

11A(a)(1)(C) (i) and (iv) sets forth the

objectives of assuring economically

efficient execution of securities

transactions and the practicability of

brokers executing investors’ orders in

the best market.24
28000 Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices

25Market 2000 Study, supra n. 10, at V–8.

26See, e.g., Herman & MacLean v. Huddleston,

459 U.S. 375, 389 (1983) (‘‘An important purpose

of the federal securities statutes was to rectify

perceived deficiencies in the available common law

protection by establishing higher standards of

conduct in the securities industry.’’).

27Third market dealers operate similarly to

Nasdaq market makers. The NASD’s rules already

prohibit trading ahead of customer limit orders in

the third market. NASD Manual, Schedules to the

By-Laws, Schedule G, Section 4(f) (CCH) ¶ 1921.

Despite this prohibition, statistics compiled by the

Consolidated Tape Association indicate that third

market dealers currently account for better than

10% of listed stock orders as a percentage of share

volume.

28Unlike institutional customers, most retail

customers do not submit orders of a character

which enables them to negotiate effectively

execution parameters.

29Market 2000 Study, supra n. 10, at V–9. 30Release 34–34753, supra n. 14.

A. Enhanced Limit Order Protection

The Commission recognizes that prior

to adoption of the Interpretation in June

1994, the practice of Nasdaq market

makers trading ahead of their customers’

limit orders was widespread and

longstanding. These practices generally

are not in the interests of customers.

The Interpretation is approved in June

1994 recognized the need to enhance

customer limit order protection on

Nasdaq. The current proposed rule

change fosters fair and open markets

and investor protection by extending

limit order protection for investors to

member-to-member trades.

Market makers argue that extending

customer limit order priority to

member-to-member orders would deny

market makers their customary

compensation for being at risk. It is not

clear, however that the risk associated

with market making in Nasdaq

securities requires compensation

derived from trading ahead of the

customer. Market makers will continue

to be able to derive trading profits in

executing orders, including limit orders,

and are entitled to receive compensation

for handling limit orders, provided that

the method of compensation chosen is

clearly disclosed to the customer, such

as by charging a commission for

handling the limit order. Accordingly,

the Commission believes that extending

the prohibition against the practice of

trading ahead of customer limit orders

to member-to-member trades will not

result in a ‘‘mass exodus’’ of market

makers from Nasdaq. Indeed, experience

with customer limit order priority since

last June suggests that such concerns are

overstated. Firms that refuse to accept

limit orders because they may not trade

ahead of such orders may find their

customers gravitating toward other firms

that are willing to provide limit order

protection.

The Commission also believes that

disclosure is not an adequate remedy for

the practice of trading ahead of

customer limit orders. In a typical

agency relationship, disclosure often is

relied upon as an adequate means of

resolving a conflict of interest between

an agent and its principal.25 Investors

enjoy greater protection under the

federal securities laws, however, than

that afforded by common law; a general

common law remedy of disclosure does

not always suffice.26 A stricter duty may

be imposed where, as here, the

principals are investors and the agents

control access to the trading market. The

NASD already has recognized this

obligation in the context of customer

limit order priority for a member’s own

customers. The NASD also has a similar

prohibition that applies to its members

trading in the third market.27

Disclosure does not protect the

interests of many customers affected by

trading ahead. The cost of the customer

each time a market maker fails to

execute a customer’s limit order it is

holding is not removed by disclosure. A

customer cannot receive the most timely

execution or best price if the dealer

handling the customer’s order trades at

superior prices without executing the

limit order. The broker trading ahead of

a public limit order is competing with

public customers for an execution. To

derive any benefit from disclosure, a

customer must find a broker that will

route orders to market makers that do

not trade ahead of customer limit

orders. Because the practice of market

makers trading ahead of customer limit

orders sent to them form other market

makers is widespread in the over-thecounter market, the choices of market

makers are limited.28

In extending customer limit order

priority to member-to-member trades,

the Commission does not intend to

suggest that trading of Nasdaq securities

must conform to all auction market

principles.29 Nevertheless, just as the

Commission believes that the dealers in

exchange-listed securities must adhere

to certain minimum standards with

respect to order handling procedures, it

also believes that market makers in

Nasdaq securities should adhere to

certain minimum standards of fair

treatment of customers.

The Commission believes that certain

current Nasdaq limit order practices

have created confusion in the minds of

investors and are inconsistent with the

growth and maturity of the Nasdaq

market. The Commission believes that a

customer’s limit order should be

protected from trading ahead regardless

of whether that order is entered in an

auction or dealer market, and regardless

of whether the order accepted and

handled by the firm is that of the firm’s

own customer or is a member-tomember limit order.

The Commission recently stated that

it is reasonable for customers to expect

that the quality of the execution

received will not vary from trade to

trade.30 NASD rules currently allow the

quality of the execution of a customer

limit order to vary depending on

whether the customer’s firm or an

affiliate makes a market in a security or

whether that firm sends the order to

another market maker for execution.

The rule change approved today will

assure that the quality of execution of

customer limit orders will not depend

upon whether the agency chosen by a

customer to handle its limit order also

makes a market in a security in which

that customer is interested.

The Commission believes that the rule

change will improve significantly the

timeliness of customer executions. By

providing a customer’s limit order

priority over the market maker’s

propriety trading, more trade volume

will be available to be matched with the

customer’s order, resulting in quicker

and more frequent executions for

customers. More expeditious handling

of customer limit orders will, in turn,

provide all investors with a more

accurate indication of the buy and sell

interest at a given moment. The rule

change also will encourage dealers to

execute customer limit orders promptly

so that they may continue their

proprietary trading activities.

The rule change also will improve the

price discovery process in Nasdaq

securities. Limit orders contribute to

price discovery by disclosing preferred

customer trading prices and by

tightening the spread between the bid

and ask price of a security. In the past,

customers may have refrained from

placing limit orders because of the

uncertainty of and difficulty in

obtaining an execution for such orders

until the inside price reached the limit

order price. The practice of delaying

executions until the inside price reaches

the customer’s limit order price also

impedes price discovery by artificially

delaying or preventing execution and

reporting of customer limit orders.

Customers also incur costs in terms of

inferior or missed executions for limit

orders when a market maker delays

execution of customer limit orders until

the inside price reaches the customer’s

limit order price. The rule change

approved today enhances the ability of

customers to monitor the cost of a
Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices 28001

31 Dealers may attempt to compensate for lost

income with wider spreads or with higher

commissions. Customers would be able to compare

such charges among dealers. See Market 2000

Study, supra n. 10, at V–8–9.

32See Letter from Richard T. Chase, Senior Vice

President and Chief Counsel, Lehman Brothers Inc.

(‘‘Lehman’’) to Jonathan G. Katz, Secretary, SEC,

dated November 16, 1994 (‘‘Lehman Letter’’). The

Lehman Letter was submitted in response to the

Commission Proposal.

33See Letter from Richard G. Ketchum, Executive

Vice President, NASD to Holly H. Smith, Associate

Director, Division of Market Regulation, SEC, dated

March 31, 1995 (available in Commission’s Public

Reference Room). See also Special NASD Notice to

Members 94–58, Answer to Question #11 (July 15,

1994) (‘‘[i]t has never been the NASD’s position that

members can trade ahead of their customer’s limit

orders when not acting as a market maker.’’).

34The Commission Proposal would require a

superior priced execution in the circumstance

where a market maker trades for its own account

at a price better than the customer’s limit order

price. See Release 34–34753, supra n. 14.

35The Commission notes that a market maker

may have executed a trade for its own account at

a price better than the customer’s limit price

because the inside market has moved. Under these

circumstances, the limit order may have become

marketable. A market maker’s best execution

obligations in such circumstances may require the

marker maker to execute the limit order at a price

more favorable to the customer than the limit price. 36See Release 34–34279, supra n. 9.

transaction and choose a broker-dealer

on that basis.31 This imposes a

competitive discipline on market

makers to achieve the best possible

execution for customers or risk losing

business. Unlike institutional clients

who are in a better position to negotiate

their own protection with market

makers, public customers have less

viable alternatives in determining where

their orders are ultimately sent for

execution. The rule change provides

market makers with a necessary

incentive to provide superior executions

to public customers.

B. Scope of the Rule Change

The NASD has determined to extend

limit order protection to Nasdaq

SmallCap securities. The Commission

Proposal also requested comment on

including within the rule Nasdaq

SmallCap securities and over-the

counter Bulletin Board-eligible

securities. Lehman recommended that

the Commission Proposal be limited to

Nasdaq National Market securities,

because the markets for non-National

Market securities are less developed.32

Lehman stated that the adverse liquidity

consequences of extending limit order

protection to non-National Market

securities is more severe. Nonetheless,

there has not been any evidence offered

to the Commission of adverse liquidity

consequences caused by the limit order

protection currently extended to Nasdaq

SmallCap securities. Indeed, the

Commission believes that the positive

effects of increased trading volume from

customer limit orders on liquidity will

surpass the negative effect, if any, from

lost market maker profits. Furthermore,

the NASD has stated that it will evaluate

carefully any impact the new

Interpretation may have on market

maker participation or market quality

during the rule’s phase-in period.

Therefore, the Commission believes that

the benefits of uniform treatment of

customer limit orders for Nasdaq

SmallCap securities outweigh

speculative concerns about adverse

liquidity consequences.

The Commission also does not believe

it is necessary to amend the

Interpretation to expressly trigger limit

order protection whenever a Nasdaq

market making firm executes a trade in

any firm account or for any person

associated with the firm. Although the

Interpretation by its terms applies only

to trades executed in a market making

account, the Commission notes that the

NASD interprets a member’s best

execution obligation to prohibit a

market maker from knowingly trading

ahead of a customer’s limit order when

it is not acting as a market maker in the

security.33

The Commission is not persuaded

that the rule is deficient because, as

suggested by Amex, it does not

guarantee a customer limit order a

superior priced execution in the

circumstance where a market maker

trades for its own account at a price

better than the customer’s limit price.34

The Interpretation will benefit the

customer by requiring execution of the

limit order if the market maker trades

for its own account even if the limit

price is inside the Nasdaq best bid and

offer.35

The Commission also believes that it

is appropriate to provide a ‘‘terms and

conditions’’ exception for certain types

of orders. As noted above, the rule

change permits a market maker to

accept and hold a customer limit order

subject to terms and conditions only if

it is an institutional order or an

institution-sized retail order.

The rule distinguishes between retail

orders and institutional orders because

firms and institutions typically have

developed business practices pursuant

to which they negotiate the conditions

under which their limit orders are to be

handled. In approving the NASD’s rule

to prohibit member firms from trading

ahead of their own customers, the

Commission noted its agreement with

an analysis provided in the Market 2000

Study that:

Because most market makers cannot

typically fill institution-size orders out of

inventory, institutions generally only hold

market makers to a ‘‘best efforts’’ standard in

return for the willingness of the market

maker to put up substantial capital to provide

liquidity for large orders. In order to permit

a member firm to employ the necessary

trading strategy without being subjected to

the requirements of the proposed ban, the

Interpretation allows the parties to set the

specific ‘‘terms and conditions’’ for

acceptance of institutional orders.36

Given that most market makers cannot

typically fill institution-sized retail

orders out of inventory, the rule permits

market makers to negotiate with retail

customers the terms and conditions

under which an institution-sized retail

limit order is to be handled. This

provision will permit customers to

negotiate separate execution parameters

with market makers on a trade-by-trade

basis.

The terms and conditions exception is

tailored to apply to limit orders which

require market makers to employ special

strategies to execute and to limit orders

from customers who have the ability to

monitor the market for the security and

to negotiate alternative execution

procedures with another market maker.

The Commission believes that the

10,000 share/$100,000 threshold for

institution-sized retail orders

appropriately distinguishes between: (1)

Those orders that do not require market

makers to exhaust their inventory or

commit large amounts of capital and

those orders that do; and (2) customers

who have the ability to negotiate

effectively the execution parameters of

their trades and those who do not.

Market makers must protect an

institutional order unless they have

negotiated specific terms and conditions

regarding the order. As a general matter,

all limit order should be entitled to limit

order protection. The Commission

recognizes, however, that market makers

may require some flexibility with

respect to larger orders and institutional

investors. Accordingly, it is appropriate

to permit market makers to negotiate

specific terms and conditions for

handling certain orders. The exception

for institutional orders recognizes the

ability of institutions to negotiate

specific order handling procedures and

their desire to have the ability to

negotiate special procedures for orders

of less than 10,000 shares or less than

$100,000 in value. In this regard, the

Commission notes that the NASD

interprets the ‘‘institutional account’’

definition in Article III, Section 21(c)(4)

of the NASD Rules of Fair Practice to

apply to any account managed by a

registered investment adviser.
28002 Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices

37The Commission has determined not to

withdraw the Commission Proposal at this time. It

will review the operation of the rule change

approved today before it determines whether to

approve, amend or withdraw the Commission

Proposal.

38See, e.g., Securities Exchange Act Release No.

34277 (June 29, 1994), 59 FR 34885 (July 7, 1994)

(approving short-sale rule for Nasdaq National

Market securities); Division of Market Regulation,

SEC, The October 1987 Market Break, 8–18–20

(1988).

39See, e.g., 17 CFR 200.12(d) (providing favorable

margin treatment for market makers).

In addition, Rule 15c3–1(a)(6)(i) provides

favorable net capital treatment for wholesale market

makers. A wholesale firm that withdraws from

market maker status no longer would be entitled to

compute its net capital pursuant to that provision.

17 CFR 240.15c3–1(a)(6)(i).

40See supra text an accompanying note 15.

41See Special NASDA Notice to Members 94–58,

surpa n. 29, Answer to Question #2.

42The Commission believes it is permissible for

a customer to instruct a market maker to purchase

(sell) a security for it such that the total costs

(proceeds) to the customer (including any

commissions, markups or other charges ) are not

greater (less) than a single net price per share. Thus,

for example, if a customer enters a limit order to

Nonetheless, the Commission would

be concerned if market makers

uniformly attempt to negotiate the terms

and conditions for execution of smallersized institutional orders in order to

trade ahead of these orders. In addition,

it may be appropriate to reconsider at a

later date whether the proposed rule

change approved today provides

sufficient protection to market

participants and, if necessary, to extend

the scope of limit order protection

beyond the classes of orders and

customers protected by the rule change

approved today.37

In this regard, the Commission also is

sensitive to the concerns expressed by

Amex about extending the protections

envisaged by the rule to limit orders

placed with Nasdaq market makers by

other broker-dealers, including options

specialists and registered options

traders. The Commission recognizes the

importance in terms of price discovery

and market efficiency and liquidity for

options specialists and market makers to

have efficient and economical

opportunities for laying off risk in the

Nasdaq market.38 Given that market

makers can refuse to accept a limit

order, and recognizing that the NASD

could allow market makers the

flexibility to negotiate terms and

conditions for the handling of options

market maker limit orders, the

Commission questions why, once

accepted, a market maker should not be

required to protect that limit order.

Accordingly, the Commission also

expects the NASD to consider extending

the scope of limit order protections to

orders of options specialists and market

makers.

C. Other Issues

Key to Herzog’s objection to the rule

change is its assertion that wholesale

firms do not charge commissions and do

not have the retail customer

relationships that would permit them to

charge commissions. The Commission

notes that there are no legal

impediments that prevent wholesale

firms from charging commissions or

establishing other clearly disclosed

compensation arrangements with

respect to limit order execution.

Furthermore, Herzog neither asserted

nor offered evidence to demonstrate that

wholesale firms would be precluded

from utilizing other methods, apart from

widening spreads, to ensure that they

are compensated for executing limit

orders.

The Commission notes that market

makers are not required to accept limit

orders to buy at the bid or limit orders

to sell at the offer. Market makers are

not precluded from acting in an agency

capacity by matching incoming limit

orders with market orders. Indeed, the

Commission notes that to the extent that

market makers act in an agency

capacity, their inventory and capital

requirements are lessened.

The Commission also does not believe

that market makers would be required to

fill limit orders at spreads narrower than

those naturally resulting from

competition. As noted above, the

Commission believes that limit order

protection will enhance quote

competition in the Nasdaq market;

therefore, the rule change should

facilitate narrower spreads that reflect a

full range of competition. The

Commission believes that limit orders

will provide market makers with

increased competition. Indeed, if market

makers expanded their spreads beyond

what was reasonable for a particular

security, the rule approved today

enhances the ability of customers to

enter limit orders to improve the

market.

The Commission also believes that the

rule change approved will not have a

significant deleterious impact upon

market participation. The Commission

notes that market makers who cease

market making also must forego certain

legal benefits available only to market

makers.39 Furthermore, as brokerdealers, these market makers would not

be entitled to limit order price

protection.40

The Commission also does not believe

that the rule change will reduce

competition for listings among different

types of markets. Rather, the

Commission believes that limit order

protection is a feature that will attract

investors and ultimately issuers to the

Nasdaq market; the rule may in fact

increase competition among market

makers to attract limit orders so that

they can match incoming limit orders

on an agency basis and reduce the

amount of capital that they must

commit to transactions. This, in turn,

may permit market makers to make

markets in a larger number of securities,

which would lead to enhanced

opportunities for small issuers to raise

capital.

The Commission does not agree with

Herzog that the rule change will favor

more sophisticated limit order traders

over traders who enter market orders.

The Commission believes that market

orders will benefit if they have the

opportunity to interact with limit orders

as well as market maker quotes. Thus,

small investors maybe among the

primary beneficiaries of the rule change,

contrary to Herzog’s assertions.

The Commission does not believe that

a market maker is required to execute a

limit order without compensation. The

Commission does believe, however, that

the terms of compensation should be

clear to the customer. The Commission

believes that a market maker who

accepts and holds a limit order from a

customer must execute the transaction

at the limit order price set by the

customer, not at a ‘‘net’’ price that

obfuscates the amount of compensation

that the market maker is receiving.41

For example, assume that the best

inter-dealer market for a particular

security is $10 bid, $101⁄4 ask. A market

maker accepts and holds a retail limit

order to sell that security at $103⁄16. The

Commission believes that if that market

maker sells the security to another

person at $101⁄4, it must also fill the

limit order to sell at $103⁄16, because the

sale at $101⁄4 constitutes a transaction at

a price that would satisfy the customer’s

limit order. Any costs incurred by the

market maker in connection with the

execution of the transaction are

irrelevant in determining whether a

transaction has occurred at a price that

would satisfy the customer’s limit order.

The Interpretation calls for market

makers to execute limit orders whenever

they execute a transaction for their

market making account at a price that

would satisfy the customer’s limit order.

The Commission emphasizes that

‘‘price’’ is determined from the vantage

point of the customer, not by reference

to ‘‘net proceeds’’ received by the firm

on a sale or the purchase price paid plus

costs incurred in connection with a

purchase.41
Federal Register / Vol. 60, No. 102 / Friday, May 26, 1995 / Notices 28003

purchase security XYZ and requests that its total

costs not exceed $10 per share, and the customer

is informed that the market maker charges a markup

of 1⁄4, then a market maker may continue to

purchase for its own account at $10 without also

executing the customer order. The customer order

would be deemed a limit order at $93⁄4. The

Commission emphasizes that ‘‘the price at which

the limit order is to be protected must be clearly

explained to the customer.’’ See id.

Finally, the Commission believes that

the rule change does not impose any

burden on competition that is not

necessary or appropriate in furtherance

of the purposes of the Act. As noted

above, Herzog asserted that the rule

change will have a disparate impact

upon wholesale firms, because such

firms allegedly lack the ability of

vertically integrated firms to directly

charge customers higher commissions,

markups or other fees to compensate for

the loss of spread income. The

Commission recognizes that as a

consequence of the rule change, some

wholesale firms may seek to establish

alternative sources of revenue,

including charging commissions. The

Commission believes that any burden

imposed by shifts in fee structures is

outweighed by the improved price

discovery, execution and pricing

advantages that customers will realize

as a result of the rule change. In

addition more customers will be

accorded treatment that satisfies

reasonable expectations of fairness and

investor protection.

V. Conclusion

For the foregoing reasons, the

Commission finds that the proposed

rule change is consistent with the Act

and the rules and regulations

thereunder applicable to the NASD and,

in particular, Sections 15A(b)(6), and

15A(b)(9) and 11A(a)(1)(C) of the Act.

It is therefore ordered, pursuant to

Section 19(b)(2) of the Act, that the

proposed rule change SR–NASD–94–62

be, and hereby is, approved, effective

June 21, 1994.

By the Commission.

Jonathan G. Katz,

Secretary.

[FR Doc. 95–12987 Filed 5–25–95; 8:45 am]

BILLING CODE 8010–01–M

[Release No. 34–35745; File No. SR–CBOE–

95–26]

Self-Regulatory Organizations; Notice

of Filing and Immediate Effectiveness

of Proposed Rule Change by the

Chicago Board Options Exchange,

Incorporated Relating to the Content

Outline for the General Securities

Sales Supervisor (Series 8)

Examination

May 19, 1995.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’), 15 U.S.C. 78s(b)(1), notice is

hereby given that on May 12, 1995, the

Chicago Board Options Exchange,

Incorporated (‘‘CBOE’’ or ‘‘Exchange’’)

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 selfregulatory organization. The

Commission is publishing this notice to

solicit comments on the proposed rule

change from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

The CBOE proposes to use a revised

Content Outline for the General

Securities Sales Supervisor (Series 8)

Examination (‘‘Series 8’’).

The text of the proposed rule change

is available at the CBOE and the

Commission.

II. Self-Regulatory Organization’s

Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule

Change

In its filing with the Commission, the

self-regulatory organization 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.

The self-regulatory organization 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 Series 8 examination is an

industry-wide qualification examination

for securities sales supervisors. The

Series 8 examination is generally

required under rules of the selfregulatory organizations (‘‘SROs’’) for

persons who are engaged in the

supervision of general securities branch

offices (i.e., branch office managers) and

of general securities registered

representatives. The Series 8

examination tests a candidate’s

knowledge of securities industry rules

and regulations and certain statutory

provisions applicable to general

securities sales supervision. The Series

8 Content Outline details the subject

coverage and question allocation of the

examination.

Revision of the Series 8 examination

and Content Outline was recently

undertaken by an industry committee

composed of representatives from SROs

(the New York Stock Exchange, the

American Stock Exchange, the Chicago

Board Options Exchange, the Municipal

Securities Rulemaking Board, the

National Association of Securities

Dealers, and the Philadelphia Stock

Exchange) and representatives from

broker-dealers, including branch office

managers, compliance personnel, and

corporate executives, in order to update

the examination in view of changes in

relevant laws, rules, and regulations, the

development of new products, and to

reflect various changes in industry

practices. The committee reviewed the

examination specifications, content

areas, and item bank and developed

some new questions in new areas.

The revised examination continues to

cover the areas of knowledge required to

supervise sales activities in securities.

However, the focus of the content of the

examination has been shifted to

concentrate more closely on supervisory

duties. Accordingly, certain questions

have been deleted from the examination

that deal with routine calculations and

basic product knowledge, and questions

on new federal and SRO rules and

regulations have been incorporated into

the examination, as well as questions on

new products, supervision, and changes

in industry practices. The Content

Outline reflects the revised content of

the examination. The examination will

remain a six-hour, two-part, 200

question examination.

2. Statutory Basis

The statutory basis for the Series 8

examination lies in Section 6(c)(3)(B) of

the Act. Under that Section, it is the

Exchange’s responsibility to prescribe

standards of training, experience, and

competence for persons associated with

Exchange members and member

organizations. Pursuant to this statutory

obligation, the Exchange has developed

examinations that are administered to

establish that persons associated with

Exchange members and member

organizations have attained specific

levels of competence and knowledge.