[Federal Register Volume 60, Number 102 (Friday, May 26, 1995)]
[Notices]
[Pages 27997-28003]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-12987]



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SECURITIES AND EXCHANGE COMMISSION
[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.

    \1\On 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.
    \4\NASD Manual, Rules of Fair Practice, Art. III, Sec. 1 (CCH) 
para.2151.07.
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    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\

    \5\See 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'').
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    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.

    \6\NASD Manual, Rules of Fair Practice, Art. III, Sec. 21 (CCH) 
para.2171.
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    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.

    \7\See 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'').
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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\

    \8\Securities 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).
    \9\Securities 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.
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    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 [[Page 27998]] 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\

    \12\Release 34-34279, supra n. 9.
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    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\

    \13\See Special NASD Notice to Members 94-79 (September 23, 
1994).
    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.

    \14\Securities Exchange Act Release No. 34753 (Sept. 29, 1994), 
59 FR 50867 (Oct. 6, 1994) (``Release 34-34753'') (proposing 17 CFR 
240.15c5-1).
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II. Description and Scope of the Proposed Rule Change

    The rule change we are considering today provides that a member 
firm cannot accept a customer\15\ 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 (so-called ``member-to-member'' 
limit orders). In either situation, such ``trading ahead'' activity 
would constitute a violation of just and equitable principles of trade.

    \15\Article 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) para.2101.
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    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-to-
member 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.

    \16\An ``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. Sec.  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 Sec. 2171.
    \17\The 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.
    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\

    \18\See 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.
    \19\See 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. Secs. 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.
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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.

    \20\Broker-dealers are not deemed to be customers for purposes 
of the NASD Rules of Fair Practice. See supra n. 15.
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    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 [[Page 27999]] 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\

    \21\Herzog claims that the rule change would violate, inter 
alia, Section 6(b)(5) of the Act, 15 U.S.C. Sec. 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. 
Sec. 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. Sec. 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).
    \22\Herzog 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.
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    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.

    \23\See March Herzog Letter.
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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\

    \24\Although 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.

[[Page 28000]]

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\

    \25\Market 2000 Study, supra n. 10, at V-8.
    \26\See, 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.'').
    \27\Third 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) para. 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.
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    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-the-counter market, 
the choices of market makers are limited.\28\

    \28\Unlike institutional customers, most retail customers do not 
submit orders of a character which enables them to negotiate 
effectively execution parameters.
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    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.

    \29\Market 2000 Study, supra n. 10, at V-9.
    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-to-member 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.

    \30\Release 34-34753, supra n. 14.
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    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 [[Page 28001]] 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.

    \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.
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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.

    \32\See 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.
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    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\

    \33\See 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.'').
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    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\

    \34\The 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.
    \35\The 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.
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    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\

    \36\See Release 34-34279, supra n. 9.


    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. [[Page 28002]] 
    Nonetheless, the Commission would be concerned if market makers 
uniformly attempt to negotiate the terms and conditions for execution 
of smaller-sized 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\

    \37\The 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.
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    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.

    \38\See, 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).
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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 broker-dealers, these market makers would not be 
entitled to limit order price protection.\40\

    \39\See, 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).
    \40\See supra text an accompanying note 15.
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    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\

    \41\See Special NASDA Notice to Members 94-58, surpa n. 29, 
Answer to Question #2.
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    For example, assume that the best inter-dealer market for a 
particular security is $10 bid, $10\1/4\ ask. A market maker accepts 
and holds a retail limit order to sell that security at $10\3/16\. The 
Commission believes that if that market maker sells the security to 
another person at $10\1/4\, it must also fill the limit order to sell 
at $10\3/16\, because the sale at $10\1/4\ 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\

    \42\The 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 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 $9\3/4\. The Commission emphasizes that ``the price 
at which the limit order is to be protected must be clearly 
explained to the customer.'' See id.

[[Page 28003]]

    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