[Federal Register Volume 60, Number 35 (Wednesday, February 22, 1995)]
[Notices]
[Pages 9878-9880]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-4358]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35391; File No. SR-NASD-94-62, Amendment No. 1]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
1 to Proposed Rule Change by National Association of Securities 
Dealers, Inc., Relating to Limit Order Protection for Member-to-Member 
Limit Order Handling on Nasdaq

February 16, 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 February 
15, 1995, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') an amendment to the proposed 
rule change as described in Items I, II, and III below, which Items 
have been prepared by the NASD. 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 NASD proposes to amend SR-NASD-94-62 relating to limit order 
protection for member-to-member limit order handling in the Nasdaq 
Stock Market. Currently, the NASD's Interpretation to the Rules of Fair 
Practice\1\ makes it a violation of just and equitable principles of 
trade for a member firm to trade ahead of its own customer's limit 
orders. In this amendment to its proposed expansion of the 
Interpretation, the NASD is proposing to amend the Interpretation to 
clarify that the ``terms and conditions'' exception to the 
Interpretation applies only to limit orders from institutional 
accounts, whether such limit orders come from a firm's own customers or 
are member-to-member limit orders. The term ``institutional account'' 
is defined in Article III, Section 21(c)(4) of the Rules of Fair 
Practice. Below is the text of the proposed rule change. Proposed new 
language, including the language that was added in the original 
proposal, is italicized; language to be deleted is bracketed.

    \1\NASD Manual, Rules of Fair Practice, Art. III, Sec. 1 (CCH) 
2151.07.
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Limit Order Protection Interpretation to Article III, Section 1 of the 
NASD Rules of Fair Practice

    To continue to ensure investor protection and enhance market 
quality, the NASD Board of Governors is issuing an Interpretation to 
the Rules of Fair Practice dealing with member firm treatment of 
[their] customer limit orders in Nasdaq securities. This Interpretation 
will require members acting as market makers to handle [their] customer 
limit orders with all due care so that market makers do not ``trade 
ahead'' of those limit orders. Thus, members acting as market makers 
that handle customer limit orders, whether received from their own 
customers or from another member, are prohibited from trading at prices 
equal or superior to that of the limit order without executing the 
limit order, provided that, prior to September 1, 1995, this 
prohibition shall not apply to customer limit orders that a member firm 
receives from another member firm and that are greater than 1,000 
shares. Such orders shall be protected from executions at prices that 
are superior but not equal to that of the limit order. In the interests 
of investor protection, the NASD is eliminating the so-called 
disclosure ``safe harbor'' previously established for members that 
fully disclosed to their customers the practice of trading ahead of a 
customer limit order by a market-making firm.

Interpretation

    Article III, Section 1 of the Rules of Fair Practice states that:
    A member, in the conduct of his business, shall observe high 
standards of commercial honor and just and equitable principles of 
trade.
    The Best Execution Interpretation states that: In any transaction 
for or with a customer, a member and persons associated with a member 
shall use reasonable diligence to ascertain the best inter-dealer 
market for the subject security and buy or sell in such a market so 
that the resultant price to the customer is as favorable as possible to 
the customer under prevailing market conditions. Failure to exercise 
such diligence shall constitute conduct inconsistent with just and 
equitable principles of trade in violation of Article III, Section 1 of 
the Rules of Fair Practice.
    In accordance with Article VII, Section 1(a)(2) of the NASD By-
Laws, the following interpretation under Article III, Section 1 of the 
Rules of Fair [[Page 9879]] Practice has been approved by the Board.

    A member firm that accepts and holds an unexecuted limit order 
from a customer (whether its own customer or a customer of another 
member) in a Nasdaq security and that continues to trade the subject 
security for its own market-making account at prices that would 
satisfy the customer's limit order, without executing that limit 
order [under the specific terms and conditions by which the order 
was accepted by the firm], shall be deemed to have acted in a manner 
inconsistent with just and equitable principles of trade, in 
violation of Article III, Section 1 of the Rules of Fair Practice, 
provided that, until September 1, 1995, customer limit orders in 
excess of 1,000 shares received from another member firm shall be 
protected from the market maker's executions at prices that are 
superior but not equal to the limit order, and provided further, 
that a member firm may negotiate specific terms and conditions 
applicable to the acceptance of limit orders only with respect to 
limit orders for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in Article III, 
Section 21(c)(4) of the Rules of Fair Practice. Nothing in this 
section, however, requires members to accept limit orders from any 
customer[s].

    By rescinding the safe harbor position and adopting this 
Interpretation of the Rules of Fair Practice, the NASD Board wishes to 
emphasize that members may not trade ahead of customer limit orders in 
their market-making capacity even if the member had in the past fully 
disclosed the practice to its customers prior to accepting limit 
orders. The NASD believes that, pursuant to Article III, Section 1 of 
the Rules of Fair Practice, members accepting and holding unexecuted 
customer limit orders owe certain duties to their customers and the 
customers of other member firms that may not be overcome or cured with 
disclosure of trading practices that include trading ahead of the 
customer's order. The terms and conditions under which institutional 
account customer limit orders are accepted must be made clear to 
customers at the time the order is accepted by the firm so that trading 
ahead in the firms' market making capacity does not occur. For purposes 
of this Interpretation, a member that controls or is controlled by 
another member shall be considered a single entity so that if a 
customer's limit order is accepted by one affiliate and forwarded to 
another affiliate for execution, the firms are considered a single 
entity and the market making unit may not trade ahead of that 
customer's limit order.
    The Board also wishes to emphasize that all members accepting 
customer limit orders owe those customers duties of ``best execution'' 
regardless of whether the orders are executed through the member's 
market making capacity or sent to another member for execution. As set 
out above, the best execution Interpretation requires members to use 
reasonable diligence to ascertain the best inter-dealer market for the 
security and buy or sell in such a market so that the price to the 
customer is as favorable as possible under prevailing market 
conditions. The NASD emphasizes that the order entry firms should 
continue to routinely monitor the handling of their customers' limit 
orders regarding the quality of the execution received.
* * * * *

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 NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The purpose of the amendment to the proposed rule change is to 
clarify that the Interpretation's ``terms and conditions'' exception to 
the protection of customer limit orders, whether the order is from a 
member's own customer or is a customer limit order sent to it for 
execution from another member (so-called ``member-to-member'' limit 
orders), is intended to apply only to limit orders from institutional 
accounts as that term is defined in Article III, Section 21(c)(4) of 
the Rules of Fair Practice. The background and rationale for this 
amendment to the proposed rule change are discussed below.
    On December 23, 1994, the Commission published for comment the 
NASD's proposed rule to expand the scope of limit order protection 
beyond that presently afforded by member firms to their customers in 
the Nasdaq Stock Market.\2\ The NASD'S current Interpretation to the 
Rules of Fair Practice makes it a violation of just and equitable 
principles of trade for a member firm to trade ahead of its own 
customer's limit orders. The proposal before the Commission now would 
extend this protection to limit orders from a customer of a firm that 
sends that customer's limit order to another member for execution (so-
called ``member-to-member'' limit orders). In addition, the proposal 
has a phase-in period until September 1, 1995, in which a firm 
receiving a member-to-member limit order of greater than 1,000 shares 
would be prohibited from trading for its own account at prices that are 
superior but not equal to the limit order price. The NASD's proposal 
also maintained language from the existing Interpretation regarding the 
member's ability to negotiate with any customer specific terms and 
conditions regarding its acceptance of limit orders, provided that the 
member makes these conditions clear to the customer. It is that 
language that this amendment is intended to affect.

    \2\Securities Exchange Act Release No. 35122 (Dec. 20, 1994), 59 
FR 66389 (Dec. 23, 1994).
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    The NASD believes that it is necessary to clarify that the terms 
and conditions exception to the handling of limit orders is intended to 
apply only to customer orders from institutional accounts as that term 
is defined in Article III, Section 21(c)(4) of the Rules of Fair 
Practice. Using that definition, a firm could negotiate limit order 
terms and conditions if the order came from:
    <bullet> Banks, savings and loan associations, insurance companies, 
or registered investment companies;
    <bullet> Investment advisers registered under Section 203 of the 
Investment Advisers Act of 1940; and
    <bullet> Any other entity (whether a natural person, corporation, 
partnership, trust, or otherwise) with total assets of at least $50 
million.
    Accordingly, under the amended language, a member firm that accepts 
a limit order from a person or entity that does not fall within the 
definition of institutional account may not initiate the negotiation of 
any terms and conditions on the acceptance of that limit order. On the 
other hand, if the account placing the limit order meets the terms of 
the definition of institutional account, the firm may negotiate special 
terms and conditions with the customer of that account, or its 
representative, that permit the firm to trade ahead of or at the same 
price as the limit order. The amended Interpretation would apply to 
limit orders placed by the firm's own customers and member-to-member 
limit orders.
    The NASD believes that this approach should minimize a retail 
customer's potential for confusion regarding the acceptance of a limit 
order that, under the existing Interpretation, could have 
[[Page 9880]] qualified the protection of the limit order rule's scope. 
At the same time, the amendment accurately reflects the ordinary 
framework in which firms and institutions typically negotiate the 
conditions under which an institution's limit order is to be handled. 
For example, in its approval of the original NASD Interpretation 
regarding the handling of customer limit orders,\3\ the Commission 
specifically indicated its view that the terms and conditions language 
of the original NASD Interpretation was included to permit special 
treatment for institutional customer limit orders. In addition, in its 
own proposal regarding customer limit order protection for Nasdaq 
National Market securities, proposed Rule 15c5-1,\4\ the Commission 
solicited comment on the ``terms and conditions'' provisions in its 
rule, which would allow the parties to a trade to set special 
conditions to allow a market maker to employ an appropriate strategy in 
filling an institutional customer's order without violating the 
proposed rule. Of course, the clarification of the Interpretation 
continues to permit a member to establish with its customers or the 
order entry firm commissioner or commission equivalents regarding the 
handling of a limit order, provided that the member makes these charges 
clear to the customer. In this connection, the NASD notes that Nasdaq 
market makers are free to negotiate additional compensation from order 
routing firms to the extent that such compensation is economically and 
competitively justified. Similarly, the Interpretation continues in 
place the understanding that nothing in the Interpretation would 
obligate a market maker to accept limit orders from any or all 
customers or member firms.

    \3\See Securities Exchange Act Release No. 34279 (June 29, 
1994), 59 FR 34883 (July 7, 1994).
    \4\See Securities Exchange Act Release No. 34753 (Sept. 29, 
1994), 59 FR 50866 (Oct. 6, 1994).
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    The NASD believes that the proposed rule change is consistent with 
section 15A(b)(6) of the Act in that these proposed changes are 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to facilitate 
transactions in these securities, to remove impediments to and to 
perfect the mechanism of a free and open market and a national market 
system, and in general to protect investors and the public interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended. Accordingly, while 
the NASD will monitor carefully for any adverse competitive effects of 
the Interpretation, it believes that any adverse effects are far 
outweighed by the enhanced execution opportunities provided public 
investors.

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

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the NASD consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to SR-NASD-94-62, Amendment No. 1 
and should be submitted by March 7, 1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority, 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-4358 Filed 2-16-95; 5:00 pm]
BILLING CODE 8010-01-M