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[Federal Register Volume 60, Number 47 (Friday, March 10, 1995)]
[Notices]
[Pages 13199-13201]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-6088]

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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35454; File No. SR-NASD-94-62, Amendment No. 2]

Self-Regulatory Organizations; Notice of Filing of Amendment No. 
2 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

March 8, 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 March 7, 
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 recently proposed to amend SR-NASD-94-62 relating to limit 
order protection for member-to-member limit order handling in The 
Nasdaq Stock Market.\1\ Currently, the NASD's Interpretation to the 
Rules of Fair Practice\2\ 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. That amendment clarified 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.\3\ The NASD now is proposing to amend 
the proposed rule change to provide that the ``terms and conditions'' 
exception to the Interpretation also applies to limit orders that are 
10,000 shares or more, unless such orders are less than $100,000 in 
value, as well as to limit orders from institutional accounts. 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\See Securities Exchange Act Release No. 35391 (Feb. 16, 
1995), 60 FR 9878 (Feb. 22, 1995. 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).
    \2\NASD Manual, Rules of Fair Practice, Art. III, Sec. 1 (CCH) 
2151.07.
    \3\NASD Manual, Rules of Fair Practice, Art. III, Sec. 21 (CCH) 
2171.
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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 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 that of the 
limit order, [[Page 13200]] 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 that are: 
(1) 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; or (2) 10,000 shares or 
greater, unless such orders are less than $100,000 in value. 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 or appropriately sized customer limit orders are accepted must 
be made clear to customers at the time the order is accepted by the 
firm so that trading ahead in the 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 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 its 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 
expand the Interpretation's ``terms and conditions'' exception to the 
protection of limited orders. The NASD is amending its proposal to 
permit member firms to negotiate terms and conditions for certain 
larger sized customer orders from accounts other than institutional 
accounts (``retail accounts'').
    The NASD believes that the terms and conditions exception to the 
handling of limit orders should apply not only to customer orders from 
institutional accounts, but also to other orders that are usually 
perceived of as ``institutional'' in nature. To ensure that markets 
makers are able to negotiate regarding the handling of such orders, the 
NASD is proposing to permit markers to negotiate terms and conditions 
with respect to orders of retail accounts that are 10,000 shares or 
greater, unless such orders are less than $100,000 in value. This 
numerical size limit is intended to ensure that ordinary limit orders 
from detail accounts are not subject to the terms and conditions 
exception.
    The provision allows market makers to negotiate specific order 
handling procedures with parties that deal in larger sized orders. 
Therefore, market makers can employ appropriate strategies in filling 
larger sized orders. The order sizes contained in this amendment are 
intended to ensure that the Interpretation provides limit order 
protection for retail investors, while maintaining the ability of 
market makers to negotiate with respect to institutional-sized orders, 
whether account customers constitute institutional accounts or retail 
accounts.
    Accordingly, the amendment provides that a member firm that accepts 
a limit order from a person or entity that does not fall with the 
definition of institional account may not initiate the negotiation of 
any terms and conditions on the acceptance of that limit order, unless 
that order is for 10,000 shares or more and is for a price of $100,000 
or greater. For example, if an order were for 10,000 shares, but the 
price per share were only $5.00, the total order value would be 
$50,000. The order would not qualify for the terms and conditions 
exception because the total value of the order would be less than 
$100,000. This amendment does not affect the ability of a member firm 
to negotiate special terms and conditions with the customer of an 
institutional account, or its representative, that permit the firm to 
trade ahead of or at the same price as the limit order, regardless of 
the size or value of that 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 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. Moreover, in its approval of the original NASD Interpretation 
regarding the handling of customer limit orders,\4\ the Commission 
specifically indicated its view that the terms and conditions language 
of the original Interpretation was included in the NASD Rule to permit 
special treatment for institutional customer limit orders. In addition, 
in its own proposal regarding customer limit order protection of Nasdaq 
securities\5\ the Commission solicited comment on the ``terms and 
conditions'' provisions in its rule, which would allow a market maker 
to set special conditions to allow it to employ the appropriate 
strategy in filling an institutional customer's order without being 
subjected to the requirements of the proposed rule. In the course of 
that discussion, the Commission proposed that measurable 
characteristics, such as numbers of shares, or dollar value of the 
order, should be used as means to distinguish retail orders from 
institutional orders with respect to terms and conditions.

    \4\See Securities Exchange Act Release No. 34279 (June 29, 
1994), 59 FR 34883 (July 7, 1994).
    \5\Securities Exchange Act Release No. 34753 (Sept. 29, 1994), 
59 FR 50867 (Oct. 6, 1994) (proposing 17 CFR 240.15c5-1).
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    Of course, the clarification of the Interpretation continues to 
permit a member to establish with its customers [[Page 13201]] or the 
order entry firm commissions or commission-equivalents regarding the 
handling of a limit order, provided that the member makes those 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.
    The NASD believes that the proposed rule change is consistent with 
Section 15A(b)(6) in that these proposed changes are designated 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 
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, NW., Washington, DC 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. 2 
and should be submitted by March 27, 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. 95-6088 Filed 3-8-95; 12:34 pm]
BILLING CODE 8010-01-M
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