Document ID: SEC-2009-1795-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2009-12-22T05:00Z

[Federal Register: December 22, 2009 (Volume 74, Number 244)]
[Notices]               
[Page 68084-68088]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22de09-74]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-61168; File No. SR-FINRA-2009-090]

 
Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of Proposed Rule Change Relating To 
Adopt FINRA Rule 5320 (Prohibition Against Trading Ahead of Customer 
Orders) in the Consolidated FINRA Rulebook

December 15, 2009.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on December 10, 2009, Financial Industry Regulatory Authority, Inc. 
(``FINRA'') (f/k/a National Association of Securities Dealers, Inc. 
(``NASD'')) filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') the proposed rule change as described in Items I, 
II, and III below, which Items have been prepared by FINRA. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing to adopt NASD Interpretive Material (IM) 2110-2 
(Trading Ahead of Customer Limit Order) and NASD Rule 2111 (Trading 
Ahead of Customer Market Orders) with significant changes in the 
Consolidated FINRA Rulebook as new FINRA Rule 5320 (Prohibition Against 
Trading Ahead of Customer Orders).
    The text of the proposed rule change is available on FINRA's Web 
site at http://www.finra.org, on the Commission's Web site at http://
www.sec.gov, at the principal office of FINRA, and at the Commission's 
Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA 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. FINRA 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
    As part of the process of developing a new consolidated rulebook 
(``Consolidated FINRA Rulebook''),\3\ FINRA is proposing to adopt NASD 
IM-2110-2 (Trading Ahead of Customer Limit Order) and NASD Rule 2111 
(Trading Ahead of Customer Market Orders) with significant changes in 
the Consolidated FINRA Rulebook as new FINRA Rule 5320 (Prohibition 
Against Trading Ahead of Customer Orders).
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    \3\ The current FINRA rulebook consists of (1) FINRA Rules; (2) 
NASD Rules; and (3) rules incorporated from NYSE (``Incorporated 
NYSE Rules'') (together, the NASD Rules and Incorporated NYSE Rules 
are referred to as the ``Transitional Rulebook''). While the NASD 
Rules generally apply to all FINRA members, the Incorporated NYSE 
Rules apply only to those members of FINRA that are also members of 
the NYSE (``Dual Members''). The FINRA Rules apply to all FINRA 
members, unless such rules have a more limited application by their 
terms. For more information about the rulebook consolidation 
process, see Information Notice, March 12, 2008 (Rulebook 
Consolidation Process).
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Background
    IM-2110-2 generally prohibits a member from trading for its own 
account in an NMS stock, as defined in Rule 600(b)(47) of SEC 
Regulation NMS, or an OTC equity security (e.g., OTCBB and pink sheets 
securities) at a price

[[Page 68085]]

that is equal to or better than an unexecuted customer limit order in 
that security, unless the member immediately, in the event it trades 
ahead, executes the customer limit order at the price at which it 
traded for its own account or better.\4\
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    \4\ For example, if a member buys 100 shares of a security at 
$10 per share while holding customer limit orders in the same 
security to buy at $10 per share equaling, in aggregate, 1,000 
shares, the member is required to fill 100 shares of the customer 
limit orders at $10 per share or better.
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    Similarly, Rule 2111 generally prohibits a member that accepts and 
holds a customer market order in a Nasdaq or exchange-listed security 
from trading for its own account at prices that would satisfy a 
customer market order, unless the firm immediately thereafter executes 
the customer market order up to the size and at the same price at which 
it traded for its own account or better. At present, Rule 2111 does not 
apply to OTC equity securities.
    While there is no Incorporated NYSE Rule counterpart to IM-2110-2 
and Rule 2111 (collectively referred to herein as ``customer order 
protection'' rules), New York Stock Exchange LLC (``NYSE'') Rule 92 
imposes similar requirements on NYSE members in NYSE-listed securities. 
NYSE Rule 92 generally prohibits members or member organizations from 
knowingly entering proprietary orders ahead of, or along with, customer 
orders that are executable at the same price as the proprietary order.
    As discussed below, FINRA is proposing several changes to the 
standards set forth in IM-2110-2 and Rule 2111 to simplify and clarify 
these rules, as well as create an industry standard that incorporates 
elements from existing FINRA and NYSE rules.
Integration of IM-2110-2 and Rule 2111
    FINRA is proposing to integrate IM-2110-2 and Rule 2111 into a 
single rule (proposed Rule 5320) governing members' treatment of 
customer orders and to apply the new rule to all equity securities 
uniformly, other than the no-knowledge interpretation as detailed 
below. In addition to streamlining and simplifying the rules, the 
principal change resulting from the proposed combination of these rules 
is to extend the application of Rule 2111 to OTC equity securities. As 
noted above, Rule 2111 currently applies only to Nasdaq or exchange-
listed securities, while IM-2110-2 applies to both NMS stocks and OTC 
equity securities. FINRA believes that the same concerns that arise 
with respect to trading ahead of limit orders in OTC equity securities 
also exist with respect to market orders and, therefore, an expansion 
of the Rule 2111 protections to those securities is appropriate.
Large Orders and Institutional Accounts
    There are several exceptions to the customer order protection 
rules. Most notably, members are permitted to negotiate terms and 
conditions on the acceptance of certain large-sized orders (orders of 
10,000 shares or more and greater than $100,000 in value) and orders 
from institutional accounts as defined in NASD Rule 3110(c) 
(collectively referred to as ``Institutional/Large-Sized Orders''). 
Such terms and conditions would permit the member to continue to trade 
along side or ahead of such customer orders if the customer agrees.
    FINRA is proposing to modify the steps necessary for a member to 
avail itself of this exception for Institutional/Large-Sized Orders. 
Specifically, under the proposed rule, a member would be permitted to 
trade a security on the same side of the market for its own account at 
a price that would satisfy a customer order provided that the member 
provides clear and comprehensive written disclosure to each customer at 
account opening and annually thereafter that: (a) Discloses that the 
member may trade proprietarily at prices that would satisfy the 
customer order, and (b) provides the customer with a meaningful 
opportunity to opt in to the Rule 5320 protections with respect to all 
or any portion of its order(s).\5\
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    \5\ FINRA reminds members that, even where a customer has not 
opted in to the protections under proposed Rule 5320, member conduct 
must continue to be consistent with the guidance provided in the 
Notice to Members 05-51 (August 2005). In Notice to Members 05-51, 
FINRA, among other things, reminded members that adherence to just 
and equitable principles of trade as mandated by Rule 2010 
``requires that members handle and execute any order received from a 
customer in a manner that does not disadvantage the customer or 
place the member's financial interests ahead of those of its 
customer.'' See also NASD Rule 2320 (Best Execution and 
Interpositioning).
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    If a customer does not opt in to the Rule 5320 protections with 
respect to all or any portion of its order(s), the member may 
reasonably conclude that such customer has consented to the member 
trading a security on the same side of the market for its own account 
at a price that would satisfy the customer's order.\6\
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    \6\ As is always the case, customers retain the right to 
withdraw consent at any time. Therefore, a member's reasonable 
conclusion that a customer has consented to the member trading along 
with such customer's order is subject to further instruction and 
modification from the customer.
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    In lieu of providing written disclosure to customers at account 
opening and annually thereafter, the proposed rule would permit members 
to provide clear and comprehensive oral disclosure to, and obtain 
consent from, a customer on an order-by-order basis, provided that the 
member documents who provided such consent and that such consent 
evidences the customer's understanding of the terms and conditions of 
the order. In addition, where a customer has opted in to the Rule 5320 
protections, a member may still obtain consent on an order-by-order 
basis to trade ahead of or along with an order from that customer, 
provided that the member documents who provided such consent and that 
such consent evidences the customer's understanding of the terms and 
conditions of the order.\7\
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    \7\ While a firm relying on this or any exception must be able 
to proffer evidence of its eligibility for and compliance with the 
exception, FINRA believes that when obtaining consent on an order-
by-order basis, members must, at a minimum, document not only the 
terms and conditions of the order (e.g., the relative price and size 
of the allocated order/percentage split with the customer), but also 
the identity of the person at the customer who approved the trade-
along request. For example, the identity of the person must be noted 
in a manner that will enable subsequent contact with that person if 
a question as to the consent arises (i.e., first names only, 
initials, and nicknames will not suffice).
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No-Knowledge Exception
    Both the FINRA customer order protection requirements and NYSE Rule 
92 have similar, but not identical, ``no-knowledge'' exceptions. 
Specifically, NYSE Rule 92, by its terms, is limited to those 
circumstances where the firm knowingly trades ahead of its customer. 
Accordingly, under NYSE Rule 92, a firm may trade ahead of a customer 
order as long as the person entering the proprietary order has no 
knowledge of the unexecuted customer order.\8\ Similarly, FINRA 
previously established a ``no-knowledge'' interpretation to its 
customer order protection requirements. Under this interpretation, if a 
firm implements and utilizes an effective system of internal controls, 
such as appropriate information barriers that operate to prevent a non-
market-making proprietary desk from obtaining knowledge of customer 
orders held at the firm's market-making desk, those ``walled off'' non-
market-making proprietary desks are permitted to trade at prices that 
would satisfy the customer orders held by the market-making desk 
without any requirement that such proprietary executions trigger an

[[Page 68086]]

obligation to fill pending customer orders at the same price.\9\
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    \8\ Under NYSE Rule 92.10, a member or employee of a member or 
member organization is ``presumed to have knowledge of a particular 
customer order unless the member organization has implemented a 
reasonable system of internal policies and procedures to prevent the 
misuse of information about customer orders by those responsible for 
entering proprietary orders.''
    \9\ See Notices to Members 95-43 (June 1995), 03-74 (November 
2003) and 06-03 (January 2006).
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    FINRA's no-knowledge interpretation was established at a time when 
the majority of retail order flow was handled by the firm's market-
making desk and viewed as a critical source of liquidity for customer 
orders. As a result, permitting firms to wall off the market-making 
desk at that time was viewed as untenable fragmentation of liquidity to 
the detriment of retail customers. However, as a result of changes in 
market structure and general order routing protocols discussed below, 
FINRA is proposing to expand and codify the current no-knowledge 
interpretation, consistent with NYSE Rule 92, to include the market-
making desk with respect to NMS stocks.
    Today, many firms handle retail-sized customer orders in NMS stocks 
on an automated basis, separate and apart from the firm's proprietary 
trading desks, including the market-making desk, in which such orders 
are routed through automated systems that search out the market centers 
offering pools of liquidity that offer immediate execution at the 
probable best available prices. Accordingly, some firms have determined 
to structure their order handling practices to ``wall off'' customer 
order flow from their market-making and other proprietary desks.\10\ 
FINRA does not believe that requiring walled-off trading desks to 
integrate orders for compliance with proposed Rule 5320 will 
necessarily enhance the execution quality for these orders in today's 
environment. Thus, with respect to NMS stocks, FINRA believes that 
expanding the current no-knowledge interpretation to include market-
making desks is appropriate and better reflects the realities of the 
current trading environment.
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    \10\ FINRA notes that such a determination must be made in 
conformance with FINRA's best execution requirements. FINRA's best 
execution requirements under NASD Rule 2320(a) generally require 
that, when executing a customer transaction, members use reasonable 
diligence to ascertain the best market for the subject security and 
buy or sell in that market so that the price to the customer is as 
favorable as possible under prevailing market conditions. FINRA 
requested comment on proposed changes to NASD Rule 2320 in 
Regulatory Notice 08-80 (December 2008). These changes would not 
impact the fundamental operation of NASD Rule 2320(a).
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    However, FINRA is not proposing to similarly expand the no-
knowledge interpretation with respect to OTC equity securities because 
the same types of changes in market structure and order handling 
practices have not occurred in that market; OTC equity securities are 
generally not traded at market centers with the same depth of liquidity 
and are not as susceptible to automated routing for best execution. 
Accordingly, the current no-knowledge standard, as set forth in prior 
Notices to Members, would continue to apply to OTC equity securities.
    To the extent a firm structures its order handling practices in NMS 
stocks to ``wall off'' customer order flow from its market-making 
desks, FINRA is proposing to require the firm to disclose that fact in 
writing to its customers. This disclosure would include a description 
of the manner in which customer orders are handled and the 
circumstances under which the firm may trade proprietarily at its 
market-making desk at prices that would satisfy a customer order. The 
proposed disclosure would be required at account opening and on an 
annual basis thereafter and may be combined with the disclosure and 
negative consent statement permitted in connection with the proposed 
Institutional/Large-Sized Order exception.
    In addition, firms that choose to structure their order handling 
practices in NMS stocks to ``wall off'' customer order flow from their 
market-making desks must obtain and use a unique market participant 
identifier (MPID) for the market-making desk. For example, if customer 
order flow is sent directly to an agency desk and is ``walled-off'' 
from the firm's market-making desk, those two desks must use different 
MPIDs.
Odd Lot and Bona Fide Error Exception
    FINRA proposes applying the customer order protection requirements 
to all customer orders (currently there is a blanket exclusion for odd 
lots), but would provide an exception for a firm's proprietary trade 
that (1) offsets a customer odd lot order (i.e., an order less than one 
round lot, which is typically 100 shares); or (2) corrects a bona fide 
error. With respect to bona fide errors, member firms would be required 
to demonstrate and document the basis upon which a transaction meets 
the bona fide error exception. For purposes of this rule, the 
definition of a ``bona fide error'' is as defined in SEC Regulation 
NMS's exemption for error correction transactions.\11\
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    \11\ Securities Exchange Act Release No. 55884 (June 8, 2007), 
72 FR 32926 (June 14, 2007) (Order Exempting Certain Error 
Correction Transactions from Rule 611 of Regulation NMS under the 
Securities Exchange Act of 1934).
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Trading Outside Normal Market Hours
    FINRA proposes expanding the customer order protection requirements 
to apply at all times that a customer order is executable by the 
member, even outside the period of normal market hours (9:30 a.m. to 4 
p.m.). Currently, the customer order protection requirements apply only 
during normal market hours and after hours (4 p.m. to 6:30 p.m.). Thus, 
customers would have the benefit of the customer order protection rules 
at all times where such order is executable by the member firm, subject 
to any applicable exceptions.
    FINRA will announce the implementation date of the proposed rule 
change in a Regulatory Notice to be published no later than 90 days 
following Commission approval.
2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\12\ which requires, among 
other things, that FINRA rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade and, in general, to protect investors and the 
public interest. FINRA believes that adopting the proposed rules as 
part of the Consolidated FINRA Rulebook will continue to protect 
investors by defining important parameters by which member firms must 
abide when trading proprietarily while holding customer limit and 
market orders.
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    \12\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA 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.

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

    The proposed rule change was published for comment in Regulatory 
Notice 09-15 (March 2009). A copy of the Regulatory Notice is attached 
as Exhibit 2a. FINRA received five comment letters in response to the 
Regulatory Notice and commenters generally supported the proposed 
provisions.\13\ A list of the comment

[[Page 68087]]

letters received is attached as Exhibit 2b, and copies of each comment 
letter received are attached as Exhibit 2c.
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    \13\ Letter from Daniel C. Rome, Esq., General Counsel, Taurus 
Compliance Consulting, LLC, to Marcia E. Asquith, Senior Vice 
President and Corporate Secretary, FINRA, dated April 22, 2009; 
letter from Manisha Kimmel, Executive Director, Financial 
Information Forum, to Marcia E. Asquith, Senior Vice President and 
Corporate Secretary, FINRA, dated April 24, 2009 (``FIF''); letter 
from Ann Vlcek, Managing Director and Associate General Counsel, 
Securities Industry and Financial Markets Association, to Marcia E. 
Asquith, Senior Vice President and Corporate Secretary, FINRA, dated 
April 30, 2009 (``SIFMA''); letter from R. Cromwell Coulson, Chief 
Executive Officer, Pink OTC Markets Inc., to Marcia E. Asquith, 
Senior Vice President and Corporate Secretary, FINRA, dated June 12, 
2009 (``Pink OTC''), and letter from Jack Rubens to Marcia E. 
Asquith, Senior Vice President and Corporate Secretary, FINRA, dated 
September 14, 2009.
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    Commenters generally supported FINRA's effort to integrate the 
limit order protection rule and the market order protection rule into a 
single rule; update and simplify the rules' provisions in light of 
changes in market practices; and work toward a uniform industry 
standard with respect to the customer order protection rule.
(a) Integration of Limit Order Protection and Market Order Protection 
Into a Single Rule
    Commenters supported a uniform industry standard and the proposal 
to apply market order protection to trading in OTC equity securities. 
While some firms asked that FINRA consider the costs and time needed 
for implementation (e.g., FIF requested a nine month implementation 
period), others recommended that FINRA move forward without delay with 
the rule proposal (e.g., SIFMA).
(b) Exception To Permit Trading Ahead of Certain Large Orders/
Institutional Accounts
    Commenters supported FINRA's approach because it provides members 
with a measure of flexibility as to what method of disclosure and 
consent is appropriate, thereby simplifying compliance, while also 
providing adequate customer protection. For example, SIFMA believes 
that negative consent plus disclosure adequately protects customers, 
while affirmative consent is unduly resource-intensive and burdensome.
(c) Expansion of the No-Knowledge Exception To Include Market-Making 
Desks
    Commenters supported the expansion of the ``no-knowledge'' 
exception to trading in NMS stocks at market-making desks. SIFMA and 
FIF recommended allowing (but not requiring) firms to use separate 
MPIDs. SIFMA argued that introducing numerous MPIDs may result in 
complex and expensive reporting and may increase the likelihood of 
operational and technical glitches in such reporting. Thus, SIFMA 
prefers a policies and procedures approach to provide individual firms 
with the flexibility to address surveillance in the best way for each 
particular firm.
    Regarding the expansion of the ``no-knowledge'' exception to 
include market-making desks for NMS stocks, SIFMA and Pink OTC support 
the proposal but also argue that the proposal should also include 
trading in OTC equity securities. SIFMA and Pink OTC also argue that 
the differences in these two markets do not justify applying the rule 
differently and further argues that, where there are differences, the 
OTC market is evolving to the structure of NMS stocks.
    SIFMA and Pink OTC believe that extending the no-knowledge 
exception to cover OTC equity securities would provide firms with the 
flexibility to adapt their order routing practices as changes occur 
without sacrificing customer protection and further argue that the 
adoption of two different standards is inconsistent with the stated 
intentions of harmonization between FINRA and NYSE, which is to bring 
consistency. Pink OTC additionally believes that adoption of a 
harmonious standard for NMS stocks and OTC equity securities would 
facilitate compliance and programming efficiencies.
(d) Extension of the Application of the Rule to Trading During Extended 
Hours
    SIFMA is concerned about the potential impact on systems and 
procedures if proposed Rule 5320 applied to extended-hours trading. 
SIFMA argues that customers who trade in extended hours are generally 
sophisticated and should be treated like institutional and large 
orders, even if smaller or submitted by an individual.
(e) Other Comments
    In response to the Regulatory Notice, Pink OTC also commented on 
aspects of the current Manning rules that were not proposed to be 
amended; particularly, the quantity of the minimum price improvement 
increments (MPI), as well as several trading scenarios with respect to 
which they believed that the timing for the triggering of the MPI 
should be altered.
    Pink OTC argued that the proposed rules should be modified to 
provide market makers with incentives to maintain priced quotations in 
order to foster pricing competition among all market participants and 
promote the institution and maintenance of liquid markets in OTC equity 
securities. Specifically, Pink OTC recommended that (i) customer orders 
qualify for price improvement generally only where defined quotation 
sizes are used; (ii) market makers should be required to provide price 
improvement only where the customer order is received before the firm 
has began the process of executing a trade for its own account; and 
(iii) publicly displayed proprietary quotes should be afforded time 
priority over customer orders that are received after a market-maker's 
proprietary quote is published.

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 self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. In particular, the Commission notes 
that, under the proposal, if a member provides disclosure to the 
customer at account opening and annually thereafter, Institutional/
Large-Sized Orders would not be subject to Manning protection, unless 
the customer affirmatively opted in to the proposed Rule 5320. The 
Commission specifically requests comment on whether such negative 
consent requirement is appropriate and sufficiently protects 
institutional accounts and customers with large orders. Should 
affirmative, written consent be required instead? Further, is 
disclosure at account opening and annually thereafter sufficient to 
protect customer orders? Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/sro.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2009-090 on the subject line.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

[[Page 68088]]

All submissions should refer to File Number SR-FINRA-2009-090. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/
rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Room, 100 F Street, 
NE., Washington, DC 20549, on official business days between the hours 
of 10 a.m. and 3 p.m. Copies of the filing also will be available for 
inspection and copying at the principal office of FINRA. All comments 
received will be posted without change; the Commission does not edit 
personal identifying information from submissions. You should submit 
only information that you wish to make available publicly. All 
submissions should refer to File Number SR-FINRA-2009-090 and should be 
submitted on or before January 12, 2010.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-30336 Filed 12-21-09; 8:45 am]

BILLING CODE 8011-01-P