Document ID: SEC-2012-1485-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2012-09-10T04:00Z

[Federal Register Volume 77, Number 175 (Monday, September 10, 2012)]
[Notices]
[Pages 55519-55523]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-22139]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-67774; File No. SR-FINRA-2012-025]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving Proposed Rule Change, as Modified by 
Amendment No. 1, To Adopt Existing NASD IM-2110-3 as New FINRA Rule 
5270 (Front Running of Block Transactions) With Changes in the 
Consolidated FINRA Rulebook

September 4, 2012.

I. Introduction

    On May 17, 2012, Financial Industry Regulatory Authority, Inc. 
(``FINRA'') (f/

[[Page 55520]]

k/a National Association of Securities Dealers, Inc. (``NASD'')) filed 
with the Securities and Exchange Commission (``Commission''), pursuant 
to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') 
\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to adopt 
existing NASD Interpretive Material (``IM'') 2110-3 (Front Running 
Policy) as proposed FINRA Rule 5270 to amend the existing Front Running 
Policy in several ways to broaden its scope and provide further clarity 
into activities that FINRA believes are inconsistent with just and 
equitable principles of trade. The proposed rule change was published 
for comment in the Federal Register on June 6, 2012.\3\ The Commission 
received two comment letters on the proposed rule change,\4\ and a 
response to comments from FINRA.\5\ On August 30, 2012, FINRA submitted 
Amendment No. 1 to the proposal.\6\ This order approves the proposed 
rule change, as modified by Amendment No. 1.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 67079 (May 30, 
2012), 77 FR 33522 (``Notice'').
    \4\ See Letters to Elizabeth M. Murphy, Secretary, Commission, 
from Ryan K. Bakhtiari, President, Public Investors Arbitration Bar 
Association (``PIABA''), dated June 26, 2012 (``PIABA Letter''); and 
Sean Davy, Managing Director, Corporate Credit Markets Division, 
Securities Industry and Financial Markets Association (``SIFMA''), 
dated July 9, 2012 (``SIFMA Letter'').
    \5\ See Letter from Brant K. Brown, Associate General Counsel, 
FINRA, to Elizabeth M. Murphy, Secretary, Commission, dated August 
29, 2012 (``FINRA Response'').
    \6\ In that amendment, FINRA clarified that the proposed rule 
would not apply to orders or transactions involving government 
securities. FINRA noted, however, that actions for similar front-
running conduct occurring in the exempted securities markets, 
including the government securities market, continue to be covered 
by FINRA Rule 2010. In the amendment, FINRA also clarified that the 
10,000 share language in proposed Supplementary Material .03 refers 
to equity securities. Because this amendment is technical in nature, 
it is not subject to notice and comment.
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II. Description of the Proposal

    As part of the process of developing a consolidated rulebook,\7\ 
FINRA proposed to adopt existing NASD IM-2110-3 (``Front Running 
Policy'') as proposed FINRA Rule 5270 with the changes described below.
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    \7\ The 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. 
See FINRA Information Notice, March 12, 2008 (Rulebook Consolidation 
Process).
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A. Current Front Running Policy

    The current Front Running Policy states that it shall be considered 
conduct inconsistent with just and equitable principles of trade for a 
member or a person associated with a member, for an account in which 
such member or person associated with a member has an interest or 
exercises investment discretion or for certain customer accounts, to 
buy or sell an option or security future when the member or person 
associated with a member has material, non-public market information 
concerning an imminent block transaction \8\ in the underlying security 
or when the customer has been provided such material, non-public market 
information by the member of any person associated with a member.\9\ 
Similarly, the same prohibition applies for a member or any person 
associated with a member with respect to an order to buy or sell an 
underlying security when such member or person associated with a member 
causing such order to be executed has material, non-public market 
information concerning an imminent block transaction in an option or a 
security future overlying that security, or when a customer has been 
provided such material, non-public market information by the member or 
any person associated with a member; prior to the time information 
concerning the block transaction has been made publicly available.\10\
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    \8\ NASD IM-2110-3 states that ``[a] transaction involving 
10,000 shares or more of an underlying security, or options or 
security futures covering such number of shares is generally deemed 
to be a block transaction, although a transaction of less than 
10,000 shares could be considered a block transaction in appropriate 
cases.''
    \9\ See NASD IM-2110-3(a).
    \10\ See NASD IM-2110-3(b).
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    The Front Running Policy also prohibits providing material, non-
public market information concerning an imminent block transaction to 
customers who then trade on the basis of the information. The Front 
Running Policy is limited to transactions in equity securities and 
options that are required to be reported on a last sale reporting 
system and to any transaction involving a security future, regardless 
of whether the transaction is reported. The prohibitions apply until 
the information concerning the block transaction has been made publicly 
available.\11\
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    \11\ See NASD IM-2110-3 (``when [the information] has been 
disseminated via the tape or high speed communications line of one 
of those systems, a similar system of a national securities exchange 
under Section 6 of the Act, an alternative trading system under 
Regulation ATS, or by a third-party news wire service'').
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    Finally, the Front Running Policy includes exceptions for 
``transactions executed by member participants in automatic execution 
systems in those instances where participants must accept automatic 
executions'' as well as situations where a member receives a customer's 
block order relating to both an option or security future and the 
underlying security and the member, in furtherance of facilitating the 
customer's block order, positions the other side of one or both 
components of the order. In the latter case, a member is still 
prohibited from covering any resulting proprietary position by entering 
an offsetting order until information concerning the block transaction 
has been made publicly available.

B. Proposed Changes to Front Running Policy

1. Expansion of the Front Running Policy
    FINRA proposes to expand the Front Running Policy to apply to all 
securities and other financial instruments and contracts (in addition 
to the existing options and security futures) that overlay the security 
that is the subject of an imminent block transaction and that have a 
value that is materially related to, or otherwise acts as a substitute 
for, the underlying security. Specifically, FINRA proposes to expand 
the Front Running Policy to cover trading in an option, derivative, 
security-based swap, or other financial instrument overlying a security 
that is the subject of an imminent block transaction if the value of 
the underlying security is materially related to, or otherwise acts as 
a substitute for, such security, as well as any contract that is the 
functional economic equivalent of a position in such security 
(``related financial instrument'').\12\
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    \12\ FINRA notes that the proposed rule is not intended to 
provide an exhaustive list of prohibited trading activity. See 
Notice, supra note 3.
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    The proposal would also expand the Front Running Policy when the 
imminent block transaction involves a related financial instrument, and 
prevent trading in the underlying security. The proposed rule change 
also would extend the Front Running Policy to include explicitly 
trading in the same security or related financial instrument that is 
the subject of an imminent block transaction.\13\
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    \13\ The trading restrictions imposed by the current Front 
Running Policy apply until information about the imminent customer 
block transaction ``has been made publicly available,'' which the 
rule defines as having been disseminated to the public in trade 
reporting data. The proposed rule change generally retains this 
standard for determining when information has become publicly 
available. However, FINRA proposes to expand the rule to include 
related financial instruments that may not result in publicly 
available trading information being made available. Accordingly, 
FINRA also proposes that the prohibitions in the rule be in place 
until the material, non-public market information is either publicly 
available or ``has otherwise become stale or obsolete.'' Whether 
information has become stale or obsolete will depend upon the 
particular facts and circumstances involved, including specific 
information the member has regarding the transaction, but could 
include factors such as the amount of time that has passed since the 
member learned of the block transaction, subsequent trading activity 
in the security, or a significant change in market conditions.

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[[Page 55521]]

2. Amended Exceptions to the Front Running Policy
    The proposed rule change would replace several existing provisions 
in the Front Running Policy with proposed Supplementary Material to 
FINRA Rule 5270. FINRA proposes to replace the existing exceptions in 
the Front Running Policy for certain transactions in automatic 
execution systems and for positioning the other side of certain orders 
when a member receives a customer's block order relating to both an 
option and the underlying security or both a security future and the 
underlying security. The new Supplementary Material identifies types of 
transactions that are permitted. Specifically, under the proposed 
Supplementary Material, there would be three broad categories of 
permitted transactions: (1) Transactions that the member can 
demonstrate are unrelated to the customer block order; (2) transactions 
that are undertaken to fulfill or facilitate the execution of the 
customer block order; or (3) transactions that are executed, in whole 
or in part, on a national securities exchange and comply with the 
marketplace rules of that exchange. These three categories of permitted 
transactions are discussed below.
    First, with respect to transactions that are unrelated to the 
customer block order, Supplementary Material .04(a) would allow members 
to engage in such transactions provided that the member can demonstrate 
that the transactions are unrelated to the material, non-public market 
information received in connection with the customer order. The 
Supplementary Material would include a list of potentially permitted 
transactions as examples of transactions that, depending upon the 
circumstances, may be unrelated to the customer block order. These 
types of transactions could include transactions where the member has 
effective information barriers established to prevent internal 
disclosure of customer order information,\14\ transactions in the 
security that is the subject of the customer block order that are 
related to a prior customer order in that security, transactions to 
correct bona fide errors, and transactions to offset odd-lot orders.
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    \14\ According to FINRA, in addition to more traditional 
information barriers, such as those in place to prevent 
communication between trading units, this provision could also 
include the use of automated systems (e.g., trades through a ``black 
box'') where the orders placed into the automated system are handled 
without the knowledge of a person associated with the member who may 
be trading in the same security. However, a person associated with a 
member who places an order into a ``black box'' or other automated 
system, or otherwise has knowledge of the order or the ability to 
access information in the system, may not then trade in the same 
security or a related financial instrument solely because the order 
ultimately was being handled by the automated system rather than by 
the person. Traders who have no knowledge of the order, due to the 
presence of an information barrier or otherwise, could continue to 
trade in the security or a related financial instrument. See Notice, 
supra note 3.
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    Second, with respect to transactions undertaken to fulfill or 
facilitate the execution of the customer block order, proposed 
Supplementary Material .04(b) would specify that Front Running Policy 
does not preclude transactions undertaken for the purpose of 
fulfilling, or facilitating the execution of, a customer's block 
order.\15\ According to FINRA, firms are permitted to trade ahead of a 
customer's block order when the purpose of such trading is to fulfill 
the customer order and when the customer has authorized such trading, 
including that the firm has disclosed to the customer that it may trade 
ahead of, or alongside of, the customer's order. FINRA proposes, 
however, that when engaging in trading activity that could affect the 
market for the security that is the subject of the customer block 
order, the member must minimize any potential disadvantage or harm in 
the execution of the customer's order, must not place the member's 
financial interests ahead of those of its customer, and must obtain the 
customer's consent to such trading activity. The Supplementary Material 
would provide that a member may obtain consent through affirmative 
written consent or through means of a negative consent letter.\16\ In 
addition, a member may provide clear and comprehensive oral disclosure 
to, and obtain consent from, the customer on an order-by-order basis, 
provided the member documents who provided the consent and such consent 
evidences the customer's understanding of the terms and conditions for 
handling the customer's order.
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    \15\ According to FINRA, these transactions may include, for 
example, hedging or other positioning activity undertaken in 
connection with the handling of the customer order. See Notice, 
supra note 3.
    \16\ The negative consent letter must clearly disclose to the 
customer the terms and conditions for handling the customer's 
orders, and if the customer does not object, then the member may 
reasonably conclude that the customer has consented and may rely on 
the letter.
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    Finally, proposed Supplementary Material .04(c) would state that 
the prohibitions in the Front Running Policy shall not apply if the 
member's trading activity is undertaken in compliance with the 
marketplace rules of a national securities exchange and at least one 
leg of the trading activity is executed on that exchange.
3. Other Proposed Changes
    FINRA proposes to adopt proposed Supplementary Material .05 to 
state that the front running of any customer order, not just imminent 
block transactions, that places the financial interests of the member 
ahead of those of its customer or the misuse of knowledge of an 
imminent customer order may violate other FINRA rules, including FINRA 
Rules 2010 and 5320, or the federal securities laws.\17\
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    \17\ Although ``not held'' orders are not subject to the 
restrictions in FINRA Rule 5320, front running a ``not held'' order 
that is not of block size may nonetheless violate FINRA Rule 2010. 
See Securities Exchange Act Release No. 63895 (February 11, 2011), 
76 FR 9386 (February 17, 2011). If the ``not held'' order is of 
block size, the proposed rule change would apply to trading activity 
ahead of the order.
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    As initially proposed, FINRA would announce the implementation date 
of the proposed rule change in a Regulatory Notice to be published no 
later than 90 days following Commission approval, with the 
implementation date occurring no later than 90 days following 
publication of that Regulatory Notice.\18\
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    \18\ See FINRA Response, supra note 5.
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III. Discussion of Comment Letters and FINRA Response

    The Commission received one comment letter in support of the 
proposed rule change,\19\ and one comment letter requesting revisions 
and clarifications to the proposed rule change.\20\ As noted above, 
FINRA responded to the comments in its response dated August 29, 2012.
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    \19\ See PIABA Letter, supra note 4.
    \20\ See SIFMA Letter, supra note 4.
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    One commenter stated its belief that the extension of the Front 
Running Policy to cover any securities and financial instruments (not 
just option contracts and futures) was a logical approach and would 
better protect investors.\21\ The commenter expressed concern with the 
exceptions provided in the Supplementary Material, and stated that 
FINRA should closely monitor the

[[Page 55522]]

exceptions to ensure member firms are not using them as loopholes to 
engage in prohibited activities. In its response, FINRA stated that it 
intends to examine firms for compliance with, and fully enforce, the 
proposed rule.\22\
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    \21\ See PIABA Letter.
    \22\ See FINRA Response.
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    The other commenter raised three substantive issues with the 
proposal.\23\ First, the commenter stated that the proposed rule change 
contained a flaw in that the barriers to the resumption of trading in 
the applicable security or related financial instrument--that the 
information concerning the block transaction has been made publicly 
available or has otherwise become stale or obsolete--could interfere 
with a broker-dealers' risk management activity, which could create 
problems in providing liquidity to the market.\24\ The commenter 
requested clarity on what serves as the trigger for lifting trading 
restrictions and stated that trading restrictions should be lifted once 
the risk of a transaction has been transferred from the customer 
through the execution of the order.\25\ According to the commenter, in 
the context of a block transaction where a member executes as a 
principal, the member provides liquidity to the market and is assuming 
the risks of the transaction. While executing a block transaction in an 
agency capacity, a member cannot trade ahead of its customer because 
the execution of the transaction eliminates the opportunity to do so. 
In certain situations where a type of security is not subject to prompt 
last sale reporting requirements, the commenter stated that the ``stale 
or obsolete'' threshold proposed by FINRA could prevent a dealer from 
performing necessary risk management activities while providing no 
additional benefit to the customer. Accordingly, the commenter 
requested confirmation that the execution of a block transaction by the 
member as principal or agent will be deemed to render the non-public 
information stale and obsolete for the purposes of front-running the 
customer, and permit the broker-dealer to transact in the security or 
related financial instrument, even if the applicable customer-related 
transaction has not become public.
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    \23\ See SIFMA Letter.
    \24\ See SIFMA Letter.
    \25\ Id.
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    FINRA responded that the ``stale or obsolete'' standard was 
intended to supplement, not replace, the existing dissemination 
standard.\26\ FINRA noted that the trading restrictions in proposed 
FINRA Rule 5270 are linked to actual reporting and dissemination rather 
than by invoking the ``stale or obsolete'' standard when transactions 
are subject to prompt reporting requirements and the transaction 
reports are disseminated. Where there is no reporting and dissemination 
regime in place for the security or financial instrument, FINRA agreed 
with the commenter that, once the customer's order is executed and the 
risk of the transaction has transferred from the customer to the firm, 
there would be no trading restrictions imposed by proposed FINRA Rule 
5270.\27\
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    \26\ Under NASD IM-2110-3, information regarding a block 
transaction is considered publicly available ``when it has been 
disseminated via the tape or high speed communications line of one 
of those systems, a similar system of a national securities exchange 
under Section 6 of the Act, an alternative trading system under 
Regulation ATS, or by a third-party news wire service.''
    \27\ See FINRA Response at 3.
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    Second, the commenter requested additional clarification on whether 
the negative consent letter described in proposed Supplementary 
Material .04 would satisfy and be consistent with the ``duty to refrain 
and disclose'' described in NASD Notice to Members 05-51 (``NTM 05-
51'') and FINRA Rule 5320.\28\ Additionally, the commenter requested 
clarity on whether the duty to refrain and disclose described in NTM 
05-51 \29\ arises on the basis of the same analysis as the obligations 
under proposed FINRA Rule 5270.
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    \28\ FINRA Rule 5320 (Prohibition Against Trading Ahead of 
Customer Orders) generally prohibits a member that accepts and holds 
a customer order in an equity security without immediately executing 
the order from trading that security on the same side of the market 
for its own account at a price that would satisfy the customer 
order, unless it immediately thereafter executes the customer order 
up to the size and at the same or better price at which it traded 
for its own account.
    \29\ NTM 05-51 addresses members' obligations involving large, 
potentially market-moving orders received from a customer, such as 
VWAPs, institutional orders, and basket transactions. It states 
that, when a member receives such an order, it must ``(1) refrain 
from any conduct that could disadvantage or harm the execution of 
the customer's order or place the member's financial interests ahead 
of those of its customer's and (2) if applicable, disclose in 
writing to the customer that the member intends to engage in hedging 
and other positioning activity that could affect the market for the 
security that is the subject of the transaction.'' It further states 
that the disclosure must be in the form of an affirmative consent 
letter, but the disclosure need not be on a transaction-by-
transaction basis.
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    In its response, FINRA agreed that, to the extent possible, 
proposed Supplementary Material .04 should be read consistently with 
NTM 05-51 and the obligations set out in FINRA Rule 5320.\30\ FINRA 
stated that the proposed Supplementary Material was intended to 
acknowledge FINRA's previous guidance and the disclosure and consent 
provision in proposed Supplementary Material .04 mirrors FINRA Rule 
5320. Moreover, FINRA stated that the duties set out in NTM 05-51 arise 
from the same concerns that FINRA Rule 5270 is designed to address. 
FINRA affirmed that proposal encapsulates the obligations established 
in NTM 05-51 with the difference noted by SIFMA: the disclosure 
obligation in proposed Supplementary Material .04 can be in the form of 
negative consent or, provided certain criteria are met, oral consent, 
which is not permitted by the duty to refrain and disclose as set out 
in NTM 05-51. FINRA further noted that, in addition to complying with 
the disclosure obligation in proposed Supplementary Material .04, the 
member must minimize any potential disadvantage to the customer or harm 
in the execution of the customer's order, and the member must not place 
its financial interests ahead of those of its customer. FINRA stated 
that, provided a member meets all of the criteria in proposed 
Supplementary Material .04, that member would have fulfilled its duty 
to refrain and disclose as set out in the Notice to Members.
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    \30\ See FINRA Response at 4.
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    Finally, the commenter requested a 180-day implementation period 
following publication of the applicable Regulatory Notice announcing 
the Commission's approval of the proposal, rather than a 90-day 
implementation period, because members will need to make additional 
technology and system modifications to comply with the rule.\31\ FINRA 
responded that it would extend the implementation date to within 180 
days following publication of the Regulatory Notice announcing the 
Commission's approval of the rule.\32\
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    \31\ See SIFMA Letter at 4.
    \32\ See FINRA Response at 5.
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IV. Discussion and Commission Findings

    After careful review of the proposal, the comment letters, and the 
FINRA Response, the Commission finds that the proposed rule change is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities association 
\33\ and, in particular, the requirements 15A(b)(6) of the Act.\34\ 
Specifically, the Commission finds that the proposed rule change is 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to remove impediments 
to and perfect the mechanism of a free and open market and a national 
market system, and, in

[[Page 55523]]

general, to protect investors and the public interest.
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    \33\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \34\ 15 U.S.C. 78o-3(b)(6).
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    The proposed rule change is intended to clarify the types of front 
running trading activity that FINRA believes are inconsistent with just 
and equitable principles of trade while also ensuring that members may 
continue to engage in transactions that do not present the risk of 
abusive trading practices that the rule is intended to prevent. The 
Commission finds that expanding the rule beyond options and security 
futures could enhance the protection of investors by further 
prohibiting the potential misuse of information from customer orders. 
Expanding the front running prohibition is reasonably designed to 
prevent fraudulent and manipulative acts and practices, promote just 
and equitable principles of trade, and better protect investors and the 
public interest, while protecting imminent block transactions.
    Moreover, the proposed rule change also would include three 
exceptions to the Front Running Policy: (1) Transactions that the 
member can demonstrate are unrelated to the customer block order; (2) 
transactions that are undertaken to fulfill or facilitate the execution 
of the customer block order; and (3) transactions that are executed, in 
whole or in part, on a national securities exchange and comply with the 
marketplace rules of that exchange. The Commission finds that these 
exceptions should not unnecessarily restrict legitimate trading 
activities of members and are consistent with just and equitable 
principles of trade and the protection of investors and the public 
interest, and should not result in fraudulent and manipulative acts and 
practices. Specifically, transactions that the member can demonstrate 
are unrelated to the customer block order do not present the potential 
for abusive trading practices that can disadvantage a customer's order 
in violation of the rule, since such transactions would not be using 
the information from the customer's order. Moreover, transactions that 
are undertaken to fulfill or facilitate the execution of the customer 
block order similarly do not present the potential for abuse, as such 
transactions would be seeking to ensure the execution of a customer 
block order. Finally, permitting transactions that are executed, in 
whole or in part, on a national securities exchange and comply with the 
marketplace rules of that exchange would remove impediments to and 
perfect the mechanism of a free and open market and a national market 
system,\35\ as it would help ensure that members would not unknowingly 
violate FINRA rules when such members rely on the rules of a particular 
national securities exchange.
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    \35\ 15 U.S.C. 78o-3(b)(6).
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    For the foregoing reasons, the Commission believes that the 
proposed rule change, as modified by Amendment No. 1, is consistent 
with the requirements of the Act.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\36\ that the proposed rule change (SR-FINRA-2012-025), as modified 
by Amendment No. 1, be, and hereby is, approved.
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    \36\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\37\
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    \37\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2012-22139 Filed 9-7-12; 8:45 am]
BILLING CODE 8011-01-P