Document ID: SEC-2011-1917-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2011-12-09T05:00Z

[Federal Register Volume 76, Number 237 (Friday, December 9, 2011)]
[Notices]
[Pages 77042-77044]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-31606]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-65895; File No. SR-FINRA-2011-052]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Granting Approval of Proposed Rule Change To 
Adopt NASD Rule 2320 (Best Execution and Interpositioning) and 
Interpretive Material (``IM'') 2320 as FINRA Rule 5310 in the 
Consolidated Rulebook

 December 5, 2011.

I. Introduction

    On October 4, 2011, Financial Industry Regulatory Authority, Inc. 
(``FINRA'') (f/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 NASD Rule 2320 (Best Execution and 
Interpositioning) and Interpretive Material (``IM'') 2320 (Interpretive 
Guidance with Respect to Best Execution Requirements) as a FINRA rule 
in the consolidated FINRA rulebook with four notable changes. The 
proposed rule change was published for comment in the Federal Register 
on October 21, 2011.\3\ The Commission received one comment letter on 
the proposal.\4\ FINRA filed a response to this comment on December 1, 
2011.\5\ This order approves the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 65579 (October 17, 
2011), 76 FR 65549 (``Notice'').
    \4\ See Letter to Elizabeth M. Murphy, Secretary, Commission, 
from David T. Bellaire, Esq., General Counsel and Director of 
Government Affairs, Financial Services Institute, dated November 14, 
2011 (``FSI Letter'').
    \5\ See Letter from Brant K. Brown, Associate General Counsel, 
FINRA, to Elizabeth M. Murphy, Secretary, Commission, dated December 
1, 2011 (``FINRA Response to Comment'').
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II. Description of the Proposal

    As part of the process of developing a new consolidated rulebook 
(``Consolidated FINRA Rulebook''),\6\ FINRA is proposing to adopt NASD 
Rule 2320 (Best Execution and Interpositioning) and IM-2320 
(Interpretive Guidance with Respect to Best Execution Requirements) as 
a FINRA rule in the consolidated FINRA rulebook with four notable 
changes.\7\ Specifically, the proposed rule change would combine and 
renumber NASD Rule 2320 and IM-2320 as FINRA Rule 5310 in the 
Consolidated FINRA Rulebook.
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    \6\ 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).
    \7\ As part of adopting the NASD rule as a FINRA rule, FINRA has 
also proposed various technical and conforming changes.
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Current NASD Rule 2320 and IM-2320

    NASD Rule 2320 currently requires a member, in any transaction for 
or with a customer or a customer of another broker-dealer, to use 
``reasonable diligence'' to ascertain the best market for a security 
and to buy or sell in such market so that the resultant price to the 
customer is as favorable as possible under prevailing market 
conditions. The rule identifies five factors that are among those to be 
considered in determining whether the member has used reasonable 
diligence.\8\ The rule also includes provisions related to 
interpositioning (i.e., interjecting a third party between the member 
and the best available market), the use of a broker's broker,\9\ the 
staffing of order rooms, and the application of the best execution 
requirements to other parties.
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    \8\ These five factors are: (1) The character of the market for 
the security; (2) the size and type of transaction; (3) the number 
of markets checked; (4) the accessibility of the quotation; and (5) 
the terms and conditions of the order as communicated to the member.
    \9\ The proposed rule change moves part of the provision 
concerning the use of a broker's broker from paragraph (b) of the 
rule to Supplementary Material .05.
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    In addition to these provisions, NASD Rule 2320(f) (commonly 
referred to as the ``Three Quote Rule'') generally requires members 
that execute transactions in non-exchange-listed securities on behalf 
of customers to contact a minimum of three dealers (or all dealers if 
three or fewer) and obtain quotations from those dealers subject to 
certain exclusions.\10\ The Three Quote Rule establishes a minimum 
standard, and compliance with the Three Quote Rule, in and of itself, 
does not mean that a member has met its best execution obligations 
under NASD Rule 2320.\11\
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    \10\ The Three Quote Rule does not apply, for example, when two 
or more priced quotations for a non-exchange-listed security are 
displayed in an inter-dealer quotation system that permits quotation 
updates on a real-time basis. Also excluded from the Three Quote 
Rule are certain transactions in non-exchange-listed securities of 
foreign issuers that are part of the FTSE All-World Index.
    \11\ See NASD Notice to Members 00-78 (November 2000).
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    IM-2320 was adopted in 2006 to codify interpretive guidance that 
FINRA staff had provided involving compliance with NASD Rule 2320.\12\ 
Specifically, IM-2320 addresses issues involving the term ``market'' 
for purposes of the rule as well as the application of the rule to debt 
securities and to broker-dealers that are executing a customer's order 
against the broker-dealer's quote.
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    \12\ See Securities Exchange Act Release No. 54339 (August 21, 
2006), 71 FR 50959 (August 28, 2006).
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Proposed Adoption and Changes to NASD Rule 2320 and IM-2320 as FINRA 
Rule 2310

    FINRA is proposing to adopt NASD Rule 2320 (Best Execution and 
Interpositioning) and IM-2320 (Interpretive Guidance with Respect to 
Best Execution Requirements) as FINRA rule 5310 in the Consolidated 
FINRA Rulebook with four notable changes, discussed in turn.
(1) Three Quote Rule
    Although the original concerns the Three Quote Rule was designed to 
address are still valid, FINRA represents that the current requirements 
in the Three Quote Rule, even with the various exclusions, are overly 
prescriptive and can often result in unnecessary delay in the execution 
of a customer's order or impose requirements that do not benefit the 
customer.\13\ Accordingly, rather than maintain the Three Quote Rule 
and the various exclusions in their current format, the proposed rule 
change replaces the Three Quote Rule with Supplementary Material 
emphasizing a member's best execution obligations

[[Page 77043]]

when handling an order involving any security, equity or debt, for 
which there is limited pricing information available.\14\
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    \13\ See Notice at 65550.
    \14\ See proposed Supplementary Material .06. NASD Rule 
2320(f)(2), which is a subparagraph within the Three Quote Rule, 
generally requires members that display priced quotations on a real-
time basis for a non-exchange-listed security in two or more 
quotation mediums that permit quotation updates on a real-time basis 
to display the same priced quotation in each medium except for 
certain customer limit orders displayed on an electronic 
communications network. Paragraph (f)(4) of the rule includes 
definitions of terms used in paragraph (f)(2). At this time, FINRA 
is proposing to move paragraph (f)(2) into the FINRA Rule 6400 
Series (Quoting and Trading in OTC Equity Securities) as FINRA Rule 
6438. FINRA is also proposing to replace the term ``non-exchange-
listed security'' with the term ``OTC Equity Security'' to conform 
the rule language to other FINRA rules addressing non-NMS stocks. 
The terms ``OTC Equity Security'' and ``quotation medium'' are 
defined in FINRA Rule 6420. Because the provisions relate to the 
quotation of OTC Equity Securities, FINRA believes that they should 
be relocated into the FINRA rule series concerning quoting and 
trading OTC Equity Securities rather than remain part of the Best 
Execution Rule.
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    NASD Rule 3110(b) (Books and Records) generally requires members to 
indicate on the customer order ticket how they complied with the Three 
Quote Rule, if applicable. FINRA is proposing to replace this provision 
with a more general documentation requirement in the Supplementary 
Material to proposed FINRA Rule 5310. Under that provision, members 
would be required to retain records sufficient to demonstrate that they 
had handled orders covered by the rule in accordance with their 
policies and procedures.
(2) Regular and Rigorous Review of Execution Quality
    The proposed rule change includes Supplementary Material to 
proposed FINRA Rule 5310 codifying a member's obligations when it 
undertakes a regular and rigorous review of execution quality likely to 
be obtained from different market centers. These longstanding 
obligations are set forth and explained in various SEC releases and 
NASD Notices to Members.\15\ The proposed rule change codifies this 
guidance as Supplementary Material and does not alter existing 
requirements regarding regular and rigorous review.
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    \15\ See, e.g., Securities Exchange Act Release No. 37619A 
(September 6, 1996), 61 FR 48290 (September 12, 1996); NASD Notice 
to Members 01-22 (April 2001).
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(3) Orders for Foreign Securities for With No U.S. Market
    While the determination as to whether a member has satisfied its 
best execution obligations must take into account the market for a 
security, NASD Rule 2320, as currently drafted, does not specifically 
distinguish between orders for domestic securities and orders for 
foreign securities, even if there is no U.S. market for the security. 
The proposed rule change includes new Supplementary Material concerning 
members' best execution obligations when handling orders for foreign 
securities, and in particular foreign securities with no U.S. trading 
activity.
    The new Supplementary Material recognizes that markets for 
different securities can vary dramatically and that the standard of 
``reasonable diligence'' must be assessed by examining specific 
factors, including ``the character of the market for the security'' and 
the ``accessibility of the quotation.'' Accordingly, the determination 
as to whether a member has satisfied its best execution obligations 
necessarily involves a ``facts and circumstances'' analysis.\16\
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    \16\ The new Supplementary Material notes that even though a 
foreign security may not trade in the U.S., members still have an 
obligation to seek best execution for customer orders involving the 
security. Consequently, a member that handles customer orders for 
foreign securities that do not trade in the U.S. must have specific 
written policies and procedures in place regarding its handling of 
customer orders for these securities that are reasonably designed to 
obtain the most favorable terms available for the customer, taking 
into account differences that may exist between U.S. markets and 
foreign markets. The Supplementary Material further notes that a 
member's best execution obligations also must evolve as changes 
occur in the market that may give rise to improved executions, 
including opportunities to trade at more advantageous prices. 
Members must therefore regularly review their policies and 
procedures to assess the quality of executions received and update 
or revise the policies and procedures as necessary.
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(4) Customer Instructions Regarding the Routing of Orders
    When placing an order with a member, customers may specifically 
instruct the member to route the order to a particular market for 
execution.\17\ The proposed rule change includes Supplementary Material 
to proposed FINRA Rule 5310 addressing situations where the customer 
has, on an unsolicited basis, specifically instructed the member to 
route its order to a particular market.\18\ Under those circumstances, 
the member would not be required to make a best execution determination 
beyond that specific instruction; however, the Supplementary Material 
mandates that members process the customer's order promptly and in 
accordance with the terms of the order. The Supplementary Material also 
makes clear that where a customer has directed the member to route an 
order to another specific broker-dealer that is also a FINRA member, 
the exception would not apply to the receiving broker-dealer to which 
the order was directed.\19\
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    \17\ When the order is for an NMS security, these orders are 
often referred to as ``directed orders.'' See 17 CFR 242.600(b)(19).
    \18\ See proposed Supplementary Material .08. FINRA also has 
proposed technical amendments to paragraph (e) of the rule to 
clarify that a member's best execution obligations extend to all 
customer orders and to avoid the potential misimpression that the 
paragraph limits the scope of the rule's requirements.
    \19\ For example, if a customer of Member Firm A directs Member 
Firm A to route an order to Member Firm B, Member Firm B would 
continue to have best execution obligations to that customer order 
received from Member Firm A.
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    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. The implementation date will be no later 
than 90 days following publication of the Regulatory Notice announcing 
Commission approval.

III. Discussion and Commission Findings

    After careful review, the Commission finds that the proposed rule 
change is consistent with Section 15A(b)(6) of the Act,\20\ which 
requires, among other things, that FINRA rules 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.\21\ The Commission believes that the proposed 
rule change clarifies the existing best execution requirements, and 
that these changes enhance investor protection and promote just and 
equitable principles of trade. The Commission also believes that 
codifying members' obligations regarding directed orders, regular and 
rigorous review, and orders involving foreign securities will bring 
clarification to these areas and ensure that all members are aware of 
their obligations.
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    \20\ 15 U.S.C. 78o-3(b)(6).
    \21\ 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).
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    One commenter \22\ urged that FINRA provide additional guidance 
regarding the manner in which a member firm may comply with its best 
execution obligations with respect to orders for foreign securities 
with no U.S. market. Specifically, the FSI Letter requests that FINRA 
amend the Supplementary Material to provide that member firms draft and 
maintain written policies and procedures regarding foreign securities 
with no U.S. market that contain certain additional specific 
elements.\23\
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    \22\ See FSI Letter, supra note 4, at 3.
    \23\ The commenter specifically requested that the Supplementary 
Material provide that written policies and procedures regarding 
foreign securities with no U.S. market: (1) Are reasonably designed 
to obtain favorable terms; (2) provide reasonable notice to 
customers of the policies and procedures; (3) require periodic 
review for compliance with policies; and (4) require periodic review 
of the policies themselves to ensure that they meet the requirements 
of the rule. See id.

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[[Page 77044]]

    In its response to the comment, FINRA notes that the Supplementary 
Material as currently drafted already provides that written policies 
and procedures regarding orders in foreign securities with no U.S. 
market be ``reasonably designed to obtain the most favorable terms 
available for the customer'' and also requires that members ``regularly 
review these policies and procedures to assess the quality of 
executions received and update or revise the policies and procedures as 
necessary.'' \24\ FINRA contends that the commenter's request for a 
requirement to provide reasonable notice to customers of a member's 
policies and procedures regarding foreign securities with no U.S. 
market would inappropriately differentiate among a member's best 
execution policies and procedures by specifically requiring 
notification in the context of foreign securities and would be 
irrelevant to those retail customers that do not trade in foreign 
securities with no U.S. market.\25\ FINRA also argues that a 
requirement requiring periodic review for compliance with the policies 
at issue is redundant since, under existing FINRA rules, a member is 
already responsible for reviewing the conduct of its associated persons 
for compliance with both its policies and procedures and applicable 
laws and rules in all aspects of its business.\26\ The Commission 
believes that the proposed rule, and FINRA's response, respond to the 
concerns raised by the commenter.
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    \24\ See FINRA Response to Comment, supra note 5, at 2, 3 
(citing Supplementary Material .07 to FINRA Rule 5310).
    \25\ See id. at 2.
    \26\ See id. at 3 (citing NASD Rule 3010(b)(1)).
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    With respect to the proposed deletion of the Three Quote Rule, 
FINRA has represented that replacing the Three Quote Rule with the 
proposed Supplementary Material will improve the handling of customer 
orders involving securities with limited quotation or pricing 
information by decreasing the likelihood that execution of these orders 
will be unnecessarily delayed while still ensuring that members 
recognize that their best execution obligations apply to these 
orders.\27\ The Commission believes that this proposed change will help 
promote just and equitable principles of trade and will protect 
investors and the public interest.
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    \27\ See Notice at 65551.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\28\ that the proposed rule change (SR-FINRA-2011-052) be, and it 
hereby is, approved.
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    \28\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\29\
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    \29\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2011-31606 Filed 12-8-11; 8:45 am]
BILLING CODE 8011-01-P