Document ID: SEC-2008-1285-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc. (f/k/a NationalAssociation of Securities Dealers, Inc.)
Posted Date: 2008-09-22T04:00Z

[Federal Register: September 22, 2008 (Volume 73, Number 184)]
[Notices]               
[Page 54649-54652]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22se08-94]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-58532; File No. SR-NASD-2007-041]

 
Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc. (f/k/a National Association of Securities Dealers, 
Inc.); Order Approving Proposed Rule Change, as Modified by Amendment 
No. 2, To Amend the Minimum Price-Improvement Standards Set Forth in 
NASD Interpretive Material (``IM'') 2110-2

September 12, 2008.

I. Introduction

    On June 27, 2007, the National Association of Securities Dealers, 
Inc. (``NASD'') (n/k/a Financial Industry Regulatory Authority, Inc. 
(``FINRA'')) \1\

[[Page 54650]]

 filed with the Securities and Exchange Commission (``Commission''), 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\2\ and Rule 19b-4 thereunder,\3\ a proposed rule change to 
amend the minimum price-improvement standards set forth in NASD 
Interpretive Material (``IM'') 2110-2. The proposed rule change was 
published for comment in the Federal Register.\4\ The Commission 
received one commenter letter on the original proposal,\5\ to which 
FINRA responded in a letter to the Commission, dated November 1, 
2007.\6\
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    \1\ On July 26, 2007, the Commission approved a proposed rule 
change filed by the NASD to amend the NASD's Certificate of 
Incorporation to reflect its name change to Financial Industry 
Regulatory Authority, Inc., or FINRA, in connection with the 
consolidation of the member firm regulatory functions of NASD and 
NYSE Regulation, Inc. See Securities Exchange Act Release No. 56146 
(July 26, 2007), 72 FR 42190 (August 1, 2007) (SR-NASD-2007-053).
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
    \4\ See Securities Exchange Act Release No. 56297 (August 21, 
2007), 72 FR 49337 (August 28, 2007) (notice of filing of SR-NASD-
2007-041) (``Release No. 34-56297'').
    \5\ See Letter to Secretary, Commission, from Jess Haberman, 
Compliance Director, Fidessa Corp., dated September 5, 2007 
(``Fidessa Corp. Letter'').
    \6\ See Letter from Andrea Orr, FINRA, to Nancy M. Morris, 
Secretary, Commission, dated November 1, 2007 (``FINRA Response 
Letter'').
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    On June 26, 2008, FINRA filed Amendment No. 2 to the proposed rule 
change to address an inconsistency in the application of the proposed 
minimum price-improvement provisions identified by the commenter.\7\ 
Amendment No. 2 was published for comment in the Federal Register on 
July 14, 2008.\8\ The Commission received one additional comment letter 
on the proposed rule change.\9\ This order approves the proposed rule 
change, as modified by Amendment No. 2.
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    \7\ On May 20, 2008, FINRA filed Amendment No. 1 to the proposed 
rule change. Amendment No. 2 superseded and replaced Amendment No. 
1.
    \8\ See Securities Exchange Act Release No. 58114 (July 7, 
2008), 73 FR 40407 (``Release No. 34-58114'').
    \9\ See Letter from R. Cromwell Coulson, Chief Executive 
Officer, Pink OTC Markets Inc. (``Pink OTC''), to Secretary, 
Commission, dated September 3, 2008. (``Pink OTC Letter'').
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II. Description of the Proposed Rule Change

A. Background

    On February 26, 2007, the Commission approved the NASD's proposed 
rule change \10\ that expanded the scope of IM-2110-2 \11\ (referred to 
as the Manning Rule) to apply to over-the-counter (``OTC'') equity 
securities.\12\ In Release No. 34-55351, the Commission also approved, 
for both National Market System (``NMS'') and OTC equity securities, 
the minimum level of price-improvement that a member must provide to 
trade ahead of an unexecuted customer limit order (``price-improvement 
standards'').
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    \10\ See Securities Exchange Act Release No. 55351 (February 26, 
2007), 72 FR 9810 (March 5, 2007) (order approving SR-NASD-2005-146) 
(``Release No. 34-55351'').
    \11\ Currently, IM-2110-2 generally prohibits a member from 
trading for its own account in an exchange-listed security at a 
price that is equal to or better than an unexecuted customer limit 
order in that security, unless the member immediately thereafter 
executes the customer limit order at the price at which it traded 
for its own account or better.
    \12\ See NASD Rule 6610(d) for definition of ``OTC equity 
security.''
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    In Release No. 34-55351, the price-improvement standards were 
modified so that for customer limit orders priced greater than or equal 
to $1.00 that are at or inside the best inside market, the minimum 
amount of price improvement required is $0.01. For customer limit 
orders priced less than $1.00 that are at or inside the best inside 
market, the minimum amount of price improvement required is the lesser 
of $0.01 or one-half (\1/2\) of the current inside spread. For customer 
limit orders priced outside the best inside market, the member is 
required to execute the incoming order at a price at or inside the best 
inside market for the security. For customer limit orders in securities 
for which there is no published inside market, the minimum amount of 
price improvement required is $0.01.
    The rule changes adopted in Release No. 34-55351 initially were 
scheduled to become effective on July 26, 2007.\13\ However, following 
the filing of the instant proposed rule change, SR-NASD-2007-041, FINRA 
filed a proposed rule change to delay implementation of the application 
of IM-2110-2 to OTC equity securities, until 60 days after Commission 
approval of SR-NASD-2007-041.\14\
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    \13\ See NASD Notice to Members 07-19 (April 2007).
    \14\ See Securities Exchange Act Release No. 56103 (July 19, 
2007), 72 FR 40918 (July 25, 2007) (notice of filing and immediate 
effectiveness of SR-NASD-2007-039). See also Securities Exchange Act 
Release No. 56822 (November 20, 2007), 72 FR 67326 (November 28, 
2007) (notice of filing and immediate effectiveness of SR-FINRA-
2007-023); and Securities Exchange Act Release No. 57133 (January 
11, 2008), 73 FR 3500 (January 18, 2008) (notice of filing and 
immediate effectiveness of SR-FINRA-2007-038). Modifications to the 
price-improvement standards applicable to NMS stocks approved in 
Release No. 34-55351 became effective on July 26, 2007. See FINRA 
Member Alert dated June 20, 2007.
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B. NASD 2007-041

    In SR-NASD-2007-041, FINRA proposed to amend the minimum price-
improvement standards set forth in IM-2110-2 to include new tiered 
standards that vary according to the price of the customer limit order. 
FINRA proposed to revise the minimum price-improvement standards to 
address three issues. First, because the minimum price improvement 
standards are determined based on the lesser of a specified amount 
($.01) or one-half (\1/2\) of the inside spread, the specified amount 
acts as an ``upper limit'' on the minimum price improvement 
requirement. FINRA believed that the specified amount or upper limit on 
the minimum price improvement requirement (i.e., $.01) is 
disproportionately high for securities trading below $.01 and that it 
should vary proportionately with the amount of the limit order price. 
FINRA proposed that, for customer limit orders priced less than $.01 
but greater than or equal to $0.001, the minimum amount of price 
improvement required would be the lesser of $0.001 or one-half (\1/2\) 
of the current inside spread. For customer limit orders priced less 
than $.001 but greater than or equal to $0.0001, the minimum amount of 
price improvement required would be the lesser of $0.0001 or one-half 
(\1/2\) of the current inside spread. For customer limit orders priced 
less than $.0001 but greater than or equal to $0.00001, the minimum 
amount of price improvement required would be the lesser of $0.00001 or 
one-half (\1/2\) of the current inside spread.\15\ Finally, for 
customer limit orders priced less than $.00001, the minimum amount of 
price improvement required would be the lesser of $0.00001 or one-half 
(\1/2\) of the current inside spread.\16\
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    \15\ The proposed minimum price-improvement provisions in this 
proposed rule change do not supersede, alter or otherwise affect any 
of the minimum pricing increment restrictions under Rule 612 of 
Regulation NMS. Rule 612 of Regulation NMS prohibits market 
participants from displaying, ranking, or accepting bids or offers, 
orders, or indications of interest in any NMS stock priced in an 
increment smaller than $0.01 if the bid or offer, order, or 
indication of interest is priced equal to or greater than $1.00 per 
share. If the bid or offer, order, or indication of interest in any 
NMS stock is priced less than $1.00 per share, the minimum pricing 
increment is $0.0001. See Securities Exchange Act Release No. 51808 
(June 9, 2005), 70 FR 37496 (June 29, 2005) (Regulation NMS Adopting 
Release).
    \16\ For customer limit orders in securities for which there is 
no published inside market, the minimum amount of price improvement 
required would default to the same tiered minimum price improvement 
standards.
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    In addition, FINRA proposed that the current minimum price 
improvement standard for limit orders priced greater than or equal to 
$1.00 would be $.01, and this standard would apply uniformly to NMS 
stocks \17\ and OTC equity securities. However, given that subpenny 
quoting and trading is permissible in OTC equity securities

[[Page 54651]]

priced at or over $1.00 (and therefore subpenny spreads are possible), 
FINRA believed that the minimum price improvement standard should be 
adjusted to also include a measure based on the inside spread, 
consistent with the standards for customer limit orders priced below 
$1.00. Accordingly, FINRA proposed that for customer limit orders in 
OTC equity securities priced greater than or equal to $1.00, the 
minimum amount of price improvement required should be the lesser of 
$0.01 or one-half (\1/2\) of the current inside spread.\18\
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    \17\ See Rule 600(b)(47) of Regulation NMS for definition of 
``NMS stock.'' 17 CFR 242.600(b)(47).
    \18\ Other than the proposed distinction to address permissible 
subpenny quoting and trading in OTC equity securities priced over 
$1.00, the proposed price-improvement standards would apply 
uniformly to NMS stocks and OTC equity securities. See supra note 
14.
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    Finally, FINRA proposed to change the minimum price-improvement 
standard for limit orders priced outside the inside market. According 
to FINRA, although trades typically occur at or inside the best inside 
market, firms may trade proprietarily outside the best inside market 
for a variety of reasons, such as where there is little or no depth at 
the inside market or the inside market is manual or not easily 
accessible. Under current requirements, such trades could trigger 
execution obligations with respect to all limit orders priced outside 
the inside market, no matter how far outside the inside market the 
limit order is priced. FINRA provided an example that assumed that the 
best inside market for a security is $.50 to $.51. The member displays 
a quote to buy at $.49 and also holds a customer limit order to buy 
priced at $.45. The member's quotation is accessed by another broker-
dealer and the member buys at $.49. Under current requirements, the 
member would be required to fill the customer's purchase order at $.45 
because it had not purchased at the inside market of $.50. Stating that 
it did not believe that this was an appropriate result, FINRA proposed 
that, where the limit order is priced outside the inside market for the 
security, the minimum amount of price improvement required must either 
meet the same tiered minimum price improvement standards set forth 
above or the member must trade at a price at or inside the best inside 
market for the security. FINRA believed that this would continue to 
require an appropriate amount of price improvement for a member to 
trade ahead of a customer limit order, irrespective of whether the 
limit order is priced inside or outside the best inside market.
    The Commission received one comment letter in response to Release 
No. 34-56297.\19\ The Fidessa Corp. Letter supported the proposed rule 
change, although the commenter suggested modifying and clarifying the 
proposal. In this regard, the commenter noted an inconsistency in the 
application of the proposed minimum price-improvement standards in low-
priced securities when the customer limit order and the proprietary 
trade fall into different minimum price improvement tiers (e.g., a 
customer limit order to sell is priced at $1.00 and the proprietary 
trade is at $.998). The commenter provided an example that assumed that 
the best inside market for an NMS stock is $.996 to $1.00 and a firm is 
holding customer limit orders to sell at prices of $.998 and $1.00. If 
the firm sells for its own account at $.996, only customer limit orders 
to sell priced below $.998 and from $1.00 up to, but not including, 
$1.006 would be protected due to the firm's $.996 triggering 
proprietary trade. As a result, the firm would not have an obligation 
under IM-2110-2 to protect the more aggressively priced $.998 customer 
limit order to sell (i.e., the minimum price improvement standard 
applicable to that order is the lesser of $.01 or one-half (\1/2\) of 
the current inside spread ($.002 (\1/2\ of $.004)), such that the $.996 
proprietary trade would only trigger customer limit orders priced less 
than $.998), but would have an obligation to protect the $1.00 customer 
limit order to sell (i.e., the minimum price improvement standard 
applicable to that order is $.01 such that a $.996 proprietary trade 
would trigger customer limit orders priced at $1.00 up to, but not 
including, $1.006). The commenter suggested instead that FINRA base the 
minimum price-improvement standard on the trade price rather than the 
customer limit order price.
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    \19\ See Fidessa Corp. letter, supra note 5.
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    FINRA responded that the commenter's suggested approach could have 
unintended consequences in its application and would require 
significant reprogramming by member firms to implement, and therefore 
initially did not propose any revisions to the proposal.\20\ FINRA 
explained that member firms could choose to provide protection 
voluntarily for more aggressively priced customer limit orders that 
fall within gaps.\21\
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    \20\ See FINRA Response Letter, supra note 6.
    \21\ Id.
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    Subsequently, however, FINRA proposed in Amendment No. 2. to 
require, and codify, as part of IM-2110-2, that any more aggressively 
priced customer limit orders also must receive limit order protection. 
Under Amendment No. 2, firms would be required to protect any more 
aggressively priced customer limit orders triggered under IM-2110-2, 
even if those limit orders were not directly triggered by the minimum 
price improvement standards of IM-2110-2.\22\ FINRA explained, however, 
that it would not mandate any particular order handling procedures or 
execution priorities among protected orders. Rather, a firm could 
choose any reasonable methodology for the way in which it executes 
multiple orders triggered by IM-2110-2, provided that the firm ensures 
that such methodology is applied consistently and complies with 
applicable rules and regulations.\23\
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    \22\ The Fidessa Corp. Letter also sought clarification on the 
required price-improvement when the limit order is priced outside 
the inside market for the security, to which FINRA responded in the 
FINRA Response Letter that the minimum amount of price improvement 
required must either meet the same tiered minimum price improvement 
standards or the member must trade at a price at or inside the best 
inside market for the security. FINRA stated that firms need only to 
meet one of the minimum price-improvement options provided for limit 
orders priced outside the inside market and may do so on a trade-by-
trade basis.
    \23\ FINRA further clarified that this statement refers to the 
firm's methodology for executing multiple orders triggered by IM-
2110-2 when their size exceeds the size of the firm's proprietary 
order that triggered the customer limit order protection obligation. 
Telephone conference, September 11, 2008, between Stephanie Dumont, 
Vice President and Director of Capital Markets Policy, FINRA, and 
Nancy Sanow, Assistant Director, Division of Trading and Markets, 
Commission.
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    Using the example above, once the limit order priced at $1.00 is 
activated upon the execution of the firm's trade at $.996 (i.e., it is 
activated because it is within .01 of the price of the firm's trade), a 
firm may implement a methodology that executes all more aggressively 
priced customer limit orders first (i.e., the limit order priced at 
$.998) before executing the limit order priced at $1.00. The proposed 
requirements would only apply in the limited circumstance where a firm 
has a limit order that is protected by IM-2110-2, but more aggressively 
priced customer limit orders are not protected. Therefore, in the above 
example, if the firm was only holding a customer limit order to sell of 
$.998 (and not a customer limit order of $1.00), the $.998 order would 
not be triggered by the proposed requirements.
    The Commission received one comment letter in response to Release 
No. 34-58114.\24\ The Pink OTC Letter supported the proposed rule 
change, as modified by Amendment No. 2, stating that it was necessary 
to correct the anomalous situation where inferior

[[Page 54652]]

priced customer limit orders are protected over superior priced limit 
orders, and that ``adoption of SR-NASD-2007-041 without correction of 
this anomalous situation would disrupt the orderly functioning of the 
market for OTC Equity Securities.''
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    \24\ See Pink OTC Letter, supra note 9.
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    The Pink OTC Letter also recommended more broadly that the minimum 
increments of IM-2110-2 be considered as part of an amendment that 
would mandate minimum quote increment tier sizes for OTC equity 
securities.\25\ The Pink OTC Letter urged that minimum increments for 
price improvement should mirror minimum quote increment tier sizes 
established on the Pink Quote interdealer quotation system to create 
``a level playing field for all market participants and improve 
investor confidence in the market.''
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    \25\ Pink OTC attached a study of its 2006 Minimum Quote 
Increment Tier Pilot Program. (``Pink OTC Pilot Program'') According 
to Pink OTC, the study showed that minimum tier sizes implemented 
during the Pink OTC Pilot Program did not result in artificial 
widening of spreads or degradation of market quality.
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III. Discussion and Commission's Findings

    The Commission has reviewed carefully the proposed rule change, as 
modified by Amendment No. 2, and the two comment letters it received, 
and finds that the proposed rule change, as modified by Amendment No. 
2, is consistent with the Act and the rules and regulations thereunder 
applicable to a national securities association, including the 
provisions of Section 15A(b)(6) of the Act,\26\ which requires, among 
other things, that FINRA rules be designed to promote just and 
equitable principles of trade, to foster cooperation and coordination 
with the persons engaged in regulating, clearing, settling, processing 
transactions in securities, and, in general, to protect investors and 
the public interest.\27\
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    \26\ See 15 U.S.C. 78o-3(b)(6).
    \27\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. See 15 U.S.C. 
78c(f).
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    The Commission previously approved revisions to IM-2110-2 to apply 
the Manning Rule to OTC equity securities,\28\ and notes that FINRA 
delayed its implementation pending Commission approval of the instant 
proposed rule change, as amended.\29\
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    \28\ See Release No. 34-55351, supra note 10.
    \29\ See supra note 13.
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    FINRA's proposal would revise the current price-improvement 
standards by adding a number of tiers to the minimum price-improvement 
standard for customer limit orders priced below $.01; adjusting the 
price-improvement standards to also include a measure based on one-half 
of the current inside spread for customer limit orders in OTC equity 
securities when such limit orders are priced greater than or equal to 
$1.00; and changing the price improvement standards for limit orders 
priced outside the inside market. The Commission believes that these 
revisions to IM-2110-2 are appropriate and reasonably designed to 
protect customer limit orders in both NMS stocks and OTC equity 
securities.
    Fidessa Corp. suggested that the minimum price-improvement 
standards should be based on the security's trade price rather than the 
limit order price of the customer limit order. The commenter observed 
that anomalies can occur at the periphery of the minimum price 
improvement tiers for low-priced securities when the minimum price-
improvement requirement is based on the order's price.
    In the FINRA Response Letter, FINRA responded that Fidessa Corp.'s 
proposed alternative approach would address some of the potential 
anomalies in the application of the proposed rule, but could have 
unintended consequences in its application and would require 
significant reprogramming by the firms to implement. Instead, FINRA 
revised its proposal, in Amendment No. 2, to require firms to institute 
written policies and procedures to fill those more aggressively priced 
customer limit orders ahead of other less aggressively priced limit 
orders covered by the Rule. This approach was supported by Pink OTC.
    The Commission believes that the revisions in Amendment No. 2 are 
reasonably designed to eliminate the anomalies that can occur in the 
case of limit orders with prices that straddle the proposed minimum 
price-improvement tiers. Although Pink OTC urged that amendments to IM-
2110-2 should be complemented by additional provisions mandating 
minimum quote increment tier sizes for OTC equity securities, the 
Commission considers this recommendation to be beyond the scope of the 
proposed rule change before it.
    Accordingly, the Commission believes that the proposed rule change 
strikes a reasonable balance between protecting customer limit orders 
and enhancing the opportunity for investors to receive superior-priced 
limit order executions in OTC equity securities.
    For the reasons described above, the Commission believes that the 
proposed rule change is consistent with the Act.

 IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-NASD-2007-041), as modified by 
Amendment No. 2, be, and it hereby is, approved.
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    \30\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\30\
Florence E. Harmon,
Acting Secretary.
[FR Doc. E8-22011 Filed 9-19-08; 8:45 am]

BILLING CODE 8010-01-P