Document ID: SEC-2006-1100-0001
Agency: sec
Document Type: Notice
Title: Self-regulatory organizations; proposed rule changes: National Association of Securities Dealers, Inc.
Posted Date: 2006-08-28T04:00Z

[Federal Register: August 28, 2006 (Volume 71, Number 166)]
[Notices]               
[Page 50959-50961]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr28au06-82]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54339; File No. SR-NASD-2004-026]

 
 Self-Regulatory Organizations; National Association of 
Securities Dealers, Inc.; Order Approving Proposed Rule Change as 
Modified by Amendment Nos. 1-5 To Amend NASD Rule 2320(a) Governing 
Best Execution

August 21, 2006.

I. Introduction

    On February 12, 2004, the 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 amend NASD Rule 2320(a) 
(``Best Execution Rule''). On May 11, 2004, NASD amended the proposed 
rule change.\3\ On February 14, 2005, NASD amended the proposed rule 
change a second time.\4\ The proposed rule change, as modified by 
Amendment Nos. 1 and 2, was published for comment in the Federal 
Register on February 25, 2005.\5\ The Commission received three comment 
letters on the proposal.\6\ On June 22, 2005, NASD filed a response to 
comments, and simultaneously amended the proposal.\7\ The Commission 
received one comment

[[Page 50960]]

letter regarding NASD's response.\8\ On September 22, 2005, NASD filed 
an amendment to modify the purpose section of the proposal, clarifying 
the scope of a member's duty to provide best execution.\9\ The proposed 
rule change, as modified by Amendment Nos. 3 and 4, was published for 
comment in the Federal Register on October 26, 2005.\10\ The Commission 
received one additional comment letter on the proposed rule change 
after it was published for the second time.\11\ On May 17, 2006, NASD 
filed Amendment No. 5.\12\ This order approves the proposed rule 
change, as modified by Amendment Nos. 1-5.\13\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Amendment No. 1.
    \4\ See Amendment No. 2.
    \5\ See Securities Exchange Act Release No. 51229 (February 18, 
2005), 70 FR 9416. The proposed rule change was published a second 
time on October 26, 2005. See footnote 10 infra.
    \6\ See letters from Amal Aly, Vice President(``VP'') and 
Associate General Counsel (``AGC''), and Ann Vlcek, VP and AGC, 
Securities Industry Association (``SIA'') dated March 18, 2005 
(``SIA Letter''); Paul A. Merolla, Executive Vice President and 
General Counsel, Instinet Group, Inc. (``Instinet'') dated March 22, 
2005 (``Instinet Letter''); Micah S. Green, President and Michele C. 
David, VP and AGC, The Bond Market Association (``BMA'') dated April 
5, 2005 (``BMA Letter''), to Jonathan G. Katz, Secretary, 
Commission. The Commission received one additional comment letter 
after NASD filed its response to comments, and another letter after 
the proposed rule change was republished on October 26, 2005. See 
footnotes 8, 10 and 11, infra.
    \7\ See Amendment No. 3.
    \8\ See letter from Marjorie Gross, Senior Vice President and 
Regulatory Counsel, BMA, to Jonathan G. Katz, Secretary, Commission, 
dated September 7, 2005 (``BMA Letter 2'').
    \9\ See Amendment No. 4.
    \10\ See Securities Exchange Act Release No. 52637 (October 19, 
2005), 70 FR 61861.
    \11\ See letter from Michele C. David, VP and AGC, BMA, to 
Jonathan G. Katz, Secretary, Commission, dated November 16, 2005 
(``BMA Letter 3'').
    \12\ Amendment No. 5 is a technical amendment. With Amendment 
No. 5, NASD took the substance of Amendment Nos. 3 and 4 and placed 
that information in IM-2320.
    \13\ In August 2005, the Commission approved two related 
proposed rule changes: SR-NASD-2004-045, which prohibits members 
from trading ahead of customer market orders in certain 
circumstances, and SR-NASD-2004-089, which provides additional limit 
order protection by requiring members to provide price improvement 
under certain circumstances. See Securities Exchange Act Release 
Nos. 52226 (August 9, 2005), 70 FR 48219 (August 16, 2005), and 
52210 (August 4, 2005), 70 FR 46897 (August 11, 2005).
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II. Summary of Comments

    The Commission received a total of five comment letters from three 
commenters on the proposed rule change.\14\ The SIA notes that NASD 
made several positive changes to the proposed rule in Amendment No. 
2.\15\ However, the SIA, the BMA and Instinet all take issue with NASD 
requiring a member to provide best execution to the customer of another 
broker-dealer. The commenters assert that the recipient broker-dealer 
does not have a relationship with the customer and thus should not be 
subject to the rule, or if subject to the rule, the SIA suggests that, 
if the recipient broker-dealer complies with the terms and conditions 
of the order, as communicated by the originating broker-dealer, the 
recipient broker-dealer should have fulfilled its best execution 
obligation under the rule.\16\
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    \14\ See footnotes 6, 8 and 11, supra.
    \15\ See SIA Letter at 2.
    \16\ Id.
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    The BMA, while objecting to this requirement, also believes that 
the Best Execution Rule should not apply to the bond market.\17\ 
According to the BMA, the rule would cause problems in the bond market 
because of the way the market operates.\18\ In addition, the BMA 
believes that the wording of the rule demonstrates that it was not 
intended to apply to the bond market.\19\ After the Commission's 
receipt of Amendment No. 3, the BMA submitted a second comment letter 
that reiterates its concerns with the proposal, and states its belief 
that Amendment No. 3 does not adequately address the BMA's 
concerns.\20\
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    \17\ See BMA Letter at 2, 5.
    \18\ Id. at 1.
    \19\ Id. at 2.
    \20\ See BMA Letter 2. The Commission notes that the BMA 
reasserts the concerns it raises in BMA Letters 1 and 2 in BMA 
Letter 3, and further states that the proposed rule change is 
deficient because it does not specifically address how certain 
provisions of the proposal pertain to the bond market. BMA Letter 3 
at 1-2.
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    Instinet raises two additional points. First, Instinet argues that 
use of the term ``market center'' creates a competitive disadvantage 
because the rule would not apply to market centers operated by NASD and 
other self-regulatory organizations (``SROs'').\21\ Instinet asks that 
NASD either exclude member-operated electronic communications networks 
(``ECNs'') or alternative trading systems (``ATSs'') that interact with 
orders on a fully automated basis from the rule, or apply the same 
obligations to the Nasdaq Market Center and the BRUT facility. Second, 
Instinet asks that implementation of the proposed rule change be 
delayed pending Commission action on Regulation NMS, including 
interpretive guidance with respect to the obligations of market centers 
under the trade through proposal.\22\
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    \21\ See Instinet Letter at 2 and 3.
    \22\ Id. at 3.
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III. NASD Response to Comments

    In response to the comments, NASD filed Amendment Nos. 3 and 4 to 
the proposed rule change.\23\ In Amendment No. 3, NASD states that the 
failure to apply the Best Execution Rule to recipient broker-dealers is 
contrary to the interests of the investing public as well as the 
general intent of the Best Execution Rule itself. As amended, the rule 
requires a member to use reasonable diligence to ascertain the best 
market for the particular security and to buy or sell in that market so 
that the price to the customer is as favorable as possible under the 
prevailing market conditions. The rule contains five factors that NASD 
will consider in determining if the broker-dealer used reasonable 
diligence to ascertain the best market for the security. Whether the 
broker-dealer used reasonable diligence is factored into the 
determination of whether the broker-dealer has met its best execution 
obligation.
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    \23\ See footnotes 7 and 9, supra.
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    NASD amended the proposed rule change to replace the term ``market 
center'' with the term ``market,'' which is a broader term. According 
to NASD, this change was made to address the BMA's concern that the 
term ``market center'' is not relevant in the bond market, as well as 
Instinet's concern with respect to the proposed rule creating a 
competitive disadvantage. As amended, the Best Execution Rule will 
apply to all trading venues.
    In response to the BMA's assertion that the proposed rule should 
not apply to the bond market, NASD stated the rule has ``never been 
limited to equity securities.'' NASD cites to Rule 0116, which 
enumerates the NASD rules that apply to government and other exempt 
securities.\24\ The BMA argues that the bond market is not subject to 
the same requirements as the equities markets, e.g. a firm quote 
requirement, pre-trade quote transparency, a uniform, regulated inter-
dealer market and an inter-dealer linkage.\25\ NASD acknowledges the 
differences in market structure and regulations between the equities 
markets and the bond markets and notes that, at the time NASD adopted 
the Best Execution Rule, the equities markets operated in a framework 
similar to the current framework for bond trading. Furthermore, NASD 
stated that the term ``quotation'' refers to either dollar (or other 
currency) pricing or yield pricing, for purposes of debt, and that 
accessibility of quotations is a factor in determining if the member 
used reasonable diligence. If quotations are readily available for a 
particular debt security, NASD will factor this into its assessment of 
whether the member complied with its obligations under the rule. In 
response to BMA Letter 2, NASD clarified the scope of the proposed rule 
change by stating that a member's duty to provide best execution to 
customer orders received from other broker-dealers arises when an order 
is routed to the member for the

[[Page 50961]]

purpose of order handling and execution.\26\
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    \24\ See Securities Exchange Act Release No. 44631 (July 31, 
2001), 66 FR 41283 (August 7, 2001)(SR-NASD-2000-38)(order approving 
NASD Rule 0116)(''Exempted Securities Order''). See also, Securities 
Exchange Act Release No. 37588 (August 20, 1996), 61 FR 44100 
(August 27, 1996)(order approving NASD's proposal implementing the 
expanded sales practice authority granted to NASD pursuant to the 
Government Securities Act Amendments of 1993 and listing the NASD 
rules that would apply to exempted securities. Among the rules was 
the Best Execution Rule.
    \25\ See BMA Letter at 4.
    \26\ See footnote 9, supra.
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    Amendment No. 5 is purely a technical amendment, as its substance 
was published for notice and comment in Amendment Nos. 3 and 4. With 
Amendment No. 5, NASD took the substance of Amendment Nos. 3 and 4 and 
placed that information in IM-2320.

IV. Discussion and Commission Findings

    The Commission has reviewed carefully the proposed rule change, the 
comment letters, and NASD's response to the comments, and believes that 
NASD has responded appropriately to the concerns raised by the 
commenters. The Commission finds that the proposed rule change, as 
amended, is consistent with the requirements of the Act and rules and 
regulations thereunder applicable to a national securities association, 
and, in particular, with Section 15A(b)(6) of the Act, which requires, 
among other things, that the rules of a national securities association 
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.\27\ Regarding the 
commenters' assertion that a recipient broker-dealer's compliance with 
the terms and conditions of the order, as communicated by the 
originating broker-dealer, solely, should constitute satisfaction of 
the duty of best execution with regard to routed orders, the Commission 
believes that such compliance should be considered a significant factor 
in determining if the recipient broker-dealer has met its duty of best 
execution, but should not be the sole factor to consider. In Amendment 
Nos. 3 and 4, NASD addressed the concerns raised by commenters. In 
response to issues raised by the BMA, NASD changed the terminology of 
the proposed rule change, replacing ``market center'' with ``market'' 
and stating that it will interpret the term broadly. Additionally, the 
Commission notes that the Best Execution Rule currently applies to the 
bond markets.\28\ NASD indicated in its amendment how it intends to 
apply the factors in the rule that provide evidence of reasonable 
diligence in the context of the bond market, and how it will interpret 
price in connection with debt. In Amendment No. 4, NASD made a clear 
distinction between a member's duties when acting as provider of 
liquidity versus acting as an order handler for another broker-dealer. 
The Commission believes that the revisions clarify how the rule applies 
in the context of the debt market. Furthermore, the Commission notes 
that, at the time NASD adopted its Best Execution Rule, the equity 
markets were subject to a regulatory regime similar to the one under 
which the bond markets operate today.\29\ The Commission expects that 
the NASD will take into account the structure and operation of the debt 
markets when applying the rule to debt market participants.
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    \27\ 15 U.S.C. 78o-3(b)(6). In approving this proposed rule 
change, the Commission has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \28\ See footnote 24, supra, and Exempted Securities Order.
    \29\ As NASD notes, in 1968 when the Best Execution Rule was 
adopted, the market for equity securities was much different than it 
is today. For example, there was no consolidated tape and thus no 
readily available trade or quotation information. Market makers in 
over-the-counter securities conducted transactions via telephone, 
after checking prices either in the pink sheets or by information 
they obtained using the telephone. In addition, there was no 
requirement to report transactions to NASD within 90 seconds.
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    With regard to the commenters' claim that the proposal would create 
an unfair competitive disparity between otherwise similarly situated 
market centers that execute orders on an electronic agency basis, the 
Commission notes that electronic communications networks (``ECNs'') are 
subject to a different regulatory regime than SROs. ECNs are broker-
dealers by definition, and must be members of an SRO; consequently ECNs 
are subject to SRO rules. Moreover, the Commission believes the 
proposed rule change, as amended, will not unfairly affect ECN 
operations.
    With respect to the commenters' concern that implementation of this 
proposal should be delayed until after the Commission has adopted 
guidance under the trade through proposal of Regulation NMS, the 
Commission notes that the Commission adopted Regulation NMS subsequent 
to the commenters filing their comment letters.
    Finally, the Commission views markup obligations and the duty of 
best execution as separate and distinct requirements. NASD Rule 2320(f) 
states that best execution obligations ``do not relate to the 
reasonableness of commission rates, markups or markdowns which are 
governed by Rule 2440 and IM-2440.''

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\30\ that the proposed rule change (SR-NASD-2004-026), as modified 
by Amendment Nos. 1-5, be, and it hereby is, approved.
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    \30\ 30 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\31\
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    \31\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E6-14196 Filed 8-25-06; 8:45 am]

BILLING CODE 8010-01-P