Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to Limit Order Protection for Member to Member Limit Order Handling on Nasdaq

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35122; File No. SR-NASD-94-62]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by National Association of Securities Dealers, Inc. Relating to

Limit Order Protection for Member to Member Limit Order Handling on

Nasdaq

December 20, 1994.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on November

22, 1994, the National Association of Securities Dealers, Inc.

(``NASDA'' or ``Association'') filed with the Securities and Exchange

Commission (``SEC'' or ``Commission'') the proposed rule change as

described in Items I, II, and III below, which Items have been prepared

by the NASD. The Commission is publishing this notice to solicit

comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule Change

Pursuant to the provisions of Section 19(b)(1) of the Act, the NASD

is filing a proposed rule change regarding the protection of limit

orders to expand the scope of limit order protection beyond that

presently afforded by member firms to their customers in the Nasdaq

Stock Market. Currently, the NASD's Interpretation to the Rules of Fair

Practice makes it a violation of just and equitable principles of trade

for a member firm to trade ahead of its own customer's limit orders.

The new proposal would extend this protection to the customer of a firm

that sends a limit order to another member for execution (so-called

member-to-member trades), with a proviso that until July 1, 1995, limit

order protection for member-to-member customer limit orders greater

than 1,000 shares in size will be protected at prices that are

superior, but not equal to the limit order price. Below is the text of

the proposed rule change. Proposed new language is italicized; language

to be deleted is bracketed.

Limit Order Protection Interpretation to Article III, Section 1 of the

NASD Rules of Fair Practice

To continue to ensure investor protection and enhance market

quality, the NASD Board of Governors is issuing an Interpretation to

the Rules of Fair Practice dealing with member firm treatment of

[their] customer limit orders in Nasdaq securities. This Interpretation

will require members acting as market makers to handle [their] customer

limit orders with all due care so that market makers do not ``trade

ahead'' of those limit orders. Thus, members acting as market makers

that handle customer limit orders, whether received from their own

customers or from another member, are prohibited from trading at prices

equal to or superior to that of the limit order without executing the

limit order provided that, prior to July 1, 1995, this prohibition

shall not apply to customer limit orders that a member firm receives

from another member firm and that are greater than 1,000 shares. Such

orders shall be protected from executions at prices that are superior

but not equal to that of the limit order. In the interests of investor

protection, the NASD is eliminating the so-called disclosure ``safe

harbor'' previously established for members that fully disclosed to

their customers the practice of trading ahead of a customer limit order

by a market-making firm.

Interpretation

Article III, Section 1 of the Rules of Fair Practice states that:

A member, in the conduct of his business, shall observe high

standards of commercial honor and just and equitable principles of

trade.

The Best Execution Interpretation states that: In any transaction

for or with a customer, a member and persons associated with a member

shall use reasonable diligence to ascertain the best inter-dealer

market for the subject security and buy or sell in such a market so

that the resultant price to the customer is as favorable as possible to

the customer under prevailing market conditions. Failure to exercise

such diligence shall constitute conduct inconsistent with just and

equitable principles of trade in violation of Article III, Section 1 of

the Rules of Fair Practice.

In accordance with Article VII, Section 1(a)(2) of the NASD By-

Laws, the following interpretation under Article III, Section 1 of the

Rules of Fair Practice has been approved by the Board:

A member firm that accepts and holds an unexecuted limit order from

a customer (whether its own customer or a customer of another member)

in a Nasdaq security and that continues to trade the subject security

for its own market-making account at prices that would satisfy the

customer's limit order, without executing that limit order under the

specific terms and conditions by which the order was accepted by the

firm, shall be deemed to have acted in a manner inconsistent with just

and equitable principles of trade, in violation of Article III, Section

1 of the Rules of Fair Practice, provided that, until July 1, 1995,

customer limit orders in excess of 1,000 shares received from another

member firm shall be protected from the market maker's executions at

prices that are superior but not equal to that of the limit order.

Nothing in this section, however, requires members to accept limit

orders from any customers[s].

By rescinding the safe harbor position and adopting this

Interpretation of the Rules of Fair Practice, the NASD Board wishes to

emphasize that members may not trade ahead of customer limit orders in

their market-making capacity even if the member had in the past fully

disclosed the practice to its customers prior to accepting limit

orders. The NASD believes that, pursuant to Article III, Section 1 of

the Rules of Fair Practice, members accepting and holding unexecuted

customer limit orders owe certain duties to their customers and the

customers of other member firms that may not be overcome or cured with

disclosure of trading practices that include trading ahead of the

customer's order. The terms and conditions under which customer limit

orders are accepted must be made clear to customers at the time the

order is accepted by the firm so that trading ahead in the firms'

market making capacity does not occur. For purposes of this

Interpretation, a member that controls or is controlled by another

member shall be considered a single entity so that if a customer's

limit order is accepted by one affiliate and forwarded to another

affiliate for execution, the firms are considered a single entity and

the market making unit may not trade ahead of that customer's limit

order.

The Board also wishes to emphasize that all members accepting

customer limit orders owe those customers duties of ``best execution''

regardless of whether the orders are executed through the member's

market making capacity or sent to another member for execution. As set

out above, the best execution Interpretation requires members to use

reasonable diligence to ascertain the best inter-dealer market for the

security and buy or sell in such a market so that the price to the

customer is as favorable as possible under prevailing market

conditions. The NASD emphasizes that order entry firms should continue

to routinely monitor the handling of their customers' limit orders

regarding the quality of the execution received.

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the NASD included statements

concerning the purpose of and basis for the proposed rule change and

discussed any comments it received on the proposed rule change. The

text of these statements may be examined at the places specified in

Item IV below. The NASD has prepared summaries, set forth in Sections

(A), (B), and (C) below, of the most significant aspects of such

statements.

(A) Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

The purpose of the proposed rule change is to expand the scope of

the current Interpretation from protecting only limit orders received

from a market maker's own customers to protecting limit orders that a

market maker receives from other member firms for execution, the so-

called ``member-to-member'' limit orders. The background and rationale

for adoption of this proposed rule change are discussed below.

I. Background

A. The Existing Interpretation. In July 1994, a limit order

protection rule became effective for NASD members accepting limit

orders in Nasdaq securities.\1\ Under the existing Limit order

Interpretation to the Rules of Fair Practice, a member firm cannot

accept and hold its customer's limit order in a Nasdaq security and

continue to trade that security for its own account at prices that

would satisfy the customer's limit order without filling that order at

the limit order price or a price more favorable to the customer. The

rule renders trading ahead of the customer's order a violation of just

and equitable principles of trade. When the NASD initially proposed the

limit order rule, it solicited comment from members on the advisability

of implementing restrictions on trading ahead for all customer limit

orders, including those passed from one member firm to another for

execution.\2\ The vast majority of members commented that limit order

protection for a firm's own customer was appropriate and beneficial to

the market, but several cautioned against the potential adverse impact

that could result from application of the rule to member-to-member

orders. In recognition of the concerns raised, the Board deferred

broader application of the rule and commissioned a special Limit Order

Task Force to review the issue. The Task Force devoted considerable

attention to discussions of the impact such additional rulemaking would

have upon the financial viability of the competing dealer system and

the potential adverse impacts upon the quality and efficiency of that

market structure. Accordingly, the Task Force recommended limit order

protection for member-to-member trades that would make it a violation

to trade ahead of customer limit orders when the market makers traded

at a price superior to the limit order price. The NASD Board thereafter

carefully considered the Task Force's recommendation and determined

that for member-to-member trades, the membership should consider

whether limit order protection should be extended beyond the Task Force

recommendation to include protection for customer orders of 1,000

shares or less from member trading at the limit order price and prices

superior to that price. The NASD solicited comment on this proposal.

---------------------------------------------------------------------------

\1\See Notice to Members 94-58 and Securities Exchange Act

Release No. 34279 (June 29, 1994

\2\See Notice to Members 93-49 (July 23, 1993).

---------------------------------------------------------------------------

B. Comments Regarding NASD Notice To Members 94-79).

The NASD received 33 letters in response to its proposal to deal

with member-to-member limit orders. Twelve member firms supported the

proposal as outlined in NTM 94-79.\3\ Two members opposed the proposal

adopted by the Board, but suggested that the Board adopt the Limit

Order Task Force recommendation.\4\ Seventeen commenters opposed the

proposal for various reasons outlined below.\5\ One person expressed no

opinion, except that more study should be done.\6\ Among the

supporters, the commenters generally stated that the proposal would

have a positive effect on investor perception of Nasdaq. In particular,

two comment letters strongly recommended the expansion of limit order

protection to all customer orders regardless of size. For example,

Charles Schwab noted that limit order protection should be extended to

all orders, regardless of size, and noted that it has already extended

limit order protection to all orders that its market making unit, Mayer

& Schweitzer, receives, regardless of order origin. According to the

Schwab letter, if a limit order protection rule were to be uniformly

applied, there would be increased trade volume, quicker executions, and

tighter spreads. Schwab also stated the belief that expansion of limit

order protection is consistent with just and equitable principles of

trade and should promote investor confidence in the Nasdaq market. In

addition, Lehman Brothers was equally strong in recommending that the

Board's proposal in NTM 94-79 should extend the benefits of limit order

protection to all customers without any order size limitations. Lehman

noted that the proposal should not have a ``significant overall impact

on market makers,'' nor should it have an effect on a market maker's

willingness to commit capital. Lehman also noted that a broadened rule

would be easier to comply with, and ultimately, would provide strong

investor protection benefits.

---------------------------------------------------------------------------

\3\See letters from: (1) Santa Barbara Securities, Inc.; (2)

Southwest Securities; (3) Wilshire Capital Management; (4) Freeman

Welwood & Co., Inc.; (5) The Advest Group, Inc.; (6) R.A. Mackie &

Co., LP; (7) Mericor Financial Services; (8) Absolute Investments;

(9) Charles Schwab; (10) Lehman Brothers; (11) Merrill Lynch; and

(12) A.G. Edwards & Sons, Inc. Merrill and A.G. Edwards qualified

their support for the proposal, essentially agreeing with the

details of the proposal, but urged that staff examine several

additional issues that could arise with the adoption of the rule as

proposed.

\4\Letters from: (1) Sherwood Securities Group; and (2) Security

Traders Association.

\5\Two comment letters from the same organization, Herzog Heine

Geduld, were received which accounts for the discrepancy in the

number totals. A number of the negative letters made reference to

the Herzog/Shearman & Sterline Letters. Five of the negative comment

letters are form letters form traders within two firms, one of

which, Southwest Securities, submitted a comment letter supporting

the Board's proposal.

\6\Letter from Andrew Peck Associates, Inc.

---------------------------------------------------------------------------

The firms opposed to any limit order action on member-to-member

trades believed that the proposal would adversely affect the dealer

market structure. In particular, many of those opposed to the concepts

contained in NTM 94-79 concurred in the formulation of the issues as

set forth in the Shearman & Sterling letter on behalf of Herzog Heine

Geduld. Specifically, that letter stated that the proposal posed the

following problems:

(1) The costs of handling limit orders would be cross-subsidized by

other market participants;

(2) Illiquid stocks could be adversely affected;

(3) Increased concentration among market making firms could occur,

favoring vertically integrated firms;

(4) The resulting concentration could lead to reduced competition;

(5) The proposal could harm liquidity, market maker profits, and

spreads; and

(6) The proposal could allow for undetectable ``smurfing'' (the

breaking up of larger orders to fit within the 1,000 share limit order

protection).

C. SEC Action. Shortly after the Board's publication of its

original proposal, on September 29, 1994, the Securities and Exchange

Commission proposed a new rule, Rule 15c5-1,\7\ that would prohibit a

market maker in Nasdaq National Market Securities from trading for its

own account, directly or indirectly, at a price at which the market

maker could execute a customer limit order it is holding, without

executing the customer's limit order at the limit price or a price more

favorable to the customer, under the specific terms and conditions by

which the order is accepted by the market maker. Although the rule as

proposed would apply only to Nasdaq National Market securities, the SEC

solicitated comment on the feasibility of extending the limit order

protection to other securities, including SmallCap and OTC Bulletin

Board securities. The Commission also solicited comment on the terms

and conditions provisions in its rule, which would allow the parties to

a trade to set special conditions to order handling parties to allow a

market maker to employ the appropriate strategy in filling a larger

sized order without being subjected to the requirements of the proposed

rule. In particular, the Commission solicited comment on whether the

rule should specifically distinguish orders by measurable

characteristics, such as number of shares or dollar amount.

---------------------------------------------------------------------------

\7\Securities Exchange Act Release No. 34753 (September 29,

1994); 59 FR 50866 (October 6, 1994).

---------------------------------------------------------------------------

II. Expanded Limit Order Protection

After carefully weighing the ramifications of its actions on the

liquidity in the Nasdaq Stock Market and after reviewing the comments

it received on this proposal, the NASD determined that it should

further expand limit order protection for all customer orders. The NASD

has determined that all customer limit orders for Nasdaq securities--

whether originating within the firm or at another member firm--should

be protected from trading ahead by the market maker holding the order.

Thus, under the NASD's new Limit Order Interpretation to the Rules of

Fair Practice Article III, Section 1, a member firm cannot accept and

hold a customer's limit order in a Nasdaq security and continue to

trade that security for its own account at prices that would satisfy

the customer's limit order without filling that order at the limit

order price or a price more favorable to the customer. Such ``trading

ahead'' activity would be a violation of just and equitable principles

of trade. Of course, the expansion of the Interpretation continues to

permit a member to establish with its customers specific terms and

conditions with regard to the acceptance of limit orders, provided that

the member makes those terms and conditions clear to the customer at

the time the order is accepted by the firm so that trading ahead in the

firm's market making capacity does not occur. Similarly, the

Interpretation continues in place the understanding that nothing in the

Interpretation would obligate a market maker to accept limit orders

from any or all customers or member firms. However, in recognition that

the expansion of the Interpretation represents a significant change in

the operation of a dealer market, the new Interpretation contains a

phase-in period to expire on July 1, 1995, during which time, the NASD

will permit member firms to handle member-to-member limit orders that

are larger than 1,000 shares in size differently. Such orders during

this phase-in period must be protected when the member firm accepting

the order trades for its own account at prices that are superior to the

limit order but not equal to the limit order price. The NASD believes

that this measured implementation of the Interpretation is wholly

prudent given the nature of the adjustment being made by certain firms

in their order handling procedures and the potential need for

reassessment of the existing revenue structure. During this period, the

NASD will evaluate carefully any adverse impact the new Interpretation

may be having on market maker participation or market quality.

The NASD believes that the expansion of its own Rule will enhance

investor confidence in the Nasdaq Stock Market by providing customers

with the opportunity to improve the quality of executions of their

orders. When a customer limit order is given priority over a market

maker's own trading activity, it is likely that the customer's order

will be executed more quickly and efficiently than before. Price

discovery may also be improved in that limit orders may contribute to

the tightening of spreads between the bid and ask prices of a security.

Expansion of limit order protection to so-called member-to-member

limit orders eliminates any adverse effect on customer protection that

may have arisen depending on whether the customer's broker was also a

market maker in a particular security. The NASD carefully considered

the potential negative effects on the Nasdaq market (loss of market

liquidity, concentration of market making firms and lack of sponsorship

for smaller capitalized companies) that could occur with the expansion

of limit order protection. The NASD has determined that in the long

term, any such negative effects should be outweighed by the increased

benefits to customers receiving the expanded protection and

accordingly, there should be an increase in investor confidence and

participation in the Nasdaq Stock Market. In this connection, the NASD

notes that Nasdaq market makers are free to negotiate additional

compensation from order routing firms to the extent that such

compensation is economically and competitively justified.

However, because a requirement that market makers yield priority to

the execution of customer interest could have a short-term, temporary

effect on the market maker' ability to offer liquidity at the limit

order price, the NASD has proposed in its rule to delay the complete

effectiveness of the rule for six months. Therefore, until July 1,

1995, market makers would be allowed to trade at the same price as the

limit order price for orders over 1,000 shares. Accordingly, the NASD

has determined that it is appropriate to propose limit order protection

standards which appropriately differentiate between small-sized and

large-sized customer limit orders for the first six months that the

rule is in effect. For small limit orders (1,000 shares or less), the

NASD proposes to implement the same limit order protection that is

currently in place for a market maker's own customers--that a market

maker may not trade ahead for its own account at a price that would

satisfy the limit order price. For larger-sized orders, however, the

NASD believes it is appropriate to impose a different standard. When a

member accepts and holds a customer limit order greater than 1,000

shares from another member firm, the dealer's obligation to fill that

limit order would be triggered when the market maker trades at a price

that is superior to the limit order price.

Thus, during the next six months, if the inside market in a Nasdaq

issue were 20--20\1/4\ and the market maker accepted a customer buy

order from another broker/dealer priced at 20 for 2,000 shares, when

the firm buys at any price superior to 20 (that is, purchases at a

price lower than a buy limit order, in this example, purchasing at

19\7/8\ or 19\15/16\, it would be required to sell to the customer at

20 or better. Using the same example, if the customer limit order were

for 500 shares at 20, the rule would prohibit members from trading

ahead at 20 without filling the customer order at 20. Accordingly, the

proposal would require protection for orders greater than 1,000 shares

when the dealer trades at a superior price, and protection for orders

of 1,000 shares or less when the dealer trades at the limit order price

or a price more favorable to the customer.

Consequently, the NASD believes that the proposed rule change is

consistent with Section 15A(b)(6) in that these proposed changes are

designed to prevent fraudulent and manipulative acts and practices, to

promote just and equitable principles of trade, to facilitate

transactions in these securities, to remove impediments to and to

perfect the mechanism of free and open market and a national market

system, and in general to protect investors and the public interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

The NASD does not believe that the proposed rule change will result

in any burden on competition that is not necessary or appropriate in

furtherance of the purposes of the Act, as amended, The NASD has looked

carefully at the suggestions by some commentators that smaller and non-

integrated firms will be unable to compete with large integrated firms

under the new requirement, but can find no substantive support for the

position advanced. First, the proposed Interpretation does not

eliminate the ability of any firm to compete with respect to service,

cost, investment recommendations or other executive parameters. For

example, the NASD notes that at least one firm has already announced a

new price improvement mechanism for Nasdaq securities. Accordingly,

while the NASD will monitor carefully for an adverse competitive

effects of the Interpretation, the NASD believes that any speculation

on potential adverse effects is far outweighed by the enhanced

execution opportunities that will be provided to public investors.

(C) Self-Regulatory Organization's Statement on Comments on the

Proposed Rule Change Received from Members, Participants, or Others

Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for

Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if its finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the NASD consents, the Commission will:

(A) By order approve such proposed rule change, or

(B) Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change that are filed with

the Commission, and all written communications relating to the proposed

rule change between the Commission and any person, other than those

that may be withheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

NASD. All submissions should refer to the file number in the caption

above and should be submitted by January 13, 1995.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\8\

---------------------------------------------------------------------------

\8\17 CFR 200.30-3(a)(12).

---------------------------------------------------------------------------

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-31658 Filed 12-22-94; 8:45 am]

BILLING CODE 8010-01-M