Self-Regulatory Organizations; Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to Handling of Customer Limit Orders

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33697; File No. SR-NASD-93-58]

Self-Regulatory Organizations; Proposed Rule Change by National

Association of Securities Dealers, Inc. Relating to Handling of

Customer Limit Orders

March 1, 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 October

13, 1993 the National Association of Securities Dealers, Inc. (``NASD''

or ``Association'') filed with the Securities and Exchange Commission

(``Commission'' or ``SEC'') 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

The Association is proposing an Interpretation to the Rules of Fair

Practice to require that member firms not trade ahead of their

customers' limit orders in their market making capacity. The

Interpretation would make it a violation of just and equitable

principles of trade for member firms to hold unexecuted customer limit

orders and trade ahead of those orders in the firm's market making

capacity without filling the orders under the specific terms and

conditions with which the orders had been accepted.

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 Association is proposing an Interpretation to the Rules of Fair

Practice that would make it a violation of just and equitable

principles of trade for member firms that hold unexecuted customer

limit orders to trade ahead of those orders in the firm's market making

capacity. In July 1993, the NASD solicited member comment on

eliminating a disclosure safe harbor for members trading ahead of

customer limit orders.\1\ In September 1993, the Board reviewed

comments received from members and others and took action to eliminate

the disclosure safe harbor and to replace it with a prohibition against

members' trading ahead of their own customer limit orders.

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\1\See Notice to Members 93-49 (July 23, 1993).

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The issue of limit order protection in the NASDAQ market was

brought to the forefront in 1985 when a customer alleged that a member

firm had accepted his limit order, failed to execute it, and failed to

discharge its fiduciary duties by trading ahead of the customer's

order. In the Manning decision, the NASD found that upon acceptance of

a customer's limit order, a member undertakes a fiduciary duty and

cannot trade for its own account at prices more favorable than the

customer's limit order unless clear disclosure is provided and there is

an understanding by the customer as to the priorities that will govern

the order. The SEC affirmed the NASD decision.\2\ After input from a

number of members, the NASD proposed a ``safe harbor'' for members to

fulfill their fiduciary obligations with disclosure when the customer's

account was first opened and periodically thereafter.\3\ The language

set out in the proposed safe harbor put customers on notice that the

firm accepting a limit order would execute that order only when the

inside bid or offer on Nasdaq reached the limit price and that the

member might, in its market making capacity, trade ahead of that order.

The membership approved the proposed language, and the NASD submitted

the rule to the SEC.\4\

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\2\In the Matter of E.F. Hutton & Co., Securities Exchange Act

Release No. 25887 (July 6, 1988), 41 SEC Doc. 473.

\3\See Notice to Members 90-37 (June 1990).

\4\SR-NASD-89-10 (March 16, 1989). With submission of this rule

proposal, the NASD, under separate cover, is withdrawing SR-NASD-89-

10.

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In July 1993, the NASD Board of Governors reviewed the handling of

limit orders in NASDAQ securities and concluded that the continuation

of the disclosure exception appeared inappropriate. Because of the

significance of this change to The NASDAQ Stock Market, a notice was

issued soliciting input on how elimination of the safe harbor would

impact the operation of member firms and the treatment of investors'

orders. The NASD also solicited comment on what if any unintended

effects or unacceptable consequences would ensue if rules prohibiting

trading ahead of customer limit orders were imposed on member firms.

Specifically, comment was requested on the impact of applying the

requirements on integrated broker-dealers handling their own customer

order flow; on customer limit orders received from other member firms

(so-called member-to-member trades); and on market liquidity.

In response to the notice, the NASD received 29 comment letters

from members and trade associations, including the Security Traders

Association (``STA''), STA of New York (``STANY''), and Securities

Industry Association (``SIA''). The vast majority of comments supported

elimination of the disclosure safe harbor for market makers trading

ahead of their own retail, or ``commission paying,'' clientele.

Commenters noted that elimination of the safe harbor would level the

playing field for investors, enhance the image of The NASDAQ Stock

Market, and instill greater confidence with investors that their NASDAQ

limit orders would be handled fairly. Some commenters noted that the

NASD should distinguish between retail and institutional customer limit

orders, so that a market maker's ability to commit capital to large

institutional orders would not be impaired by a narrow reading of

``trading ahead.'' Members believed that the new rule language might

interfere with a market maker's ability to commit capital to large

institutional orders as filling these orders might necessarily involve

a trading strategy to cover short positions or to buy stock along with

the institution that on its face might appear to be trading in front of

those or other customer limit orders. Other commenters believed that

distinguishing between institutional and retail customers was not

necessary because the proposed rule language that allows members to

establish specific terms and conditions on each order adequately covers

handling of institutional orders.

Many commenters, including STA, SIA and STANY, argued that the NASD

should draw a distinction between orders from a member's own customers

and orders from another broker/dealer. They pointed out that unlike an

integrated firm which may charge a mark-up or commission to its

customers, the only profit potential for orders received from other

members lies in trading revenues derived from the spread. If the effect

of the NASD's proposed rule were to require a market maker to satisfy a

limit order sent from another broker/dealer when the market maker

traded at the same price, these commenters agreed that the NASD would

be in effect forcing the market makers to handle the order at no profit

or indeed at a loss net of processing costs. These commenters also

argued that alternative means of compensating market makers, such as

sharing the order entry firm's commission, were infeasible given the

structure of the NASDAQ market. As a result, these commenters argued

that extension of the Interpretation to member-to-member orders would

dramatically reduce market maker commitment. Further, several members

argued that by extending the requirements to other members' customer

limit orders, the NASD would be inappropriately expanding the

requirements of a fiduciary in the securities markets.

Many also commented on the new rule's potential for unintended

consequences on market liquidity, including a significant increase in

limit orders as opposed to market orders, loss of market maker

commitment, wider spreads and increased volatility. Members pointed out

that the NASD had not yet fully explored the economic ramifications of

the new requirements and noted that further economic analysis should be

undertaken prior to rulemaking.\5\

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\5\Some members also argued that procedural due process was

being by-passed by framing the new requirement as an Interpretation

to the just and equitable principles of trade standards of Article

III, Section 1 of the NASD Rules of Fair Practice. The NASD notes

that these comments misconstrue the regulatory process involved with

NASD Interpretations. All NASD Interpretations are submitted to the

SEC for review, publication in the Federal Register and public

comment prior to SEC action.

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After full consideration of the concerns articulated in the comment

process, the NASD is proposing to eliminate the disclosure safe harbor

for member firms that hold their own customer limit orders and trade

ahead of those orders and to make such actions a violation of just and

equitable principles of trade. The language of the Interpretation

establishes that a member holding its customers' limit order may not

continue to trade its market making position without executing that

limit order under the specific terms and conditions that the customer

understands and accepts. If the member does trade ahead of its

customer, it will be in violation of article III, section 1 of the

Rules of Fair Practice regarding just and equitable principles of

trade.

The NASD believes that it is inappropriate to distinguish between

the limit order protection provided fee-paying, or retail customers,

and non-fee paying, institutional clientele. The NASD recognizes,

however, that filling institutional-sized orders generally involves

best-effort commitments and trading strategies other than a straight

acceptance of a limit order. Firms accepting institutional orders on a

best-efforts basis, that may involve trading to a cover short position

or buying stock along with the institution, would not be in violation

of the rule as long as the firm maintains a clear understanding with

its institutional clientele of the terms under which the order is being

executed. Accordingly, the NASD does not distinguish between

institutional and retail customers in the Interpretation because the

proposed language that allows members to establish specific terms and

conditions on each order clearly encompasses institutional orders. This

language recognizes that institutions generally do not leave standard

limit orders with market makers. Instead, in return for the willingness

of member firms to put up substantial capital to provide liquidity for

large orders, institutions generally only hold market makers to a best-

efforts standard in attempting to execute their order at a specific

price. The ability of the member firm and the institution to reach

agreement on the terms and conditions of the order would allow them to

negotiate these arrangements without subjecting the member firm to the

requirements of the proposed rule.

Further, the NASD has determined to temporarily defer application

of the Interpretation to member-to-member orders in order to avoid any

unintended consequences from a broader application of the rule. The

NASD will form a special task force to examine ramifications of

extending limit order protections to include member-to-member

transactions. The task force will analyze the effect of the proposal on

market liquidity, volume of limit orders, market maker commitment,

spreads and volatility. The NASD believes that the issues raised by

customer limit orders passed from one member firm to a second member

firm are very complex. Dealers that trade as ``wholesale'' market

makers, whether exclusively or as a part of an integrated firms'

business, have profit potential only in the trading revenues received--

they do not rely on commissions or commission equivalents as revenue to

support their trading activities. Relying on pure trading profit and

loses is unique to a dealer market and cannot be compared to a

specialist that executes transactions for members on an exchange while

charging a fee for that service. Accordingly, requiring a market maker

to execute such limit orders any time it trades for its own account at

the same price effectively eliminates any opportunity for that market

maker to profit on that trade. The NASD is concerned that the economic

implications for market makers and the potential impact on liquidity

and spreads in the NASDAQ stock market have not fully been reviewed.

For these reasons, the NASD will form a task force composed of diverse

industry and investor interests to review the issues raised by limit

orders passed from one member to another.

In the Interpretation, the NASD also emphasizes that brokers

forwarding orders to dealers for execution continue to be subject to

their duties of best execution. Firms owe fiduciary duties of best

execution to their customers and the NASD emphasizes that order entry

firms should continue to routinely monitor the handling of their

customer limit orders for quality of execution.

The NASD believes that elimination of the safe harbor for a broker/

dealer's own customer orders is squarely in line with the original

Manning decision which was premised on a firm's fiduciary duty not to

trade ahead of its own customer order.\6\ Feedback from members

commenting on the new rules indicates that integrated market makers on

the whole do not trade ahead of their own customer orders, and

accordingly, eliminating the safe harbor would not materially or

adversely affect the way these market makers conduct their business

today.

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\6\In this regard, the NASD Interpretation on the obligation to

protect the firm's customer limit orders will also apply to firms

that control or are controlled by another member firm, e.g., where

the order entry firm is a broker that owns or controls the executing

dealer.

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Finally, as the handling of customer limit orders entails duties

that are not subject to a disclosure safe harbor, nothing in the rule

compels market makers to accept limit orders from their customers or

from other broker/dealers.

The NASD believes the proposed rule change is consistent with

section 15A(b)(6) of the Act. Section 15A(b)(6) requires 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, to foster cooperation and coordination with

persons engaged in regulating, clearing, settling, processing

information with respect to, and facilitating transactions in

securities, to remove impediments to and perfect the mechanism of a

free and open market and a national market system and in general to

protect investors and the public interest. The new requirement ensures

protection of investor's limit orders when placed with market making

firms and enhances the quality of the marketplace. The affirmative

obligation for firms to protect their customer limit orders and to give

them standing over their own market making activity also enhances

opportunities for price improvement which is a benefit for public

investors.

B. Self-Regulatory Organization's Statement on Burden on Competition

The NASD believes that the proposed rule change will not result in

any burden on competition that is not necessary or appropriate in

furtherance of purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

Comments were solicited in Notice To Members 93-49 and the content

of those comments are summarized in the description of the rule

proposal in part II(A) above.

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 it 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. In this regard, the Commission

notes that in the recently issued Market 2000 study, the Division of

Market Regulation recommends that the NASD revise its proposal to

prohibit broker-dealers from trading ahead of all customer limit orders

for NASDAQ/NMS securities.

Persons making written submissions should file six copies thereof

with the Secretary, Securities and Exchange Commission, 450 Fifth

Street, NW., Washington, DC 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 communication 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 March 29, 1994.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority, 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-5205 Filed 3-7-94; 8:45 am]

BILLING CODE 8010-01-M