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91-67 SEC Approves Rules to Curb SOES Abuse

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EXECUTIVE SUMMARY

On October 10, 1991, the Securities and Exchange Commission (SEC) unanimously approved four changes to the Small Order Execution System (SOES) operated by NASD Market Services, Inc. for Nasdaq securities. Currently, NASD rules prohibit members from using SOES to enter orders on behalf of a "professional trading account." Two new rules expand the definition of a professional trading account to include criteria such as excessive frequency of short-term trading and excessive short selling through SOES and also establish that executing either one or both sides of a day trade through SOES may be deemed professional use. These new rules are effective immediately.

Additionally, the SEC approved two operating modifications to SOES; market makers will have approximately 15 seconds to update their quotations following an execution as well as the ability to accept preferencing on a firm-by-firm basis. These modifications are scheduled to be implemented November 18, 1991.

OVERVIEW OF THE SYSTEM

NASD Market Services, Inc., a subsidiary of the NASD, developed the Small Order Execution System (SOES) to assist order-entry firms and market makers in executing small retail customer orders for Nasdaq securities in an efficient, fast, and inexpensive manner by providing an automated, paperless execution and a locked-in trade for purposes of clearance and settlement. The system was designed to accommodate small-sized orders that were routinely executed at the Nasdaq best bid or offer and that did not require negotiation or special handling by traders. In recognition of the order-routing relationships in the market, the NASD also permitted preferencing of SOES orders to particular market makers, which have an obligation to execute the orders at the best price, regardless of the quote they may be displaying. Participation in SOES initially was voluntary.

After the October 1987 market break, the NASD adopted rules to require dealers to participate in SOES if they were market makers in Nasdaq National Market System (Nasdaq/NMS) securities and penalized market makers that withdrew on an unexcused basis with a 20-day suspension from Nasdaq and SOES. Since 1988, market makers have been required to execute orders in sizes of 200, 500, or 1,000 shares, depending on the trading characteristics of the stocks, and have been required to execute up to five consecutive orders in SOES stocks at the designated tier size.

SOES ABUSES

SOES abuse has become a serious problem. In 1988, the SEC approved rules to prohibit NASD members from using SOES to enter orders on behalf of professional trading accounts because SOES was designed to accommodate small orders for investors, not professional traders. At that time, professionals were deemed to be "day traders" who used SOES to buy and sell stock the same day.

Since the professional trading account rules were implemented, however, the NASD has become aware of other abuses of the system. They include rapid entry of SOES orders after news on a security has come out, but before the market has had an opportunity to absorb the news and reflect it in quotation changes; day trading using SOES for only one side of a trade to elude the application of SOES rules; consecutive immediate executions of orders usually all at the maximum size permitted in the system to a market maker remaining at the inside quotation after all or most of the other market makers have moved their quotes; or preferencing orders to disadvantage particular market makers because SOES executes preferenced orders at the inside Nasdaq quote regardless of the displayed quote of the preferenced market maker.

NASD RULES TO CURB SOES ABUSE

To eliminate these abuses, the NASD proposed and the SEC approved the following four changes to SOES. With these new rules, the NASD is attempting to eliminate the disparity in position between the investor and the professional trader. The SEC acknowledged that without professional trading account prohibitions, investors may be forced to wait in line behind professionals and agreed with the NASD that SOES is not intended to accommodate professionals. The first two changes take effect immediately; the last two are scheduled to be implemented November 18, 1991.

1. Rules defining a professional trading account have expanded the criteria under which the NASD may designate an account as professional and prohibit SOES access for that account. The factors include: (1) excessive frequency of short-term trading; (2) excessive frequency of short-sale transactions; (3) trading of discretionary accounts; (4) direct or physical access to Nasdaq quotation screens or SOES terminals.
2. The rule defining day trading clarifies that it includes one or both sides of a transaction occurring through SOES. For example, if a customer sold a stock through SOES and purchased it over the telephone, it would be considered a day trade for purposes of SOES rules.
3. A market maker will have approximately 15 seconds after receipt of an execution report in SOES to update its quote before receiving another execution in the same stock.
4. Market makers and order-entry firms will be permitted to enter preferencing relationships only when mutually agreeable. SOES will treat all preferenced orders not subject to an agreement between the parties as unpreferenced orders, to be executed through SOES in the usual manner, in rotation against any market maker at the inside quotation.

COMPLIANCE WITH THE NEW RULES

It is important to emphasize that the criteria set forth in the new rules in defining a professional trading account will not automatically be applied to all active accounts. On the contrary, the NASD's Market Surveillance Department will make determinations only after a pattern or practice of professional trading has been detected. These criteria are additional factors that will be taken into consideration when reviewing the activity in a particular account and do not necessarily mean that the existence of any single factor will cause an account to be designated a professional trading account.

With regard to day trading, the SOES rules state that a professional trading pattern encompasses not only the inclusion of accounts executing five or more day trades each day, but also includes other activities such as (1) the existence of a pattern or practice of executing day trades; (2) the execution of a high volume of day trades in relation to the total transactions in the account; or (3) the execution of a high volume of day trades in relation to the amount and value of securities held in the account.

Thus, a pattern of excessive short-term trading, including but not limited to day trading, could be deemed professional trading, and the account would be prohibited from using SOES. Such determinations could result, for example, if an account exhibits a pattern of consistently executing fewer than five day trades during a trading day because the frequency of day trades could constitute excessive short-term trading.

Additionally, the Association in the past has interpreted the SOES rules to prohibit circumvention of the rules through entry of a group or series of transactions for one or more accounts that are related or controlled by a person associated with a member firm or by a customer (see Notice to Members 88-61). To assure that the limitations with respect to professional trading or day trading are not circumvented through the use of multiple related or controlled accounts, the Association intends to closely monitor patterns of trading in these accounts. Accordingly, day trades occurring in accounts that are related or under common control will be viewed by the NASD as occurring in a single account for purposes of the SOES rules. Likewise, the NASD will closely monitor related or controlled accounts for other indications of professional trading patterns including the practice of entering fewer than five day trades. An associated person or customer will be deemed to control an account if he or she exercises discretion over the account or has been granted a power of attorney to execute transactions in the account; if the account is his or her personal account; or if, in the case of an associated person, it is the account of a member of his or her immediate family, as that term is defined in the NASD Interpretation on Free-Riding and Withholding (see Notice to Members 88-61).

The NASD will monitor members' SOES activity on a daily basis through automated regulatory systems in the Market Surveillance Department and will increase the intensity of its on-site field examinations of SOES trading patterns. Apparent violations of SOES rules will be reviewed by the Market Surveillance Committee for a determination as to whether disciplinary action is appropriate. When the NASD notifies a firm that accounts have been designated professional accounts, the SOES system is no longer available for purchases or sales from those accounts. Furthermore, members should instruct their associated persons not to knowingly accept orders for execution in SOES from accounts designated as professional trading accounts. Members or customers that feel aggrieved by such a designation may appeal the action by following procedures set forth in Article IX of the NASD's Code of Procedure. Questions on the SOES rules should be directed to James M. Cangiano, Vice President, Market Surveillance at (301) 590-6424 or Beth E. Weimer, Assistant General Counsel at (202) 728-6998. The complete text of the rules follows.

RULES OF PRACTICE AND PROCEDURES FOR THE SMALL ORDER EXECUTION SYSTEM

(Note: New language is underlined.)

(a) Definitions

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10. The term "professional trading account" shall mean
(A) an account in which five or more day trades have been executed during any trading day; or
(B) an account in which there has been a professional trading pattern as demonstrated by:
(1) a pattern or practice of executing day trades;
(2) executing a high volume of day trades in relation to the total transactions in the account;
(3) executing a high volume of day trades in relation to the amount and value of securities held in the account;
(4) excessive frequency of short-term trading;
(5) excessive frequency of short sale transactions;
(6) existence of discretion; or
(7) direct or physical access to SOES execution capability, to Nasdaq Level 2 service, or to NQDS service.
11. The term "day trade" or "day trading" shall mean the execution through SOES of either one or both sides of offsetting trades in the same security for generally the same size during the same trading day.
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(c) Participation Obligations in SOES

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2. Market Makers — (A) A SOES Market Maker shall commence participation in SOES by initially contacting the SOES Operation Center to obtain authorization for the trading of a particular SOES security and identifying those terminals on which the SOES information is to be displayed and thereafter by an appropriate keyboard entry which obligates the firm, so long as it remains a Market Maker in SOES, (i) for any security for which it is a SOES Market Maker, to execute individual orders in sizes equal to or smaller than the maximum order size; and (ii) for any Nasdaq/NMS security for which it is a Market Maker, to execute individual orders equal in the aggregate to the minimum exposure limit. Market Makers shall have a period of time following their receipt of an execution report in which to update their quotation in the security in question before being required to execute another transaction at the same bid or offer in the same security. This period of time shall initially be established as 15 seconds, but may be modified upon appropriate notification to SOES participants. All entries in SOES shall be made in accordance with the requirements set forth in the SOES User Guide.
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3. SOES Order Entry Firms —
(A) All entries in SOES shall be made in accordance with the procedures and requirements set forth in the SOES User Guide. Orders may be entered in SOES by the SOES Order Entry Firm through either its Nasdaq terminal or computer interface. The system will transmit to the firm on the terminal screen and printer, if requested, or through the computer interface, as applicable, an execution report generated immediately following the execution.
(B) SOES will accept both market and limit orders for execution. Orders may be preferenced to a specific SOES Market Maker or may be unpreferenced, thereby resulting in execution in rotation against SOES Market Makers. A Market Maker may indicate order entry firms from which it agrees to accept preferenced orders. If an order is received by a Market Maker from an order entry firm from which it has not agreed to accept preferencing, the order will be executed at the inside market on an unpreferenced basis.
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(E)(i) No member or person associated with a member shall enter any order for execution in SOES on behalf of a professional trading account. The Association shall take into account the factors enumerated in Section (a)(10) in determining whether an account will be designated as a professional trading account.
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(F) Article IX of the Code of Procedure shall apply to Order Entry Firms and other persons seeking review of the restrictions imposed due to the designation of a professional trading account, pursuant to this Sub-section.

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