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94-63 New Section 46 Of Article III Of The Rules Of Fair Practice Governing The Repricing Of Open Orders Takes Effect September 15, 1994

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Executive Summary

The NASD is publishing this Notice to remind members that new Section 46 of Article III of the Rules of Fair Practice requiring members holding open orders to adjust the price and size of such orders by the amount of any dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest will be effective on September 15, 1994. Members will be required to comply with the new rule on that date regardless of whether automated repricing systems are available internally on proprietary systems or from outside vendors. The NASD is also announcing resolutions of certain issues raised by member firms with respect to the availability of dividend or distribution information and the obligations of member firms.

Background

In Notice to Members 94-09, published in February 1994, the NASD announced the Securities and Exchange Commission's (SEC) approval of new Section 46 of Article in of the Rules of Fair Practice requiring members holding open orders to adjust the price and size of such orders by the amount of any dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest and announced that the new rule would be effective May 15, 1994. In Notice to Members 94-22, the NASD announced that the effective date of new Section 46 would be delayed until September 15, 1994.

Compliance

To comply with the requirements of the rule, members may choose to handle open orders in one or more of the following ways:

1. Manually reprice such orders according to the requirements of the rule;
2. Automatically reprice such orders according to the requirements of the rule by using an in-house proprietary order-handling system;
3. Automatically reprice such orders according to the requirements of the rule by using a Nasdaq® system; (See below for information on the availability of such systems.)
4. Route such orders to an order execution firm for handling pursuant to 1,2, or 3, above;
5. Accept open orders only on a "do not reduce" (DNR) or "do not increase" (DM) basis; or
6. Not accept open orders.

Currently, the NASD's Small Order Execution System (SOESSM) limit order file will "pend" an order (take it out of the automatic execution mode) when the security trades ex-dividend. When SOES pends an order, it is returned to the member that entered the order for reconfirmation. If the order is not reconfirmed by the member, it is canceled. When Section 46 takes effect, members will be required to reprice such returned orders according to the requirements of the rule. The member will not be required to return the order to SOES after repricing; however, Section 46 does not permit a member to ignore or refuse to reprice a returned order, unless the order was originally accepted with a DNR/DNI instruction.

Regardless of the method chosen for handling open orders, the member accepting an order from a customer or another member is responsible for ensuring compliance with Section 46. Thus, if a member accepts an open order from a customer and routes it to another member for execution, the member accepting the order must ensure that the order-executing firm has agreed to and can, in fact, comply with Section 46, and the order-executing firm must, in fact, comply with Section 46. Failure to comply with Section 46 in such a situation may subject both firms to disciplinary action.

Information On Securities Traded Ex

Members have expressed concern about obtaining timely information on securities traded ex to permit them to comply with the requirements of the rule. Currently, issuers are required by SEC Rule 10b-17, adopted under the Securities Exchange Act of 1934, to report dividends or other distributions to the NASD or to the exchange (pursuant to the exchange's rules) on which its securities are listed, unless the SEC has exempted the issuer from complying with the rule. When an issuer reports a dividend to the NASD, for instance, an ex-date is set by the NASD Operations Department and reported to an information vendor. Subscribers to such vendors are, therefore, advised of the dividend and in a position to reprice open orders.

To comply with new Section 46, members accepting open orders must ensure that they have access to, whether by subscription, on-line, or some other method, the ex-date information for the securities for which they are accepting orders. The NASD is exploring methods for supplying all ex-date information directly or through a third party and, if created, will announce such a program at a later date.

Finally, members have expressed concern about their liability under Section 46 where the issuer has not reported a dividend or distribution pursuant to SEC Rule 10b-17. The NASD has determined that members should not be liable for failing to reprice orders in such situations and has submitted a proposed rule change to the SEC for approval that would amend Section 46 to exempt open orders where the issuer has not reported the dividend or distribution pursuant to SEC Rule 10b-17. This would mean that orders for the securities of an issuer that was not required to submit 10b-17 reports, or was exempted from reporting under 10b-17 by the SEC, or where the issuer failed to report as required, would not be subject to the repricing requirements of Section 46.

Fractional Pricing

Several member firms have asked whether the 1/8 minimum increment in Section 46 specified for calculating prices is consistent with the possibility that there may be smaller minimum increments for quotations and transaction reports. Further, members have asked whether, for securities quoted or traded in smaller fractions, rounding prices to the nearest 1/8 would create problems for such repriced orders. The NASD recognizes that occasional problems as described might arise; however, because the NYSE relies on l/8s in pricing and in the interests of having Section 46 function in a manner substantially the same as the NYSE's rule, the NASD does not believe that reducing the repricing increment is advisable at this time. The NASD suggests that if members wish to avoid problems in such situations that they consider accepting open orders for securities that trade in less than 1/8 increments only on a DNR/DNI basis. The NASD will continue to keep abreast of developments in this area.

Nasdaq Systems

The NASD is planning updates of The Nasdaq Stock Market's operating systems by, among other things, improving the features of SOES1 and implementing the Advanced Computerized Execution System (ACESSM). These updates will include automatic repricing of open orders and will permit a member to comply with new Section 46 by placing such orders in the system. It is unlikely, however, that these changes will receive SEC approval before the September 15, 1994, effective date of Section 46. Therefore, the NASD will not be able to provide automated repricing capability for member firms subscribing to our systems on the effective date of the rule. Nevertheless, members will be expected to comply with the requirements of the rule when it becomes effective.

Repricing Calculation Methodology In Notice to Members 94-09 announcing the approval of new Section 46, the NASD discussed the calculation methodology to be used to reprice orders in accordance with the rule. The NASD is aware that the discussion appearing on page 44 of that Notice may mislead people into believing that there is a particular dollar value that may be ascribed to a share of stock in a dividend. This is not the case; the value of a stock dividend is a ratio of old stock to new stock that has a dollar value only in the context of a particular open order at a particular price. Thus, when Subsection 46(a)(ii) speaks of the "dollar value" of the stock dividend, it is referring to the dollar value as it relates to the particular order being repriced. As the NASD stated in Notice to Members 93-61 published in September 1993, the dollar value of a dividend with respect to particular order is discovered by applying the ratio of old shares to new shares to the price of the particular order.

This is accomplished by multiplying the current order price by the number of old shares being exchanged and dividing the product by the number of new shares to be issued. For example, in a 3 for 2 distribution, multiply the per share price of the original order by 2 and divide the result by 3. Finally, round the resulting price up to the nearest 1/8. This method eliminates the need to find a dollar value for the split, round it up 1/8, and then subtract it from the current price of the order. Expressing this as a formula:

Where

P = the price per share of the original order,

C = number of shares being exchanged for new shares,

D = number of new shares being distributed, and

n = the resulting new price of the order

Then,

n = (P x C)/D

The resulting new price must then be rounded up to the nearest 1/8.2

Combined Cash/Stock Dividends Finally, the NASD wishes to advise members that for dividends in both cash and stock, do the cash dividend calculation first and the stock calculation second. If the putative dollar value of the combined dividend is less than 25 percent and the NASD sets the ex-date for both on the same date pursuant to current practice, repricing an open order involves calculating the cash dividend adjustment first and then calculating the stock dividend adjustment based on the new price. Thus, if an open order at $10 per share were the subject of a $1.00 cash dividend and a 5 percent stock dividend, the price would first be reduced by $1.00 to $9.00 and then would be reduced by applying the preceding formula, thus: (9 x 20)/21 = $8.57 = 8 S8. If the putative dollar value of the combined dividend is greater than 25 percent, pursuant to current practice, the NASD sets an ex-date for the cash dividend and then the stock dividend. In such cases, open orders are repriced once on the cash dividend ex-date and once on the stock dividend ex-date.

Treatment Of DNR/DNI Instructions While Subsection 46(e) states that the provisions of the rule will not apply to orders marked DNR or DNI, several members have inquired whether the provision means, for instance, that an order marked DNI will not be adjusted either for size or price, or just for size. Because the NASD's intent in adopting this rule was for it to function in the same manner as the NYSE's Rule 118, and under Rule 118 a DNI instruction only applies to size adjustments, the NASD has determined that Section 46 should be read in the same manner. Therefore, a DNI instruction in a stock dividend situation will require the member to adjust the price of the order pursuant to Subsection 46(a)(ii), but not the size of the order. Similarly, a DNR instruction in a stock dividend situation will require the member to adjust the size of the order, but not the price. If a customer does not want the order adjusted as to size or price, both DNR and DNI instructions should be included. The NASD will announce at a later date whether its automated systems will be able to distinguish between orders carrying one instruction and orders carrying both.

Questions regarding this Notice may be directed to Dorothy L. Kennedy, Assistant Director, Nasdaq Operations, at (203) 385-6246, or Elliott R. Curzon, Assistant General Counsel, Office of General Counsel, (202) 728-8451.


1 The NASD recently filed proposed rule change SR-NASD-94-13 to adopt a Nasdaq Primary Retail Order View and Execution System (N'PROVE). N'PROVE will replace SOES and will include an automatic repricing feature that will comply with the new Section 46.

2 Members may apply any formula or method of calculation that yields the same result.


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