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94-58 SEC Approves New NASD Limit Order Protection Rule
On June 29, 1994, the Securities and Exchange Commission (SEC) approved a proposed Interpretation to Article III, Section 1 of the NASD Rules of Fair Practice that prohibits a member firm from trading ahead of its customer's limit orders in a firm's market-making capacity.1 Accordingly, the Interpretation is now in effect.
Approval of the Limit Order Protection Interpretation thus eliminates the so-called "Manning safe harbor" that permitted a member firm to trade ahead of its customers' limit orders in the firm's market-making capacity if the firm adequately disclosed to its customers that the firm may accept a limit order and then trade ahead of it in the process of discharging its market-making obligations. The enactment of this Limit Order Protection Interpretation by the NASD reflects the ongoing effort of the NASD and The Nasdaq Stock Market, Inc., to ensure investor protection and enhance market quality. The affirmative obligation for a firm to protect its customer's limit orders and to give those orders standing over its own market-making activity enhances opportunities for price improvement that directly benefit public investors.
Background And Description Of The Interpretation
The issue of limit-order protection in The Nasdaq Stock Market™ was highlighted in 1985 when a customer alleged that a member firm accepted his limit order, failed to execute it, and failed to discharge its fiduciary duties by trading ahead of the customer's order without notifying the customer that it was doing so. In the Manning decision, the SEC affirmed the findings of an NASD disciplinary proceeding whereby the NASD determined that, upon accepting 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 the member provides clear disclosure and the customer understands the priorities that will govern the order.2
In July 1993, the NASD Board of Governors reviewed the background of the Manning disclosure safe harbor and voted to replace it with the Limit Order Protection Interpretation that would eliminate the Manning safe-harbor approach and prohibit a member from trading ahead of a customer's limit order. Because of the significance of the change to The Nasdaq Stock Market, the Board authorized a Notice to Members soliciting comment on how elimination of the safe harbor and adoption of rules prohibiting trading ahead of customer limit orders would affect the operation of member firms and the treatment of investors' orders.3 The Board also solicited comment on any unintended effects or unacceptable consequences of any new requirements on member firms. Specifically, comment was requested on the impact of the requirements on an integrated broker/dealer handling its own customer order flow, on customers limit orders received from other member firms (member-to-member trades), and on market liquidity.
After full consideration of the concerns articulated during the comment process, the Board reaffirmed its decision to eliminate the disclosure safe harbor and to adopt the Limit Order Protection Interpretation.4 In light of numerous comments from member firms of the adverse market impacts that could result from application of the Interpretation to member-to-member limit orders, however, the Board determined to defer application of the Interpretation to these limit orders until a special task force could examine the ramifications of extending the Interpretation to include these limit orders. Accordingly, the Limit Order Protection Interpretation approved by the SEC does not apply to member-to-member limit orders.
Under the Interpretation approved by the SEC, 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 market-making account at prices that would satisfy the customer's limit order. The Interpretation, however, does not mandate that a member firm accept limit orders from its customers.
In addition, the Board recognized that member firms handling and committing substantial capital to institutional orders generally have reached a separate understanding as to the execution parameters for those orders. Accordingly, the Interpretation provides that a firm may attach terms and conditions governing the acceptance of a limit order, provided that such terms and conditions are made clear to the customer at the time that the order is accepted.
Following are answers to questions frequently asked about the Interpretation.
It is a facts-and-circumstances analysis to determine whether one member controls or is controlled by another member. For example, the NASD would view the following factors as indications of a "control" relationship between two members:
In addition, the Interpretation emphasizes that any member accepting customer limit orders owes 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. Accordingly, the Interpretation reiterates that 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 Interpretation also emphasizes that order-entry firms should continue to routinely monitor the handling of their customers' limit orders regarding the quality of the execution received.
Questions regarding this Notice should be directed to James Cangiano, Senior Vice President, Market Surveillance, at (301) 590-6424; Glen Shipway, Senior Vice President, Nasdaq Market Operations, at (203) 385-6250; Robert Aber, General Counsel, at (202) 728-8290; or Thomas Gira, Assistant General Counsel, at (202) 728-8957.
1 See Securities Exchange Act Release No. 34279 (June 29, 1994).
2 In the Matter of E.F. Button & Co., Securities Exchange Act Release No. 25887 (July 6, 1988).
3 See Notice to Members 93-47 (July 23, 1993).
4 See Notice to Members 93-67 (October 1993).
Text Of 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. 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.
Article III, Section I 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 its customer 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. Nothing in this section, however, requires members to accept limit orders from their customers.
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 their 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 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.