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94-58 SEC Approves New NASD Limit Order Protection Rule

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Executive Summary

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.

Question #1: Must a firm accept a customer's limit order?
Answer: No. The Interpretation specifically provides that the NASD does not impose any obligation upon members to accept and handle limit orders from any or all of its customers.
Question #2: If a firm assesses commission-equivalent charges on its customers' limit orders, does the Interpretation require that the firm not trade ahead of the limit order at the "gross" limit price (including the commission-equivalent charge), or at the "net" limit price (excluding the commission-equivalent charge)?
Answer: The interpretation requires that the firm provide protection for customer limit orders at the "net" limit price, exclusive of any markup, markdown, commission, or commission equivalent charged. If a member intends to protect a customer limit order at a price net of an amount equal to a sales credit or other internal credit charged, then the price at which the limit order is to be protected must be clearly explained to the customer. Any transaction effected by the member at a price equal or superior to the price agreed upon with the customer for protection of the limit order will obligate the member to immediately execute such limit order.
Question # 3: Does the Interpretation apply to limit orders placed by large institutions?
Answer: The Interpretation does not distinguish between institutional and retail customers because language in the Interpretation that allows members to establish specific terms and conditions on each order clearly encompasses the handling of institutional orders. The NASD notes that filling institutional-sized orders generally involves best-effort commitments and the commitment of substantial capital that many times results in agreement upon separate execution parameters. Accordingly, members accepting institutional orders on a best-efforts basis that may involve trading to cover a short position or buying stock along with the institution would not violate the Interpretation as long as the member maintains a clear understanding with its clients of the terms and conditions under which the order is being executed.
Question #4: Does the Interpretation require a member to disclose the terms and conditions under which it will accept a limit order in a particular fashion?
Answer: The Interpretation provides that the terms and conditions under which customer limit orders are accepted by a firm must be made clear to customers at the time their orders are accepted so that trading ahead in the firms' market-making capacity does not occur. Thus, the Interpretation clearly mandates clarity and specificity by the firms in making each of their customers aware of the terms and conditions under which their limit orders are accepted. However, the Interpretation does not dictate the means by which members must make this disclosure. The SEC also stated that the Interpretation "establishes that a member holding its customer's limit order may not continue to trade for its own position without executing that limit order under the specific terms and conditions that the customer understands and accepts."
Question #5: If a member provides an automated service for the entry of limit orders without human intervention, is the member still obligated to disclose the specific terms and conditions under which it will accept each limit order?
Answer: Regardless of how a limit order is transmitted by a customer to a member, the Interpretation clearly mandates clarity and specificity by the firms in making each of their customers aware of the terms and conditions under which their limit orders are accepted.
Question #6: If a member firm routes limit orders to an affiliated firm for execution, are these limit orders subject to the Interpretation or are they considered member-to-member limit orders?
Answer: For purposes of the Interpretation, if a member controls or is controlled by another member, both members shall be considered a single entity. Thus, if a customer's limit order is accepted by one affiliate and forwarded to another affiliate that it controls for execution, the firms are considered a single entity and the market-making unit must protect the limit order as if it were its own and, thus, may not trade ahead of that limit order.

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:
•  common ownership;
•  the existence of a common parent corporation or partnership;
•  ownership by one member of a significant amount of the voting securities of another member; or
•  ownership by one member of a significant partnership interest in another member.
NASD staff is available to assist members in determining whether a "control" relationship may exist between the member and another firm.
Question #7: Does the Interpretation apply to orders routed by one firm to another for execution?
Answer: Assuming the two firms are not deemed to be one entity under the Interpretation because of a "control" relationship, the Interpretation does not apply to member-to-member limit orders. The NASD is reviewing the appropriateness of application of the Interpretation to these orders. Any expansion of the scope of the Interpretation to include these orders will require NASD Board and SEC approval.

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.
Question #8: If a firm holds a customer limit order to buy 500 shares of XYZ at 20 1/4 and purchases 200 shares of XYZ at 20 1/8 in its market-making capacity, must the market maker execute the full 500 shares at 20 1/4 or only 200 shares at 20 1/4? Would the answer be the same if the limit order were an all-or-none (AON) order?
Answer: The market maker need only execute 200 shares of the limit order in this instance. However, the market maker would have to continue to protect the remaining 300 shares. If the limit order were an AON order, the market maker would not have to execute the limit order unless the market maker traded in an amount equal to or greater than the size of the AON limit order.
Question #9: Does the Interpretation apply to odd-lot orders?
Answer: No.
Question #10: Do Small Order Execution System (SOESSM) trades activate the execution of limit orders?
Answer: Yes. Any transaction effected by a member at a price equal or superior to the price agreed upon with the customer for protection of the limit order will obligate the member to immediately execute such limit order.
Question #11: If a non-market maker holds a customer limit order, can it trade ahead of that limit order?
Answer: No. Even though the Interpretation speaks in terms of members trading in their market-making capacity, it would be inconsistent with a member's best execution obligation if the member were to trade ahead of a customer's limit order when it is not acting as a market maker in the security. It has never been the NASD's position that members can trade ahead of their customer's limit orders when not acting as a market maker.
Question #12: Does the Interpretation apply to all Nasdaq® securities or just Nasdaq National Market® securities?
Answer: The Interpretation applies to all Nasdaq securities.

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.

Interpretation

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.


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