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94-9 SEC Approves New NASD Rule Governing The Pricing Of Open Orders

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Executive Summary

On January 6, 1994, the Securities and Exchange Commission (SEC) approved an amendment adding a new Section 46 to the NASD Rules of Fair Practice that requires members holding open orders to adjust the price and the size, if necessary, of the order 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. The text of the amendment, which takes effect May 16, 1994, follows the discussion below.

Background And Description Of The Amendment

On January 6, 1994, the SEC approved an amendment to the Rules of Fair Practice to require members holding open orders of securities to adjust the price and the size, if necessary, of the order 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. Open orders, also known as "good 'til cancelled," "limit," or "stop limit" orders, are orders to buy or sell that remain in effect until they are executed or canceled, or that expire.

The NASD believes it is important to adopt a standard for business practices and ethics in dealing with customer open orders. In the absence of an NASD rule governing open orders, members adjust open orders according to their own procedures, unless the rules of another self-regulatory organization apply. These procedures can vary from automatic adjustment, automatic withdrawal, reconfirmation of the order with the customer, or no action. Further, the procedures may vary among orders entered at the same firm because the orders are routed to different firms for execution. As a result, investors may find that their open orders are executed without adjustment on or after the ex-date at a higher cost per share than they intended based on their valuation of the security.

Additionally, the fact that some members might, and others might not, adjust open orders on ex-dates creates confusion for customers, which is inconsistent with the high quality and confidence the NASD has sought to promote in The Nasdaq Stock Market™ and the over-the-counter market. The NASD believes that the rule sets forth a unitary and predictable method of handling the adjustment of open orders, eliminates the potential unfairness associated with the failure to adjust such orders, and provides consistency in the adjustment of open orders for NASD members that are also members of the stock exchanges.

It is important that members advise their customers in advance how open orders will be treated as of the effective date of the rule so that customers have sufficient notice to make a decision on their part to maintain or cancel existing open orders or to enter new open orders.

Subsection (a) of the new Rule of Fair Practice requires a member holding an open order from a customer or broker/dealer to adjust the price of the order by the amount of any dividend, payment, or other distribution on the ex-date, prior to executing, or permitting the execution of, the order. Subsections (a)(i) through (a)(iii) specify the adjustment procedures for certain situations.

Subsection (a)(i) provides that in the case of a cash dividend or distribution, the price of the order shall be reduced by subtracting the dollar amount of the cash dividend or distribution from the price of the order and rounding the result to the next lower 1/8 of a dollar. For example, if an issuer declares a $.30 per share dividend, the price of an investor's open order to purchase 100 shares of that security at $10 per share would be reduced by $.30 on the ex-dividend date, which, when rounded down to the nearest variation in trading units, results in a price of $9-5/8 per share. Thus, the investor's initial valuation at $10 per share before the ex-date is proportionately maintained by revising the order to $9-5/8 per share after the ex-date, reflecting the diminished post-dividend value of the security.

Subsection (a)(ii) provides that for stock dividends or splits the price of the order shall be reduced by rounding the dollar value of the dividend distribution or split to the next higher 1/8 of a dollar and subtracting that amount from the price of the order. To determine the dollar value per share of the distribution or split, multiply the adjusted value per share after the dividend by the percentage increase in shares. For example, for an open order @ $10 per share and a 3 for 2 distribution, the dollar value per share of the dividend is determined by: ($10 x 2) ÷ 3 x (% increase in shares) = $20 ÷ 3 x 1/2 = $6.67 x .50 = $3.33.

When rounded to the next higher 1/8 of a share, $3.33 is $3-3/8 per share. Then, subtracting $3-3/8 from $10 per share, the resulting price is $6-5/8 per share. Using another example, for an open order @ $10 per share and a 5 for 3 distribution, the dollar value per share of the distribution is first determined by: ($10 x 3) ÷ 5 x (% increase in shares) = $30 ÷ 5 x 2/3 = $6 x .667 = $4 which, not requiring rounding, is $4 per share. Then, subtracting $4 from $10 per share, the resulting price is $6 per share.1

Subsection (a)(ii) also provides for increasing the size of the order to maintain its proportionality with the dollar amount of the original order taking into account the price reduction. This is accomplished by multiplying the number of shares of the original order by the number of shares to be distributed for each share. The result is then divided by the number of shares to be exchanged for new shares in the distribution and rounded to the next lower round lot. For example, for a 100 share open order and a 3 for 2 distribution, the resulting number of shares is: (100 x 3) ÷ 2 = 150 shares, which when rounded down to the next lower round lot equals 100 shares, the size of the original order. For a 1,000-share open order and a 3 for 2 distribution the resulting number of shares is: (1,000 x 3) ÷ 2 = 1,500 shares, which is equal to a round lot and therefore does not require rounding. Finally, for a 1,000-share open order and a 5 for 3 distribution the resulting number of shares is: (1,000 x 5) ÷ 3 = 1,666 shares, which when rounded down to the next lower round lot equals 1,600 shares.

Subsection (a)(iii) provides that when a dividend is payable at the option of the stockholder in either cash or securities, the order shall be reduced by the dollar value of the cash or securities, whichever is greater, according to the formulas in Subsections (a)(i) and (a)(ii) of the rule. However, if the stockholder opts for securities, the size of the order shall be increased according to the formula in Subsection (a)(ii).

Subsection (b) requires the member to reconfirm an open order before execution if the value of the distribution cannot be determined.

Subsection (c) requires cancellation of open orders where the security is the subject of a reverse split. Subsection (d) defines the term "open order" as an order to buy that remains in effect for any period of time until it is executed or canceled or it expires, including, but not limited to, orders marked "good 'til canceled," "limit," or "stop limit."

Finally, Subsection (e) exempts: open orders subject to the rules of a registered national securities exchange; open stop orders to buy; and open sell orders as well as orders marked "do not reduce" or "do not increase." Open stop orders to buy and open sell orders are exempted because the assumptions underlying such orders may not include the value of an upcoming dividend and the combination of stop and limit prices in such an order makes the effect of repricing unpredictable. Orders marked "do not reduce" or "do not increase" are methods for customers to state their awareness of the implications of not adjusting the order on the ex-date.

The amendment takes effect May 16, 1994. Questions regarding this Notice should be directed to Elliott R. Curzon, Senior Attorney, (202) 728-8451, and Robert J. Smith, Attorney, (202) 728-8176, at the Office of General Counsel.


1 Notice to Members 93-61 (September 1993), publishing the proposed rule change for vote, included a suggested alternative for calculating the price adjustment.

Text Of New Section To Article II To The Rules Of Fair Practice Regarding Adjustment Of Open Orders

(Note: New text is underlined.)

* * * * *

Adjustment of Open Orders

Sec. 46.

(a) A member holding an open order from a customer or another broker/dealer shall, prior to executing or permitting the order to be executed, reduce, increase or adjust the price and/or number of shares of such order by an amount equal to the dividend, payment or distribution, on the day that the security is quoted ex-dividend, ex-rights, ex-distribution or ex-interest, as follows:
(i) In the case of a cash dividend or distribution, the price of the order shall be reduced by subtracting the dollar amount of the dividend or distribution from the price of the order and rounding the result to the next lower 1/8 of a dollar;
(ii) In the case of a stock dividend or split, the price of the order shall be reduced by rounding the dollar value of the stock dividend or split to the next higher 1/8 of a dollar and subtracting that amount from the price of the order: provided, further, that the size of the order shall be increased by d) multiplying the size of the original order by the numerator of the ratio of the dividend or split. (2) dividing the result by the denominator of the ratio of the dividend or split, and (3) rounding the result to the next lower round lot: and
(iii) In the case of a dividend payable in either cash or securities at the option of the stockholder, the price of the order shall be reduced by the dollar value of the cash or securities, whichever is greater, according to the formulas in (a)(i) or (a)(ii), above: provided, that if the stockholder opts for securities, the size of the order shall be increased pursuant to the formula in (a)(ii), above.
(b) If the value of the distribution cannot be determined, the member shall not execute or permit such order to be executed without reconfirming the order with the customer.
(c) If a security is the subject of a reverse split, all open orders shall be cancelled.
(d) The term "open order" means an order to buy or an open stop order to sell, including but not limited to "good 'til cancelled", "limit" or "stop limit" orders which remain in effect for a definite or indefinite period until executed, cancelled or expired.
(e) The provisions of this rule shall not apply to orders: 1) governed by the rules of a registered national securities exchange; 2) marked "do not reduce": 3) marked "do not increase;" (4) open stop orders to buy; or (5) open sell orders.

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