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93-49 Solicitation of Member Comment on Board Action to Eliminate the Disclosure Safe Harbor for Customer Limit Orders;
Comment Period Expires August 31, 1993
As part of its ongoing efforts to ensure investor protection and enhance market quality, the NASD® Board of Governors, at its July 16, 1993 meeting, approved issuance of a Notice to Members soliciting comment on its action to eliminate a "safe harbor" for those members that may trade ahead of customer limit orders. The safe harbor is available today to members that disclose to their customers that the firm may accept a limit order and then trade ahead of that customer's limit order in the firm's market-making capacity. The NASD is soliciting comment on specific issues that follow the discussion below, as well as any other concerns this action raises for members or interested parties. Comments received on or before August 31, 1993, will be considered before filing this Interpretation with the SEC. It is anticipated that the SEC will also publish this Interpretation for comment before acting on it. SEC approval of this Interpretation is required before it can become effective.
The issue of limit-order protection in the Nasdaq® market was highlighted in 1985 when a customer alleged that a member firm had 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 NASD found and the SEC affirmed1 that on 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.
Following the SEC decision and after input from a number of member firms, the Board authorized a Notice to Members that proposed a "safe harbor" disclosure approach for those members who wished to avail themselves of it.2 The language set out in that proposal put customers on notice that the firm accepting a limit order would execute that order only when the inside bid or offer on Nasdaq reached the limit price and that the member might, in its market-making capacity, trade ahead of that order. After the language was approved, the NASD filed a proposed rule with the SEC.
The rule language has been pending action by the SEC since 1990, but some members have used similar disclosure notices in reliance on the exception identified by the NASD and the SEC in the Manning decision. The SEC has recently indicated that it views this issue to be related to topics under consideration in the Market 2000 study.
On July 16, 1993, the NASD Board of Governors reviewed the background of the Manning safe harbor and voted to replace it with an Interpretation of Article III, Section 1 of the Rules of Fair Practice that would eliminate the "safe harbor" disclosure approach and effectively prohibit a member firm from trading ahead of a customer's limit order. In recommending this action to the Board, the Trading Committee indicated its belief that the proposed interpretation reflected the manner in which most integrated retail firms handle their customer limit orders. Because of the significance of this Interpretation and the concerns expressed to Board members and the staff by certain members of the trading community, the Board voted unanimously to solicit member comment on its action.
The Board particularly wishes to receive comment on how the elimination of the safe harbor and adoption of rules prohibiting trading ahead of customer limit orders will impact the operation of member firms and the treatment of investors' orders. Further, the Board is sensitive to avoiding unintended effects or unacceptable consequences of any new requirements on member firms. Accordingly, the Board solicits comments on the following points, as well as any other concerns that this action raises for members or interested parties:
- As noted above, elimination of the safe harbor would not appear to have a significant impact on the operation of integrated retail firms dealing with their own customer limit orders because the NASD understands that these firms do not trade ahead of their customer limit orders. Accordingly, members should address whether this perception is correct.
- The language of the interpretation does not differentiate between integrated retail firms dealing with their own customer limit orders and market makers who receive orders from other NASD member firms (i.e., member-to-member transactions). Members should comment on whether this consistent treatment is appropriate.
- Some members of the trading community have expressed concern regarding the impact of the action on market liquidity. In this connection, some have noted that application of the trading-ahead prohibition could significantly increase the risks of market makers' handling institutional orders. Members are requested to comment on any adverse impact on market liquidity that may result from the Board action. Members should also comment on whether any such impact on market liquidity outweighs the benefits to public investors provided by more complete limit-order protection.
Request for Comments
The Board is soliciting comments from members and interested parties so that the ramifications of the Board action may be thoroughly reviewed. Comments must be received no later than August 31, 1993, and addressed to Stephen D. Hickman, Secretary, NASD, 1735 K Street, NW, Washington DC 20006-1500. Questions regarding this Notice should be directed to Beth E. Weimer, Associate General Counsel, at (202) 728-6998.
1 In the Matter of E.F. Hutton & Co., Release No. 34-25887 (July 6, 1988).
2 Notice to Members 90-37 (June 1990).
Text of Proposed Interpretation To Article III, Section 1 of the Rules of Fair Practice
(Note: New language is underlined).
A member firm that accepts and holds an unexecuted customer limit order 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, under the terms and conditions by which the order was accepted by the firm, without filling that customer's limit order, shall be deemed to have acted in a manner inconsistent with just and equitable principles of trade, Article III, Section 1 of the Rules of Fair Practice. Nothing in this rule, however, compels market makers to accept limit orders from their customers or from other broker/dealers, nor does the rule curtail a market maker's ability to place terms and conditions upon the pricing or acceptance of such limit orders.