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95-43 SEC Approves Expanded Limit-Order Protection Rule

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Executive Summary

On May 19, 1995, the Securities and Exchange Commission (SEC) approved an expansion of the Interpretation to Article III, Section 1 of the NASD Rules of Fair Practice that prohibits a member firm from trading ahead of customers' limit orders in a firm's market-making capacity (commonly known as Manning II).1 The effective date for the expanded Interpretation is June 21, 1995.

Approval of the expanded limit-order protection rule expands the coverage of the existing Interpretation, which affected the handling of limit orders from a firm's own customers, to limit orders sent to a market maker from another member firm (member-to-member trades). The enactment of this expanded Limit-Order Protection Interpretation by the NASD reflects the continuing effort of the NASD and The Nasdaq Stock Market, Inc., to ensure investor protection and to enhance market quality. The obligation of a member firm under the new rule to protect all customers' limit orders and to give those same-priced or better-priced limit orders priority over its own market-making activity enhances opportunities for price improvement, which directly benefits public investors. However, until September 1, 1995, a market maker holding a member-to-member limit order greater than 1,000 shares may trade at the same price as such limit order without protecting the limit order.

Background And Description Of Rule Change

On June 29, 1994, the SEC approved an Interpretation to Article III, Section 1 of the NASD Rules of Fair Practice that prohibited a member firm from trading ahead of its own customers' limit orders in the firm's market-making capacity. When it was approved, the NASD examined further the effect that a limit-order protection rule would have on customer limit orders received from other member firms. After consideration of a limit-order task force report, and comments from members regarding a proposed member-to-member limit-order protection rule circulated in Notice to Members 9479 (September 1994), the NASD concluded that it was important to ensure investor protection and to enhance the market quality of The Nasdaq Stock MarketSM by expanding the existing limit-order protection rule to cover all customers' limit orders, including member-to-member orders.

The expanded Interpretation builds on the existing rule language to include within its scope not only the member firm's customers' limit orders, but also customers' limit orders that are sent from another member firm to a market maker for execution. The member firm handling those limit orders is obligated under the expanded Interpretation to treat those limit orders the same as its own customers' limit orders. The member firm may not accept and hold a customer limit order in a Nasdaq® security, whether that order comes from one of its own customers or the customers of another member firm, and continue to trade that security for its own market-making account at prices that satisfy the limit order it is holding.

The expanded Interpretation thus requires that a member firm holding a customer limit order must execute that limit order, in full or in part, to the extent that the member firm trades at the limit-order price or at a price lower than a limit order to buy or higher than a limit order to sell. For example, if the member firm is quoting a market of 20 bid and 20 1/4 offer, and accepts a limit order of 100 shares to buy at 20 1/8, then the firm may not purchase stock for its own account by executing a market order to sell or a limit order to sell at a price of 20 1/8 or lower, without also executing the limit order to buy at 20 1/8.

However, until September 1, 1995, for limit orders greater than 1,000 shares in size that are sent from other member firms, market makers may trade at the same price as the limit order without protecting the limit order. Thus, until September 1, if a market maker accepts a 2,000-share limit order to buy at 20 1/8 and the market is currently 20 bid and 20 1/4 offer, the market maker may execute sell orders at 20 1/8 without having to execute the limit order to buy at 20 1/8. However, if the market maker executes sell orders at 20 1/16 or 20, the limit order to buy at 20 1/8 must be executed at 20 1/8. After September 1, this temporary, limited exception to the Interpretation no longer applies.

As with the existing Interpretation, the new Interpretation does not mandate that a member firm must accept limit orders from its own customers or the customers of another firm. In a significant change from the language of the original limit-order Interpretation, however, member firms may attach terms and conditions only to limit orders that are either: for institutional accounts; or orders that are 10,000 shares or greater, regardless of whether they are for institutional accounts, provided that the order is $100,000 or more in value. Institutional limit orders are orders for institutional accounts as defined in the Rules of Fair Practice, Article III, Section 21(c)(4). Section 21(c)(4) defines an institutional account as an account for:

  • banks, savings and loan associations, insurance companies, or registered investment companies;

  • investment advisers registered under Section 203 of the Investment Advisers Act of 1940; and

  • any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.

The Interpretation also permits a member firm to negotiate terms and conditions with customers who place limit orders that are 10,000 shares or greater, unless the value of that order does not exceed $100,000. This holds true even if the customer placing the order does not meet the definition of an institutional account. Accordingly, a member firm that accepts a limit order from a person or entity that does not fall within the definition of institutional account or does not meet the order size requirements above may not impose any terms and conditions on the acceptance of that limit order. However, if the account placing the limit order is an institutional account or is appropriately sized, the firm may negotiate special terms and conditions with the customer of that account that permit the firm to trade ahead of, or at the same price, as the limit order. The new terms and conditions language applies to both the firm's own customers' limit orders and orders received in the member-to-member context.

Questions And Answers

Here are answers to questions frequently asked about the expanded Interpretation:

Q. When is the new Interpretation effective?
A. The new Interpretation is effective on June 21, 1995. However, until September 1, 1995, member firms may trade at the same price as the member-to-member customers' limit orders that are greater than 1,000 shares in size. The firm is not permitted to trade at a price that is superior to the limit order without satisfying that limit order. Moreover, under the terms of the existing Interpretation, the member firm is not permitted to trade at the same price as or at a price superior to its own customers' limit orders. After September 1, 1995, member firms accepting member-to-member limit orders must treat all customer limit orders the same as they treat their own customers' limit orders. Member firms are encouraged, of course, to commence providing full protection even earlier than September 1.

Finally, the restriction regarding the negotiation of terms and conditions on customers' limit orders begins on June 21. This restriction applies to a member firm's own customers and to member-to-member situations.
Q. Are member-to-member limit orders subject to a separate Interpretation?
A. No. The language of the original Interpretation has been revised to reflect the expansion of the Interpretation to cover member-to-member trades. The Interpretation is in the Rules of Fair Practice, Article III, Section 1.
Q. What are member-to-member limit orders?
A. The Interpretation defines member-to-member limit orders as customer limit orders that are received by one member firm and are sent to another member firm, typically a market maker in the security that is the subject of the limit order, for handling and execution. Thus, member-to-member limit orders are customer orders and not proprietary orders from a member firm. In the Rules of Fair Practice, Article II, Section 1(f), the NASD definition of "customer" does not include a broker or a dealer. In this respect, then, the protections of the Interpretation do not apply if a limit order is placed with a member by another registered broker/dealer for that broker/dealer's proprietary account.
Q. Must a firm accept a customer's limit order?
A. 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.
Q. May a member firm handling a limit order charge the customer special fees or charges for accepting or executing the limit order?
A. Yes. The Interpretation permits a member firm to impose commissions, fees, or separate charges for the handling of a limit order. A customer must be adequately informed by the member firm that such commission, fees, or charges are being imposed. In so assessing a commission, fee, or order-handling charge, the member firm must remain cognizant of Article III, Section 4 of the NASD Rules of Fair Practice and the NASD Guidelines on Markups and Fair Commissions.
Q. Does the Interpretation apply to limit orders placed by large institutions?
A. Yes, but with certain differences from the earlier Interpretation. As institutional-sized orders generally involve best-effort commitments and substantial capital commitments by the market maker, institutional-sized limit orders often have separate execution parameters. As long as the member firm handling the orders has made the terms and conditions clear to the institutional account customer, trading along with the institution should not violate the Interpretation.

Unlike the previous Interpretation, however, the new Interpretation distinguishes between institutional and retail customers; the new Interpretation allows members to establish specific terms and conditions on orders that meet certain new criteria. A member firm may negotiate terms and conditions on the acceptance of a limit order that permits the member firm to continue to trade along side of, or ahead of, the limit order only if the limit order is placed on behalf of an institutional account or is greater than 10,000 shares (unless the value of that order is less than $100,000). The member firm cannot impose terms and conditions on orders for accounts that do not meet the definition of institutional account or are not appropriately sized. This prohibition applies whether they are the accounts of the member firm's own customers or are accounts of another member firm's customers.
Q. As to the terms and conditions that must be disclosed to the customer, how should the member firm disclose such terms and conditions to customers of another member firm?
A. As noted, the new Interpretation allows member firms to accept limit orders subject to terms and conditions only with respect to institutional accounts or orders that are 10,000 shares or more, as long as the value of that order is $100,000 or more. The member firm imposing the terms and conditions on the limit order must ensure that those terms and conditions are clearly communicated to the customer. Because these orders received are from investment professionals typically, the NASD believes that generalized, arms-length disclosure and acceptance procedures will suffice, depending on the customer's level of sophistication with limit orders.

The means for disclosure and communication may be arranged between the market maker holding the limit order and the member firm initially accepting the limit order from the customer. If the firm holding the order chooses to rely on the order-entry firm for disclosing and explaining the terms and conditions and securing the customer's acceptance, the market maker must reasonably believe that an order-entry firm's disclosure and acceptance procedures are effective and being complied with.
Q. How do the restrictions on terms and conditions apply in the convertible bonds context?
A. Although the Interpretation provides that a member firm may negotiate terms and conditions with customers who have limit orders of 10,000 shares or more, so long as the value of the order is $100,000 or more, the Interpretation does not directly address the size limit for convertible bonds. By implication there is a comparable-size restriction for convertible bonds. A unit of trading for convertible bonds quoted on Nasdaq is $1,000 original principal amount. For the purposes of the Interpretation, an institutional-sized convertible bond limit order is $100,000. Therefore, a member firm can negotiate terms and conditions with a customer with a convertible bond limit order of $100,000 or more.
Q. May a customer place special conditions on the handling of a limit order it seeks to place with a member firm?
A. Yes. Although member firms may not seek to negotiate special terms and conditions with non-institutional customers, any customer may seek to qualify or specify certain conditions regarding the handling of a limit order. Various customers have different needs or expectations in the handling of a limit order and thus, a customer, whether considered an institution or not, placing a limit order may seek special conditions to minimize execution costs. For example, a customer placing a larger-sized limit order, such as 1,000 shares, may determine that he or she is best served if the limit order is handled as an "all-or-none" (AON) order, or is not subject to minimal partial fills as a market maker trades with smaller-sized market orders at the same or inferior price as the limit order. Thus, a customer may seek to have executions in such situations limited to circumstances where the market maker trades at the same price in 500-share increments.

In addition, nothing in this Interpretation prohibits a customer from voluntarily categorizing a limit order as "not held," which permits a member firm to trade at any price without being required to execute the customer order. A broker with a not-held order must use its brokerage judgment in the execution of the order, and if such judgment is properly exercised, the broker is relieved of all responsibility with respect to the time of execution and the price or prices of execution of such an order.
Q. If a customer's limit order resides on the books of a market maker and the market maker, in interacting with a market order from another customer, offers to accept the market order at a price that improves upon the limit-order price, does the limit order have to be executed?
A. No. If the market maker offers to execute a market order at a price that improves the limit-order price, the limit order does not have to be executed. For example, the best inside price is 10 bid and 10 1/4 offer. Customer A sends in a limit order to buy at 10 for 500 shares. Customer B sends to the market maker a market order to sell 500 shares. If the market maker offers to execute the market order at 10 1/16, the market maker need not execute the limit order to buy at 10 because the market maker has offered price improvement at a price that will not trigger the limit order. The increment that will be considered sufficient to qualify for price improvement is the minimum increment that can be permitted for price reporting purposes, that is, 1/64.
Q. Does the member firm that does not intend to impose terms and conditions have to make any affirmative disclosure to a customer placing a limit order?
A. No. There is no need to inform the customer of order-handling techniques as long as the member firm has not attempted to impose terms and conditions on the order. Thus, the member firm is not obliged to inform the customer that odd-lot orders are treated differently or that orders that a customer conditions as AON may be traded ahead of, if the size of the order that the member firm executes at the same or an inferior price is not large enough to fill the AON order.
Q. Does the NASD mandate any particular methodology for limit-order handling priorities, and if so, what disclosure must be made to a customer regarding the priority of same-priced limit orders residing on the member firm's book?
A. The NASD has not mandated any particular limit-order handling priority procedures. Thus, a firm may choose any reasonable methodology for the way in which it chooses to execute multiple limit orders it holds. However, the NASD requires that a firm choose a methodology and consistently apply it. Typically, a firm will choose to award priority to the best-priced order, followed by the time priority of each order, and then establish a ranking based on size of orders held.

The NASD does not consider the priority handling mechanism for same-priced limit orders as a term or condition to a customer's limit order. Accordingly, the NASD does not require that a member firm make an affirmative disclosure to the customer at the time that a customer limit order is accepted regarding the priority that the particular limit order will be provided. Thus, if two customer limit orders for the same size and price in the same security reside on the firm's limit-order book and a firm fills a market order at a price and size that satisfies either limit order but not both, the market maker may fill as much of one order as it is obligated to do under this rule. No allocation between the two limit orders is necessary.

For example, the firm has two limit orders to buy for 500 shares at 10. A market order to sell 400 shares is executed by the market maker at 10. The market maker is obligated to provide an execution of only one of the two limit orders at 10 up to 400 shares. The other limit order will not receive any execution, partial or otherwise.
Q. 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)?
A. The Interpretation continues to require that the firm provide protection for customer limit orders at the "net" limit price, exclusive of any markup, markdown, commission, commission-equivalent, or service fee charged. If a member intends to protect a customer's 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 to or inferior to the price agreed upon with the customer for protection of the limit order will obligate the member to immediately execute such limit order.
Q. How does a member firm determine the price at which it is trading, such that it must protect a customer's limit order?
A. The customer's limit order must be protected when the member firm executes a trade at a reportable price that is the same as, or is inferior to, the limit order price, that is, when the firm buys at a price lower than a buy limit order it holds, or sells at a price higher than a sell limit order it holds. Such reportable prices are the last-sale prices reported to Nasdaq transmitted through the Automated Confirmation Transaction (ACTSM) service. Such prices are not affected by ticket, clearing, or other order-handling charges assessed by a market center in executing the reportable transaction.

For example, a member firm holds a customer limit order to buy at 10. While holding the limit order, the member firm executes an order to buy at 10 in a proprietary trading system. Based on the fees charged for use of the system, the operator of the proprietary trading systems assesses the member firm a $.02 order fee for the execution, based on the number of trades the firm has executed in the system over the previous month. Even though the proprietary trading system assesses the member firm a $.02-share fee for trading in its system, the price reported through the ACT service is $10, not $10.02. Therefore, the trade in the proprietary trading system at $10 triggers the Interpretation requirement that the member firm execute the customer's limit order to buy at $10.

The NASD notes that firms continue to have an obligation to report executions in a timely fashion. Failures to report executed transactions in accordance with Schedule D to the NASD By-Laws will be monitored closely and subject a firm to sanctions.
Q. If a firm holds a customer's 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 AON order?
A. The market maker need only exe-cute 200 shares of the limit order in this instance. However, the market maker must continue to protect the remaining 200 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.
Q. Does the Interpretation apply to odd-lot orders?
A. No.
Q. Do Small Order Execution System (SOESSM) or SelectNetSM trades activate the execution of limit orders?
A. Yes. Any transaction effected by a member at a price equal to or inferior to the limit-order price obligates the member to immediately execute such limit order. Thus, if a firm executes a SOES order at a price inferior to a customer's limit order it holds, the firm must immediately provide an execution for the limit order.
Q. If a non-market maker holds a customer's limit order, can it trade ahead of that limit order?
A. No. Even though the Interpretation speaks in terms of members trading in their market-making capacity, it is 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.
Q. May a trading desk other than the market-making desk of the firm trade at the same or inferior price to that of a limit order held by the market-making desk?
A. Although the Interpretation speaks in terms of members trading in their market-making capacity, it would be inconsistent with a member's best execution obligations to knowingly trade ahead of a customer's limit order in any other capacity in which it may also be trading. Thus, if a firm has a market-making desk, a risk-arbitrage desk and a derivatives desk, among others, it may be trading in a Nasdaq security in a variety of circumstances. As long as a firm implements and utilizes an effective system of internal controls, such as appropriate "Chinese walls," that operate to prevent the non-market-making desk from obtaining knowledge of customers' limit orders, those other desks may continue to trade at prices the same as or inferior to the customers' limit orders. The NASD will carefully monitor firms that develop such controls and the trading activity of desks subject to such controls to determine if the controls are effective.
Q. Does the Interpretation apply to all Nasdaq securities or just Nasdaq National Market® securities?
A. The Interpretation applies to all Nasdaq National Market and The Nasdaq SmallCap MarketSM securities. It does not apply to other securities traded by means of the OTC Bulletin Board Service or other means.
Q. If a market maker holds a day limit order, may a market maker trade at prices that would satisfy the limit order in an after-market hours trading system without protecting the day limit order?
A. Yes. The day limit order expires at 4 p.m., Eastern Time, the time when official Nasdaq market hours end. Thereafter, because the limit order has expired, the member firm may trade at any price in proprietary trading systems that operate after the close of the market. If the limit order is a good-til-canceled limit order or other such order, however, the member firm may not trade at a price that triggers its limit-order protection requirements without executing the limit order.

Direct questions regarding this Notice to James Cangiano, Senior Vice President, Market Surveillance, at (301) 590-6424 or (800) 9258156; Glen Shipway, Senior Vice President, Nasdaq Market Operations, at (203) 385-6250; Robert E. Aber, Vice President and General Counsel, Office of General Counsel, at (202) 728-8290; or Eugene A. Lopez, Senior Attorney, Office of General Counsel, at (202) 728-6998.


1 See Securities Exchange Act Release No. 35751 (May 19, 1995).


Text Of Interpretation To Article III, Section 1 Of The NASD Rules of Fair Practice

Effective June 21, 1995

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 customer limit orders in Nasdaq securities. This Interpretation will require members acting as market makers to handle customer limit orders with all due care so that market makers do not "trade ahead" of those limit orders. Thus, members acting as market makers that handle customer limit orders, whether received from their own customers or from another member, are prohibited from trading at prices equal or superior to that of the limit order without executing the limit order, provided that, prior to September 1, 1995, this prohibition shall not apply to customer limit orders that a member firm receives from another member firm and that are greater than 1,000 shares. Such orders shall be protected from executions at prices that are superior but not equal to that of the limit order. 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 1 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 a customer (whether its own customer or a customer of another member) 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, 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, provided that, until September 1, 1995, customer limit orders in excess of 1,000 shares received from another member firm shall be protected from the market maker's executions at prices that are superior but not equal to that of the limit order, and provided further, that a member firm may negotiate specific terms and conditions applicable to the acceptance of limit orders only with respect to limit orders that are: (1) for customer accounts that meet the definition of an "institutional account" as that term is defined in Article III, Section 21(c)(4) of the Rules of Fair Practice; or (2) 10,000 shares or more, unless such orders are less than $100,000 in value. Nothing in this section, however, requires members to accept limit orders from any customer.

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 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 and the customers of other member firms 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 institutional account or appropriately sized 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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