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83-7 Solicitation of Comments on SEC Proposed Anti-Internalization Rule

I M P O R T A N T

TO: All NASD Members

SUMMARY

The Securities and Exchange Commission has published for comment a proposed rule addressing the issue of exchange and over-the-counter market makers internalizing customer orders in Rule 19c-3 securities and whether inter market exposure of customer orders should be required. Internalization has been defined by the Commission as a dealer executing customer transactions as principal or crossing agency transactions in-house without exposing those orders to buying and selling interest in other markets.

The Board of Governors is publishing this Notice to inform the membership of the proposed rule and to elicit members' comments. The Board believes that this is a most important issue for Association members in light of the competitive impact the rule will have on market makers, its impact on the efficiency of execution of customer orders and the possible future implications its adoption may have on the market for NASDAQ National Market System securities.

The proposed rule would apply to all broker/dealers executing transactions as principal with their customers and generally would prohibit the execution of a customer order as principal unless (1) the transaction is executed on an exchange or the broker/dealer is registered in the Association's Computer Assisted Execution System (CAES) as an ITS market maker, (2) the broker/dealer's quotations can be reached through the ITS/CAES interface, and (3) the order is executed in compliance with the proposed rule's order exposure requirements or order export requirements.

The rule's order exposure requirement would require a broker/dealer to stop (i.e., guarantee) each customer order at the proposed execution price, and then publish a bid or offer on behalf of the order for 30 seconds at a price 1/8 better than the proposed execution price. The rule's order export alternative would require the broker/dealer to "export" the order to CAES or the Cincinnati Stock Exchange's National Securities Trading System in such a manner that the order is not designated to a market maker and the broker/dealer either (1) establishes procedures reasonably designed to separate the firm's order entry and execution functions, or (2) has not improved its quotation in the 30 seconds prior to trading with a customer order.

A more detailed description of the proposed rule is provided later in this Notice and a copy of the proposed rule is attached.

The Board's views on the proposed rule are summarized as follows:

  • The Board believes that adoption of the proposed rule would be a classic example of over-regulation. Both the SEC and NASD conducted studies of off-board trading and found that off-board transactions were being executed at prices at least as favorable and in some cases better than transactions on exchanges and that virtually no evidence was found that customers were being taken advantage of when their transactions were executed in the over-the-counter market. The Commission has stated in the release that "it has not observed any objectively identifiable negative impacts of internalization on Rule 19c-3 trading in the past that would justify imposition of an order exposure rule."
  • The Commission has now stated that the decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation. The Board believes that the costs of this burdensome regulation far outweigh any speculative benefits that may result. The complexity of the exposure requirement and the steps involved in complying with the rule would render the efficient execution of retail principal transactions extremely difficult, if not virtually impossible.
  • The Board believes that the insignificant off-board volume in 19 c- 3 securities does not justify such an all encompassing regulation and certainly does not represent a threat to the manner of doing business on stock exchanges.
  • It is the Board's view that the proposed rule will result in imposing an insurmountable burden on competition in off-board transactions and would constitute a de facto repeal of Rule 19c-3.
  • The Board notes that the proposed rule would substantially reduce the efficiency of industry built systems which automatically process customer orders. The proposal would not only affect the Association's Computer Assisted Execution System, but would also require modifications to the automated systems of the regional stock exchanges. The proposed rule would impair the progress made in developing facilities to efficiently automate the execution of small orders which facilities are even more crucial today in light of the recent increase in volume in all markets.
  • The Board is deeply concerned with the potential for the proposed rule applying to NASDAQ/National Market System securities. The Commission has publicly stated that it has no intention of expanding the coverage of the rule to securities traded exclusively in the over-the-counter market. The Board recognizes, however, that no firm commitment can be made as to the action of a future Commission. The Commission has already by rule designated certain NASDAQ securities as national market system securities subject to the same trade reporting and quotation display rules as listed securities. The number of NASDAQ securities designated as national market system securities will increase as the national market system evolves. The Board is concerned that at some future time more of the distinctions between listed national market securities and over-the-counter national market system securities will be eliminated. Since the rule is heavily biased against in-house principal transactions, this could substantially impact the long-term profitability of a large portion of the membership's business.

For these reasons, the Board of Governors believes that the proposed rule is of vital interest to the entire membership and urges members to analyze the rule and to communicate their views to the Commission. Substantial comments have already been received by the Commission from proponents of the rule. The Board believes it essential for the membership to recognize the importance of this issue and to communicate their views in a comment letter to the Commission as soon as possible. All comments should be submitted by March 1, 1983 to:

George A. Fitzsimmons
Secretary
Securities and Exchange Commission
450 Fifth Street, N. W.
Washington, D. C. 20549

In addition, the Association would appreciate receiving a copy of your comments. Please send a copy to:

S. William Broka
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N. W.
Washington, D. C. 20006

Sincerely,

Gordon S. Macklin
President

Attachments

DISCUSSION OF THE SECURITIES AND EXCHANGE COMMISSION'S RE-PROPOSAL OF AN ORDER EXPOSURE RULE

The SEC proposed order exposure rule is the second publication of this issue by the Commission. Last year the Commission published for comment three alternative means of dealing with internalization. The first alternative was to defer Commission action on an anti-internalization rule. The second alternative, which was based on a New York Stock Exchange proposal, would have applied only to over-the-counter market makers and would have required the exposure of customer orders and market maker principal interest in these orders to other markets prior to execution. The third alternative which was based on principles developed by a special Securities Industry Association committee would have required both exchange and over-the-counter market makers to expose customer orders to other markets prior to execution.

The Association commented to the Commission that action on an anti-internalization rule should be deferred until such time that a demonstration has been made that internalization has created a regulatory problem warranting further action. The Association reminded the Commission that this had been the Commission's longstanding policy on this issue and that it should continue to adhere to this policy.

The basis for publishing the previous anti-internalization rules was the argument put forth by stock exchanges that customer orders executed off of an exchange will result in inferior executions for those orders because of a loss of order interaction in the exchange auction crowd and the potential for dealers to overreach and take advantage of their customers. The basis for this argument is that dealers executing transactions in the over-the-counter market will execute customer buy orders at their offer price and execute customer sell orders at their bid price. The argument is made that dealer executions will be inferior to exchange auction executions because the auction process is characterized by order interaction in the auction crowd. Theoretically, a customer order when brought to the floor of an exchange and exposed in the auction crowd will have the opportunity to be matched with another customer order exposed in the crowd. The specialists' bid and ask quotation will only come into play when there are imbalances of buy or sell orders. Therefore, orders can meet in the crowd and be matched in between the specialist's bid and ask and will only be executed at the bid or ask when there is an imbalance of orders on the buy or sell side and the order cannot be matched. The argument concludes that this can only occur through an auction process and removing customer orders from this process will result in inferior executions for customer orders because it eliminates the possibility of these orders being executed in between the quotation at better prices.

The Association's response to these arguments contained an analysis of the results of the SEC's own Monitoring Report on the Operation and Effects of Rule 19c-3 as well as the NASD's surveillance and monitoring program both of which revealed that off-board transactions in these securities were being executed at prices at least as favorable and in some cases better than transactions on exchanges. In addition, the analysis concluded that virtually no evidence was found of inferior executions or that customers were being taken advantage of when their transactions were executed in the over-the-counter market. The Association concluded in its comments to the Commission:

The Commission's policy as enunciated in its various releases is a sound one. That is, added regulation and rules are not appropriate until there is some demonstrated adverse effects on the markets resulting from dealer internalization of customer orders. The limited trading which has taken place in 19c-3 securities is insufficient to form the definite conclusions necessary to resolution of the question with finality. However, this limited experience does reveal that off-board trading in 19c-3 securities has not had negative consequences and that the theoretical dangers have not materialized. Thus, no substantive case can be made at this time that the experience with off-board trading in 19c-3 securities requires regulatory action. The Commission should adhere to its historical position that regulatory action on internalization should be reserved until such time as a regulatory problem has been established and such action is demonstratably appropriate. This has been the Commission's firm position for many years. No empirical evidence exits requiring an alteration of its policy.

After several months of studying the comments received, the Commission has now republished a proposed anti-internalization rule, but the basis upon which the rule is to be adopted has changed. Previous anti-internalization rules have been proposed in an attempt to curb the potential regulatory abuses which could result from internalization. The Commission has now concluded that "it has not observed any objectively identifiable negative impacts of internalization on Rule 19c-3 trading in the past that would justify imposition of an order exposure rule." The basis for adopting the proposed rule would be the benefits that would flow from order exposure. The Commission states in its release:

The Commission recognizes the arguments made by a number of commentators that increased OTC competition in Rule 19c-3 securities inherently increases depth, liquidity, and pricing efficiency. The Commission, in adopting Rule 19c-3, made the determination that, in that limited context, these potential competitive benefits outweighed any potential concerns arising from the absence of exposure by OTC market makers. The Commission has not to date been provided any data or analysis which would cause it to reverse that determination. Therefore, any decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation.
In this connection, the Commission believes that adoption of an order exposure rule for linked securities could possibly provide benefits for the markets for those securities and give the Commission experience with which to consider and evaluate the role of order exposure generally as a means to improve intermarket competition and best execution and thereby foster development of a national market system. The Commission is mindful, however, that some commentators have raised concerns that an order exposure rule could negate benefits already achieved through enhanced opportunities for intermarket competition and best execution afforded by adoption of Rule 19c-3. The Commission specifically requests comment on this issue.

The Board of Governors believes that under this new basis for adopting an anti-internalization rule, the costs involved in complying with the rule results in substantial inefficiencies in executing transactions and anti-competitive impacts which far outweigh any potential benefits. The Board is also very concerned as to the future application of the proposed rule. As proposed, the rule only applies to 19c-3 securities, that is, those securities which have listed on an exchange since April 26, 1979. There are currently 484 19c-3 securities and 53 members making markets in these securities. The Commission has publicly stated that it has no intention of expanding the coverage of the rule to securities traded exclusively in the over-the-counter market. The Board recognizes, however, that no firm commitment can be made as to the action of a future Commission. In addition, as the national market system evolves and the number of NASDAQ stocks designated as national market system securities increases, the potential exists for an anti-internalization rule to be expanded to cover NASDAQ securities. This could occur either through the granting of unlisted trading privileges on NASDAQ stocks to exchanges or the adoption of the view that all national market system stocks and exchange listed stocks should trade under the same rules. Following is a brief description of the proposed rule and we suggest that the membership keep in mind the possible extension of the rule to NASDAQ securities when analyzing its provisions. A copy of the proposed rule is attached to this notice.

The rule provides that no broker/dealer may buy a 19c-3 security from a customer or sell such security to a customer for the broker/dealer's account unless:

(1) the broker/dealer is registered and acting as an ITS/CAES market maker or the transaction is executed on an exchange (an ITS/CAES market maker is an over-the-counter market maker making quotations available on the Association's Computer Assisted Execution System and is utilizing the ITS interface. See recently adopted ITS/CAES rules governing ITS/CAES market makers); and,
(2) the broker/dealer has access to the ITS/CAES interface and its quotations can be executed against through the ITS/CAES interface; and,
(3) the broker/dealer complies with the rule's order exposure requirements or its order export requirements.
(The following explanation will only refer to broker/dealer purchases from customers, but is equally applicable to broker/dealer sales to customers.)

Order Exposure Requirements

Before a broker/dealer could execute a customer's order as principal it would be required to:

(1) "Stop" the total number of shares of the order, i.e., guarantee the execution of the order at the intended execution price. The stop price would have to be at least the best price available in any participating ITS market;
(2) Publish and maintain for at least 30 seconds an offer on behalf of the customer, in a size equal to the number of shares it intends to buy from the customer at a price l/8th better than the intended execution price (stop price).

If the broker/dealer receives an order from the published offer l/8th above the stop price, the customer will receive the improved price. If no one takes the published offer after 30 seconds, the broker/dealer can execute the order at the stop price.

The requirement to publish at l/8th above the stop price will not be required if:

(1) an offer for the broker/dealer's account is already being published at l/8th above the stop price, at or greater than the size of the customer order and such offer is maintained for at least 30 seconds from the receipt of the customer's order;
(2) the customer's order is not executed as principal for 30 seconds after receipt; and,
(3) any transaction during the 30 second period with the broker/dealer at its published offer up to the size of the customer's order shall be for the account of the customer.

If a broker /dealer is publishing an offer on behalf of a customer order at l/8th above the stop price, and a second order is received, the second order may be executed immediately as principal at the stop price of the first order in any size up to 1,000 shares more than the size of the first order.

If a broker/dealer is publishing an offer on behalf of a customer order at l/8th above the stop price, that order may be immediately executed as principal at the stop price if:

(1) An unrelated transaction is executed by the broker/dealer at a price equal to or lower than the stop price; (an unrelated transaction could be the "second order" referred to above) or
(2) The broker/dealer lowers its offer to the stop price to match an offer published by another ITS market.

Order Export Requirements

A broker/dealer need not comply with the order exposure requirements if it complies with the order export requirements. The broker/dealer can enter the customer's order in the Computer Assisted Execution System (CAES) on a neutral basis, i.e., not directed to a particular market maker, or enter the order in the Cincinnati Stock Exchange's National Securities Trading System (NSTS) provided that the broker/dealer either:

(1) adopts procedures reasonably designed to preclude all persons responsible for making bids and offers or dealing for the firm's account from having any knowledge of the existence of the customer order and all persons responsible for solicitation of customer orders or entering such orders in CAES or NSTS from having knowledge of positions or trading strategies for the firm's account in that security; or
(2) the broker/dealer's bid has not been raised for 30 seconds before receipt of the customer's order and the size of such bid has been equal to or greater than the customer's order.

The rule also provides that agency cross transactions executed off of an exchange or CAES may only be executed at a price between the best ITS bid and offer if the spread is 1/4 or more or at the best ITS bid or offer if the spread is 1/8.

The rule also provides a number of exclusions, the most important of which relates to block transactions. The rule would require the ITS participants to submit to the Commission within 18 months of the effective date of the rule a plan providing for an effective means of exposing blocks to other markets. Until the adoption of such a plan, block transactions would be excluded from the rule. The rule defines a block as 10,000 shares or more or a quantity of a security having a market value of $200,000 or more.

* * * * * *

The Commission has stated that the decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation. They have specifically requested comments on this issue. The Board of Governors believes that the costs of this burdensome regulation far outweigh any speculative benefits that may result. The Board believes that the complexity of the exposure requirement and the mechanical steps involved in complying with the rule would render the efficient execution of retail principal transactions extremely difficult, if not virtually impossible. Each retail principal transaction would require separate mechanical input entries and display through the firm's terminal and a waiting period of up to 30 seconds prior to execution of the order. In addition, the process of determining what price to expose, when the firm's quotation would have to be altered, a determination of the applicable holdout period and whether the various exceptions are available creates a process for executing each transaction that is extremely cumbersome and inefficient. A firm with a steady flow of retail orders would simply be physically unable to execute customer orders with any degree of efficiency.

With respect to the order export alternative, it would not, under any circumstances, result in a customer receiving a better execution than if the firm executed the transaction internally. Conversely, the customer could receive an inferior price taking into consideration commissions and costs of execution. First, since the firm is currently obligated under NASD rules to achieve best execution, the execution price to the customer, if executed internally, would be required to be the best bid or offer. Therefore the blind routing of the order would not result in an improved execution price. Secondly, firms dealing directly with their customers are able to execute such transactions at a lesser cost than if the order were routed to another market. There are significant costs savings (e.g., clearing costs, resolving questioned trades) resulting from the internalization of customer orders which could be passed on to the customer in the form of reduced commissions and/or markups. We, therefore, do not view the order export alternative as having any advantages for customers and could result in disadvantages. The alleged conflict of interest on the part of the dealer is dealt with by existing rules and regulations. More importantly, this conflict is controlled by the widespread disclosure of current quotations and transaction reports and the active competition in the market for these securities. From the data available with respect to customer executions in 19c-3 securities, this alleged conflict has resulted in virtually no evidence of overreaching or inferior executions.

It is the Association's view that the anti-internalization proposal will clearly result in imposing an insurmountable burden on competition in off-board transactions in 19c-3 securities and would constitute a de facto repeal of Rule 19c-3. Firms participating in the 19c-3 experiment have indicated that they could not continue trading 19c-3 securities under the proposed rule. Not only would it effectively repeal Rule 19c-3, but the rule would also impose an insurmountable burden on non-exchange member market makers who have been trading listed securities for many years. In effect, the rule would eliminate the over-the-counter market in 19c-3 securities. We believe this result would be clearly inconsistent with the '75 Act Amendments, eliminate the recent gains that have been made in promoting competition in listed securities and be contrary to the public interest.

We believe that the objectives of the '75 Act could best be achieved by establishing an industry-wide best execution rule applicable to all markets and equally enforced in all markets. Customers ought to receive the best price displayed from any market. We do not believe the current ITS trade through rule goes far enough due to its many exceptions, its unequal treatment of market centers and the fact that only a complaint by a market center within five minutes of an execution gives rise to action under the rule. We believe that the focus of the national market system should be on the execution of customer orders and insuring that customers receive the best price displayed from any market center.

The Board of Governors believes that this proposed anti-internalization rule is a classic example of overregulation. The Commission itself has stated that no regulatory abuses are evident which would justify adoption of a rule. We believe that the burdens imposed by the rule not only clearly outweigh any benefits, but would stifle competition among market makers. For the past 10 years the securities industry has spent a considerable amount of time and money to develop automated systems which have resulted in the establishment of more efficient facilities to automatically process customer orders. These facilities are even more crucial today in light of the recent increase in volume in all markets. The Board believes that adoption of the proposed rule would not only impair the progress made so far, but would require modifications to these systems and their use by members to such an extent as to substantially reduce their efficiency. It should be noted that the proposed rule would not only affect the Association's Computer Assisted Execution System, but would also require modifications to the automated systems of the regional stock exchanges which are specifically covered by the proposed rule.

Finally, the Board urges members to consider the potential of this rule applying to the trading of NASDAQ NMS securities. Despite the assurances from the Commission that this will not happen, the Board is very concerned that at a future date it will occur. This concern is based on the evolution of the national market system as envisaged by the '75 Act Amendments as a unified trading system for all national market system securities. The Commission has already by rule designated certain NASDAQ securities as national market system securities subject to the same trade reporting and quotation display rules as listed securities. The Board is concerned that at some future time more of the distinctions between listed national market securities and over-the-counter national market system securities will be eliminated.

The Board believes that there has clearly been no demonstration of a need for an anti-internalization rule. Such a rule would eliminate competition among market makers; would be harmful to existing industry automated facilities; and poses a dangerous threat to the manner in which securities are traded. In addition, since the rule is heavily biased against in-house principal transactions, it could substantially impact the long-term profitability of a large portion of the membership's business.

PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

§ 240.11A-1 Exposure of principal and agency cross transactions.

Preliminary Note to Rule 11A-1— Rule 11A-1 applies both to broker-dealer principal transactions with customers and agency cross transactions in specified securities. With respect to broker-dealer principal transactions, the rule applies both to broker-dealer purchases from customers and broker-dealer sales to customers. In order to make the substantive requirements of the rule as easy to follow as possible, only subparagraph (a)(l) of the ruler refers both to broker-dealer purchases and sales. Throughout the remainder of the rule, the text of the rule refers only to the situation where the broken dealer buys from the customer. With respect to broker-dealer sales to a customer, the requirements of the rule parallel the requirements specified for broker-dealer purchases, but on the opposite side of the market. For example, while the rule provides the broker-dealer with the alternative requirement of "exposing" a customer sell order at a price 1/8 dollar higher than the stop price with respect to broker-dealer purchases, the broker-dealer would have to expose customer buy orders at a price 1/8 dollar lower than the stop price. As a general matter in interpreting requirements with respect to broker-dealer purchases from customers, unless the context requires otherwise, terms such as "purchase," "offer," "higher," "sell," "lowered," "bid," and "raised" used with respect to broker-dealer purchases, should be road as "sale," "bid," "lower," "purchase," "raised" "offer," and "lowered" with respect to broker-dealer sales.

(a) Principal transactions.
(1) No broker-dealer shall buy a subject Rule 19c-3 security from a customer (or sell such a security to a customer] for a proprietary account of the broker-dealer unless the broker-dealer (i) is registered and acting as an ITS/CAES market maker in the subject security or executes the purchase (or sale) on or through the facilities of a national securities exchange; (ii) has access to, and the published bids and offers of such broker-dealer in the subject Rule 19c-3 security can be reached through, the ITS/CAES Interface; and (iii) complies with either paragraph (a)(2) or (a] (3] of this section.
(2) Alternative 1: Order exposure. The broker-dealer, prior to execution of any purchase from a customer as principal, shall complete the steps set forth in this paragraph.
(i) The broker-dealer must "stop" (i.e., guarantee the execution of) the total number of shares he intends to buy at his intended purchase price from the customer (hereinafter referred to as the "stop price");
(ii) Subject to the provisions of paragraph (a)(2)(iv), the broker-dealer must publish and maintain for at least 30 seconds an offer on behalf of the customer, in a size equal to the total number of shares he intends to buy from the customer, at an offer price which is 1/8 dollar higher than the stop price;
(iii) After completing the steps required by paragraphs (a)(2)(i) and (a)(2)(ii), the broker-dealer may execute the customer's order (or whatever portion thereof remains unexecuted after publication of an offer on behalf of the customer in accordance with subparagraph (a)(2)(ii)) at the stop price, as principal;
(iv)
(A) The requirements of paragraph (a)(2)(ii) shall be deemed to be satisfied with respect to a customer order if, subject to the other provisions of this paragraph (a)(2)(iv), (1) an offer already being published by the broker-dealer for its proprietary account meets the price requirement and meets or exceeds the size requirement of subparagraph (a)(2)(ii) and is maintained for at least 30 seconds from the time the customer order is received; (2) the customer's order is not executed as principal for 30 seconds after it is received; and (3) during such 30 second period any transaction with the broker-dealer that would otherwise be for its proprietary account at the broker-dealer's published offer price in a size up to the size of the customer's order shall be for the account of the customer.
(B) Any offer required to be published and maintained under paragraph (a)(2)(ii) may be reduced in size to the extent of any partial acceptance by one or more third parties of the offer occurring during the 30 second period contemplated by that paragraph.
(C) A customer's order to sell (hereinafter referred to as the "first order") with respect to which publication of an offer is being maintained in compliance with paragraph (a)(2)(ii) may be executed immediately by the broker-dealer as principal at the stop price if, after such publication has commenced or, in the case of an order to which paragraph (a)(2)(iv)(A) applies, after the order is received:
(1) An unrelated transaction is executed in that broker-dealer's ITS market at a price equal to or lower than the stop price;
(2) The broker-dealer lowers his offer to the stop price to match an offer published by another ITS market; or
(3) The published offer in that broker-dealer's ITS market is lowered to the stop price to reflect an independent offer in that market at that price.
(D) A customer's order to sell (hereinafter referred to as the "second order") received by a broker-dealer while that broker-dealer is maintaining a published offer with respect to the first order in compliance with paragraph (a)(2)(ii) may be executed in whole or in part immediately by the broker-dealer as principal at the stop price of the first order in any size up to 1,000 shares in excess of the amount of the first order that was stopped by the broker-dealer pursuant to paragraph (a)(2)(i).
(3) Alternative 2: Order export. The customer's order shall be entered in ITS/CAES on a neutral basis {i.e.. otherwise than by directing the order to the broker-dealer for execution) or in the National Securities Trading System (NSTS) of the Cincinnati Stock Exchange and executed in ITS/CAES or NSTS (as the case may be) at the price of the bid published by the broker-dealer for his proprietary account at the time the order is entered either:
(i) Under circumstances reasonably designed to preclude (A) all persons responsible for making bids and offers or effecting transactions for the broker-dealer's proprietary account in that security from having any knowledge of the existence of that customer's order prior to its entry in ITS/CAES or NSTS, and (B) all persons responsible for the solicitation of customers' orders or for the manner and timing of entry of such orders in that security in ITS/CAES or NSTS from having knowledge of positions or trading strategies then existing for the broker-dealer's proprietary account in that security; or
(ii) where (A) the broker-dealer's bid has not been raised for at least 30 seconds before receipt of the customer order, and (B) the size of such bid during such 30 second period has been equal to or greater than the size of the customer order or that portion of the customer order purchased by the broker-dealer.
(b) Principal transactions in automated execution or derivative pricing systems. No broker-dealer who provides executions to others within or by means of an automated execution or derivative pricing system shall buy a subject 19c-3 security for a proprietary account of the broker-dealer from any person within or by means of such a system, whether on an immediate or delayed basis, unless the broker-dealer (1) complies with paragraph (a)(l) of this rule, and (2) complies with the procedures set forth in paragraph (a)(2) or (a)(3) of this section with respect to the execution of such order. For purposes of applying paragraphs (a)(2) and (a)(3) to the .execution of orders covered by this paragraph (b), all such orders shall be deemed customer orders whether or not the person for whose account the order is effected is a customer of the broker-dealer within the meaning of paragraph (g)(14) of this section.
(c) Agency cross transactions. No broker-dealer shall effect an agency cross transaction involving a subject Rule 19c-3 security unless such transaction is executed on or through the facilities of a national securities exchange or in ITS/CAES; Provided, however, that an ITS/CAES market maker may effect an agency cross transaction .otherwise than on or through the facilities of a national securities exchange or in ITS/CAES (1) at a price higher than the best bid and lower than the best offer for the subject 19c-3 security then being disseminated by any ITS market(s) (if the spread between such best bid and best offer is % or more); or (2) at a price equal to the best bid or best offer for the subject 19c-3 security then being disseminated by any ITS market(s) (if the spread between such best bid and best offer is 1/8).
(d) Exclusions. The provisions of this section shall not apply to:
(1) A principal transaction or agency cross transaction involving a block of a subject Rule 19c-3 security effected on or through the facilities of a national securities exchange or with or through an ITS/ CAES market maker, except as provided in paragraph (e) of this section;
(2) Any transaction which is part of a primary distribution by an issuer, or a registered or unregistered secondary distribution;
(3) Any transaction made in reliance on Section 4(2) of the Securities Act of 1933;
(4) Any trade at a price unrelated to the current market price for the subject Rule 19c-3 security involved for the purpose of correcting an error or to enable the seller to make a gift;
(5) Any transaction pursuant to a tender offer;
(6) Any purchase or sale of a subject Rule 10c-3 security effected upon the exercise of an option pursuant to the terms thereof or the exercise of any other right to acquire a subject Rule 19c- 3 security at a pre-established consideration unrelated to the current market for such security;
(7) Any transaction in any subject security for less than 100 shares;
(8) Any transaction effected outside of normal operating hours of the ITS/CAES interface;
(9) Any transaction effected in any foreign country;
(10) Any principal transaction in a subject Rule 19c-3 security effected on or through the facilities of a national securities exchange or with or through an ITS/CAES market maker during any period when the principal exchange market for that security is relieved of its obligation to collect, process and make available to quotation vendors bids and offers in such security pursuant to paragraph (b)(3)(i) of § 240.11Ac1-1 (Rule 11Ac1-1 under the Act);
(11) Any principal transaction in a subject Rule 19c-3 security effected on or through the facilities of a national securities exchange during any period when such exchange is relieved of its obligation to collect, process and make available to quotation vendors bids and offers in such security pursuant to paragraph (b)(3)(i) of 5 240.11Acl-l (Rule llAcl-1 under the Act;
(12) Any transaction effected in any opening or reopening of a stock in conformity with the provisions of the plan governing operation of ITS as approved by the Commission pursuant to § 240.1lAa3-2 (Rule HAa3-2 under the Act);
(13) Any transaction effected with an order (i) which was received within one minute of the close of the ITS market in which that transaction is effected, or (ii) as to which instructions were given to execute the order "at the close";
(14) Any purchase from a customer by a broker-dealer with respect to a non-marketable limit order of that customer if (i) there is published and maintained for at least 30 seconds prior to the purchase (and up to the time the purchase or sale is effected) an offer with respect to the customer order at the limit price of that order in a size at least equal to the number of shares purchased or sold; and (ii) for at least 30 seconds prior to the broker-dealer's purchase, that published offer price is equal to or lower than the price of the lowest offer published by any ITS market for the same security during that 30 second period. For purposes of this paragraph (d)(14), a "non-marketable limit order" shall mean a limited price order to sell at a price at least 1/8 above the price of the highest bid, published by any ITS market for the same security at the time the order was received;
(15) Any purchase from a customer by a broker-dealer with respect to any limit order in an ITS market which is executed in connection with a block transaction in that or another ITS market effected outside the best bid or best offer from any ITS market; and
(16) Any purchase from a customer by a broker-dealer on or through the facilities of a national securities exchange executed pursuant to a percentage order.
(e) Exposure of block transactions.
(1) On or before the last business day of the eighteenth month following the effective date of this section, the participants in the Intermarket Trading System shall jointly file with the Commission a plan establishing procedures for the exposure of covered block transactions prior to execution ("block exposure plan"). Such plan shall specify, at a minimum:
(i) The length of time, and the method by which, covered block transactions will be exposed;
(ii) Procedures designed to assure that buying and selling interest represented in any ITS market at the time a covered block transaction is exposed has a reasonable opportunity to respond to such exposure and, subject to the rules of priority, parity, and precedence in the market where the block transaction is to be effected, participates in the transaction;
(iii) Safeguards designed to prevent "step-ins" or other participation by any person whose interest in buying or selling the security which is the subject of the covered block transaction is not represented in an ITS market at the time the block transaction is exposed; and
(iv) Appropriate penalties in the event of non-compliance with the terms of the block exposure plan.
(2) The block exposure plan required by paragraph (e)(1) of this section shall be deemed to be a national market system plan within the meaning of § 240.11Aa3-2 (Rule 11Aa3-2 under the Act) and shall be considered by the Commission, and shall become effective, in accordance with the procedures specified in § 240.11Aa3-2.
(3) Once the block exposure plan becomes effective pursuant to § 240.11Aa3-2, notwithstanding any other provision of this section, no broker-dealer shall effect any covered block transaction without complying with the provisions of such effective block exposure plan.
(f) Exemptions. The Commission may exempt from the provisions of this section, either unconditionally or on specified terms and conditions, and broker, dealer, transaction or class of transactions if the Commission determines that such exemption is consistent with the public interest, the protection of investors the maintenance of fair and orderly markets or the removal of impediments to, and perfection of the mechanisms of, a national market system.
(g) Definitions. For purposes of this section,
(1) The term "Rule 19c-3 security," shall mean any security listed and registered on a national securities exchange for which transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan, other than a "covered security" as defined in
§ 240.19c-3 (Rule 19c-3 under the Act).
(2) The term "effective transaction reporting plan" shall mean any plan approved by the Commission pursuant to § 240.11Aa3-1 (Rule 11Aa3-1 under the Act) for collecting, processing and making available transaction reports with respect to transactions in an equity security or class of equity securities.
(3) The term "transaction report" shall mean a report containing the price and volume associated with a completed transaction involving one or more round lots of a security.
(4) The term "subject Rule 19c-3 security" shall mean any Rule 19c-3 security which is eligible to be traded through the ITS/CAES Interface.
(5) The term "Intermarket Trading System" ("ITS") shall mean the intermarket communications linkage operated jointly by certain self- regulatory organizations pursuant to a plan filed with, and approved by, the Commission pursuant to § 240.11Aa3-2 (Rule 11Aa3-2 under the Act) ("ITS Plan").
(6) The term "participant," when used with respect to the Intermarket Trading System, shall mean any self-regulatory organization which is included in the ITS Plan and has agreed to act in accordance with the terms of the ITS Plan.
(7) The term "Computer Assisted Execution System" ("CAES") shall mean the computerized order routing and execution system owned and operated by the National Association of Securities Dealers, Inc. ("NASD") as part of the NASDAQ inter-dealer quotation system.
(8) The term "ITS/CAES" shall mean the linked trading systems connected by the ITS/CAES Interface.
(9) The term "ITS/CAES Interface" shall mean the automated interface between the-ITS and CAES.
(10) The term 'ITS market" shall mean, with respect to any subject Rule 19c-3 security, any national securities exchange which is a participant in the ITS and trades such security through ITS and any ITS/CAES market maker in such security.
(11) The term "ITS/CAES market maker" shall mean, with respect to any subject Rule 19c-3. security, any third market maker that is registered as a market maker in such security with the NASD for purposes of use of ITS/CAES.
(12) The term "third market maker" shall mean, with respect to any subject Rule 19c-3 security, any broker-dealer who holds himself out as being willing to buy and sell such security for his own account on a regular or continuous basis otherwise than on a national securities exchange in amounts of less than block size (including any such person who also represents, as agent, orders to buy and sell such security on behalf of any other person and communicates bids and offers to a national securities association pursuant to § 240.11Ac1-1 (Rule 11Ac1-1 under the Act) on behalf of such other persons as well as for his own account).
(13) The term "broker-dealer" shall mean any broker or dealer.
(14) The term "customer" of a broker-dealer shall mean (i) any person other than a broker or dealer, except that the term "customer" shall include a broker or dealer (A) which, directly or indirectly controls, is controlled by, or is under common control with such broker-dealer, or (B) whose customers' accounts are introduced to the broker-dealer and are carried by it on either a disclosed or undisclosed basis; and (ii) any person from whom an order has been accepted by the broker-dealer for execution, but only with respect to orders so accepted.
(15) The term "proprietary account" shall mean any one or more accounts in which the broker-dealer has a direct or indirect interest.
(16) A bid or offer made available by a national securities exchange or national securities association pursuant to | 240.11Ac1-1 (Rule 11Ac1-1 under the Act) shall be deemed "published" when it is displayed on or through the facilities of such exchange or in CAES (as the case may be).
(17) The term "intended purchase price from the customer" in a principal transaction shall exclude any commission, commission equivalent, differential or comparable charge to be imposed by the broker-dealer in connection with the transaction.
(18) The term "block" shall mean a transaction involving 10,000 shares or more of a subject Rule 19c-3 security or a quantity of such security having a market value of $200,000 or more.
(19) The term "covered block transaction" shall mean a block of a covered Rule 19c-3 security which is an agency cross transaction or in which a broker-dealer buys such security from a customer for a proprietary account of the broker-dealer.

By the Commission.

December 23, 1982.

George A. Fitzsimmons,
Secretary.

[FR Doc. 82-35493 Filed 12-29-82; 8:45 am]

BILLING CODE 8010-01-M

TABLE OF CONTENTS

BY-LAWS

Page

Article I

Definitions

1

Article II

Qualifications of Members and Associated Persons

Sec.

1.

Persons Eligible to become Members and Associated Persons of Members

4

2.

Authority of Board to Adopt Qualification Requirements

7

3.

Ineligibility of Certain Persons for Membership or Association

8

4.

Definition of Disqualification

11

Article III

Membership

1.

Application for Membership

13

2.

Similarity of Membership Names

15

3.

Executive Representative

15

4.

Membership Roll

16

5.

Resignation of Members

17

6.

Transfer and Termination of Membership

17

7.

Registration of Branch Offices

19

8.

Vote of Branch Offices

19

9.

District Committees' Right to Classify Branches

20

Article IV

Registered Representatives and Associated Persons

1.

Qualification Requirements

22

2.

Application for Registration

23

3.

Notification by Member to Corporation of Termination

25

4.

Retention of Jurisdiction

26

Article V

Affiliates

1.

Qualifications for Affiliation

27

2.

Application for Admission as Affiliate

27

3.

Agreement of Affiliate

27

4.

Conditions of Affiliation

28

5.

Approval of Admission as an Affiliate

29

6.

Suspension or Cancellation of Affiliation

29

7.

Exclusion of Territory Covered by Affiliated Association

29

Article VI

Dues, Assessments and Other Charges

1.

Power of Board to Fix and Levy Assessments

30

2.

Reports of Members

31

3.

Suspension or Cancellation of Membership for Non-Payment of Dues

31

4.

Reinstatement of Membership

31

5.

Membership List Showing Dues-Paying Classification

32

Article VII

Organization and Administration

1.

Administrative Districts

32

2.

Powers and Authority of Board of Governors

33

3.

Authority to Suspend for Failure to File Regulatory Reports

35

4.

Composition of Board

36

5.

Term of Office of Governors

37

6.

Succession to Office

38

7.

Election of Board Members

38


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