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88-61 Interpretations - Effective Immediately - of SOES Rules Regarding Compliance With Maximum Order Size Restrictions.

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations
Trading

*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

The Small Order Execution System (SOES) was created to allow public customers to enter orders of limited size into the NASDAQ System for immediate execution at the best available price. Section 3(c) of the SOES Rules states that, "Agency orders in excess of the maximum order size may not be divided into smaller parts for purposes of meeting the size requirements for orders entered into SOES."

In light of certain order aggregation practices by associated persons and by customers who control several accounts, the NASD has adopted interpretations of SOES Rules to clarify the intent of the rules. These interpretations are effective immediately.

Where a single investment decision has been made involving the purchase or sale of more than the maximum order size, the order cannot be executed through SOES. Trades entered within any five-minute period in accounts controlled by an associated person or customer will be presumed to be based on a single investment decision.

For purposes of SOES Rules, an order will not be considered an order from a public customer if it is for an account of a person associated with a member firm who has physical access to a terminal capable of entering orders into SOES or if it is for an account of a member of the "immediate family" of the associated person.

BACKGROUND

In 1984, the NASD implemented the Small Order Execution System (SOES) to enable public customers to have their orders of limited size entered into the NASDAQ System for immediate execution at the best available price. SOES was designed exclusively for individual retail customer orders restricted to a maximum size. Accordingly, the SOES rules prohibit any practice designed to circumvent the SOES execution size limits, including breaking up larger orders for execution in SOES. The NASD Market Surveillance Committee has taken several disciplinary actions against firms and individuals for such conduct. SOES rules also restrict its use to agency orders of public customers, not principal trades by dealers. Disciplinary actions have also been taken against firms entering professional, proprietary orders through the system.

After the market break of October 1987, SOES was upgraded to enhance the quality of service and access provided to individual customers. Participation in SOES became mandatory for all market makers in NASDAQ National Market System securities. Such market makers are committed to executions for at least five times the maximum order size in every security for which they are making markets if their quotes are the inside market or the orders are preferenced to them. NASDAQ market makers are also now subject to a 20-business-day penalty for any unexcused withdrawal from NASDAQ. All of these changes were made to enhance SOES as a system designed to serve individual customers entering small orders.

As a result of the system's enhancements and the increased commitment of market makers to SOES, the NASD has carefully monitored the utilization of SOES since the June 30, 1988 effective date of mandatory SOES participation. It appears that the SOES size limitations are being circumvented by the entry of a group or series of orders which individually may appear to be SOES eligible but are the result of one investment decision. These orders are generally entered in the form of a group or series of transactions for one or more accounts that are related or controlled by a person associated with a member firm or by a customer, and therefore should be aggregated for purposes of determining compliance with SOES size limitations.

The NASD is issuing this interpretation of the SOES Rules of Practice and Procedures to clarify how those rules apply to these practices.

INTERPRETATIONS OF SOES RULES

Aggregation of Transactions in Related Accounts -Section c) 3) C) of the SOES Rules provides:

Only agency orders no larger that the maximum order size, as defined herein, received from public customers may be entered by a SOES Order Entry Firm in to SOES for execution against a SOES Market Maker. Agency orders in excess of the maximum order size may not be divided into smaller parts for purposes of meeting the size requirements for orders entered in to SOES.

Section a) 7) of the SOES Rules defines "maximum order size" for SOES as:

the maximum size of individual orders for a security that may be entered into or executed through SOES.1

Since the initiation of SOES, the NASD has interpreted the above-cited provisions as preventing a firm or customer from breaking up an order too large for SOES into a series of smaller orders executed through the system. Thus, where a single investment decision has been made involving the purchase or sale of more than the maximum order size, the order cannot be executed through SOES.

The recent development of certain aggregation practices by associated persons and customers who control several accounts makes it necessary to clarify the application of the SOES rules to these new situations. In some cases, an associated person or customer controlling several accounts may, after making one investment decision, simultaneously place a group of maximum-size orders, one for each controlled account. Associated persons have been accepting these orders and entering them into SOES as a series of SOES-eligible transactions. In other cases, customers or associated persons have executed a series of orders in their personal accounts based on one investment decision. These practices violate the intent underlying the SOES Rules.

For purposes of the SOES rules, orders that are based on a single investment decision and that are entered by a SOES order entry firm for accounts under the control of an associated person or public customer will be deemed to constitute a single order and will be aggregated for determining compliance with the SOES order size limits. Trades entered within any five-minute period in accounts controlled by an associated person or customer will be presumed to be based on a single investment decision. An associated person or customer will be deemed to control an account if he exercises discretion over the account or has been granted a power of attorney to execute transactions in the account, or if the account is his personal account or, in the case of an associated person, the account of a member of his "immediate family" as that term is defined in the NASD Free-Riding Interpretation.

Restriction to Public Customer Orders -The restriction in the SOES Rules that permits the system to be used only for agency orders of public customers is intended to preclude use by firms for their proprietary trading or for similar types of activity by professionals trading for their own accounts. It would change the character of SOES as a system designed exclusively for individual investors' small orders to permit professional trading activity to occur in the system.

To assure that SOES is utilized only for orders of public customers and not for orders for firms' accounts or accounts of professional trading personnel, the NASD is clarifying what constitutes an order from a public customer.

For purposes of the SOES Rules, an order will not be considered an order from a public customer if it is for any account of a person associated with a member firm who has physical access to a terminal capable of entering orders in to SOES or for any account of a member of the "immediate family" of such associated person, as that term is defined in the NASD Free-Riding Interpretation.2

The NASD believes these clarifying interpretations of the SOES Rules will assure the continued integrity of the Small Order Execution System as a premier order execution system for public customers.

Activity of members inconsistent with the provisions of this Interpretation shall, in addition to violating the referenced SOES rules, violate Article III, Section 1 of the NASD Rules of Fair Practice.

This Interpretation shall be effective immediately.

Any questions regarding this notice may be directed to Dennis Hensley (202) 728-8245, James M. Cangiano (202) 728-8186, or Laura R. Singer (202) 728-8204.


1 The maximum size for each security is published from time to time by the NASD. See, for example, NASD Notice to Members 88-43 (June 22, 1988) in which levels of 1,000,500, and 200 shares were established.

2 See Interpretation of the Board of Governors - Free-Riding and Withholding under Article III, Section 1 of the NASD Rules of Fair Practice, NASD Manual (CCH), pages 2041, 2045. The Free-Riding Interpretation defines "immediate family as including parents, mother-in-law or father-in-law, husband or wife, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children.



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