02-32073. Self-Regulatory Organizations; Order Granting Approval of Proposed Rule Change by the National Association of Securities Dealers, Inc., and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 1 to Proposed Rule Change ...

December 13, 2002.

I. Introduction

On May 28, 2002, the National Association of Securities Dealers, Inc. (”NASD” or “Association”), through its subsidiary, the Nasdaq Stock Market, Inc. (“Nasdaq”), filed with the Securities and Exchange Commission (”Commission”), pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (Act) ^[1] and Rule 19b-4 thereunder,^[2] a proposed rule change that would modify NASD Interpretative Material 2110-2 to establish a riskless principal customer facilitation exemption. Notice of the proposed rule change appeared in the Federal Register on June 7, 2002.^[3] The Commission received two comment letters in response to the proposed rule change.^[4] On November 26, 2002, Nasdaq submitted Amendment No. 1 to the proposed rule change.^[5] For the reasons discussed below, the Commission is approving the proposed rule change and granting accelerated approval to Amendment No 1.

II. Description of the Proposed Rule Change

The proposed rule change seeks Commission approval of Nasdaq's proposal to establish a riskless principal customer facilitation exemption to NASD Interpretative Material 2110-2-Trading Ahead of Customer Limit Order (“Manning Interpretation” or “Manning”). NASD's current Manning Interpretation prohibits market makers from trading at prices equal or superior to customer limit orders they hold without executing those limit orders.^[6]

Nasdaq has determined to adopt a customer facilitation exemption to Manning that would exempt from Manning single-priced riskless principal transactions done by market makers who are buying or selling securities to satisfy the order(s) of other customers. In these situations, since the true beneficiary of the market maker's activity is another customer, and not the firm's proprietary account, Manning will be interpreted to exempt such trading from being considered triggering trades obligating the market maker to protect other held customer limit orders.^[7] Additionally, this proposed exemption is intended to addresses some of the consequences created by Manning's minimum price improvement standard in a decimal environment.

To ensure that market maker transactions that will not trigger Manning obligations are being done for the ultimate benefit of other customers, the customer facilitation exemption will be strictly construed. As such, only those market maker trades meeting all of the following requirements would be eligible for an exemption from Manning:

(1) The handling and execution of the facilitated order must satisfy the definition of a “riskless” principal transaction, as that term is defined in NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 4652(d)(3)(B);

(2) A member that relies on this exemption to this interpretation must give the facilitated order the same per-share price at which the member accumulated or sold shares to satisfy the facilitated order, exclusive of any markup or markdown, commission equivalent or other fee;

(3) A member must submit, contemporaneously with the execution of the facilitated order, a report as defined in NASD Rules 4632(d)(3)(B)(ii), 4642(d)(3)(B)(ii) and 4652(d)(3)(B)(ii) to the Automated Confirmation Transaction Service;

(4) Members must have written policies and procedures to assure that riskless principal transactions relied upon for this exemption comply with NASD Rules 4632(d)(3)(B), 4642(d)(3)(B) and 4652(d)(3)(B). At a minimum these policies and procedures must require that the customer order was received prior to the offsetting transactions, and that the offsetting transactions are allocated to a riskless principal or customer account within 60 seconds of execution. Members must have supervisory systems in place that produce records that enable the member and NASD Regulation to accurately and readily reconstruct, in a time-sequenced manner, all orders on which a member relies in claiming this exemption.

Non-agency trades not meeting all of these standards would remain subject to Manning and require, upon execution, the protection and execution of appropriate limit orders in full conformity with the Interpretation. This exemption would apply only to the actual number of shares executed by the member necessary to fill the customer order(s).

In Nasdaq's view, a transaction meeting these requirements is closely akin to an agency trade and does not materially implicate a market maker's proprietary trading. Nasdaq notes that the Commission in its release concerning the availability of the section 28(e) safe harbor also highlighted the similarities in compensation transparency provided by agency and riskless principal trade reporting pursuant to NASD Rules 4632(d)(3)(B), 4642(d)(3)(B), and 6420(d)(3)(B), coupled with the requirements of Exchange Act Rule 10b-10.^[8] As such, Nasdaq will not consider riskless principal trades meeting the requirements of the exemption as triggering trades for the market maker's own market-making account for purposes of Manning. This view rests primarily on the requirement that only trades where a market maker gives the customer a trade price that reflects the market maker's actual cost in acquiring the stock be eligible for the exemption. This obligation to trade ‘flat’ effectively removes concerns about a member breaching its fiduciary duty to customer limit orders that it holds that underlie the Manning protections in other trading contexts. Nasdaq believes that the above exemption draws an appropriate balance between the important customer protections afforded by Manning and the practical needs of market participants to assist other customers.

III. Comment Letters

The Commission received two comment letters in response to the proposed rule change. Knight Trading Group, Inc. (“Knight”) supported the proposed rule change but expressed concern about the conditions included in the exemption. In particular, Knight objected to the requirements that an offsetting riskless principal transaction must be allocated within 60 seconds of execution and that the transaction be allocated to a separate “allocation account.” Knight contended that these requirements were redundant in light of the proposed condition that members must have systems in place that enable a member to accurately and readily reconstruct, in a time sequenced manner, all orders upon which a member relies in claiming the exemption.

Another commenter, Schwab Capital Markets L.P. (“Schwab”), expressed a broader concern about the application of the Manning Interpretation in a decimals environment where subpenny quotes are rounded to the nearest penny. Schwab stated that under certain market conditions, a member may attempt to execute a trade at least $0.01 ahead of a customer limit order it holds pursuant to Manning but because a quote was rounded to the nearest penny the execution may trigger a fill of a customer limit order held by the member. Schwab suggested several solutions to the problem, including requiring an asterisk identifier to a rounded quote and the elimination of a penny price improvement standard where the spread in a security is a penny.

Nasdaq submitted Amendment No. 1 in response to one of the concerns raised by Knight. As discussed, Amendment No. 1 seeks to provide an alternative allocation account for those members for whom it may be cumbersome to establish a separate “riskless principal account.” With regards to Knight's concern about the requirement that an offsetting transaction be allocated to either a riskless principal or customer account within 60 seconds, Nasdaq has not sought to make any changes to the proposed rule in response to this concern as this condition is consistent with previously stated Nasdaq policy regarding the handling of mixed capacity trades and compliance with the Manning Interpretation.^[9]

Further, Nasdaq has not sought any changes to the rule proposal in response to the concerns raised by Schwab. The issues raised by Schwab largely relate to the operation of Manning relative to the rounding of quotes to the nearest penny due to subpenny trading that are beyond the scope of the proposed rule change.

IV. Discussion

The Commission has reviewed carefully the proposed rule change and the two comment letters and finds that the proposed rule change is consistent with the Act and the rules and regulations promulgated thereunder.^[10] Specifically, the Commission finds that approval of the proposed rule change is consistent with section 15A(b)(6) of the Act.^[11]

The Commission finds that proposed rule change is consistent with section 15A(b)(6) of the Act ^[12] in that it is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest. The Commission finds the proposed rule change promotes the just and equitable principles of trade by continuing to provide protection to customer limit orders while removing possible impediments to filling customer orders on a riskless principal basis. In particular, the Commission finds that an exemption from Manning for single-priced riskless principal transactions done by market makers who are buying or selling securities to satisfy the order(s) of other customers is consistent with the goals of Manning since the true beneficiary of the market maker's activity is another customer and not the firm's proprietary account. Additionally, we believe the proposed exemption will appropriately address some of the concerns raised by members regarding the consequences created by Manning's minimum price improvement standard in a decimal environment.

The Commission also finds good cause for approving proposed Amendment No. 1 prior to the 30th day after the date of publication of notice of the filing in the Federal Register. The Amendment provides an alternative allocation account, other than a riskless principal account, as a more efficient means of complying with the conditions of the exemption for some members for whom establishing a separate riskless principal account may be cumbersome. Approving the Amendment on an accelerated basis will allow some members to implement the exemption without having to unnecessarily establish a separate riskless principal account. For this reason, the Commission finds good cause for accelerating approval of the proposed rule change, as amended.

Interested persons are invited to submit written data, views, and arguments concerning Amendment No. 1, including whether the Amendment is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of Nasdaq. All submissions should refer to file number SR-NASD-2002-66 and should be submitted by January 10, 2003.

V. Conclusion

For the above reasons, the Commission finds that the proposed rule change is consistent with the provisions of the Act, in general, and with section 15A(b)(6),^[13] in particular.

It is therefore ordered, pursuant to section 19(b)(2) of the Act,^[14] that the proposed rule change (SR-NASD-2002-66), as amended, be and hereby is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[15]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  See Securities Exchange Act Release No. 46006 (May 30, 2002), 67 FR 39455 (June 7, 2002).

4.  Letters from Michael T. Dorsey, Senior Vice President, Director of Legislative and Regulatory Affairs, Knight Trading Group, Inc. (June 28, 2002); Michael Corrao, Vice President and Chief Compliance officer, Schwab Capital Markets L.P. (July 9, 2002).

5.  See Letter from Thomas P. Moran, Associate General Counsel, Nasdaq (November 26, 2002). NASD's Amendment seeks to add the language “or customer account” to the proposed rule language for subparagraph (c) (4) of Interpretative Material 2110-2 as an alternative account to which a riskless principal offsetting transaction may be allocated in addition to the “riskless principal account” referenced in the original rule filing.

6.  In addition, Nasdaq has adopted price-improvement standards that obligate market makers to execute held customer limit orders unless the market maker either buys at a price sufficiently higher than a customer's buy order, or sells at a price sufficiently lower than a customer's sell order.

7.  In this sense, the exemption is similar in purpose and effect to the treatment of agency executions in IM-2110-2. Specifically, if a broker-dealer executes a customer order on an agency basis, the firm is not required to protect (execute) other customer limit orders.

8.  See Securities Exchange Act Release No. 45194 (January 2, 2002), 67 FR 6 (January 2, 2002).

9.  See NASD Notice to Members 01-85, at Question 7 and Notice to Members 95-67, at Question 5.

10.  In approving this proposal, the Commission has considered the proposed rule's impact on efficiency, competition and capital formation. 15 U.S.C. 78c(f).

11.  15 U.S.C. 78o-3(b)(6).

12.  Id.

13.  15 U.S.C. 78o-3(b)(6).

14.  15 U.S.C. 78s(b)(2).

15.  17 CFR 200.30-3(a)(12).