05-3678. Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment No. 1 Thereto Relating to Proposed Amendments To Require Limit Order Protection and To Expand the ...

February 18, 2005.

Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) ^[1] and Rule 19b-4 thereunder,^[2] notice is hereby given that June 9, 2004, the National Association of Securities Dealers, Inc. (“NASD”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in items I, II, and III below, which items have been prepared by the NASD. On November 2, 2004, the NASD filed Amendment No. 1 to the proposed rule change.^[3] The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

NASD is proposing to require providing price improvement to customer limit orders under certain circumstances and to expand the application of NASD IM-2110-2 to exchange-listed securities.

Below is the text of the proposed rule change. Proposed new language is italicized; proposed deletions are in brackets.

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IM-2110-2. Trading Ahead of Customer Limit Order

(a) General Applications

To continue to ensure investor protection and enhance market quality, NASD's [the Association's] Board of Governors is issuing an interpretation to NASD [the] Rules [of the Association] dealing with member firms' treatment of their customer limit orders in Nasdaq and exchange-listed securities. This interpretation, which is applicable from 9:30 to 6:30 p.m. Eastern Time, will require members acting as market makers to handle their 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. [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, NASD [the Association] 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 (1).

(1) For purposes of [the pilot program expanding] the operation of certain Nasdaq transaction and quotation reporting systems and facilities [in SR-NASD-99-57] during the period from 4 p.m. to 6:30 p.m. Eastern Time. If a customer does not formally assent (“opt-in”) to processing of [their]the customer's limit order(s) during the extended hours period commencing after the normal close of the Nasdaq market, limit order protection will not apply to that customer's order(s).

Interpretation

The following interpretation of Rule 2110 has been approved by the Board:

A member firm that accepts and holds an unexecuted limit order from its customer (whether its own customer or a customer of another member) in a Nasdaq or exchange-listed 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 Rule 2110, 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: (a) for customer accounts that meet the definition of an “institutional account” as that term is defined in Rule 3110(c)(4); or (b) 10,000 shares or more, unless such orders are less than $100,000 in value. In the event that a member acting as market maker trades ahead of an unexecuted customer limit order at a price that is better than the unexecuted limit order, such member is required to execute the limit order at the price received by the member or better. Nothing in this interpretation, however, requires members to accept limit orders from any customer.

By rescinding the safe harbor position and adopting this interpretation, NASD [the Association] wishes to emphasize that members may not trade ahead of their 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. NASD [The Association] believes that, pursuant to Rule 2110, 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 firm's 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.]

As outlined in NASD Notice to Members 97-57, the minimum amount of price improvement necessary in order for a market maker to execute an incoming order on a proprietary basis when holding an unexecuted limit order for a Nasdaq security trading in fractions, and not be required to execute the held limit order, is as follows:

• If actual spread is greater than 1/16 of a point, a firm must price improve an incoming order by at least a 1/16. For stocks priced under $10[,] (which are quoted in 1/32 increments), the firm must price improve by at least 1/64.
• If actual spread is the minimum quotation increment, a firm must price improve an incoming order by one-half the minimum quotation increment.

For Nasdaq securities authorized for trading in decimals pursuant to the Decimals Implementation Plan for the Equities and Options markets, the minimum amount of price improvement necessary in order for a market maker to execute an incoming order on a proprietary basis in a security trading in decimals when holding an unexecuted limit order in that same security, and not be required to execute the held limit order, is as follows:

(1) For customer limit orders priced at or inside the best inside market displayed in Nasdaq, the minimum amount of price improvement required is $0.01; and

(2) For customer limit orders priced outside the best inside market displayed in Nasdaq, the market maker must price improve the incoming order by executing the incoming order at a price at least equal to the next superior minimum quotation increment in Nasdaq (currently $0.01).

NASD [The Association] 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 Rule 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. NASD [The Association] emphasizes that order entry firms should continue to routinely monitor the handling of their customers' limit orders regarding the quality of the execution received.

(b) and (c) No change.

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II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed rule Change

In its filing with the Commission, NASD included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in item IV below. NASD has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

NASD Interpretive Material (IM) 2110-2, Trading Ahead of Customer Limit Order (commonly referred to as the “Manning Interpretation”) generally prohibits a member from trading for its own account at prices that would satisfy a customer's limit order, unless the member immediately thereafter executes the customer limit order.^[4] The legal underpinnings for the Manning Interpretation are a member's basic fiduciary obligations and the requirement that it must, in the conduct of its business, “observe high standards of commercial honor and just and equitable principles of trade.” ^[5]

The Manning Interpretation is designed to ensure that customer limit orders are executed in a fair manner by prohibiting a member firm from trading ahead of customers' limit orders in its principal capacity without executing the customer limit order. The Interpretation currently, however, only requires that a member that “trades ahead” of a customer limit order execute the customer limit order at its limit price. If the member trades ahead of a customer limit order and receives a better price than the unexpected customer limit order, the Manning Interpretation currently would not obligate the member to pass along the better price if received; it need only fill the customer limit order at the limit price.

NASD believes that where a member trades at a price better than an unexpected customer limit order, the member should be required to pass along such price improvement to the unexecuted customer limit order. Accordingly, NASD is proposing to prohibit a member from trading for its own account in a Nasdaq or exchange-listed security ^[6] at a price that is better than an unexpected customer limit order in that security, unless the member immediately thereafter executes the customer limit order at the price at which it traded for its own account or better.

In recognition that the proposed rule change may alter the way that many members handle customer orders, NASD believes that it is important to provide members with adequate time to develop and implement systems to comply with the proposed rule change. Therefore, NASD will announce the effective date of the proposed rule change in a Notice to Members to be published no later than 60 days following SEC approval. The implementation date will be 90 days after the issuance of such Notice to Members announcing SEC approval of the proposed rule change.

NASD also is proposing several technical changes to the Manning Interpretation to delete language contained in the rule text that is no longer necessary. Specifically, as part of a proposed expansion of the Manning Interpretation in 1994 to include all member-to-member customer limit orders, the Manning Interpretation included a phase-in period that expired on September 1, 1995.^[7] Prior to that time period, the Manning Interpretation permitted member firms to handle member-to-member limit orders that were larger than 1,000 shares more liberally (such limit orders were only required to be protected from executions at prices that were superior but not equal to that of the limit order). Given that the phase-in period has expired, NASD is proposing to delete the rule text related to the phase-in period.

NASD also proposes to delete the rule text relating to the application of the Manning Interpretation to affiliates as it also is no longer necessary. The rule text relating to affiliates was necessary when the Manning Interpretation did not apply to member-to-member limit orders to ensure that limit orders routed between affiliates were protected. However, because the Manning Interpretation has since been expanded to apply to member-to-member customer limit orders, if a member accepts a customer limit order and forwards that order to another member (regardless of whether or not such member is an affiliate) for execution, the Manning Interpretation would apply.

In addition, NASD is proposing to delete certain unnecessary rule text contained in footnote one relating to a Nasdaq pilot program expanding the operation of certain Nasdaq transaction and quotation reporting systems and facilities during the period from 4 p.m. to 6:30 p.m. eastern time. This Nasdaq pilot program became a permanent program in 2003 and this footnote text inadvertently was not deleted as part of the rule filing making the pilot permanent.^[8] Finally, NASD no longer refers to itself or its subsidiary, NASD Regulation, Inc., using its full corporate name, “the Association,” “the NASD” or “NASD Regulation, Inc.” Instead, NASD uses “NASD” unless otherwise appropriate for corporate or regulatory reasons. Accordingly, the proposed rule change replaces several references to “Association” in the text of the proposed rule change with “NASD.”

2. Statutory Basis

NASD believes that the proposed rule change, as amended, is consistent with the provisions of section 15A(b)(6) of the Act,^[9] which requires, among other things, that NASD's rules must be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest. NASD believes that the proposed rule change, as amended, will improve treatment of customer limit orders and enhance the integrity of the market.

B. Self-Regulatory Organization's Statement on Burden on Competition

NASD does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants or Others

Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:

(A) By order approve such proposed rule change, or

(B) Institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change, as amended, is consistent with the Act. Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (http://www.sec.gov/​rules/​sro.shtml); or
• Send an e-mail to [e-mail]. Please include File Number SR-NASD-2004-089 on the subject line.

Paper Comments

• Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609.

All submissions should refer to File Number SR-NASD-2004-089. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/​rules/​sro.shtml). 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 Section, 450 Fifth Street, NW., Washington, DC 20549. Copies of such filing also will be available for inspection and copying at the principal office of NASD. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-NASD-2004-089 and should be submitted on or before March 18, 2005.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[10]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  Amendment No. 1 to SR-NASD-2004-089 replaces and supercedes the NASD's original 19b-4 filing in its entirety.

4.  For example, if a member bought 100 shares at $10 when holding customer limit orders in the same security to buy at $10 equaling, in aggregate, 1000 shares, the member is required to fill 100 shares of the customer limit orders. NASD Rule 6440(f)(2) imposes similar requirements with respect to the receipt of customer limit orders in exchange-listed securities traded over-the-counter.

5.  See NASD rule 2110. See also NASD Rule 232(a) (the “Best Execution Rule”). Note: NASD has proposed changes to the Best Execution Rule in SR-NASD-2004-026. See Securities Exchange Act Release No. 51229 (February 18, 2005). See also related filing, File No. SR-NASD-2004-045. See Securities Exchange Act Release No. 51230 (February 18, 2005).

6.  NASD Rule 6440(f)(2) currently prohibits members from trading ahead of their customer limit orders in exchange-listed securities traded over-the-counter. To ensure consistency in the application of limit order protection to Nasdaq and exchange-listed securities, NASD also is proposing to apply explicitly its Manning Interpretation to exchange-listed securities. NASD will recommend to Nasdaq that it consider deleting NASD Rule 6440(f)(2), in light of the proposed application of NASD IM-1210-2 to exchange-listed securities.

7.  See Securities Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995) (File No. SR-NASD-94-62).

8.  See Securities Exchange Act No. 47308 (February 4, 2003), 68 FR 6976 (February 11, 2003) (File No. SR-NASD-2003-14).

9.  15 U.S.C. 78 o-3(b)(6)

10.  17 CFR 200.30-3(a)(12).