June 20, 2007
On June 20, 2007, NASD filed an immediately effective rule change with the SEC to delay until November 26, 2007 the effective date of the expansion of IM-2110-2 (Trading Ahead of Customer Limit Orders) to OTC equity securities and the related deletion of Rule 6541. Members should review Notice to Members 07-19 (April 2007) for more information regarding the approved changes to IM-2110-2. The extended implementation date is being provided in response to requests by several firms to delay the effective date of the approved rule changes in light of other competing technological demands required by the implementation of Regulation NMS.
Members should note, however, that certain other rule changes that were approved in conjunction with the expansion of IM-2110-2 to OTC equity securities will still become effective on July 26, 2007. Specifically, effective July 26, 2007, under IM-2110-2, the minimum amount of price-improvement required for customer limit orders in exchange-listed securities priced less than $1.00 that are at or inside the best inside market will be the lesser of $0.01 or one-half (1/2) of the current inside spread. Previously, the minimum price improvement required was $0.01, irrespective of the current inside spread. This change will go into effect on July 26, 2007, as currently scheduled. In addition, the requirements in Rule 6541 will continue to apply to OTCBB securities until IM-2110-2 is implemented for OTC equity securities on November 26, 2007.
Members and other interested parties should review the recently filed rule change for more detailed information on the delayed implementation. The changes to IM-2110-2 that become effective on July 26, 2007 are set forth in Attachment A of this Alert.
Below is the text of those rule changes approved pursuant to SR-NASD-2005-146, which become effective on the initial implementation date of SR-NASD-2005-146, July 26, 2007. New language is underlined; deletions are in brackets.
IM-2110-2. Trading Ahead of Customer Limit Order
(a) General Application
To continue to ensure investor protection and enhance market quality, NASD's Board of Governors is issuing an interpretation to NASD Rules dealing with member firms' treatment of their customer limit orders in exchange-listed securities. This interpretation, which is applicable from 9:30 a.m. to 6:30 p.m. Eastern Time, will require members to handle their customer limit orders with all due care so that members do not "trade ahead" of those limit orders. Thus, members 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. In the interests of investor protection, 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.1
Rule 2110 states that:
A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade. Rule 2320, the Best Execution Rule, 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.
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 an exchange-listed security and that continues to trade the subject security for its own 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 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 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 wishes to emphasize that members may not trade ahead of their customer limit orders even if the member had in the past fully disclosed the practice to its customers prior to accepting limit orders. NASD 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.
[As outlined in NASD Notice to Members 97-57, the minimum amount of price improvement necessary in order for a member 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:]
[For Nasdaq securities authorized for trading in decimals pursuant to the Decimals Implementation Plan For the Equities and Options Markets, t]The minimum amount of price improvement necessary in order for a member 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 greater than or equal to $1.00 that are 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 less than $1.00 that are at or inside the best inside market, the minimum amount of price improvement required is the lesser of $0.01 or one-half (1/2) of the current inside spread;
3) For customer limit orders priced outside the best inside market [displayed in Nasdaq], the member 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 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 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 emphasizes that order entry firms should continue to monitor routinely the handling of their customers' limit orders regarding the quality of the execution received.
(b) through (c) No change.
1 For purposes of 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, members may generally limit the life of a customer limit order to the period of 9:30 a.m. to 4 p.m. Eastern Time. If a customer does not formally assent ("opt-in") to processing of 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).