Interpretive Letter to Name Not Public
April 16, 1997
Re: Exemption from Limit Order Protection Rule involving ERISA
In your letter dated February 25, 1997, as supplemented by conversations with staff, you request confirmation that [Broker/dealer] would not be prohibited, under NASD Rule 2110 and interpretation IM-2110-2 (the "Limit Order Protection Rule"), from executing certain transactions in its market making capacity ahead of limit orders that [Broker/dealer] receives involving accounts for which [Broker/dealer] is a fiduciary under the Employment Retirement Income Security Act ("ERISA"), as more fully described below.
We understand the facts to be as follows:
[Broker/dealer] is a broker-dealer registered with the Securities and Exchange Commission ("SEC"), a member of the National Association of Securities Dealers, Inc. ("NASD"), and a market maker in more than 100 securities listed on The Nasdaq Stock Market, Inc. ("Nasdaq"). Some of the customer accounts that [Broker/dealer] maintains, such as pension plans, are subject to ERISA.
Pursuant to ERISA, a fiduciary for an entity that is subject to ERISA is not permitted, subject to a limited exemption, to act as principal in any transaction with that entity.1 To ensure compliance with this prohibition, [Broker/dealer] does not act as principal in connection with these accounts. Instead, [Broker/dealer] sends all orders for these accounts to other broker-dealers for execution, even if [Broker/dealer] is a market maker in the security that is the subject of the order.
In this context, however, [Broker/dealer] must also comply with the Limit Order Protection Rule. That rule generally prohibits NASD members from trading ahead of unexecuted customer limit orders. The rule’s prohibition also applies to orders for which [Broker/dealer] acts as agent by sending the order to another NASD member for execution. Thus, if an order that [Broker/dealer] has sent to another market maker is triggered at [Broker/dealer] because [Broker/dealer] has traded as principal, [Broker/dealer] must protect the order by ensuring that it is immediately executed. The broker-dealer holding the order, however, may not be obligated to execute the order at that time, and as a consequence, [Broker/dealer] would be obligated under the Limit Order Protection Rule to retrieve the order and execute it as principal. This would result in a conflict between the Limit Order Protection Rule, which would require [Broker/dealer] to trade with its customer as principal, and ERISA, which prohibits [Broker/dealer] from doing so.
The staff believes that, in this situation, compliance with applicable ERISA regulations supercedes the Limit Order Protection Rule. Accordingly, to the extent that [Broker/dealer] is handling limit orders for fiduciary accounts as defined under ERISA, it would be permissible for [Broker/dealer] to execute transactions in its market making capacity ahead of such limit orders when those orders are forwarded to another broker-dealer for execution. The staff believes that this is a logical resolution to the conflict, which ensures that [Broker/dealer] may continue to accommodate its customers’ needs while complying with the requirements of ERISA. Importantly, the limit orders for these accounts would still be protected by the broker-dealer to whom they were directed.
The staff notes that the broker-dealer receiving the limit orders would continue to have a duty of best execution under the federal securities laws and rules of the NASD. Furthermore, [Broker/dealer] would continue to have the obligation, consistent with recent pronouncements from the SEC, to regularly and rigorously assess the quality of executions provided by other market makers to assure that orders routed to other broker-dealers receive the most beneficial terms of execution.
If you have any questions, please contact Andrew S. Margolin at (202) 728-8869.
Thomas R. Gira
Associate General Counsel
Office of General Counsel
The NASDAQ Stock Market
1 29 U.S.C. §1106(b).