Interpretive Letter to Lloyd H. Feller, Morgan, Lewis & Bockius
August 29, 1997
Lloyd H. Feller
Morgan, Lewis & Bockius
1800 M Street, N.W.
Washington, D.C. 20036-5869
Re: Certain Activity in Connection with Use of POSIT
Dear Mr. Feller:
I am responding to your July 24, 1997 letter to Alden Adkins requesting the views of NASD Regulation, Inc. ("NASD Regulation") with respect to certain behavior you think may be occurring in connection with the use of limit orders that are placed in Electronic Communications Networks ("ECNs") that comply with the ECN Display Alternative under the SEC’s Order Handling Rules. The orders may be delivered to the ECNs with the apparent intent of affecting the price of transactions effected through the Portfolio System for Institutional Trading ("POSIT") operated by your client, Investment Technology Group, Inc. ("ITG"). You have asked whether the behavior described in your letter is consistent with just and equitable principles of trade and other applicable provisions of the NASD rules and the federal securities laws.
We understand the pertinent facts to be the following: ITG is a U.S. registered broker/dealer that, among other things, operates POSIT. POSIT is an automated equity trading/crossing system that is designed to facilitate trading in exchange-listed and over-the-counter equity securities and portfolios of such securities. While the system is designed to accommodate portfolios, customer orders may range from large portfolios consisting of multiple stocks to orders consisting of only a single stock. POSIT is not an ECN.
Matched trades are generally executed through POSIT five times each trading day at random times within seven minute intervals (10:00-10:07 am; 11:30-11:37 am; 12:00-12:07 pm; 1:30-1:37 pm; and 3:00-3:07 pm). Trades are priced at the mid-point between the best bid quotation and best asked quotation for each matched stock in the primary market on that trading day.
The SEC’s Order Handling Rules require market makers to reflect in their quotes any better priced orders that the market maker privately quotes through an ECN.1 Alternatively, a market maker can deliver better priced orders anonymously to an ECN without changing its public quote if that ECN (1) ensures that the best prices market makers have entered are communicated to Nasdaq and (2) provides broker/dealers access to orders entered by market makers into the ECN ("ECN Display Alternative").2 Under this Alternative, the full size of the order must be displayed.
ITG’s customers and ITG believe that certain market makers have placed orders in ECNs that comply with the ECN Display Alternative in order to move the contra side of the market for a security in which that market maker has placed an order for a match in POSIT. For example, if a market is 10 - 10-1/4, that match in POSIT will occur at 10-1/8. If a POSIT customer seeking to buy shares through the POSIT match causes the national best to change to 10 - 10-3/16, the price of the POSIT match will be reduced to 10-3/32, thus resulting in an improved price to that person to the disadvantage of all other customers on the other side of the market in that particular cross.
ITG states that it has a sophisticated system by which it monitors for this type of behavior on the part of its customers. ITG further states, however, that the adoption of the SEC’s Order Handling Rules and the availability of an ECN as a vehicle to anonymously change the inside market has
limited the effectiveness of ITG’s surveillance of POSIT.
The behavior you have described may constitute market manipulation in violation of the antifraud provisions of the securities laws and NASD rules. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976): Manipulation is a "term of art . . . connot[ing] intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities;" In re Randolph K. Pace, et al., 53 S.E.C. Docket 2330, Securities Exchange Act Release No. 32153 (April 15, 1993): "the purpose of a manipulation . . . is not merely to create an artificial price increase, but also to garner profits from the creation of the artificial trading price." See also, e.g., NASD IM-3310, prohibiting manipulative and deceptive quotations. Accordingly, we request that you immediately bring to our attention any instances of the described behavior so that we can investigate and determine whether a manipulation has taken place. Please call Tom Gira in the Office of Market Regulation at (301) 590-6410 with this information.
I hope this letter is responsive to your inquiry. Please note that the opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation, Inc. This letter responds only to the issues you have raised based on the facts as you have described them in your letter, and does not necessarily address any other rule or interpretation of the NASD or all the possible regulatory and legal issues involved.
Very truly yours,
Mary N. Revell
1 See Securities Exchange Act Release No. 37619A (August 29, 1996); 61 FR 48290 (September 12, 1996).
2 See 17 CFR § 240.11Ac1-1(c)(5)(ii).