Fiduciary Obligations of Members When Handling Customer Limit Orders
IMPORTANT
TO: All NASD Members and Other Interested Persons
Over the past several months, some questions have arisen relating to members' procedures when executing transactions for their own accounts while in possession of unexecuted customer limit orders for over-the-counter securities. In May 1984, the NASD Board of Governors appointed an Ad Hoc Committee on Limit Orders to review members' responsibilities. Based upon that Committee's recommendation, the Board of Governors has directed that this educational notice be published to provide NASD members guidance concerning their fiduciary obligations with respect to customer limit orders.
At least as far back as 1966, the courts have held that, under federal securities laws and general agency principles, a broker-dealer is a fiduciary when it accepts a customer's limit order and cannot prefer its own interests over the best interests of its customer. The Securities and Exchange Commission also has found violations of the anti-fraud provisions of the federal securities laws where broker-dealers have executed sales or purchases for their own accounts on preferable terms while holding an unexecuted customer order which the broker-dealer could have executed had it chosen to do so.
In one case, 1/ a court found that a broker-dealer had accepted a limit order to sell which remained unexecuted while the firm, a market maker in the security, sold substantial amounts from its own inventory at prices superior to the customer's limit price without prior disclosure to the customer. The court concluded that the broker-dealer's actions in placing its own interests ahead of the limit order customer was a clear breach of fiduciary responsibilities established by common law agency principles. The court also stated that the broker-dealer's "self-preferment" constituted a violation of the anti-fraud provisions of Section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934.
The Board of Governors is concerned that market makers and other members which choose to accept limit orders from customers may be unaware that they have undertaken a fiduciary duty under the above legal principles. A failure to satisfy such legal principles would also raise questions about compliance with Article III, Section 1 of the NASD Rules of Fair Practice requiring observance of high standards of commercial honor and just and equitable principles of trade. In addition, members accepting limit orders from other members undertake a fiduciary responsibility and would be required to observe such principles.
Therefore, to prevent inadvertent failure to comply with Association policies in the handling of limit orders where a member is also buying or selling for its own trading or investment account, the Board of Governors suggests that members take care to observe existing principles of agency law. Under those principles, a member which has accepted a limit order assumes the responsibilities of an agent, whether the transaction is to be confirmed as principal or agent. Nevertheless, the fiduciary responsibility of a member in handling a particular order may be modified by a clear understanding between the parties as to the modification before the order is accepted. In such a situation, full disclosure must have been made.
The Board further suggests that members review their policies and procedures for handling limit orders and take steps to assure that their salespeople, customers and other members understand the way in which their limit orders will be handled. In this connection, the Board of Governors will shortly publish for comment a proposed amendment to Article III, Section 27 of the Association's Rules of Fair Practice which will require that a member's internal supervisory procedures specify whether the firm accepts limit orders and, if so, the procedures it follows in handling and processing them. Where appropriate, members should consult with their counsel to assure that the firm's policies and procedures are consistent with existing legal principles.
Questions concerning this notice may be directed to the undersigned at (202) 728-8319 or to either Dennis C. Hensley or John F. Mylod at (202) 728-8294.
Sincerely,
Frank J. Wilson
Executive Vice President and General Counsel
1/Opper v. Hancock Securities Corporation, 250 F. Supp. 668 (1966), aff'd 367 F.2d 157 (2d Cir. 1966).