Payment for Order Flow
TO: All NASD Members and Other Interested Persons
It has come to the NASD's attention that some members are engaging in a practice whereby market making or wholesale dealers pay retail firms to direct those firms' customer orders to the market maker. The Board of Governors has established a special subcommittee of the National Business Conduct Committee to study potential problems related to these arrangements. That subcommittee is continuing its study, but on the basis of the analysis thus far, the Board of Governors has concluded that members should be alerted to two important areas: the requirement for firms to disclose fully all compensation received in connection with payment arrangements, and the requirement for firms to assure best execution of trades processed under these arrangements. These issues are discussed below.
Disclosure of Compensation
Rule 10b-10 1/ under the Securities Exchange Act of 1934 prescribes information that a broker or dealer must disclose to its customer on the customer's confirmation. The rule requires that the broker-dealer disclose to the customer, among other things:
... the amount of any remuneration received or to be received by him from [his] customer in connection with the transaction ... and . . . the source and amount of any other remuneration received or to be received by him in connection with the transaction . . . 2/
The rule provides, however, that in the case of ordinary secondary market trades, the confirmation can simply state whether other remuneration has been or will be received and that the source and amount of this remuneration will be furnished upon written request. In the context of payments for order flow, therefore, firms receiving compensation from market makers should disclose that they are receiving "other remuneration" in connection with the transaction. It appears Rule 10b-10 does not require disclosure on the confirmation of the source and amount of this remuneration, but permits that information to be furnished upon request. 3/
Under Rule 10b-10 therefore, payments received by a retail firm from a market maker in return for their directing order flow to the market maker should be considered additional compensation received in connection with each transaction. Any firm receiving such compensation should disclose information on the source and amount of the compensation in an appropriate manner. Firms may wish to consult with their counsel to determine the manner in which this disclosure requirement should be satisfied.
Best Execution
The Interpretation of the Board of Governors on Execution of Retail Transactions, 4/ the "Best Execution Interpretation," requires that:
[i]n any transaction for or with a customer, a member and persons associated with a member shall... buy or sell ... so that the resultant price to the customer is as favorable as possible under prevailing market conditions.
This requirement is clearly applicable to situations in which firms direct all of their order flow to a particular dealer. Although examinations by the NASD indicate that firms that have entered into agreements for the payment for order flow are obtaining the best execution of their customers' transactions, it is important for all firms to assure that they continue to obtain the best execution of trades subject to these arrangements. This area will continue to be reviewed by NASD examiners during on-site examinations to ensure ongoing compliance.
As noted earlier, the NASD subcommittee reviewing arrangements for the payment for order flow has not yet concluded its study and may issue additional recommendations with respect to these arrangements.
Questions or comments regarding this notice may be directed to John E. Pinto, NASD Surveillance Department, (202) 728-8233 or Dennis C. Hensley, NASD General Counsel's Office, (202) 728-8245.
Sincerely
Frank J.Wilson
Executive Vice President and General Counsel
1/ 17 CFR §240.10b-10.
2/ Rule 10b-10(a)(7), 17 CFR § 240.10b-10(a)(7).
3/ Article III, Section 12 of the NASD Rules of Fair Practice contains requirements that are basically similar to those in Rule 10b-10. Section 12 specifically states that a member:
. . . shall give or send to [its] customer written notification disclosing . . . the source and amount of any commissions or other remuneration received or to be received by such member in connection with the transaction.
The NASD Ad Hoc Committee on Rule and By-Law Amendments has recommended that Section 12 be rescinded as redundant to Rule 10b-10, and that recommendation will be published for comment shortly.
4/ NASD Manual (CCH) p. 2035.