Intersection between the NASD's Limit Order Protection Rule and Rule 206(3) of the Investment Advisors Act of 1940 for fee-based wrap accounts.
[NASDAQ Staff Interpretive Letter]
July 3, 1997
Re: Exemption from Limit Order Protection Rule for Registered Investment Advisers Maintaining Wrap Fee Account Programs
In your letter dated April 28, 1997 as supplemented by conversations with staff, you request confirmation that [Broker/dealer] would not be prohibited, under NASD Conduct Rule 2110 and interpretation IM-2110-2 (the "Limit Order Protection Rule"), from executing certain transactions in its market making capacity ahead of unexecuted limit orders transmitted to another broker-dealer for execution that [Broker/dealer] receives from fee-based wrap accounts to which [Broker/dealer] provides non-discretionary investment advisory and brokerage services.
We understand the facts to be as follows:
[Broker/dealer] is registered with the Securities and Exchange Commission ("SEC") as a broker-dealer and as a registered investment advisor ("RIA"). [Broker/dealer] also is 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"). In its capacity as a RIA, [Broker/dealer] provides non-discretionary investment advisory and brokerage services for fee-based wrap accounts ("Wrap Accounts").
As you note, Section 206(3) of the Invest Advisers Act of 1940 ("Investment Advisers Act"), provides that when acting as principal for his own account, a RIA may not "knowingly. . . sell any security to or purchase any security from a client. . .without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to the transaction." Section 206(3) further provides that, "[t]he prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker-dealer if such broker-dealer is not acting as an investment adviser in relation to such transaction." According to your letter, to ensure compliance with this prohibition, [Broker/dealer] does not act as a principal in connection with the Wrap 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 that security that is the subject of the order.
In this context, however, [Broker/dealer] also must comply with the Limit Order Protection Rule, which 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] sends 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 executed immediately. 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 the Investment Advisers Act, which prohibits [Broker/dealer] from doing so.
The staff believes that in this situation where [Broker/dealer] is acting as a RIA to the Warp Accounts, compliance with the Investment Advisers Act supercedes the Limit Order Protection Rule. Accordingly, to the extent that [Broker/dealer] is handling limit orders for Wrap Accounts for which it acts as a RIA, 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 Investment Advisers Act. 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 John F. Malitzis, Senior Attorney, at (202) 728-8245.
Thomas R. Gira
Associate General Counsel
Office of General Counsel
The NASDAQ Stock Market