SEC Approves Extension Of Limit Order Protection Principles To Certain OTCBB Securities On A Pilot Basis

INFORMATIONAL

Limit Order Protection

Executive Summary

On February 8, 2001, the Securities and Exchange Commission (SEC) approved new National Association of Securities Dealers, Inc. (NASD^®) Rule 6541 (Rule), which, on a pilot basis, applies the basic customer limit order protection principles that presently apply to Nasdaq^® securities to certain designated securities that are quoted on the OTC Bulletin Board (OTCBB). The Rule, in general, will prohibit member firms that accept customer limit orders in these securities from trading "ahead" of their customers for their own account at prices equal or superior to the limit orders, without executing them at the limit price. The text of the Rule is contained in Attachment A.

The Rule extends the principles that are incorporated in IM-2110-2 (Manning Interpretation) for the first time to some OTCBB stocks, although the Rule differs in application from the Manning Interpretation in certain specific respects. Specifically, Rule 6541: (i) contains a lower size threshold for the order size at which firms may negotiate terms and conditions regarding the acceptance of limit orders; (ii) prescribes a longer maximum time limit (5 minutes) within which execution of a customer order will be deemed to be "contemporaneous" with an execution for the firm's account; (iii) will apply from 9:30 a.m. to 4:00 p.m. with no option for applicability between 4:00 p.m. and 6:30 p.m.; (iv) extends protection to limit orders that are marketable at the time of receipt; and (v) prescribes a different minimum level of price improvement that a firm must provide in order to trade ahead of a customer limit order. This Notice contains a series of questions and answers that are designed to clarify the application of the Rule to various circumstances.

The Rule will become effective on August 1, 2001, for a pilot period until February 8, 2002, although the minimum price improvement standard set forth in subsection (b) will be effective on a pilot basis from August 1, 2001 until November 1, 2001. The Rule will initially apply to 300 securities, and will be phased in over a period of two weeks, as described in Attachment B to this Notice. During the pilot period, an additional 25 securities may be selected for inclusion in the pilot program, which will be identified in advance in later communications.

Questions/Further Information

Questions concerning this Notice may be directed to Jeffrey Davis, Nasdaq Office of General Counsel, at (202) 728-8461; the NASD Regulation Market Regulation Department; or visit www.otcbb.com.

Background And Information

The SEC has approved a Nasdaq rule change that will, on a pilot basis, apply limit order protection to a select subset of securities traded on the OTCBB.¹ The text of this Rule is contained in Attachment A.

NASD-IM-2110-2, the Manning Interpretation, currently prohibits NASD member firms from trading ahead of customer limit orders in Nasdaq securities. A member firm, upon acceptance of a customer's limit order, undertakes a fiduciary duty to its customer and cannot then trade for its own account at prices more favorable than the customer's order. In general, under the Manning Interpretation, unless a specific exception applies, a member firm holding a customer limit order many not trade for its own account at a price equal or superior to the limit price, unless it contemporaneously executes the customer order at the limit price.

Nasdaq believes that it is now appropriate to extend the principles of the Manning Interpretation to the OTCBB. NASD Rule 6541, which will apply limit order protection to a select subset of OTCBB securities, will be instituted as a pilot program. While NASD members will be under no obligation to accept limit orders, those willing to do so will be prohibited from trading ahead for their own accounts in the securities covered by the pilot program at prices equal or superior to any customer limit orders held by the firm, regardless of whether those orders are from their own customers or from customers of firms who have routed those orders to the member for execution.²

The pilot program will apply to 325 OTCBB securities.³ Nasdaq has selected or will select securities for the pilot that it believes will afford it the best opportunity to test the effects of the Rule on a wide range of OTCBB securities. The securities fall into the following categories:

• the 200 most actively traded OTCBB securities.



• 100 securities have been selected as a representative cross-section of the remaining OTCBB securities.



• up to 25 securities will be selected at a later date on a case-by-case basis based on a determination that these securities are highly liquid and widely held, or where they have recently been delisted from Nasdaq or an exchange.

The Rule will be implemented in a series of phases, beginning with the 200 actively traded securities, and proceeding to the 100 representative securities. The final 25 securities will be named in subsequent communications. The list of securities, tickersymbols, and their respective phase-in dates are contained in Attachment B.

Nasdaq will monitor the operation of the Rule and its effect on the OTCBB market throughout the pilot period. Prior to the end of the pilot, Nasdaq will evaluate the impact of the Rule, report its findings to the SEC and, thereafter, determine the appropriate course of action.

Unless otherwise indicated, the Rule applies the Manning Interpretation to the OTCBB, as well as relevant guidance contained in NASD Notices to Members ⁴ or SEC releases.⁵ The questions and answers that follow describe how these principles will apply to securities that are subject to the pilot program. In addition, members should be cognizant of their best execution responsibilities when receiving customer orders for any OTCBB or other security.

Nasdaq recognizes that there are certain operational and other characteristic differences between the OTCBB and the Nasdaq National Market and SmallCap Market. Accordingly, the Rule contains provisions that differ from the application of the Manning Interpretation in four significant respects.

First, under paragraph (b), members are not obligated to execute a customer limit order if they provide the required price improvement over the limit price. For customer limit orders priced at or inside the current inside spread, the minimum price improvement required is, at least, the lesser of (i) one cent or (ii) one-half of the current inside spread.⁶ For customer limit orders priced outside the current spread by $.01 or less, the incoming order must be executed at or better than the inside bid (for held buy orders) or offer (for held sell orders). Unlike the Manning Interpretation, under the Rule, customer limit orders priced more than $.01 away from the inside receive no Manning protection and, therefore, no price improvement is required with respect to those orders.

The "current inside spread" for these purposes is considered to be the difference between the best reasonably available bid and offer. Accordingly, members must use the same diligence in finding the best prices when trading OTCBB securities as they do when trading Nasdaq National Market and SmallCap securities, and they may not rely exclusively on OTCBB quotes in determining the inside spread when there are other quotations available in another system of general circulation that regularly disseminates quotations of identified broker/dealers. What is "reasonably available" is a fact and circumstances analysis, and is separate from the analysis, required by the three-quote rule.

The second difference between the Rule and the Manning Interpretation is that, under paragraph (c), a member may negotiate special terms for acceptance of limit orders, including an agreement that the firm may trade ahead, with respect to orders that are for an "institutional account" as defined in Rule 3110(c)(4), or that are for at least 10,000 shares and greater than $20,000 in value. Under the Manning Interpretation, the comparable dollar value that qualifies for this exception is $100,000. This difference reflects the lower average dollar amount for OTCBB trades.

Third, under paragraph (d) of the Rule, in order for a transaction with a customer to be considered "contemporaneous" with a trade for the member's own account, it must be executed as quickly as possible, but in no case later than five minutes after the proprietary transaction. Under the Manning Interpretation, "contemporaneous" has been interpreted to require an execution as quickly as possible, but, absent reasonable and documented justification, within one minute.⁷ Nasdaq believes the longer time period is justified because there presently is no automated order delivery and execution system for OTCBB securities, and executions generally take longer than is the case for Nasdaq securities. Consistent with the approach under the Manning Interpretation, however, the five-minute standard is intended to be an outside limit, absent extraordinary circumstances, and not a normal practice.

Further, the program will apply only from 9:30 a.m. to 4:00 p.m., in contrast to the option available to customers for the application of the Manning Interpretation to Nasdaq securities until 6:30 p.m. This difference reflects the fact that quotes by market makers on the OTCBB are required to be firm only until 4:00 p.m.

Members should also note that the Rule requires that protection be provided to limit orders that are marketable at the time of receipt, unlike the Manning Interpretation, which specifically excludes such orders from its requirement.

Nasdaq will consider the ppropriateness of all of these provisions, and whether they should be modified, as it evaluates the Rule's operation prior to the end of the pilot period.

The following questions and answers help to illustrate the scope of the pilot program and the application of the Rule.

I. Scope Of The Pilot Program

Question 1: When is NASD Rule 6541 effective?

Answer 1: NASD Rule 6541 will operate on a pilot basis from August 1, 2001 to February 8, 2002. The price improvement requirements set forth in paragraph (b) will operate on a pilot basis from August 1, 2001 until November 1, 2001.

Question 2: What OTCBB securities are covered by the Rule?

Answer 2: Nasdaq intends to apply the pilot program to 325 OTCBB securities. A security subject to the Rule will have the identifier " following its name as it appears on the Nasdaq Workstation II. Of the 325 OTCBB securities, 200 are the most actively traded OTCBB securities based on their respective average daily trading volume over the period from January and February of 2001. An additional 100 securities were selected as a representative cross-section of all remaining OTCBB securities. Attachment B to this Notice lists the 300 securities, their tickersymbols, and respective phase-in dates. The remaining 25 securities will be selected on a case-by-case basis after the initial phase-in period has been completed. Nasdaq will provide members appropriate notice before incorporating any of the remaining 25 securities into the pilot program.

Question 3: What time during the trading day will members be subject to Rule 6541?

Answer 3: The requirements of the Rule will only apply from 9:30 a.m. until 4:00 p.m. If the OTCBB's market hours are shortened due to holidays or other events, the hours of the Rule's application would be adjusted accordingly.

Question 4: Does Rule 6451 apply to NASD members that no longer submit bid and offer quotations to the OTCBB for a security covered by the pilot program?

Answer 4: Provided at least one market maker is submitting quotations to the OTCBB for a security covered by the pilot program, the Rule applies to all NASD members effecting transactions in that security with customers, regardless of the place of execution. For example, if Market Maker A (MMA) and Market Maker B (MMB) both submit quotations for ABCD security on the OTCBB, and MMA later ceases to submit quotations for ABCD on the OTCBB and trades ABCD through Pink Sheets Electronic Quotation Service (or any other quotation medium), MMA must still protect limit orders it accepts in accordance with the requirements of the Rule.⁸

Question 5: Must an NASD member accept a customer's limit order?

Answer 5: No. Rule 6541 specifically provides that the NASD does not impose any obligation upon members to accept and handle limit orders from any customer.

Question 6: If a non-market maker holds a customer's limit order, can it trade ahead of that limit order?

Answer 6: No. Rule 6541 specifically states that "members" are prohibited from trading ahead of customer limit orders that a member accepts in securities quoted on the OTCBB.

II. Treatment Of Orders

Question 7: Basic Obligation

• Inside Market for OTCBB Security—ABCD



• 5 bid—5.50 ask



• Market Maker A (MMA) holds an undisclosed customer limit order (from its own firm or a customer limit order from another broker/dealer) to buy 1,500 shares at 5.25.



• MMA receives a market order to sell 1,000 shares from another customer.



• What must MMA do?

If MMA executes the market order to sell at a price equal to or less than 5.25, Rule 6541 requires that MMA protect the limit order at its price. Therefore, the limit order would have to be executed at its price. The remaining 500 shares of the limit order would continue to reside undisplayed on MMA's book, and MMA could not trade ahead of that order without executing it at the limit order price.

Question 8: Market Maker and Order Entry Firm

• Inside Market for OTCBB Security—ABCD



• 5 bid—5.50 ask



• Market Maker A (MMA) holds an undisclosed customer limit order (from its own customer or from another broker/dealer) to buy 1,500 shares at 5.25.



• MMA is quoting publicly 5 bid.



• Broker/dealer B (BD-B) telephones MMA to sell 1,000 shares at the market for BDB's wn account (i.e., noncustomer limit order) where MMA has no agreement or understanding to treat BD-B's orders as customer orders or otherwise provide them with best execution.



• What must MMA do?

Answer 8: MMA may execute BD-B's market order to sell at MMA's published quote of 5. MMA does not owe a best execution obligation to a non-customer where no understanding or expectation of treatment as a customer has been reached by MMA and BD-B. Broker/dealers are not considered customers for the purposes of this obligation.

If MMA executes BD-B's order at 5, MMA, however, has traded through the customer limit order it holds. Under Rule 6541, therefore, MMA must execute 1,000 shares of the customer limit order at the limit price of 5.25.

Question 9: Limit Order Protection on the Other Side of the Market

• Inside Market for OTCBB Security—ABCD



• 8 bid—8.20 ask



• Market Maker A (MMA) holds a customer limit order to buy priced at 8.10 and a limit order from another customer to sell priced at 8.10



• MMA buys ABCD at 8 and immediately executes as principal the limit order to buy.



• Would MMA then also have to execute the limit order to sell because it sold ABCD at a price equal to the price of the limit order to sell?

Answer 9: Once the firm has executed the limit order it has traded through, it has satisfied its obligation under Rule 6541. Where Rule 6541 obligates a member to execute a limit order on one side of the market, that Rule does not trigger an obligation to execute another limit order on the opposite side of the market.

Question 10: Are member-tomember limit orders subject to Rule 6541?

Answer 10: Yes. Customer limit orders received by one member firm and then sent to another member firm, typically a market maker in the security, for handling and execution must be protected. For example, in Question 8, MMA must protect the customer limit order regardless of whether the order is from its own customer or the customer of another broker/dealer. In the same example, if MMA sends the customer limit order to another market maker, MMA would not be able to trade through the customer limit order without violating the Rule. Members must monitor the status of the order and not trade ahead of it until the order has been executed.

Moreover, order-entry firms that forward customer orders to market makers for execution will continue to be subject to their duties of best execution and will owe a fiduciary duty to their customers with respect to those orders. Accordingly, member firms should routinely monitor the handling of their customer limit orders to ensure that the executing broker is complying with the Rule.⁹

III. Minimum Price Improvement

Question 11: Minimum Price Improvement to Avoid Rule 6541 Violation

• Inside Market for OTCBB Security—ABCD



• 8 bid—8.50 ask



• Market Maker A (MMA) receives a customer limit order to buy at 8.25 for 2,000 shares.



• MMA receives a market order to sell 2,500 shares.



• May MMA offer the market order price improvement over the 8.25 limit order and execute the market order for its own account? If so, what is the minimum amount of price improvement allowable?

Answer 11: MMA is allowed to execute the market order at a price better than the limit order. Rule 6541 states that the minimum amount of price improvement that would permit a market maker to avoid a violation of the Rule is the lesser of $0.01 (1 cent) per share or one-half the current inside spread. Because one-half of the current inside spread for ABCD (0.50 x .50 = 0.25) is greater than $0.01, MMA could trade ahead of the limit order at 8.26 without violating the Rule.

Question 12:

• Inside Market for OTCBB Security—ABCD



• 5 bid—.01 ask



• Market Maker A (MMA) receives a customer limit order to buy at 5.004 for 2,000 shares.



• MMA receives a market order to sell 1,000 shares and immediately executes that order on a proprietary basis.



• May MMA offer the market order price improvement over the 5.004 limit order and execute the market order for its own account? If so, what is the minimum amount of price improvement allowable?

Answer 12: Since MMA has executed within $0.01 off the customer limit order priced inside-the-spread, MMA would be obligated to protect that order and execute 1000 shares of the customer limit order at a price of 5.004. If MMA wished to avoid a Manning obligation with respect to that 5.004 buy limit order, MMA would have to execute its proprietary trade at a price at least $0.005 better than that limit order and execute at 5.009, because $0.005 represents one-half of the correct inside spread.

Question 13:

• Inside Market for OTCBB Security—ABCD



• 10 bid—10.01 ask



• Market Maker A (MMA) receives a customer limit order to buy at 9.993 for 2,000 shares.



• MMA receives a market order to sell 700 shares and immediately executes that order on a proprietary basis at 10.



• Is MMA obligated to execute the held limit order?

Answer 13: No. Since the market maker's 700 share proprietary order was executed at a price (10.00) that is at least equal to the inside bid, it would not be obligated to execute that limit order. Similarly, if the market remained at 10.00 to 10.01 and MMA held a customer limit order to sell priced at 10.016, MMA could trade proprietarily with an incoming buy order without triggering a Manning obligation with respect to the 10.016 outside-the-spread limit order if the market maker executes its proprietary trade at a price of at least 10.01.

Question 14:

• Inside Market for OTCBB Security—ABCD



• $0.026 bid—$0.032 ask



• Market Maker A (MMA) receives a customer limit order to buy at 0.03 for 500 shares.



• MMA receives a market order to sell 700 shares and immediately executes that order on a proprietary basis at $.032.



• Is MMA obligated to execute the held limit order?

Answer 14: Yes. Since MMA has executed within $0.01 of the inside-the-spread buy limit order of 0.03, MMA would be obligated to protect that order and execute it at a price of 0.03. If MMA wished to avoid a Manning obligation with respect to the held 0.03 buy limit order, MMA would have to execute its proprietary trade at a price at least $0.003 better than that limit order and execute at 0.033.

Question 15: For purposes of the price improvement exception from Rule 6541, what does "inside spread" mean?

Answer 15: Rule 6541(b) states that for the purposes of the Rule, the inside spread shall be defined as the difference between the best reasonably available bid and offer in the subject security. The determination of what is "reasonably available" is largely factual and best determined on a caseby-case basis; Nasdaq would expect, however, that members would monitor not only the OTCBB quotations distributed as part of the Nasdaq Level 1 service, but also quotations for those same securities in Pink Sheets Electronic Quotation Service (and any other system of general circulation to broker/dealers that disseminates real-time quotations of identified broker/dealers in securities quoted on the OTCBB).

For example, if the current inside spread quoted on the OTCBB is 8—8.20, and the current inside spread quoted on the Pink Sheets Electronic Quotation Service is 7.75—8.10, then the current "inside spread" for the purposes of the Rule is 8—8.10.

IV. Marketable Limit Orders

Question 16: Limit Orders that are Marketable at Time of Receipt

• Inside Market for OTCBB Security—ABCD.



• 5 bid—5.20 ask.



• Market Maker A (MMA) has a market order to sell ABCD for 1,000 shares.



• MMA then receives a customer limit order to sell 1,000 shares at 5.



• MMA fills the market order to sell at 5 for 1,000 shares.



• The inside bid for ABCD moves to 5.05.



• MMA does not execute the customer limit order.



• Did MMA violate the Rule by not executing the customer limit order?

Answer 16: Yes. While IM-2110-2 specifically excludes from its coverage limit orders that are marketable at the time of receipt, Rule 6541 provides no similar exclusion. Accordingly, MMA is prohibited from trading ahead of the customer limit order, regardless of whether the limit order was marketable at the time of receipt. Nasdaq will monitor the treatment of marketable limit orders during the operation of the pilot program to determine whether marketable limit orders in OTCBB securities should be treated as market orders for purposes of determining execution priority and be excluded from the requirements of the Rule.

V. Contemporaneous Execution Of Limit Order

Question 17: Once a member is obligated to execute a limit order, how quickly must it execute the limit order?

Answer 17: If a member trades through a limit order that it has accepted, a member must contemporaneously execute such limit order. To meet this obligation, a member must execute the limit order as quickly as possible. The limit order must at least be executed within five minutes after the member has traded at a price equal to or superior to that of the customer limit order. The Rule is not intended to allow members to wait for five minutes before executing the customer limit order. Under normal market conditions, a member should be able to execute the customer limit order well before the expiration of the five minute period. If extraordinary circumstances beyond the member's control (e.g., OTCBB systems problems, telephone outages, volume-related queues) cause the member to exceed the five-minute time period, the member should continue to attempt to execute the order as quickly as possible while sufficiently documenting the particular conditions or circumstances causing the delay.

VI. Net Trades

Question 18: Member's Obligation Regarding a Net-Price Limit Order

• Inside Market for OTCBB Security—ABCD



• 5 bid—5.50 ask



• Market Maker A (MMA) accepts a 500 share order to buy from a customer, who states that he or she wants to trade with total transaction costs not to exceed 5.50.



• MMA charges a markup of 0.10.



• What must MMA do?

Answer 18: First, the member must inform the customer at the time of order entry that the limit order will be held and protected at 5.40 (5.50—0.10). Accordingly, the member must not buy for its own account at 5.40 or below, without filling the customer's order at the protected price, up to the number of shares that the member has traded.

For example, assume that while holding the 500-share limit order to buy at 5.40, MMA receives and executes a market order to sell 500 shares in that security that the member purchases at its bid of 5. Because MMA bought 500 shares at a price better than the 500-share customer limit order at 5.40, MMA must sell 500 shares to the customer placing the limit order at 5.40. MMA must report the trade through the Automated Confirmation Transaction (ACT) service at 5.40, with the price exclusive of any markup or other remuneration. On the confirmation sent to the customer, the member must disclose the reported trade price, 5.40, the price to the customer, 5.50, and the difference between them, 0.10, as the member's remuneration for the transaction.

Members are not permitted to report trade prices in such net transactions in a manner inconsistent with the stated agreement between the customer and the member. Thus, in net transactions, after the customer and the member have agreed to the actual limit price at which a limit order is protected, it is not permissible for a member to report a trade with the customer at a price higher (lower) than the agreed-upon price in the context of a buy (sell) limit order and report a smaller markup (or markdown) on the confirmation.

VII. Negotiated Terms and Conditions Of Certain Limit Orders

Question 19: Does Rule 6541 apply to institutional accounts?

Answer 19: Rule 6541 does not apply if an institutional account meets the definition of "institutional account" in Rule 3110(c)(4) and the member firm handling the order has made the terms and conditions of how the member will handle the limit order clear to the institutional account customer. An "institutional account" is limited to a bank, savings and loan association, insurance company, or registered investment company, SEC or state registered investment adviser, or any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.

Question 20: Does Rule 6541 apply to large transactions?

Answer 20: Rule 6541 does not apply if the member firm has agreed to the terms and conditions as to how the member will handle the large limit order. A member may negotiate terms and conditions for the handling of a limit order for an OTCBB security of at least 10,000 shares that has a value greater than $20,000 or on orders for "institutional accounts." The member firm cannot impose terms and conditions on orders for accounts that do not meet the definition of "institutional account" or orders that are not appropriately sized. These exceptions to the Rule apply whether they are accounts of the member firm's own customers or are accounts of another member firm's customers.

Question 21: How should member firms disclose the terms and conditions to their respective customers?

Answer 21: As noted, the Rule allows member firms to accept limit orders subject to terms and conditions only with respect to institutional accounts or orders that are 10,000 shares or more, as long as the value of that order is $20,000 or more. While the Rule does not dictate the means by which members must disclose the terms and conditions, such terms and conditions under which institutional accounts or appropriately sized customer limit orders are accepted must be made clear to customers at the time the order is accepted by the member firm, and the member must be prepared to demonstrate compliance with the condition.

Question 22: How should member firms disclose the terms and conditions to customers of another member firm?

Answer 22: The member firm imposing the terms and conditions of the limit order must ensure that those terms and conditions are clearly communicated to the customer.

The means for disclosure and communication may be arranged between the market maker holding the limit order and the member firm initially accepting the limit order from the customer. If the firm holding the order chooses to rely on the order-entry firm for disclosing and explaining the terms and conditions and securing the customer's acceptance, the market maker must reasonably determine that an order-entry firm's disclosure and acceptance procedures are effective and being followed.

Endnotes

¹ Exchange Act Release No. 34-43944 (February 8, 2001).

² Order entry firms that forward customer orders to dealers for execution will continue to be subject to their duties of best execution and will owe a fiduciary duty to their customers with respect to those orders. Accordingly, firms should routinely monitor the handling of their customer limit orders to ensure that the executing broker is complying with the provisions of the Rule.

³ A security subject to NASD Rule 6541 will have the identifier " following its name as it appears on the Nasdaq Workstation II.

⁴See, e.g., Selected NASD Notices to Members: 95-43, 95-67, 96-10.

⁵See Securities Exchange Act Release Nos. 34297 (June 29, 1994) (SRNASD-93-58); 35751 (May 22, 1995) (SR-NASD-94-62); 41990 (October 7, 1999) (SR-NASD-99-44).

⁶ The SEC approved Nasdaq's proposal to, among other things, amend the Manning Interpretation in connection with the transition to decimal trading for Nasdaq NM and SmallCap stocks. Pursuant to that pilot program, which extends until March 2, 2002, the minimum price improvement with respect to securities traded under the Decimals Implementation Plan for the Equities and Options Markets would be ne cent. See Securities Exchange Act Release No. 44030 (March 2, 2001) (SR-NASD-01-09).

⁷NASD Notice to Members 95-67 (Question and Answer No. 5); NASD Notice to Members 98-78.

⁸ Subsection (e)(2) of Rule 6541 states that the Rule applies regardless of whether the subject security is additionally quoted in a separate quotation medium. This provision is intended to clarify that market makers will not be permitted to avoid their obligations under the Rule by trading via another quotation medium.

⁹See NASD Notice to Members 01-22.

ATTACHMENT A

6541. Limit Order Protection

Attachment B