Notice To Members 89-39

Proposed New Rule Re: Handling Customer Limit Orders Last Voting Date: June 1, 1989

Published Date:

May 01, 1989

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations
Trading
Training

*These are suggested departments only. Others may be appropriate for your firm.

IMPORTANT MAIL VOTE

EXECUTIVE SUMMARY

Members are invited to vote on a proposed new Section 45 to Article III of the NASD Rules of Fair Practice that would set forth obligations of member firms that accept customer limit orders and continue their own market-making activities in the security that is the subject of the limit order. The rule would also provide a model statement that the NASD believes constitutes adequate disclosure to customers of the manner in which their order may be handled. The text of the proposed rule follows this notice.

BACKGROUND AND ANALYSIS

In Notice to Members 85-12 (February 15, 1985), the NASD set forth its views that, on accepting a customer limit order, a member undertakes a fiduciary obligation and cannot trade for its own account at prices more favorable than the customer limit order unless there is an understanding by the customer as to the priorities that will govern the order. At the time it issued Notice to Members 85-12, the NASD contemplated an amendment to the Rules of Fair Practice that would codify this position. Because an appeal of an NASD disciplinary action involving this issue was pending, however, the NASD did not proceed with such rule making. The Commission has now ruled in that disciplinary action and has affirmed the conclusion reached by the NASD.¹ The NASD Board has, therefore, determined that it is now appropriate to provide guidance to NASD member firms on the type of communication with customers that would satisfy member firms' obligations regarding handling customer limit orders.

The proposed rule change requires that each member firm that accepts and holds an unexecuted customer limit order, and anticipates continuing to trade for its own market-maker account in the security that is the subject of this order at prices equal to or better than the limit price, provide a written statement to each existing customer at the time the rule is adopted and to each new customer upon the opening of an account. This statement would be required to clearly disclose the circumstances under which the firm accepts limit orders and the policies and procedures followed by the firm in handling those orders. The rule further provides the text of a model disclosure statement that the NASD deems to constitute adequate disclosure of the fact that a firm may accept a limit order but not grant the order priority over its own market-making activities.

The NASD Board of Governors believes the proposed rule amendments will provide necessary guidance to NASD members as to what steps they must take to ensure that customers placing limit orders with the firm are treated in a manner consistent with the firm's obligations under Article III, Section 1 of the Rules of Fair Practice. Thus, the Board believes the proposed amendments are necessary and appropriate and recommends that members vote their approval. Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to The Corporation Trust Company. Ballots must be postmarked no later than June 1, 1989.

Questions concerning this notice may be directed to T. Grant Callery, NASD Associate General Counsel, at (202) 728-8285.

PROPOSED NEW SECTION 45 TO ARTICLE III OF THE NASD RULES OF FAIR PRACTICE

(Note: All of the proposed text is new language.)

Sec. 45. Customer Limit Orders

(a) A member firm that has accepted and holds an unexecuted limit order from a customer and continues to trade the subject security for its own market-maker account at prices equal to or better than the limit order price shall not be deemed to have acted in a manner inconsistent with Article HI, Section 1 of the Rules of Fair Practice if the member firm provides to its existing customers as of the effective date of this rule and to each new customer at the time his or her account is opened a written statement clearly disclosing:

(i) the circumstances in which the firm accepts limit orders, and

(ii) the policies and procedures followed by the firm in handling such orders.

(b) If it is the policy of a member firm that acts as a market maker to accept limit orders from its customers but not to grant priority to such orders over transactions for its own market-maker account, a written statement substantially as follows provided by the member firm would be deemed to constitute adequate disclosure to its customers for purposes of paragraph (a) of this Section:

"By accepting your limit order for transactions in securities in the NASDAQ or over-the-counter market, we undertake to monitor the interdealer market and to seek to execute your order only if the inside bid (in the case of a limit order to sell, the highest price at which a dealer is being quoted as willing to buy securities) or the inside asked (in the case of a limit order to buy, the lowest price at which a dealer is being quoted as willing to sell securities) reaches your limit price. We reserve the right, while your limit order remains unexecuted, to trade for our own market-maker account at prices equal to or better than your limit order price and not to execute your order against incoming orders from other customers. For example, if the inside market is 10 bid, 10 1/4 asked and you place a limit order to sell securities at 10 1/8, we" will seek to execute your order only if the inside bid reaches your limit price of 10 1/8 (exclusive of any markdown or commission equivalent that we may charge in connection with the transaction) and, while your order remains unexecuted, we may continue to sell securities for our market-maker account at prices at or above 10 1/8."

¹In the Matter of E. F. Hutton & Co., Securities Exchange Act Release No. 25587 (July 6,1988).