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Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Limit Order Protection for OTC Bulletin Board Securities

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Start Preamble June 7, 2000.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) [1] and rule 19b-4 thereunder,[2] notice is hereby given that on April 19, 2000, the National Association of Securities Dealers, Inc. (“NASD” or “Association”), through its wholly owned subsidiary, the Nasdaq Stock Start Printed Page 37809Market, Inc. (“Nasdaq”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by Nasdaq. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

1. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

Nasdaq is proposing a new Rule 6541 to implement a pilot program specifically prohibiting member firms from trading ahead of customer limit orders in designated OTC Bulletin Board (“OTCBB”) securities. Below is the text of the proposed rule change. Proposed new language is in italics.

6541. Limit Order Protection

(a) Members shall be prohibited from “trading ahead” of customer limit orders that a member accepts in securities quoted on the OTCBB. Members handling customer limit orders, whether received from their own customers or from another member, are prohibited from trading at prices equal or superior to that of the customer limit order without executing the limit order. Members are under no obligation to accept limit orders from any customer.

(b) Notwithstanding subparagraph (a) of this rule, a member may negotiate specific terms and conditions applicable to the acceptance of limit orders only with respect to such orders that are:

(1) for customer accounts that meet the definition of an “institutional account” as that term is defined in Rule 3110(c)(4); or

(2) for 10,000 shares or more, and greater than $20,000 in value.

(c) Contemporaneous trades

A member that trades through a held limit order must execute such limit order contemporaneously, or as soon as practicable, but in no case later than five minutes after the member has traded at a price more favorable than the customer's price.

(d) Application

(1) This rule shall apply only to OTCBB securities specifically identified as such through the Nasdaq Workstation service.

(2) This rule shall apply, regardless of whether the subject security is additionally quoted in a separate quotation medium.

(3) This rule shall apply from 9:30 a.m. to 4:00 p.m. Eastern Time.

(4) This rule shall be in effect until [12 months from date of Commission approval].

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, Nasdaq included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. Nasdaq has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

Background. NASD IM-2110-2 (commonly known as the “Manning Rule”) was adopted in 1994 [3] and further amended in 1995 [4] to prohibit NASD member firms from trading ahead of customer limit orders in Nasdaq securities. The impetus for this rule was a case brought several years earlier by a customer of a member firm, William Manning, who alleged that the firm had accepted his limit order, failed to execute it, and violated its fiduciary duties to him by trading ahead of the order. In the Manning decision, the NASD found and the SEC affirmed that a member firm, upon acceptance of a customer's limit order, undertakes a fiduciary duty and cannot trade for its own account at prices more favorable than the customer's order.[5] In the wake of this decision, however, members continued to trade ahead of customer limit order provided the practice was fully disclosed to the customer.

Through adoption of IM-2110-2, the NASD effectively eliminated the disclosure “safe-harbor” that developed after the Manning decision for all securities listed on Nasdaq. In proposing the interpretation, the Nasdaq recognized the growing importance of Nasdaq as a major equity market and noted that such a rule would enhance the image of the market by creating a more equitable, fair, and accessible market for all investors. Indeed, although the Manning Rule does not explicitly apply to OTCBB issues, it has always been the position of NASD and Nasdaq that a member owes a duty of best execution to all accepted customer orders.

Nasdaq now believes that it is appropriate to employ this same rationale in applying limit order protection to the OTCBB.[6] Over the past six years, the OTCBB has evolved into a marketplace for numerous securities, with market makers providing real-time quotations available for reviewing by other market participants.[7] In 1994, the average daily volume in all OTCBB securities was approximately 28.5 million shares, a number that grew to more than 300 million shares per day in 1999. OTCBB trading volume in February 2000 averaged more than 1.2 billion shares per day.[8]

As a result of this increase in trading volume, the OTCBB has become a more open and transparent market in which investors can obtain considerable information regarding the quoted issuers. For instance, by July 2000, all issuers quoted on the OTCBB will be required to provide updated financial information to the Commission, or to banking or insurance regulators, on a periodic basis.[9] The accessibility of this disclosure information, along with last-sale information available through the Internet, has provided the retail investor with additional tools to make educated investment decisions regarding many formerly obscure OTCBB issuers.

In short, the OCTBB is far different today than it was at its inception ten years ago. In light of these notable changes, the increased retail participation, and the continuous efforts by Nasdaq and the NASD to provide fair Start Printed Page 37810and efficient markets for all investors, Nasdaq now proposes to extend limit order protection to investors of OTCBB securities.

Proposed Pilot Program. Nasdaq proposes to institute a 12-month pilot program that will apply limit order protection to a select subset of OTCBB securities.[10] Nasdaq will monitor the progress of this rule and its effect on the market throughout the entire period. Prior to the completion of this pilot, Nasdaq will evaluate the impact of the proposed rule and report its findings to the Commission and, thereafter, determine the appropriate course of action.

Nasdaq intends to examine the effects of the proposed rule by applying it to approximately 325 OTCBB securities.[11] Securities subject to the proposed rule will be positively designated as such through the Nasdaq Workstation II.[12] Nasdaq will select as one sample set the 200 most actively traded OTCBB securities, which will be selected on the basis of specific price and volume parameters. An additional 100 securities will be selected as a representative cross-section of all remaining OTCBB securities, therein providing an opportunity to test the effects of this rule upon the wide variety of securities quoted on the OTCBB. The implementation of the proposed rule upon these 300 securities would be phased in over a period of several weeks, beginning with the top 200 actively traded securities, then proceeding to the 100 representative cross-section securities. This phase-in process is intended to protect against any unanticipated or deleterious effect that could occur through an immediate application to all securities.

The remaining 25 securities would consist of selected securities added to the OTCBB after the initial phase-in period had been completed. This additional allowance is intended to provide Nasdaq with the flexibility to impose the proposed rule upon securities that necessitate its protections. It is expected that these securities, which would be selected by Nasdaq on a case-by-case basis, would be those that are highly liquid and widely held by retail investors. The securities expected to be included in this category are those that have been delisted from Nasdaq or an exchange and start trading on the OTCBB.

Application of the proposed rule is intended to substantially mirror IM-2110-2, although some minor modifications, discussed below, have been afforded due to the distinction between Nasdaq and the OTCBB. While members will be under no obligation to accept limit orders, those willing to do so would be prohibited from trading at prices equal or superior to any held customer limit orders, 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.[13] This rule would apply even to those members who, in the past, have fully disclosed to their customers that they may trade ahead of customer limit orders.

As with IM-2110-2, Nasdaq recognizes that filling institutional-sized orders involves differing trading strategies and risks, and that an application of limit order protection to all orders could prove unduly burdensome to those members willing to accept institutional orders. For that reason, Nasdaq has determined that the member may apply terms and conditions concerning limit order protection when accepting an institutional-sized order [14] or an order from an institutional account.[15]

An additional distinction in the application of limit order protection to OTCBB securities will be the time interval allocated for “contemporaneous” executions. In Nasdaq securities, a member is not deemed to have traded ahead of a customer limit order if the member provides a contemporaneous execution of the customer's order. “Contemporaneous” has been interpreted by Nasdaq to require an execution as quickly as possible, but absent reasonable and documental justification, within one minute.[16] This interpretation recognizes that additional time beyond the one minute provision may be necessary during unusual market conditions (e.g., at the opening or upon the commencement of trading following a trading halt or an initial public offering), provided that the member has taken all reasonable steps to execute the trade as soon as possible.[17]

Unlike Nasdaq, in which trades may be executed or delivered through automated means, the OTCBB service provides no means of automated communication. Participants in OTCBB securities are generally required to contact each other via telephone, a time consuming process that can prove especially burdensome during periods of high trade volume. Recognizing this distinction, Nasdaq proposes to require a “contemporaneous” trade to be executed as quickly as possible, but no later than five minutes after becoming marketable. If market conditions or other circumstances cause the member to exceed this five-minute requirement, the member should continue to attempt to execute the order as quickly as possible, while sufficiently documenting the particular conditions or circumstances causing this delay. Nasdaq will study this provision and modify it as appropriate at the conclusion of this pilot.

This rule will apply only during normal market hours of 9:30 a.m. to 4:00 p.m. Although the OTCBB service is available from 7:30 a.m. to 6:30 p.m., prices on the OTCBB are required to be firm only during the normal market hours. The hours of application of this rule would adjust accordingly on days in which normal market hours are shortened due to holidays or other events.

2. Statutory Basis

Nasdaq believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) of the Act [18] which requires, among other things, that the Association's rules be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protest investors and the public interest. The new rule would ensure the protection of investor's limit orders, enhance the Start Printed Page 37811quality of trading on the OTCBB, and significantly reduce the potential for unfair discrimination, real or perceived, of customer orders.

(B) Self-Regulatory Organization's Statement on Burden on Competition

Nasdaq does not believe that the proposed rule change would result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

(C) Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) As the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding, or (ii) as to which the NASD consents, the Commission will:

(A) By order approve such proposed rule change, or

(B) Institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the NASD. All submissions should refer to File No. SR-NASD-00-22 and should be submitted by July 7, 2000.

Start Signature

For the Commission, by the Division of Market Regulation, pursuant to delegated authority. [19]

Margaret H. McFarland,

Deputy Secretary.

End Signature End Preamble


3.  See Exchange Act Release No. 34279 (June 29, 1994), 59 FR 34883 (July 7, 1994).

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4.  See Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995).

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5.  See In re E.F. Hutton & Co., Exchange Act Release No. 25887 (July 6, 1998).

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6.  The OTCBB, unlike Nasdaq, is a quotation medium for subscribing NASD members, not an issuer listing service. OTCBB securities are traded by market makers that enter quotes and trade reports through a sophisticated, closed computer network, which is accessed through the Nasdaq Workstation II. The OTCBB differs from Nasdaq in several ways; for example, the OTCBB does not maintain relationships with quoted issuers or impose quantitative listing standards. Also, the OTCBB also has different quotation obligations and does not currently provide a method for automated trade executions.

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7.  All priced market maker quotations entered into the service are required to be firm up to a minimum size. However, market makers may still enter unpriced indications of interest in the OTCBB. See NASD Rules 6540 and 6750.

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8.  By comparison, during the same month, Nasdaq averaged over 1.8 billion shares per day, while the New York Stock Exchange averaged 1.06 billion share per day.

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9.  This requirement was effective immediately for all issuers initiating quotation on the OTCBB after January 4, 1999. All issuers quoted on the OTCBB as of that date were required to comply with the rule on a phased-in basis, beginning in July 1999 and ending in June 2000. See Exchange Act Release No. 40878 (Jan. 4, 1999), 64 FR 1255 (Jan. 8, 1999).

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10.  Although the proposed rule will specifically apply only to selected securities during the pilot program, general duties of best execution will continue to apply to all customer orders in all securities.

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11.  This number represents roughly 10 percent of the total number of securities expected to remain on the OTCBB upon the completed implementation of Rule 6530. See supra note 10. For OTCBB securities that are not included in the pilot, members may trade ahead of customer limit orders if full and clear disclosure regarding this practice is provided to the customer.

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12.  Nasdaq currently intends to display the identifier “##” following the security name denoting it as among the securities to which the proposed rule would be applicable. This same method of identification was utilized successfully by Nasdaq in designating securities subject to the SEC Order Handling Rules during their initial phase-in period.

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13.  Order entry firms that forward customer orders to dealers for execution would continue to be subject to their duties of best execution and would owe a fiduciary duty 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 this rule.

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14.  Member firms may impose terms and conditions in the case of limit orders involving at least 10,000 shares and having a value greater than $20,000. The corresponding thresholds for IM-2110-2 are 10,00 shares and $100,000. The distinction in price is due to the relatively lower share prices of OTCBB securities. Nasdaq will study this limit as part of the pilot period analysis and adjust it as appropriate if deemed necessary.

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15.  This term is defined in NASD Rule 3110(c)(4).

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16.  See NASD Notice to Members 95-67.

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17.  See NASD Notice to Members 98-78.

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[FR Doc. 00-15242 Filed 6-15-00; 8:45 am]