Notice To Members 90-37

Proposed New Rule Re: Handling Customer Limit Orders; Last Voting Date: July 5, 1990

Published Date:
Last Voting Date: July 5, 1990

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations
Trading
Training

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

MAIL VOTE

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 ruled in that disciplinary action and affirmed the conclusion reached by the NASD.1

The NASD Board, therefore, determined that it was appropriate to provide guidance to NASD member firms as to the type of communication with customers that would satisfy member firms' obligations with respect to the handling of customer limit orders. To this end, the NASD set forth a proposal in Notice to Members 89-39 (May 1989). Based on concerns raised by the SEC staff relating to the form and frequency of the disclosure contemplated by the 1989 proposal, the NASD Board of Governors decided to make certain modifications to the rule.

The proposed rule change provides that each member firm that accepts and holds an unexecuted customer limit order, and anticipates continuing to trade in the security that is the subject of this order for its own market-maker account at prices equal to or better than the limit price, shall not be deemed to have acted in a manner inconsistent with Article III, Section 1 of the Rules of Fair Practice if it provides a separate written statement to each existing customer at the time the rule is adopted and to each new customer upon the opening of an account, clearly disclosing 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 that additional disclosure shall be provided in the form of a separate statement that is either distributed annually or enclosed with confirmations of limit-order transactions. 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 is also included. Lastly, the rule requires that nonstandardized disclosure documents be filed with the NASD at or before the time they are first used. The documents will not be pre-approved, but will be reviewed for compliance.

The NASD Board of Governors believes the proposed rule amendments will provide necessary guidance to NASD members on 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 July 5, 1990.

Questions concerning this notice may be directed to T. Grant Callery, Vice President and Deputy General Counsel, at (202) 728-8285.

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

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 III, 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 separate document containing 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; and subsequently provides additional disclosure in the form of a separate notice either distributed annually or enclosed with each confirmation of a limit order transaction.
(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 mark-down 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."
(c) In the event a member firm chooses to use non-standardized disclosure documents, examples of these documents must be filed with the Associa tion at the time they are first used or made public. The advance filing of such documents shall not, however, constitute approval of the statements by the Association.

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