Proposed Amendment Re: Disclosure of Payment for Order Flow Practices on Customer Confirmations; Last Voting Date: April 5, 1990

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EXECUTIVE SUMMARY

To improve disclosure of broker-dealer compensation for order flow and to make the disclosure more uniform, the NASD Board of Governors approved a change to the NASD Rules of Fair Practice on which members are requested to vote. The change would require specific language to appear in bold typeface in a prominent location on each applicable customer confirmation disclosing the kind of compensation arrangements. Prior to becoming effective, the change must be filed with and approved by the Securities and Exchange Commission. The text of the proposed change follows this notice.

BACKGROUND AND EXPLANATION

In the past several months, the subject of broker-dealer compensation for sending customer orders to particular market makers has come under scrutiny by the NASD and the Securities and Exchange Commission. In June 1989, the NASD issued a questionnaire to market makers that, among other things, requested information about their "hard dollar" payment practices. In July 1989, the SEC hosted the "Roundtable on Commission Dollar and Payment For Order Flow Practices," which featured commentators from broker-dealers, self-regulatory organizations, money managers, and pension plan sponsors.

The NASD survey and SEC roundtable showed that, although payment for order flow practices exist, they are generally well documented in broker-dealer records and are generally disclosed to customers with boiler-plate language on the back of confirmations. In order to study the issue further and to determine if any NASD regulatory action were warranted, the NASD formed a special subcommittee of the Trading Committee. The subcommittee reviewed current compensation practices and found that, while disclosure to customers was being made, the quality and method of disclosure varied from firm to firm.

In the interest of improving disclosure to customers and making it more uniform, the subcommittee recommended, and the NASD Board of Governors approved, a change to the NASD Rules of Fair Practice, Article III, Section 12, "Disclosure on Confirmations." The Board of Governors believes that payment for order flow practices should be more specifically disclosed and highlighted on customer confirmations and that members should again be reminded of their obligations to assure best execution for customer trades processed under these arrangements.

Disclosure of Compensation

Rule 10b-10 under the Securities Exchange Act of 1934 prescribes information that a broker or dealer must disclose to its customer on the confirmation form. The rule requires, among other things, that the broker-dealer disclose whether additional remuneration has been or will be received in connection with a transaction, and that the source and amount of such payment be furnished to the customer upon written request.¹ Under this rule, therefore, payments received by a retail firm from a market maker in return for directing its order flow to the market maker is considered additional compensation and must be disclosed to the customer. The NASD Board of Governors believes that this disclosure must be more specifically stated than is the current practice and that the following language must appear in bold typeface, in a prominent location, on each customer confirmation transaction that has been subject to a compensation plan:

The firm may receive remuneration for directing orders to a particular broker or dealer, through which your transaction is executed. Such remuneration is considered compensation to us and the source and amount of any compensation will be disclosed upon request.

The Board believes that the proposed language, appearing prominently in bold print on customer confirmations, will more clearly disclose these compensation arrangements. Therefore, it approved submitting the rule change to the SEC for approval, pending membership vote on the change.

Best Execution

The Interpretation of the Board of Governors on Execution of Retail Transactions,² the "Best Execution Interpretation," requires that:

[i]n any transaction for or with a customer, a member and persons associated with a member shall ... buy or sell ... so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

In accordance with longstanding NASD policy, this requirement is particularly applicable to situations in which firms direct their order flow to a selected dealer. Although examinations by the NASD indicate that firms that have entered into agreements for payment for order flow are obtaining the best execution of their customers' transactions, it is important for all firms to assure that they continue to obtain the best execution of trades subject to these arrangements. NASD examiners will continue to review this area during on-site examinations to ensure ongoing compliance.

The NASD Board of Governors believes this change to the Rules of Fair Practice is 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 April 5, 1990.

Questions or comments regarding this notice may be directed to P. William Hotchkiss in the Surveillance Department at (202) 728-8235.

PROPOSED AMENDMENT TO ARTICLE III, SECTION 12, NASD RULES OF FAIR PRACTICE

(Note: New language is underlined)

Section 12 (b) A member that receives compensation for sending customer orders to a particular market center or market maker must give or send to each customer, at or before the completion of each transaction, written notification disclosing, in bold print:

The firm may receive remuneration for directing orders to a particular broker or dealer, through which your transaction is executed. Such remuneration is considered compensation to us and the source and amount of any compensation will be disclosed upon request.

¹Rule 10b-10(a)(7), 17 CFR §240.10b-10(a)(7).

²NASD Manual (CCH) p.2037.