Amendment to Proposed Rule Re: Disclosure of Payment for Order Flow Practices On Customer Confirmations; Last Voting Date: November 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 submitted a change to the Rules of Fair Practice to the Securities and Exchange Commission (SEC) in April 1990. The NASD Board of Governors has now approved a change to that proposal on which members are requested to vote. The change would require specific language to appear on each applicable customer confirmation disclosing that remuneration has been received by the firm for directing orders to particular market makers or market centers. Prior to becoming effective, the amendment must be filed with and approved by the SEC. The text of the proposed amendment follows this notice.

BACKGROUND AND EXPLANATION

In Notice to Members 90-11, the NASD submitted a rule proposal regarding enhanced disclosure of certain payment for order flow practices to the membership for vote. Members approved the proposal, and the rule was submitted to the Securities and Exchange Commission (SEC) for approval. After discussions with the SEC and after reviewing comment letters filed by members and others, the Association is proposing an amendment to the rule proposal that would more specifically identify members' receipt of remuneration for directing orders to particular markets.

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 will be furnished to the customer on 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 are 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 on each customer confirmation for a transaction that has been subject to a compensation plan:

The firm receives remuneration for directing orders to particular broker/ dealers or market centers for execution. When such remuneration is received, it is considered compensation to the firm, and the source and amount of any compensation received by the firm in connection with your transaction will be disclosed upon request.

The proposed language differs from that previously submitted to the membership in that the new language is a more affirmative statement of payment practices. Rule 10b-10 requires the member to state whether it has received additional remuneration in connection with transactions, and the new language reflects this requirement. (Members that participate in payment for order flow arrangements may, of course, elect to identify that a specific payment has or has not been received on individual customer confirmations, rather than utilizing the language appearing above.) The Board of Governors approved the amended language for customer confirmations, believing that it will more clearly disclose these compensation arrangements. Therefore, the amendment will be submitted to the SEC for approval, if the membership approves the change.

Best Execution: The Board also reiterates its interpretation on 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 long-standing 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 November 5, 1990.

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

^lRule 10b-10(a)(7), 17 CFR §240.10b-10(a)(7).

²NASD Manual (CCH) Art. III, Sec. 1, §2151.03, p. 2037.