Notice To Members 95-67

NASD Clarifies The Expanded Limit-Order Protection Interpretation

Published Date:

August 01, 1995

SUGGESTED ROUTING

Senior Management
Institutional
Legal & Compliance
Systems
Trading

Executive Summary

On June 5, 1995, the NASD issued Special Notice to Members 95-43 (Special Notice) discussing the expansion of the Limit-Order Protection Interpretation (Interpretation) to Article III, Section 1 of the NASD Rules of Fair Practice that prohibits member firms from trading ahead of customer limit orders (commonly known as Manning II). The expanded Interpretation extends the scope of limit-order protection in The Nasdaq Stock Market (Nasdaq) to ensure that all customers' limit orders are afforded the same protection throughout Nasdaq.

Previously, the Interpretation required that member firms only protect their own customers' limit orders. Under the expanded Interpretation, a member firm may not accept and hold a limit order from a customer of the firm or a customer of another firm that has directed the limit order to the member (member-to-member limit orders) and continue to trade that security for its own account at prices that would satisfy the limit order it is holding. The expanded Interpretation thus requires that a member firm handling a customer's limit order must execute that limit order, in full or in part, to the extent that the member firm trades at a price equal or inferior to the limit-order price. For example, if a firm accepts a limit order to buy (sell) 100 shares of XYZ at 10 1/8, then the firm may not purchase (sell) XYZ for its own account at a price equal to or lower (greater) than 10 1/8, without also executing the limit order to buy (sell) at 10 1/8.

The expanded Interpretation also has a phase-in schedule for the treatment of member-to-member orders greater than 1,000 shares and provisions governing the attachment of terms and conditions to the execution of limit orders placed by institutions and limit orders that are 10,000 shares or greater and have a value of $100,000 or more.

Since the Special Notice was issued, the NASD has received numerous questions concerning the implications under Manning II of reporting trades on a net basis (that is, transactions where the customer pays no fees or commissions). To enhance member firm compliance with the expanded Interpretation, this Notice provides a further discussion on this issue and responds to other issues raised since the Special Notice was published.

Questions And Answers

Q. 1: Assuming the market for XYZ is 50 - 50 1/2 and a firm is holding a limit order to sell 100 shares of XYZ at 50 1/4, if the firm were to sell 1,000 shares of XYZ to another customer on a "net" basis, whereby it reported the trade at 50 3/8 and provided a sales credit of a 1/4 point/share to its salesperson, would the firm have to execute the limit order to sell?

A: Yes. The reported price is the "benchmark" price to determine whether a member's obligation to execute a limit order has been activated. The member reported a trade in which it sold XYZ at 50 3/8, therefore it is obligated to execute the limit order priced at 50 1/4.

However, the 1/4 point sales credit could constitute a form of remuneration. In such case, the member could have reported the trade at 50 1/8 with the 1/4-point sales credit disclosed on the confirmation statement required to be furnished to the customer pursuant to SEC Rule 10b-10. In this case, the member would not have been obligated to execute the limit order because it would not have reported a trade at a price inferior to the limit-order price.

Even though a member's trade-reporting practices may have implications for its obligations under the Interpretation, the NASD emphasizes that implementation of the Interpretation has in no way modified, altered, or amended the NASD's trade-reporting rules or SEC Rule 10b-10. The Interpretation does not constrain or preclude members from executing and reporting trades on a "net" basis. However, to the extent members choose to report trades on a "net" basis, they must protect limit orders based on the reported prices of such trades, not the reported prices of such net trades inclusive or exclusive of any markup, markdown, commission, sales credit or commission-equivalent charge.

(See attached chart.)

Q. 2: If a member firm accepts limit orders from its retail customers that incorporate a commission, commission-equivalent, mark-up, or mark-down in the limit-order price (collectively referred to as remuneration), may the firm protect the limit orders at their "stated" limit-order price instead of at their "actual" limit-order price (that is, excluding the remuneration for limit orders to buy and including the remuneration for limit orders to sell)?

A: The Interpretation requires member firms to protect retail customers' limit orders at their "stated" limit-order price. Member firms may protect retail customers' limit orders at the "actual" limit-order price if instructed to do so by the customer. In this connection, the SEC specifically addressed this issue in its release approving Manning II:

The Commission believes it is permissible for a customer to instruct a market maker to purchase (sell) a security for it such that the total costs (proceeds) to the customer (including any commissions, markups or other charges) are not greater (less) than a single net price per share. Thus, for example, if a customer enters a limit order to purchase security XYZ and requests that its total costs not exceed $10 per share, and the customer is informed that the market maker charges a markup of 1/4, then a market maker may continue to purchase for its own account at $10 without also executing the customer order. The customer order would be deemed a limit order at $9-3/4. The Commission emphasizes that 'the price at which the limit order is to be protected must be clearly explained to the customer.'¹

If a member intends to protect a retail customer's limit order at the "actual" limit-order price pursuant to the customer's instructions, then the "actual" limit-order price must be clearly explained to and understood by the customer.

It necessarily involves a fact-and-circumstances analysis to determine whether a retail customer instructed a member firm to protect its limit order at the "actual" limit-order price instead of the "stated" limit-order price. In this connection, a member firm bears the burden of establishing that its retail customer attached such instructions to the execution of its limit order and that the customer clearly understood what the protectable limit-order price was.

In addition, with respect to limit orders placed by institutional accounts² and limit orders that are for 10,000 shares or more and greater than $100,000 in value (collectively referred to as institutional limit orders), the amended Interpretation permits member firms to negotiate terms and conditions on the acceptance and handling of such limit orders. Accordingly, for institutional limit orders, member firms can negotiate and arrange to protect them at their "actual" limit-order price instead of their "stated" limit-order price. If a member firm imposes terms and conditions on the execution of an institutional limit order (such as, protecting it at the "actual" limit-order price), it must be able to demonstrate that the customer clearly understood such terms and conditions. If the actual limit-order price for an institutional limit order is different than its stated limit-order price, the member must be able to demonstrate that the customer knew what the actual limit-order price was.

Q. 3: Does the Interpretation require members to protect limit orders 24 hours a day or only during regular trading hours?

A: The Interpretation is in effect during regular Nasdaq trading hours, from 9:30 a.m. to 4 p.m., Eastern Time, unless a particular trading day is shortened by Nasdaq due to a holiday or other event. In such cases, the time that the rule is in effect corresponds to the hours that Nasdaq is open.

Q. 4: May a firm afford its own customers' limit orders priority over limit orders received from another member?

A: No. A member may not knowingly favor its own customers' limit orders in determining the priority of limit orders accepted by the firm from its own customers and customers of other members.

Q. 5: Once a member is obligated to execute a limit order, how quickly must it execute the limit order?

A: If a member trades through a limit order that it has accepted, the Interpretation provides that it must contemporaneously execute such limit order. To meet this obligation, a member must execute the limit order as quickly as possible. Absent reasonable justification that is adequately documented by the member firm, a limit order must at least be executed within a general time parameter of one minute after it has been activated.

Q. 6: Assuming the market for XYZ is 20 - 20 1/2 and a firm holds a limit order to buy priced at 20 1/4 and a limit order to sell priced at 20 1/4, if the firm purchases XYZ at 20 and immediately thereafter executes the limit order to buy, would the firm then also have to execute the limit order to sell because it sold XYZ at a price equal to the price of the limit order to sell?

A: No. Once the firm has executed the limit order it has traded through, it has satisfied its obligation under the Interpretation. The execution of a limit order pursuant to the Interpretation does not trigger an obligation to execute another limit order on the opposite side of the market.

Q. 7: Does the Interpretation require members to protect limit orders preferenced to them through the Small Order Execution System (SOES^SM) or directed to them via the Advanced Computerized Execution System (ACES^®)?

A: Yes. Once a member firm has agreed to accept preferenced SOES orders from another member, it must protect limit orders preferenced to it from that firm. In addition, a firm receiving limit orders through ACES must protect such limit orders under the Interpretation.

Q. 8: If a firm is facilitating a "buy/write" transaction for a customer whereby it seeks to execute a short-call transaction and a corresponding stock-purchase transaction at specified prices or at a specified spread, does the stock component of such combination order have priority over other limit orders held by the firm?

A: No. Limit orders that are part of combination orders involving multiple transactions in related financial instruments are not accorded any special priority under the Interpretation. Limit orders that are part of combination orders should be handled and processed just like any other limit order received by the firm. Thus, such limit orders should be subject to the same limit-order priority procedures as the firm applies to other limit orders. In addition, the execution of the equity component of a combination order would activate the execution of a limit order to the same extent as any other equity transaction.

Direct questions regarding this Notice to James Cangiano, Senior Vice President, Market Surveillance, at (301) 590-6424 or (800) 9258156; Glen Shipway, Senior Vice President, Nasdaq Market Operations, at (203) 385-6250; Robert E. Aber, Vice President and General Counsel, Office of General Counsel, at (202) 728-8290; Thomas R. Gira, Assistant General Counsel, Office of General Counsel, at (202) 728-8957; or Eugene A. Lopez, Assistant General Counsel, Office of General Counsel, at (202) 728-6998.

¹See Securities Exchange Act Rel. No. 35751 (May 22, 1995), 60 FR 27997, at note 42.

² For the Interpretation, institutional accounts are as defined in Article III, Section 21(c)(4) of the NASD Rules of Fair Practice. Specifically, Section 21(c)(4) defines institutional accounts as accounts for: (1) banks, savings and loan associations, insurance companies, or registered investment companies; (2) investment advisers registered under Section 203 of the Investment Advisers Act of 1940; and (3) any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of a least $50 million.

The following chart illustrates the limit order protection obligation resulting from particular transactions in XYZ stock. In all examples the inside market for XYZ is 50 – 50 1/2.

Trades in XYZ Stock	Trading Department			Confirmed to Customer	Markup¹	Sales Credit	Reported Price	Limit Order Protection Obligation
Trades in XYZ Stock	Beginning Inventory	Position Costs	Proceeds/ Share	Confirmed to Customer	Markup¹	Sales Credit	Reported Price	Limit Order Protection Obligation
MM Sells 1,000 Shares	Long 1,000 Shares	N/A	50 1/8	As Principal the firm SOLD Customer BOT 1,000 Shares @ 50 1/2 Net Gross $50,500	N/A	3/8	50 1/2	Limit Orders to Sell Priced at 50 1/2 or Below
MM Sells 20,000 Shares	0 Shares	BUYS 10,000 @ 50	50 3/16	As Principal the firm SOLD Customer BOT 20,000 Shares @ 50 1/4 Net Gross $1,005,000	N/A	1/16	50 1/4	Limit Orders to Sell Priced at 50 1/4 or Below
MM Sells 1,000 Shares	Short 5,000 Shares	N/A	50 1/8	As Principal the firm SOLD Customer BOT 1,000 Shares @ 50 3/8 Net Gross $50,375	N/A	1/4	50 3/8	Limit Orders to Sell Priced at 50 3/8 or Below
MM Sells 1,000 Shares	Long 1,000 Shares	N/A	50 3/8	As Principal the firm SOLD Customer BOT 1,000 Shares @ 50 3/8 w/Comm. equivalent of $250 Gross $50,625	N/A	$250	50 3/8	Limit Orders to Sell Priced at 50 3/8 or Below
MM Sells 1,000 Shares	Long 1,000 Shares	N/A	50 1/4	As Principal the firm SOLD Customer BOT 1,000 Shares @ 50 5/8 Net inclusive of a Markup of 1/8 point Gross $50,625	1/8	3/8	50 1/2	Limit Orders to Sell Priced at 50 1/2 or Below

¹ Members are directed to Notice-to-Members 92–16 for guidance concerning compliance with the NASD's Policies and Procedures relating to markups/markdowns in equity securities.