-------------------- BEGINNING OF PAGE #1 ------------------- SECURITIES AND EXCHANGE COMMISSION (17 CFR Part 240) (Release No. 34-34902; File No. S7-29-93) RIN 3235-AG00 Payment for Order Flow AGENCY: Securities and Exchange Commission. ACTION: Final Rule SUMMARY: The Securities and Exchange Commission announces the adoption of Rule 11Ac1-3 and amendments to Rule 10b-10 under the Securities Exchange Act of 1934 which, together, require enhanced disclosure of payment for order flow practices on customer confirmations, and account statements, as well as upon opening new accounts. The new Rule and amendments to Rule 10b-10 are designed to provide relevant information to customers regarding factors influencing the routing of their orders. The new Rule and amendments to Rule 10b-10 also will serve to enhance investor protection and further competition for retail orders by enabling customers to evaluate more effectively the markets to which their orders are routed. EFFECTIVE DATE: April 3, 1995. FOR FURTHER INFORMATION CONTACT: Jill W. Ostergaard, Attorney, 202/942-3197, Branch of the National Market System, Office of Market Supervision, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington, D.C. 20549. For interpretation of Rule 10b-10 after March 1, 1996, please contact the Office of the Chief Counsel, 202/942-0073, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 7-10, Washington, D.C. 20549. For interpretation of Rule 11Ac1-3 please contact the Office of Market Supervision, Division of Market Regulation, 202/942-3197. SUPPLEMENTARY INFORMATION: I. Executive Summary On October 6, 1993, the Securities and Exchange Commission ("SEC" or "Commission") proposed for comment amendments to Rule 10b-10 (17 CFR 240.10b-10) and new Rule 11Ac1-3 (17 CFR 240.11Ac1-3) under the Securities Exchange Act of 1934 ("Act") concerning payment for order flow practices. -[1]- Taken together, those proposals were designed to improve information available to investors about their broker-dealer's order routing practices, and whether the broker-dealer received market center -[2]- inducements for routing unspecified order flow to them. These disclosures would occur when the investor opened an account, annually thereafter, and on the required trade confirmations. In the Proposing Release, the Commission invited commenters to address issues related to the proposals as well as alternative approaches to payment for order flow, such as banning the practice outright, mandatory pass-through of payments to customers, and requiring exchanges, national securities associations and broker-dealers to convert to decimal pricing. The Commission received 53 comment letters concerning the proposals. Of those commenters, 31 supported the disclosure -[1]- Securities Exchange Act Release No. 33026 (Oct. 6, 1993), 58 FR 36262 (Oct. 13, 1993)("Proposing Release"). -[2]- As used in this release, the term market center includes exchanges and dealers acting as market makers. See 17 CFR 240.11Ac1-2(a)(14)(defining "reporting market center"). -------------------- BEGINNING OF PAGE #2 ------------------- approach and 17 opposed it. -[3]- Many of the commenters supporting the approach offered suggestions to improve the effectiveness of disclosure. The Commission is adopting the proposed disclosure approach as discussed below. The Commission believes this approach will further the investor protection goals of the Act, and is consistent with the general philosophy underlying disclosure that "sunlight is the best disinfectant." -[4]- The Commission, in response to commenters' suggestions, has modified the proposed Rule and amendments to Rule 10b-10, as described below. The Commission is modifying Rule 11Ac1-3 and amendments to Rule 10b-10 as proposed, to include Nasdaq Small-Cap and Over- The-Counter ("OTC") Bulletin Board securities. The Commission also is modifying the proposed amendments to Rule 10b-10 to limit the disclosure of payment for order flow on customer confirmations to a statement that the broker or dealer receives payment for order flow. In addition, the Commission is revising proposed Rule 11Ac1-3 regarding customer account statements by requiring disclosure of the broker-dealer's policies for determining where to route customer orders that are the subject of payment for order flow absent specific instructions from customers, including a description of the extent to which orders can be executed at prices superior to the national best bid or best offer ("NBBO"). In a parallel action, the Commission is proposing for comment amendments to Rule 10b-10 and Rule 11Ac1-3 that would extend those Rules to the options market. -[5]- In addition, the Commission is proposing for comment a requirement that broker- dealers disclose in writing, on confirmations, upon opening new accounts and on annual disclosure statements, ranges of payment for order flow received on a per share basis; and include, in new account documentation and on annual disclosure statements, an estimate of the aggregate amount of payment for order flow received on an annual basis. -[6]- The Commission also is proposing for comment a requirement that broker-dealers disclose whether they execute orders as principal ("internalize") or route orders to an affiliated broker-dealer or exchange specialist for execution and, a requirement that broker-dealers quantify and -[3]- The Commission's staff has prepared a summary of the comments, a copy of which has been placed in the official file. The Division of Market Regulation ("Division") also solicited comment on payment for order flow in its study of the equity markets. See Securities Exchange Act Release No. 30920 (July 14, 1992), 57 FR 32587 (July 22, 1992)("Market 2000 Concept Release"). See also Division of Market Regulation, Securities and Exchange Commission, Market 2000: An Examination of Current Equity Market Developments (Jan. 1994)("Market 2000"). Many of the same parties commenting on this proposal commented on Market 2000. Id., Appendix IV at 41-48. -[4]- L. Brandeis, Other People's Money and How the Bankers Use It, 92 (Frederick A. Stokes Co. ed. 1932). -[5]- See Securities Exchange Act Release No. 34903 (October 27, 1994) ("Companion Release"). -[6]- Id. -------------------- BEGINNING OF PAGE #3 ------------------- disclose information about internalized/affiliate practices. -[7]- The Commission further is proposing for comment a requirement that broker-dealers disclose their order routing practices regardless of whether the broker-dealer received payment for order flow or engaged in internalized/affiliate practices. The Companion Release also solicits comment on expanding the definition of payment for order flow. -[8]- II. Basis and Purpose of the Rule The practice of paying for order flow has generated much debate and controversy -[9]- regarding the potential benefits and harm to public investors and whether receipt and retention of payment for order flow compromises a broker-dealer's duties to its customer. -[10]- Congress has shown continuing interest in the resolution of that controversy. -[11]- The history of that debate and other background information can be found in the Proposing Release. -[12]- In their response to the Proposing Release, few commenters suggested that the Commission not act at all regarding payment for order flow practices. -[13]- Most commenters supported the disclosure approach, with modifications. These commenters suggested that payment for order flow practices are a mechanism for competition among market centers for order flow. Many commenters argued that there is no harm in these practices. Others argued that disclosure to the customer adequately would address any perceived conflict of interest. -[7]- Id. -[8]- Id. -[9]- For a detailed discussion of this controversy, see Note, The Perils of Payment for Order Flow, 107 Harv. L. Rev. 1675 (1994). -[10]- Private litigation in several state courts currently is pending regarding payment for order flow. See, e.g., Investors' State Actions Against Brokers Seek Return of Cash Paid for Order Flow (BNA), Special Report, Vol. 26, pp. 590-94 (April 22, 1994). Two cases were dismissed on grounds of federal preemption and are currently on appeal. See Dahl v. Charles Schwab & Co., Inc. (MC 93-106272, District Court, Forth Judicial District, Hennepin County, Minnesota); Orman v. Charles Schwab & Co., Inc. (93 CH 7365, Circuit Court of Cook County, Illinois). -[11]- See letter from John D. Dingell, Chairman, House Committee on Energy and Commerce, to Honorable Richard C. Breeden, Chairman, SEC, dated March 6, 1992. On May 13, 1993, the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce held a hearing regarding the future of the stock market and inducements for order flow. See National Market System: Hearings Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy & Commerce, 103d Cong., 1st Sess. (1993)("National Market System Hearings"). -[12]- See Proposing Release, supra note 1, 58 FR at 52935. -[13]- Some commenters believe that current disclosure requirements are adequate and additional disclosure is unnecessary. -------------------- BEGINNING OF PAGE #4 ------------------- As noted in the Proposing Release, payment for order flow may result in lower execution costs, facilitate technological advances in retail customer order handling practices and facilitate competition among broker-dealers and securities markets. At the same time, however, the practice raises concern as to whether the customer is being treated fairly. Specifically, payment for order flow raises concerns about whether a firm is meeting its obligation of best execution to its customer. Not all market centers expose market orders to other order flow or attempt to improve the price at which market orders are executed. Thus, the decision to route an unpriced order to a market center offering immediate execution at the NBBO, could mean that the customer has lost an opportunity for execution at a superior price because of the lack of exposure to other order flow. -[14]- For the reasons discussed below, the Commission believes disclosure that payment for order flow has been received and a description of whether the customer's order has an opportunity for price improvement will enhance investor protection and provide customers with information to evaluate more effectively the markets to which their orders are routed. III. Discussion The Rules adopted today represent a tiered approach to disclosure of payment for order flow practices in the broader context of broker-dealer order handling practices and the special relationship that already exists between a broker-dealer and its customer. -[15]- The components of the Rules include disclosure at the time an account is opened, annually thereafter, and on the transaction confirmation. First, the Rules adopted today require broker-dealers to inform customers in writing, when a new account is opened, about the dealer's policies regarding the receipt of payment for order flow, including whether payment for order flow is received; and a detailed description of the nature of the compensation received. As discussed in greater detail below, the new Rule and Rule amendments require that broker-dealers provide information in account opening documents about order routing decisions in orders subject to payment for order flow, including an explanation of the extent to which unpriced orders can be executed at prices superior to the displayed NBBO at the time the order is received. Second, the Rules adopted today require dealers to update this information and to provide such information annually to all customers. Taken together, this information should assist customers in assessing the quality of trade executions they receive and encourage broker-dealers to consider the opportunity for price improvement in establishing order routing arrangements. Finally, the Rules adopted today require broker-dealers to indicate on confirmations whether the broker or dealer receives payment for order flow, and the availability of further information on request. These are described in greater detail below, beginning with the scope of securities subject to the -[14]- See Market 2000, supra note 3, Study V at 3-4. -[15]- A broker-dealer's duty to seek to obtain best execution of customer orders derives, in part, from the common law agency duty of loyalty, which obligates an agent to act exclusively in the principal's best interest. Restatement 2d Agency 387 (1958). Thus, when an agent acts on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for the customer. Restatement 2d Agency 424 (1958). -------------------- BEGINNING OF PAGE #5 ------------------- Rules and the types of inducements covered by the Rules. A. Securities Subject to Disclosure Obligations and Definition of Payment for Order Flow 1. Securities Subject to Disclosure Obligations As proposed, the obligations of both Rule 11Ac1-3 and the amendments to Rule 10b-10 were limited to orders in national market system securities. The Commission requested comment on whether both Rules should be extended to Nasdaq Small-Cap and OTC Bulletin Board Securities. -[16]- Commenters addressing this issue supported the inclusion of both and, accordingly, the Commission is expanding Rule 11Ac1-3 and amendments to Rule 10b- 10 to include these securities. As revised, both Rules would include "any subject security as defined in Section 240.11Ac1-2 or a security authorized for quotation on an automated interdealer quotation system that has the characteristics set forth in Section 17B of the Act . . . . " -[17]- The Commission believes that inclusion of these securities provides customers with the best picture of a broker-dealer's policies regarding the routing of customer orders and the receipt of payment for order flow. As discussed in the Proposing Release, -[18]- the practice of payment for order flow originated -[16]- See Proposing Release, supra note 1, 58 FR at 52940 n.44 and n.46. Two commenters support the inclusion of Nasdaq Small-Cap and OTC Bulletin Board securities in the Commission's proposal. One commenter states that if the goal of disclosure is to provide customers with as much information as possible to make an informed decision regarding where to place their orders, it does not make sense to limit the disclosure requirement to national market system securities but rather the requirement should extend to Nasdaq Small-Cap and OTC Bulletin Board securities. Two exchanges support the inclusion of options in the confirmation disclosure requirements. One exchange suggests that the Commission consider the ramifications that payment for order flow may have on the options marketplace, especially once multiple trading of options is taken into consideration. See letter from Leopold Korins, Chairman and Chief Executive Officer, Pacific Stock Exchange, Inc., to Jonathan G. Katz, Secretary, SEC, dated December 9, 1993. The Commission, therefore, is soliciting comment in a parallel action today on whether amendments to Rule 10b-10 and Rule 11Ac1-3 should extend to the options markets. See Companion Release, supra note 5. -[17]- The OTC Bulletin Board is currently the only automated quotation system that has the characteristics set forth in Section 17B of the Act. See letter from Margaret H. McFarland, Deputy Secretary, SEC, to Richard Ketchum, Executive Vice President, National Association of Securities Dealers, Inc. ("NASD"), dated Dec. 30, 1992. The revision to Rule 11Ac1-3 is intended to cover securities included in any other automated quotation systems at such time as the Commission designates them under Rule 15g-3(c)(5). -[18]- See Proposing Release, supra note 1, 58 FR at 52935. -------------------- BEGINNING OF PAGE #6 ------------------- in the OTC market, and since then has been routinely used as a competitive tool in that market. Payments for Nasdaq and OTC Bulletin Board stocks, moreover, are generally greater than for exchange-listed national market system securities. -[19]- Accordingly, the Commission believes that the disclosure protections should be extended to the OTC market. 2. Definition of Payment for Order Flow As proposed, Rule 10b-10(e)(9) defined payment for order flow broadly, to include all forms or arrangements compensating for directing order flow. The Commission received 23 comment letters addressing the scope of the definition. The majority of these commenters were supportive of the Commission's efforts and agreed that non-cash inducements for order flow are economically equivalent to, and have the same effect as, cash payments for order flow. Opponents of the proposed definition, which include most of the exchanges, argued that rebates and fee reductions are structurally different from other cash payments and should be excluded from "monetary" payment for order flow. -[20]- The Commission has considered all the comments, and for the reasons discussed below, believes that the items enumerated in Rule 10b- 10(e)(9) appropriately include arrangements involving payment for order flow. -[21]- Rule 10b-10(e)(9) defines payment for order flow to include any monetary payment, service, property, or any other benefit that results in remuneration, compensation or consideration to a broker or dealer in return for the routing of customer orders. Broker-dealers should examine order routing arrangements carefully, with a view toward determining whether the firm has received some form of remuneration as a result of routing orders to that market. As noted, payment for order flow includes non- monetary compensation, such as clearing services or reciprocal order swapping arrangements. It is the Commission's view that monetary and non-monetary inducements are alternative methods of payment to attract order flow and are economically equivalent. -[22]- As such, non-cash remuneration is as likely to influence the broker's order routing decision as cash. In addition, as is the case with monetary payments, the customer is unlikely to be aware of many of these practices. Thus, the net effect of non- monetary arrangements is not appreciably different than that of monetary payment for order flow. Therefore, the Commission -[19]- See id., 58 FR at 52936 n.16. -[20]- Several exchanges argue that, unlike cash payments, all exchange charges and fees are filed with the Commission pursuant to Rule 19b-4 under the Act and are a matter of public record. The New York Stock Exchange ("NYSE") added that unlike exchange fee structures, dealers do not charge fees to brokers for use of their services; because there is no "fee" to discount, the NYSE argues that it is disingenuous to suggest any similarity between the two practices. See letter from James E. Buck, Senior Vice President and Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC, dated December 9, 1993. -[21]- In the Companion Release, the Commission is soliciting comment on whether to expand the definition of payment for order flow. -[22]- See, e.g., "Inducements for Order Flow," A Report to the Board of Governors, NASD, July 1991; see also National Market System Hearings, supra note 11. -------------------- BEGINNING OF PAGE #7 ------------------- concludes that non-monetary payment for order flow should be included in the definition and should be subject to the regulatory treatment set forth in the proposal. Payment for order flow also includes any credit, rebate, or discount against execution fees that exceeds the fee charged for executing the order. -[23]- It is the Commission's view that although SRO fee schedules are reviewed by the Commission under Section 19(b) of the Act and appear in the Federal Register, the connection between these fee arrangements and a member firm's order routing practices may not be known or apparent to that firm's customers. Moreover, it is possible for an exchange to adjust its fee schedule for members routing orders to provide the economic equivalent of payment for order flow. The existence of such remuneration to the firm, whether in the form of monetary payments or other benefits, should be disclosed directly to customers. -[24]- B. New Account and Annual Disclosure The Commission is adopting Rule 11Ac1-3 to require broker- dealers to provide to customers information regarding their payment for order flow practices when a new account is opened and to all customers annually. The Commission is modifying the Rule to require a description of the broker-dealer's policies for determining where to route customer orders that are subject to payment for order flow absent specific instructions from customers, including a description of the extent to which orders can be executed at prices superior to the NBBO. In sum, the revised Rule requires broker-dealers to disclose whether they receive payment for order flow. If any type of payment for order flow is received, the broker-dealer must -[23]- Thus, payment for order flow would include a fee arrangement in which an exchange charges 50 cents per order but offers a $2.00 per order credit for agency orders, which can be used to offset other fees incurred on that exchange. See e.g., Securities Exchange Act Release No. 32377 (May 27, 1993), 58 FR 31568 (Approving NYSE practice of offering a rebate on every small order (100-2099 shares) delivered via SuperDot and executed by the NYSE specialist). However, payment for order flow would not include fee arrangements in which the market's net charge for executing the order, after any discount, rebate, or credit, is greater than zero. -[24]- As initially proposed, "payment for order flow" was defined as "any compensation received from any broker- dealer (including market makers), exchange members, or exchanges to which a broker-dealer routes customers orders for execution, including: monetary payments, research, products or services . . . discounts and rebates, or any other reduction of or credit against any fee, expense or other financial obligation of the broker or dealer routing a customer order." In response to comments, the Commission has clarified that the definition of payment for order flow includes discounts, rebates, credits, or other fee arrangements only to the extent that such discounts exceed the fee charged. In addition, the Commission has clarified that payment for order flow received from a registered securities association is also subject to the disclosure rules. The Companion Release solicits comment on whether the definition of payment for order flow should be expanded. -------------------- BEGINNING OF PAGE #8 ------------------- provide a detailed description of the nature of the compensation received and, as discussed below, information about the routing of unspecified orders and whether those orders can be executed at prices better than the NBBO at the time the order is received. 1. Order Routing and Best Execution To the extent that market center structures differ materially in the opportunity for unpriced orders to be executed at prices that are superior to the NBBO, the receipt of payment for order flow could be viewed as improperly affecting a dealer's determination regarding where to route customer orders and the dealer's ability to satisfy its best execution obligation, if the dealer does not provide as good an overall opportunity for best execution as it would without the payment for order flow. -[25]- In particular, this could happen when dealers decide to route orders to a market center which does not provide an opportunity for price improvement, although other factors such as the size of the order, speed of execution, and the costs and difficulty associated with achieving best execution in a particular market may negate this conclusion. -[26]- The Commission noted in the Proposing Release that broker-dealers are under a duty to seek the "best execution" of their customer's orders. -[27]- Broker- -[25]- See Market 2000, supra note 3, Study V at 4. -[26]- As stated in the Second Report on Bank Securities Activities, [While] brokers have not been held by the Commission, the self-regulatory organizations or the courts to an absolute requirement of achieving the most favorable price on each order[,][w]hat has been required is that the broker endeavor, using due diligence, to obtain the best execution possible given all the facts and circumstances. These factors include, among other things, the size of the order, the trading characteristics of the security involved, the availability of accurate information affecting choices as to the most favorable market in which execution might be sought, the availability of technological aids to process such data, the availability of economic access to the various market centers and the costs and difficulty associated with achieving an execution in a particular market center. See Second Report on Bank Securities Activities: Comparative Regulatory Framework Regarding Brokerage-Type Services 97-98, n.233 (Feb. 3, 1977), as reprinted in H.R. Rep. No. 145, 95th Cong., 1st Sess 2333 (Comm. Print 1977). Furthermore, the Commission has stated that "the creation of [other] explicit obligation[s] upon broker-dealers would in no way limit a broker's existing duty to seek to obtain best execution of his customers' orders." SEC, Status Report on the Development of a National Market System, Securities Exchange Act Release No. 15671 (Mar. 22, 1979), 44 FR 20360 (April 4, 1979)("Status Report") (citing Restatement 2d Agency 424 (1958)). -[27]- See Proposing Release, supra note 1 at n.24. As a general matter, the duty of "best execution" refers to (continued...) -------------------- BEGINNING OF PAGE #9 ------------------- dealers accepting remuneration from a market center for directing order flow to that market center are still obligated to fulfill their duty of best execution to their customers. -[28]- The Commission understands that most firms that pay for order flow guarantee, at a minimum, executions at the NBBO. As stated in the Proposing Release, such so-called quote-derived executions in many ways are not materially different from automated execution systems operated by the regional exchanges for years. While automated execution systems offer fast and assured executions to customers, orders sent to an exchange for manual handling and orders sent to an OTC dealer for manual (or in some cases automated) handling may have a greater opportunity for an execution between the spread than do orders that are routed to a quote-based automated execution system. -[29]- -[27]-(...continued) the duty of the broker to seek to execute a customer's order in the best available market. See Section 11A(a)(1)(C)(iv) of the Act, 15 U.S.C. 78k-l(a)(1)(C)(iv)(1988); Securities Exchange Act Release No. 26870 (May 26, 1989), 54 FR 23963, 23966 n.51 (June 5, 1989)("Multiple Trading of Standardized Options Release"). See also Market 2000, supra note 3, Study V. In its purest form, best execution can be thought of as executing a customer's order so that the customer's total cost or proceeds are the most favorable under the circumstances. See Market 2000 Concept Release, supra note 3, note 57 and accompanying text. -[28]- A broker-dealer's duty to seek best execution of customer orders derives from, among other sources, the common law agency duty of loyalty, which obligates an agent to act exclusively in the principal's best interest. The Commission noted in the Proposing Release its concern that the availability of payments in return for order flow commitments may influence the evaluation by a broker-dealer of the most advantageous market or market maker to whom to route its customer order. Indeed, some opponents of the practice of payment for order flow believe that acceptance and retention of payments by brokers from market makers constitute a breach of duty not permitted under agency common law. See Restatement 2d Agency 388 (1958). While the Commission is concerned about a broker- dealer's fiduciary duty to seek to obtain the best execution for its customer, it believes that bulk order routing based, in part, on the receipt of payment for order flow is not, in and of itself, a violation of those duties. Disclosure of payment for order flow, moreover, could help inform customers and negate the concern that customers are unable to evaluate whether they receive inferior executions due to undisclosed rebates. See Securities Exchange Act Release No. 19047 (Sept. 14, 1982), 47 FR 41896 (Sept. 21, 1982). -[29]- See Proposing Release, supra note 1, 58 FR at 52941 n.59. The footnote cites several studies in this regard: C. Lee, Purchase of Order Flow and Favorable Executions: An Intermarket Comparison (1991); T. McInish and R. Wood, Price Discovery, Volume and Regional/Third Market Trading (Feb. 1992); M. Bloom and (continued...) -------------------- BEGINNING OF PAGE #10 ------------------- The Commission traditionally has concluded that a broker- dealer routing customer orders for automated execution could satisfy its best execution obligations so long as the broker- dealer assesses periodically the quality of competing markets to ensure that its order flow is directed to markets providing the most advantageous terms for its customers' orders. -[30]- Nevertheless, the Commission's staff recently has warned against presuming that guaranteed executions at the best bid or offer always will satisfy the broker-dealer's best execution duties for small orders in listed securities. -[31]- For example, as a general matter, trades in listed securities routed to an exchange will be exposed to other public orders or interest in the trading crowd, with the possibility that the order may receive a price that is better than the existing quotations (so-called "price improvement"). Most regional exchanges, for example, have incorporated order exposure features into their small order routing and execution systems with a view toward offering price improvement. -[32]- The Commission believes that the possibility for price improvement, while not the exclusive factor, bears on the question of whether a broker-dealer is fulfilling its duty to seek best execution, especially when payment is received by the broker-dealer in return for guaranteeing order flow. -[33]- -[29]-(...continued) M. Goldstein, Displayed and Effective Spreads by Market (Dec. 1992). -[30]- See Status Report, supra note 26. See also Market 2000, supra note 3, Study V at 1 n.8; Multiple Trading of Standardized Options Release, supra note 27, 54 FR at 23973 n.127; and Securities Exchange Release Act Nos. 17583 (Feb. 27, 1981), 46 FR 15713, 15715 n.16 (Mar. 9, 1981); and 15926 (June 15, 1979), 44 FR 36912, 36923 n.118 (June 6, 1979). -[31]- Market 2000, supra note 3, Study V at 4. -[32]- Id. This feature by itself, however, rarely provides an execution between the spread. Most regional exchanges program their automatic execution systems to ensure that customer orders receive a price at the NBBO or better, and the specialist is provided an opportunity to improve the price. The Philadelphia Stock Exchange ("Phlx") does not have such a feature in its automatic execution system, although the Commission has recommended for years that it be included. See Market 2000, supra note 3, Study V at 4 n.19; Proposing Release, supra note 1, 58 FR at 52938 n.28; Market 2000 Concept Release, supra note 3, 57 FR at 32595 n.53; Securities Exchange Act Release Nos. 27013 (July 7, 1989) 54 FR 30298 n.2 (July 19, 1989); 22750 (Dec. 31, 1985), 51 FR 799, 801 (Jan. 6, 1986); 20350 (Nov. 4, 1983), 48 FR 51722, 71723 n.10 (Nov. 10, 1983); 19858 (June 9, 1983), 48 FR 27872, 27873 (June 17, 1983); and 19372 (Dec. 23, 1982), 47 FR 58287, Technical Appendix, n.12 (Dec. 30, 1982). -[33]- Because executions of market orders for listed stocks in an exchange market include the possibility for a price between the quotes, the staff has concluded that the existence of this possibility, even if the price is (continued...) -------------------- BEGINNING OF PAGE #11 ------------------- Although it may be impractical for a broker or dealer that handles a heavy volume of orders to make an individual determination regarding where to route each order it receives, the broker or dealer must use due diligence to seek the best execution possible given all facts and circumstances. The Commission believes a broker or dealer must assess whether the order flow in the aggregate, is receiving best execution and that a broker-dealer must not allow a payment or an inducement for order flow to interfere with its efforts to obtain best execution. Accordingly, in light of a broker-dealer's obligation to assess periodically the quality of the markets to which it routes packaged order flow absent specific instructions from customers, the Commission does not believe such a broker-dealer violates its best execution obligation merely because it receives payment for order flow. In this connection, the Commission has taken several steps recently to expand the opportunity for customer market orders to be executed at prices better than the NBBO at the time of receipt, including proposal of a Rule to require limit order price protection in Nasdaq National Market securities. -[34]- Nevertheless, considerable differences among market centers exist today. Accordingly, consistent with these steps to help customers understand payment for order flow practices, and to facilitate fair competition among exchange and non-exchange market centers, the Commission believes that it is appropriate to require broker-dealers to disclose to customers their policies regarding where they route unspecified orders that are subject to payment for order flow. -[35]- This provision requires a description of the extent to which orders so routed can be executed at prices superior to the NBBO at the time the order is received. Dealers should explain, in simple terms, whether the market center to which they route unspecified orders executes orders to purchase or sell at the NBBO and whether it provides an opportunity for execution at prices superior to the NBBO. -[36]- 2. Annual Disclosure Several commenters opposed annual disclosure because it would duplicate the account opening disclosure and suggested that the Commission require additional disclosure only upon a material change in the firm's policies. The Commission is retaining the annual disclosure requirement because it believes this will serve to remind customers that evaluation of a dealer's services involves more than a comparison of commission rates and to -[33]-(...continued) not actually improved, can be a factor in determining whether best execution has been sought. Market 2000, supra note 3, Study V. -[34]- See Securities Exchange Act Release No. 34753 (Sept. 29, 1994), 59 FR 50866 (Oct. 6, 1994). -[35]- As revised, paragraph (a)(2) of the Rule would require broker-dealers to provide information concerning the broker-dealer's policies for determining where to route customer orders that are subject to payment for order flow absent specific instructions from customers, including a description of the extent to which orders can be executed at prices superior to the NBBO. -[36]- By the terms of the Rule, this disclosure would be limited to orders that are subject to payment for order flow. -------------------- BEGINNING OF PAGE #12 ------------------- encourage broker-dealers to continue to evaluate the quality of service they receive from market centers from which they receive payment for order flow. 3. Quantification of Monetary Payment For Order Flow Over 20 commenters addressed the proposed requirement that broker-dealers inform customers annually about the aggregate amount of monetary compensation received for routing order flow. The majority oppose the inclusion of any aggregate value requirement. -[37]- The Commission has determined to solicit further comment on this issue in the Companion Release because it believes that aggregate information provides useful information to customers to evaluate the magnitude of payment for order flow practices and whether such payments, taken as a whole, might affect adversely order routing determinations. As discussed in the Companion Release, the Commission has determined to solicit further comment on this issue in conjunction with its proposal to require valuation of all forms of payment for order flow because disclosure of monetary payment for order flow without similar disclosures regarding non-monetary payment for order flow and internalization could mislead investors or foster non-monetary payments or internalized/affiliate practices. C. Customer Confirmation Statements As proposed, amended Rule 10b-10(a)(7)(iii) -[38]- required customer confirmations to disclose whether any payment for order -[37]- Several broker-dealers argue that disclosure of aggregate amounts of monetary order flow would be misleading to customers. One commenter voiced concerns that investors who transact business in mutual funds or options would be misled by disclosure which only derives from equity order flow. Others believe that even equity customers are likely to be misled because payment derives from large numbers of the broker's own or other customer's orders directed to various marketplaces which may be unrelated to that particular customer's business with the broker-dealer. Still others believe that such disclosure may lead to the misperception that investors are being disadvantaged. It should be noted that the same commenters opposing aggregate disclosure of monetary compensation also oppose the Commission's proposal regarding confirmation disclosure of monetary compensation. See infra Section III.C. (Customer Confirmation Statements). In contrast, some commenters suggest quantification requirements extend to non-monetary inducements for order flow and to internalization. -[38]- Currently, the Commission's confirmation disclosure rule, Rule 10b-10 under the Act, requires that confirmations sent to customers for agency transactions disclose the "price" of the security purchased or sold by the customer, as well as the remuneration paid to the broker-dealer by the customer in the trade. Rule 10b-10 also requires broker-dealers to disclose the source and amount of any other remuneration received in connection with a transaction. In most transactions, however, the Rule permits broker-dealers merely to state "whether any other remuneration has been or will be received," and to furnish the source and amount of such other remuneration on written request. -------------------- BEGINNING OF PAGE #13 ------------------- flow has been received for a national market system security and the amount of any monetary payment, discount, rebate or reduction of fee. More than 30 commenters expressed concern about the proposed requirement that broker-dealers disclose on customer order confirmations the amount of any monetary payment, discount, rebate or reduction of fee received in connection with a transaction in a national market system security. Most of these commenters considered this unworkable. -[39]- In response to commenters' concerns, the Commission has modified the Rule to require a statement on order confirmations that payment for order flow is received by the broker or dealer and that the source and nature of the payment for order flow received in connection with the particular transaction will be furnished upon written request of the customer. -[40]- The Commission has determined to allow broker-dealers to conform the statement to the firm's practices, for instance, specifically noting that it limits the receipt of payment for order flow to market orders only, if applicable. Because the definition of payment for order flow includes non-monetary forms of payment for order flow, broker-dealers will be expected to include those forms of compensation in preparing confirmations and to provide the nature and source of the compensation upon written request. The Commission believes that the Rule, as modified, retains informative disclosures to investors. -[41]- The Commission recognizes that information on the confirmation may not communicate all information of interest to investors about payment for order flow or the quality of order execution. The -[39]- Several commenters argue that specific confirmation disclosure is nearly impossible considering that brokers have a variety of arrangements with firms which often include conditions, such as requiring a minimum amount of order flow per month before payments begin; different rates for low-priced securities; and graduated payments based on dollar volume per month. Others argue that it would place an extreme burden on recipient broker-dealers to determine the amount of order flow received for each order in time for a confirmation. Several commenters also argue that specific disclosure would require broker-dealers to reprogram computer systems, perform tracking and report cash payments, and that such expenses are disproportionately high in relation to the potential benefits to customers. Some commenters recommend a generic disclosure statement which would eliminate the high cost of systems changes, yet still inform the customer as to the receipt of payment for order flow. Another concern raised by opponents of the Commission's proposal is that payment is given for an aggregation of orders directed to a particular market center and does not attach to a particular order. -[40]- In the Companion Release, the Commission solicits comment on whether broker-dealers should be required to provide ranges, on confirmations, of monetary and non- monetary payment for order flow received and quantification of internalization/affiliate practices on a per share basis. See Companion Release, supra note 5. -[41]- The Commission, however, is proposing in a parallel action, to require quantification of monetary and non- monetary compensation and internalization. Id. -------------------- BEGINNING OF PAGE #14 ------------------- role of the required disclosures on the confirmation is more limited and is intended to inform customers about the existence of payment for order flow practices and to confirm that which the customer, if interested, already should know about the broker's order handling practices as a result of the new account and annual disclosure statements. IV. Alternative Proposals The Commission also solicited comment in the Proposing Release on alternative approaches to regulating the practice of payment for order flow. The Commission invited commenters to address such alternatives as banning payment for order flow and requiring the broker-dealers to pass payment for order flow through to their customers, -[42]- and directing securities markets to convert quotations to decimal-based pricing from the current one-eighth fractions. The Commission, however, has determined that these approaches are not the appropriate regulatory response at this time. A. Banning Payment for Order Flow The Commission believes disclosure is the appropriate response to the issues raised by payment for order flow. The Commission does not believe that all payment for order flow arrangements are against the customer's best interest and must be banned per se as compromising a broker's duty to seek best execution of the customer's order. -[43]- For example, it is unclear what harm lurks in specialists' or market makers' payment for order flow practices if unpriced orders are subject to a meaningful opportunity for price improvement, or if other benefits are provided to the customer due to the dealer's ability to use the payments. Additionally, the disclosures required by the new Rule and Rule amendments should mitigate concerns opponents may have that investors are unaware of a broker- dealer's order routing practices. An outright ban at this time, moreover, would represent a radical change to the industry where the payment of cash or its -[42]- No commenters fully supported the alternative of passing payments through to customers. Three commenters, however, oppose the alternative and argue that the economic advantages of order flow payments already benefit customers of retail firms in the form of lower commission rates. Moreover, some argue compulsory remission of payments may be administratively burdensome for brokers and difficult to enforce due to the difficulty in allocating direct payments for particular orders. -[43]- See NASD Rules of Fair Practice, Art. III, 1, Interpretation of the Board of Governors on Execution of Retail Transactions in the Over-The-Counter Market; and Section 11A(a)(1)(D) of the Act, 15 U.S.C. 78k- 1(a)(1)(D) (1988). Broker-dealers also have obligations under the "shingle theory," which states that a dealer who engages in business impliedly represents that he will deal fairly with the public and in accordance with the standards of the profession. See SEC v. Great Lake Equities Co., 755 F. Supp. 211 (E.D. Mich. Sept. 4, 1990); and N. Wolfson, R. Phillips & T. Russo, Regulation of Brokers, Dealers and Securities Markets 2.10, at 2-51 (1977). -------------------- BEGINNING OF PAGE #15 ------------------- monetary equivalent has become widespread. -[44]- In addition, banning payment for order flow has associated workability problems. -[45]- If the practice of cash payment for order flow were banned, because it is only one of many forms of inducement for order flow, the Commission has every reason to believe that an attendant increase in related "soft" inducements for order flow or internalization of order flow would follow. -[46]- Moreover, it would be impractical to attempt to ban solely soft practices (everything except monetary payment for order flow); such practices are difficult to monitor and industry participants would find alternative avenues for accomplishing the same result. The Commission will continue to monitor developments and will consider additional regulatory steps if necessary to ensure the protection of investors. B. Decimal Pricing The Commission also solicited comment on adopting a decimal- based system for the pricing and reporting of all securities for which transactions are reported. Some commenters believe that payment for order flow is, in effect, a reduction in the spread that a market maker charges for executing a pre-determined package of order flow. Under this view, if the NBBO is 20 bid and 20 1/4 offered, these commenters view the payment of two cents a share for order flow as little more than an indication that, in effect, a market maker is willing to buy at 20.02 and willing to sell at 20.23. Accordingly, these commenters believe that if a decimal pricing system were adopted, market makers could more easily compete by narrowing their displayed quotes, resulting in reduced incentive to pay for order flow. Others question whether the availability of decimals would, in fact eliminate payment for order flow because market makers still only may want to pay for certain types of orders (e.g., a diverse group of small market orders) and, as a result, may not lower their published quotes. The Commission believes that decimal pricing is the logical next step for the markets to pursue to improve the transparency of the markets and provide opportunities for narrower spreads. -[47]- Indeed, as an interim measure, the Commission's staff called for the markets to move to pricing in 1/16ths in the near future. -[48]- In this regard, the Commission understands the markets have undertaken a study of the costs and benefits of -[44]- Some commenters favor a complete ban on payment for order flow; others favor a ban on cash payments only. -[45]- Opponents of a ban argue that payment for order flow is not illegal or unethical and that banning payment for order flow would pose serious workability problems regarding banning some, but not all, practices. -[46]- The Commission recognizes that in urging a complete ban, some commenters are looking to address a potential conflict of interest that they believe affects a dealer's ability to meet its fiduciary duties to customers and provide a level playing field for exchange and OTC markets in exchange listed stocks. -[47]- See Market 2000, supra note 3, Study IV at 8-9. -[48]- In January 1994, the Division recommended the adoption of a 1/16th of a dollar increment as a transitional step leading to decimal pricing. See id. at 9. -------------------- BEGINNING OF PAGE #16 ------------------- changing the current display mechanisms. -[49]- The Commission looks forward to the prompt completion of the SRO study and the ultimate implementation of revised pricing procedures. While it is currently unclear how decimalization would affect payment for order flow practices, the Commission will monitor the progress of such endeavors and is prepared to reconsider the Rules adopted today, and even to rescind them if decimal pricing or other reforms render payment for order flow obsolete. V. Implementation Date The Commission is setting April 3, 1995 as the implementation date for both the amendments to Rule 10b-10 and Rule 11Ac1-3. Thus, for orders received or trades effected on or after April 3, 1995, all customer confirmation statements must contain the new disclosures required by Rule 10b-10, as modified today. For all new accounts opened on or after April 3, 1995, the disclosures required by Rule 11Ac1-3 will be in effect. For existing accounts, the disclosures required by Rule 11Ac1-3 should be made to customers beginning with the first commercially reasonable date after April 3, 1995, but in no event, later than April 3, 1996. For example, if a firm provides annual disclosure statements in January of each year, the disclosures should be made beginning with the January 1996 account statement. If the firm provides quarterly statements, the disclosures should be made beginning with the July 1995 account statement. The April 3, 1995 date was selected to provide firms with four months to make the necessary systems and forms changes to prepare for the implementation. VI. Competition Findings Section 23(a)(2) of the Act -[50]- requires the Commission in adopting rules under the Act, to consider the anti-competitive effects of such rules, if any, and to balance any impact against the regulatory benefits gained in terms of furthering the purposes of the Act. The Commission believes the proposed Rules -[49]- On June 22, 1994, the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce held a hearing regarding decimal-based pricing and unlisted trading privileges. Panelists included: Richard Ketchum, Executive Vice President and Chief Operating Office, NASD; Edward Kwalwasser, Executive Vice President for Regulation, NYSE; Nicholas Giordano, President and Chief Executive Officer, Phlx; and Brandon Becker, Director, Division of Market Regulation, SEC. Congressman Markey and the panelists discussed decimal pricing and moving to sixteenths as an interim measure. Congressman Markey asked the self-regulatory organizations ("SROs") to undertake a joint study, to be completed by January 1995, of the implications of moving to sixteenths (as well as decimal pricing) and the costs and benefits associated with the move. All of the SRO panelists agreed to participate in the study. The Unlisted Trading Privileges Act of 1994 and Review of the SEC's Market 2000 Study: Hearings Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, 103d Cong., 2d Sess. (1994). -[50]- 15 U.S.C. 78w(a)(2). -------------------- BEGINNING OF PAGE #17 ------------------- will enhance competition among brokers, dealers, and market centers, consistent with the goals of Sections 11A and 23(a) of the Act. Several commenters raised concerns that the Rules, as proposed, would require substantial systems changes and therefore, would increase the costs of doing business which would be passed on to customers. The Commission has modified the portion of proposed Rule 10b-10(a)(7)(iii)(B) requiring individualized confirmation disclosure of and the amounts of monetary payment for order flow received. The Rule, as adopted, may eliminate the need for individualized disclosures and for the quantification of payment for order flow. The Commission intends to evaluate these issues further in connection with its Companion Release soliciting comment on amendments to Rule 10b-10 and Rule 11Ac1-3(a)(2). -[51]- The Commission has considered Rule 11Ac1- 3 and amendments to Rule 10b-10 in light of the standard cited in Section 23(a)(2) and believes that adoption of the Rules, as modified, will not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Act. VII. Conclusion The Commission believes that Rule 11Ac1-3 and amendments to Rule 10b-10(a)(7)(iii) and 10b-10(e) will provide relevant, uniform disclosure to customers regarding details of their order executions. It is the Commission's view that the Rule and Rule amendments will enhance investor protection and further competition for retail orders by enabling customers to evaluate better the markets to which their orders are routed. The Commission further believes that broker-dealers can make the necessary systems and forms changes to comply with the Rules, as amended, with limited resource and systems changes. The Commission recognizes, however, that the extent and nature of the modifications depends upon the current capabilities of each firm. Nevertheless, the Commission recommends that, as necessary, broker-dealers that need to make systems changes evaluate their progress as the implementation date approaches and make adjustments as appropriate to ensure a smooth transition to the enhanced disclosure of payment for order flow. VIII. Summary of Final Regulatory Flexibility Analysis The Commission has prepared a Final Regulatory Flexibility Analysis ("FRFA") regarding Rules 10b-10 and 11Ac1-3, in accordance with 5 U.S.C. 604. The FRFA notes the potential costs of operational and procedural changes that may be necessary to comply with the Rule. A copy of the FRFA may be obtained by contacting Jill W. Ostergaard, Attorney, Branch of the National Market System, Office of Market Supervision, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington, D.C. 20549. List of Subjects 17 CFR Part 240 Brokers and dealers, Registration and regulation, Securities. Text of the Amendments For the reasons set out in the preamble, the Commission amends Part 240 of Chapter II of Title 17 of the Code of Federal Regulations to read as follows: PART 240 -- GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 -[51]- See Companion Release, supra note 5. -------------------- BEGINNING OF PAGE #18 ------------------- 1. The general authority citation for Part 240 is revised to read as follows: Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted. * * * * * 2. By amending 240.10b-10 by redesignating paragraph (a)(7)(iii) as paragraph (a)(7)(iv), adding paragraphs (a)(7)(iii) and (e)(9), and revising paragraph (a)(8) to read as follows: 240.10b-10 Confirmation of transactions. (a) * * * (7) * * * (iii) For a transaction in any subject security as defined in 240.11Ac1-2 or a security authorized for quotation on an automated interdealer quotation system that has the characteristics set forth in Section 17B of the Act (15 U.S.C. 78q-2), a statement whether payment for order flow is received by the broker or dealer for transactions in such securities and that the source and nature of the compensation received in connection with the particular transaction will be furnished upon written request of the customer; and (8) If he is acting as principal for his own account. (i)(A) If he is not a market maker in that security and, if, after having received an order to buy from such customer, he purchased the security from another person to offset a contemporaneous sale to such customer or, after having received and order to sell from such customer, he sold the security to another person to offset a contemporaneous purchase from such a customer, the amount of any mark-up, mark-down, or similar remuneration received in an equity security; or (B) In any other case of a transaction in a reported security, the trade price reported in accordance with an effective transaction reporting plan, the price to the customer in the transaction, and the difference, if any, between the reported trade price and the price to the customer. (ii) In the case of a transaction in an equity security, whether he is a market maker in that security (otherwise than by reason of his acting as a block positioner in that security). * * * * * (e) * * * (9) Payment for order flow shall mean any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration to a broker or dealer from any broker or dealer, national securities exchange, registered securities association, or exchange member in return for the routing of customer orders by such broker or dealer to any broker or dealer, national securities exchange, registered securities association, or exchange member for execution, including but not limited to: research, clearance, custody, products or services; reciprocal agreements for the provision of order flow; adjustment of a broker or dealer's unfavorable trading errors; offers to participate as underwriter in public offerings; stock loans or shared interest accrued thereon; discounts, rebates, or any other reductions of or credits against any fee to, or expense or other financial obligation of, the broker or dealer routing a customer order that exceeds that fee, expense or financial obligation. * * * * * -------------------- BEGINNING OF PAGE #19 ------------------- 3. 240.11Ac1-3 is added to read as follows: 240.11Ac1-3 Customer account statements . (a) No broker or dealer acting as agent for a customer may effect any transaction in, induce or attempt to induce the purchase or sale of, or direct orders for purchase or sale of, any subject security as defined in 240.11Ac1-2 or a security authorized for quotation on an automated interdealer quotation system that has the characteristics set forth in Section 17B of the Act (15 U.S.C. 78q-2), unless such broker or dealer informs such customer, in writing, upon opening a new account and on an annual basis thereafter, of the following: (1) The broker's or dealer's policies regarding receipt of payment for order flow as defined in 240.10b-10(e)(9), from any broker or dealer, national securities exchange, registered securities association, or exchange member to which it routes customers' orders for execution, including a statement as to whether any payment for order flow is received for routing customer orders and a detailed description of the nature of the compensation received; and (2) The broker's or dealer's policies for determining where to route customer orders that are the subject of payment for order flow as defined in 240.10b-10(e)(9) absent specific instructions from customers, including a description of the extent to which orders can be executed at prices superior to the best bid or best offer as defined in 240.11Ac1-2. (b) Exemptions. The Commission, upon request or upon its own motion, may exempt by rule or by order, any broker or dealer or any class of brokers or dealers, security or class of securities from the requirements of paragraph (a) of this section with respect to any transaction or class of transactions, either unconditionally or on specified terms and conditions, if the Commission determines that such exemption is consistent with the public interest and the protection of investors. By the Commission. Jonathan G. Katz Secretary Dated: October 27, 1994