

[Federal Register: July 10, 2006 (Volume 71, Number 131)]
[Notices]               
[Page 38950-38953]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10jy06-98]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54088; File No. SR-NASD-2004-135]

 
Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval of Proposed Rule Change and 
Amendment Nos. 1, 2, and 3 Thereto, and Notice of Filing and Order 
Granting Accelerated Approval of Amendment No. 4 to the Proposed Rule 
Change, to Adopt NASD Rule 2441 to Require Disclosure and Consent When 
Trading on a Net Basis With Customers

June 30, 2006

I. Introduction

    On September 1, 2004, the National Association of Securities 
Dealers, Inc. (``NASD'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to require disclosure and consent 
when trading on a net basis with customers. NASD amended the proposed 
rule change on February 16, 2005,\3\ February 25, 2005,\4\ and March 
21, 2005.\5\ The

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proposed rule change, as modified by Amendment Nos. 1, 2, and 3, was 
published for notice and comment in the Federal Register on April 6, 
2005.\6\ The Commission received three comments on the proposal.\7\ On 
September 13, 2005, NASD responded to the comments, and amended the 
proposed rule change.\8\ This order provides notice of filing of 
Amendment No. 4, and approves the proposed rule change as modified by 
Amendment Nos. 1, 2, 3, and grants accelerated approval to Amendment 
No. 4.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Amendment No. 1.
    \4\ See Amendment No. 2.
    \5\ See Amendment No. 3.
    \6\ See Securities Exchange Act Release No. 51457 (March 31, 
2005), 70 FR 17489.
    \7\ See April 20, 2005 letter from David Sieradzki, Esquire, 
Milbank Tweed, to Lourdes Gonzales, Division of Market Regulation, 
SEC (via e-mail) (``Milbank Letter''); April 27, 2005 letter from 
Klindt Ginsberg, Managing Director, The Seidler Companies, Inc. (via 
e-mail) (``Seidler Letter''); May 4, 2005 letter from Amal Aly and 
Ann Vlcek, Vice Presidents and Associate General Counsels, 
Securities Industry Association (``SIA''), to Jonathan G. Katz, 
Secretary, SEC (``SIA Letter'').
    \8\ See Amendment No 4.
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II. Summary of Comments

    The Commission received a total of three comment letters on the 
NASD's proposal to require consent and disclosure when trading with 
customers on a net basis. One commenter requested clarification with 
respect to the interplay between the proposal and NASD Rule 4632. The 
other two comment letters expressed various objections to the proposal. 
The following summary of comments provides an overview of the 
commenters' concerns.
     With Respect to Non-Institutional Clients, Requiring 
Mandatory, Written, Pre-trade Disclosure and Consent on an Order-By-
Order Basis is Unnecessarily Burdensome to Broker-Dealers
    One commenter asserts that the rule as proposed places an 
unnecessary burden on broker-dealers when trading on a net basis on 
behalf of non-institutional clients. The rule requires that, for non-
institutional clients, broker-dealers must provide pre-trade disclosure 
to and obtain consent from the client in writing on an order-by-order 
basis.\9\ The commenter stated that ``the actions detailed in this 
proposed rule change would be confusing to the client, costly to the 
firm, and impossible to manage and track on an order-by-order basis.'' 
\10\ The commenter expressed concern that ``[t]he proposed rule would 
burden the firm with additional time and money spent on record keeping 
and auditing practices'' and hinder a broker-dealer's ability to obtain 
best execution of its customers' orders.\11\ Similarly, another 
commenter--while agreeing in principle with disclosure and consent 
rules--stated that the requirement ``for a knowing, written consent on 
an order-by-order basis * * * is impractical where most orders are not 
taken in writing, and there is no opportunity to obtain [such a 
consent].'' \12\ This commenter proposed modifying the rule to permit 
the use of negative consent letters (similar to what the rule requires 
vis-[agrave]-vis institutional clients) or of obtaining oral consent on 
an order-by-order basis and to permit such consent to be evidenced on 
the customer order ticket.\13\
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    \9\ This contrasts with the lower burden for institutional 
clients under the proposed rule, in which broker-dealers may fulfill 
their disclosure and consent requirements via a one-time ``negative 
consent'' letter. See Securities Exchange Act Release No. 51457 
(March 31, 2005), 70 FR 17489 (April 6, 2005) (SR-NASD-2004-135).
    \10\ Seidler Letter.
    \11\ Id.
    \12\ SIA Letter at 5.
    \13\ SIA Letter at 2, 5. The letter further recommended that, 
for firms choosing to obtain oral consent on an order-by-order 
basis, pre-trade disclosure be required in the form of a one-time 
comprehensive disclosure statement, and also that, for fiduciaries 
of non-institutional customers granted trading discretion who on 
their own qualify as an ``institutional account'' under the proposed 
rule, members be permitted to obtain the consent of such fiduciaries 
in the same manner as permitted for their institutional customers. 
Id.
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    Moreover, the two commenters opined that the additional burdens 
placed on broker-dealers by the rule could not be justified by any 
added benefit to investors.\14\ One commenter pointed out that, because 
the advent of decimal pricing in 2000 substantially reduced the 
practice of net trading generally, the rule would have little practical 
benefit.\15\
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    \14\ See, e.g., Seidler Letter (``Having the client sign a 
disclosure document prior to each and every trade provides no 
benefit. It will confuse the client and will provide no additional 
information that is not available elsewhere.''); SIA Letter at 5 
(``[N]o purpose is served by imposing onerous and impractical 
requirements on customers who do wish to consent to [trading on a 
net basis].'').
    \15\ SIA Letter at 4.
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     With Respect to Institutional Clients, Requiring 
Disclosure and Consent via Negative-Consent Letters is Unnecessarily 
Burdensome to Broker-Dealers
    Regarding institutional clients, the commenters similarly objected 
to the rule's consent and disclosure requirements via a ``negative 
consent'' letter as unnecessarily burdensome. One commenter stated that 
the rule was wholly unnecessary because ``investors already receive a 
`net' trading disclosure when an account is opened * * * [and] 
institutional investors by nature are accredited and sophisticated.'' 
\16\ Another commenter, citing the declining practice of net trading 
since decimalization, argued that ``the costs and burden of sending, 
receiving and tracking negative consent letters are excessive in light 
of the fact that institutional customers would receive the requisite 
level of protection, if not greater, by providing verbal consent on an 
order-by-order basis.'' \17\ This commenter therefore suggested 
modifying the proposed rule to allow the use of negative consent 
letters or of obtaining oral consent on an order-by-order basis and to 
permit the consent to be evidenced on the customer order ticket.\18\
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    \16\ Seidler Letter.
    \17\ SIA Letter at 4.
    \18\ Id. at 2, 4.
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     Member Firms and Other Registered Broker-Dealers Should Be 
Explicitly Exempt from the Proposed Rule
    One commenter requested that the NASD clarify the proposed rule 
change to ``confirm that member firms and other registered broker-
dealers are exempt from the requirements of the Proposed Rule, as they 
are neither institutional nor non-institutional customers.'' \19\
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    \19\ Id. at 2.
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     The Proposed Rule Should Be Clarified With Respect to Net 
Orders Routed Between Broker-Dealers
    The commenter further requested that the NASD clarify the proposed 
rule change to ``confirm [that] an executing broker-dealer handling an 
order marked `net' routed to it from an originating broker-dealer has 
no consent and disclosure obligation to the customer of the originating 
broker-dealer for whom it is handling the order.'' \20\
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    \20\ SIA Letter at 2.
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     The Proposed Rule Potentially Conflicts With Rule 
4632(d)(3)(A) Regarding Reporting Trades Exclusive of Any Mark-Up, 
Mark-Down, or Service Charge
    One commenter noted a potential conflict between the proposed rule 
and Rule 4632(d)(3)(A), which states that trades must be reported 
exclusive of any mark-up, mark-down, or service charge.\21\
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    \21\ Milbank Letter.
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III. The NASD's Response to Comments

    NASD responded to the comments in Amendment No. 4. Regarding the 
commenters' assertion that the proposed disclosure and consent 
requirements were unnecessary for institutional customers, NASD amended 
the proposed rule change to allow members the option of obtaining 
consent from institutional customers orally, on an order-by-order 
basis. However, NASD does not believe a one-time disclosure

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would be appropriate under such circumstances, thus, NASD proposes that 
members that choose to obtain oral consent on an order-by-order basis 
must also explain the terms and conditions for handling the order to 
the institutional customer before each transaction, and provide the 
institutional customer with ``a meaningful opportunity to object to the 
execution of the transaction on a net basis.'' Additionally, members 
must document the customer's understanding of the terms and conditions 
of the order and the customer's consent on an order-by-order basis.
    Regarding the comments relating to net transactions with non-
institutional customers, NASD states it ``recognizes the burdens that 
result from having to obtain written consent on an order-by-order 
basis'' but believes the written disclosure and consent requirements 
are important to ensure that information regarding members' methods of 
compensation on transactions is provided to non-institutional 
customers, and that such customers agree to the methods of 
compensation. NASD does not believe that the market information 
available to customers will assist customers to determine whether a 
member is trading net or to understand the ramifications for the 
customer of trading net. Ultimately, NASD believes that benefits of 
requiring member disclosure and consent outweigh the related burdens to 
members.
    NASD amended the proposal to allow a member, absent instructions to 
the contrary, to look to the institutional or non-institutional status 
of the fiduciary, rather than the underlying account, when deciding 
which method of disclosure and consent is allowable under the proposal.
    NASD clarified that the scope of the proposal does not include 
orders received from member firms and other registered broker-dealers. 
As such, the proposal would not apply to orders received from members 
and other registered broker-dealers, nor would a receiving broker-
dealer handling an order marked ``net'' routed to it from an 
originating broker-dealer have consent and disclosure obligations to 
the customer of the originating broker-dealer.\22\ In both scenarios, 
the originating broker-dealer would be responsible for adhering to the 
requirements.
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    \22\ Id. at 10-11.
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    Finally, with regard to the possible inconsistency between net 
trading and NASD Rule 4632(d)(3)(A), NASD explained that the trade 
reporting requirements for net trades ``are not germane to this 
proposed rule change'' and that no changes to those requirements are 
needed.\23\
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    \23\ Id. at 19.
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IV. Discussion and Commission Findings

    The Commission has reviewed carefully the proposed rule change, the 
comment letters, and the NASD's response to the comments, and finds 
that the proposed rule change is consistent with the requirements of 
the Act and the rules and regulations thereunder applicable to a 
national securities association.\24\ Specifically, the Commission finds 
that the proposed rule change is consistent with the provisions of 
Section 15A(b)(6) of the Act, which requires, among other things, that 
NASD's rules be designed to prevent fraudulent and manipulative acts 
and practices, promote just and equitable principles of trade, and, in 
general, protect investors and the public interest. The Commission 
believes that the proposed rule change should promote investor 
protection by codifying the requirement that members provide disclosure 
and obtain customer consent when trading on a net basis. The consent 
provided by non-institutional investors must evidence the customer's 
understanding of the terms and conditions of the order. The Commission 
also believes that the benefit to investors of requiring certain 
disclosures and obtaining customer consent when trading on a net basis 
outweighs the additional responsibilities placed on broker-dealers.
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    \24\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
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    The Commission understands the commenters' assertion that the 
proposed rule change's disclosure and consent requirements were 
unnecessary for institutional customers, and is satisfied that NASD's 
modification of the proposal to require that members that choose to 
obtain oral consent on an order-by-order basis also explain the terms 
and conditions for handling the order to the institutional customer 
before each transaction and provide the institutional customer with an 
opportunity to object to the execution of the transaction on a net 
basis in a meaningful way to be a reasonable resolution of the issue. 
The Commission also believes it is reasonable and not unduly burdensome 
to require members to document a customer's understanding of the terms 
and conditions of the order and the customer's consent on an order-by-
order basis.
    The Commission believes that the modifications to the proposed rule 
change that NASD made in response to issues raised by the commenters 
are reasonable and designed to ease the burdens placed on members 
without sacrificing the benefits to investors contemplated by the 
proposal. For example, the Commission believes that (i) absent 
instructions to the contrary, it is reasonable for a member to look to 
the institutional or non-institutional status of the fiduciary, rather 
than the underlying account, when deciding which method of disclosure 
and consent is consistent with the rule, and (ii) NASD's decision to 
allow members the option of obtaining consent from institutional 
customers orally on an order-by-order basis, but not allowing a one-
time disclosure under such circumstances, is consistent with investor 
protection and the public interest. Additionally, the Commission is 
satisfied that the clarifications NASD offered in response to the 
comments should provide sufficient guidance to allow members to satisfy 
the requirements of the rule. Finally, the Commission agrees with NASD 
that the trade reporting requirements for net trades contained in NASD 
Rule 4632(d)(3)(A) are not implicated in this proposed rule change.
    The Commission finds good cause for approving Amendment No. 4 on an 
accelerated basis. Amendment No. 4 modifies the proposal in response to 
issues raised by the commenters. Because Amendment No. 4 raises no 
novel issues, and provides improvements to the proposed rule change in 
direct response to issues raised by the commenters, the Commission 
finds good cause for approving Amendment No. 4 before the 30th day 
since its publication in the Federal Register.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act 
\25\, that the proposed rule change (SR-NASD-2004-135), as modified by 
Amendment Nos. 1, 2, 3 be, and it hereby is, approved, and Amendment 
No. 4 is approved on an accelerated basis.
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    \25\ 15 U.S.C. 78s(b)(2).
    \26\ 17 CFR 200.30-3(a)(12).


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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\26\
Nancy M. Morris,
Secretary.
[FR Doc. E6-10718 Filed 7-7-06; 8:45 am]

BILLING CODE 8010-01-P
