April 1, 2010
I would like to comment briefly on Payment for Order Flow practices and the need for the Securities and Exchange Commission to initiate Rule Making Proceedings to amend Existing Rule 10b-10 and to adopt a Rule prohibiting the payment of order flow credits where a customer does not seek to profit from trades.
1. In De Kwiatkowski v. Bear Stearns Co. et al Docket # 01-7712 (2d Cir. 2002), the Second Circuit cited approvingly Press v. Chem. Inv. Services Corp. 166 F 3d 526,539 (2d Cir. 1999) that a "broker's fiduciary duty is limited to the narrow task of consummating the transaction in question." As a fiduciary in executing orders, brokers are not permitted to retain payments other than commissions or commission equivalents such as markups or markdowns without express written permission of the clients. These cases definitively disagree with the position of the Securities and Exchange Commission in its Release with regard to order flow payments for execution of orders that it was an 'open" qustion whether brokers are fiduciaries. As the controlling statement by the courts on the law of fiduciaries, Rule 10b-10 needs to be amended to provide that order flow payments must flow thru to customers and not retained by brokers. There is no satisfactory explanation why this Rule 10b-10 amendment was not adopted in 1999 after the Press decision and certainly none after DeKwiakowski in 2002. Brokers can adjust their commission or markup policies with the written consent of their customers to reflect the flow thru of order flow payments.
2. Where customers do not seek to make a profit on their orders by entering a limit order at the same price on the other side of the market after one limit order is executed in order to capture order flow credits, such a practice is in apparent violation of Sections 9 and 10 of the Securities Exchange Act of 1934 and Section 17 of the Securities Act of 1933. Common sense dictates that, in the absence of order flow credits, orders would not be placed that had no possibility of profitability. Yet, a strategy of seeking to capture order flow credits in extremely liquid high volume penny spreads is viable in microseconds by computer generated programs. Such a strategy is precisely the fraudulent "active and apparent" activity that Section 9 prohibits in Exchange Markets and Section 10 prohibits in non-exchange markets. The Securities and Exchange Commission is charged by Congress with the obligation to preserve the integrity of securities markets. The practice of solely seeking to obtain order flow credits that are otherwise by definition unprofitable undermines that integrity. A specific rule needs to be adopted to prohibit this activity.