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August 4, 2005 Ms. Aleksandra Radakovic
Dear Ms. Radakovic: In your letter of August 3, 2005, on behalf of J.P. Morgan Securities Inc. ("JPMSI"), you request assurance that the staff of the Division of Market Regulation ("Staff") will not recommend enforcement action to the Commission under paragraph (a) of Rule 10b-10 under the Securities Exchange Act of 1934 ("Exchange Act") if JPMSI confirms its capacity as "agent" in certain transactions for its customers, as described below. Specifically, you plan to indicate on a customer confirmation that JPMSI has acted as agent when JPMSI submits a customer's order through the electronic trading facilities of the Archipelago Exchange ("ArcaEx"), in JPMSI's role as the customer's agent, and the order is executed in a trade with an anonymous contra-party that turns out to be JPMSI or one of its affiliates (collectively, "JPM Entities") trading in a principal (including proprietary) capacity, so long as the conditions set out below are met and JPMSI complies with all other requirements of Rule 10b-10 in confirming the customer's order, including paragraph (a)(2)(i) thereof. In your letter, you refer to the order that JPMSI submits to ArcaEx as agent for a customer as the "Customer Order," and the orders that the JPM Entities submit for trading as principal (including proprietary orders) as the "Principal Orders." Your request is limited to those situations in which: (1) the representative of JPMSI submitting Customer Orders to ArcaEx does not have knowledge of Principal Orders submitted by the JPM Entities, and the representatives of the JPM Entities submitting Principal Orders to ArcaEx do not have knowledge of Customer Orders submitted by JPMSI (the "No Knowledge Requirement"); and (2) JPMSI does not determine or influence the selection of the contra-party against which the Customer Order will be executed (the "Parity Requirement"). Response:Based on the facts and representations set forth in your letter, the Staff will not recommend enforcement action to the Commission under paragraph (a) of Rule 10b-10 if JPMSI indicates on confirmations to its customers that JPMSI acted as agent on a customer's behalf when a representative of JPMSI submits a Customer Order to ArcaEx on an agency basis and that order is executed in ArcaEx in a trade with an anonymous contra-party that turns out to be a JPM Entity trading in a principal (including proprietary) capacity, provided that JPMSI complies with all other requirements of Rule 10b-10 in confirming the customer's order, including paragraph (a)(2)(i) thereof, and provided that the handling and execution of the Customer Order complies with the No Knowledge and Parity Requirements, as described in your letter. In taking this position, we note your representation regarding the low probability of a broker-dealer that submits an agency order in ArcaEx executing against its own principal trading interest. We also note that JPMSI continues to have a duty of best execution.1 This position concerns enforcement action only. It is based solely upon the representations you have made and is limited strictly to the facts and conditions described in your letter. Any different facts or circumstances, including any change to the operation of ArcaEx, may require a different response. Finally, we express no view with respect to other questions the proposed activities of JPMSI may raise, including the applicability of any other federal or state laws or the applicability of self-regulatory organization rules concerning customer account statements or confirmations. Sincerely, Brian A. Bussey Endnotes
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Re: |
Request for No-Action Relief from Paragraph (a)(2) of Rule 10b-10 under the Securities Exchange Act of 1934 by J.P. Morgan Securities Inc. |
Dear Ms. McGuire:
J.P. Morgan Securities Inc. ("JPMSI"), a broker dealer registered with the Commission, respectfully requests your assurance that the staff of the Division of Market Regulation ("Staff") will not recommend that the Commission take any enforcement action under paragraph (a) of Rule 10b-10 under the Securities Exchange Act of 1934 (the "Act") in connection with its activities executing orders for its customers in the circumstances described below. Specifically, JPMSI requests this relief to permit it to indicate on a customer confirmation that JPMSI has acted as agent where JPMSI submits a customer's order through the electronic trading facilities of the Archipelago Exchange ("ArcaEx"), in JPMSI's role as the customer's agent, and the order is executed in a trade with an anonymous contra-party that turns out to be JPMSI or one of its affiliates (collectively, "JPM Entities") trading in a principal (including proprietary) capacity, so long as the conditions set out below are met and JPMSI otherwise complies with all other requirements of Rule 10b-10 in confirming the customer's order, including paragraph (a)(2)(i) thereof.1
For purposes of clarity, we will call herein "Customer Orders" the orders that JPMSI submits to ArcaEx as agent for a customer, and "Principal Orders" the orders that the JPM Entities submit for trading as principal (including proprietary orders).
This request for no-action relief is limited, however, to those situations in which the following requirements are met: (1) the representative of JPMSI submitting Customer Orders to ArcaEx does not have knowledge of Principal Orders submitted by the JPM Entities, and the representatives of the JPM Entities submitting Principal Orders to ArcaEx do not have knowledge of Customer Orders submitted by JPMSI (the "No Knowledge Requirement"); and (2) JPMSI does not determine or influence the selection of the contra-party(ies) against which such Customer Orders will be executed (the "Parity Requirement").2
The Archipelago Exchange ("ArcaEx") is an all-electronic stock market which trades equity securities listed with the New York Stock Exchange ("NYSE"), Nasdaq, American Stock Exchange ("Amex") and Pacific Exchange, as well as exchange-traded funds ("ETFs") and other exchange-listed securities. Currently, ArcaEx operates as the exclusive equities trading facility of PCX Equities, Inc., a wholly-owned subsidiary of the Pacific Exchange, Inc. ("PCX"). Only registered broker-dealers who have applied for and received an Equity Trading Permit ("ETP Holders") are permitted to trade on ArcaEx. The ArcaEx matching engine follows strict price-time priority rules for displayed orders and supports additional order types to augment traditional limit and market orders. ArcaEx maintains an open, electronic file of orders called the ArcaEx Book. The ArcaEx Book is divided into a number of execution processes. Limit orders are ranked and maintained in each process based on order type thus allowing orders to be organized by time of entry. For example, a limit order is stored in the Display Order Process. The displayed portion of a reserve order is ranked in the Display Order Process while its reserve portion is filed in the Working Order Process. The best-ranked displayed order(s) to buy and sell in the ArcaEx Book and the corresponding aggregate size of such orders associated with such prices are collected and made available to quotation vendors. ArcaEx may route orders that are not matched on the ArcaEx Book to a different market center for execution.3
Paragraph (a)(2) of Rule 10b-10 requires a broker dealer to disclose on a confirmation to a customer the capacity in which it handled the customer's order (i.e., as agent or principal), and whether the broker dealer acted as agent for some other person, or as agent for both the customer and some other person (the "Capacity Requirement"). The Capacity Requirement, in conjunction with the other requirements of paragraph (a)(2) of Rule 10b-10, is designed to provide customers with information that could alert them to potential conflicts of interest their broker dealer may have had when handling their orders.
JPMSI is requesting assurance that the Staff will not recommend enforcement action to the Commission under paragraph (a) of Rule 10b-10 if JPMSI indicates on confirmations to its customers that JPMSI acted as agent on a customer's behalf when JPMSI submits a Customer Order to ArcaEx on an agency basis and that order is filled in ArcaEx by execution against an anonymous contra-party, even if the anonymous contra-party could be a JPM Entity trading in a principal (including proprietary) capacity, provided that JPMSI complies with all other requirements of Rule 10b-10 in confirming the Customer Order, including paragraph (a)(2)(i) thereof.
This request for no-action relief is limited, however, to those circumstances in which JPMSI complies with the No Knowledge and Parity Requirements, discussed below.
This request for no-action relief is limited to those situations in which the representatives of the JPM Entities submitting Principal Orders do not have knowledge about Customer Orders submitted by JPMSI, and the representatives of JPMSI submitting Customer Orders do not have knowledge about the Principal Orders submitted by the JPM Entities.
The No Knowledge Requirement is consistent with a position adopted by the Commission in an analogous setting. In the context of the NASD's rule giving certain customer limit orders an absolute right of priority, commonly known as the "Manning" right, and prohibiting broker dealers from trading ahead of their customer limit orders, the Commission reviewed prior to issuance and approved an NASD Special Notice to Members stating that "[a]s long as a firm implements and utilizes an effective system of internal controls, such as appropriate 'Chinese walls,' that operate to prevent the non market making desk from obtaining knowledge of customers' limit orders, those other desks may continue to trade at prices the same as or inferior to the customers' limit orders."4
Similar to the Manning interpretation, JPMSI will be able to satisfy the No Knowledge Requirement if it implements and utilizes an effective system of internal controls, such as appropriate information barriers, that operate to prevent the representatives of the JPM Entities submitting Principal Orders from obtaining knowledge about the Customer Orders submitted by JPMSI, and the representative of JPMSI submitting Customer Orders from obtaining knowledge about the Principal Orders submitted by the JPM Entities. To be effective, such a system of internal controls must include specific policies and procedures that prevent each Principal Order submitter separated by the information barriers from obtaining knowledge regarding Customer Orders submitted by JPMSI, and each Customer Order submitter separated by the information barriers from obtaining knowledge regarding Principal Orders submitted by the JPM Entities. In addition, to satisfy the No Knowledge Requirement, all Customer Orders of JPMSI and all Principal Orders of the JPM Entities must be submitted on an anonymous basis (either with pre-trade anonymity or full anonymity).
For purposes of the no-action relief sought hereby, it is relevant that JPMSI has currently in place an effective system of internal controls, policies and procedures that prevents its proprietary trading desks from gaining knowledge of the open Customer Orders and vice versa.
In addition to the No Knowledge Requirement, this request for no-action relief is limited to those situations in which JPMSI does not determine or influence the selection of the trading interest against which a Customer Order will be executed.5 The Parity Requirement thus eliminates from the no-action request situations in which JPMSI sends directed orders to ArcaEx and orders that assign preference to itself.
JPMSI believes it would be appropriate in the case of an order submitted for execution to ArcaEx for JPMSI to indicate in the customer's confirmation that, in executing the Customer Order, JPMSI was acting as agent, even if the order was executed against a Principal Order submitted by a JPM Entity if the No Knowledge and Parity Requirements are met.
JPMSI believes that stating in the customer's confirmation that JPMSI acted as agent, under such circumstances, would not contravene any of the purposes of Rule 10b-10. The Commission has summarized the purposes of the Confirmation Rule as follows: "[T]he confirmation requirement . . . provides basic investor protection by conveying information allowing investors to verify the terms of their transactions; alerting investors to potential conflicts of interest with their broker-dealers; acting as a safeguard against fraud; and providing investors a means to evaluate the costs of their transactions and the quality of their broker-dealer execution."6 The relief sought hereby is discussed below in light of each of the stated purposes of Rule 10b-10.
By submitting an order to ArcaEx marked as an agent order, JPMSI has evidenced its intent to act in an agency capacity. Further, the No Knowledge and Parity Requirements are designed to ensure that this intent to act as agent and the actual handling and execution of the order as agent are not compromised.
Where the Customer Order and the Principal Order are executed against each other by the systems of the electronic order execution facility of ArcaEx, indicating in the confirmation that JPMSI has acted as agent does not increase the risk of fraud against the customer, where the No Knowledge Requirement and Parity Requirement are met. To the contrary, the matching of the agency and proprietary trading interests occurs at the best price available and the contra-party is determined randomly based upon priority factors established by the rules of the exchange, which have been approved by the Commission. In addition, JPMSI does not know that it executed the order against itself until after the order is executed. Further, we have been informed that statistics measuring the degree of order interaction among the participants in ArcaEx suggest that the probability of a broker-dealer that submits an agency order executing against its own principal trading interest is low.7,8 In such circumstances, the broker-dealer cannot disadvantage the customer.
Additionally, stating in a confirmation that JPMSI acted as an agent is an accurate statement of JPMSI's manner of handling the Customer Order. Therefore, it is not inconsistent with the purposes of the Capacity Requirement to allow JPMSI to indicate that it executed the customer's order on an agency basis.
Moreover, the proposed no-action relief will not diminish investor protection because it does not relieve JPMSI of its duty of best execution.9 It should also be noted that the failure by JPMSI to seek the most advantageous terms reasonably available under the circumstance for a Customer Order may be a violation of NASD rules.10 In these circumstances, the conflicts that can arise when an order is handled and executed as principal are not present, and therefore it is not inconsistent with the purposes of the Capacity Requirement to allow JPMSI to indicate it executed the Customer Order on an agency basis.
Finally, the information contained in the confirmation will still allow the customer to verify the terms of its transactions and will provide investors with a means to evaluate the costs of its transactions and the quality of JPMSI's execution.
In view of the foregoing, JPMSI respectfully requests that the Staff will not recommend enforcement action to the Commission under paragraph (a) of Rule 10b-10 if JPMSI indicates on confirmations to its customers that JPMSI acted as agent on a customer's behalf when a representative of JPMSI submits a Customer Order to ArcaEx on an agency basis and that order is executed in ArcaEx in a trade with an anonymous contra party that turns out to be a JPM Entity trading in a principal (including proprietary) capacity, provided that JPMSI complies with all other requirements of Rule 10b-10 in confirming the customer's order, including paragraph (a)(2)(i) thereof. This request for no-action relief is limited, however, to those order handling and execution scenarios that comply with the No Knowledge and Parity Requirements discussed above. We note that the Commission has previously granted relief to broker-dealers trading through the Nasdaq Market Center that is analogous to the relief we are now requesting as to trades through ArcaEx. See Letter, dated January 26, 2005, from Brian Bussey, Assistant Chief Counsel of the Division of Market Regulation at the SEC, to Edward S. Knight, Executive Vice President and General Counsel of The Nasdaq Stock Market.
If you have any questions, I can be reached at (212) 622-5227, or you can call Steven Lofchie of Davis Polk & Wardwell, at (212) 450-4075.
Sincerely,
cc: |
Brian Bussey |
http://www.sec.gov/divisions/marketreg/mr-noaction/jpmorgan080405.htm
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