Division of Market Regulation:
|Question 1:||Format of Quarterly Reports (modified)|
|Question 2:||Identifying Significant Execution Venues|
|Question 3:||Materiality of Order Percentage Figures|
|Question 4:||Introducing Broker/Clearing Firm - Reporting Responsibility (modified)|
|Question 5:||Multiple Reports by a Broker-Dealer|
|Question 6:||Definition of Customer Orders - Large Order Exclusion (modified)|
|Question 7:||Definition of Customer Orders - Orders Received from Other Broker-Dealers or Foreign Banks Acting as Broker-Dealers|
|Question 8:||Definition of Directed Order - Default Routing Instructions (modified)|
|Question 9:||Classifying Market, Limit, and Other Orders|
|Question 10:||Orders Executed at Multiple Venues|
|Question 11:||Execution Venue for Riskless Principal Orders|
|Question 12:||Nasdaq Execution Venues|
|Question 13:||Disclosing Payment for Order Flow|
|Question 14:||Disclosing Internalized Order Flow|
|Question 15:||Procedures for Making Quarterly Reports Publicly Available|
|Question 16:||Responding to Requests from Customers for Individual Information|
|Question 17:||Written Notice to Customers Concerning Availability of Quarterly Reports and Individual Information|
|Question 18:||Orders That Are Cancelled and Replaced (new)|
|Question 19:||Products Traded in Multiple Markets (new)|
|Question 20:||Exemption from Public Posting Requirement for Firms with a De Minimus Number of Orders (new)|
|Question 21:||Definition of Customer Orders-After-hours Trading (new)|
|Question 22:||Orders in Foreign Securities (new)|
Q: Are broker-dealers required to follow any particular format in preparing their quarterly reports?
A: Yes. The Rule requires that a quarterly report be divided into four sections, one each for (1) covered securities listed on the New York Stock Exchange, Inc. ("NYSE") and reported as a Network A eligible security;3 (2) covered securities listed on The Nasdaq Stock Market, Inc.; (3) covered securities listed on the American Stock Exchange LLC ("Amex") or any of the regional stock exchanges and reported as a Network B eligible security;4 and (4) exchange-listed options. The Rule also specifies items of information that should be included in the quarterly reports in a clear format that will be understandable by customers and the public.
Attached as Exhibit A is an example of a quarterly report that is intended to offer guidance on a format that the Division would consider to be clear and understandable. The example report includes an introduction and a section with sample statistics. The section first sets forth summary statistics for the category of securities covered by the section. It next identifies the significant execution venues in descending order of the percentage of total non-directed orders routed to the venues. Finally, the section sets forth information relating to individual venues, including the percentages of different types of orders routed to each venue and the material aspects of the broker-dealer's relationship with each venue.
The report in Exhibit A is intended only as an example. Broker-dealers also are free to include additional information that they believe would be useful for customers and the public.
Q: If a broker-dealer routes the great majority of non-directed orders to a few execution venues, but also routes a small number of orders to several other venues, is the broker-dealer still required to identify and disclose its relationships with these other venues?
A: No. Broker-dealers need only identify and prepare disclosures for their most significant execution venues, as explained further below. The Commission noted in the Adopting Release that "the quarterly reports on order routing are intended to provide a general overview of a broker-dealer's practices that is accessible and useful to individual investors."5 To this end, the Rule requires broker-dealers to disclose only those execution venues to which they routed the most orders for a section of a report - the top ten and any others to which they routed five percent or more of orders.
Where, however, a broker-dealer routes the great majority of its orders for a section of the report to only a few venues, it also might route orders to other venues that fall within the top ten, but actually receive only a small number of orders. The inclusion of these venues in quarterly reports would not provide materially more useful information to investors, yet could impose a significantly higher compliance burden. Consequently, the Commission has exempted broker-dealers from the disclosure requirements of paragraph (b)(1)(ii) of the Rule with respect to execution venues that receive only a small percentage of the non-directed orders.6 Under the exemption, a broker-dealer is not required to identify execution venues that received less than 5% of non-directed orders for a section of the broker-dealer's quarterly report, as long as it has identified the top execution venues that in the aggregate received at least 90% of the broker-dealer's total non-directed orders for the relevant section.
Q: Is a broker-dealer required to capture, on an order-by-order basis, all information necessary to generate quarterly reports that precisely set forth the percentages of orders routed to different execution venues, or may it use reasonable procedures to estimate the percentages so long as they generate materially accurate overviews of the broker-dealer's routing practices?
A: Unlike the monthly execution quality statistics required of market centers under Rule 11Ac1-5, where precise information must be captured on an order-by-order basis, the order routing percentages in quarterly reports are intended to provide a general overview of a broker-dealer's routing practices. If interested, individual customers are entitled to request specific information on their own orders. Consequently, a broker-dealer need only generate quarterly reports that provide a materially accurate overview of its routing practices.
A broker-dealer should develop reasonable procedures to estimate order percentages within a range that is materially accurate. For example, a firm could adopt procedures that are based on a variety of available sources, such as clearing records and the firm's order routing algorithms. In preparing its quarterly report (as opposed to responding to customer requests for individual information), a firm is not required to account precisely for every individual order, particularly those categories of "niche" orders that represent a de minimus percentage of the firm's total non-directed orders.7 The cost of this administrative task could outweigh the limited additional benefit of more precise order routing percentages. The end result, however, must be a quarterly report that the broker-dealer has a reasonable basis to believe sets forth a materially accurate overview of its routing practices.
Q: Do introducing brokers who transmit all customer orders to their clearing firms for execution have a reporting responsibility under the Rule? If so, to what extent can clearing firms assist their introducing brokers in meeting the Rule's requirements?
A: Introducing brokers have the reporting responsibility under the Rule. Introducing brokers may contract with their clearing firms for assistance in meeting their reporting responsibilities (analogous to the assistance provided by clearing firms to some introducing brokers in meeting the duty of best execution), but the responsibility remains the introducing brokers'. This is true even when orders are transmitted directly from customers to clearing and execution firms without being handled by employees or systems of the introducing brokers. Given the many functions that a clearing firm may perform on behalf of its introducing brokers, however, the clearing firm often will play a substantial role in generating the quarterly reports of its introducing brokers.
For example, if an introducing broker transmits all customer orders to its clearing firm, and the clearing firm in fact makes the routing decision concerning those customer orders without regard to the identity of the particular introducing broker, the clearing firm may be in the best position to prepare a quarterly report that reflects the clearing firm's routing practices on behalf of the introducing broker. Introducing brokers could disclose the existence of the clearing relationship (including payment for order flow, if any, received by the introducing broker) and adopt by reference the clearing firm's report to comply with the Rule, provided that they have examined the report and do not have reason to believe it materially misrepresents the order routing practices. Such a report would identify significant execution venues, as well as the percentages of non-directed orders routed to the venues, from the standpoint of the clearing firm. In addition, the report's discussion of relationships with execution venues should reflect the standpoint of the clearing broker - the entity that is actually making the order routing decision. If, for example, the clearing broker internalized orders or received payment for order flow from other execution venues, these facts would need to be disclosed in the quarterly report.
Similarly, an introducing broker that has clearing and execution relationships with more than one clearing firm could disclose the existence of each such relationship (including any payment for order flow) and the amount of order flow directed to each of its clearing firms, and adopt by reference each of its clearing firms' reports to comply with the Rule. All of the conditions that apply to a single clearing firm relationship as described above, would apply to each of multiple clearing agents separately. In particular, the clearing agent in each such relationship must in fact make the routing decisions for the customer orders that it handles, and it must prepare a report reflecting its standpoint.
Given the many different relationships that can exist between introducing brokers and their clearing firms, those brokers with reporting responsibility will need to evaluate their specific situation and produce quarterly reports that are appropriate to their circumstances. An introducing broker may meet its responsibilities under the Rule in several ways. As noted above, an introducing broker may rely on a "generic" report prepared by its clearing firm on behalf of all the clearing firm's clients for whom the clearing firm makes all routing decisions. If an introducing broker makes a material number of routing decisions itself, it must produce, or arrange for the production of, an individual report covering its activities under the Rule. In such cases, a clearing firm may prepare individual reports on behalf of its correspondents, or make the required information that it possesses available to its correspondents. In all cases, the responsibility for complying with the Rule remains with the introducing brokers.
Q: Is it permissible for a broker-dealer to prepare two or more reports that correspond to functional differences in the firm's order routing practices?
A: A single firm may prepare two or more reports that correspond to functional differences in the firm's order routing practices, but only if the separate reports will provide a clearer picture of the firm's practices and the basis for the separate reports is fully disclosed to customers and the public. Each report should clearly explain the orders to which it applies, as well as identify the other reports for the firm and the orders to which they apply. Customers must be able to determine which report applies to their type of orders.
For example, a broker-dealer with two divisions, each with its own customers and order routing practices, may generate a separate report for each division. Each report should explain that it applies only to orders submitted by customers of that division, and that another report has been issued that applies to orders submitted by customers of the other division.
Similarly, an introducing broker whose customer accounts are carried by two different clearing firms, with customers assigned to only one of the two firms, may generate a separate report for each clearing firm. Each report should explain that it applies only to orders submitted by customers whose accounts are carried by the particular clearing firm, and that a separate report has been issued that applies to orders submitted by customers whose accounts are carried by the other clearing firm.
Q: The definition of "customer order" in paragraph (a)(2) of the Rule excludes any order for a quantity of a security having a market value of at least $200,000 for equity orders and $50,000 for options orders. How should a broker-dealer determine the market value of an order? Can orders linked together for execution by the customers (such as program and arbitrage orders), or a single order submitted on behalf of more than one account, be considered a single order when calculating market value? Does it matter if an order is executed in more than one transaction?
A: Broker-dealers may adopt any reasonable procedure to determine the market value of an order.8 For example, firms could use the previous day's closing price for the security or the inside quotes at the time the order was placed. Orders linked together for execution by the customer, or single orders submitted for more than one account, may be considered a single order when calculating their market value. The fact that an order ultimately is executed in more than one transaction does not affect its status as an excluded order.
Q: Firm A is a U.S. registered broker-dealer that receives orders from other broker-dealers and foreign banks acting as broker-dealers and routes them to U.S. execution venues. Are these orders properly excluded from the Rule, even if they are submitted on behalf of customers of the other broker-dealers and foreign banks?
A: Yes. The orders received from other broker-dealers and foreign banks acting as broker-dealers may properly be excluded from the Rule. The definition of "customer order" in paragraph (a)(2) of the Rule excludes an order that is for the account of a broker or dealer. The other broker-dealers and foreign banks should evaluate the applicability of the Rule with respect to their customers' orders. Orders routed by a clearing firm on behalf of an introducing broker are addressed in Question 4 above.
Q: Firm BD is a broker-dealer that provides on-line services to its customers. It offers customers an order routing program that has a specific execution venue installed as a default routing instruction. Firm BD clearly discloses that the customer is free to set a different default at any time and provides a reasonable list of alternative default venues from which to choose. Firm BD does not provide any inducements for customers to retain the initial default setting (such as a lower commission rate). Should Firm BD classify orders routed pursuant to the default setting as directed orders under the Rule?
A: Yes. The orders routed pursuant to the initial default setting are directed orders and therefore should not be included in the quarterly reports of Firm BD. Paragraph (a)(3) of the Rule defines a "directed order" as an order that "the customer specifically instructed the broker or dealer to route to a particular venue for execution." Paragraph (b)(1) of the Rule requires broker-dealers to report on their routing of "non-directed orders," which is defined in paragraph (a)(5) of the Rule as "any customer order other than a directed order." Because customers of Firm BD can readily choose a different default venue from a reasonable list of execution venues other than the initial default setting, and the broker-dealer does not charge a higher commission if the customer chooses another venue, orders routed pursuant to the initial default setting are appropriately classified as directed orders.
In addition, once an order is properly classified as a directed order, it need not subsequently be reclassified as a non-directed order if the venue to which the customer directed the order is unable to execute the order (for example, due to a systems problem) and the broker-dealer then routes the order elsewhere for execution. The initial classification under the Rule, of course, would not relieve the broker-dealer of its duty of best execution with respect to the re-routed order.
However, if customers are not offered a reasonable choice of execution venues their orders must be considered non-directed even if they have accepted the default venue offered by the broker-dealer. In the example above, if firm BD does not offer a reasonable list of alternatives to the default venue, then orders routed to the default venue may not be classified as directed orders under the Rule.
Q: How should orders be divided into the three classes (market, limit, other) specified by the Rule?
A: The three classes of orders are intended to correspond generally to the division of orders in Rule 11Ac1-5, thereby facilitating use of the monthly execution quality reports of market centers in conjunction with the quarterly order routing reports of broker-dealers. Rule 11Ac1-5 requires market centers to report on their executions of standard market orders and limit orders, but excludes a wide variety of orders for which the customer requests special handling. These exclusions include market opening and closing orders, orders submitted with stop prices, all-or-none orders, orders that must be executed on a particular tick or bid (such as non-exempt short sale orders), and "not held" orders. All of these special handling orders would fall within the "other order" category for purposes of the quarterly order routing reports required by the Rule. Marketable limit orders are appropriately classified as limit orders under the Rule.
Q: What should be considered the execution venue for an order when it is executed in two or more transactions at different venues?
A: Broker-dealers may adopt any reasonable, consistent approach for assigning an execution venue to orders that are executed in multiple venues. For example, the venue that handled the largest partial execution or the venue that handled the first partial execution would both be reasonable approaches.
Q: When a broker-dealer receives a non-directed order from a customer, and then executes the order as riskless principal based on a contemporaneous order execution at another venue, who should be identified as the execution venue under the Rule - the broker-dealer or the other venue?
A: The appropriate disclosure for riskless principal orders depends on the nature of the broker-dealer's activity in the relevant security. If the broker-dealer acts as a market center in the security for purposes of Exchange Act Rule 11Ac1-5, the broker-dealer should identify itself as the execution venue for riskless principal orders. If the broker-dealer does not act as a market center in the security, it should identify the venue at which it obtained the contemporaneous order execution.
Q: The Adopting Release provides that, to assure meaningful disclosure of significant execution venues, all orders routed to a particular exchange for execution should be aggregated when calculating a broker-dealer's top ten venues and those with 5% of orders. How should a firm make this calculation in the context of Nasdaq systems?
A: Nasdaq should be identified as the execution venue for orders that are routed directly to Nasdaq's order execution systems, such as SOES (or its upcoming replacement, SuperSOES). SelectNet, in contrast, is an order delivery system, not an order execution system, and therefore should not be identified as an execution venue. For orders transmitted directly (whether through SelectNet or otherwise) to an individual market center, such as a market maker or ECN, that market center, rather than Nasdaq, should be identified as the execution venue.
Q: What is considered payment for order flow and how should payment for order flow arrangements be disclosed in the quarterly reports?
A: Payment for order flow is broadly defined in Exchange Act Rule 10b-10(d)(9), which is cross-referenced in paragraph (a)(8) of the Rule. It provides, among other things, that "any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration" to a broker-dealer in return for the routing of orders is payment for order flow. This definition would include, for example, both direct monetary payments for orders (such as a market maker's payments for marketable orders and an ECN's payments for non-marketable limit orders) and in-kind goods and services (such as T1 lines, clearing services, and reciprocal agreements for the provision of order flow). The wide-ranging forms that payment for order flow can assume precludes any definitive list of specific instances of payment for order flow.
In its quarterly reports, a broker-dealer must disclose the "material aspects" of its relationship with its significant execution venues, including a description of any payment for order flow arrangement. In this context, "materiality" should be interpreted as those aspects of the payment for order flow arrangement that would be important to a reasonable investor in evaluating a broker-dealer's routing practices. As noted in the Adopting Release, broker-dealers are not required to estimate or calculate the aggregate dollar amounts of payment for order flow. They are, however, required to describe the material terms of the arrangement, such as any amounts per share or per order that the broker-dealer receives.
Given the intensively fact-based nature of payment for order flow arrangements, definitive guidance on their disclosure is not possible. Firms should be aware, however, that the new disclosure requirements were adopted to provide investors with a clearer understanding of broker-dealer order routing practices than is provided under current rules. Firms should not merely assume that their past disclosures will satisfy the new requirements of the Rule.
Q: Firm A is an integrated broker-dealer that receives non-directed orders as agent from its brokerage customers and routes to its market making desk those orders in securities for which it acts as market maker. Such orders represent a significant portion of the total non-directed orders of Firm A. What must Firm A disclose concerning this internalized order flow?
A: Firm A would identify itself as a significant execution venue on its quarterly reports and set forth the percentage of orders that it routes to itself for execution. In discussing the material aspects of this order routing relationship, Firm A should disclose that it stands to share in 100% of whatever profits it generates by trading as principal with its customers' orders. If Firm A executes a material percentage of internalized orders during a quarter as agent by crossing them with other customer orders, it would be appropriate for Firm A to disclose a reasonable estimate of this percentage to clarify further the extent to which it stands to share in profits from principal trading.
Q: What procedures must a broker-dealer follow in making its quarterly reports publicly available? Must it have its own web site on which to post its report, or would it be permissible for the broker-dealer to post its report on another web site? For how long must a report be posted on the web site?
A: The phrase "make publicly available" is defined in paragraph (a)(4) of the Rule as "posting on an Internet site that is free and readily accessible to the public, furnishing a written copy to customers on request without charge, and notifying customers at least annually in writing that a written copy will be furnished on request."
Although a broker-dealer is not required to post its report on its own Internet site, the site on which it does choose to post its report must be readily accessible to the public. Consequently, a broker-dealer that has an Internet site, but chooses to post its report on another site, must include a hyperlink on its Internet site to the report's Internet site. A broker-dealer that does not have its own Internet site must take reasonable steps to assure that its report is readily accessible to the public. These could include, for example, making arrangements to provide the location of the report's Internet site to any caller at the broker-dealer's main telephone number.
A quarterly report should remain posted on an Internet site until it is replaced by the next report for the succeeding quarter.
Q: How frequently must a broker-dealer respond to requests from customers for their individual order routing information?
A: Broker-dealers must establish reasonable procedures for responding to customer requests in a useful manner. The Rule does not, however, require order-by-order responses analogous to those that are required for confirmation of transactions under Exchange Act Rule 10b-10. For example, the Division would view as reasonable a procedure pursuant to which all customers who requested individual information were issued reports on a standardized monthly basis that covered orders submitted up to the preceding six months (a broker-dealer need not duplicate information on previous months' orders that already was provided to the customer).
Q: When must broker-dealers provide the first written notice to customers under the Rule relating to the availability of written quarterly reports and of individual order information?
A: A broker-dealer must provide the written notice required by the Rule no later than in its first annual communication in compliance with Exchange Act Rule 11Ac1-3 that is transmitted to customers after its first quarterly report is made available in October 2001.
Q: How should orders that are cancelled and later replaced be treated under the Rule? Does it matter whether the replacement order goes to the same venue as the order that was cancelled?
A: A replacement order would be considered a new order, regardless of whether it goes to the same venue or to another venue. In a partial cancellation, when the only change is a reduction in the number of shares covered by an order, the remainder need not be reported as a new order. In the case of an increase in the number of shares, or any other change in an order, the event should be treated as a cancellation with replacement creating a new order.
Q: How should certain new securities products that are traded on both the NYSE and the Amex be categorized on the Rule 11Ac1-6 report? The Nasdaq 100 Trust ("QQQ"), for example, is traded on both the NYSE and the Amex.
A: Broker-dealers should refer to the security's classification for trade reporting purposes (as a Network A eligible security, Network B eligible security, or Nasdaq-listed security) when categorizing new securities products. Generally, Network A eligible securities are NYSE-listed securities, and Network B eligible securities are listed on the Amex and regional exchanges. Orders in QQQ, which is a Network B eligible security, would be disclosed in the section describing the routing of non-directed customer orders in Amex/Regional securities.
Q: Is there an exemption from the public posting requirement of the Rule for broker-dealers who would otherwise report the routing of a de minimus level of customer orders in covered securities?
A: The Commission has exempted from the quarterly reporting requirement of Rule 11Ac1-6(b) those firms that have routed, on average, 500 or fewer customer orders in covered securities per month during the preceding calendar quarter.9 Thus, for example, a firm that routed 500 or fewer customer orders per month during the second calendar quarter (April, May, June) would not file a report covering its routing practices during the third quarter, regardless of how many customer orders the firm routed during the third quarter. The number of customer orders routed during the third quarter would be relevant, however, to the question of whether the firm is exempt from the quarterly reporting requirement for the fourth quarter.
In determining eligibility for this exemption, the number of customer orders may be calculated after any exclusions permitted by the Rule have been applied. In permitting the exemption, the Commission emphasized, however, that firms eligible for this limited exemption would remain responsible to comply with Rule 11Ac1-6(c), which requires them to provide interested customers with routing information about specific orders and to notify customers annually that such information is available.
Q: Does Rule 11Ac1-6 require the disclosure only of non-directed customer orders routed during regular trading hours?
A: No. The Rule requires the disclosure of all non-directed customer orders in covered securities routed by a broker-dealer. This includes orders routed before or after regular trading hours.
Q: Would a foreign security be a "covered security" under Rule 11Ac1-6?
A: A "covered security" is defined under Rule 11Ac1-6(a)(1)(i) as any national market system security and any other security for which a transaction report, last sale data or quotation information is disseminated through an automated quotation system as defined in Section 3(a)(51)(A)(ii) of the Securities Exchange Act of 1934. This definition incorporates all Consolidated Tape Association ("CTA") eligible securities of both Network A and Network B, as well as all Nasdaq-listed securities. Therefore, a foreign security whose ordinary shares are listed and traded in one of these groups is a covered security. This is true even if an order in the covered security is executed in a foreign country. Many foreign securities that trade in the United States, however, are traded as American Depository Receipts ("ADRs"). In such cases, the ADRs may be a covered security under the Rule, but the underlying ordinary shares are not unless the ordinary shares separately meet the definition. For example, an order for the ordinary shares of Foreign Security A may not be an order in a covered security, even though the ADRs for Foreign Security A are listed on a national securities exchange and are CTA eligible securities (and would be covered securities).
1 Securities Exchange Act Release No. 43590 (November 17, 2000), 65 FR 75414 ("Adopting Release").
2 The Rule requires the broker or dealer to make the report publicly available within one month after the end of the quarter addressed in the report. Under a temporary exemption granted by the Commission, however, the public reporting for the third calendar quarter of 2001 was delayed by one month. Letter to Stuart J. Kaswell, Senior Vice President and General Counsel, Securities Industry Association, from Annette L. Nazareth, Director, Division of Market Regulation ("Division"), dated September 21, 2001.
3 Network A is operated pursuant to the Consolidated Tape Association Plan ("CTA Plan") and the Consolidated Quotation Plan ("CQ Plan"). It disseminates market information for any common stock, long-term warrant, or preferred stock admitted to dealings on the NYSE. CTA Plan, Sections I(p) and VII(a)(i).
4 Network B is also operated pursuant to the CTA Plan and the CQ Plan. It disseminates market information for any common stock, long-term warrant, or preferred stock admitted to dealings on the Amex or the regional exchanges, but not also admitted to dealings on the NYSE or included in the Nasdaq market. CTA Plan, Section I(q) and VII (a).
5 Adopting Release, note 1 above, Section VI.B.
6 Letter to Neal E. Sullivan & Gail Marshall-Smith, Bingham Dana LLP (on behalf of First Union Securities, Inc.), from Annette L. Nazareth, Director, Division, dated June 22, 2001 ("First Union Letter").
7 See First Union Letter, note 3 above.
8 The market value of an option shall be determined by its premium, not the value of the underlying security.
9 Letter to William C. Alsolver, Jr. and A. Louis Denton, NASD Small Firm Advisory Board, from Annette L. Nazareth, Director, Division, dated September 21, 2001.
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