-------------------- BEGINNING OF PAGE #1 ------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 (Release No. 34-34753; File No. S7-28-94) RIN 3235-AG21 Customer Limit Orders AGENCY: Securities and Exchange Commission ACTION: Proposed Rule SUMMARY: The Securities and Exchange Commission proposes a rule setting standards for market makers in handling customer limit orders in NASDAQ National Market System securities. The rule would prohibit a market maker from trading for its own account, directly, or indirectly, at a price at which the market maker could execute a customer limit order it is holding, without executing the customer's limit order at the limit price or a price more favorable to the customer, under the specific terms and conditions by which the order is accepted by the market maker. DATES: Comments should be submitted on or before 60 days from the date of the publication of this release in the Federal Register. ADDRESSES: Interested persons should submit three copies of their written data, views and opinions to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, and should refer to File No. S7-28-94. All submissions will be made available for public inspection and copying at the Commission's Public Reference Room, Room 1024, 450 Fifth Street, N.W., Washington D.C. 20549. FOR FURTHER INFORMATION CONTACT: Scott C. Kursman, (202) 942- 3197, Attorney, Office of Market Supervision, Division of Market Regulation, Securities and Exchange Commission, Mail Stop 5-1, 450 Fifth Street, N.W., Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: I. Introduction and Background The Securities and Exchange Commission ("SEC" or "Commission") today is proposing a rule (17 CFR 240.15c5-1) to prohibit market makers in NASDAQ National Market System ("NASDAQ/NMS") securities from trading ahead of customer orders that they are holding at the same or better price. The Commission is proposing to change existing practices because it believes this will enhance broker-dealer competition, promote efficient pricing of securities, facilitate best execution of customer orders and better reflect investor expectations in the NASDAQ/NMS market. The growth of the NASDAQ market and the concomitant visibility of and investor interest in its companies has changed investors' expectations. In designing the proposed rule, the Commission has been mindful of the special role of NASDAQ market makers in discovering prices and providing liquidity in NASDAQ/NMS stocks. The proposal seeks comment on specific trading standards that would govern individual market makers. The proposed rule is intended to have the effect of giving priority to orders that improve the market (i.e., narrow the bid-ask spread) being made by a specific market maker. Generally, an order to buy or sell a security at a specified price ("limit order") is first received by the customer's broker, who either routes the order to an affiliated or non-affiliated market maker for execution or, if the firm is itself a market -------------------- BEGINNING OF PAGE #2 ------------------- maker in the security, to the firm's market making desk. The combination of limit order execution and market maker functions can lead to the market maker competing with a customer for executions. While the past few years have seen several positive efforts at improving limit order handling practices in the NASDAQ market, the Commission believes that it should consider a limit order priority rule to ensure protection for all customer orders in this market. The priority accorded a customer limit order today is different depending on the structure of the marketplace of execution. The rules of national securities exchanges generally require specialists and other market professionals to yield to a customer's limit order; the specialist cannot trade for its own account at prices equal to or better than the limit order until the limit order is executed.-[1]-/ The rules of the National Association of Securities Dealers ("NASD") similarly prohibit third market makers (over-the-counter market makers in listed securities) from trading ahead of customer limit orders in the third market.-[2]-/ In 1988, the Commission addressed the issue of customer limit order protection in the NASDAQ market.-[3]-/ In the Manning decision, the Commission affirmed, based on principles of agency law, an NASD determination that it is inconsistent with just and equitable principles of trade for a market maker to trade ahead of a customer limit order unless the customer is first informed of the firm's limit order policy. As a result of the Manning decision, the NASD filed a proposed rule change with the Commission stating that a member firm will not be deemed to have violated NASD Rules of Fair Practice if it provides customers with a statement setting forth the circumstances in which the member firm accepts limit orders and the policies and procedures that the firm follows in handling these orders.-[4]-/ In July, 1993, the NASD Board of Governors reviewed the handling of limit orders in NASDAQ securities and concluded that -[1]-/ See, e.g., New York Stock Exchange ("NYSE") Rule 92, 2 NYSE Guide (CCH) 2092. The priority rules of the New York Stock Exchange do permit an exception to this general principle for pre-arranged crosses of 25,000 shares or more. Such a cross may be executed on the floor without interacting with pre-existing limit orders at the same price. A preexisting limit order, however, may interact with the buyer or seller in the cross if it provides a price that is better than the proposed cross price. See Securities Exchange Act Release No. 31343 (October 21, 1992), 57 FR 48645 (October 27, 1992). -[2]-/ NASD Bylaws, Schedule G, Section 4(f), NASD Manual (CCH) 1921. Third market dealers account for more than 9% of listed stock trades. -[3]-/ See In re E.F. Hutton & Co. (the so-called "Manning decision"), Securities Exchange Act Release No. 25887 (July 6, 1988), 41 SEC Doc. 473, appeal filed, Hutton & Co. Inc. v. SEC, Dec. No. 88-1649 (D.C. Cir. Sept. 2, 1988), (Stipulation of Dismissal Filed, Jan. 11, 1989). -[4]-/ Securities Exchange Act Release No. 26824 (May 15, 1989), 54 FR 22046 (May 22, 1989). The proposal included model disclosure language to be used by firms whose policy is not to grant priority to customer limit orders over the member's own proprietary trading. -------------------- BEGINNING OF PAGE #3 ------------------- "the continuation of the disclosure exception appeared inappropriate."-[5]-/ The NASD solicited member comment on eliminating the disclosure "safe-harbor" approach for members trading ahead of customer limit orders and the effect a rule prohibiting trading ahead might have on integrated broker- dealers, on limit orders received from other firms, and on market liquidity.-[6]-/ After full consideration of the concerns articulated in the comment process, the NASD withdrew its rule filing proposing the disclosure safe harbor approach,-[7]-/ and submitted a proposed Interpretation to its Rules of Fair Practice, prohibiting member firms from trading ahead of their customers' limit orders in their market making capacity.-[8]-/ The Division of Market Regulation's Market 2000 study examined this practice and recommended that a ban apply to trading ahead of all customer limit orders, not just those of a firm's own customer.-[9]-/ The study noted that the adverse effects of trading ahead exist whether the customer's order is handled by the customer's firm or by another market maker.-[10]-/ The Commission approved the NASD Interpretation on June 29, 1994, but expressed concern that the prohibition did not extend to trading ahead of limit orders of other firms' customers that have been sent to the market maker for execution.-[11]-/ The NASD also convened a special task force to study the potential effect of expanded limit order protection on market liquidity and market maker capital commitment and to report back to the Board in September. The Commission stated that while such a study could be helpful to a future consideration of this issue, the Commission believed that member-to-member trades raise significant concerns that should be addressed and, if necessary, the Commission would consider instituting its own rulemaking proceeding for that purpose.-[12]-/ The task force has now submitted its report to the NASD Board of Directors and the Board has proposed for member comment market maker standards that would restrict market makers from trading ahead of certain member-to-member trades, keyed in part on the size of the customer limit order.-[13]-/ Under the NASD -[5]-/ See File No. SR-NASD-93-58, p.6. -[6]-/ See NASD Notice to Members 93-49 (July 23, 1993). -[7]-/ See Letter from Robert E. Aber, Vice President and General Counsel, NASD, to Selwyn Notelovitz, Branch Chief, Over-the-Counter Regulation, Division of Market Regulation, SEC (October 13, 1993). -[8]-/ Securities Exchange Act Release No. 33697 (March 1, 1994), 59 FR 10842 (March 8, 1994). -[9]-/ Division of Market Regulation, SEC, Market 2000: An Examination of Current Equity Market Developments ("Market 2000 Study"), V-5 (1994). -[10]-/ Id. -[11]-/ Securities Exchange Act Release No. 34279 (June 29, 1994), 59 FR 34883 (July 7, 1994). -[12]-/ Id. -[13]-/ See Special NASD Notice to Members 94-79 (September 23, 1994). -------------------- BEGINNING OF PAGE #4 ------------------- proposal, market makers would be prohibited from trading at prices equal to or better than the price of a customer limit order they hold if the size of that order was 1,000 shares or less and from trading at prices better than a customer's limit order if the size of that order was greater than 1,000 shares. The Commission believes that the NASD's proposal is an instructive step and will provide useful comment from the member firm community. The Commission, however, believes that comment from the broader constituency of the investing public and other non-NASD members will be critical in formulating adequate limit order protection for the NASDAQ market. In addition, the Commission believes that alternatives which provide more extensive limit order protection for public customers also should be the subject of public comment. Therefore, the Commission has determined to propose its own rule. Publication of the proposal will compliment the efforts of the NASD and enable the Commission to act on its own initiative if it deems such action appropriate. -------------------- BEGINNING OF PAGE #5 ------------------- II. Discussion The Commission proposes to adopt Rule 15c5-1 pursuant to Section 15(c)(5) of the Securities Exchange Act of 1934 ("Exchange Act")-[14]-/, among other provisions.-[15]-/ Section 15(c)(5) grants the Commission authority over dealers acting in the capacity of market makers by permitting the Commission to impose standards with respect to dealing as the Commission, by rule, shall prescribe as necessary or appropriate in the public interest and for the protection of investors, to maintain fair and orderly markets, or to remove impediments to and perfect the mechanism of a national market system.-[16]-/ The legislative history of the Securities Acts Amendments of 1975, under which Section 15(c)(5) was adopted, endorsed priority for customer limit orders in national market system securities and stated that the Commission should have discretion to achieve this protection. Congress noted that for suitable securities, every effort should be made to ensure that public investors in these securities would receive the benefits and protections that would result from the placing of public orders ahead of dealers' orders in determining the sequence in which orders entering the market are executed.-[17]-/ NASDAQ has evolved from a market of thinly traded companies in 1975 to one that today accounts for 42% of share volume and 29.2% of dollar volume in the U.S. equity markets.-[18]-/ During that time, the Commission, together with the NASD, has attempted to implement rules that reflect increased investor interest in this market. The events which gave rise to the Manning case date back to 1984 and the Commission has been pressing for improved limit order priority since then. In its order approving the recent NASD Interpretation, the Commission indicated that a further Commission rule might be necessary to ensure protection for all public limit orders in NASDAQ/NMS securities, should the NASD fail to do so. The NASD's Interpretation prevents a market maker from trading ahead of its own customers' limit orders, but does not prevent the same market maker from trading ahead of the limit orders of other firms' customers that are sent to the market maker for execution.-[19]-/ The Commission believes that it is reasonable for customers to expect that the quality of the execution received will not vary from trade to trade. Under current NASD rules, the quality of the execution received could vary depending on whether the customer's firm or an affiliate makes a market in a security or whether that firm sends the order to another market maker for execution. Customers choose their brokers for a variety of reasons, including cost and integrity; whether the broker also makes a market in a security in which the customer may be interested should not affect the quality of the execution. The Commission agrees with the conclusion of the Division of Market Regulation's Market 2000 Study that the adverse effects -[14]-/ Section 15(c)(5), 15 U.S.C. 78o. -[15]-/ Section 11A, 15 U.S.C. 78k-1; Section 23, 15 U.S.C. 78w. -[16]-/ See Exchange Act Section 15(c)(5), supra note 14. -[17]-/ S. Rep. No. 75, 94th Cong., 1st Sess. 16 (1975)("Senate Report"). -[18]-/ See supra note 9, at 9. -[19]-/ See supra note 11. -------------------- BEGINNING OF PAGE #6 ------------------- of trading ahead exist whether the customer's order is handled by the customer's firm or by another market maker.-[20]-/ Rule 15c5-1 would apply to customer limit orders, regardless of where the order is ultimately routed for execution. The Commission believes that the principles of investor protection and market integrity would be advanced by a limit order priority rule. The lack of limit order protection results in inferior executions for customers and adversely affects the price discovery process for these securities.-[21]-/ By providing a customer's limit order priority over the market maker's proprietary trading, more trade volume will be available to be matched with the customer's order, resulting in quicker and more frequent executions for limit order customers. In the past, customers may have refrained from placing limit orders because of the uncertainty of and difficulty in obtaining an execution at a price between the spread. A customer limit order rule will encourage dealers that accept customer limit orders to execute them in a timely fashion so that they may resume their proprietary trading activities. With the improvement in the quality of these executions, investors will have greater confidence in this market and trade volume from retail investors could increase.-[22]-/ In addition, customer limit order priority would improve the price discovery process in NASDAQ/NMS securities. Limit orders aid price discovery by adding liquidity to the market and by tightening the effective spread between the bid and ask price of a security, even though these limit orders would not be displayed in the market maker's quote. The practice of not executing a limit order until the inside quotation price reaches the customer's limit order price also impedes the price discovery process by preventing those orders from interacting with other orders. More expeditious handling of customer limit orders under the proposed rule could provide investors with a more accurate indication of the buy and sell interest at a given moment.-[23]-/ One of the problems with not giving customer limit orders priority is the cost to public customers in terms of inferior or missed executions for limit orders. It is currently impossible for customers to monitor these costs. The ability of a customer to monitor the cost of the transaction and choose a broker- dealer on that basis imposes a competitive discipline on the market maker to achieve the best possible execution for the customer or risk losing the business. Unlike institutional clients who are in a better position to negotiate their own protection with market makers, public customers have less viable alternatives in determining where their orders are ultimately sent for execution. Under these circumstances, market makers lack the same incentive to provide superior executions to public customers. Market makers who oppose a comprehensive rule mandating limit order priority for customers do so in part on the ground that such a rule would reduce their return from market -[20]-/ See supra note 9, at V-8. -[21]-/ Id. at V-7. -[22]-/ Id. -[23]-/ Id. -------------------- BEGINNING OF PAGE #7 ------------------- making.-[24]-/ Market makers are, of course, entitled to earn a profit from their service; A limit order rule could force market makers to recoup the cost of the transaction in ways more apparent to the customer, such as by charging a commission for handling the limit order. The Commission requests comment in the form of specific data regarding the potential consequences of the proposed rule for market liquidity and market maker capital commitment. III. Description of the Proposed Rule Limit order protection in the NASDAQ market is now required only of firms that execute their own customers' limit orders. Market makers still may trade ahead of the limit orders entered by customers of other firms that are sent to them for execution. Proposed Rule 15c5-1 would provide limit order protection to all customers in NASDAQ/NMS securities, regardless of where the order is ultimately sent for execution. -[24]-/ See letter from Frank Masi, President, Securities Traders Association of New York ("STANY"), to Jonathan G. Katz, Secretary, SEC (March 29, 1994). -------------------- BEGINNING OF PAGE #8 ------------------- A. General Prohibition on Trading Ahead Paragraph (a) of the proposed rule establishes the general prohibition on trading ahead of limit orders: a market maker shall not effect a transaction involving a covered security for its own account, directly or indirectly, at a price at which the market maker could execute a customer limit order it is holding without executing the customer limit order at the limit price or a price more favorable to the customer, under the specific terms and conditions by which the order was accepted by the market maker. The rule applies once a market maker has accepted a customer limit order for execution.-[25]-/ The rule applies to all market makers, whether they are handling orders for their firm's clients or orders sent from another firm. Finally, the rule applies to all accounts of the market maker in which the market maker or any person associated with the market maker is directly or indirectly interested. The application of the rule can best be illustrated through the following example. Firm A is a retail brokerage firm. Firm B is a market making firm with no customers of its own. Firm C is an integrated firm with both brokerage and market making units. The present NASD Interpretation applies only to orders received and executed internally by firm C.-[26]-/ The proposed rule would cover these orders as well as orders sent from firm A to firms B or C, and orders sent from firm C to firm B. For instance, firm A may send firm B a customer limit order to buy 1,000 shares of stock at $20 1/4. Firm B, a market maker in that security, is quoting a bid of $20 and an offer of $20 1/2. Under the proposed rule, a purchase of a certain number of shares by firm B at $20 1/4 or lower would trigger an obligation to fill the same number of shares in the customer's order at $20 1/4. A failure to execute the customer's limit order either before or immediately after the market maker's purchase would constitute a violation of the rule. The Commission is requesting comment on whether it should exclude from the protection of the rule limit orders to buy at the bid or limit orders to sell at the offer. B. "Covered Security" The rule would apply to NASDAQ securities that have been designated National Market System securities. A NASDAQ security is a registered equity security for which quotation information is disseminated in the National Association of Securities Dealers Automated Quotation system. A NASDAQ National Market System security is a NASDAQ security as defined above for which transaction reports are required to be made on a real-time basis pursuant to an effective transaction reporting plan.-[27]-/ The Commission requests comments on the feasibility of extending the limit order protection measures incorporated herein to other NASDAQ securities, such as NASDAQ SmallCap securities and over- the-counter ("OTC") Bulletin Board-eligible securities.-[28]-/ -[25]-/ NASD rules do not require a market maker to accept a customer limit order. -[26]-/ The Interpretation also applies to firm A if it forwards limit orders to an affiliated firm (e.g., Firm D, a firm that it controls) for execution. -[27]-/ See 17 CFR 240.11Aa3-1. -[28]-/ A NASDAQ SmallCap security is one which (1) satisfies all applicable requirements for qualification as a (continued...) -------------------- BEGINNING OF PAGE #9 ------------------- C. Definition of "Customer Limit Order" Paragraph (c)(3) of the proposed rule defines the term "limit order" as an order to buy or sell shares of a security at a specified price or other price more favorable to the customer. In the example above, the customer placed a limit order to buy 1,000 shares of stock at 20 1/4, indicating that the customer wishes to pay no more than $20.25 for the security. The market maker may fill the order at a lower price, but not at a price higher than the limit the customer has set. The Commission proposes to limit the class of persons who would be protected by the rule to public customers only. To this end, the term "customer" in paragraph (c)(3) is defined as a person who is not a registered broker or dealer. Nevertheless, because customer limit orders often are sent to a market maker by a broker or another market maker that originally received the order, the definition of "customer" would encompass such orders as customer orders entitled to protection under the rule. Orders for registered brokers or dealers that are sent to a market maker by another broker or market maker would not be entitled to this protection. The Commission requests comment on the necessity of restricting limit order protection to customers and the effectiveness of the definition in carrying out that purpose. D. "Terms and Conditions" While the proposed rule does not distinguish institutional from retail orders, the Commission believes that larger-sized orders may qualify for special treatment. The language of the proposed rule that would allow the parties to set the specific terms and conditions for acceptance of limit orders is intended to permit market makers to employ the appropriate strategy in filling a larger sized order without being subjected to the requirements of the proposed ban. By distinguishing the protection afforded a limit order by its size or dollar value, the rule would recognize the greater significance of larger size orders to market makers seeking to establish or liquidate a position and the ability of larger sized customers to negotiate specific order handling procedures. Market makers actively compete for customer order flow. A customer dealing in greater size or amount generally can better monitor the market for the security and negotiate alternative execution procedures with another market maker.-[29]-/ The Commission preliminarily believes that larger sized orders should be distinguished by measurable characteristics such as number of shares or dollar amount. To this end, comment is requested on the appropriate level of a size limit, i.e. 5,000 or 10,000 shares, and/or a dollar value limit, i.e. $50,000, -[28]-/(...continued) NASDAQ security and is not a NASDAQ National Market System security; (2) is a right to purchase such security; or (3) is a warrant to subscribe to such security. See File No. SR-NASD-94-48. The OTC Bulletin Board provides an electronic quotation medium for subscribing members to reflect market making interest in eligible securities, which are generally domestic or foreign equity securities or American Depository Receipts not listed on NASDAQ or the New York or American Stock Exchanges. See NASD Over-the-Counter Bulletin Board Service Rules, 3, NASD Manual (CCH) 2573. -[29]-/ There are an average of 11.9 market makers for every NASDAQ/NMS security. See NASD, 1994 NASDAQ Fact Book and Company Directory (1994). -------------------- BEGINNING OF PAGE #10 ------------------- $100,000 or $200,000, that would determine market maker obligations with respect to these two types of orders in the final rule. This will insure that the rule ultimately adopted includes limit order protection for retail investors while maintaining the ability of market makers to negotiate order handling arrangements with their institutional clients. E. Exceptions The rule proposal also establishes exceptions for all-or- none and odd-lot orders as well as a general exemptive provision [paragraph (d)]. The specific exceptions to the rule [paragraph (b)] are discussed below. The Commission requests comment on the need for an all-or-none or odd-lot order exception and a general exemptive provision. Exception for All-or-None Orders The proposed rule includes an exception for all-or-none customer limit orders [paragraph (b)(2)]. An all-or-none customer limit order is defined in paragraph (c)(1) as one that carries a condition that instructs the market maker to execute all of the shares in the order only if it can be done all at once. The purpose of this exception is to prevent delays in executing other orders that a market maker may be receiving at the time the market maker is handling the all-or-none order. In the example above, the customer's limit order for 1,000 shares of stock could be filled in several separate transactions. With an all-or-none order, a market maker must execute all the shares of the order in a single trade. The market maker may not have immediate access to that number of shares. In the meantime, other orders may be received that require the market maker to purchase shares from other market makers or their customers. Without this exception, the market maker would not be able to buy any stock at less than the all-or-none limit order price and, ultimately, the execution quality of other customer orders would suffer. Thus, using the above example, the exception would permit a market maker handling an all-or-none order to purchase shares in the security for its own account at $20 1/4 or lower without filling the customer's limit order, but only for amounts smaller than the 1,000 shares in the all-or-none order. The market maker could not, however, purchase 1,000 shares or more at $20 1/4 or lower for its own account without satisfying the customer limit order. -------------------- BEGINNING OF PAGE #11 ------------------- IV. Initial Regulatory Flexibility Analysis The Commission has prepared an Initial Regulatory Flexibility Analysis ("IRFA") in accordance with 5 U.S.C. 603 regarding proposed Rule 15c5-1. The IRFA uses certain definitions of small entities adopted by the Commission for purposes of the Regulatory Flexibility Act. The IRFA indicates that regulatory action is required in order to ensure that market makers in NASDAQ/NMS securities adhere to certain minimum standards of fair treatment of customers. Specifically, by prohibiting a market maker from trading ahead of a customer limit order that it holds, the rule would improve the quality of executions for customers and the price discovery process in the market for these securities. In 1993, there were 492 active NASDAQ market makers.-[30]-/ Data on the number of market makers meeting the definition of small entity that make markets in NASDAQ/NMS securities and execute customer limit orders is unavailable. The Commission is unable to quantify reasonably the impact that the proposed rule would have on small market makers or small issuers. The Commission does not believe it would be practicable to exempt small market makers from the proposed rule because to do so would be inconsistent with the Commission's statutory mandate to protect investors. A copy of the Initial Regulatory Flexibility Analysis may be obtained by contacting Scott C. Kursman, Attorney, Office of Market Supervision, Division of Market Regulation, Securities and Exchange Commission, Washington, D.C. 20549 (202) 942-3197. V. Effects on Competition Section 23(a)(2) of the Exchange Act-[31]-/ requires the Commission, in adopting rules under the Act, to consider any anti-competitive effects of such rules and to balance these effects against the regulatory benefits gained in furthering the purposes of the Act. As previously noted, comment letters received prior to the adoption of the NASD Interpretation suggested that such a rule would deny market makers an opportunity to earn a profit in some situations. If true, this may result in less market maker commitment in the NASDAQ/NMS market which may in turn effect competition in this market. The Commission is soliciting comment on the effect the rule may have on market maker capital commitment and small issuers. The Commission preliminarily views Rule 15c5-1 as causing no burden on competition unnecessary or inappropriate in furtherance of the purposes of the Exchange Act. The Commission believes that the principles of customer protection that Congress envisioned and that would be advanced by this rule justify the burdens that the rule will impose on market makers. The Commission, however, requests comment on any competitive burdens that might result from adoption of the proposed rule described in this release. -[30]-/ See supra note 29. -[31]-/ 15 U.S.C. 78w(a)(2). -------------------- BEGINNING OF PAGE #12 ------------------- List of Subjects in 17 CFR Part 240 Reporting and recordkeeping requirements, Securities. Text of Proposed Rule For the reasons set out in the preamble, part 240 of Chapter II of Title 17 of the Code of Federal Regulations is amended to read as follows: PART 240 -- GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for Part 240 continues to read in part 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, 788s, 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. Section 240.15c5-1 is added to read as follows: 240.15c5-1. Prohibition on Market Makers Trading Ahead of Customer Limit Orders. (a) General Prohibition - A market maker shall not effect a transaction involving a covered security for its own account, directly or indirectly, at a price at which the market maker could execute a customer limit order it is holding without executing the customer limit order at the limit price or a price more favorable to the customer, under the specific terms and conditions by which the order is accepted by the market maker. (b) Exceptions. The prohibition in paragraph (a) of this section shall not apply to the following customer limit orders: (1) "all-or-none" customer limit orders, provided that the number of shares executed by the market maker is less than the number of shares in the customer's all-or-none order; or (2) odd-lot customer limit orders. (c) Definitions. For purposes of this section: (1) The term all-or-none refers to a condition placed upon a customer limit order that instructs the market maker to either execute all of the shares in the order at the specified price or execute none. (2) The term covered security shall mean a NASDAQ security that has been designated a National Market System security pursuant to 240.11Aa2-1. (3) The term customer limit order shall mean an order to buy or sell a security at a specified price or a price more favorable to the customer, that is not for the account of either a broker or dealer; provided, however, that the term customer limit order shall include an order transmitted by a broker or dealer on behalf of a customer. (4) The term market maker shall have the meaning provided in Section 3(a)(38) of the Act (15 U.S.C. 78c(a)(38)). -------------------- BEGINNING OF PAGE #13 ------------------- (d) Exemptions. The Commission, upon request or upon its own motion, may exempt, by rule or by order, any market maker or any class of market makers from the requirements of paragraph (a) of this section with respect to any limit order or class of limit orders, 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 Date: September 29, 1994