Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019-6099
212 728 8000
Direct: 212 728 8206
Roger D. Blanc
October 5, 2000
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Attention: Mr. Jonathan G. Katz, Secretary
Re: Disclosure of Order Routing and Execution Practices; SEC File No. S7-16-00
Ladies and Gentlemen:
We are commenting on behalf of Ameritrade Holding Corporation; DLJdirect Inc.; National Discount Brokers; TD Waterhouse Group, Inc.; and Wit Capital Corporation (collectively, the "Firms") on the Commission's Release on Disclosure of Order Routing and Execution Practices, Securities Exchange Act Release No. 43084 (July 28, 2000) (the "Proposing Release"). The rules proposed in the Proposing Release would substantially affect the businesses of the Firms and, the Firms have concluded, would lead to several adverse effects on the markets and on investors. We are accordingly submitting these comments on behalf of the Firms. We hope these comments will be helpful to the Commission as it considers what actions to take in this important area.
Summary of proposed rules. In the Proposing Release, the Commission proposes to adopt two rules, Rules 11Ac1-5 and 11Ac1-6 under the Securities Exchange Act of 1934 (the "Exchange Act").
Proposed Rule 11Ac1-5 would impose the following requirements:
Proposed Rule 11Ac1-6 would impose the following requirements:
Discussion. The Firms understand and applaud the Commission's overall desire to improve the quality and efficiency of our equity securities markets. The Firms also applaud the Commission's decision, in response to comments received on its Fragmentation Release, Securities Exchange Act Release No. 42450 (February 23, 2000), not to adopt any of the non-disclosure approaches enumerated in that release. Nonetheless, the Firms believe the disclosure approach embodied in proposed Rules 11Ac1-5 and 11Ac1-6 goes far beyond what is sensible or required to address the Commission's market structural and other objectives.
The Commission should recognize that the reporting and disclosure burdens imposed on broker-dealers involve costs that are in turn passed on to customers in one way or another. That suggests that the Commission's approach to augmenting disclosure requirements should be viewed with an eye to weighing closely the benefits to investors thought to be achievable against the costs investors will have to bear to buy the protections the Commission will be requiring them to pay for.
We suggest that the approach reflected in the proposed rules does not reflect an adequate balancing of those considerations. As a general matter, the Firms believe the Commission's approach in this area should be refocused in two ways. First, if Commission rules of the kind proposed should be adopted at all, the reporting requirements for market centers in Rule 11Ac1-5 and by brokers to their customers in Rule 11Ac1-6 should be geared to order flow from the retail investor because institutional investors have their own ways of assessing best execution and the considerations are more complex, as we explain below. Second, the data asked of the market centers under proposed Rule 11Ac1-5, and the data asked of brokers under Rule 11Ac1-6, are too elaborate to be helpful in making order-routing decisions. The very detailed data required of market makers under Rule 11Ac1-5 and of brokers under Rule 11Ac1-6, if made available generally to the public, could inappropriately reveal proprietary information to the market center's competitors that could harm the disclosing party's competitive position. For that reason, the Firms believe the information should be much less detailed and should be available to regulators and to the customers of a market maker on request but not to the general public.
More specifically, the Firms have the following concerns about the proposals:
1. Cost. While the Firms have not done rigorous cost analysis with respect to the proposals, the Firms expect that the cost of compliance would be considerable, in terms of programming and monitoring tasks. It may be that vendors would build and sell programs to the industry to achieve the tasks that would be imposed on the brokerage firms, but the costs of those programs would, the Firms expect, be considerable, possibly many hundreds of thousands of dollars per firm. The burden on small firms in complying particularly with proposed Rule 11Ac1-5 in the securities in which they make markets, to which the Commission gives insufficient attention in the Proposing Release, could well be greater than the burden on large firms. That could impose substantial burdens on competition, burdens that would be lessened if the disclosure requirements were made less onerous.1
In that regard, the Firms believe a broker should be prepared to disclose to its customer, on request, detailed information about how the customer's order was handled, as Rule 11Ac1-6 would require. The Firms do not believe, however, that information by market makers under proposed Rule 11Ac1-5 should be anywhere near as detailed as the Commission proposes. The information should be aggregated and not reported on a security-by-security basis.2 The categories of securities covered should be broad, such as New York Stock Exchange listings and Nasdaq National Market securities, rather than any more specific subcategories. The very detailed information the Commission would require under the proposed rules would be too stale to be interesting to institutional investors, who obtain the information they need today, and much too detailed for a retail customer, who might well not understand the information without having a much greater understanding of the markets and a much greater interest in minutiae than, in the Firms' collective experience, is likely to be found among retail investors.3
2. Focus on numbers. Numbers are helpful in evaluating execution, but they tell only part of the story. Equally, if not more important factors in selecting market centers, for example, are how well the market center responds to difficult orders, how well it resolves trade problems, and whether it has adequate capacity to handle additional order flow beyond what it is currently servicing.
In view of a broker's obligation to perform a regular and rigorous review of its execution practices,4 there always will be a tendency to look for readily identifiable and verifiable measures. That will tend, however, to cause brokers to emphasize numerical measures in preference to other, possibly more important factors since the numbers have a simplistic appeal and an incontrovertible aspect that more subjective factors lack. As in the case of evaluating the overall quality of securities research and brokerage services, however, subjective factors, no matter how difficult to quantify and verify, often are quite important. Indeed, in enacting Section 28(e) of the Exchange Act, which establishes a safe harbor in which fiduciaries can negotiate commission rates, the Congress recognized that fact and recognized also the dangers of evaluating fiduciary conduct on the basis of numerical considerations alone. In view of the need to permit fiduciaries to consider all appropriate aspects of brokerage and research in negotiating commissions, the Congress devised a provision that recognized the complexity of that issue and sought to avoid the risk of looking at numbers alone, including the risk that the normative consequence of an overemphasis on the numbers might ill-serve the fiduciary's clients and the markets.5 There is a similar risk of an overemphasis on the raw numbers in the context of best execution analyses since the numbers are easy to quote and rely and the more subjective factors, by their very nature, more difficult to quantify and, possibly, to explain to NASD inspectors and others.
3. Impact on broker behavior. The Firms expect that, if the Commission adopted Rule 11Ac1-5 and Rule 11Ac1-6, it would induce market makers and possibly other market centers to "work to the test", that is, to arrange their affairs to make their numbers look attractive to their customers. One might conclude from the information market makers and others would be required to make available that the Commission believes that the rule would discourage payment for order flow and encourage the adoption of more exhaustive market-checking routines and more price-sensitive order-routing procedures than they now employ. The Firms expect, however, that while the rules might have some of those effects, they also would have some other, more problematic effects. For example, the rules would discourage market makers and brokers from dealing in hard-to-execute stocks, such as regional stocks and other stocks that tend to be thinly traded because they would skew the reporting party's numbers and make it look worse in relation to its competitors. Brokers and market makers would be disincented to handle the difficult securities and difficult executions. Today, some market makers are reluctant to service day-trading business, program trading order flow and other high-volume business because of the strain it puts on their order-handling capacity, which tends to crowd out other business, and in some cases because they fear the business may represent "smart" orders that will be less profitable for them than other orders of similar size and volume. Under the proposed Rule 11Ac1-5, market makers will have an additional disincentive to accept such orders since they are difficult to handle, and opportunities to offer them price improvement are often limited or non-existent, which will tend to make the broker's "best execution numbers" look worse.
4. Inflexibility of rule approach. Today, there are a number of private systems that measure quality of execution. To some extent, they can be criticized as being inflexible and not in tune with the rapid changes in the markets. The Firms believe the Commission's proposed Rules 11Ac1-5 and 11Ac1-6 would be worse than the existing, private systems, because they would be relatively more inflexible, more difficult to amend quickly, and probably less responsive to changes in market structure and market behavior.
5. Exclusion of block orders. The Commission's attempt to exclude block orders, priced at $50,000 or more for options and $200,000 or more for other securities, from the definition of "customer order" in proposed Rule 11Ac1-6 does not reflect current circumstances in the markets, where block players frequently atomize block orders, that is, break them up into randomly sized smaller pieces, to disguise their true dimensions and, it is hoped, their market impact. As a result, many innovative techniques for order handling would not be taken into account in applying the block order exclusion. The Firms expect that this aspect of Rule 11Ac1-6, which if implemented today would be outmoded at the outset, would become only more so as time goes on.
6. Price versus speed and liquidity. Best execution is multi-dimensional, not one-dimensional. For example, many investors, both institutional and retail, believe that speed of execution is at least as important, and often more important, than capturing the last eighth or sixteenth in price, particularly if execution size is taken into account. In addition, obtaining greater liquidity is often far more important than achieving the last few pennies in execution price-for that reason, institutional investors are often willing to receive or pay a clean-up price to a block positioner rather than to "walk" the market up or down by succeeding trading increments until their order is completed. Retail customers that trade online usually demand immediate execution and value that more than whether the broker has searched high and low for the last possible price advantage, while delaying satisfaction of the customer's service demand. The retail investor wants to see his or her order execution immediately after hitting the "Submit" button. Proposed Rule 11Ac1-6 does not adequately take those factors into account and, if it induces brokers to change their behavior to "look good", will likely harm investors and the markets.6
7. Preferencing. It appears from the Proposing Release that the Commission may now view preferencing as a suspect market practice, notwithstanding its approval of the practice only a few years ago.7 What the Commission seems to have lost sight of, though, is that there are very good reasons for preferencing in the search for best execution, among them that dealers do not always display all their liquidity offering to the public at large and may in fact do better than their advertised prices would seem to suggest, that ECNs frequently offer "reserve" quantities and other, better prices than their displayed prices would suggest and that the speed and quality of execution in automated formats may not always be evident from the statistics the Commission would ask the brokers to collect and display under proposed Rule 11Ac1-6.
8. Institutional versus retail order flow. Today, institutional clients may find acceptable and may even seek execution of large orders that do not involve walking the market up or down but instead involve a variety of other sophisticated execution techniques to control the market impact of their orders. Those techniques, since they do not involve simply plugging away at the NBBO, would tend to make the broker's "best execution numbers" look bad from the point of view of the Commission's proposed disclosure matrix. That might in turn lead to a further bifurcation between institutional brokers and retail brokers, which might well not serve the interests of investors or the markets. The Commission's view of price and time priority is aimed at a single, price-only model of best execution:
Price priority provides assurance that other markets will not trade at inferior prices before a better-priced quote is satisfied, which is important to investor confidence. When most individual investors enter a market order, they expect to receive at a minimum the best quoted price available when the order is executed. When the markets trade at prices inferior to the best quotes published by other markets, investors may lose confidence that orders are treated fairly across markets and that they can be assured of obtaining the best possible prices for their orders. Therefore, the Commission believes that it is important to encourage price priority across markets, particularly as new sources of quotes emerge and order routing technology improves.8
What that discussion fails to recognize is the impact of liquidity and other concerns, particularly for large orders. In addition to price, best execution concerns include speed, service, likelihood of achieving an execution, reliability of a market maker's or ECN's systems, the market maker's or ECN's ability and procedures for handling volatile markets and its responsiveness to order-entry firms. In addition, in the case of institutional orders, the need for liquidity and depth are paramount. Governmental and private pension funds, and other financial institutions, which typically invest assets on behalf of many thousands of investors, often investors whose stake is too small to invest individually in the market while achieving appropriate diversification, seek executions of their orders that do not always fit the Commission's model of time and price priority. They may avoid walking the market up or down because taking the market-walking approach might well result in an execution that, overall, would be worse for them than electing to deal at a single, discounted sale price or augmented purchase price, regardless of whether the print reflecting that block trade might give retail investors investing directly and watching the tape the sense that they were being left behind. As the Commission's staff has wisely observed in the past, fiduciary considerations may prompt an investment manager's decision to take an approach that differs from the Commission's apparent current preference for seriatim executions at the market's "best" quoted prices:
A money manager has a duty to obtain `best execution' of client transactions, whether or not the transaction is covered by Section 28(e) [of the Exchange Act]. The Division believes that money managers executing transactions in large size (`block transactions') should consider carefully their best execution obligations. In certain situations, a money manager may obtain better overall execution by dealing with a broker-dealer that will commit its own capital (i.e., act in a principal capacity) for all or a portion of a block transaction. Although, as stated above, the portion handled by the broker-dealer as principal would not be covered by Section 28(e), if a better trade price execution was obtained through a broker-dealer with the ability to commit its own capital, that better trade price could far outweigh the benefit to the client of paying a lower commission rate to another broker-dealer without comparable execution facilities.9
9. Discouragement of certain types of order flow. The proposed rules, particularly Rule 11Ac1-5, would tend to add further reasons for market makers to determine not to accommodate order flow from day traders, program traders and other high-volume trading activity such as momentum traders . Proposed Rule 11Ac1-5 would do so because it may be difficult to handle those orders today and difficult to offer price improvement to them. Market makers today often discourage that order flow because it tends to crowd out other order flow that may be more profitable and less risky. Proposed Rule 11Ac1-5 would offer further discouragement because of the likely negative impact on a market maker's best execution numbers. Day traders and program traders offer an important source of liquidity in today's markets. The Commission's rules should be neutral with respect to those market activities and should not be designed either to favor or to disfavor them.
10. Harnessing market forces. In the Firms' experience, competition in the markets shows a robust tendency to reward brokers who do best for their customers and to punish brokers that do not. While disclosure can be an important aid to competition to the extent it increases investor understanding and highlights differences in quality and quantity of service, the disclosure requirements should not be so detailed and directed as to foreclose other competitive alternatives, but should instead leave room for innovation and "thinking outside the box". The Firms believe it likely that, by their very specificity, the detailed, one-size-fits-all disclosure requirements envisioned in proposed Rule 11Ac1-6 would tend to drive the industry toward a mean of uniform mediocrity and to discourage innovative approaches to improving the quality of brokerage service. If adopted in the form proposed, the rule would deter market forces from spurring brokers to compete with one another to provide excellent service on the basis of criteria and measuring scales not reflected in the rule.
Particularly given the rapid introduction of new market phenomena in the recent past and the likely continuation of that trend, market centers and brokers are rapidly adjusting their business models and their execution strategies. The risk of adopting regulation of the kind proposed in Rules 11Ac1-5 and 11Ac1-6 is that it will tend to stifle needed innovation as broker build business strategies more with a view to making their disclosures better than to taking maximum advantage of trading opportunities and trading techniques. Also, if a market center or an order-routing broker does change its order-routing and execution practices, the introduction of those changes would tend, in any subsequent period, to reduce the comparability and usefulness of reported numbers for prior periods.
11. Litigation risks. The Firms are concerned that one effect of the Commission's adoption of the proposed rules would be to expose market centers and broker-dealers to litigation without usefully advancing investor protection. There has been a substantial amount of private civil litigation already on the subject of best execution. As noted above, the detailed numerical data that would be called for in the proposed rules is not likely to be of much use to the retail investor and the regulatory compulsion represented by the proposed rules is likely not to be needed by the institutional investor. The rules would, however, present a significant risk of increased class-action litigation, litigation that would not necessarily be of much practical utility to investors and would be expensive and time-consuming for the markets. The resulting costs would likely be passed on to investors.
Recommendation. The Firms believe that market makers should make available to their customers on request information concerning the execution capabilities of the market makers, particularly to other brokers making order-routing decisions. The Firms recommend, however, that to the extent regulatory measures are needed in this arena, an NASD rule or interpretation articulating that general principle as part of just and equitable principles of trade would suffice.
If the Commission nevertheless determines to adopt a rule such as Rule 11Ac1-5, the rule should be made much more general and should focus on retail order flow since institutional orders may have any number of additional considerations concerning execution techniques. In addition, the Firms believe the disclosures should be more general, should not be made on a stock-by-stock basis and, in view of business confidentiality concerns, should be made available only to regulators and to customers of a market maker on request but not to the general public.
The Firms believe further that if a rule such as Rule 11Ac1-6 is to be adopted, it should be limited to requiring a broker to disclose on request to its customers: (i) the market venues to which it has access; (ii) its order-routing procedures; and (iii) possibly, a description of its policies concerning the acceptance of payment for order flow. Concerning the third item, the Firms are not persuaded that payment of order flow presents the unalloyed evil the Commission seems to associate with it and indeed it may be that in some contexts at least, payment for order flow may provide for greater competition in market making and narrower spreads.
In any event, the Firms expect that the typical retail customer, if presented even with general information, may well be indifferent. If presented with the more detailed and probably confusing information the proposed rule would require, the typical retail customer would likely be more confused than enlightened. As noted above, if Rule 11Ac1-6 rule were adopted and had normative effects, many of those effects would be deleterious because of the very specificity of the information called for and the incentives it would present. If the disclosures were limited to the three items listed above, the cost of compliance would be substantially reduced, the ill effects on market behavior would be avoided and the Commission would likely achieve much of the normative consequences it seeks.
The Firms appreciate the opportunity to make their views known on this important topic. If members of the Commission or the staff would like to discuss these matters further, the Firms would be pleased to make themselves available.
Roger D. Blanc
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Annette L. Nazareth, Esq., Director,
Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director,
Division of Market Regulation
Belinda Blaine, Esq., Associate Director,
Division of Market Regulation
1 The estimated costs of compliance the Commission identified in the Proposing Release probably fall far short of the actual costs. While it may be difficult to judge in advance how many hours will required, the Commission's estimate that the internal staff cost per hour would be $58 under Rule 11Ac1-5 and $85 under Rule 11Ac1-6 is unrealistically low given the need on the part of the affected market centers and brokers to employ persons with extensive technical and systems expertise to effect the compliance. See Proposing Release at Part VII.
2 It is likely that a report of all the data called for in proposed Rule 11Ac1-5 would, in the case of an active market maker, be 100 pages long, or more.
3 Investors, particularly retail investors, would derive little benefit from a chart that said that the broker executed, for example, 50% of its trades at one market maker, 20% at another, 20% at the New York Stock Exchange and 2.5% at each of the Pacific, Cincinnati and American Stock Exchanges, without any differentiation by type of order and security. Also, the requirement to provide any client on request with order-routing details for all their orders for the past six months would be very expensive to do after the fact. While these data could be built into confirmation disclosure requirements, the confirmation already is festooned with elaborate disclosures and there may be little practical utility in making the confirmation still more complex.
4 See, e.g., NASD Notice to Members No. 99-12 (February 12, 2000) at n.1: Firms that direct order flow likewise have a best execution obligation to conduct regular and rigorous review of the quality of executions of orders sent to correspondent market makers.
5 See, Securities Acts Amendments of 1975, Report of the Senate Comm. on Banking, Housing and Urban Affairs to Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess. 70 (1975)
Many fear that governing law applicable to fiduciaries will dictate that the money manager must always seek the lowest execution cost for portfolio transactions and that he may not charge a managed account or fund with an execution-plus research rate which may be higher than an execution-only rate. If that interpretation of fiduciary law should prove accurate, the future availability and quality of research and other service in an environment of unfixed rates could be jeopardized, with potentially harmful consequences to all investors.
6 While the SEC's proposed rules are quite complex, they actually do not cover a number of issues significant to best execution the SEC has previously said firms must examine in connection with best execution. In focusing entirely on price and speed, proposed Rule 11Ac1-5 leaves entirely alone a number of other factors very important to retail orders, which would not require a laborious number-intensive inquiry but rather a statement of the market maker's policies, which would not be expensive or cumbersome to state to customers and in which customers would have a genuine interest. For example, does the market center provide automatic order execution guarantees above the size of the NBBO? If so, in what size? When and how often does the market center lower those order execution guarantees? Does the market center provide a single-priced opening? Does it cross markets and limits? What are the trade error rates in the market center, and will the market center work with a broker-dealer to reverse trade errors? Does the market center automatically display limit orders, and if so, after what period of time? Does it automatically comply with the broker's Manning obligations (see NASD Rule IM-2110-2)? Does the market center provide intra-market time-price priority, or does it allow priority to later institutional-size orders? In other words, for all the data proposed Rule 11Ac1-5 would require, much of which is of little practical utility to investors, particularly retail investors, it fails to address many of the factors the SEC itself has said are required to be considered in evaluating best execution.
7 See Securities Exchange Act Release No. 37046 (March 29, 1996), in which the Commission, in approving preferencing, concluded:
The Commission believes it is consistent with the Act to approve the CSE's dealer preferencing program, as amended, on a permanent basis. In making this determination, the Commission has carefully evaluated the data provided by the CSE and commenters, as well as data collected by the Commission. The Commission has concluded that preferencing, as supplemented by the order handling policies, is not necessarily inconsistent with the attainment of best execution of customer orders, the maintenance of fair and orderly markets, or the protection of investors and the public interest under Section 6(b)(5) of the Act. In addition, the Commission believes approval of the DPP, as amended, also is consistent with Section 11A of the Act, particularly considering the order handling policies being adopted herein. Moreover, to the extent that preferencing does not have the effect of increasing order interaction, it fulfills the other national market system goals of Section 11A(a)(1)(C) of the Act, such as furthering competition among brokers and dealers, among exchange markets and markets other than exchange markets.
Nevertheless, Commission approval of the CSE's preferencing program is not a determination by the Commission that mere default routing by a firm to its affiliated preferencing dealer is consistent with a firm's best execution obligations. A broker-dealer associated with a preferencing dealer must still ensure that its order routing decisions and the preferencing dealer's order handling practices on the CSE (even if in technical compliance with the CSE's order handling requirements) are consistent with the firm's best execution obligations and assess periodically the quality of competing markets to assure that order flow is directed to markets providing the most advantageous terms for its customers' orders.
Id. at VII. Conclusion.
8 Proposing Release in text following n.66.
9 Letter from Richard G. Ketchum to Ronald H. Hoenig, SEC No-Action Letter (Oct. 15, 1990), 1990 SEC No-Act. LEXIS 1212.