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U.S. Securities and Exchange Commission

National Futures Association Rulemaking

File No. SR-NFA-2002-02

Exhibit 4
Text of Proposed Rule Changes

NFA Compliance Rule 2-4: Broker-Dealer Registration Requirements for Security Futures Products Interpretive Notice

The Commodity Futures Modernization Act of 2000 (CFMA), which was signed into law on December 21, 2000, amended the Commodity Exchange Act (CEA) to lift the ban on single-stock futures and narrow-based security indices ("security futures products"). Under the CFMA, security futures products are securities as well as futures and, therefore, trading in these products is subject to regulatory schemes in both the futures and securities industries, including registration requirements. As a result, NFA Member FCMs and IBs that solicit or accept orders or carry accounts for security futures products are also required to be registered as broker-dealers under the Securities Exchange Act of 1934 (Exchange Act). NFA Member FCMs and IBs that are not fully registered broker-dealers may fulfill the broker-dealer registration requirement through notice registration by filing Form BD-N with NFA.

NFA Compliance Rule 2-4 requires all Members and Associates to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their commodity futures business. This includes the requirement that Members abide by all applicable state and federal laws and regulations governing their commodity futures business, including security futures products. It is a violation of NFA Compliance Rule 2-4 for an NFA Member FCM or IB to solicit or accept orders, carry accounts, or otherwise act as a broker-dealer for security futures products unless the Member is properly registered either as a full broker-dealer under Section 15(b)(1) or as a notice registered broker-dealer under Section 15(b)(11) of the Exchange Act.

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COMPLIANCE RULES

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Part 2 - RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

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RULE 2-37. SECURITY FUTURES PRODUCTS.

This rule applies to Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act and their Associates.

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(g) Members shall not charge customers more than a fair commission or service charge for transactions in security futures products, taking into consideration all relevant circumstances, including the expense of executing the order and the value of any service the Member may have rendered by reason of its experience in and knowledge of the security futures product and the market in that product.

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NFA COMPLIANCE RULE 2-37: FAIR COMMISSIONS

INTERPRETIVE NOTICE

Under Section 15A(k) of the Securities and Exchange Act of 1934 (Exchange Act), NFA is a national securities association for the limited purpose of regulating the activities of Members who are registered as brokers and dealers in security futures products under Section 15(b)(11) of the Exchange Act (i.e., FCMs and IBs who "passport" in to broker-dealer registration because they limit their securities activities to security futures products). Section 15A(k) also requires NFA to impose customer protection requirements reasonably comparable to those of national securities associations registered under Section 15A(a) of the Exchange Act. One of these requirements relates to the amount of commissions these Members may charge for security futures transactions.

NFA Compliance Rule 2-37(g) prohibits Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act from charging more than a fair commission for security futures transactions. That rule also provides that what is a fair commission depends on all of the relevant circumstances, including the expense of executing the order and the value of any service the Member may have rendered based on its experience and knowledge.

The vast majority of NFA Members charge fair commissions, and Compliance Rule 2-37(g) will not require them to make any changes to their commission practices for security futures products. Commissions for futures transactions have been set competitively since the 1970s. They are usually based on the Member's costs plus a reasonable profit. Commission rates also vary based on the services provided by the Member. Additionally, Members who deal with institutional customers often negotiate commissions based on volume or similar measures. All of these practices continue to be acceptable for security futures products.1

NFA has occasionally encountered retail firms that have charged fees significantly out-of-line with the Member's costs and services and the industry norm. In most of these cases, customers have been misled as to either the amount of the commission, the effect of the commission on profitability, or how the commission rate compares with other firms in light of the services offered. High commissions also have a significant effect on commission-to-equity ratios and increase the likelihood that the Member will churn accounts over which they or their Associates have discretionary authority or de facto control. As a result, NFA has consistently responded to unreasonably high commission rates by charging the firms and their Associates with violating NFA Compliance Rule 2-2(a) and/or NFA Compliance Rule 2-29, and NFA will continue to do so.2

NFA Compliance Rule 2-37(g) and this interpretive notice do not relieve Members of their obligation to make the applicable per trade or round-term commission charges available to customers prior to the commencement of trading and to fully explain any fees and charges that are not determined on a per trade or round-turn basis.3

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NFA COMPLIANCE RULE 2-4: THE BEST EXECUTION OBLIGATION OF NFA MEMBERS REGISTERED AS BROKER-DEALERS UNDER SECTION 15(b)(11) OF THE SECURITIES EXCHANGE ACT OF 1934

INTERPRETIVE NOTICE

Under Section 15A(k) of the Securities Exchange Act of 1934 ("Exchange Act"), NFA is a national securities association for the limited purpose of regulating the activities of NFA Members who are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Exchange Act (i.e. FCMs and IBs that passport in to broker-dealer registration because they limit their securities activities to security futures products). NFA Compliance Rule 2-4 requires Members and Associates to observe high standards of commercial honor and just and equitable principles of trade. This rule imposes an obligation on all Members and Associates to put their customers' interests before their own when soliciting and executing futures transactions. To this end, in executing security futures transactions, Members and Associates have an obligation to use reasonable diligence to ensure that customer orders receive the most favorable terms under the circumstances.

When a customer's order may be executed on only one exchange, Members do not have to decide where to route the order and, consequently, satisfying their best execution obligation is simpler than when Members must consider the relative merits of routing an orders to two or more markets. In those cases where a customer's order may be executed on two or more markets trading security futures contracts that are not materially different, Members and Associates have an obligation to use reasonable diligence to ascertain the market in which the customer's security futures order will receive the most favorable terms and, in particular, the best price available under prevailing market conditions. This notice provides guidance on how to fulfill that obligation.

First, it should be clear that if a customer or customer's designee4 requests that a security futures order be directed to a particular market, or specifies the purchase or sale of a particular security futures product that trades on only one market, then the Member or Associate is required to follow the customer's or designee's instructions. In this particular case, a Member does not have an obligation to ascertain the best market for a customer's security futures order.

A Member or Associate must consider the relevant facts and circumstances including, at a minimum, the following factors in discharging its obligation to use reasonable diligence in ascertaining where a customer's security futures order will receive the most favorable execution available:

  • The character of the market including, but not limited to, price, volatility, liquidity, depth, speed of execution, and pressure on available communications;
     
  • The size and type of transaction, including the type of order; and
     
  • The location, reliability and accessibility to the customer's intermediary of primary markets and quotation sources.

Members and Associates must also consider differences in the fees and costs to customers ( e.g. transaction fees, clearing costs and expenses) associated with executing transactions in each market. Unless specifically instructed by a customer or customer's designee or necessary to obtain the execution of an order, a Member shall not channel an order through a third party unless the Member can show that by doing so the total cost or proceeds of the transaction were better than if the Member decided not to channel the order through the third party. Moreover, a Member through whom a retail order is channeled and who knowingly is a party to an arrangement whereby the initiating Member firm has not fulfilled its best execution obligation will also be deemed to have violated NFA Compliance Rule 2-4. Members should be aware that channeling orders through a third party to receive reciprocation for service or business will not relieve a Member of its best execution obligation. Likewise, Members should not allow an order routing inducement, such as payment for order flow, to interfere with a Member's duty of best execution.

Failure of Member firms to maintain or adequately staff an order room or other department assigned to execute customer orders cannot be considered justification for executing away from the best available market. NFA recognizes that it may be impracticable for Members and Associates to make order routing decisions for retail orders on an order-by-order basis. Members and Associates that do not make order routing decisions for retail orders on an order-by-order basis should, at a minimum, consider the above factors and the materiality of any differences among contracts traded on different markets when establishing their retail order-routing practices and perform a regular and rigorous review of those practices to ensure that their best execution obligation is fulfilled.

This notice describes the best execution obligation of Members that are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Exchange Act for transactions in security futures products only and does not impose such an obligation upon Members for transactions in other products. By necessity, this notice is general in nature since it is issued before security futures products have begun trading. NFA will provide further guidance if necessary as the markets for security futures products evolve.

Endnotes

1 NFA does not believe it is appropriate to apply a guideline similar to NASD's 5% guideline for securities mark-ups. The cost of executing orders in the futures markets tends to have little correlation with either the notional value of the contract or the amount of margin. Although nothing prohibits NFA Members from setting commissions for security futures contracts based on the notional value of the contract or the amount of margin, those commissions must be reasonable in light of all of the circumstances, including the Member's expenses and the value of the Member's services.

2 See, e.g., In re Bachus & Stratton Commodities, Inc., NFA Case No. 92-BCC-15 (Hearing Panel, Feb. 18, 1993), aff'd, NFA Case No. 93-APP-2 (App. Comm., Nov. 11, 1993); In re Churchill Group, Inc., NFA Case No. 90-BCC-12 (BCC, Sep. 5, 1990) (settlement); In re The Siegel Trading Co., Inc., NFA Case No. 97-BCC-7 (Hearing Panel, Jan. 4, 1999) (settlement).

3 See Interpretation of NFA Compliance Rule 2-4: Guideline for the Disclosure by FCMs and IBs of Costs Associated With Futures Transactions, ¶ 9005, National Futures Association Manual.

4 A person that exercises discretion over a customer's account.

 

http://www.sec.gov/rules/sro/34-45720ex4.htm


Modified: 04/11/2002