October 25, 2000
Via Electronic Mail and
Federal Express
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
Attn: Jonathan Katz, Secretary
Re: File No. S7-16-00, Disclosure of Order Routing and Execution Practices
Dear Mr. Katz:
Knight Trading Group, Inc. ("Knight") welcomes this opportunity to comment on the Securities and Exchange Commission's (the "Commission") proposed rules to improve public disclosure of order routing and execution practices.1 Knight, headquartered in Jersey City, New Jersey, is the parent company of Knight Securities, L.P., Knight Capital Markets, Inc. (formerly Trimark Securities, L.P.), Knight Financial Products, L.L.C. (formerly Arbitrade Holdings, L.L.C.), and Knight Securities International, Ltd. Knight's subsidiaries make markets in equity securities listed on Nasdaq, the OTC Bulletin Board, the New York Stock Exchange, American Stock Exchange, Easdaq and in options on individual equities, equity indices, fixed income instruments and certain commodities in the United States and Europe. The firm also maintains an asset management business for institutional investors and high net worth individuals through its Deephaven subsidiary.
As a leading destination for online trade executions, Knight is the processing power behind the explosive growth in securities trading via the Internet. Knight's clients include the leading brokerage firms, and more than 1200 broker-dealers and 1000 institutional clients. The Company is included in Fortune's "e-50 Stock Index," an elite collection of companies that are shaping the new Internet-based economy. Currently, the five-year-old company employs more than 1200 people worldwide.
SUMMARY AND OVERVIEW
Knight strongly commends the Commission for its efforts to promote best execution and the continuing quality of America's markets. Improving public disclosure of order routing and execution practices is a legitimate and productive use of the Commission's rulemaking authority and will serve to effectuate the ultimate purpose of the Securities Exchange Act of 1934 (the "Exchange Act") - protecting investors and the public interest. The proposed rules will serve to enhance investor protection and further competition for retail orders by enabling investors and their fiduciaries to evaluate more effectively the market centers to which their orders are routed. 2
The proposed rules are designed to provide more information to investors and their fiduciaries about the quality of executions available at various market centers and their broker-dealer's order routing practices. Proposed Rule 11Ac1-5 will lead to more informed investors and incentivizes market participants to ensure customers are receiving best execution and not merely executing orders at the National Best Bid and Offer. While Knight supports proposed Rule 11Ac1-5, we believe the proposed rule should be adopted as a temporary rule to afford the industry, the public and the Commission ample opportunity to study its impact. Knight also supports the formation of an advisory committee comprised of industry and public representatives to analyze the impact of the rules and the metrics set forth in the rules. This advisory committee should analyze the value of the metrics selected and should, if necessary, recommend new metrics.
The Commission has asked for comment on a variety of issues; Knight respectfully submits comments on the following issues:
While Knight's comments focus primarily on proposed Rule 11Ac1-5, Knight believes that the proposed rules would further the investor protection goals of the Exchange Act, and are consistent with the general philosophy underlying disclosure that "sunlight is the best disinfectant."3
DISCUSSION
It is not the pace of technology or the brilliance of innovation . . . that guarantees the success of our markets, but rather an unyielding commitment to quality. Quality in the marketplace is faster, cheaper execution of transactions . . . [and] efficient price discovery. Quality is the best execution of customer orders. Quality . . . is the protection of the investor interest. This last principal . . . reaffirms a simple and salient truth -- markets exist by the grace of investors.4
Proposed Rule 11Ac1-5 will promote quality execution and protection of investors by making more readily available to the public reliable information that was previously hard to obtain and measure in a variety of ways. The information disclosed pursuant to the proposed rule is currently used by market centers and broker-dealers to analyze the quality of executions provided by market centers. However, market centers are not required to share this information with the public or with broker-dealers.
The information disclosed pursuant to the proposed rule would provide uniform and consistent reports on commonly used yardsticks by which broker-dealers and the public can make informed decisions. Like the Securities Act of 1933 (the "Securities Act") which requires disclosure of certain relevant financial and other information for sales of securities to the public, the proposed rules protect the public by ensuring that they have adequate and accurate information to assist them in making investment decisions. The disclosure regimen set forth in proposed Rule 11Ac1-5 represents a substantial step towards ensuring best execution.
Best execution is a cornerstone of the self-regulatory framework that has guided our markets for over sixty years. The duty of best execution requires a broker-dealer to seek the most advantageous terms reasonably available under the circumstances for its customer's transaction. Originally derived from agency law principles and fiduciary obligations,5 the duty of best execution was incorporated into the rules of each self-regulatory organization ("SRO").6 Judicial and Commission decisions have established that a broker-dealer's failure to perform its best execution obligation may form the basis for an action under the antifraud provisions of the federal securities laws.7
The Commission has not set forth a best execution rule or explicitly defined best execution. The duty of best execution as understood by the Commission and industry participants is a dynamic concept that has evolved over time. Traditionally, price has been the predominant factor in determining whether a broker-dealer has satisfied its best execution obligations.8 However, the Commission has stated that broker-dealers also should consider at least six additional factors as part of satisfying their best execution responsibilities: (1) the size of the order; (2) the speed of execution available on competing markets; (3) the trading characteristics of the security; (4) the availability of accurate information comparing markets and the technology to process such data; (5) the availability of access to competing markets; and (6) the cost of such access.9 One of the Commission's main concerns regarding best execution has been that internalization and inducements for order flow could adversely affect a broker-dealer's routing decisions.
The Commission's most detailed pronouncement regarding a broker-dealer's best execution obligations came in the 1996 Order Handling Rules Adopting Release.10 In this release, the Commission emphasized the importance of price improvement opportunities in determining best execution. Specifically, the Commission stated that broker-dealers must modify their best execution evaluations to consider price improvement opportunities that become "reasonably available." The Commission stated that internalizing or routing order flow for execution at the national best bid or offer ("NBBO") would not necessarily satisfy a broker-dealer's duty of best execution for retail-sized orders in listed and over-the-counter ("OTC") securities. The Commission concluded a broker-dealer's regular and rigorous evaluation should include the extent to which directed order flow would result in better terms if executed in a market offering price improvement opportunities. As part of that evaluation, a broker-dealer must take into account material differences that exist among the price improvement opportunities offered in different markets. In addition, the broker-dealer must consider that different markets are more suitable for certain types of orders or particular securities.11
Another more current development affecting the best execution analysis involves the technological advances on-line brokerages offer their customers - services previously available only to market professionals. Currently, several on-line firms offer active traders the ability to direct orders in Nasdaq stocks to the market center of their choice.12 These systems enable customers to direct orders through a connection to the on-line broker's order routing system.13 Broker-dealers also have developed sophisticated software that reduces best execution to an algorithm. These algorithms direct customer order routing on an order-by-order basis.14 Several on-line firms are marketing order-by-order routing to active traders.15
Despite the development of new intelligent order routing technologies, there is a public perception that a conflict exists between a broker-dealer's best execution obligation and its receipt of payment for order flow.16 A broker-dealer receiving payment for order flow that fails to conduct thorough regular and rigorous analyses may be unable to establish that it has satisfied its fiduciary duties to its customers. However, while concerned with best execution, the Commission has noted that bulk order routing based, in part, on payment for order flow is not, in and of itself, a violation of the duty to provide best execution. The Commission has repeatedly stated that disclosure of payment for order flow could help inform investors and negate the concern that investors receive inferior executions due to undisclosed rebates.17
The belief that disclosure is the best means to address concerns about payment for order flow has been echoed by industry leaders. In his testimony before Congress, Knight's Chief Executive Officer and co-founder, Kenneth Pasternak, noted:
The regulation of [America's] securities markets-arguably the most enlightened in the world-has always rested on the precept of full and fair disclosure. That is, by providing all investors-not just market professionals-with clear, adequate information, we empower them to make intelligent choices among all the available options without unnecessarily stifling competition.18
Knight believes that the disclosure regimen of the proposed rules will make great strides in addressing concerns that order entry firms cannot satisfy their best execution responsibilities while accepting payment for order flow. The proposed rules will also allay concerns that market centers are facilitating possible violations of broker-dealers' best execution responsibilities to their clients.
Proposed Rule 11Ac1-5 will provide broker-dealers, the financial press, and the public with benchmarks by which they can measure the quality of executions afforded orders by competing market centers. Recently, the financial press has included quality of execution as part of its analysis of broker-dealers. The information disclosed pursuant to the proposed rules will enable the financial press to analyze the quality of execution as part of reviews of retail brokerage services. Eventually, the financial press coverage of the subject of quality of execution may elevate public awareness of such information to a level equal to information about commission rates.
Knight strongly supports the disclosure regimen of proposed Rule 11Ac1-5. Greater disclosure will produce a more informed marketplace by unleashing competitive pressures that will inure to the investors' benefit. Informed investors and their fiduciaries will exercise their power as consumers and ensure that broker-dealer order flow arrangements and order routing technologies do not compromise quality for profitability. Proposed Rule 11Ac1-5 will help broker-dealers perform their fiduciary duty to ensure best execution of customer orders by providing them previously unavailable information from market centers regarding execution quality.
1. Proposed Rule 11Ac1-5 will help to establish uniform statistical measures of execution quality, which are feasible and implementable without undue burden on market centers. The costs of implementing the disclosure-based approach are minimized by the fact that much of the information to be produced is already collected by broker-dealers.
Knight supports the Commission's effort to establish uniform statistical measures of execution quality. Market centers such as Knight, already compile information regarding and compete based on execution quality and compete based on execution quality. Proposed Rule 11Ac1-5 will promote the development of common metrics for measuring the execution quality afforded by various between market centers and will foster the competition between market centers.
We believe proposed Rule 11Ac1-5 and the statistical measures set forth therein are feasible and implementable without undue burden on market centers because they already must produce much of the required information pursuant to Rule 17a-3 and their Order Audit Trail ("OATS") reporting responsibilities.19 While Rules 17a-3 and the OATS Rules do not require all of the information required by the proposed rules, Knight believes the systems modifications necessary to produce the new reports are minimal and not unduly burdensome.
a. The OATS Rules require broker-dealers to collect much of the information required by proposed Rule 11Ac1-5.
Currently, the OATS Rules require member firms to record in electronic form and to report to NASD Regulation certain items of information with respect to orders they receive to effect transactions in equity securities traded in the Nasdaq Stock Market ("Nasdaq"). NASD Regulation combines this order information with transaction data reported by members through the Automated Confirmation Transaction Service ("ACT") and quotation information disseminated by members through Nasdaq to construct an integrated audit trail of quotation, transaction, and order data.
The OATS Rules require members receiving an order relating to equity securities traded in the Nasdaq to capture electronically specified information related to the order, record this information to the hour, minute, and second, and electronically transmit this information to OATS.20 These requirements apply both to orders originated by investors and to proprietary orders originated by a department of a member firm and sent to its trading desk or to another member for execution. The requirement to capture and transmit information applies whenever the order is transmitted to another department of the same firm. This requirement, however, does not apply when the order is routed to the trading department. Order information must be submitted to OATS in electronic file transmissions on the day that the order, or the specific information pertaining to the order, was received, originated, transmitted, modified, canceled, or executed. When information containing a particular order is not complete or changes, the additional information must be transmitted on the day that the information first becomes available. The OATS Rules allow a firm to enter into an arrangement with a third party pursuant to which the third party agrees to report order information on its behalf, in the same manner that firms now contract with others to report transaction data to ACT. In each case, however, the member that actually receives or originates the order would remain primarily responsible for fulfilling each of its obligations under the OATS Rules.21
The information reported by market centers pursuant to their OATS reporting responsibilities is very similar to that required by proposed Rule 11Ac1-5 and could easily be used to measure the quality of executions. Proposed Rule 11Ac1-5 requires market centers to produce reports categorized by order type, order size, and security. Market centers are also required to produce statistical information for a variety of subcategories, including but not limited to, market orders and marketable limit orders.22 While not producing the specific reports required by the proposed rule, the OATS information could be used to produce the required reports and to provide investors with meaningful information about the handling of their orders.
b. Rule 17a-3 requires the collection of information needed to facilitate compliance with proposed Rule 11Ac1-5.
Rule 17a-3 requires broker-dealers to maintain records that would facilitate the implementation of proposed Rule 11Ac1-5. Specifically, Rule 17a-3(a)(7) requires:
Every member of a national securities exchange who transacts a business in securities directly with other than members of a national securities exchange, and every broker or dealer who transacts a business in securities through the medium of any such member . . . [to] make and keep . . . A memorandum of each purchase and sale for the account of such member, broker, or dealer showing the price and, to the extent feasible, the time of execution; and, in addition, where such purchase or sale is with a customer other than a broker or dealer, a memorandum of each order received, showing the time of receipt, the terms and conditions of the order, and the account in which it was entered.
Rule 17a-3 also requires broker-dealers to record the following information regarding internal broker-dealer systems: a record of the broker's or dealer's customers that have access to an internal broker-dealer system sponsored by such broker or dealer; daily summaries of trading in the internal broker-dealer system, including, securities for which transactions have been executed through use of such system, and transaction volume, stated in number of trades, number of shares, and total U.S. dollar value, with respect to debt securities, stated in total settlement value in U.S. dollars, and with respect to other securities, stated in number of trades, number of units of securities, and in dollar value, or other appropriate commonly used measure of value of such securities; and time-sequenced records of each transaction effected through the internal broker-dealer system, including the date and time executed, the price, the size, the security traded, counter-party identification information, and the method of execution (if the internal broker-dealer system allows alternative means or locations for execution, such as routing to another market, matching with limit orders, or executing against the quotations of the broker or dealer sponsoring the system).
Like the data collection requirements of Rule 17a-3, proposed Rule 11Ac1-5 is feasible because it requires market centers to produce electronic files with raw data on an order-by-order basis. Much of the information required by proposed Rule 11Ac1-5 is already collected electronically by broker-dealers pursuant to their responsibilities under Rule 17a-3, and under the OATS Rules. Moreover, the data collection requirements of proposed Rules 11Ac1-5 are similar to those of broker-dealers operating Alternative Trading Systems.23 Concerns that proposed Rule 11Ac1-5 will impose unduly burdensome costs associated with the collection of the required information are exaggerated. As is the case with the data collection requirements of Rule 17a-3, the data collected pursuant to Rule 11Ac1-5 can be stored electronically pursuant to Rule 17a-4(f).24
c. Third party vendors can provide the required reports for parties within the scope of the proposed rule.
Similarly, like Rule 17a-4 which allows broker-dealers to use outside service providers to collect and maintain the information required by Rule 17a-3, proposed Rule 11Ac1-5 should allow market centers to use outside vendors to collect and disseminate the required information. Any market center that cannot or elects not to design and administer systems needed to make the necessary computations pursuant to the proposed rules, should be allowed to use an outside service provider. Such an approach would offer an alternative for market centers that do not wish to incur the costs associated with developing and administering any systems needed to collect and disseminate the required information.25
Any concerns about the burdens created by proposed Rule 11Ac1-5 can be addressed by third parties that are interested in collecting and summarizing electronic data on execution quality. Currently, there are firms that provide much of the analysis required by the proposed rules. These firms use data provided by broker-dealer clients to generate equity and option audits. The equity audit program assists broker-dealer clients to document the required regular and rigorous analysis. The reports are generated from electronic trade files compiled by the broker-dealers' executing market center. The equity audit programs are reasonably priced and available for Limit, Marketable Limit and Market Orders.26 These proprietary reports provide information including: execution price vs. limit price; primary print count protection; limits executed in lieu of display; possible occurrences of non-display; response to primary trade-throughs; and missed execution opportunities vs. NBBO.
d. Proposed Rule 11Ac1-5 is sufficiently narrow to ensure that it does not unduly burden parties ill-equipped to satisfy the requirements of the rule.
Concerns about the scope of proposed Rule 11Ac1-5 are also minimized by the fact that the proposed rule only applies to "covered orders." The scope of the proposed rule is limited by the definition of covered order in paragraph (a)(8) that limits the rule to orders that provide for meaningful statistical measures of execution quality. The definition ensures that the requirements of the proposed rules only apply to market orders or limit orders that are received by a market center during the time that a consolidated BBO is being disseminated.
While Knight supports proposed Rule 11Ac1-5, we believe that the definition of covered order should not exclude certain orders for which the customer requested special handling for execution. Specifically, Knight believes proposed Rule 11Ac1-5 and the definition of covered order should include pre-opening orders, fill or kill orders, stop orders, and stop limit orders.27 While some market centers may argue that including these figures will skew the value of the statistical information produced pursuant to proposed Rule 11Ac1-5, Knight disagrees. We believe the public has a right to uniform and consistent metrics regarding execution quality for these types of orders. Proposed Rule 11Ac1-5 is based on commonly used industry yardsticks and will provide valuable information to the public. Investors have a right to know if the market center to which their orders were routed had routine or systemic technological failures that substantially impaired the quality of the execution of their orders.
Concerns that the requirements of proposed Rule 11Ac1-5 are unduly burdensome are also addressed by the definition of "market center" set forth in paragraph (a)(14). By definition, the proposed rule will only apply to those entities that "hold themselves out as willing to accept and execute orders in national market system securities." The functional effect of the proposed rule and the definition of "market center" is that it will only include exchange market makers, OTC market makers, alternative trading systems, national securities exchanges and national securities associations; all of which are technologically capable of producing the required information. Accordingly, the proposed rule ensures that smaller broker-dealers that are ill equipped to address the duties created by the rule are not subject to the proposed Rule.
Furthermore, concerns about the scope of proposed rule 11Ac1-5 are mitigated by the fact that the rule will only apply to securities that are designated as a national market system security under Rule 11Aa2-1. This designation applies to exchange-listed equities and equities included in the National Market tier of Nasdaq. Knight believes it is appropriate to exclude Nasdaq SmallCap securities and exchange-listed options from the scope of Rule 11Ac1-5 at this time because SmallCap stocks tend to be inactively traded and, as a group, generate less than 5% of the dollar volume on Nasdaq while making up nearly 25% of Nasdaq companies. 28 Excluding options at this time is appropriate because there are not suitable market linkages between the options markets to facilitate the collection and dissemination of the information required by the proposed rule.
Finally, concerns that proposed Rule 11Ac1-5 is unduly burdensome can be addressed in part by excluding Nasdaq SmallCap equities and listed options. By initially excluding OTC Bulletin Board securities from the scope of proposed Rule 11Ac1-5, the Commission would afford market participants the opportunity to develop new and modify existing technologies that would be needed to satisfy the requirements of the proposed rules. The value of including a disclosure requirement for OTC Bulletin Board securities does not justify the costs associated with producing the required reports. Unlike Nasdaq National Market Securities that are heavily traded and have suitable audit trail mechanisms and reporting requirements in place, OTC Bulletin Board securities do not. Accordingly, the statistical measures of trading SmallCap and OTC Bulletin Board securities currently do not justify the costs to produce the information required by the rule.
e. The time of order receipt should be the time an order was received by a market center, not when the specialist on the exchange floor receives the order.
Proposed Rule 11Ac1-5(b)(1)(ii) sets forth nine criteria to assist in the evaluation of market orders and marketable limit orders by comparing their execution prices with the consolidated BBO at the time of order receipt. Knight believes the time of order receipt is an accurate and easily understandable criterion of execution quality of market orders and marketable limit orders that should be provided to the public. Proposed Rule 11Ac1-5(a)(20) defines "time of receipt" as "the time (to the second) that an order was received by a market center for execution." Knight believes the definition of "time of receipt" is workable and sufficiently clear to facilitate cross-market comparisons of execution speed and quality. The definition, however, should clearly note that "time of receipt," means the time a market center receives an order, not when the specialist on the exchange floor receives the order. By requiring market centers to measure execution prices with the consolidated BBO at the time of order receipt, investors and the media will be able to evaluate price improvement and price disimprovement for each market center.
f. Decimal trading will help to reduce concerns about best execution and payment for order flow and will help to prevent ongoing ECN fee disputes.
The proposed rules and the implementation of decimal trading will help to reduce concerns and negative perceptions about best execution and payment for order flow. Decimal pricing will help to further reduce spreads and enable market makers to compete more easily by narrowing their displayed quotes. The implementation of decimal pricing will also resolve the current dispute between market participants over Electronic Communications Network ("ECN") non-subscriber access fees. Knight believes strongly that all market participants should display their true bid and offer price with no collateral or ancillary fees levied after the trade. By including ECN fees in the quote, ECNs will provide the public and broker-dealers a true indication of the costs of execution through their system.
2. The disclosures required by proposed Rule 11Ac1-5 will produce valuable information for investors and improve market efficiency without exposing market centers to potential litigation. However, the proposed rules should not supplant the business judgment of market centers.
Knight supports the disclosure regimen of proposed Rule 11Ac1-5 that requires market centers to disseminate information regarding order execution quality and payments for order flow to broker-dealers and the public. Market centers already compete based on execution quality. However, this competition lacks uniform metrics for broker-dealers to measure the quality of executions afforded by the various market centers. Proposed Rule 11Ac1-5 will promote the development of common metrics for measuring execution quality between market centers and will foster the competition between market centers. Proposed Rule 11Ac1-5 will enable broker-dealers to provide their clients with a description of the reasons why orders were routed to one market center rather than another market center. This information will also enable investors to compare the execution results of various market centers and to choose those market centers and firms that offer superior execution results. Knight believes the proposed rules should be implemented on a temporary basis and that a committee comprised of public and industry participants should be appointed to examine the criteria set forth in the rule and to consider the value of including additional criteria.
The Commission should also state in preliminary notes to the rules that the rules do not establish a private right of action. Litigation concerns could be addressed in the adopting release. The adopting release could also state that while the information is being provided to aid market professionals in the exercise of their professional judgment in making order routing decisions, the quantitative metrics are not the only criteria that should be considered by broker-dealers in making such decisions. Subjective material criteria, including but not limited to, access, capacity, breathe of stocks covered, and customer service, are legitimate criteria on which to make order routing decisions.
a. Concerns about litigation are unwarranted.
Some commenters have raised concerns about the proposed disclosure rules fueling an explosion of private litigation.29 While Knight appreciates these concerns, Knight respectfully disagrees. Currently, every broker-dear is responsible for satisfying their duty of best execution to their clients. Firms that fail, or allegedly fail, to satisfy this duty face potential claims by clients pursuant to Rule 10b-5.30
However, the dangers of potential litigation based on proposed Rule 11Ac1-5, are overstated. In 1995 Congress amended the Securities Act of 1933 and the Exchange Act when it passed legislation designed to reform and codify the federal securities laws, including § 10(b) of the 1934 Act.31 The Private Securities Litigation Reform Act of 1995 ("PSLRA") was meant to curb "meritless securities lawsuits [which] were harming the nation's securities markets . . . "32 The PSLRA established heightened pleading requirements, an automatic stay of discovery pending motions to dismiss, and limitations on damages and a safe-harbor for certain forward-looking statements.33
The protections afforded market participants from frivolous lawsuits by the PSLRA were expanded by Congress in the Securities Litigation Uniform Standards Act of 1998 ("SLUSA") which established national rules and exclusive federal jurisdiction for virtually all private securities class action litigation.34 Congress passed SLUSA in 1998 to address the efforts of plaintiffs to circumvent the PSLRA's protections by filing their actions in state courts under state law.35 SLUSA shuts the door on private securities class actions which are based on state law and which allege misrepresentation, omission or deception in connection with the purchase or sale of nationally traded securities. The PSLRA and SLUSA were specifically designed to prohibit securities plaintiffs from launching costly litigation by asserting vague, conclusory federal securities claims or from disrupting national securities regulation by asserting non-uniform state claims.36
The PSLRA and SLUSA will serve to protect market participants from frivolous lawsuits based on the proposed rules. Any class action claim against a market participant based on an alleged violation of the proposed rules would fall within the scope of the PSLRA and SLUSA. Accordingly, such class actions would have to be filed in federal court and would be subjected to the heightened pleading requirements, the automatic stay of discovery pending motions to dismiss, and the limitations on damages.
Moreover, the information produced by market centers to broker-dealers pursuant to proposed Rule 11Ac1-5 may provide a shield against the frivolous claims of many potential litigants. The information transmitted by market centers to broker dealers could serve as prima facie evidence that the broker-dealer's order routing and execution decisions were based on sound business judgments. If broker-dealers routinely disclose reports to investors based on the information produced by the market centers and their own internal records, arguments by potential litigants that they did not know of the order routing practices will be specious at best.
Finally, Knight, believes the Commission should state clearly that the proposed rules do not create a private right of action. The Commission can do this by including a safe harbor provision in the proposed rules similar to the safe harbor provision included in Regulation FD.37 The text of Regulation FD makes it clear that the regulation is a disclosure rule and that it does not create liability for fraud. Where the regulation is violated, the Commission can bring an administrative proceeding seeking a cease and desist order or a civil action seeking an injunction and/or civil penalties. With the inclusion of a safe harbor provision in the proposed rules the Commission could address the concerns of market centers and broker-dealers while promoting the development of best execution as a quantifiable criterion by which the public can select market centers and broker-dealers.
b. The information disclosed by market centers will be valuable to broker-dealers and their clients.
Some firms claim that the disclosures required by the rules will result in the production of virtually useless "prospectus like" documents.38 These claims are without merit and belittle the value of disclosure as the ultimate disinfectant. Proposed Rule 11Ac1-5 will raise investor trust and confidence in the marketplace that market participants will treat them fairly and justly. Like the Securities Act which requires the disclosure of certain financial and other information for sales of securities to the public, proposed Rule 11Ac1-5 protects the public by ensuring that they and their fiduciaries have adequate and accurate information to assist them in making investment decisions. Under the proposed rules, investors and their fiduciaries will have access to information regarding the quality of the execution of their orders. As was the case with the information disclosed pursuant to the Securities Act, the ultimate value of the information disclosed pursuant to the proposed rules will be determined by the public and the media, not by the parties required to disclose the information.
The disclosure regimen set forth in proposed Rule 11Ac1-5 represents a substantial step towards ensuring best execution. The increased disclosure will result in increased competition among market centers for order flow. Execution quality will become a yardstick by which firms, the financial press, and the public will measure the services of competing market centers. The increased competition for order flow will also encourage innovation and the use of technology as a means of providing more efficient and higher quality trading services.
c. Broker-dealers' fiduciary decisions regarding best execution should not be pre-empted by formulaic de facto standards of best execution.
The proposed rules should not impose formulaic de facto standards of best execution that will interfere with broker-dealers making decisions that will result in best execution. A rigid set of criteria that are deemed to constitute best execution, yet fail to allow broker-dealers to set forth the reasons for their business decisions, will only serve to create a disincentive to satisfying their best execution duties. A de facto best execution criterion will also discourage broker-dealers from exploring new technologies and linkages that could in fact promote improved execution quality. The proposed rules must allow broker-dealers to make informed business decisions on behalf of their clients, including decisions to use new order routing technologies that may at first glance appear to provide inferior execution when judged in light of the criteria set forth in the rule. Firms must remain free to make informed business decisions on behalf of their clients without concern that those decisions will be judged by an arbitrary best execution litmus test.
d. The concerns of industry participants can be effectively addressed in the adopting release and by including preliminary notes to the rules.
Knight believes the Commission should address the concerns of industry participants in the adopting release and in preliminary notes to the proposed rules.39 The adopting release and the preliminary notes should state that best execution is ultimately the fiduciary duty of broker-dealers to their clients and that this duty is not satisfied by means of rote performance and measurement of the criteria set forth in the proposed rules. The adopting release and the preliminary notes should encourage broker-dealers to provide the basis of their order routing decisions. The Commission, however, should acknowledge that the proposed rules do not define all of the considerations that should be taken into account by broker-dealers in satisfying their duty of best execution. The Commission should also advise the public, the media, and broker-dealers that the duty of best execution is still ultimately the duty of the broker-dealer to exercise their professional judgment in making order routing decisions based on a variety of criteria, including, but not limited to, the criteria set forth in the proposed rules.
The adopting release and the preliminary notes should also state that the proposed rules are being adopted as temporary rules for one year to afford the industry, the public and the Commission ample opportunity to address the impact and application of the rules. This period will also afford the industry, the Commission and the public, ample opportunity to suggest revisions to the rules needed to effectuate the purposes of the rule - promoting best execution. Finally, the Commission should state in the adopting release that a committee of public and industry representatives will be appointed to examine the impact of the rules and to recommend changes to the rules to the Commission.
CONCLUSION
In conclusion, Knight believes the proposed rules, if adopted on a temporary basis and in conjunction with the formation of an advisory committee, will promote best execution. The proposed rules, however, should not be deemed to supersede the broker's ultimate fiduciary duty to provide best execution. Broker-dealers that make informed professional judgments, as part of fulfilling their fiduciary duties to their clients should not face the burdens of litigation. If a suitable safe harbor provision is not incorporated into the rules, broker-dealers will be placed in the untenable position of having to make execution decisions based on criteria that may not be relevant to their business or their clients' interests. A safe harbor provision will also ensure the criteria set forth in the rules do not become the de facto standards utilized by regulators as a template for judging best execution.
Knight fully supports the Commission's efforts to promote a quality marketplace and best execution of customer orders. The disclosure regimen set forth in the proposed rules will rely on the forces of competition to encourage market centers and broker-dealers to provide superior executions that they can promote in their advertising campaigns. For the first time in the history of our markets, full disclosure of order routing considerations and execution quality statistics could become another criteria for consumers to make educated choices about the brokers they choose to use for the services in question. This competition based solution could ensure that firms that excel in providing their clients best possible execution will be rewarded, while firms that fail to satisfy their fiduciary duty, risk losing their clients' trust and business.
I hope that the Commission and staff find these comments helpful. If Knight or I can be of further assistance to you on this matter, please do not hesitate to contact me.
Sincerely,
Michael T. Dorsey
Senior Vice President and
General Counsel
cc: Hon. Arthur Levitt
Hon. Norman S. Johnson
Hon. Isaac C. Hunt, Jr.
Hon. Paul R. Carey
Hon. Laura S. Unger
Annette Nazareth
Robert L.D. Colby
Belinda Blaine
Daniel M. Gray
| 1 | Exchange Act Release No. 43,084 (July 28, 2000), 65 Fed. Reg. 48,406 (Aug. 8, 2000) (the "proposed rules"). |
| 2 | Proposed Rule 11Ac1-5 limits the definition of "market center" to exchange market makers, OTC market makers, alternative trading systems, national securities exchanges and national securities associations. |
| 3 | L. Brandeis, Other People's Money and How the Bankers Use It, 92 (Frederick A. Stokes Co. ed. 1932). |
| 4 | Arthur Levitt, Dynamic Markets, Timeless Principles, Remarks at Columbia Law School, New York, N.Y. (Sept. 23, 1999) (transcript available at http://www.sec.gov/news/speeches/spch295.htm) (emphasis added). |
| 5 | The duty of best execution derives from the common law agency duties of loyalty and care, which obligates an agent to act exclusively in the principal's best interest. Restatement (Second) of Agency § 387 (1958). When a broker-dealer acts as agent on behalf of its customer in a transaction, the agent is under a duty to exercise reasonable loyalty and care to obtain the most advantageous terms for its customer. Restatement (Second) of Agency § 424 (1958). The duty applies whether a broker-dealer is acting as agent or principal. See E.F. Hutton & Co., Exchange Act Release No. 25,887 (July 6, 1988), 49 S.E.C. 829, 832 (1988); Opper v. Hancock, 250 F. Supp. 668, 673-74 (S.D.N.Y.), aff'd 367 F.2d 157 (2d Cir. 1966); Rule 2320(f), NASD MANUAL (CCH) (1999). For a detailed discussion on the development of the duty of best execution, see Exchange Act Release No. 37,619A (Sept. 6, 1996), 61 Fed. Reg. 48,290 (1996) [hereinafter Order Handling Rules Adopting Release] at 162-3; SEC, Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments [hereinafter Market 2000] (Jan. 1994) at Study V, V-1, V-2 and sources cited therein. |
| 6 | See, e.g., NASD MANUAL (CCH), Rule 2320; NYSE CONSTITUTION AND RULES, Rule 123.41. |
| 7 | See Market 2000, supra note 5 and cases cited at Study V, V-17, nn. 8-10; see also Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998) (en banc) (noting that liability may exist under Section 10(b) for firms' violations of duty of best execution); SEC v. Great Lake Equities Co., 775 F. Supp. 211 (E.D. Mich. 1990); and N. Wolfson, R. Phillips & T. Russo, Regulation of Brokers, Dealers and Securities Markets 2.10, at 2-51 (1977) (noting that broker-dealers have obligations under the "shingle theory," which states that a dealer who engages in business impliedly represents that he will deal fairly with the public and in accordance with the standards of the profession). |
| 8 | The Commission has stated that "[i]n its purest form, best execution can be thought of as executing a customer's order so that the customer's total cost or proceeds are the most favorable under the circumstances." Exchange Act Release No. 34,902 (Oct. 27, 1994), 59 Fed. Reg. 55,006 (1994) [hereinafter Payment for Order Flow Adopting Release]. The Third Circuit went even further in Newton by stating "the broker-dealer is expected to use reasonable efforts to maximize the economic benefit to the client in each transaction." Newton, supra note 7, at 270. However, the Commission never has stated that a broker-dealer is bound exclusively by price considerations in satisfying its best execution obligations. See Order Handling Rules Adopting Release, supra note 5. |
| 9 | See, e.g., SEC, Second Report on Bank Securities Activities, at 97-98, n.233, as reprinted in H.R. Rep. No. 145, 95th Cong., 1st Sess. 233 (Comm. Print 1977). |
| 10 | See Order Handling Rules Adopting Release, supra note 5. |
| 11 | The Commission reiterated this point in its 1997 Report on the Practice of Preferencing. See Report on the Practice of Perferencing (Apr. 15, 1997) (available at http://www.sec.gov/news/studies/prefrep.htm). In concluding that preferencing arrangements were not necessarily inconsistent with a broker-dealer's best execution obligations, the Commission again stressed that firms automatically routing orders to a particular exchange must regularly and rigorously evaluate execution quality in the various markets trading the security. |
| 12 | Among the on-line firms currently offering this service are A.B. Watley, OnlinetradingInc.com, and TradeCast. See http://www.abwatley.com; http://www.onlinetrading.com; and http://www.tradecast.com. |
| 13 | Generally, these customers have direct access to one or more ECNs, to other ECNs and market makers through Nasdaq's SelectNet service, and access to Nasdaq's Small Order Execution System ("SOES"). For listed stocks, these firms may offer customers direct access to the NYSE's and Amex's order entry systems (SuperDOT and PERS), but do not offer access, direct or otherwise, to the regional exchanges or third market makers trading these stocks. |
| 14 | An order-by-order routing algorithm may take into account factors such as currently displayed prices and sizes, as well as markets' past performance in filling orders and market makers' automatic execution guarantees. The broker's order management system may monitor the results of the algorithm, and reapply it if any part of the order remains unexecuted after a certain time period. |
| 15 | Among the on-line firms offering this service are CyberBroker, Timber Hill, and Tradescape. See http://www.cyberbroker.com; http://www.timberhill.com; and http://www.tradescape.com. |
| 16 | Exchange Act Rule 10b-10(d)(9) defines payment for order flow as:
any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration to a broker or dealer from any broker or dealer, national securities exchange, registered securities association, or exchange member in return for the routing of customer orders by such broker or dealer to any broker or dealer, national securities association, or exchange member for execution, including but not limited to: research, clearance, custody, products or services; reciprocal agreements for the provision of order flow; adjustment of a broker or dealer's unfavorable trading errors; offers to participate as underwriter in public offerings; stock loans or shared interest accrued thereon; discounts, rebates, or any other reductions of or credits against any fee to, or expense or other financial obligation of, the broker or dealer routing a customer order that exceeds that fee, expense, or financial obligation. |
| 17 | See, e.g., Exchange Act Release No. 19,047 (Sept. 14, 1982), 47 Fed. Reg. 41,896 (Sept. 21, 1982). |
| 18 | Competition and Transparency in the Financial Marketplace of the Future, Hearings Before the Senate Subcomm. on Securities of the Senate Banking Comm., 106th Cong., 2d Sess. 10 (2000) (statement of Kenneth D. Pasternak, President and CEO, Knight Trading Group, Inc.). |
| 19 | Between the OATS reporting requirements and compliance with Rules 17a-3 and 17a-4, Knight already captures most of the information required by the proposed rules for Nasdaq securities. While OATS is currently limited to Nasdaq securities, Knight is confident that other markets will develop order audit trails systems that can be used as part of their compliance with proposed Rule 11Ac1-5. |
| 20 | Generally, the OATS Rules require members to transmit the following information to NASDR: (a) the order identifier; (b) the identification symbol for the security; (c) the market participant symbol; (d) the identification of any department or the identification number of any terminal where an order is received directly from a customer; (e) where applicable, the identification of the Reporting Member's Reporting Agent; (f) the number of shares to which the order applies; (g) the designation of the order as a buy or sell order; (h) the designation of the order as a short sale order; (i) the designation of the order as a market order, limit order, stop order, or stop limit order; (j) any limit or stop price prescribed by the order; (k) the date on which the order expires, and, if the time in force is less than one day, the time when the order expires; (l) the time limit during which the order is in force; (m) any request by a customer that an order not be displayed, or that a block size order be displayed, pursuant to Rule 11Ac1-4(c); (n) special handling requests; (o) the date and time the order is originated or received; and (p) an identification of the order as related to a Program Trade or an Index Arbitrage Trade. Other relevant information must be recorded and reported when the order is modified, canceled, or executed. |
| 21 | See Exchange Act Release No. 38,990 (Aug. 28, 1997), 62 Fed. Reg. 47,096 (Sept. 5, 1997). |
| 22 | Proposed Rule 11Ac1-5 specifies eleven criteria for each subcategory of security, order type, and order size. The proposed rule also identifies nine additional criteria for each subcategory. Consequently, each market center's report would include 20 subcategories for each security and 20 criteria for each subcategory. |
| 23 | Similarly, broker-dealers operating Alternative Trading Systems are required to collect and information similar to that required by the proposed rules. See Rule 302 (requiring Alternative Trading Systems to make and keep records of: securities for which transactions were executed; transaction volume with respect to equity securities in number of trades, number of shares traded, and total settlement value; transaction volume in number of trades and total dollar value; time sequenced records of order information including date and time, identity of the security, number of shares, an identification of order as related to a program trade or an index arbitrage trade, whether the order was a buy or sell; whether the order was a short sale; whether the order was a market, limit, stop, stop limit, or other type of order; any limit or stop price; the date on which the order expires; time in force; any instructions to modify or cancel the order; the type of account; the date and time of execution; price at which the order was executed; size of the order executed; and the identity of the parties to the transaction). |
| 24 | Rule 17a-4(f) states in pertinent part:
The records required to be maintained and preserved pursuant to Rule 17a-3 and 17a-4 may be immediately produced or reproduced on micrographic media . . . or by means of electronic storage media . . . that meet the conditions set forth in this section and be maintained and preserved for the required time in that form. |
| 25 | The merits of the arguments of market centers objecting to the disclosure requirements of the proposed rules are dubious at best in light of the fact that the Commission as part of the implementation of Regulation ATS, required broker-dealers operating Alternative Trading Systems to collect information similar to that required by the proposed rules. |
| 26 | An example of an equity limit order report is available at http://www.tagaudit.com/samp_rep_lim.html. |
| 27 | For pre-opening orders, the time of receipt should be viewed as 9:30 a.m. Eastern Standard Time and for stop orders and stop limit orders, the time of receipt should be viewed as when the stop price is first reached by the NBBO. |
| 28 | See NASD Economic Research at http://www.marketdata.nasdaq.com. |
| 29 | Letter from Robin Roger, Managing Director and Counsel, Morgan Stanley Dean Witter and Co., to Jonathan G. Katz, Secretary, SEC (letter dated Sept. 25, 2000) ("MSDW Letter on Disclosure of Order Routing Practices") (claiming that "plaintiff's attorney's and opportunistic litigants would have access to voluminous, government-sanctioned data to press spurious claims and potentially impose devastating discovery costs on the securities industry."). Id. at p11. |
| 30 | See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998) (en banc) (noting that liability may exist under Section 10(b) for firms' violations of duty of best execution); SEC v. Great Lake Equities Co., 775 F. Supp. 211 (E.D. Mich. 1990); Sinclair v. SEC, 444 F.2d 399, 400 (2d Cir. 1971) (noting that the duty of best execution requires a broker-dealer to seek to obtain for its customer orders the most favorable terms reasonably available under the circumstances). |
| 31 | Thomas E. Patton & Terry R. Saunders, Securities Fraud: Litigating Under Rule 10b-5 at § 1.11, p. 1:28 (1989). Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of an manipulative or deceptive device or contrivance in connection with the purchase or sale of any security. 15 U.S.C. § 78j. Rule 10b-5 prohibits the making of any untrue statement of a material fact or the omission of a material fact in connection with the purchase or sale of any security. 17 C.F. R. § 240.10b-5. See also In re Bank of America Corp. Sec. Litig., 78 F. Supp. 2d 976, 989 (E.D. Mo. 1999). |
| 32 | Gibson v. PS Group Holdings, Inc., 2000 U.S. Dist. Crt. Lexis 3158 (S.D. Cal. 2000); see also Pub. L. No. 104-67, 109 Stat. 737 (1995); see also Pub. L. No. 104-67, 109 Stat. 737 (1995); H.R. Conf. Rep. No. 104-369, at 31-32, 41 (1995). |
| 33 | See Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999). In the PSLRA, Congress stated that in any case in which a plaintiff alleges Section 10(b) fraud:
[T]he complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which the belief is formed. 1934 Act. § 21D(b)(1). Congress also set forth a higher standard for pleading scienter: In any private action arising under [Section 10(b)], in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate [Section 10(b)], state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. 1934 Act § 21D(b)(2). |
| 34 | See Amended 1933 Act Section 16(b), 15 U.S.C. § 77p(b). |
| 35 | See Pub. L. No. 105-353, 112 Stat. 3227 (1998); H.R. Conf. Rep. No. 105-803, at 13-15 (1998). |
| 36 | Id. |
| 37 | Exchange Act Release No. 43,154 (Aug. 15, 2000) [hereinafter Regulation FD]. |
| 38 | See MSDW Letter on Disclosure of Order Routing Practices at 9. |
| 39 | In the past, the Commission has included preliminary notes to new rules that serve as highly persuasive authority regarding the scope of the new rules. See, e.g., Preliminary Notes to Regulation ATS-Alternative Trading Systems. |