SEC Adopts Rules to Enhance Order Handling Information Available to Investors

Transcription

1 Alert SEC Adpts Rules t Enhance Order Handling Infrmatin Available t Investrs December 14, 2018 On Nv. 2, 2018, the U.S. Securities and Exchange Cmmissin adpted amendments ( Amendments ) t Rule 606 f the Securities Exchange Act f 1934, as amended ( Exchange Act ), t require new and enhanced disclsures by brker-dealers t custmers regarding the handling f their rders. 1 The Amendments are intended t prvide custmers with greater clarity int brker-dealers rder ruting practices in light f significant changes t equity market structure that have ccurred since the ruting disclsure rules were riginally adpted in In particular, the Amendments will: 1. Require brker-dealers, upn custmer request, t prvide custmer-specific disclsures regarding the brker-dealer s handling f a custmer s rders in NMS stcks 3 submitted n a nt held basis fr the prir six mnths, subject t tw de minimis exceptins; 4 2. Require that brker-dealers quarterly rder ruting reprts required by Exchange Act Rule 606(a) cver all custmer rders in NMS stcks submitted n a held basis 5 and prvide enhanced disclsures relating t payment fr rder flw, including bth the net aggregate amunts f payment received frm identified market centers and amunts received n a per share basis; and 3. Require that brker-dealers maintain the quarterly rder ruting reprts required by Exchange Act Rule 606, as well as the rder executin reprts currently required by Exchange Act Rule 605, free and accessible n a website fr three years frm the initial date f psting n the website. The Amendments will becme effective Jan. 18, 2019 and the cmpliance date will be May 20, Backgrund and Current Regulatry Framewrk Currently, Exchange Act Rule 606 requires brker-dealers t publicly disclse, n a quarterly basis, certain aggregated rder ruting infrmatin fr custmer rders 6 and t disclse separately t any custmer, upn request, certain custmer-specific rder ruting infrmatin fr the six-mnth perid 1 See Exchange Act Release N (Nv. 2, 2018), 83 Fed. Reg (Nv. 19, 2018) ( Adpting Release ). 2 See Exchange Act Release N (Nv. 17, 2000), 65 Fed. Reg (Dec. 1, 2000), adpting Exchange Act Rule 11Ac1-6, predecessr t Exchange Act Rule As that term is defined at Exchange Act Rule 600(b)(47). 4 As further discussed herein, the requirements f the newly adpted Exchange Act Rule 603(b)(3) are subject t a firm-level de minimis exceptin and a custmer level de minimis exceptin. 5 Currently, Exchange Act Rule 606(a) des nt cver held rders in NMS stcks with a market value f $200,000 r mre. 6 See Exchange Act Rule 606(a).

2 preceding the request. 7 The SEC adpted the Amendments t address changes in the equity market structure, rder ruting and handling practices since Exchange Act Rule 606 was riginally adpted, 8 including the increased percentage f rders being handled by trading algrithms and related ruting systems. The Amendments are intended t assist market participants in cmparing the ruting services f brker-dealers and the relative merits f cmpeting trading centers, and t help custmers evaluate hw brker-dealers handle cnflicts f interest and risks f infrmatin leakage. Amendments t Exchange Act Rule 606 f Regulatin NMS Custmer-Specific Reprt n Nt Held Order Handling Newly adpted Exchange Act Rule 606(b)(3) will require brker-dealers t prvide a custmer, within seven business days f the custmer s request, a reprt n the brker-dealer s handling f the custmer s NMS stck rders 9 submitted n a nt held basis fr the prir six mnths, including the handling f all child rders derived therefrm. These reprts must be separated by calendar mnth and include separate sectins fr directed and nn-directed rders. Each sectin must identify the ttal number f shares sent by the custmer, the number f shares executed by the brker-dealer as principal, the number f rders expsed by the brker r dealer thrugh an actinable indicatin f interest and the related venue(s). Additinally, each reprt will require the fllwing infrmatin fr each venue t which the brker-dealer ruted the custmer s nt held rders: 1. Infrmatin n Order Ruting: a. Ttal shares ruted; b. Ttal shares ruted marked immediate r cancel; c. Ttal shares ruted that were further rutable; and d. Average rder size ruted. 2. Infrmatin n Order Executin: a. Ttal shares executed; b. Fill rate; c. Average fill size; d. Average net executin fee r rebate; e. Ttal number f shares executed at the midpint; 10 f. Percentage f shares executed at the midpint; g. Ttal number f shares executed that were priced n the side f the spread mre favrable t the nt held rder; 7 See Exchange Act Rule 606(b). 8 That is, since Exchange Act Rule 11Ac1-6, the predecessr t Exchange Act Rule 606, was adpted. 9 While the quarterly reprting requirements f Exchange Act Rule 606(a) apply t all NMS securities (subject t certain exceptins), the custmer-specific reprts required by Exchange Act Rule 606(b)(3) will nly apply t NMS stcks. 10 This is nt limited t custmer rders pegged t the midpint f the NBBO, but rather includes any midpint executin. 2

3 h. Percentage f ttal shares executed that were priced at the side f the spread mre favrable t the nt held rder; i. Ttal number f shares executed that were priced n the side f the spread less favrable t the nt held rder; and j. Percentage f ttal shares executed that were priced n the side f the spread less favrable t the nt held rder. 3. Infrmatin n Orders that Prvided Liquidity: a. Ttal number f shares executed f rders prviding liquidity; b. Percentage f shares executed f rders prviding liquidity; c. Average time between rder entry and executin r cancellatin, fr rders prviding liquidity; and d. Average net executin rebate r fee fr shares f rders prviding liquidity. 4. Infrmatin n Orders that Remved Liquidity: a. Ttal number f shares executed f rders remving liquidity; b. Percentage f shares executed f rders remving liquidity; and c. Average net executin fee r rebate fr shares f rders remving liquidity. Definitin f Custmer The Adpting Release ntes that the term custmer, when used in Exchange Act Rule 606(b)(3), means the custmer that places the rder with the brker-dealer, even if that custmer may be acting n behalf f thers and is nt the ultimate beneficiary f any resulting transactins, such as when an investment adviser, as the custmer f a brker-dealer, places an rder with the brker-dealer that represents the trading interest f clients f the investment adviser. 11 This interpretatin f the term custmer fr purpses f Exchange Act Rule 606(b)(3) has a number f implicatins. Fr instance, an underlying custmer f an investment adviser is nt the brker-dealer s custmer fr purpses f Exchange Act Rule 606(b)(3) and may nt demand an Exchange Act Rule 606(b)(3) reprt (such reprts, Rule 606(b)(3) Reprts ) unless the underlying custmer maintains a separate relatinship with the brker-dealer. 12 Further, an investment adviser, as custmer, may nly demand Rule 606(b)(3) Reprts fr rders the investment adviser submitted t a brker-dealer in aggregate (that is, the investment adviser culd nt demand a Rule 606(b)(3) Reprt at the underlying accunt level). Brkerdealers shuld nte that the SEC s interpretatin f custmer fr purpses f Exchange Act Rule 606(b)(3) may limit the brker-dealer s ability t rely n the custmer-specific de minimis exceptin. 13 Technlgy Outsurcing Scenaris The Adpting Release ntes that where a brker-dealer simply frwards its custmers rders n t anther brker-dealer and that secnd brker-dealer exercises all discretin in determining where and 11 See Adpting Release, 83 FR at (emphasis added). 12 Id. 13 That is, the brker-dealer will likely be unable t lk thrugh an intermediary t the underlying accunt in determining whether it may rely n the custmer-specific de minimis exceptin. 3

4 hw t rute and execute the rders, [ ] the first brker-dealer is nt required t prvide disclsures under Exchange Act Rule 606(b)(3) beynd thse relevant t its activity in frwarding rders t the executing brker. 14 Hwever, the Adpting Release separately ntes that where a brker-dealer license[s] r utsurce[s] technlgy fferings, such as trading algrithms, frm third-parties, including ther brker-dealers, t use fr ruting and executing rders, 15 the brker-dealer utilizing these utsurced slutins must ensure it can prvide the infrmatin required by Exchange Act Rule 606(b)(3). Accrdingly, brker-dealers that utsurce trading algrithms frm ther brker-dealers shuld be aware f the SEC distinctin when generating Rule 606(b)(3) Reprts. The Adpting Release des nt address hw such arrangements shuld be viewed under Exchange Act Rule 606(a). Newly Defined Terms The SEC, as part f the amendments, has adpted a number f newly defined terms, including (i) rders prviding liquidity, (ii) rders remving liquidity and (iii) actinable indicatin f interest. Liquidity Prviding and Remving Orders The term rders prviding liquidity is defined as any rder executed against after resting at a trading center. 16 Relatedly, the term rders remving liquidity is defined as any rder executed against resting trading interest at a trading center. 17 Imprtantly, the Adpting Release des nt discuss hw brker-dealers shuld address the use f derivatively priced rders (e.g., pegged rders) that may be viewed as bth prviding and remving liquidity under the adpted definitins. While participants may chse t rely n liquidity tags prvided by destinatin market centers (such as alternative trading systems) in determining whether an rder prvided r remved liquidity, destinatin venues may have different appraches in determining whether a derivatively priced rder prvides r remves liquidity. Actinable Indicatins f Interest The Amendments define the term actinable indicatin f interest as any indicatin f interest that explicitly r implicitly cnveys all f the fllwing infrmatin with respect t any rder available at the venue sending the indicatin f interest: (i) [s]ymbl; (ii) [s]ide (buy r sell); (iii) [a] price that is equal t r better than the natinal best bid fr buy rders and the natinal best ffer fr sell rders; and (iv) [a] size that is at least equal t ne rund lt. 18 The Cmmissin affirmed that the definitin applies t indicatins f interest ( IOIs ) that are cmmunicated electrnically as well as IOIs that are cmmunicated manually (e.g., via telephne). 19 As such, brker-dealers may need t adpt prcedures t track manual IOIs and ensure infrmatin relating t such manual IOIs is included in Exchange Act Rule 606(b)(3) reprts where apprpriate. The Adpting Release ntes that where terms (e.g., size r price) are implicitly included in an IOI, the IOI may meet the definitin f actinable indicatin f interest. 20 The Adpting Release further ntes that 14 See Adpting Release, 83 FR at See Adpting Release, 83 FR at (emphasis added). 16 See Exchange Act Rule 600(b)(54), effective Jan. 18, See Exchange Act Rule 600(b)(55), effective Jan. 18, See Exchange Act Rule 600(b)(1), effective Jan. 18, See Adpting Release, 83 FR at Assuming the ther factrs required by the definitin are met. 4

5 past dealings may be relevant in determining whether an IOI is actinable. Fr instance, where past dealings indicate that submissin f a marketable rder in respnse t IOI will result in an executin (unless the represented trading interest had already been executed r cancelled), the SEC will likely view the IOI as actinable. Ntwithstanding the freging, the SEC ntes that IOIs that require further agreement f the brker-dealer that cmmunicated the IOI (e.g., cnditinal rders) shuld nt be cnsidered actinable IOIs, unless curse f cnduct suggests that the brker-dealer s agreement can be assumed. 21 The Cmmissin believes that the adpted definitin f actinable indicatin f interest is apprpriately designed t capture trading interest that is the functinal equivalent t an rder r qutatin. 22 Hwever, the Cmmissin was careful t nte that it is nt expanding the scpe f existing rules, regulatins, r guidance related t rders r qutatins, ther than Exchange Act Rule 606 and guidance related theret, with regard t actinable IOIs. 23 De Minimis Exceptins The Cmmissin has als adpted tw de minimis exceptins t the Exchange Act Rule 606(b)(3) reprting requirements. Specifically, a brker-dealer is nt bligated t prvide an Exchange Act Rule 606(b)(3) reprt: (i) t any custmer if nt held NMS stck rders cnstitute less than 5 percent f the ttal shares f NMS stck rders that the brker-dealer receives frm its custmers ver the prir six mnths, 24 r (ii) t a particular custmer if that custmer trades thrugh the brker-dealer, n average each mnth fr the prir six mnths, less than $1 millin f ntinal value f nt held rders in NMS stcks. 25 Imprtantly, where a brker-dealer relies n a de minimis exceptin t Exchange Act Rule 606(b)(3) s reprting requirements, it must nevertheless cmply with any requests fr rder ruting infrmatin under Exchange Act Rule 606(b)(1). 26 Held Order Disclsures The Cmmissin, as part f the Amendments, is als enhancing the existing bligatin under Exchange Act Rule 606 that brker-dealers prvide public quarterly reprts n their rder ruting practices. 27 The Amendments will require the quarterly reprts t cver NMS stck rders f any size (currently, rders in NMS Stcks with a market value f $200,000 r higher are excluded) that are submitted n a held basis and cntinue t cver any rder, whether held r nt held, fr an NMS security that is an ptin cntract with a market value less than $50,000. Brker-dealers will nw als be required t: Reprt ruting infrmatin separately fr marketable limit rders and nn-marketable limit rders; 21 See Adpting Release, 83 FR at See Adpting Release, 83 FR at (emphasis added). 23 See Adpting Release, 83 FR at See Exchange Act Rule 606(b)(4), effective Jan. 18, Under the rule, the first time a brker-dealer meets r exceeds the 5 percent threshld, it has a grace perid f up t three calendar mnths t prvide the Exchange Act Rule 606(b)(3) reprt. There is n such grace perid fr cmpliance after the first time the threshld is met r exceeded. 25 See Exchange Act Rule 606(b)(5), effective Jan. 18, When either de minimis exceptin applies, the brker-dealer still must prvide, if requested, the Exchange Act Rule 606(b)(1) custmer-specific disclsures fr nt held NMS stck rders that it receives frm custmers. 26 That is, the current custmer-specific disclsure requirements under Exchange Act Rule 606(b)(1). Exchange Act Rule 606(b)(1) is being amended t clarify its scpe in relatin t Exchange Act Rule 606(b)(3) and the related de minimis exceptins. 27 See Exchange Act Rule 606(a). 5

6 Reprt ruting infrmatin by calendar mnth instead f quarterly and n lnger categrize NMS stcks by listing market; Reprt ruting infrmatin fr NMS stck rders separately fr securities included in the S&P 500 Index as f the first day f the quarter and ther NMS stcks; Include the fllwing infrmatin fr the ten venues t which the largest number f ttal nndirected rders were ruted fr executin and fr any venue t which five percent r mre f nn-directed rders were ruted fr executin: The net aggregate amunt f any payment fr rder flw received, payment frm any prfit-sharing relatinship received, transactin fees paid, and transactin rebates received, bth as a ttal dllar amunt and per share fr: nn-directed market rders, nn-directed marketable limit rders, nn-directed nn-marketable limit rders and ther nn-directed rders; and Include a descriptin f the terms f any payment fr rder flw and any prfit-sharing arrangements that may influence a brker-dealer s rder ruting decisin, including, amng ther things: Incentives fr equaling r exceeding an agreed upn rder flw vlume threshld; Disincentives fr failing t meet an agreed upn minimum rder flw threshld; Vlume-based tiered payment schedules; and Agreements regarding the minimum amunt f rder flw that the brker-dealer wuld send t a venue. Other Order Type While nt discussed in the Adpting Release, the quarterly disclsures currently required by Exchange Act Rule 606(a) must be separated by (i) market, (ii) limit and (iii) ther rder types. SEC staff previusly issued guidance regarding what rders shuld be included in the ther rder type categry, nting that market pening and clsing rders, rders submitted with stp prices, all-r-nne rders, rders that must be executed n a particular tick r bid (such as nn-exempt shrt sale rders), and nt held rders 28 shuld all be included. While Exchange Act Rule 606(a), as amended, retains the ther rder type categry, 29 amended Exchange Act Rule 606(a) is expressly limited t rders handled n a held basis. Brker-dealers, hwever, shuld be aware that the ther rder type categry will nevertheless remain. Implicatins Brker-dealers will need t assess the rder and executin infrmatin they recrd when effecting an rder t ensure they are able t cmply with the Amendments. As nted abve, brker-dealers will have t prvide cmprehensive disclsures regarding their handling f custmers nt held rders upn custmer request. Given the relatively quick seven business day turnarund time t prduce such reprts, brker-dealers will need t ensure their systems capture all required infrmatin at the time f rder receipt, ruting r executin, as applicable. Further, the Amendments, which will prvide 28 See here (Emphasis added). 29 That is, disclsures under Exchange Act Rule 606(a)(1) will be separated the fllwing rder types: (A) market rders, (B) marketable limit rders, (C) nn-marketable limit rders and (D) ther rders. 6

7 regulatrs and market participants a significant amunt f infrmatin n the effects f payment fr rder flw arrangements, maker-taker pricing systems and changes t exchanges fee structures, may als lead examiners t begin t ask brker-dealers hw they use such data in their wn best executin analyses. Investment advisers and ther fiduciaries shuld assess hw best t utilize the additinal disclsure infrmatin prvided by the Rule 606(b)(3) Reprts t ensure that the advisers fulfill their best executin bligatins. Furthermre, as the Amendments require the disclsure f a significant amunt f additinal infrmatin n the effects f payment fr rder flw arrangements, maker-taker pricing systems and changes t exchanges fee structures, investment advisers and ther fiduciaries shuld prepare t be questined by custmers and regulatrs n the impact f these arrangements and structures n executin quality. Authred by Julian Rainer, William J. Barbera, Derek N. Lacarrubba and Akshay Ramanan. If yu have any questins cncerning this Alert, please cntact yur attrney at Schulte Rth & Zabel r ne f the authrs. Schulte Rth & Zabel New Yrk Washingtn DC Lndn This cmmunicatin is issued by Schulte Rth & Zabel LLP fr infrmatinal purpses nly and des nt cnstitute legal advice r establish an attrney-client relatinship. In sme jurisdictins, this publicatin may be cnsidered attrney advertising Schulte Rth & Zabel LLP. All rights reserved. SCHULTE ROTH & ZABEL is the registered trademark f Schulte Rth & Zabel LLP. 7