On Dec. 5, 2011, the SEC approved FINRA’s proposed rule change to adopt FINRA Rule 5310 (Best Execution and Interpositioning) in the FINRA Consolidated Rulebook, replacing the former NASD Rule 2320 and IM-2320. In Regulatory Notice 12-13, FINRA announced that the approved changes and renumbering of the rule will take effect on May 31, 2012. Although the general best execution requirements remain the same, new Rule 5310 is noteworthy for certain changes with respect to the “Three Quote Rule,” regular and rigorous review of execution quality, orders for foreign securities with no U.S. market, and customer instructions regarding the routing of orders. This Alert includes a brief summary of the changes. FINRA member firms are encouraged to review new Rule 5310 and the entire Regulatory Notice.1
Securities With Limited Quotation or Pricing Information
The most significant change in the new rule is the removal of the requirement under NASD Rule 2320(f) that firms that execute transactions in non-exchange-listed securities on behalf of customers contact a minimum of three dealers (or all dealers if there are fewer than three) and obtain quotations from those dealers if there are fewer than two quotations displayed on an inter-dealer quotation system that permits quotation updates on a real-time basis (the “Three Quote Rule”). In its proposed rule filing, FINRA reasoned that the Three Quote Rule was overly prescriptive and could result in unnecessary delays in the execution of a customer order.2 FINRA replaced the Three Quote Rule with a requirement in Supplementary Material .06 to Rule 5310 that with respect to customer orders involving securities for which there is limited pricing information or quotations, firms must have written policies and procedures in place that address how the firm will determine the best inter-dealer market and must document its compliance with the policies and procedures. The Supplementary Material lacks the precision of a three quotation requirement but requires that members generally should seek out other sources of pricing information and potential liquidity, which similarly may include contacting other broker-dealers. FINRA provides no further guidance as what procedure would be acceptable other than the “three quote rule.” Firms that transact in non-exchange-listed securities on behalf of customers should adopt procedures for compliance with the best execution requirements, be able to demonstrate that they are reasonable, and retain sufficient documentation to demonstrate that it has complied with the policies and procedures in place.
Regular and Rigorous Review of Execution Quality
Supplementary Material .09 to Rule 5310 for the first time codifies a FINRA member firm’s obligation to conduct a regular and rigorous review of execution quality likely to be obtained from different market centers. The regular and rigorous review requirements are consistent with prior guidance set forth in NASD Notice to Members 01-22 (April 2001), and with guidance provided by the SEC when it adopted the Order Execution Obligation rules in 1997. Regular and rigorous review permits firms that route customer orders to other broker-dealers for execution on an automated, non-discretionary basis, as well as firms that internalize customer order flow, to conduct a periodic (at least quarterly) regular and rigorous review of execution quality in lieu of an order-by-order review. FINRA has consistently maintained that no member can transfer its obligation to provide best execution. Even introducing firms must perform a sufficient review to conclude that its clearing firm is providing best execution and is conducting a thorough regular and rigorous review.
Orders for Foreign Securities With No U.S. Market
With respect to orders for foreign securities with no U.S. market, FINRA recognizes that foreign markets may not have pre-trade or post-trade transparency standards comparable to those in the U.S. and that “reasonable diligence” may vary depending on the markets. Supplementary Material .07 specifies that the determination as to whether a member firm has satisfied its best execution obligations requires a “facts and circumstances” analysis. Firms that handle customer orders involving foreign securities that do not trade in the U.S. are required to have specific written policies and procedures in place regarding the handling of customer orders for such securities that are reasonably designed to obtain the most favorable terms available for the customer, taking into account differences that may exist between U.S. markets and foreign markets. In recognition of the fact that best execution obligations evolve as changes occur in market structure, Supplemental Material .07 requires that firms regularly review, and update if necessary, their policies and procedures for orders for foreign securities with no U.S. market. This requirement does not appear any different than the general requirements under NASD Conduct Rule 3010 to establish and maintain supervisory procedures reasonably designed to achieve compliance with applicable securities laws and regulations.
Customer Instructions Regarding the Routing of Orders
Supplementary Material .08 specifies that a member firm is not required to make an independent best execution determination when it receives an unsolicited instruction from a customer to route that customer’s order to a particular market for execution. In such an instance, the member firm remains responsible for processing the customer order promptly and in accordance with the terms of the order. The term “promptly” is not defined. Nor is it defined in Supplementary Material .01 to Rule 5310, which requires that a member must make every effort to execute a marketable customer order that it receives fully and promptly. FINRA notes only that best execution “requires firms to minimize the time between order receipt, order acceptance and order entry.”3 Supplementary Material .08 reiterates that the receiving broker-dealer to which the order was directed would be required to satisfy the best execution requirements.4
New FINRA Rule 5130 and accompanying supplementary materials largely codify firms’ existing best execution obligations. Nevertheless, firms should review the rule and the related Regulatory Notice so that they can make necessary changes to the affected areas.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Boch-David
1 A copy of Notice 12-13 is available at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p125747.pdf.
2 Securities Exchange Act Release No. 65579 (Oct. 17, 2011).
4 Effective Nov. 8, 2006, the best execution requirements were expanded to include “any transaction for or with a customer or a customer of another broker-dealer.” NASD Notice to Members 06-58 (Oct. 2006).
This article was originally published by Bingham McCutchen LLP.