SLB 13

Date: June 22, 2001

Summary: This staff legal bulletin sets forth the views of the Division of Market Regulation in response to frequently asked questions concerning Rule 11Ac1-6 under the Securities Exchange Act of 1934.

Supplementary Information: The statements in this legal bulletin represent the views of the staff of the Division of Market Regulation. This legal bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission ("Commission"). Further, the Commission has neither approved nor disapproved its content.

Contact Person: For further information, please contact Daniel M. Gray, Senior Special Counsel, at (202) 942-4164, or Susie Cho, Attorney, at (202) 942-0748, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington D.C. 20549-1001.

Since adoption of the Rule, the Division of Market Regulation ("Division") has received a number of inquiries concerning the implementation and operation of the Rule, some of which indicate that interpretive guidance would be helpful. The Division is issuing this staff legal bulletin to address a variety of frequently asked questions.

The following questions and answers do not necessarily contain a discussion of all the material considerations necessary to reach the conclusions stated. Consequently, these questions and answers are intended to provide general guidance, but the facts and circumstances relating to particular broker-dealers may differ, and the staff notes that even slight variations may require different responses. The Commission is not bound by these statements and may interpret the Rule as it deems necessary or appropriate in the public interest or for the protection of investors.

In addition, these questions and answers are premised on several important assumptions. First, the discussions assume close familiarity with the text of the Rule and the Adopting Release, and we urge you to read carefully the Rule and Adopting Release. The responses are a complement to, and not a substitute for, these sources. Second, the terms used in this staff legal bulletin have the meanings set forth in the definitions of paragraph (a) of the Rule.

The Division may update these questions and answers periodically by issuing an updated staff legal bulletin. In each updated staff legal bulletin, the questions and answers with modified or new material since the last update will be marked as "modified" or "new."

The interpretive questions addressed in this bulletin are as follows:

Question 1: Format of Quarterly Reports

Question 2: Identifying Significant Execution Venues

Question 3: Materiality of Order Percentage Figures

Question 4: Introducing Broker/Clearing Firm - Reporting Responsibility

Question 5: Multiple Reports by a Broker-Dealer

Question 6: Definition of Customer Orders - Large Order Exclusion

Question 7: Definition of Customer Orders - Orders Received from Other Broker-Dealers or Foreign Banks Acting as Broker-Dealers

Question 8: Definition of Directed Order - Default Routing Instructions

Question 9: Classifying Market, Limit, and Other Orders

Question 10: Orders Executed at Multiple Venues

Question 11: Execution Venue for Riskless Principal Orders

Question 12: Nasdaq Execution Venues

Question 13: Disclosing Payment for Order Flow

Question 14: Disclosing Internalized Order Flow

Question 15: Procedures for Making Quarterly Reports Publicly Available

Question 16: Responding to Requests from Customers for Individual Information

Question 17: Written Notice to Customers Concerning Availability of Quarterly Reports and Individual Information

Q:   Are broker-dealers required to follow any particular format in preparing their quarterly reports?

A:   Yes. The Rule requires that a quarterly report be divided into four sections, one each for (1) covered securities listed on the New York Stock Exchange, Inc., (2) covered securities listed on The Nasdaq Stock Market, Inc., (3) covered securities listed on the American Stock Exchange LLC or any of the regional stock exchanges, and (4) exchange-listed options. The Rule also specifies items of information that should be included in the quarterly reports in a clear format that will be understandable by customers and the public.

Attached as Exhibit A is an example of a quarterly report that is intended to offer guidance on a format that the Division would consider to be clear and understandable. The example report includes an introduction and a section with sample statistics. The section first sets forth summary statistics for the category of securities covered by the section. It next identifies the significant execution venues in descending order of the percentage of total non-directed orders routed to the venues. Finally, the section sets forth information relating to individual venues, including the percentages of different types of orders routed to each venue and the material aspects of the broker-dealer's relationship with each venue.

The report in Exhibit A is intended only as an example. Broker-dealers also are free to include additional information that they believe would be useful for customers and the public.

Q:   If a broker-dealer routes the great majority of non-directed orders to a few execution venues, but also routes a small number of orders to several other venues, is the broker-dealer still required to identify and disclose its relationships with these other venues?

A:   No. Broker-dealers need only identify and prepare disclosures for their most significant execution venues, as explained further below. The Commission noted in the Adopting Release that "the quarterly reports on order routing are intended to provide a general overview of a broker-dealer's practices that is accessible and useful to individual investors."2 To this end, the Rule requires broker-dealers to disclose only those execution venues to which they routed the most orders for a section of a report - the top ten and any others to which they routed five percent or more of orders.

Where, however, a broker-dealer routes the great majority of its orders for a section of the report to only a few venues, it also might route orders to other venues that fall within the top ten, but actually receive only a small number of orders. The inclusion of these venues in quarterly reports would not provide materially more useful information to investors, yet could impose a significantly higher compliance burden. Consequently, the Commission has exempted broker-dealers from the disclosure requirements of paragraph (b)(1)(ii) of the Rule with respect to execution venues that receive only a small percentage of the non-directed orders.3 Under the exemption, a broker-dealer is not required to identify execution venues that received less than 5% of non-directed orders for a section of the broker-dealer's quarterly report, as long as it has identified the top execution venues that in the aggregate received at least 90% of the broker-dealer's total non-directed orders for the relevant section.

Q:   Is a broker-dealer required to capture, on an order-by-order basis, all information necessary to generate quarterly reports that precisely set forth the percentages of orders routed to different execution venues, or may it use reasonable procedures to estimate the percentages so long as they generate materially accurate overviews of the broker-dealer's routing practices?

A:   Unlike the monthly execution quality statistics required of market centers under Rule 11Ac1-5, where precise information must be captured on an order-by-order basis, the order routing percentages in quarterly reports are intended to provide a general overview of a broker-dealer's routing practices. If interested, individual customers are entitled to request specific information on their own orders. Consequently, a broker-dealer need only generate quarterly reports that provide a materially accurate overview of its routing practices.

A broker-dealer should develop reasonable procedures to estimate order percentages within a range that is materially accurate. For example, a firms could adopt procedures that are based on a variety of available sources, such as clearing records and the firm's order routing algorithms. In preparing its quarterly report (as opposed to responding to customer requests for individual information), a firm is not required to account precisely for every individual order, particularly those categories of "niche" orders that represent a de minimus percentage of the firm's total non-directed orders.4 The cost of this administrative task could outweigh the limited additional benefit of more precise order routing percentages. The end result, however, must be a quarterly report that the broker-dealer has a reasonable basis to believe sets forth a materially accurate overview of its routing practices.

Q:   Do introducing brokers who transmit all customer orders to their clearing firms for execution have a reporting responsibility under the Rule? If so, to what extent can clearing firms assist their introducing brokers in meeting the Rule's requirements?

A:   Introducing brokers, which have the primary relationship with its customers, have the reporting responsibility under the Rule. Introducing brokers may contract with their clearing firms for assistance in meeting their reporting responsibilities (analogous to the assistance provided by clearing firms to some introducing brokers in meeting the duty of best execution), but the responsibility remains the introducing brokers'. Given, however, the many functions that a clearing firm may perform on behalf of its introducing brokers, the clearing firm often will play a substantial role in generating the quarterly reports of its introducing brokers.

For example, if an introducing broker transmits all customer orders to its clearing firm, and the clearing firm in fact makes the routing decision concerning those customer orders without regard to the identity of the particular introducing broker, the clearing firm may be in the best position to prepare a quarterly report that reflects the clearing firm's routing practices on behalf of the introducing broker. Introducing brokers could disclose the existence of the clearing relationship (including payment for order flow, if any, received by the introducing broker) and adopt by reference the clearing firm's report to comply with the Rule, provided that they have examined the report and do not have reason to believe it materially misrepresents the order routing practices. Such a report would identify significant execution venues, as well as the percentages of non-directed orders routed to the venues, from the standpoint of the clearing firm. In addition, the report's discussion of relationships with execution venues should reflect the standpoint of the clearing broker - the entity that is actually making the order routing decision. If, for example, the clearing broker internalized orders or received payment for order flow from other execution venues, these facts would need to be disclosed in the quarterly report.

Given the many different relationships that can exist between introducing brokers and their clearing firms, those with reporting responsibility will need to evaluate their specific situation and produce quarterly reports that are appropriate to their circumstances. For example, introducing brokers that route a material number of orders themselves, as well as transmit orders to their clearing firm for routing, will be responsible for reports that reflect both categories of orders.

Q:   Is it permissible for a broker-dealer to prepare two or more reports that correspond to functional differences in the firm's order routing practices?

A:   A single firm may prepare two or more reports that correspond to functional differences in the firm's order routing practices, but only if the separate reports will provide a clearer picture of the firm's practices and the basis for the separate reports is fully disclosed to customers and the public. Each report should clearly explain the orders to which it applies, as well as identify the other reports for the firm and the orders to which they apply. Customers must be able to determine which report applies to their type of orders.

For example, a broker-dealer with two divisions, each with its own customers and order routing practices, may generate a separate report for each division. Each report should explain that it applies only to orders submitted by customers of that division, and that another report has been issued that applies to orders submitted by customers of the other division.

Similarly, an introducing broker whose customer accounts are carried by two different clearing firms, with customers assigned to only one of the two firms, may generate a separate report for each clearing firm. Each report should explain that it applies only to orders submitted by customers whose accounts are carried by the particular clearing firm, and that a separate report has been issued that applies to orders submitted by customers whose accounts are carried by the other clearing firm.

Q:   The definition of "customer order" in paragraph (a)(2) of the Rule excludes any order for a quantity of a security having a market value of at least $200,000 for equity orders and $50,000 for options orders. How should a broker-dealer determine the market value of an order? Can orders linked together for execution by the customers (such as program and arbitrage orders), or a single order submitted on behalf of more than one account, be considered a single order when calculating market value? Does it matter if an order is executed in more than one transaction?

A:   Broker-dealers may adopt any reasonable procedure to determine the market value of an order. For example, firms could use the previous day's closing price for the security or the inside quotes at the time the order was placed. Orders linked together for execution by the customer, or single orders submitted for more than one account, can be considered a single order when calculating their market value. The fact that an order ultimately is executed in more than one transaction does not affect its status as an excluded order.

Q:   Firm A is a U.S. registered broker-dealer that receives orders from other broker-dealers and foreign banks acting as broker-dealers and routes them to U.S. execution venues. Are these orders properly excluded from the Rule, even if they are submitted on behalf of customers of the other broker-dealers and foreign banks?

A:   Yes. The orders received from other broker-dealers and foreign banks acting as broker-dealers may properly be excluded from the Rule. The definition of "customer order" in paragraph (a)(2) of the Rule excludes an order that is for the account of a broker or dealer. The other broker-dealers and foreign banks should evaluate the applicability of the Rule with respect to their customers' orders. Orders routed by a clearing firm on behalf of an introducing broker are addressed in Question 4 above.

Q:   Firm BD is a broker-dealer that provides on-line services to its customers. It offers customers an order routing program that has a specific execution venue installed as a default routing instruction. Firm BD clearly discloses that the customer is free to set a different default at any time and provides a reasonable list of alternative default venues from which to choose. Firm BD does not provide any inducements for customers to retain the initial default setting (such as a lower commission rate). Should Firm BD classify orders routed pursuant to the default setting as directed orders under the Rule?

A:   Yes. The orders routed pursuant to the initial default setting are directed orders and therefore should not be included in the quarterly reports of Firm BD. Paragraph (a)(3) of the Rule defines a "directed order" as an order that "the customer specifically instructed the broker or dealer to route to a particular venue for execution." Paragraph (b)(1) of the Rule requires broker-dealers to report on their routing of "non-directed orders," which is defined in paragraph (a)(5) of the Rule as "any customer order other than a directed order." Because customers of Firm BD can readily choose a different default venue from a reasonable list of execution venues other than the initial default setting, and the broker-dealer does not charge a higher commission if the customer chooses another venue, orders routed pursuant to the initial default setting are appropriately classified as directed orders.

In addition, once an order is properly classified as a directed order, it need not subsequently be reclassified as a non-directed order if the venue to which the customer directed the order is unable to execute the order (for example, due to a systems problem) and the broker-dealer then routes the order elsewhere for execution. The initial classification under the Rule, of course, would not relieve the broker-dealer of its duty of best execution with respect to the re-routed order.

Q:   How should orders be divided into the three classes (market, limit, other) specified by the Rule?

A:   The three classes of orders are intended to correspond generally to the division of orders in Rule 11Ac1-5, thereby facilitating use of the monthly execution quality reports of market centers in conjunction with the quarterly order routing reports of broker-dealers. Rule 11Ac1-5 requires market centers to report on their executions of standard market orders and limit orders, but excludes a wide variety of orders for which the customer requests special handling. These exclusions include market opening and closing orders, orders submitted with stop prices, all-or-none orders, orders that must be executed on a particular tick or bid (such as non-exempt short sale orders), and "not held" orders. All of these special handling orders would fall within the "other order" category for purposes of the quarterly order routing reports required by the Rule. Marketable limit orders are appropriately classified as limit orders under the Rule.

Q:   What should be considered the execution venue for an order when it is executed in two or more transactions at different venues?

A:   Broker-dealers may adopt any reasonable, consistent approach for assigning an execution venue to orders that are executed in multiple venues. For example, the venue that handled the largest partial execution or the venue that handled the first partial execution would both be reasonable approaches.

Q:   When a broker-dealer receives a non-directed order from a customer, and then executes the order as riskless principal based on a contemporaneous order execution at another venue, who should be identified as the execution venue under the Rule - the broker-dealer or the other venue?

A:   The appropriate disclosure for riskless principal orders depends on the nature of the broker-dealer's activity in the relevant security. If the broker-dealer acts as a market center in the security for purposes of Exchange Act Rule 11Ac1-5, the broker-dealer should identify itself as the execution venue for riskless principal orders. If the broker-dealer does not act as a market center in the security, it should identify the venue at which it obtained the contemporaneous order execution.

Q:   The Adopting Release provides that, to assure meaningful disclosure of significant execution venues, all orders routed to a particular exchange for execution should be aggregated when calculating a broker-dealer's top ten venues and those with 5% of orders. How should a firm make this calculation in the context of Nasdaq systems?

A:   Nasdaq should be identified as the execution venue for orders that are routed directly to Nasdaq's order execution systems, such as SOES (or its upcoming replacement, SuperSOES). SelectNet, in contrast, is an order delivery system, not an order execution system, and therefore should not be identified as an execution venue. For orders transmitted directly (whether through SelectNet or otherwise) to an individual market center, such as a market maker or ECN, that market center, rather than Nasdaq, should be identified as the execution venue.

Q:   What is considered payment for order flow and how should payment for order flow arrangements be disclosed in the quarterly reports?

A:   Payment for order flow is broadly defined in Exchange Act Rule 10b-10(d)(9), which is cross-referenced in paragraph (a)(8) of the Rule. It provides, among other things, that "any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration" to a broker-dealer in return for the routing of orders is payment for order flow. This definition would include, for example, both direct monetary payments for orders (such as a market maker's payments for marketable orders and an ECN's payments for non-marketable limit orders) and in-kind goods and services (such as T1 lines, clearing services, and reciprocal agreements for the provision of order flow). The wide-ranging forms that payment for order flow can assume precludes any definitive list of specific instances of payment for order flow.

In its quarterly reports, a broker-dealer must disclose the "material aspects" of its relationship with its significant execution venues, including a description of any payment for order flow arrangement. In this context, "materiality" should be interpreted as those aspects of the payment for order flow arrangement that would be important to a reasonable investor in evaluating a broker-dealer's routing practices. As noted in the Adopting Release, broker-dealers are not required to estimate or calculate the aggregate dollar amounts of payment for order flow. They are, however, required to describe the material terms of the arrangement, such as any amounts per share or per order that the broker-dealer receives.

Given the intensively fact-based nature of payment for order flow arrangements, definitive guidance on their disclosure is not possible. Firms should be aware, however, that the new disclosure requirements were adopted to provide investors with a clearer understanding of broker-dealer order routing practices than is provided under current rules. Firms should not merely assume that their past disclosures will satisfy the new requirements of the Rule.

Q:   Firm A is an integrated broker-dealer that receives non-directed orders as agent from its brokerage customers and routes to its market making desk those orders in securities for which it acts as market maker. Such orders represent a significant portion of the total non-directed orders of Firm A. What must Firm A disclose concerning this internalized order flow?

A:   Firm A would identify itself as a significant execution venue on its quarterly reports and set forth the percentage of orders that it routes to itself for execution. In discussing the material aspects of this order routing relationship, Firm A should disclose that it stands to share in 100% of whatever profits it generates by trading as principal with its customers' orders. If Firm A executes a material percentage of internalized orders during a quarter as agent by crossing them with other customer orders, it would be appropriate for Firm A to disclose a reasonable estimate of this percentage to clarify further the extent to which it stands to share in profits from principal trading.

Q:   What procedures must a broker-dealer follow in making its quarterly reports publicly available? Must it have its own web site on which to post its report, or would it be permissible for the broker-dealer to post its report on another web site? For how long must a report be posted on the web site?

A:   The phrase "make publicly available" is defined in paragraph (a)(4) of the Rule as "posting on an Internet site that is free and readily accessible to the public, furnishing a written copy to customers on request without charge, and notifying customers at least annually in writing that a written copy will be furnished on request."

Although a broker-dealer is not required to post its report on its own Internet site, the site on which it does choose to post its report must be readily accessible to the public. Consequently, a broker-dealer that has an Internet site, but chooses to post its report on another site, must include a hyperlink on its Internet site to the report's Internet site. A broker-dealer that does not have its own Internet site must take reasonable steps to assure that its report is readily accessible to the public. These could include, for example, making arrangements to provide the location of the report's Internet site to any caller at the broker-dealer's main telephone number.

A quarterly report should remain posted on an Internet site until it is replaced by the next report for the succeeding quarter.

Q:   How frequently must a broker-dealer respond to requests from customers for their individual order routing information?

A:   Broker-dealers must establish reasonable procedures for responding to customer requests in a useful manner. The Rule does not, however, require order-by-order responses analogous to those that are required for confirmation of transactions under Exchange Act Rule 10b-10. For example, the Division would view as reasonable a procedure pursuant to which all customers who requested individual information were issued reports on a standardized monthly basis that covered orders submitted up to the preceding six months (a broker-dealer need not duplicate information on previous months' orders that already was provided to the customer).

Q:   When must broker-dealers provide the first written notice to customers under the Rule relating to the availability of written quarterly reports and of individual order information?

A:   A broker-dealer must provide the written notice required by the Rule no later than in its first annual communication in compliance with Exchange Act Rule 11Ac1-3 that is transmitted to customers after its first quarterly report is made available in October 2001.

3 Letter to Neal E. Sullivan & Gail Marshall-Smith, Bingham Dana LLP (on behalf of First Union Securities, Inc.), from Annette L. Nazareth, Director, Division, dated June 22, 2001 ("First Union Letter").

4 See First Union Letter, note 3 above.