Timpinaro v. S.E.C., s. 91-1502
| Decision Date | 09 November 1993 |
| Docket Number | 91-1650,Nos. 91-1502,s. 91-1502 |
| Citation | 2 F.3d 453 |
| Parties | , Fed. Sec. L. Rep. P 97,702 William TIMPINARO, et al., Petitioners, v. SECURITIES AND EXCHANGE COMMISSION, Respondent. |
| Court | U.S. Court of Appeals — District of Columbia Circuit |
Barry S. Augenbraun, New York City, argued the cause, for petitioners. With him on the briefs were W. Reece Bader and Simon S. Kogan, New York City. Joan A. McCarthy, Sr. Special Counsel, S.E.C., Washington, DC, argued the cause, for respondent. With her on the briefs were Paul Gonson, Sol., James R. Doty, Gen. Counsel, Anne E. Chafer, Associate Gen. Counsel, and David U. Thomas, Sr. Counsel, S.E.C., Washington, DC.
Before WALD, D.H. GINSBURG, and HENDERSON, Circuit Judges.
Opinion for the Court filed by Circuit Judge D.H. GINSBURG.
Several securities broker-dealers and their customers petition for review of three orders that the Securities Exchange Commission issued on October 10, 1991 pursuant to Sec. 19(b) of the Securities Exchange Act of 1934, as amended. Two of the orders approved new rules for the Small Order Execution System (SOES), an automated system developed by the National Association of Securities Dealers (NASD), Inc., the self-regulatory organization for the over-the-counter securities market: The Professional Trader Rule defines "professional traders" and bars them from using the SOES, see Exch. Act. Rel. No. 29809 (Oct. 10, 1991), 56 Fed.Reg. 52092 (Oct. 17, 1991), while the 15-Second Rule provides for a grace period in which a market maker may update its price quotations between trades over the SOES. See Exch. Act. Rel. No. 29810 (Oct. 10, 1991), 56 Fed.Reg. 52098 (Oct. 17, 1991). The third order denies a petition for rulemaking to lift all restrictions on SOES trading. We deny the petitions for review with respect to both the 15-Second Rule and the SEC's denial of the petition for rulemaking, and remand the Professional Trader Rule for further explanation.
The NASD developed the SOES in 1984 in order to allow automatic execution of small trades at prices advertised on the National Association of Securities Dealers Automated Quotation System (NASDAQ). See 56 Fed.Reg. 52092 (Oct. 17, 1991) (). Using the SOES, a broker-dealer can instantly execute a trade for a customer at the "inside market"--the best bid or ask price offered by any firm making a market in the relevant security. Because the order is executed on the NASDAQ computer, the OTC market maker whose offer is accepted does not know about the SOES trade until just after it has been executed.
In June 1988 the NASD began requiring that each market maker automatically execute at its quoted price orders aggregating five times the maximum order size (200, 500, or 1,000 shares, depending upon the security) for every security in which it makes a market. It soon emerged, however, that an attentive trader using the SOES could exploit even a momentary disparity among the prices being offered by the firms making a market in a particular security; traders would closely track movements in the price of a volatile stock and, if one market maker was the least bit behindhand in repricing the stock, lock in an arbitrage profit at no risk. The traders would also monitor news developments constantly and use the instantaneous execution feature of the SOES to purchase shares before the market makers--who frequently handle many stocks--could adjust their quotations to reflect the new information. By executing within a few seconds as many as five orders for up to 1,000 shares each and liquidating the position shortly afterward at the new market price, a trader could profit handsomely at the expense of the market maker.
In December 1988 the NASD tried to prevent these traders from using the instant execution feature of the SOES to profit from disparities in the prices quoted by various market makers. This it did by barring broker-dealers from using the SOES on behalf of "professional trading accounts." A professional trading account is defined as any account in which either five or more "day trades" (i.e., offsetting purchases and sales of the same security on the same day) are executed through the SOES on any single trading day, or in which the NASD Market Surveillance Department detects a "professional trading pattern" using the SOES. The prohibited pattern was to be discerned on the basis of three factors: (1) a pattern or practice of day trading; (2) a high volume of day trades in relation to all trading in the account; and (3) a high volume of day trades in relation to the number and value of securities held in the account.
Notwithstanding this regulatory approach, the NASD found that some traders were still able to exploit price disparities "while carefully evading the definition of a professional trading account." 56 Fed.Reg. 52092, 52096 (Oct. 17, 1991). Consequently, in 1990 and 1991 the NASD filed with the SEC proposed rules designed further to restrict access to the SOES; the Commission approved these rule changes in October 1991.
As amended, the Professional Trader Rule expands the definition of a "professional trading account" by including day trades in which only one side of the transaction is executed through the SOES and by adding four more factors to be considered in determining whether an account is a professional trading account: (1) excessive frequency of short-term trading; (2) excessive frequency of short sale transactions; (3) broker-dealer discretionary authority over the account; and (4) direct or physical access to the SOES execution capability, to NASDAQ level 2 quotation information, or to the National Quotation Data Service. See Exch. Act Rel. No. 29809 (Oct. 10, 1991), 56 Fed.Reg. 52092 (Oct. 17, 1991). The 15-Second Rule provides market makers with a grace period, after executing a trade on the SOES, in which to update their quotations before they must stand ready to execute another SOES transaction on the same side (i.e., as buyer or seller) of the same security. See Exch. Act Rel. No. 29810 (Oct. 10, 1991), 56 Fed.Reg. 52098 (Oct. 17, 1991). A market maker may, however, waive the 15-Second Rule pursuant to a "preferencing agreement" with a particular broker-dealer, which may then execute multiple trades on the SOES without any delay between them.
Meanwhile, in August 1991 the petitioners had asked the SEC for a rulemaking to eliminate all restrictions on use of the SOES. The Commission denied their petition for rulemaking at the same time and for the same reasons that it approved the tighter restrictions outlined above. The SEC took the position that, if access to the SOES were unrestricted, then market makers would reduce the number of securities in which they make a market so that they could monitor and update their quotations more quickly, the better to eliminate arbitrage opportunities.
Under the '34 Act, the SEC may approve a proposed change in the NASD's rules only if it finds that the change is "consistent with the requirements of [the Act]." 15 U.S.C. Sec. 78s(c). Section 15A(b)(6) provides that NASD rules must, among other things, remove impediments to a free and open market and a national market system, and protect investors and the public interest. 15 U.S.C. Sec. 78o-3(b)(6). The rules may not permit any unfair discrimination among customers, issuers, or dealers, id. nor impose any burden upon competition that is not necessary or appropriate in furtherance of the purposes of the Act. Sec. 15A(b)(9) of the Act, 15 U.S.C. Sec. 78o-3(b)(9).
We are concerned here with only one aspect of the 15-Second Rule, viz. the exemption for "preferenced" firms. The petitioners do not object to the 15-second grace period before a market maker must accept a second SOES trade, perhaps because the Firm Quote Rule, 17 CFR 240.11Ac1-1(c)(2), already provides for a similar grace period after executing a telephonic order. Exch. Act Rel. No. 14415, 43 Fed.Reg. 4344 (Feb. 1, 1978). The 15-Second Rule merely extends that provision into the realm of automated executions.
The petitioners challenge the exemption for "preferenced" broker-dealers on the ground that it "discriminates between those who have a 'preferencing agreement' and all others." The '34 Act, however, prohibits "unfair discrimination," not "discrimination" simpliciter, 15 U.S.C. Sec. 78o-3(b)(6), and the petitioners have not shown that it is in any way unfair for a market maker to waive the protection of the 15-second grace period. As we have seen, the grace period is designed to protect the market maker from having to make an involuntary second trade at an untimely inside quotation. Under a "preferencing" arrangement the broker-dealer presumably agrees not to take advantage of the market maker when it is showing an untimely inside quotation, in return for which the market maker waives the grace period. It would be peculiar indeed to force upon the market maker and its customer the broker-dealer, both investment professionals, a grace period that neither party wants.
Moreover, as the Commission noted, "[m]any broker-dealers have order routing arrangements ... under which they agree in advance to send their order flow to a specific [market maker]." By waiving the grace period, a market maker can give a broker-dealer immediate execution in exchange for a higher volume of the broker-dealer's trading business. In effect, the market maker is giving a non-price volume discount in the form of immediate execution. Non-price discounts are an everyday feature of business; not only is there nothing inherently "unfair" about them, they have the same pro-competitive effect as a price...
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