[Federal Register Volume 59, Number 211 (Wednesday, November 2, 1994)]
[Rules and Regulations]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-27109]
[[Page Unknown]]
[Federal Register: November 2, 1994]
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Part IV
Securities and Exchange Commission
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17 CFR Part 240
Payment of Order Flow; Internalized/ Affiliate Practices, Payment for
Order Flow and Order Routing Practices; Final Rule and Proposed Rule
Federal Register / Vol. 59, No. 211 / Wednesday, November 2, 1994 /
Rules and Regulations
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-34902; File No. S7-29-93]
RIN 3235-AG00
Payment for Order Flow
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission announces the adoption
of Rule 11Ac1-3 and amendments to Rule 10b-10 under the Securities
Exchange Act of 1934 which, together, require enhanced disclosure of
payment for order flow practices on customer confirmations, and account
statements, as well as upon opening new accounts. The new Rule and
amendments to Rule 10b-10 are designed to provide relevant information
to customers regarding factors influencing the routing of their orders.
The new Rule and amendments to Rule 10b-10 also will serve to enhance
investor protection and further competition for retail orders by
enabling customers to evaluate more effectively the markets to which
their orders are routed.
EFFECTIVE DATE: April 3, 1995.
FOR FURTHER INFORMATION CONTACT:
Jill W. Ostergaard, Attorney, 202/942-3197, Branch of the National
Market System, Office of Market Supervision, Division of Market
Regulation, Securities and Exchange Commission, 450 Fifth Street NW.,
Mail Stop 5-1, Washington, DC 20549. For interpretation of Rule 10b-10
after March 1, 1996, please contact the Office of the Chief Counsel,
202/942-0073, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street NW., Mail Stop 7-10, Washington, DC 20549.
For interpretation of Rule 11Ac1-3 please contact the Office of Market
Supervision, Division of Market Regulation, 202/942-3197.
SUPPLEMENTARY INFORMATION:
I. Executive Summary
On October 6, 1993, the Securities and Exchange Commission (``SEC''
or ``Commission'') proposed for comment amendments to Rule 10b-10 (17
CFR 240.10b-10) and new Rule 11Ac1-3 (17 CFR 240.11Ac1-3) under the
Securities Exchange Act of 1934 (``Act'') concerning payment for order
flow practices.\1\ Taken together, those proposals were designed to
improve information available to investors about their broker-dealer's
order routing practices, and whether the broker-dealer received market
center\2\ inducements for routing unspecified order flow to them. These
disclosures would occur when the investor opened an account, annually
thereafter, and on the required trade confirmations. In the Proposing
Release, the Commission invited commenters to address issues related to
the proposals as well as alternative approaches to payment for order
flow, such as banning the practice outright, mandatory pass-through of
payments to customers, and requiring exchanges, national securities
associations and broker-dealers to convert to decimal pricing.
\1\Securities Exchange Act Release No. 33026 (Oct. 6, 1993), 58
FR 52934 (Oct. 13, 1993) (``Proposing Release'').
\2\As used in this release, the term market center includes
exchanges and dealers acting as market makers. See 17 CFR 240.11Ac1-
2(a)(14) (defining ``reporting market center'').
The Commission received 53 comment letters concerning the
proposals. Of those commenters, 31 supported the disclosure approach
and 17 opposed it.\3\ Many of the commenters supporting the approach
offered suggestions to improve the effectiveness of disclosure.
\3\The Commission's staff has prepared a summary of the
comments, a copy of which has been placed in the official file.
The Division of Market Regulation (``Division'') also solicited
comment on payment for order flow in its study of the equity
markets. See Securities Exchange Act Release No. 30920 (July 14,
1992), 57 FR 32587 (July 22, 1992) (``Market 2000 Concept
Release''). See also Division of Market Regulation, Securities and
Exchange Commission, Market 2000: An Examination of Current Equity
Market Developments (Jan. 1994) (``Market 2000''). Many of the same
parties commenting on this proposal commented on Market 2000. Id.,
Appendix IV at 41-48.
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The Commission is adopting the proposed disclosure approach as
discussed below. The Commission believes this approach will further the
investor protection goals of the Act, and is consistent with the
general philosophy underlying disclosure that ``sunlight is the best
disinfectant.''\4\ The Commission, in response to commenters'
suggestions, has modified the proposed Rule and amendments to Rule 10b-
10, as described below.
\4\L. Brandeis, Other People's Money and How the Bankers Use It,
92 (Frederick A. Stokes Co. ed. 1932).
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The Commission is modifying Rule 11Ac1-3 and amendments to Rule
10b-10 as proposed, to include Nasdaq Small-Cap and Over-The-Counter
(``OTC'') Bulletin Board securities. The Commission also is modifying
the proposed amendments to Rule 10b-10 to limit the disclosure of
payment for order flow on customer confirmations to a statement that
the broker or dealer receives payment for order flow. In addition, the
Commission is revising proposed Rule 11Ac1-3 regarding customer account
statements by requiring disclosure of the broker-dealer's policies for
determining where to route customer orders that are the subject of
payment for order flow absent specific instructions from customers,
including a description of the extent to which orders can be executed
at prices superior to the national best bid or best offer (``NBBO'').
In a parallel action, the Commission is proposing for comment
amendments to Rule 10b-10 and Rule 11Ac1-3 that would extend those
Rules to the options market.\5\ In addition, the Commission is
proposing for comment a requirement that broker-dealers disclose in
writing, on confirmations, upon opening new accounts and on annual
disclosure statements, ranges of payment for order flow received on a
per share basis; and include, in new account documentation and on
annual disclosure statements, an estimate of the aggregate amount of
payment for order flow received on an annual basis.\6\ The Commission
also is proposing for comment a requirement that broker-dealers
disclose whether they execute orders as principal (``internalize'') or
route orders to an affiliated broker-dealer or exchange specialist for
execution and, a requirement that broker-dealers quantify and disclose
information about internalized/affiliate practices.\7\ The Commission
further is proposing for comment a requirement that broker-dealers
disclose their order routing practices regardless of whether the
broker-dealer received payment for order flow or engaged in
internalized/affiliate practices. The Companion Release also solicits
comment on expanding the definition of payment for order flow.\8\
\5\See Securities Exchange Act Release No. 34903 (October 27,
1994) (``Companion Release''`).
\6\Id.
\7\Id.
\8\Id.
II. Basis and Purpose of the Rule
The practice of paying for order flow has generated much debate and
controversy\9\ regarding the potential benefits and harm to public
investors and whether receipt and retention of payment for order flow
compromises a broker-dealer's duties to its customer.\10\ Congress has
shown continuing interest in the resolution of that controversy.\11\
The history of that debate and other background information can be
found in the Proposing Release.\12\ In their response to the Proposing
Release, few commenters suggested that the Commission not act at all
regarding payment for order flow practices.\13\ Most commenters
supported the disclosure approach, with modifications. These commenters
suggested that payment for order flow practices are a mechanism for
competition among market centers for order flow. Many commenters argued
that there is no harm in these practices. Others argued that disclosure
to the customer adequately would address any perceived conflict of
interest.
\9\For a detailed discussion of this controversy, see Note, The
Perils of Payment for Order Flow, 107 Harv. L. Rev. 1675 (1994).
\10\Private litigation in several state courts currently is
pending regarding payment for order flow. See, e.g., Investors'
State Actions Against Brokers Seek Return of Cash Paid for Order
Flow (BNA), Special Report, Vol. 26, pp. 590-94 (April 22, 1994).
Two cases were dismissed on grounds of federal preemption and are
currently on appeal. See Dahl v. Charles Schwab & Co., Inc. (MC 93-
106272, District Court, Fourth Judicial District, Hennepin County,
Minnesota); Orman v. Charles Schwab & Co., Inc. (93 CH 7365, Circuit
Court of Cook County, Illinois).
\11\See letter from John D. Dingell, Chairman, House Committee
on Energy and Commerce, to Honorable Richard C. Breeden, Chairman,
SEC, dated March 6, 1992. On May 13, 1993, the Subcommittee on
Telecommunications and Finance of the House Committee on Energy and
Commerce held a hearing regarding the future of the stock market and
inducements for order flow. See National Market System: Hearings
Before the Subcomm. on Telecommunications and Finance of the House
Comm. on Energy & Commerce, 103d Cong., 1st Sess. (1993) (``National
Market System Hearings'').
\12\See Proposing Release, supra note 1, 58 FR at 52935.
\13\Some commenters believe that current disclosure requirements
are adequate and additional disclosure is unnecessary.
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As noted in the Proposing Release, payment for order flow may
result in lower execution costs, facilitate technological advances in
retail customer order handling practices and facilitate competition
among broker-dealers and securities markets. At the same time, however,
the practice raises concern as to whether the customer is being treated
fairly. Specifically, payment for order flow raises concerns about
whether a firm is meeting its obligation of best execution to its
customer. Not all market centers expose market orders to other order
flow or attempt to improve the price at which market orders are
executed. Thus, the decision to route an unpriced order to a market
center offering immediate execution at the NBBO, could mean that the
customer has lost an opportunity for execution at a superior price
because of the lack of exposure to other order flow.\14\ For the
reasons discussed below, the Commission believes disclosure that
payment for order flow has been received and a description of whether
the customer's order has an opportunity for price improvement will
enhance investor protection and provide customers with information to
evaluate more effectively the markets to which their orders are routed.
\14\See Market 2000, supra note 3, Study V at 3-4.
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III. Discussion
The Rules adopted today represent a tiered approach to disclosure
of payment for order flow practices in the broader context of broker-
dealer order handling practices and the special relationship that
already exists between a broker-dealer and its customer.\15\ The
components of the Rules include disclosure at the time an account is
opened, annually thereafter, and on the transaction confirmation.
\15\A broker-dealer's duty to seek to obtain best execution of
customer orders derives, in part, from the common law agency duty of
loyalty, which obligates an agent to act exclusively in the
principal's best interest. Restatement 2d Agency section 387 (1958).
Thus, when an agent acts on behalf of a customer in a transaction,
the agent is under a duty to exercise reasonable care to obtain the
most advantageous terms for the customer. Restatement 2d Agency
section 424 (1958).
First, the Rules adopted today require broker-dealers to inform
customers in writing, when a new account is opened, about the dealer's
policies regarding the receipt of payment for order flow, including
whether payment for order flow is received; and a detailed description
of the nature of the compensation received. As discussed in greater
detail below, the new Rule and Rule amendments require that broker-
dealers provide information in account opening documents about order
routing decisions in orders subject to payment for order flow,
including an explanation of the extent to which unpriced orders can be
executed at prices superior to the displayed NBBO at the time the order
is received. Second, the Rules adopted today require dealers to update
this information and to provide such information annually to all
customers. Taken together, this information should assist customers in
assessing the quality of trade executions they receive and encourage
broker-dealers to consider the opportunity for price improvement in
establishing order routing arrangements. Finally, the Rules adopted
today require broker-dealers to indicate on confirmations whether the
broker or dealer receives payment for order flow, and the availability
of further information on request. These are described in greater
detail below, beginning with the scope of securities subject to the
Rules and the types of inducements covered by the Rules.
A. Securities Subject to Disclosure Obligations and Definition of
Payment for Order Flow
1. Securities Subject to Disclosure Obligations
As proposed, the obligations of both Rule 11Ac1-3 and the
amendments to Rule 10b-10 were limited to orders in national market
system securities. The Commission requested comment on whether both
Rules should be extended to Nasdaq Small-Cap and OTC Bulletin Board
Securities.\16\ Commenters addressing this issue supported the
inclusion of both and, accordingly, the Commission is expanding Rule
11Ac1-3 and amendments to Rule 10b-10 to include these securities. As
revised, both Rules would include ``any subject security as defined in
Sec. 240.11Ac1-2 or a security authorized for quotation on an automated
interdealer quotation system that has the characteristics set forth in
Section 17B of the Act * * *.''\17\
\16\See Proposing Release, supra note 1, 58 FR at 52940 n.44 and
n.46. Two commenters support the inclusion of Nasdaq Small-Cap and
OTC Bulletin Board securities in the Commission's proposal. One
commenter states that if the goal of disclosure is to provide
customers with as much information as possible to make an informed
decision regarding where to place their orders, it does not make
sense to limit the disclosure requirement to national market system
securities but rather the requirement should extend to Nasdaq Small-
Cap and OTC Bulletin Board securities.
Two exchanges support the inclusion of options in the
confirmation disclosure requirements. One exchange suggests that the
Commission consider the ramifications that payment for order flow
may have on the options marketplace, especially once multiple
trading of options is taken into consideration. See letter from
Leopold Korins, Chairman and Chief Executive Officer, Pacific Stock
Exchange, Inc., to Jonathan G. Katz, Secretary, SEC, dated December
9, 1993. The Commission, therefore, is soliciting comment in a
parallel action today on whether amendments to Rule 10b-10 and Rule
11Ac1-3 should extend to the options markets. See Companion Release,
supra note 5.
\17\The OTC Bulletin Board is currently the only automated
quotation system that has the characteristics set forth in Section
17B of the Act. See letter from Margaret H. McFarland, Deputy
Secretary, SEC, to Richard Ketchum, Executive Vice President,
National Association of Securities Dealers, Inc. (``NASD''), dated
Dec. 30, 1992. The revision to Rule 11Ac1-3 is intended to cover
securities included in any other automated quotation systems at such
time as the Commission designates them under Rule 15g-3(c)(5).
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The Commission believes that inclusion of these securities provides
customers with the best picture of a broker-dealer's policies regarding
the routing of customer orders and the receipt of payment for order
flow. As discussed in the Proposing Release,\18\ the practice of
payment for order flow originated in the OTC market, and since then has
been routinely used as a competitive tool in that market. Payments for
Nasdaq and OTC Bulletin Board stocks, moreover, are generally greater
than for exchange-listed national market system securities.\19\
Accordingly, the Commission believes that the disclosure protections
should be extended to the OTC market.
\18\See Proposing Release, supra note 1, 58 FR at 52935.
\19\See id., 58 FR at 52936 n.16.
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2. Definition of Payment for Order Flow
As proposed, Rule 10b-10(e)(9) defined payment for order flow
broadly, to include all forms or arrangements compensating for
directing order flow. The Commission received 23 comment letters
addressing the scope of the definition. The majority of these
commenters were supportive of the Commission's efforts and agreed that
non-cash inducements for order flow are economically equivalent to, and
have the same effect as, cash payments for order flow. Opponents of the
proposed definition, which include most of the exchanges, argued that
rebates and fee reductions are structurally different from other cash
payments and should be excluded from ``monetary'' payment for order
flow.\20\ The Commission has considered all the comments, and for the
reasons discussed below, believes that the items enumerated in Rule
10b-10(e)(9) appropriately include arrangements involving payment for
order flow.\21\
\20\Several exchanges argue that, unlike cash payments, all
exchange charges and fees are filed with the Commission pursuant to
Rule 19b-4 under the Act and are a matter of public record. The New
York Stock Exchange (``NYSE'') added that unlike exchange fee
structures, dealers do not charge fees to brokers for use of their
services; because there is no ``fee'' to discount, the NYSE argues
that it is disingenuous to suggest any similarity between the two
practices. See letter from James E. Buck, Senior Vice President and
Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC, dated December
9, 1993.
\21\In the Companion Release, the Commission is soliciting
comment on whether to expand the definition of payment for order
flow.
Rule 10b-10(e)(9) defines payment for order flow to include any
monetary payment, service, property, or any other benefit that results
in remuneration, compensation or consideration to a broker or dealer in
return for the routing of customer orders. Broker-dealers should
examine order routing arrangements carefully, with a view toward
determining whether the firm has received some form of remuneration as
a result of routing orders to that market. As noted, payment for order
flow includes non-monetary compensation, such as clearing services or
reciprocal order swapping arrangements. It is the Commission's view
that monetary and non-monetary inducements are alternative methods of
payment to attract order flow and are economically equivalent.\22\ As
such, non-cash remuneration is as likely to influence the broker's
order routing decision as cash. In addition, as is the case with
monetary payments, the customer is unlikely to be aware of many of
these practices. Thus, the net effect of non-monetary arrangements is
not appreciably different than that of monetary payment for order flow.
Therefore, the Commission concludes that non-monetary payment for order
flow should be included in the definition and should be subject to the
regulatory treatment set forth in the proposal.
\22\See, e.g., ``Inducements for Order Flow,'' A Report to the
Board of Governors, NASD, July 1991; see also National Market System
Hearings, supra note 11.
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Payment for order flow also includes any credit, rebate, or
discount against execution fees that exceeds the fee charged for
executing the order.\23\ It is the Commission's view that although SRO
fee schedules are reviewed by the Commission under section 19(b) of the
Act and appear in the Federal Register, the connection between these
fee arrangements and a member firm's order routing practices may not be
known or apparent to that firm's customers. Moreover, it is possible
for an exchange to adjust its fee schedule for members routing orders
to provide the economic equivalent of payment for order flow. The
existence of such remuneration to the firm, whether in the form of
monetary payments or other benefits, should be disclosed directly to
customers.\24\
\23\Thus, payment for order flow would include a fee arrangement
in which an exchange charges 50 cents per order but offers a $2.00
per order credit for agency orders, which can be used to offset
other fees incurred on that exchange. See e.g., Securities Exchange
Act Release No. 32377 (May 27, 1993), 58 FR 31568 (Approving NYSE
practice of offering a rebate on every small order (100-2099 shares)
delivered via SuperDot and executed by the NYSE specialist).
However, payment for order flow would not include fee arrangements
in which the market's net charge for executing the order, after any
discount, rebate, or credit, is greater than zero.
\24\As initially proposed, ``payment for order flow'' was
defined as ``any compensation received from any broker-dealer
(including market makers), exchange members, or exchanges to which a
broker-dealer routes customers orders for execution, including:
Monetary payments, research, products or services * * * discounts
and rebates, or any other reduction of or credit against any fee,
expense or other financial obligation of the broker or dealer
routing a customer order.''
In response to comments, the Commission has clarified that the
definition of payment for order flow includes discounts, rebates,
credits, or other fee arrangements only to the extent that such
discounts exceed the fee charged. In addition, the Commission has
clarified that payment for order flow received from a registered
securities association is also subject to the disclosure rules. The
Companion Release solicits comment on whether the definition of
payment for order flow should be expanded.
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B. New Account and Annual Disclosures
The Commission is adopting Rule 11Ac1-3 to require broker-dealers
to provide to customers information regarding their payment for order
flow practices when a new account is opened and to all customers
annually. The Commission is modifying the Rule to require a description
of the broker-dealer's policies for determining where to route customer
orders that are subject to payment for order flow absent specific
instructions from customers, including a description of the extent to
which orders can be executed at prices superior to the NBBO.
In sum, the revised Rule requires broker-dealers to disclose
whether they receive payment for order flow. If any type of payment for
order flow is received, the broker-dealer must provide a detailed
description of the nature of the compensation received and, as
discussed below, information about the routing of unspecified orders
and whether those orders can be executed at prices better than the NBBO
at the time the order is received.
1. Order Routing and Best Execution
To the extent that market center structures differ materially in
the opportunity for unpriced orders to be executed at prices that are
superior to the NBBO, the receipt of payment for order flow could be
viewed as improperly affecting a dealer's determination regarding where
to route customer orders and the dealer's ability to satisfy its best
execution obligation, if the dealer does not provide as good an overall
opportunity for best execution as it would without the payment for
order flow.\25\ In particular, this could happen when dealers decide to
route orders to a market center which does not provide an opportunity
for price improvement, although other factors such as the size of the
order, speed of execution, and the costs and difficulty associated with
achieving best execution in a particular market may negate this
conclusion.\26\ The Commission noted in the Proposing Release that
broker-dealers are under a duty to seek the ``best execution'' of their
customer's orders.\27\ Broker-dealers accepting remuneration from a
market center for directing order flow to that market center are still
obligated to fulfill their duty of best execution to their
customers.\28\ The Commission understands that most firms that pay for
order flow guarantee, at a minimum, executions at the NBBO. As stated
in the Proposing Release, such so-called quote-derived executions in
many ways are not materially different from automated execution systems
operated by the regional exchanges for years. While automated execution
systems offer fast and assured executions to customers, orders sent to
an exchange for manual handling and orders sent to an OTC dealer for
manual (or in some cases automated) handling may have a greater
opportunity for an execution between the spread than do orders that are
routed to a quote-based automated execution system.\29\
\25\See Market 2000, supra note 3, Study V at 4.
\26\As stated in the Second Report on Bank Securities
Activities,
[While] brokers have not been held by the Commission, the self-
regulatory organizations or the courts to an absolute requirement of
achieving the most favorable price on each order [,] [w]hat has been
required is that the broker endeavor, using due diligence, to obtain
the best execution possible given all the facts and circumstances.
These factors include, among other things, the size of the order,
the trading characteristics of the security involved, the
availability of accurate information affecting choices as to the
most favorable market in which execution might be sought, the
availability of technological aids to process such data, the
availability of economic access to the various market centers and
the costs and difficulty associated with achieving an execution in a
particular market center.
See Second Report on Bank Securities Activities: Comparative
Regulatory Framework Regarding Brokerage-Type Services 97-98, n.233
(Feb. 3, 1977), as reprinted in H.R. Rep. No. 145, 95th Cong., 1st
Sess. 2333 (Comm. Print 1977).
Furthermore, the Commission has stated that ``the creation of
[other] explicit obligation(s) upon broker-dealers would in no way
limit a broker's existing duty to seek to obtain best execution of
his customers' orders.'' SEC, Status Report on the Development of a
National Market System, Securities Exchange Act Release No. 15671
(Mar. 22, 1979), 44 FR 20360 (April 4, 1979) (``Status Report'')
(citing Restatement 2d Agency section 424 (1958)).
\27\See Proposing Release, supra note 1 at n.24.
As a general matter, the duty of ``best execution'' refers to
the duty of the broker to seek to execute a customer's order in the
best available market. See Section 11A(a)(1)(C)(iv) of the Act, 15
U.S.C. 78k-1(a)(1)(C)(iv)(1988); Securities Exchange Act Release No.
26870 (May 26, 1989), 54 FR 23963, 23966 n.51 (June 5, 1989
(``Multiple Trading of Standardized Options Release''). See also
Market 2000, supra note 3, Study V. In 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. See Market 2000 Concept Release, supra note 3,
note 57 and accompanying text.
\28\A broker-dealer's duty to seek best execution of customer
orders derives from, among other sources, the common law agency duty
of loyalty, which obligates an agent to act exclusively in the
principal's best interest. The Commission noted in the Proposing
Release its concern that the availability of payments in return for
order flow commitments may influence the evaluation by a broker-
dealer of the most advantageous market or market maker to whom to
route its customer order. Indeed, some opponents of the practice of
payment for order flow believe that acceptance and retention of
payments by brokers from market makers constitute a breach of duty
not permitted under agency common law. See Restatement 2d Agency
section 388 (1958). While the Commission is concerned about a
broker-dealer's fiduciary duty to seek to obtain the best execution
for its customer, it believes that bulk order routing based, in
part, on the receipt of payment for order flow is not, in and of
itself, a violation of those duties. Disclosure of payment for order
flow, moreover, could help inform customers and negate the concern
that customers are unable to evaluate whether they receive inferior
executions due to undisclosed rebates. See Securities Exchange Act
Release No. 19047 (Sept. 14, 1982), 47 FR 41896 (Sept. 21, 1982).
\29\See Proposing Release, supra note 1, 58 FR at 52941 n. 59.
The footnote cites several studies in this regard: C. Lee, Purchase
of Order Flow and Favorable Executions: An intermarket Comparison
(1991); T. McInish and R. Wood, Price Discovery, Volume and
Regional/Third Market Trading (Feb. 1992); M. Bloom and M.
Goldstein, Displayed and Effective Spreads by Market (Dec. 1992).
The Commission traditionally has concluded that a broker-dealer
routing customer orders for automated execution could satisfy its best
execution obligations so long as the broker-dealer assesses
periodically the quality of competing markets to ensure that its order
flow is directed to markets providing the most advantageous terms for
its customers' orders.\30\ Nevertheless, the Commission's staff
recently has warned against presuming that guaranteed executions at the
best bid or offer always will satisfy the broker-dealer's best
execution duties for small orders in listed securities.\31\ For
example, as a general matter, trades in listed securities routed to an
exchange will be exposed to other public orders or interest in the
trading crowd, with the possibility that the order may receive a price
that is better than the existing quotations (so-called ``price
improvement''). Most regional exchanges, for example, have incorporated
order exposure features into their small order routing and execution
systems with a view toward offering price improvement.\32\
\30\See Status Report, supra note 26. See also Market 2000,
supra note 3, Study V at 1 n.8; Multiple Trading of Standardized
Options Release, supra note 27, 54 FR at 23973 n. 127; and
Securities Exchange Release Act Nos. 17583 (Feb. 27, 1981), 46 FR
15713, 15715 n. 16 (Mar. 9, 1981); and 15926 (June 15, 1979), 44 FR
36912, 36923 n.118 (June 6, 1979).
\31\Market 2000, supra note 3, Study V at 4.
\32\Id. This feature by itself, however, rarely provides an
execution between the spread. Most regional exchanges program their
automatic execution systems to ensure that customer orders receive a
price at the NBBO or better, and the specialist is provided an
opportunity to improve the price. The Philadelphia Stock Exchange
(``Phlx'') does not have such a feature in its automatic execution
system, although the Commission has recommended for years that it be
included. See Market 2000, supra note 3, Study V at 4 n.19;
Proposing Release, supra note 1, 58 FR at 52938 n.28; Market 2000
Concept Release, supra note 3, 57 FR at 32595 n.53; Securities
Exchange Act Release Nos. 27013 (July 7, 1989) 54 FR 30298 n.2 (July
19, 1989); 22750 (Dec. 31, 1985), 51 FR 799, 801 (Jan. 6, 1986);
20350 (Nov. 4, 1983), 48 FR 51722, 71723 n.10 (Nov. 10, 1983); 19858
(June 9, 1983), 48 FR 27872, 27873 (June 17, 1983); and 19372 (Dec.
23, 1982), 47 FR 58287, Technical Appendix, n.12 (Dec. 30, 1982).
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The Commission believes that the possibility for price improvement,
while not the exclusive factor, bears on the question of whether a
broker-dealer is fulfilling its duty to seek best execution, especially
when payment is received by the broker-dealer in return for
guaranteeing order flow.\33\ Although it may be impractical for a
broker or dealer that handles a heavy volume of orders to make an
individual determination regarding where to route each order it
receives, the broker or dealer must use due diligence to seek the best
execution possible given all facts and circumstances. The Commission
believes a broker or dealer must assess whether the order flow in the
aggregate, is receiving best execution and that a broker-dealer must
not allow a payment or an inducement for order flow to interfere with
its efforts to obtain best execution. Accordingly, in light of a
broker-dealer's obligation to assess periodically the quality of the
markets to which it routes packaged order flow absent specific
instructions from customers, the Commission does not believe such a
broker-dealer violates its best execution obligation merely because it
receives payment for order flow.
\33\Because executions of market orders for listed stocks in an
exchange market include the possibility for a price between the
quotes, the staff has concluded that the existence of this
possibility, even if the price is not actually improved, can be a
factor in determining whether best execution has been sought. Market
2000, supra note 3, Study V.
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In this connection, the Commission has taken several steps recently
to expand the opportunity for customer market orders to be executed at
prices better than the NBBO at the time of receipt, including proposal
of a Rule to require limit order price protection in Nasdaq National
Market securities.\34\ Nevertheless, considerable differences among
market centers exist today. Accordingly, consistent with these steps to
help customers understand payment for order flow practices, and to
facilitate fair competition among exchange and non-exchange market
centers, the Commission believes that it is appropriate to require
broker-dealers to disclose to customers their policies regarding where
they route unspecified orders that are subject to payment for order
flow.\35\ This provision requires a description of the extent to which
orders so routed can be executed at prices superior to the NBBO at the
time the order is received. Dealers should explain, in simple terms,
whether the market center to which they route unspecified orders
executes orders to purchase or sell at the NBBO and whether it provides
an opportunity for execution at prices superior to the NBBO.\36\
\34\See Securities Exchange Act Release No. 34753 (Sept. 29,
1994), 59 FR 50866 (Oct. 6, 1994).
\35\As revised, paragraph (a)(2) of the Rule would require
broker-dealers to provide information concerning the broker-dealer's
policies for determining where to route customer orders that are
subject to payment for order flow absent specific instructions from
customers, including a description of the extent to which orders can
be executed at prices superior to the NBBO.
\36\By the terms of the Rule, this disclosure would be limited
to orders that are subject to payment for order flow.
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2. Annual Disclosure
Several commenters opposed annual disclosure because it would
duplicate the account opening disclosure and suggested that the
Commission require additional disclosure only upon a material change in
the firm's policies. The Commission is retaining the annual disclosure
requirement because it believes this will serve to remind customers
that evaluation of a dealer's services involves more than a comparison
of commission rates and to encourage broker-dealers to continue to
evaluate the quality of service they receive from market centers from
which they receive payment for order flow.
3. Quantification of Monetary Payment for Order Flow
Over 20 commenters addressed the proposed requirement that broker-
dealers inform customers annually about the aggregate amount of
monetary compensation received for routing order flow. The majority
oppose the inclusion of any aggregate value requirement.\37\ The
Commission has determined to solicit further comment on this issue in
the Companion Release because it believes that aggregate information
provides useful information to customers to evaluate the magnitude of
payment for order flow practices and whether such payments, taken as a
whole, might affect adversely order routing determinations. As
discussed in the Companion Release, the Commission has determined to
solicit further comment on this issue in conjunction with its proposal
to require valuation of all forms of payment for order flow because
disclosure of monetary payment for order flow without similar
disclosures regarding non-monetary payment for order flow and
internalization could mislead investors or foster non-monetary payments
or internalized/affiliate practices.
\37\Several broker-dealers argue that disclosure of aggregate
amounts of monetary order flow would be misleading to customers. One
commenter voiced concerns that investors who transact business in
mutual funds or options would be misled by disclosure which only
derives from equity order flow. Others believe that even equity
customers are likely to be misled because payment derives from large
numbers of the broker's own or other customer's orders directed to
various marketplaces which may be unrelated to that particular
customer's business with the broker-dealer. Still others believe
that such disclosure may lead to the misperception that investors
are being disadvantaged.
It should be noted that the same commenters opposing aggregate
disclosure of monetary compensation also oppose the Commission's
proposal regarding confirmation disclosure of monetary compensation.
See infra Section III.C. (Customer Confirmation Statements). In
contrast, some commenters suggest quantification requirements extend
to non-monetary inducements for order flow and to internalization.
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C. Customer Confirmation Statements
As proposed, amended Rule 10b-10(a)(7)(iii)\38\ required customer
confirmations to disclose whether any payment for order flow has been
received for a national market system security and the amount of any
monetary payment, discount, rebate or reduction of fee. More than 30
commenters expressed concern about the proposed requirement that
broker-dealers disclose on customer order confirmations the amount of
any monetary payment, discount, rebate or reduction of fee received in
connection with a transaction in a national market system security.
Most of these commenters considered this unworkable.\39\
\38\Currently, the Commission's confirmation disclosure rule,
Rule 10b-10 under the Act, requires that confirmations sent to
customers for agency transactions disclose the ``price'' of the
security purchased or sold by the customer, as well as the
remuneration paid to the broker-dealer by the customer in the trade.
Rule 10b-10 also requires broker-dealers to disclose the source and
amount of any other remuneration received in connection with a
transaction. In most transactions, however, the Rule permits broker-
dealers merely to state ``whether any other remuneration has been or
will be received,'' and to furnish the source and amount of such
other remuneration on written request.
\39\Several commenters argue that specific confirmation
disclosure is nearly impossible considering that brokers have a
variety of arrangements with firms which often include conditions,
such as requiring a minimum amount of order flow per month before
payments begin; different rates for low-priced securities; and
graduated payments based on dollar volume per month. Others argue
that it would place an extreme burden on recipient broker-dealers to
determine that amount of order flow received for each order in time
for a confirmation. Several commenters also argue that specific
disclosure would require broker-dealers to reprogram computer
systems, perform tracking and report cash payments, and that such
expenses are disproportionately high in relation to the potential
benefits to customers. Some commenters recommend a generic
disclosure statement which would eliminate the high cost of systems
changes, yet still inform the customer as to the receipt of payment
for order flow. Another concern raised by opponents of the
Commission's proposal is that payment is given for an aggregation of
orders directed to a particular market center and does not attach to
a particular order.
In response to commenters' concerns, the Commission has modified
the Rule to require a statement on order confirmations that payment for
order flow is received by the broker or dealer and that the source and
nature of the payment for order flow received in connection with the
particular transaction will be furnished upon written request of the
customer.\40\ The Commission has determined to allow broker-dealers to
conform the statement to the firm's practices, for instance,
specifically noting that it limits the receipt of payment for order
flow to market orders only, if applicable. Because the definition of
payment for order flow includes non-monetary forms of payment for order
flow, broker-dealers will be expected to include those forms of
compensation in preparing confirmations and to provide the nature and
source of the compensation upon written request. The Commission
believes that the Rule, as modified, retains informative disclosure to
investors.\41\ The Commission recognizes that information on the
confirmation may not communicate all information of interest to
investors about payment for order flow or the quality of order
execution. The role of the required disclosures on the confirmation is
more limited and is intended to inform customers about the existence of
payment for order flow practices and to confirm that which the
customer, if interested, already should know about the broker's order
handling practices as a result of the new account and annual disclosure
statements.
\40\In the Companion Release, the Commission solicits comment on
whether broker-dealers should be required to provide ranges, on
confirmations, of monetary and non-monetary payment for order flow
received and quantification of internalization/affiliate practices
on a per share basis. See Companion Release, supra note 5.
\41\The Commission, however, is proposing in a parallel action,
to require quantification of monetary and non-monetary compensation
and internalization. Id.
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IV. Alternative Proposals
The Commission also solicited comment in the Proposing Release on
alternative approaches to regulating the practice of payment for order
flow. The Commission invited commenters to address such alternatives as
banning payment for order flow and requiring the broker-dealers to pass
payment for order flow through to their customers,\42\ and directing
securities markets to convert quotations to decimal-based pricing from
the current one-eigth fractions. The Commission, however, has
determined that these approaches are not the appropriate regulatory
response at this time.
\42\No commenters fully supported the alternative of passing
payments through to customers. Three commenters, however, oppose the
alternative and argue that the economic advantages of order flow
payments already benefit customers of retail firms in the form of
lower commission rates. Moreover, some argue compulsory remission of
payments may be administratively burdensome for brokers and
difficult to enforce due to the difficulty in allocating direct
payments for particular orders.
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A. Banning Payment for Order Flow
The Commission believes disclosure is the appropriate response to
the issue raised by payment for order flow. The Commission does not
believe that all payment for order flow arrangements are against the
customer's best interest and must be banned per se as compromising a
broker's duty to seek best execution of the customer's order.\43\ For
example, it is unclear what harm lurks in specialists' or market
makers' payment for order flow practices if unpriced orders are subject
to a meaningful opportunity for price improvement, or if other benefits
are provided to the customer due to the dealer's ability to use the
payments. Additionally, the disclosures required by the new Rule and
Rule amendments should mitigate concerns opponents may have that
investors are unaware of a broker-dealer's order routing practices.
\43\See NASD Rules of Fair Practice, Art. III, section 1,
Interpretation of the Board of Governors on Execution of Retail
Transactions in the Over-The-Counter Market; and Section
11A(a)(1)(D) of the Act, 15 U.S.C. Sec. 78k-1(a)(1)(D) (1988).
Broker-dealers also 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. See SEC v. Great
Lake Equities Co., 755 F. Supp. 211 (E.D. Mich. Sept. 4, 1990); and
N. Wolfson, R. Phillips & T. Russo, Regulation of Brokers, Dealers
and Securities Markets para.2.10, at 2-51 (1977).
An outright ban at this time, moreover, would represent a radical
change to the industry where the payment of cash or its monetary
equivalent has become widespread.\44\ In addition, banning payment for
order flow has associated workability problems.\45\ If the practice of
cash payment for order flow were banned, because it is only one of many
forms of inducement for order flow, the Commission has every reason to
believe that an attendant increase in related ``soft'' inducements for
order flow or internalization of order flow would follow.\46\ Moreover,
it would be impractical to attempt to ban solely soft practices
(everything except monetary payment for order flow); such practices are
difficult to monitor and industry participants would find alternative
avenues for accomplishing the same result. The Commission will continue
to monitor developments and will consider additional regulatory steps
if necessary to ensure the protection of investors.
\44\Some commenters favor a complete ban on payment for order
flow; others favor a ban on cash payments only.
\45\Opponents of a ban argue that payment for order flow is not
illegal or unethical and that banning payment for order flow would
pose serious workability problems regarding banning some, but not
all, practices.
\46\The Commission recognizes that in urging a complete ban,
some commenters are looking to address a potential conflict of
interest that they believe affects a dealer's ability to meet its
fiduciary duties to customers and provide a level playing field for
exchange and OTC markets in exchange listed stocks.
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B. Decimal Pricing
The Commission also solicited comment on adopting a decimal-based
system for the pricing and reporting of all securities for which
transactions are reported. Some commenters believe that payment for
order flow is, in effect, a reduction in the spread that a market maker
charges for executing a pre-determined package of order flow. Under
this view, if the NBBO is 20 bid and 20\1/4\ offered, these commenters
view the payment of two cents a share for order flow as little more
than an indication that, in effect, a market maker is willing to buy at
20.02 and willing to sell at 20.23. Accordingly, these commenters
believe that if a decimal pricing system were adopted, market makers
could more easily compete by narrowing their displayed quotes,
resulting in reduced incentive to pay for order flow. Others question
whether the availability of decimals would, in fact eliminate payment
for order flow because market makers still only may want to pay for
certain types of orders (e.g., a diverse group of small market orders)
and, as a result, may not lower their published quotes.
The Commission believes that decimal pricing is the logical next
step for the markets to pursue to improve the transparency of the
markets and provide opportunities for narrower spreads.\47\ Indeed, as
an interim measure, the Commission's staff called for the markets to
move to pricing in \1/16\ths in the near future.\48\ In this regard,
the Commission understands the markets have undertaken a study of the
costs and benefits of changing the current display mechanisms.\49\ The
Commission looks forward to the prompt completion of the SRO study and
the ultimate implementation of revised pricing procedures. While it is
currently unclear how decimalization would affect payment for order
flow practices, the Commission will monitor the progress of such
endeavors and is prepared to reconsider the Rules adopted today, and
even to rescind them if decimal pricing or other reforms render payment
for order flow obsolete.
\47\See Market 2000, supra note 3, Study IV at 8-9.
\48\In January 1994, the Division recommended the adoption of a
\1/16\th of a dollar increment as a transitional step leading to
decimal pricing. See id. at 9.
\49\On June 22, 1994, the Subcommittee on Telecommunications and
Finance of the House Committee on Energy and Commerce held a hearing
regarding decimal-based pricing and unlisted trading privileges.
Panelists included: Richard Ketchum, Executive Vice President and
Chief Operating Office, NASD; Edward Kwalwasser, Executive Vice
President for Regulation, NYSE, Nicholas Giordano, President and
Chief Executive Officer, Phlx; and Brandon Becker, Director,
Division of Market Regulation, SEC. Congressman Markey and the
panelists discussed decimal pricing and moving to sixteenths as an
interim measure. Congressman Markey asked the self-regulatory
organizations (``SROs'') to undertake a joint study, to be completed
by January 1995, of the implications of moving to sixteenths (as
well as decimal pricing) and the costs and benefits associated with
the move. All of the SRO panelists agreed to participate in the
study. The Unlisted Trading Privileges Act of 1994 and Review of the
SEC's Market 2000 Study: Hearings Before the Subcomm. on
Telecommunications and Finance of the House Comm. on Energy and
Commerce, 103d Cong., 2d Sess. (1994).
V. Implementation Date
The Commission is setting April 3, 1995 as the implementation date
for both the amendments to Rule 10b-10 and Rule 11Ac1-3. Thus, for
orders received or trades effected on or after April 3, 1995, all
customer confirmation statements must contain the new disclosures
required by Rule 10b-10, as modified today. For all new accounts opened
on or after April 3, 1995, the disclosures required by Rule 11Ac1-3
will be in effect. For existing accounts, the disclosures required by
Rule 11Ac1-3 should be made to customers beginning with the first
commercially reasonable date after April 3, 1995, but in no event,
later than April 3, 1996. For example, if a firm provides annual
disclosure statements in January of each year, the disclosures should
be made beginning with the January 1996 account statement. If the firm
provides quarterly statements, the disclosures should be made beginning
with the July 1995 account statement.
The April 3, 1995 date was selected to provide firms with four
months to make the necessary systems and forms changes to prepare for
the implementation.
VI. Competition Findings
Section 23(a)(2) of the Act\50\ requires the Commission in adopting
rules under the Act, to consider the anti-competitive effects of such
rules, if any, and to balance any impact against the regulatory
benefits gained in terms of furthering the purposes of the Act. The
Commission believes the proposed Rules will enhance competition among
brokers, dealers, and market centers, consistent with the goals of
Section 11A and 23(a) of the Act. Several commenters raised concerns
that the Rules, as proposed, would require substantial systems changes
and therefore, would increase the costs of doing business which would
be passed on to customers. The Commission has modified the portion of
proposed Rule 10b-10(a)(7)(iii)(B) requiring individualized
confirmation disclosure of and the amounts of monetary payment for
order flow received. The Rule, as adopted, may eliminate the need for
individualized disclosures and for the quantification of payment for
order flow. The Commission intends to evaluate these issues further in
connection with its Companion Release soliciting comment on amendments
to Rule 10b-10 and Rule 11Ac1-3(a)(2).\51\ The Commission has
considered Rule 11Ac1-3 and amendments to Rule 10b-10 in light of the
standard cited in Section 23(a)(2) and believes that adoption of the
Rules, as modified, will not impose any burden on competition not
necessary or appropriate in furtherance of the purposes of the Act.
\50\15 U.S.C. 78w(a)(2).
\51\See Companion Release, supra note 5.
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VII. Conclusion
The Commission believes that Rule 11Ac1-3 and amendments to Rule
10b-10(a)(7))iii) and 10b-10(e) will provide relevant, uniform
disclosure to customers regarding details of their order executions. It
is the Commission's view that the Rule and Rule amendments will enhance
investor protection and further competition for retail orders by
enabling customers to evaluate better the markets to which their orders
are routed. The Commission further believes that broker-dealers can
make the necessary systems and forms changes to comply with the Rules,
as amended, with limited resource and systems changes. The Commission
recognizes, however, that the extent and nature of the modifications
depends upon the current capabilities of each firm. Nevertheless, the
Commission recommends that, as necessary, broker-dealers that need to
make systems changes evaluate their progress as the implementation date
approaches and make adjustments as appropriate to ensure a smooth
transition to the enhanced disclosure of payment for order flow.
VIII. Summary of Final Regulatory Flexibility Analysis
The Commission has prepared a Final Regulatory Flexibility Analysis
(``FRFA'') regarding Rules 10b-10 and 11Ac1-3, in accordance with 5
U.S.C. 604. The FRFA notes the potential costs of operational and
procedural changes that may be necessary to comply with the Rule. A
copy of the FRFA may be obtained by contacting Jill W. Ostergaard,
Attorney, Branch of the National Market System, Office of Market
Supervision, Division of Market Regulations, Securities and Exchange
Commission, 450 Fifth Street NW. , Mail Stop 5-1, Washington, DC 20549.
List of Subjects in 17 CFR Part 240
Brokers and dealers, Registration and regulation, Securities.
Text of the Amendments
For the reasons set out in the preamble, the Commission amends Part
240 of Chapter II of Title 17 of the Code of Federal Regulations to
read as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The general authority citation for part 240 is revised to read
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p,
78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-
37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
2. By amending Sec. 240.10b-10 by redesignating paragraph
(a)(7)(iii) as paragraph (a)(7)(iv), adding paragraphs (a)(7)(iii) and
(e)(9), and revising paragraph (a)(8) to read as follows:
Sec. 240.10b-10 Confirmation of transactions.
(a) * * *
(7) * * *
(iii) For a transaction in any subject security as defined in
Sec. 240.11Ac1-2 or a security authorized for quotation on an automated
interdealer quotation system that has the characteristics set forth in
Section 17B of the Act (15 U.S.C. 78q-2), a statement whether payment
for order flow is received by the broker or dealer for transactions in
such securities and that the source and nature of the compensation
received in connection with the particular transaction will be
furnished upon written request of the customer; and
(8) If he is acting as principal for his own account. (i)(A) If he
is not a market maker in that security and, if, after having received
an order to buy from such customer, he purchased the security from
another person to offset a contemporaneous sale to such customer or,
after having received an order to sell from such customer, he sold the
security to another person to offset a contemporaneous purchase from
such a customer, the amount of any mark-up, mark-down, or similar
remuneration received in an equity security; or
(B) In any other case of a transaction in a reported security, the
trade price reported in accordance with an effective transaction
reporting plan, the price to the customer in the transaction, and the
difference, if any, between the reported trade price and the price to
the customer.
(ii) In the case of a transaction in an equity security, whether he
is a market maker in the security (otherwise than by reason of his
acting as a block positioner in that security).
* * * * *
(e) * * *
(9) Payment for order flow shall mean 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 exchange, registered 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.
* * * * *
3. Section 240.11Ac1-3 is added to read as follows:
Sec. 240.11Ac1-3 Customer account statements.
(a) No broker or dealer acting as agent for a customer may effect
any transaction in, induce or attempt to induce the purchase or sale
of, or direct orders for purchase or sale of, any subject security as
defined in Sec. 240.11Ac1-2 or a security authorized for quotation on
an automated inter-dealer quotation system that has the characteristics
set forth in section 17B of the Act (15 U.S.C. 78q-2), unless such
broker or dealer informs such customer, in writing, upon opening a new
account and on an annual basis thereafter, of the following:
(1) The broker's or dealer's policies regarding receipt of payment
for order flow as defined in Sec. 240.10b-10(e)(9), from any broker or
dealer, national securities exchange, registered securities
association, or exchange member to which it routes customers' orders
for execution, including a statement as to whether any payment for
order flow is received for routing customer orders and a detailed
description of the nature of the compensation received; and
(2) The broker's or dealer's policies for determining where to
route customer orders that are the subject of payment for order flow as
defined in Sec. 240.10b-10(e)(9) absent specific instructions from
customers, including a description of the extent to which orders can be
executed prices superior to the best bid or best offer as defined in
Sec. 240.11Ac1-2.
(b) Exemptions. The Commission, upon request or upon its own
motion, may exempt by rule or by order, any broker or dealer or any
class of brokers or dealers, security or class of securities from the
requirements of paragraph (a) of this section with respect to any
transaction or class of transactions, either unconditionally or on
specified terms and conditions, if the Commission determines that such
exemption is consistent with the pubic interest and the protection of
investors.
By the Commission.
Dated: October 27, 1994.
Jonathan G. Katz,
Secretary.
[FR Doc. 94-27109 Filed 11-1-94; 8:45 am]
BILLING CODE 8010-01-P-M