AUGUST 8, 2016
SIDLEY UPDATE
SEC Proposes Rules to Enhance Order Handling Information
Available to Investors
On July 13, 2016, the U.S. Securities and Exchange Commission (SEC) voted unanimously to propose
amendments to Rule 606 of Regulation NMS1 to enhance order handling information available to investors. 2
The proposed amendments to Rule 606 would require broker-dealers to disclose their handling of “institutional
orders” upon request and in an aggregate quarterly report, as well as expand existing disclosure obligations
related to retail customer orders.
The proposed disclosures regarding institutional orders would require a broker-dealer to provide its customer
detailed order handling information, including a wide variety of performance metrics such as the fill rate and the
number and percentage of shares receiving price improvement at each venue. A broker-dealer would also be
required to aggregate information regarding its handling of institutional orders across all customers and make
this report publicly available each quarter. These quarterly reports would allow for a standardized comparison of
each broker-dealer’s performance with respect to institutional orders against its competitors.
The proposed amendments would require significantly greater disclosure of a broker-dealer’s financial
incentives to route both retail customer and institutional orders to a particular trading venue. For example, a
broker-dealer would be required to disclose the average net execution fee or rebate it receives at each venue for
institutional orders and the net aggregate amount of any payment for order flow received at each venue for retail
customer orders.
If the proposal to amend Rule 606 is adopted, broker-dealers will face significant costs related to the generation
of the institutional order reports. Nonetheless, the proposal largely reflects industry support for expanded and
standardized routing disclosure, so it appears reasonably likely that some version of the proposal will be
adopted.
Background – Rule 606 Today
Currently, Rule 606 requires broker-dealers to disclose order routing information with respect to non-directed
“customer” orders. A customer order generally means a non-broker-dealer order for less than $200,000 for
equities or $50,000 for options. Accordingly, the existing disclosure obligations under Rule 606 only apply to
smaller-sized orders, i.e., retail orders.
1
17 CFR 242.606.
2
See Securities Exchange Act Release No. 78309 (July 27, 2016), available at: https://www.gpo.gov/fdsys/pkg/FR-2016-07-27/pdf/2016-16967.pdf.
Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a
lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New
York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.
SIDLEY UPDATE
Page 2
The current reporting obligations require quarterly disclosure by broker-dealers of, among other things, the
identity of the venues, such as exchanges or alternative trading systems, to which five percent or more of retail
orders are sent and certain statistics such as the number of market orders or limit orders sent to each venue.
Broker-dealers are also required to disclose the material aspects of their relationship with each such venue,
including any payment for order flow arrangement or profit-sharing relationship.
Under Rule 606, broker-dealers must also disclose, upon the request of a customer, the identity of the venue to
which the customer’s orders were routed for execution and certain related information for the six months prior
to the request.
The Impetus for the Proposal
Because Rule 606 disclosures only apply to smaller-sized retail orders, institutional investors executing
larger-sized orders generally did not benefit from the rule. Although certain large institutional investors may be
able to leverage their market size to obtain order routing information from their broker-dealers, smaller
institutional investors may not have this bargaining power. Accordingly, there is no standardized order handling
information with respect to institutional orders.
In addition, because of their larger size, institutional orders tend to be routed and executed using algorithms
that break their orders into smaller orders that are sent to a variety of venues. This may lead to information
leakage, whereby a institutional investor’s interest in buying or selling a particular security may be revealed to
the market before its order can be fully executed. Information leakage may lead to additional costs as other
market participants, aware of the presence of large institutional order, may use this information to their
advantage. Thus, understanding how or where a broker-dealer routes large orders is particularly important to
institutional investors.
The above concerns, among others, prompted the Investment Company Institute (ICI) and the Securities
Industry and Financial Markets Association (SIFMA) to propose certain enhancements to Rule 606 in 2014. 3
The SEC appears to have taken notice, as its proposed rules closely track the ICI/SIFMA proposal with a few
exceptions.
Disclosures Related to Institutional Orders
As noted, the proposal would require broker-dealers to provide their customers with standardized information
about their handling of institutional orders and execution quality. Under the proposal, an institutional order
would generally be defined as a non-broker-dealer order for a quantity of NMS stock with a market value of at
least $200,000. The term “NMS stock” generally includes all stocks listed on national securities exchanges.
Notably, the disclosure obligations for institutional orders would not extend to transactions in options.
3 Letter to Mary Jo White, Chair, SEC, from Dorothy M. Donohue, Deputy General Counsel, ICI, Stuart J. Kaswell, Executive Vice President &
Managing Director, General Counsel, Managed Funds Association, and Randy Snook, Executive Vice President, SIFMA, dated October 23, 2014,
available at: http://www.sec.gov/comments/s7-02-10/s70210-428.pdf.
SIDLEY UPDATE
Page 3
Customer-Specific Report on Institutional Order Handling
Upon the request of a customer, a broker-dealer would be required to provide specific monthly data for the
previous six months relating to: (i) the handling of the customer’s institutional orders at the broker-dealer, e.g.,
the number of shares internalized by the broker-dealer; (ii) the routing of the customer’s institutional orders to
other venues; (iii) the quality of execution of those institutional orders; and (iv) whether the customer’s
institutional orders added or took liquidity and the average net execution fee or rebate. The metrics relating to
quality of execution include: the fill rate; the total number and percentage of shares executed at the midpoint;
and the total number and percentage of shares priced on the side more (and less) favorable to the institutional
order.
Under the proposal, a broker-dealer would have to disclose quality of execution metrics for each venue in the
aggregate and broken down based on an institutional order’s routing strategy. Specifically, a broker-dealer
would be required to group institutional orders, in a consistent manner, into either: (i) passive strategies, i.e.,
strategies that emphasize minimizing the price impact; (ii) neutral strategies; and (iii) aggressive strategies, i.e.,
strategies that prioritize speed of execution over price impact. The SEC believes that organizing the institutional
order reports based on routing strategy may provide customers with more useful information that takes account
of customers’ varying needs at a particular point in time, e.g., a customer might use an aggressive strategy when
trying to quickly liquidate a position. A broker-dealer would be required to document the specific methodologies
it relies upon for assigning a particular strategy to one of these categories and preserve these methodologies as
part of its books and records.
Of particular note is the requirement that a broker-dealer disclose the average net execution fee or rebate for a
customer’s institutional orders. The SEC believes that requiring disclosure of the average net execution fee or
rebate may shed light on the economic incentives of a broker-dealer in handling institutional orders and may
help institutional investors assess any potential conflicts of interest a broker-dealer may face. For example, the
SEC stated in the proposal that an institutional investor would be able to assess the average net execution fee at
a particular venue in light of performance of that venue on other metrics such as the venue’s fill rate.
The proposal would also require certain disclosures regarding the number of institutional orders exposed by a
broker-dealer through an actionable indication of interest (actionable IOI) and the venues where they were
exposed. Under the proposal, an actionable IOI would generally be defined as any indication of interest that
conveys the: (i) symbol; (ii) side, i.e., buy or sell; (iii) a price equal to or better than the prevailing best bid or
offer; and (4) a size of at least one round lot, i.e., 100 shares. Because actionable IOIs effectively communicate all
of the material terms of an institutional order and thus have the potential to result in information leakage by
signaling the presence of the institutional order, the SEC generally believes that customers would find such
disclosures useful in assessing a broker-dealer.
Publicly Available Aggregated Report on Institutional Order Handling
Under the proposal, broker-dealers would also be required to publicly disclose the institutional order
information described above on an aggregated basis across all customers for all institutional orders received. A
SIDLEY UPDATE
Page 4
broker-dealer would be required to post these reports on a website that is free and readily accessible to the
public for a period of three years from the date of initial posting. 4
The proposed aggregated institutional order handling report would not disclose the customers of the
broker-dealer. The SEC stated that it believes that the design of the report would not provide other market
participants with information that would allow them to reverse engineer a broker-dealer’s proprietary order
handling techniques.
Enhancements to Disclosures Relating to Retail Orders
To enhance the existing disclosure requirements of Rule 606, the proposal would rename the term “customer
order,” i.e., a non-broker-dealer order for less than $200,000 for equities or $50,000 for options, to “retail
order.” The two most significant changes to the existing Rule 606 reporting requirements with respect to retail
order are to require separate reporting of marketable versus non-marketable limit orders, and greater detail with
respect to the financial incentives that might influence the broker-dealer’s routing decisions. Under the
proposal, broker-dealers would be required to post these reports on a website that is free and readily accessible
to the public for a period of three years from the date of initial posting.
Rule 606 does not currently distinguish between marketable limit orders, i.e., orders that are immediately
executable against the prevailing best bid or offer, and non-marketable limit orders, i.e., orders priced such that
they are not immediately executable. Whether an order is marketable or non-marketable is a significant factor in
determining how a broker-dealer will route the particular order. For example, a broker-dealer may post a nonmarketable order on a venue that provides a rebate for adding liquidity. Consequently, the proposal would
require existing Rule 606 reports to distinguish between these types of limit orders to allow customers to better
assess a broker-dealer’s routing determinations.
Payment for Order Flow
To enhance disclosure obligations relating to a broker-dealer’s financial incentives, the proposal would require
that a broker-dealer disclose the net aggregate amount of any payment for order flow received or payment from
any profit-sharing arrangement based on each order type, e.g., market order, marketable limit order etc., for
each venue to which it sends five percent or more of its retail orders. These payments or rebates would be
disclosed both as a total dollar amount and on a per share basis.
The SEC is proposing to require that a broker-dealer provide greater detail surrounding its discussion of the
material aspects of its payment for order flow or profit-sharing relationship with each venue to which it routes
retail orders. Specifically, a broker-dealer would be required to include in this discussion a description of the oral
or written terms of the arrangements that may influence the broker-dealer’s order routing decision, including:
(i) incentives for equaling or exceeding an order flow volume threshold; (ii) disincentives for failing to meet
minimum order flow volume thresholds; and (iii) agreements to send a minimum amount of order flow to a
particular venue.
Comments on the proposal should be received on or before September 26, 2016.
4 The SEC is also proposing to require that broker-dealers post order execution reports required pursuant to Rule 605 on a website that is free and
readily accessible to the public for a period of three years from the date of initial posting.
SIDLEY UPDATE
Page 5
If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or
James Brigagliano
Partner
[email protected]
+1 202 736 8135
Michael D. Wolk
Partner
[email protected]
+1 202 736 8807
Mark Borrelli
Partner
[email protected]
+1 312 853 7531
Andrew P. Blake
Partner
[email protected]
+1 202 736 8977
Charles A. Sommers
Associate
[email protected]
+1 202 736 8125
Securities & Derivatives Enforcement and Regulatory Practice
Sidley’s Securities & Derivatives Enforcement and Regulatory group advises and defends clients in a wide range of securities- and
derivatives-related matters. With more than 150 lawyers in 10 offices worldwide, we provide comprehensive regulatory,
enforcement, and litigation solutions in matters involving the Securities and Exchange Commission (SEC), the Commodity Futures
Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), self-regulatory organizations (SROs), state
attorneys general and state securities regulators. Our team is distinctive in that it combines the strength of nationally recognized
enforcement lawyers with the skills of equally prominent counseling lawyers. We work collaboratively to provide our clients with
informed, efficient and effective representation.
To receive Sidley Updates, please subscribe at www.sidley.com/subscribe.
BEIJING ∙ BOSTON ∙ BRUSSELS ∙ CENTURY CITY ∙ CHICAGO ∙ DALLAS ∙ GENEVA ∙ HONG KONG ∙ HOUSTON ∙ LONDON
LOS ANGELES ∙ MUNICH ∙ NEW YORK ∙ PALO ALTO ∙ SAN FRANCISCO ∙ SHANGHAI ∙ SINGAPORE ∙ SYDNEY ∙ TOKYO ∙
WASHINGTON, D.C.
Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer.
www.sidley.com