Practitioner's Guide for Broker-Dealers Chapter 11 Trade reporting and compliance

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1 Practitioner's Guide for Broker-Dealers Chapter 11 Trade reporting and compliance Author Ida Wurczinger Draim Ida is a partner in the Washington, DC office of Schulte Roth & Zabel. Her practice focuses on securities and commodities compliance counseling and the representation of securities industry and corporate clients in regulatory investigations and proceedings. With more than 25 years of experience, Ida is known for her expertise in investment adviser and broker-dealer compliance and her highly effective representation of industry clients before the SEC, NYSE, FINRA, CFTC, NFA and other regulatory authorities. Some of the areas that Ida addresses on behalf of her investment adviser clients include conflicts of interest, Form ADV disclosure, third-party marketing arrangements, soft-dollar practices, personal trading compliance, principal and agency trades, advertising, valuation, best execution, custody, trading restrictions and prohibitions, and commodity pool operator registration and regulatory issues. In the broker-dealer context, Ida regularly deals with Regulations NMS and SHO, best execution, dark pools, prime brokerage functions, institutional and retail sales practices, insider trading and rumors, marketing materials, research, short-sale restrictions, supervisory structure, trade surveillance and monitoring, and statutory disqualifications. In addition, Ida supervises mock audits, advises clients undergoing regulatory examinations and inspections, provides compliance training and develops supervisory and compliance policies and procedures. After several years as a securities litigation associate with a Wall Street law firm, Ida joined the SEC, first serving as staff attorney in the Division of Enforcement, where she earned a Special Achievement award, then as special counsel to SEC chairman John Shad. She is a member of the FINRA Board of Arbitrators and Board of Mediators, and for 10 years she served as a member of the Nasdaq Listing Qualifications Panel. Ida is a panelist and member of the SIFMA Legal and Compliance Division and a former chair of the Corporation, Finance and Securities Law Section of the District of Columbia Bar. Ida received her JD from Harvard Law School and BA (cum laude) from Rutgers University. She has been recognized by The Best Lawyers in America ( ) in the area of securities law. Ida can be contacted at ida.draim@srz.com

2 Introduction Under the current market structure, highly automated trading centers compete for order flow in the same stocks and price competition is facilitated through the simultaneous display of competing quotations by a number of trading venues. The transformation in equity trading has come about in large part due to the continual evolution of technologies for generating, routing, displaying and executing orders, which has greatly improved the speed, capacity and sophistication of the trading functions that are available to market participants. The dramatic change in the trading markets also reflects the impact of regulatory initiatives and developments such as the adoption of the Securities and Exchange Commission's (SEC) order handling rules in 1996, the prosecution of anti-competitive behavior among market makers in Nasdaq stocks during the late 1990s and the adoption of SEC Regulation NMS in This chapter provides a primer for broker-dealers on certain trading-related regulatory initiatives through which the SEC has sought to achieve greater transparency and price competition on the secondary trading markets. It also addresses certain trading-related restrictions and prohibitions through which the SEC has sought to ensure fairness among market participants, and prevent market abuse and manipulation. Trading markets overview Contents in this section The National Market System (NMS) Registered exchanges Electronic communication networks (ECNs) Dark pools Broker-dealer internalization The National Market System (NMS) In Section 11A of the Securities Exchange Act of 1934 (Exchange Act), enacted in 1975, Congress directed the SEC to facilitate the establishment of a national market system in furtherance of five main objectives: economically efficient execution of securities transactions fair competition among brokers and dealers, among exchange markets, and between exchange markets and other non-exchange markets the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities the practicability of brokers executing investors' orders in the best market an opportunity, consistent with the other objectives above, for investors' orders to be matched and executed without the participation of a dealer Section 11A also sets forth Congress' finding that "the linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to best execution of such orders." The current structure of the trading markets is defined by the five main objectives and the use of intermarket linkages to achieve them.

3 Registered exchanges Section 6 of the Exchange Act provides for registration of "national securities exchanges" with the SEC, provided that such exchanges undertake self-regulatory responsibility for their members, file their proposed rule changes for approval with the SEC, publicly disclose and obtain SEC approval for their trading services and fees; and institute certain forms of self-governance. The principal registered exchanges in the United States are: Nasdaq New York Stock Exchange (NYSE) NYSE Arca BATS Exchange Nasdaq OMX BX Registered exchanges as a group accounted for approximately 64 percent of the trading volume in US publicly-traded equities as of the end of the third quarter of The registered exchanges all have highly automated trading systems that facilitate extremely high-speed or "low-latency" order execution. Many of these exchanges offer co-location services that enable exchange market participants to place their servers in close proximity to the exchange's matching engine, thereby further reducing latency. Order types Registered exchanges typically offer a wide range of order types; some orders are displayed in full to other market participants if they are not executed immediately; others are undisplayed in full or in part. For instance, a reserve order will display part of the size of the order at a particular price, while holding the balance of the order in reserve and refreshing the displayed size as needed. See, e.g., BATS Rule In general, displayed orders are given execution priority at any given price over fully undisplayed orders and the undisplayed size of reserve orders. See, e.g., BATS Rule "Maker-taker pricing" Trading on the traditional exchanges, such as the NYSE, was previously dominated by specialists and overthe-counter (OTC) market makers. In an effort to attract liquidity providers, however, many exchanges recently have adopted a "maker-taker" pricing model. Under this model, non-marketable, resting orders that offer (make) liquidity at a particular price receive a liquidity rebate if they are executed, while incoming orders that execute against (take) the resting orders are charged an access fee. SEC Rule 610(c) of Regulation NMS caps the amount of the access fee for executions against the best displayed prices of an exchange at 0.3 cents per share. 1 SEC Release No at 16.

4 Electronic communication networks (ECNs) An ECN is a type of alternative trading system (i.e., a virtual marketplace for bringing together purchasers and sellers of securities) that is operated by a broker-dealer and whose participants are known as "subscribers." ECNs are required to comply with SEC Regulation ATS. The most important characteristic of an ECN is that it submits its best-priced orders for inclusion in the consolidated quotation data, either voluntarily or because it is required to do so under SEC Rule 301(b)(3) of Regulation ATS. ECNs offer trading services, such as displayed and undisplayed order types, maker-taker pricing and data feeds, that are similar to those offered by registered exchanges. As of the end of the third quarter of 2009, the five ECNs that actively trade US publicly-traded equities accounted for approximately 11 percent of share volume. 2 2 SEC Release No at 19. Dark pools A dark pool is an alternative trading system operated by a broker-dealer that, in contrast to an ECN, does not submit its best-priced orders for inclusion in the consolidated quotation data. Like ECNs, dark pools are required to comply with SEC Regulation ATS; however, they do not display their subscribers' orders and hence are not subject to mandatory submission of best-priced orders for inclusion in consolidated quotation data. Institutional investors and other market participants use dark pools to execute large trades in a manner that will minimize the movement of prices against them. As of the end of the third quarter of 2009, there were approximately 32 dark pools that actively traded US publicly-traded equities and they executed approximately 8 percent of share volume in such stocks. 3 3 SEC Release No at 18. Broker-dealer internalization Broker-dealers that do not operate alternative trading systems but execute customer orders solely through their internal resources, either as an agent matching their customers' buy and sell orders or as a principal taking the other side of those orders, are engaged in a practice known as "internalization." These internalized executions are not included in the consolidated quotation data. Broker-dealer internalization accounts for approximately 17 percent of share volume in US publicly-traded equities. Trade execution requirements Contents in this section SEC Regulation NMS SEC Regulation NMS The SEC adopted Regulation NMS in April 2005 to strengthen the linkage of individual markets in a unified system that promotes interaction among the orders of buyers and sellers in a particular NMS stock, thereby facilitating pricing efficiency. There are many aspects to Regulation NMS; this Chapter primarily will address those that directly relate to trade execution by broker-dealers. One of the keys to interpreting Regulation NMS's provisions relating to trade execution consists of the definitions in SEC Rule 600.

5 SEC Rule 600 defines "NMS stock" as: any security or class of securities [other than options] for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan Currently, there are three such reporting plans: the CTA Plan, which is operated by the Consolidated Tape Association the CQ Plan, which disseminates consolidated quotation information for exchange-listed securities the Nasdaq UTP Plan, which disseminates consolidated transaction and quotation information for Nasdaq-listed securities In addition, SEC Rule 600 defines "protected bid" or "protected offer" as: a quotation in an NMS stock that: (i) is displayed by an automated trading center (essentially an order execution facility that displays quotations, including an exchange or ECN); (ii) is disseminated pursuant to one of the three above-mentioned reporting plans; and (iii) is the best bid or best offer of a national securities exchange or The Nasdaq Stock Market (known as the "NBBO") Finally, SEC Rule 600 defines "trade-through" as: the purchase or sale of an NMS stock during regular trading hours, either as principal or agent, at a price that is lower than a protected bid or higher than a protected offer For purposes of Regulation NMS, a broker-dealer is one or more of the following: an "automated trading center" a "trading center" an "order-router" Automated trading centers and trading centers are essentially order execution facilities, including exchanges, alternative trading systems or broker-dealers that internalize order flow. The difference between them is that an automated trading center directly displays protected bids and offers in the three reporting plans (CTA, CQ and UTP) by participating in FINRA's Alternative Display Facility (ADF), whereas a trading center does not. "Order routers" are broker-dealers that are responsible for the routing of orders in NMS stocks on behalf of customers or themselves to trading centers and automated trading centers. SEC Rule 600(b)(4) requires all automated trading centers to implement the technology and procedures necessary to enable the firm to display quotations that meet the rule's specifications regarding display of quotations, order marking, trade execution and confirmation of trades. Only automated trading centers display the protected bids and offers that are subject to the order protection rule. SEC Rule 611 (known as the "order protection rule") requires every automated trading center and trading center to: establish, maintain and enforce written policies and procedures designed to prevent trade-throughs regularly surveil to ascertain the effectiveness of such policies and procedures take prompt action to remedy any deficiencies that permit trade-throughs to occur

6 SEC Rule 611 contains a number of exceptions to the prohibition against trade-throughs. The most widelyused exception is that for "intermarket sweep orders" (ISOs), which are defined in SEC Rule 600 as: a limit order for an NMS stock that (i) upon routing to a market center is identified as an ISO; and (ii) simultaneously with the routing of that ISO, there are one or more limit orders (also marked as ISOs) routed to execute against the full displayed size of any protected bid (in the case of a limit sell ISO) or any protected offer (in the case of a limit buy ISO) with a price that is superior to the limit price of the first ISO While not directly subject to SEC Rule 611, order routers can control the handling of the orders that they submit to automated market centers and market centers to comply with SEC Rule 611 through three means: the use of a limit price an "immediate or cancel" (IOC) order designation an ISO designation Use of a limit price precludes any execution at a price inferior to such price. Use of an IOC designation triggers the requirements for automated quotations set forth in SEC Rule 600(b)(3) of Regulation NMS, particularly the requirement that the trading center provide an immediate response to the order, which must be a fill, in full or in part, or a non-fill, and a cancellation of any unfilled balance of the order, without routing the order away to another trading center. Finally, use of an ISO designation enables the destination trading center to execute the order immediately without regard to better-priced protected quotations displayed by automated trading centers. When an order is designated as an ISO, the broker-dealer routing the order must assume the responsibility for transmitting additional orders, as necessary, to execute against any better-priced protected quotations. Trade execution issues relating to Regulation NMS are answered in greater detail on the SEC's website at Responses to Frequently Asked Questions Concerning Rule 611 and Rule 610 of Regulation NMS. SEC Rules 606 and 607 impose certain disclosure requirements upon order routers. Under Rule 606, order routers must make publicly available, within one month after the end of each quarter, a report on their routing of non-directed orders in NMS securities during that quarter, including a discussion of the material aspects of the order router's relationship with each of the 10 venues to which it routed the largest number of orders and a description of any arrangement for payment of order flow and any profit-sharing relationship with any such venues. Under Rule 607, order routers must inform each of their customers, in writing, upon the opening of a new account and annually thereafter, of the firm's policies regarding receipt of payment for order flow from any trading venue, including a detailed description of the nature of any compensation received by the firm. SEC Rule 612 establishes minimum pricing increments for orders in NMS stocks and prohibits brokerdealers from displaying or even accepting any bid or offer, order or indication of interest in an NMS stock priced: (i) in an increment smaller than $0.01 if the bid or offer, order or indication of interest is priced at or above $1.00 per share or (ii) in an increment smaller than $ if the bid or offer, order or indication of interest is priced below $1.00 per share. Handling and prioritizing customer orders Contents in this section Duty of best execution "Trading ahead" of customer limit and market orders Fair prices and commissions

7 Duty of best execution Whether trading on a principal, riskless principal or agency basis, FINRA member firms have a duty to provide "best execution" for the customer orders that are submitted to them by their customers or by other broker-dealers on behalf of their customers. Under NASD Rule 2320 (known as the "best execution rule"), the member firm must use "reasonable diligence" in selecting the appropriate market and in executing the customer's order "so that the resultant price to the customer is as favorable as possible under prevailing market conditions." Best execution is the focal point of virtually every routine examination performed by FINRA and most oversight examinations performed by the SEC. In reviewing best execution, these regulators look at the facts and circumstances surrounding the order and its execution, including: the character of the market for the security, e.g., price, volatility, relative liquidity, and pressure on available communications the size and type of transaction the number of markets checked the accessibility of the quotation the terms and conditions of the order, as communicated to the member firm and its associated persons The term "market," as used in NASD Rule 2320, is intended to be interpreted broadly to include a variety of different trading venues, including trading markets other than exchanges and Nasdaq, and to require that FINRA member firms include such markets in their search for best execution. (NASD IM-2320) "Interpositioning" refers to the member firm's interjection of another broker-dealer (such as a broker's broker) into the trade execution process. Prior to September 2009, member firms were prohibited, under NASD Rule 2320(b), from interpositioning unless they could demonstrate that, to their knowledge, "at the time of the transaction the total cost or proceeds of the transaction was better than the prevailing inter-dealer market for the security." FINRA's current stance on interpositioning is more flexible in view of the emergence of electronic communications networks, order routing services and other technological innovations offered by intermediary broker-dealers that "improve the handling of customer orders with no additional cost to the customer and minimal or no delay in the execution of the customer's order." See FINRA Regulatory Notice Accordingly, Rule 2320(b) now makes clear that: [a]lthough the resultant price a customer pays remains a crucial factor in determining whether a firm has fulfilled its best execution obligations, particularly in the context of retail customer order executions, the rule allows an analysis of a variety of factors, based on the terms of the customer's order and instructions, rather than focusing solely on cost any time a firm interposes a third party between the firm and the best available market for a security. Compliance Tip A FINRA member firm's duty to provide best execution does not apply where another broker-dealer is simply executing its customer's order against that firm's quote. FINRA draws a distinction between those situations in which the member firm is acting solely as the buyer or seller in connection with orders presented by another broker-dealer and those circumstances in which the member firm is accepting order flow from another broker-dealer for the purpose of facilitating the handling and execution of such orders. (NASD IM- 2320) "Trading ahead" of customer limit and market orders NASD IM (referred to as the "Manning rule") generally prohibits a member firm that is holding an unexecuted customer limit order for an exchange-listed or OTC equity security from trading for its own account in that security, unless immediately afterward the firm executes the customer limit order at a price that is the same or better than the price at which it traded for its own account. The same requirement applies

8 to customer market orders under NASD Rule 2111, i.e., a member firm that is holding an unexecuted market order cannot "trade ahead" of that order unless immediately after trading for its proprietary account, it transacts at the same or better price for the customer order. NYSE Rule 92 imposes a similar prohibition upon NYSE member firms against knowingly entering proprietary orders ahead of, or along with, customer orders that are executable at the same price as the proprietary order. In an attempt to harmonize the existing rules, FINRA has proposed FINRA Rule 5320, which would combine the above-mentioned prohibitions into a single rule. See FINRA Regulatory Notice Exceptions (A) Large order/institutional account: Under IM and NASD Rule 2111(d), a member firm may negotiate specific terms and conditions applicable to the acceptance of limit or market orders, respectively, that suspend the prohibition against trading ahead provided that: (i) the order is for a customer account that meets the definition of an "institutional account" as that term is defined in NASD Rule 3110(c)(4) or (ii) the order is for 10,000 shares or more and at least $100,000 in value. (B) No-knowledge exception: NYSE Rule 92 and the FINRA provisions in (A) have similar, but not identical, "no-knowledge" exceptions. Under NYSE Rule 92, a firm may trade ahead of a customer order so long as the person entering the firm's proprietary order has no knowledge of the unexecuted customer order. FINRA has issued a "no-knowledge" interpretation of its customer order protection requirements. See, e.g., Question 15 of NASD Notice to Members Under that interpretation, a firm that implements and utilizes an effective system of internal controls, such as appropriate information barriers aimed at preventing a non-market-making proprietary desk from obtaining knowledge of customer orders held at the firm's proprietary market-making desk, the non-market-making proprietary desk may trade at prices that would satisfy the customer orders held by the market-making desk without filling those pending orders at the same or better prices. (C) Riskless principal exception: Under IM (c) and NASD Rule 2111(f), a member firm can engage in a proprietary trade to facilitate the execution, on a riskless principal basis, of an order from its customer or the customer of another broker-dealer without having to execute unexecuted customer orders at the same or a better price provided that the member firm gives the facilitated customer order the same per share price at which the member firm accumulated or sold shares to satisfy the facilitated order, exclusive of any mark-up or mark-down, commission equivalent or other fee. (D) ISO exception: Under IM (d) and NASD Rule 2111(g), a member firm is exempt from the prohibition against trading ahead of customer orders with respect to trading for its own account that is the result of an ISO order that is routed in compliance with SEC Rule 600(b)(30)(ii) of Regulation NMS where (i) the customer limit order was received after the member firm routed the ISO; or (ii) where the member firm executed the ISO to facilitate a customer limit order and that customer consented to not receiving the better prices obtained by the ISO. Fair prices and commissions NASD Rule 2440 generally requires that in any OTC transaction with or for a customer, a member firm charge "only fair commissions or charges" and buy and sell securities only at "fair prices." IM sets forth FINRA's mark-up policy, which begins with the general premise: It shall be deemed a violation of Rule 2440 for a member to enter into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable. The policy goes on to set forth the general underlying principles that will guide FINRA in determining whether a member firm's mark-up or mark-down is fair and not excessive, such as: The policy that the mark-up/mark-down should not exceed 5 percent of the trade price for the security is a guide, not a rule. The member firm may not justify excessive mark-ups on the basis of expenses which are excessive. The mark-up over the prevailing market price is the significant spread from the point of view of fairness of dealings with customers in principal transactions and in the absence of other bona fide

9 evidence of the prevailing market, a member's own contemporaneous cost is the best indication of the prevailing market price of a security. A mark-up pattern of 5 percent or even less may be considered unfair or unreasonable under the "5 percent policy." Determination of the fairness of mark-ups must be based on a consideration of all the relevant factors, of which the percentage of mark-up is only one. Significantly, FINRA states, in IM : any disclosure to the customer, before the transaction is effected, of information which would indicate (A) the amount of commission charged in an agency transaction or (B) the mark-up made in a principal transaction is a factor to be considered. Disclosure itself, however, does not justify a commission or mark-up which is unfair or excessive in light of all other relevant circumstances. For debt securities (other than municipal securities), FINRA has supplemented the guidance in IM with IM This guidance makes clear that in principal and riskless principal transactions, which are common for debt securities trades, the member firm's mark-up or mark-down is calculated on the basis of its contemporaneous cost to acquire or proceeds to sell the relevant security. Further, under IM : When the dealer is selling the security to a customer, countervailing evidence of the prevailing market price may be considered only where the dealer made no contemporaneous purchases in the security or can show that in the particular circumstances the dealer's contemporaneous cost is not indicative of the prevailing market price. When the dealer is buying the security from a customer, countervailing evidence of the prevailing market price may be considered only where the dealer made no contemporaneous sales in the security or can show that in the particular circumstances the dealer's contemporaneous proceeds are not indicative of the prevailing market price. Safe harbor for certain qualified institutional buyer (QIB) trades As noted earlier, NASD Rule 2440 applies only to transactions with or on behalf of customers. IM provides that "customer," for purposes of Rule 2440, IM and IM , does not include a QIB, as defined in SEC Rule 144A, that is purchasing or selling a non-investment grade debt security when the dealer has determined, after considering the factors set forth in NASD IM , that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction. For purposes of Rule 2440, IM and IM , "non-investment grade debt security" means a debt security that: if rated by only one nationally recognized statistical rating organization (NRSRO), is rated lower than one of the four highest generic rating categories; if rated by more than one NRSRO, is rated lower than one of the four highest generic rating categories by any of the NRSROs; or if unrated, either was analyzed as a non-investment grade debt security by the dealer and the dealer retains credit evaluation documentation and demonstrates to NASD (using credit evaluation or other demonstrable criteria) that the credit quality of the security is, in fact, equivalent to a noninvestment grade debt security, or was initially offered and sold and continues to be offered and sold pursuant to an exemption from registration under the Securities Act of 1933 (Securities Act).

10 OTC market quoting and reporting requirements Contents in this section Overview Quoting and trading in ADF-eligible securities Display of limit orders Withdrawal of quotations Reporting OTC equity trades TRFs and trading reporting requirements TRACE reporting requirements Overview The focal point of the OTC market quotation and reporting requirements is FINRA's "Alternative Display Facility" (ADF), which is a FINRA-owned and operated facility for posting quotes and reporting and comparing trades in "ADF-eligible securities" (defined as all NMS stocks). All FINRA members are eligible to participate in ADF. As is discussed later, FINRA operates three additional facilities that do not post quotations but are alternative Trade Reporting Facilities (TRFs) for NMS and non-nms stocks. In addition, FINRA operates the Trade Reporting and Compliance Engine (TRACE) reporting system for the reporting of transactions in certain types of debt securities. Quoting and trading in ADF-eligible securities Only FINRA-registered market makers and ECNs can enter quotations into the ADF. A FINRA member seeking registration as a market maker or ECN in the ADF is required to undergo an application and approval process and to specify whether it is seeking registration in Nasdaq and/or CQS securities. See FINRA Rule A "Nasdaq security" means any security listed on the Nasdaq market. A "CQS security" is a security that is eligible for inclusion in the Consolidated Quotation Plan and reported to the Consolidated Tape in accordance with the Consolidated Tape Association Plan. The obligations of registered ADF market makers are set forth in FINRA Rule 6272 and consist of the following: Two-sided quotations: ADF market makers are required to buy and sell the securities for which they make a market for their own accounts on a continuous basis and to enter and maintain twosided quotations through the ADF. The quotation size must be for at least one normal unit of trading. Firm quotations: The displayed quotations of ADF market makers are treated as "firm quotations," i.e., upon receipt of an offer to buy or sell from another broker-dealer, the market maker must execute a transaction for at least a normal unit of trading at its displayed quotation size or for the full amount of any greater-than-normal-unit quotation size that it is displaying. Quotations reasonably related to the market: ADF market makers are required to enter and maintain quotations that are "reasonably related to the prevailing market."

11 Display of limit orders Under SEC Rule 604(a)(2), which is part of Regulation NMS, every OTC market maker, whether on FINRA's ADF system or another trading market, must immediately publish a bid or offer that reflects the price and full size of each customer limit order held by that market maker if either: (i) the limit order is at a price that would improve the market maker's bid or offer; or (ii) the limit order is priced equal to the market maker's bid or offer and equal to the NBBO and represents more than a de minimis change in relation to the size associated with the market maker's bid or offer. Exceptions OTC market makers are not required to display customer limit orders that are: executed upon receipt the subject of a customer request that they not be displayed odd lot orders block size orders, unless the customer requested that it be displayed delivered immediately upon receipt to a national securities exchange or ECN that complies with the display requirement delivered immediately upon receipt to another exchange member or OTC market maker that complies with the requirement "all or none" orders Withdrawal of quotations Under FINRA Rule 6275, ADF market makers that wish to withdraw quotations in a security are required to contact ADF Operations to obtain excused withdrawal status prior to withdrawing their quotations. The rule sets forth the grounds upon which excused withdrawal status may be granted. A denial of excused withdrawal status may be appealed to the appropriate FINRA subcommittee. Reporting OTC equity trades FINRA Rule 6110 generally requires FINRA member firms to report to FINRA transactions in NMS stocks that are executed "otherwise than on an exchange," i.e., OTC equity transactions. Under FINRA Rule 6181, securities transactions generally must be reported within 90 seconds after execution; all transactions reported more than 90 seconds after execution are to be reported as late. Effective November 1, 2010, the maximum time period for trade reporting will be shortened from 90 seconds to 30 seconds for all FINRA trade reporting requirements. See FINRA Regulatory Notice All short sales transactions in NMS stocks that are reported to FINRA must carry a "short sale" indicator. See FINRA Rule TRFs and trading reporting requirements In addition to the ADF, discussed earlier, FINRA has established the following TRFs for the reporting of OTC transactions in NMS stocks: the FINRA/NASDAQ TRF and the FINRA/NYSE TRF. In addition, FINRA has established the Options Regulatory Fee (ORF) for the reporting of transactions in non-nms stocks, such as OTC Bulletin Board securities, American Depository Receipts (ADRs), shares of Canadian issuers, foreign securities and restricted securities. The are four substantially identical sets of trade reporting requirements that correspond to the four TRFs. FINRA Rule 6282 sets forth requirements for the reporting of transactions in ADF-eligible securities through FINRA's Trade Reporting and Comparison Service (TRACS). FINRA Rules 6380A and 7230A set forth the trade reporting requirements for the reporting of transactions in certain designated securities through the FINRA/NASDAQ TRF. FINRA Rules 6380B and 7230B set forth the trade reporting requirements for the reporting of transactions in all NMS stocks through the FINRA/NYSE TRF. FINRA Rules 6622 and 7330 set forth the trade reporting requirements for the reporting of transactions in OTC equity securities (defined in FINRA Rule 6420(e) as "any equity security that is not an NMS stock" but not any security that is a "restricted security" within SEC Rule 144(a)(3)).

12 Which party reports? As a general matter, the "executing party" is required to report OTC equity trades to FINRA. FINRA Rule 6282(b) defines "executing party" as the member firm that "receives an order for handling or execution or is presented an order against its quote, does not subsequently re-route the order, and executes the transaction." The rule further provides: in a transaction between two members where both members may satisfy the definition of executing party (e.g., manually negotiated transactions via the telephone), the member representing the sell-side shall report the transaction, unless the parties agree otherwise and the member representing the sell-side contemporaneously documents such agreement. FINRA Rule 6282(b) also provides that in a transaction between a member and a customer or non-member, the member shall report the trade using TRACS. Similar definitions and requirements are found in FINRA Rules 6380A(b), 6380B(b) and 6622(b). During what time periods does the 90-second (30-second from November 1, 2010 onward) reporting requirement apply? The requirement applies to all transactions executed between 8:00 a.m. and 6:30 p.m. (Eastern Time). What is a "trade" or "transaction" that must be reported under the trade reporting rules? For this purpose, a "trade" or "transaction" entails a change of beneficial ownership of securities between parties (e.g., a purchase or sale of securities) in which a member firm participates (e.g., as a dealer or an agent). If a trade is not reported within the time period prescribed by the trade reporting rules, must it still be reported? Yes. If a trade is not reported within the prescribed time period, it must be reported as soon as practicable and shall be designated as late. Trades that are required to be reported on trade date, but are not reported on trade date, must be reported on an "as/of" basis on a subsequent date (T+N) and designated as late. Trades that are required to be reported on an "as/of" basis the following business day (T+1) (e.g., certain trades executed outside normal market hours), but are not reported on T+1, must be reported on a subsequent date (T+N) and designated as late. Additional guidance concerning FINRA's trade reporting requirements for equity securities transactions is found in Trade Reporting Frequently Asked Questions (FAQ). TRACE reporting requirements TRACE is an automated system developed by FINRA that, among other things, accommodates reporting and dissemination of transaction reports in TRACE-eligible securities." FINRA Rule 6710(a) defines "TRACE-eligible security" as: a debt security that is [US] dollar-denominated and issued by a US or foreign private issuer, and, if a 'restricted security' as defined in Securities Act Rule 144(a)(3), sold pursuant to Securities Act Rule 144A; or is a debt security that is US dollardenominated and issued or guaranteed [by certain US government agencies and enterprises.] Participation in the TRACE reporting system is mandatory for FINRA member firms. See FINRA Rule Under FINRA Rule 6730, each member firm that is a party to a transaction in a TRACE-eligible security must report the transaction within 15 minutes of the "time of execution" or the transaction report will be "late." The member must transmit the report to TRACE during the hours the TRACE system is open, which are 8:00 a.m. Eastern Time through 6:29:59 p.m. Eastern Time, unless otherwise announced by FINRA (TRACE system hours). Specific trade reporting obligations during a 24-hour cycle are set forth in detail in FINRA Rule 6730.

13 For purposes of this reporting requirement, "time of execution" for a transaction in a TRACE-eligible security means the time when the parties to a transaction agree to all of the terms of the transaction that are sufficient to calculate the dollar price of the trade. The time of execution for transactions involving TRACEeligible securities that are trading "when issued" on a yield basis is when the yield for the transaction has been agreed to by the parties. For a transaction in a TRACE-eligible security in which the actual yield for the transaction is established by determining the yield from one or more designated securities (e.g., a "benchmark security" such as a US Treasury security maturing in 5 years, or a combination of such "benchmark securities) and adding the agreed upon "yield spread" (e.g., 150 basis points above the benchmark security), the time of execution occurs when the yield has been agreed to by the parties. See FINRA Rule 6710(d). Short selling Contents in this section SEC Regulation SHO Regulation SHO "locate" requirement Regulation SHO close-out requirement Short-seller anti-fraud rule Circuit-breaker rule SEC Regulation SHO Regulation SHO was adopted in 2004 to establish uniform "locate" and "close-out" requirements to reduce failures to deliver, particularly those arising from potentially abusive "naked" short selling. SEC Rule 200(a) defines a "short sale" as: any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. The "deemed to own" provisions of SEC Rule 200(b) through (e) are highly significant in determining whether the seller owns the subject security. For example, under SEC Rule 200(b)(3), a person will be deemed to own a security if he owns a security convertible into or exchangeable for it and has tendered such security for conversion or exchange. Independent trading unit aggregation Under SEC Rule 200(f) a broker-dealer generally must aggregate all of its proprietary positions in a security to determine whether it is net long or net short. It may qualify for "independent trading unit aggregation" however, under which each unit establishes a separate and distinct net position, if all of the following conditions are met: The broker or dealer has a written plan of organization that identifies each aggregation unit, specifies its trading objective(s), and supports its independent identity. Each aggregation unit within the firm determines, at the time of each sale, its net position for every security that it trades. All traders in an aggregation unit pursue only the particular trading objective(s) or strategy(s) of that aggregation unit and do not coordinate that strategy with any other aggregation unit. Individual traders are assigned to only one aggregation unit at any time.

14 Order marking requirements SEC Rule 200(g) requires each broker-dealer to mark every sell order for an equity security as "long," "short," or "short exempt." SEC Rule 201(d) sets forth the circumstances warranting the marking of an order as "short exempt," thereby exempting the order from the circuit-breaker provisions of SEC Rule 201. Regulation SHO "locate" requirement Under SEC Rule 203(b), a broker-dealer may not accept a short sale order in an equity security from another person, or effect a short sale in an equity security for its own account, unless the broker-dealer: (i) has borrowed the security; or (ii) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) has documented its compliance with points (i) or (ii). "Easy-to-borrow" lists generally may be used to establish a reasonable basis for a locate. Such lists are prepared by broker-dealers to indicate that firm's ability to supply the identified securities. For example, introducing firms may rely on easy-to-borrow lists of the clearing firms through which they clear and settle transactions unless circumstances indicate that it would not be reasonable to rely on such lists. For one, If the securities on the easy-to-borrow list have experienced delivery failures, it would not be reasonable to rely on the list. Regulation SHO close-out requirement SEC Rule 204(a) provides that a participant in a registered clearing agency (typically a clearing brokerdealer) must deliver securities to the registered clearing agency for clearance and settlement on a long or short sale in any equity security by settlement date (typically trade date plus three business days or "T+3"), and that if the participant has a "fail to deliver" on the settlement date, by no later than the beginning of regular trading hours on the business day following the settlement date, the participant must immediately close-out the fail to deliver by borrowing or purchasing securities of like kind and quantity. Under certain circumstances, SEC Rule 204 provides additional time during which fails may be closed out. For instance, under SEC Rule 204(a)(1) and (3), certain fails resulting from long sales or bona fide market making must be closed out by no later than the beginning of regular trading hours on the third business day following the settlement date. Penalty box SEC Rule 204(b) contains what is known as the "penalty box provision." Under that provision, if a participant of a registered clearing agency has a fail to deliver position and does not close out the position in accordance with the rule's requirements, the participant and any broker-dealer from which it receives trades may not accept a short sale order in the equity security that is the subject of the fail to deliver from another person, or effect a short sale in the equity security for its own account without first borrowing the security. This requirement remains in place until the participant closes out the original fail to deliver position by purchasing securities of like kind and quantity and that purchase has cleared and settled at a registered clearing agency. Short-seller anti-fraud rule SEC Rule 10b-21 (known as the "short seller anti-fraud rule") provides that it shall constitute a manipulative and deceptive device for any person to submit a sell order for an equity security if: (i) such person deceives a broker-dealer or a purchaser about its intention or ability to deliver the security on or before the settlement date; and (ii) such person fails to timely make delivery. Circuit-breaker rule SEC Rule 201 contains certain "circuit breaker" provisions that are intended to prevent price volatility from turning into a rapid downward spiral in securities prices due to escalating short sale activity. The rule requires trading centers (defined in SEC Rule 600(b)(78)) to establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution or display of a short sale order in an NMS

15 stock at a price that is less than or equal to the current national best bid if the price of that covered security decreases by 10 percent or more from the stock's closing price as determined by its listing market as of the end of regular trading hours on the prior day. These "circuit breaker" provisions are required to remain in effect for the remainder of the day on which they are triggered and the following business day. Under SEC Rule 201, trading centers also are required to regularly surveil the effectiveness of their circuit-breaker policies and procedures and to take prompt action to remedy deficiencies. SEC Rule 201 contains various exemptions from the circuit breaker requirements, which must be implemented by trading centers as part of their policies and procedures. Market conduct Contents in this section Overview Front-running Manipulative "wash trades" and "matched orders" Other types of manipulative trading "Marking the close" "Spoofing" Overview The rules and guidance adopted by the SEC, exchanges and self-regulatory organizations such as FINRA prohibit a wide variety of market practices that are viewed as potentially manipulative. In this section we discuss some of the major prohibited practices. Front-running FINRA IM provides that it shall be considered conduct inconsistent with just and equitable principles of trade for a member firm or its associated person to buy or sell an option or security future, for any account as to which they exercise investment discretion, while in possession of material, non-public information concerning an imminent block transaction in the underlying security or conversely to buy or sell the underlying security while in possession of material, non-public information concerning an imminent block transaction in the option or security future. Further, the interpretation provides: The violative practice noted above may include transactions which are executed based upon knowledge of less than all of the terms of the block transaction, so long as there is knowledge that all of the material terms of the transaction have been or will be agreed upon imminently. Exception The front-running prohibition does not include situations in which a member firm or its associated person receives a customer's order of block size relating to both an option and the underlying security or both a security future and the underlying security. In such cases, the member firm and its associated person may position the other side of one or both components of the order. In these instances, however, the member firm and its associated person would not be able to cover any resulting proprietary position(s) by entering an offsetting order until information concerning the block transaction involved has been made publicly available. Manipulative "wash trades" and "matched orders" Section 9(a)(1) of the Exchange Act prohibits (i) the effectuation of any trade in an exchange-listed security, which involves no change in the beneficial ownership of the security (a "wash trade") or (ii) the entry of any order fro the purchase or sale of an exchange-traded security with the knowledge that an order on the opposite side of the market for substantially the same size and price has been or will be entered - for the purpose of creating a false or misleading appearance of active trading in the subject security or a false or

16 misleading appearance with respect to the market for the security. The same conduct with respect to a broader range of securities will constitute a violation of the generic anti-fraud/anti-manipulation provisions of Section 10(b) of the Exchange Act and SEC Rule 10b-5 under the Exchange Act. FINRA Rule 6140(b) contains a virtually identical prohibition applicable to FINRA member firms. Other types of manipulative trading FINRA Rule 6140 also prohibits member firms from executing or participating in an account for which there are executed purchases of any NMS stock at successively higher prices, or sales of any such security at successively lower prices, for the purpose of creating or inducing a false, misleading or artificial appearance of activity in such security or for the purpose of unduly or improperly influencing the market price for such security or for the purpose of establishing a price which does not reflect the true state of the market in such security. "Marking the close" The SEC has brought a number of civil actions and administrative proceedings for violation of Section 10(b) of the Exchange Act and SEC Rule 10b-5 where the conduct at issue consisted of the execution of a series of trades at or near the close of trading with the intent of "marking" the closing price of a security. See, e.g., In the Matter of James T. Patten, Administrative Proceeding File No (Dec. 12, 2005). "Spoofing" The SEC has described "spoofing" as occurring when a person trading in the stock markets uses a displayed limit order to manipulate prices and then trades to its advantage into the manipulated prices. Two civil actions have been brought by the SEC for placement and cancellation of intra-day orders under circumstances that were deemed by the SEC to constitute illegal spoofing. In each of those cases, the conduct at issue consisted of: (i) the entry of one or more limit orders during the trading day in an effort to move the NBBO, (ii) the execution of one or more trades on the opposite side of the market in an effort to benefit from the movement in the NBBO, and (iii) immediately after the execution of the profitable trade(s), the cancellation of the original limit orders under circumstances indicating that the party that entered them never intended that they be executed. See SEC v Leonid Shpilsky et al., Litigation Release No. LR (Nov. 5, 2001); In the Matter of Leonard Sheehan, SEC Release Nos and (March 18, 2003).