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January 2, 2007

NASD Closes Best-Execution Loophole

By Peter Chapman

Here's a riddle: When is a customer not a customer?

Until last month, the answer might have been: when the order comes from a broker-dealer - at least as far as "best execution" was concerned. Now, however, the answer is never.

NASD members must now treat orders from other broker-dealers on a par with orders they receive from their non-broker-dealer customers.

Previously, the NASD's best execution rule, Rule 2320, didn't make that clear enough. The word "customer" wasn't defined. Trading firms could argue the less-than-stellar fills they gave broker-dealers did not put them in violation of the rule.

No longer.

After a four-year, "tortuous process," the NASD was finally able to secure approval from the Securities and Exchange Commission to make changes to its Rule 2320(a).

"It took us five years to add seven lines into the rulebook," Tom Gira, the NASD's director of market regulation, quipped recently. "It was a contentious issue."

Trading houses argued, as did the Securities Industry Association, that an order recipient couldn't possibly provide best execution on orders from other broker-dealers because the ultimate customer was not their own. They did not know the customer.

The NASD disagreed and so did the SEC. Rule 2320(a) now covers "any transaction for or with a customer or a customer of another broker-dealer."

The changes do not let the broker that sends the order-the "originating" broker-dealer-off the hook. This party is still obligated to perform a "regular and rigorous review" of its order-routing practices, according to the NASD.

"What the rule change didn't do," Gira told a group at this year's Security Traders Association's annual conference, "is to take away any obligations of the order sender."