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SEC Grants Relief From Tick Test for Riskless Principal Transactions

The SEC's Division of Market Regulation has granted an exemption sought by the Securities Industry Ass’n from 1934 Act rule 10a-1 to permit a broker-dealer to fill customer orders without complying with the "tick" provisions of the rule under certain circumstances. The broker-dealer must receive the sell order from a customer who is net "long" in the securities being sold. The broker-dealer must then seek to execute the order in whole or in part by selling the security as riskless principal, even if the broker-dealer has an overall net short position in the security. The second circumstance is where the broker-dealer receives a buy order from a customer and seeks to execute the order in whole or in part by purchasing the security as riskless principal and selling the security to the customer, even if the broker-dealer has an overall net short in the security.

The exemption is subject to a number of conditions. First, the broker-dealer, after receiving an order to sell a security from a customer who has a net long position, must sell the security as principal at the same price to satisfy the order to sell, or after receiving an order to buy a security from a customer, must purchase the security as principal at the same price and then sell it to the customer. The sell and buy order must be given the same per-share price at which the broker-dealer sold or bought the shares in order to satisfy the facilitated order, exclusive of any explicitly disclosed markups or markdowns, commission equivalents or other fees.

The Division advised that broker-dealers must have policies and procedures to assure that, at a minimum, the customer order was received prior to the offsetting transaction. The offsetting transaction must be allocated to a riskless principal account or a customer account within 60 seconds of the execution. The broker-dealer must also have supervisory systems in place to produce records in which all of the orders subject to the exemption can be readily reconstructed in a time-sequenced manner. Sales that are effected in reliance on the relief must be marked "short exempt" in accordance with Regulation SHO. The sales should not, in any event, be marked long.

In seeking the relief, the SIA noted that where a broker-dealer is facilitating a customer sale in a riskless principal transaction, the ultimate seller is long the shares being sold, so the transactions do not present the abuses that the short sale rule was designed to prevent. The SIA explained that applying the tick test to riskless principal transactions may inhibit a broker-dealer's ability to provide timely, if any, execution to the customer long sale since a broker-dealer with a net short position will be restricted from executing its own principal trade to complete the first leg of the riskless principal transaction.

The SEC deferred consideration of the adoption of a proposed riskless principal exception to rule 10a-1 pending the completion of the Regulation SHO pilot program. However, the Division noted that Regulation NMS, which was adopted June 9, requires trading centers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The SIA explained that broker-dealers may send an order to another market center for execution to provide best execution, to facilitate price discovery or to access displayed or hidden liquidity. The staff agreed that this would be consistent with the order protection rule as well as the riskless principal exception.