SEC Staff Legal Bulletin: SLB 8

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Action: Publication of Division of Market Regulation Staff Legal Bulletin

Date: September 9, 1998

Summary: This staff legal bulletin sets forth the views of the Division of Market Regulation ("Division") about how broker-dealers should handle customer orders and notify customers when marketwide circuit breakers halt trading on exchanges. This bulletin also states the Division's views about the need for broker-dealers to maintain enough internal systems capacity to operate properly when trading volume is extremely high.

Supplementary Information: The statements in this legal bulletin represent the views of the Division's staff. This bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission. Further, the Commission has not approved or disapproved its contents.

Contact Person: For further information about order handling and circuit breaker issues, contact Alton Harvey at (202) 942-4167. For further information about technological capacity issues, contact Sheila Slevin at (202) 942-0796. I. Problems That Arose During Trading on October 27 and 28, 1997 On October 27 and 28, 1997, the nation's securities markets fell by a record absolute amount on then-record trading volume.

1 In reconstructing the events of October 27 and 28, the Commission staff became aware that a number of broker-dealers and their customers faced significant problems trading on those days. On October 27, the first day that cross-market circuit breakers had ever been triggered, some broker-dealers were apparently confused about how to properly execute retail market orders. On the next day, October 28, historically high trading volume overwhelmed the capacity of some broker-dealer systems, causing those broker-dealers to fail to receive or execute customer orders in a timely manner. This legal bulletin is intended to provide broker-dealers with guidance on how to handle orders and notify customers should circuit breakers close the markets in the future. This bulletin also is intended to remind broker-dealers that they need to have sufficient internal systems capacity to provide for continuous operation during episodic surges in trading volume. II. Broker-Dealers Should Handle Circuit Breaker Trading Halts the Same Way That They Handle Other Regulatory Trading Halts Two circuit breakers halted trading on October 27, 1997. The first circuit breaker stopped trading for 30 minutes between 2:36 and 3:06 p.m. The second circuit breaker closed the markets for the day at 3:30 p.m. A number of broker-dealers reportedly had problems determining how to properly route retail orders they received following the market's early close. Those firms were uncertain as to whether they should hold the orders for execution at the next day's opening, execute the orders at the last reported price, or cancel the orders. It appears that most firms held those customer orders for execution at the next day's market opening. A. The Basic Rule – Follow Practices Used During Other Regulatory Halts The Division believes that on the rare occasions when circuit breakers halt trading, 2 broker-dealers should handle pending orders and new orders in the same manner they handle orders for a security in which a self-regulatory organization ("SRO") has imposed a regulatory trading halt. For example, if an issuer is about to release material corporate news during a trading session, the SRO that serves as the primary market for the issuer's securities ( i.e ., a securities exchange or Nasdaq) would impose a regulatory trading halt (for "news pending") that is honored by all of the other SROs until the news is disseminated and the halt is lifted. SROs impose these types of regulatory trading halts virtually on a daily basis. It is not uncommon for some of these halts to remain in effect through the remainder of the trading session. Broker-dealers and the markets already know how to handle orders when trading in an individual stock is halted, and there is no reason to adopt different practices for circuit breaker halts. Accordingly, during intraday circuit breaker trading halts, broker-dealers should send pending orders and new orders to a market for execution upon the resumption of trading,
unless they receive instructions to the contrary from their customers during the halt. If circuit breakers close the markets early for the day, broker-dealers should handle pending and new orders in a similar manner. In particular:

Unless a customer indicates otherwise when submitting an order, broker-dealers and the markets should treat orders that are pending when the circuit breaker is triggered, or that are received afterward, as "Good Til Cancelled" or "GTC" orders, and should hold the orders for execution at the reopening on the next trading session. This should be the case even if the order originally was marked as "Off-Hours Eligible." 3

Broker-dealers and the markets should treat pending orders marked as "At-the-Close" orders (including "Market-at-Close" or "MOC" orders, "Limit-at-Close" or "LOC" orders, or any other orders related to closing prices) as cancelled. 4 Broker-dealers and the markets should not accept any new orders relating to closing prices.

B. After-Hours and Pre-Opening Trading The rules that govern circuit breakers on the stock exchanges are SRO rules, not Commission rules. Accordingly, the SROs have the latitude to make interpretations about the circuit breaker rules, including interpretations about whether members can engage in after-hours or pre-opening trading after circuit breakers have closed the markets early. For example, the New York Stock Exchange currently interprets NYSE Rule 80B, which governs circuit breaker trading halts, as barring members from engaging in trading in NYSE-listed securities prior to the next day's opening when a circuit breaker trading halt has closed the market early for the day. In the case of over-the-counter securities, the National Association of Securities Dealers ("NASD") has no circuit breaker rule per se. The NASD instead has stated that it would halt trading on Nasdaq upon the Commission's request when other markets have halted trading due to extraordinary market conditions. In response, the Commission has made a standing request that the NASD halt trading whenever circuit breakers have stopped trading on the exchanges. 6 After the NASD halted trading on Nasdaq on October 27, the NASD asked the Division to clarify whether the Commission's standing request prevented trading by NASD members prior to the next day's opening. The Division in response agreed with the NASD that it appeared reasonable to permit pre-opening trading starting at 8:00 a.m. on October 28, to assist the price-discovery process. In future instances when late-day circuit breakers stop trading early, the Division would consult with the NASD and evaluate market circumstances prior to determining whether pre-opening trading should be permitted on the next day. In general, however, the Division believes that allowing pre-opening trading is appropriate when late-day circuit breakers stop trading early. C. Broker-Dealers Should Take Steps to Notify Customers About Order Treatment When circuit breakers have closed the markets, it is likely that customers will try to reach their broker-dealers to determine how their orders will be treated. Ideally, broker-dealers should be prepared to receive telephone calls and other direct communications from customers and to inform them of how pending orders and new orders will be handled. The Division recognizes that direct communications might not always be feasible under those conditions, especially during a brief intraday trading halt. At a minimum, however, broker-dealers (both online and full-service) that maintain a web page should promptly post a notice stating that circuit breaker halts have closed the markets and explaining how pending or new orders will be handled. Moreover, the Division believes that broker-dealers that handle orders through the Internet should have mechanisms in place so that, when a customer attempts to transmit an order after the triggering of a circuit breaker, an electronic response will indicate that the
markets are closed and explain how pending orders and new orders will be handled.

III. Broker-Dealers Need to Have Enough Systems Capacity to Ensure a High Degree of Operational Capability The Commission received several complaints from customers regarding broker-dealer operations during the heavy trading volume effected on October 27 and 28. In particular, customers complained about receiving poor or untimely executions from broker-dealers. Customers of online broker-dealers also complained about delays in accessing their online brokerage accounts. Because of those problems, some broker-dealers made substantial adjustments to customer accounts. Because broker-dealers are becoming increasingly reliant on technology to perform trading functions and to route customer orders to markets, these problems could be more severe during future periods of high trading volume. Broker-dealers therefore need to take steps to prevent their operational systems from being overwhelmed by periodic spikes in systems message traffic due to high volume. In particular, broker-dealers should not merely have sufficient systems capacity to handle average-to-heavy loads. Rather, broker-dealers should have the systems capacity to handle exceptional loads of several times the average trading volume. 8

A. Access Problems Faced by Customers of Online Broker-Dealers Numerous customers of online broker-dealers were unable to gain timely access to their accounts on October 28. Because the Internet contains multiple potential choke points that can slow the flow of information, it is difficult to determine what caused the delays faced by online users attempting to request information or place orders electronically. Moreover, some of the delays faced by online broker-dealers and their customers reflected the existing limitations of the Internet. Overall Internet traffic was extremely heavy on October 28, causing widespread slowness. Also, problems with regional Internet service providers ("ISPs") meant that investors in some areas of the country faced greater delays than investors in other areas of the country. On the other hand, some of the problems that online investors experienced stemmed from broker-dealers' online systems and their websites. One significant problem was that some broker-dealers' web servers had reached their maximum capacity to handle simultaneous users. Not only did an extraordinarily high number of online investors access broker-dealer web sites on October 28, but they tended to stay connected for longer periods of time than typical. Delays with third-party vendor services and excessive non-customer requests for financial information may also have contributed to the problems. Other potential difficulties with online broker-dealers' web sites included poor distribution of demand across system resources (load balancing), slow access equipment, slow web server software, and poor integration with back-end databases. Some online broker-dealers also faced other access problems, including broker-dealer telephone lines that were overwhelmed with callers who were frustrated by the inability to access information online. B. Execution Problems Faced by Broker-Dealers Some broker-dealers experienced disruptions in their trading system operations that prevented them from routing customer orders to the designated market center for execution on a timely basis. Although disruptions occurred throughout the day, capacity problems were particularly high just after the opening of the market and prior to the close of trading on October 28. An unusually high numbers of orders that queued up in broker-dealers' internal order handling systems prior to the opening of trading on October 28 helped precipitate these problems. In addition, a number of broker-dealers were forced to manually execute some customer orders because mainframe computer capacity problems prevented automated routing systems from sending orders to designated market centers for execution. C. Adequate Capacity Should be a Top Priority for Broker-Dealers The Commission has long been concerned about the need to take steps to prevent capacity or other operational problems from disrupting market operations. Previously, the Commission published two Automation Review Policy ("ARP") statements
9 that address the technological capacity needs of participants in the securities markets. The policy statements highlighted the Commission's concern that market participants, including exchanges, clearing agencies and broker-dealers, take voluntary steps to establish comprehensive planning and assessment programs to determine systems capacity and vulnerability. 10 The first policy statement in particular discussed the importance of: (i) formally establishing capacity estimates; (ii) conducting periodic capacity stress tests; and (iii) contracting with independent reviewers to assess performance at current and future capacity levels and to assess vulnerability to physical threats. 11

With this bulletin, the Division seeks to emphasize to broker-dealers the importance of having adequate capacity to handle high volume or high volatility trading days, and conducting capacity planning on a regular basis. The Division does not intend to mandate standards for broker-dealer capacity at this time. Rather, the Division encourages broker-dealers to look to the guidance provided by the ARP statements, and to consider other appropriate measures to minimize potential capacity problems. These might include developing backup technology systems and procedures for handling system capacity problems. Online broker-dealers could consider additional steps, including: employing multiple ISPs, implementing class "B" Internet addresses to improve access quality, improving server capacity, giving priority at times of peak usage to customers who wish to enter orders ( i.e. , preventing non-customers from accessing websites to review financial information), educating customers about Internet access issues, and providing alternatives means to place orders when Internet access is slow or unavailable. As discussed above regarding circuit breakers, broker-dealers should use every reasonable effort to notify customers about operational difficulties. Broker-dealers also need to properly record all customer complaints, including e-mail complaints, as required by SRO and Commission rules. D. Outsourcing Does Not Excuse Broker-Dealers from Focusing on Capacity Issues Some broker-dealers have delegated responsibility for their technology operations, including trading systems, to outside vendors. Those broker-dealers should recognize that they are not excused from taking the steps necessary to ensure that adequate systems are in place merely because they rely on outside vendors. They need to exercise oversight of vendors' operations,and ensure that vendors adequately address capacity problems. 12

On Monday, October 27, the Dow Jones Industrial Average ("DJIA") declined 554.26 points (7.18%) to close at 7161.15. This represented the tenth largest percentage decline in the index since 1915. On Tuesday, October 28, market prices initially resumed their decline before rallying sharply. The DJIA closed up 337.17 points (4.71%) at 7498.32 on then-record share volume of over a billion shares each on the New York Stock Exchange ("NYSE") and the Nasdaq Stock Market ("Nasdaq").

Circuit breaker halts should be rare, due to the exchanges' April 1998 modification of the circuit breaker rules. The new circuit breaker rules have trigger levels based on a one-day decline of 10%, 20% and 30% of the Dow Jones Industrial Average.

NYSE Rule 13 defines a "Good Til Cancelled" order as "[a]n order to buy or sell which remains in effect until it is either executed or cancelled. A good til cancelled order that is designated Off-Hours eligible' and that is not also a stop limit order may be executed through the Off-Hours Trading Facility.'" During circuit breaker trading halts, the exchange would not operate the Off-Hours Trading Facility.

NYSE Rule 13 defines an "At the Close" order as "[a] market order which is to be executed in its entirety at the closing price, on the Exchange, of the stock named in the order, and if not so executed, is to be treated as cancelled[, including] a limit order that is entered for execution at the closing price."

Those practices for handling pending orders and new orders also would apply to "At-the-Close" orders attempting to unwind stock positions related to expiring option and futures contracts on an "expiration Friday."

The NASD initially set forth its practice in a policy statement filed with the Commission after the October 1987 Market Break. In approving the NASD's policy statement, the Commission requested that the NASD impose a trading halt as quickly as practicable whenever the NYSE and other equity markets have suspended trading. See Securities Exchange Act Release No. 26198 (October 19, 1988), 53 FR 41637 (October 24, 1988). The NASD has extended its Market Closing Policy until April 30, 2000 (unless otherwise modified or extended by the NASD's board of governors). See Securities Exchange Act Release No. 39846 (April 9, 1998), 63 FR 18477 (April 15, 1998); NASD Rule IM-4120-3.

The Division believes that the SROs should also promptly provide notification of the circuit breaker to financial newswires and other financial media.

The Commission has previously cautioned broker-dealers (during the back-office problems of the late 1960s) that accepting or executing orders without adequate order-handling capacity would violate the anti-fraud provisions of the securities laws. "The Commission also warns broker-dealers that it is a violation of applicable anti-fraud provisions for a broker-dealer to accept or execute any order for the purchase or sale of a security or to induce or attempt to induce such purchase or sale, if he does not have the personnel and facilities to enable him to promptly execute and consummate all of his securities transactions." Securities Exchange Act Release No. 8363 (July 29, 1968), 33 FR 11150 (August 7, 1968).

See Securities Exchange Act Release No. 27445 (Nov. 16, 1989), 54 FR 48703 (Nov. 24, 1989); Securities Exchange Act Release No. 29185 (May 9, 1991); 56 FR 22490 (May 15, 1991).

The Commission took the position that broker-dealers should use the policy statements as a guideline. See 54 FR at 48706 n.17.

See 54 FR at 48706-07. The second policy statement highlighted the importance of: (i) obtaining independent reviews of the general controls and risks in place in automated trading and information dissemination systems to determine the need for further reviews and enhancements; (ii) providing notice of significant additions, deletions or other changes to automated systems on an annual and as-needed basis; and (iii) providing the Commission staff with real-time notifications of unusual events such as significant outages involving automated systems. See 56 FR 22491-95.

On prior occasions when the Commission has considered broker-dealers' use of third-party vendors, the Commission has specified that broker-dealers remain ultimately responsible for abiding by all applicable regulatory requirements. For example, the Commission's electronic storage media rules require that any broker-dealer who uses electric storage media "provide its own representation or one from the storage medium vendor" that the selected storage media meets certain conditions. See 17 CFR 240.17a-4(f)(2)(i).

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Modified:09/14/98