• FINRA’s New Limit Up/Limit Down Rules to Take Effect as of April 8, 2013
  • March 19, 2013 | Authors: Timothy C. Foley; Michael D. Wolk
  • Law Firm: Bingham McCutchen LLP - Washington Office
  • The Financial Industry Regulatory Authority (“FINRA”) recently issued a regulatory notice regarding the pending implementation of the joint industry Regulation NMS Plan to Address Extraordinary Market Volatility (the “Plan”) and adopting a new FINRA Rule and amending other FINRA rules to facilitate implementation, operation and member firm compliance with the Plan. As of April 8, 2013, the Plan will begin to impose significant new responsibilities on FINRA member firms (“Firms”) that are trading centers in NMS stocks (“trading centers”).1 Specifically, the Plan will implement a market-wide limit up/limit down (“LULD”) and related trading pause mechanism, which will restrict trades in NMS stocks from occurring outside of specified price bands (“LULD bands”) depending on the type of NMS stock. As of that date, Firms must establish written policies and procedures designed to ensure compliance with the Plan.

    Plan Phases

    The Plan is set to take effect in two phases. On April 8, Phase I implementation will begin with respect to certain “Tier 1” NMS stocks (i.e., S&P 500 and Russell 500 stocks, and selected ETPs). Full Phase I for all Tier 1 NMS stocks will be completed on or around July 8, 2013 (or such earlier date as may be announced with at least 30 days notice). During Phase I, securities information processors (“SIPs”) will calculate and disseminate price bands between 9:45 am and 3:30 pm on each trading day.

    Phase II will commence on or around October 8, 2012 (or such earlier date as may be announced with at least 30 days notice), during which time the Plan will apply to all NMS stocks from 9:30 am to 4:00 pm each trading day.

    LULD Price Bands

    The LULD band structure is based upon percentages away from a “reference price,” which is the mean price of regular way, last sale eligible trades for a specified security over the immediately preceding five-minute period. During regular trading hours, the SIP for each covered NMS stock will calculate and disseminate the applicable upper and lower LULD bands. The percentage parameters have a two-tiered structure and are doubled during the first 15 and last 25 minutes of trading:

    • Tier 1 - S&P 500 and Russell 500 stocks, and selected ETPs:

      • If the reference price is less than $0.75, the percentage parameter is the lesser of $0.15 and 75%.

      • If the reference price is greater than or equal to $0.75, up to and including $3.00, the percentage parameter is 20%.

      • If the reference price exceeds $3.00, the percentage parameter is 5%.

    • Tier 2 - All other NMS stocks (excluding rights and warrants), provided that if the security is a leveraged ETP, the percentage parameter is multiplied by the leverage ratio of the product

      • If the reference price is less than $0.75, the percentage parameter is the lesser of $0.15 and 75%.

      • If the reference price is greater than or equal to $0.75, up to and including $3.00, the percentage parameter is 20%.

      • If the reference price exceeds $3.00, the percentage parameter is 10%.

    Trading Restrictions

    When one side of the market for a security is outside the applicable LULD band (i.e., when the national best bid (“NBB”) is below the lower band or the national best offer (“NBO”) is above the upper band), the SIP will flag the NBB or NBO as non-executable prior to dissemination.

    If the other side of the market reaches the applicable LULD band (i.e., when the NBB is equal to the upper band or the NBO is equal to the lower band), the market for the security will enter a limit state, and the SIP will flag the NBB or NBO as a limit state quotation prior to dissemination. Trading will exit the limit state if the entire size of all limit state quotations is executed or cancelled within 15 seconds of entering the limit state.
     
    If the market does not exit the limit state within 15 seconds, then the primary listing market for the security will declare a five-minute trading pause. The primary listing market may also declare a trading pause when a security is in a “straddle state,” which occurs when the NBB is below the lower LULD band or the NBO is above the upper LULD band and the stock is not in a limit state.

    During a trading pause, no trades in the paused security can be executed, but all bids and offers may be displayed.

    Firm Compliance

    FINRA has added or amended certain of its rules in connection with the implementation of the Plan. Under the following rules, which will take effect on April 8, trading centers will be required to develop written policies and procedures to ensure compliance with the Plan.

    FINRA Rule 6190. New FINRA Rule 6190 requires trading centers to establish, maintain and enforce written policies and procedures that are reasonably designed to comply with the requirements of the Plan and specifically to prevent:

    • The execution of trades at prices that are below the lower price band or above the upper price band for an NMS stock, except as permitted under the Plan;

    • The display of offers below the lower price band and bids above the upper price band for an NMS stock; and

    • The execution of trades in an NMS stock during a trading pause.

    Rule 6190 applies to trading centers only to the extent they are acting as a trading center with respect to a given trade or quotation. For example, if a Firm is both an OTC market maker and a trading center, and the Firm, in its capacity as an OTC market maker, receives a customer order to sell and routes the order to an exchange or other trading center, the Firm could rely on the exchange or other trading center to ensure compliance with the Plan.

    FINRA Rule 5260. Amended Rule 5260 generally prohibits Firms from directly or indirectly effecting any transaction or publishing any quotation during a trading halt, including a trading pause. This Rule has been amended to permit the display of bids and offers during a trading pause, to the extent permitted under the Plan.

    FINRA Rule 6121. Amended Rule 6121.01(a) reflects the Plan’s trading pause provisions and clarifies that if trading in an NMS stock is permitted to resume after a trading pause under the Plan, then FINRA may permit the resumption of OTC trading in the security if trading has commenced on at least one other national securities exchange (i.e., when a transaction has been executed on an exchange, not merely
    when quoting has commenced on the exchange). Consistent with its current policy, FINRA expects that in most cases, it will not resume OTC trading until the primary listing market resumes trading.

    Amended Rule 6121.01(b) provides that the current trading pause provisions, which provide for halts in individual NMS stocks due to extraordinary market volatility, will continue to apply to Tier 1 and Tier 2 NMS stocks until the Plan is implemented for those securities. Rule 6121.01(b) will cease to apply to the specified Tier 1 NMS stocks as of the beginning of Phase I of the Plan, but will continue to apply to all other Tier 1 and Tier 2 NMS stocks until they are incorporated into the active LULD mechanism pursuant to the complete implementation of Phases I and II, respectively.

    FINRA Rule 11892. Under new Supplementary Material .03 under Rule 11892, the existing provisions of Rule 11892 regarding clearly erroneous transactions will continue to apply to all OTC transactions in NMS stocks subject to the Plan. Significantly, even those transactions that occur within the Plan’s price bands could still be deemed clearly erroneous to the extent they fall within the existing thresholds of Rule 11892.

    Rule 11892.03, furthermore, recognizes that a Firm may experience a technology or systems problem that erroneously permits the execution of an OTC transaction in an NMS stock outside of the LULD price bands. In the event of such a problem, a FINRA officer may review and deem such trade clearly erroneous, provided the Firm meets the certification requirements of Rule 11892.

    In the event that the SIP experiences a technology or systems problem that prevents the dissemination of price bands, FINRA may deem the transactions clearly erroneous under Rule 11892.

    Conclusion

    The Plan imposes significant new regulatory obligations on Firms that are trading centers for NMS stocks. By April 8, Firms must have implemented written policies and procedures, and train their employees, to ensure that Firm systems prevent the display of offers and permit the execution of orders outside of the LULD bands. Firms should undertake a review of their existing policies, procedures, and systems to ensure the Firm will be in full compliance with the phased implementation of the Plan. Given the Plan’s roots in the regulatory fallout from events of extreme market volatility, Firms should anticipate that these new rules will be a focus of FINRA exam and enforcement staff in the coming year.


    Endnotes

    1 A trading center for these purposes includes an ATS, exchange market maker, an OTC market maker or any broker or dealer that executes orders internally by trading as principal or crossing orders as agent.