CLIENT MEMORANDUM

RECENT SEC MARKET STRUCTURE INITIATIVES

The Securities and Exchange Commission (the “SEC”), continuing its efforts in the area of market structure, recently:

• voted to adopt Rule 15c3-5 under the Securities Exchange Act of 1934, which would effectively prohibit a broker-dealer from providing customers with “unfiltered” or “naked” access to an exchange or an alternative trading system (“ATS”);1 and

• approved amendments to self-regulatory organization (“SRO”) rules to prohibit so-called “stub quotes.”2

The compliance date for Rule 15c3-5 is July 14, 2011. The planned implementation date for the stub quote rules is December 6, 2010. Overviews of the new rules are set out below.

Rule 15c3-5

In the release adopting Rule 15c3-5 (the “Adopting Release”), the SEC states that customers of broker-dealers, particularly sophisticated institutional customers, have begun using technology to place orders “with little or no substantive intermediation by their broker-dealers,”3 giving rise to “direct market access” or “sponsored market access.” This type of market access generally involves an institutional or individual customer who uses the broker-dealer’s market participant identifier (“MPID”) or other mechanism to access an exchange or ATS electronically. “Direct market access” typically refers to a customer securities order that flows through a broker-dealer’s systems before entering the markets. “Sponsored access” typically involves a customer securities order that flows directly to the markets without first passing through a broker-dealer’s systems. Irrespective of how such orders flow to the markets, the broker-dealer is responsible for all trading that occurs using its MPID.

1 Risk Management Controls for Brokers or Dealers with Market Access, Exchange Act Release No. 63241, 75 Fed. Reg. 69792 (Nov. 15, 2010), available at http://www.sec.gov/rules/final/2010/34-63241.pdf. For additional information, see our memorandum on proposed Rule 15c3-5 at http://www.willkie.com/files/tbl_s29Publications/FileUpload5686/3213/Further%20SEC%20Action%20O n%20Market%20Structure%20Issues.pdf. 2 Self-Regulatory Organizations; BATS Exchange, Inc.; NASDAQ OMX BX, Inc.; Chicago Board Options Exchange, Incorporated; The Chicago Stock Exchange, Inc.; Financial Industry Regulatory Authority, Inc.; The NASDAQ Stock Market LLC; National Stock Exchange, Inc.; New York Stock Exchange LLC; NYSE Amex LLC; NYSE Arca, Inc.; Order Granting Accelerated Approval to Proposed Rule Changes, as Modified by Amendment No. 1, to Enhance the Quotation Standards for Market Makers; Exchange Act Release No. 63255 (Nov. 5, 2010), available at http://www.sec.gov/rules/sro/bats/2010/34-63255.pdf (the “Stub Quotes Release”). 3 Adopting Release at 69793.

NEW YORK WASHINGTON PARIS LONDON MILAN ROME FRANKFURT BRUSSELS in alliance with Dickson Minto W.S., London and Edinburgh

The SEC is particularly concerned about sponsored access arrangements in which a broker- dealer does not employ any pre-trade risk management controls, referred to as “unfiltered,” or “naked,” access. The concern is that if a customer has such access, the broker-dealer might be unaware of the trading activity being effected under its market identifier and therefore would be unable to control such activity.4 This lack of oversight could raise risks relating to potential breaches of credit or capital limits, the submission of erroneous orders, the failure to comply with SEC or exchange trading rules, or the failure to detect other unlawful conduct. The SEC believes that risk management controls and supervisory procedures that are not applied on a pre- trade basis or that are not under the broker-dealer’s exclusive control are inadequate to address risks associated with direct market access or sponsored access that could pose a significant danger to the U.S. national market system.

General Requirements

Rule 15c3-5(b) requires a broker-dealer with “market access,” as defined in the rule, or that provides another party with access to an exchange or ATS through use of the broker-dealer’s MPID or through other means, to establish, document, and maintain a system of risk management controls and supervisory procedures designed to manage the financial, regulatory and other risks associated with providing such access. The Rule applies to all securities trading on an exchange or ATS, including equities, options, exchange-traded funds, debt securities and security-based swaps.

Market Access

The definition of “market access” in Rule 15c3-5(a)(1), as adopted, is broader than the definition that was set out in proposed Rule 15c3-5, and determines to which broker-dealers the rule applies and the scope of the necessary risk management controls and supervisory procedures that such broker-dealer must apply on a pre-trade basis. The term “market access,” as set out in proposed Rule 15c3-5, would have applied to access to exchanges but not access to ATSs. Accordingly, it would not have encompassed a non-broker-dealer market participant that subscribes to ATSs or a broker-dealer that operates an ATS and provides access to the ATS to non-broker-dealer market participants. As adopted, however, Rule 15c3-5(a)(1) defines “market access” to include “access to trading in securities on an alternative trading system provided by a broker-dealer operator of an alternative trading system to a non-broker-dealer.” According to the SEC, a “broker-dealer operator of an ATS is the best positioned broker-dealer to implement the risk management controls, particularly pre-trade controls.”5 A broker-dealer operator of an ATS would have market access for purposes of the rule if it provides non-broker-dealer subscribers access to the ATS and it would, therefore, be subject to the requirements of Rule 15c3-5.

4 Adopting Release at 69793. 5 Id. at 69797.

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As adopted, Rule 15c3-5(a) also adds an exception to the definition of market access. The SEC notes that exchanges and ATSs use both affiliated and unaffiliated broker-dealers to provide outbound order routing services to access other trading centers with protected quotations so that the exchanges and ATSs may comply with Rule 611 of Regulation NMS or a national market system plan for listed options.6 Orders subject to outbound routing would fall within the definition of market access and therefore be subject to Rule 15c3-5, even though such orders would first have to flow through broker-dealer systems subject to risk controls required by Rule 15c3-5 before being submitted to an exchange or ATS. To address this issue, the SEC adopted an exception from the definition of “market access” in paragraph (b) of Rule 15c3-5 for broker- dealers that provide outbound routing services for the sole purpose of accessing other trading centers with protected quotations on behalf of an exchange or ATS in order to comply with Rule 611 of Regulation ATS or with a national market system plan for listed options.

Risk Management Controls

Rule 15c3-5(c) outlines the financial and regulatory risk management controls and supervisory procedures that a broker-dealer providing direct market access should adopt.

Financial Risk Management Controls

A broker-dealer’s financial risk management controls and supervisory procedures should be designed to limit the broker-dealer’s financial responsibility arising from granting market access to others. Rule 15c3-5(c)(1) requires such controls and procedures to be reasonably designed to (i) prevent the entry of orders that exceed appropriate credit or capital limits in the aggregate for each customer and the broker-dealer, and (ii) prevent the entry of erroneous orders by rejecting orders that exceed specified price or size parameters, either on an order-by-order basis or over a short period of time, or that indicate duplicative orders.

Given the speed of electronic markets, the SEC believes that a broker-dealer’s financial risk management controls and supervisory procedures should be “systematized and automated” and applied on a pre-trade basis. Such controls should block orders that do not comply with the controls from being routed to a securities market. Controls should be reasonably designed to detect malfunctions of automated systems that could lead to erroneous orders, as well as to block the routing of erroneous orders entered manually. Moreover, the broker-dealer is required to set a credit threshold for each customer with market access, as well as to set appropriate capital thresholds for the broker-dealer’s proprietary trading, and to institute controls and procedures to help ensure that the credit or capital thresholds are not exceeded. If appropriate, credit and capital limits could be established by sector, security, or otherwise.

6 Adopting Release at 69799. Rule 611, commonly referred to as the “trade through rule,” requires exchanges and ATSs to, among other things, establish, maintain, and enforce written policies and procedures reasonably designed to prevent trade-throughs on such exchanges and ATSs of protected quotations in NMS stocks. Exchanges and ATSs typically comply with this requirement, in part, by using an affiliated or unaffiliated broker-dealer to route orders that the exchanges and ATSs receive to other trading centers displaying protected quotations.

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Rule 15c3-5(c)(1)(i) permits a broker-dealer to set a reasonable aggregate credit limit for each customer, then set sub-limits to be applied at each exchange or ATS to which the broker-dealer provides access that, when added together, equal the aggregate limit.7 The SEC notes that the sub-limit approach “would necessarily require that, when assessing the customer’s credit exposure at one market center, the broker-dealer assume that the maximum credit limit has been reached by the customer at all other exchanges and ATSs to which it provides access.”8 That is, a customer’s credit sub-limit at one market center could not be increased to reflect an unused but still available credit sub-limit at another market center.

Regulatory Risk Management Controls

Proposed Rule 15c3-5(c)(2) requires a broker-dealer to implement and maintain regulatory risk management controls and supervisory procedures reasonably designed to: (i) prevent the entry of orders unless applicable regulatory requirements have been met on a pre-order basis; (ii) prevent the entry of orders for securities for a broker-dealer, customer, or other person who is restricted from trading in such securities; (iii) grant access to systems that provide market access only to those persons and accounts authorized by the broker-dealer; and (iv) provide surveillance personnel with immediate post-trade execution reports resulting from market access. Because certain risk management controls and supervisory procedures have to be applied on a pre-trade basis (and, in some instances, on an automated basis), Rule 15c3-5 effectively prohibits “unfiltered,” or “naked,” access.

Among other things, regulatory risk management controls have to be reasonably designed to prevent orders from being sent to securities markets unless the order complies with, for example, exchange trading rules relating to special order types, trading halts, odd-lot orders, SEC rules under Regulations SHO and NMS, and margin rules. The controls also have to be designed to prevent the entry of orders for securities restricted from trading. Supervisory tools must allow monitoring in real time.9

To limit access to systems that provide market access, a broker-dealer must review and approve all persons at the broker-dealer or its customer with such access. The systems that provide such access have to be physically secured and access be subject to electronic security, such as password protection. Post-trade surveillance must include review of execution reports relating to market access. These reports should allow identification of the customer associated with each report to assist in detecting potential regulatory violations, and provide data regarding financial exposure faced by the broker-dealer at a given time.

7 Adopting Release at 69800. 8 Id. 9 Id. at 69802.

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Regulatory Requirements

As under proposed Rule 15c3-5, the term “regulatory requirements,” as set out in paragraph (a)(2) of the rule, as adopted, is defined as “all federal securities laws, rules and regulations, and rules of self-regulatory organizations, that are applicable in connection with market access.” This definition is intended to capture all existing regulatory requirements related to a broker- dealer’s access to trading on an exchange or ATS.

Responsibility for Risk Management Controls and Supervisory Procedures

Rule 15c3-5(d) requires the financial and risk management controls and supervisory procedures to be under the direct and exclusive control of the broker-dealer providing market access. The broker-dealer nevertheless may use risk management technology and software developed by a third party, provided the third party is independent of the broker-dealer’s market access customers or such customers’ affiliates and the broker-dealer performs appropriate due diligence on third-party technology and software to ensure that the controls and procedures are effective and are otherwise consistent with Rule 15c3-5.10 The independent third-party technology or software provider can perform routine maintenance or implement technology upgrades to its risk management controls, subject to the broker-dealer’s due diligence. The broker-dealer cannot, however, outsource oversight of, or the power to adjust, its controls to a third party.11

Paragraph (d)(1) of Rule 15c3-5 permits a broker-dealer that provides market access reasonably to allocate to another broker-dealer control over specific regulatory risk management controls and supervisory procedures, but not financial risk controls, provided the allocation is made by written contract and the broker-dealer allocating control has conducted appropriate due diligence on the broker-dealer that is being allocated control. A broker-dealer may be allocated this control because “based on its position and relationship with an ultimate customer, [it] has better access to that ultimate customer and its trading information such that it can more effectively implement the specified controls and procedures.”12 The broker-dealer to which control is allocated, moreover, must have “specific knowledge of the ultimate customer and its trading activity that the broker-dealer providing market access would not have.”13 That is, allocation is permissible “where — and only where — another registered broker-dealer is better positioned to implement it than the broker-dealer providing market access.”14 The broker-dealer providing market access has an ongoing obligation to review the effectiveness of the risk controls of the broker-dealer to which such controls are allocated.15

10 Adopting Release at 69804, 69810 11 Id. at 69804. 12 Id. at 69807. 13 Id. 14 Id. at 69808. 15 Id.

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Review of Risk Management Controls and Supervisory Procedures

Rule 15c3-5(e) requires a broker-dealer that provides market access to establish, document, and maintain a system to review, at least annually, the effectiveness of the controls and supervisory procedures mandated by proposed Rule 15c3-5(c) and to address any issues that might arise from the review. The chief executive officer, or an equivalent officer, of the broker-dealer must certify annually that the broker-dealer’s risk management controls and supervisory procedures comply with proposed Rule 15c3-5 and that the regular (at least annual) review has been conducted.

Recordkeeping

A broker-dealer has to preserve for three years a copy of its supervisory procedures and a written description of its risk management controls as part of its books and records per Rule 17a-4(e)(7) and Rule 17a-4(b) under the Exchange Act.

Stub Quotes

In the Stub Quotes Release, the SEC ordered the approval, on an accelerated basis, of rule filings by a number of SROs, proposing rule amendments relating to so-called “stub quotes.” “Stub quotes” are quotations that are so far away from the prevailing market that they are not intended to be executed.16 According to the SEC, the major disruption of the equities markets on May 6, 2010 (sometimes referred to as the “Flash Crash”) was characterized by severe price that “led to a large number of trades being executed at temporarily depressed prices, including many that were more than 60% away from pre-decline prices and subsequently broken.”17 The SEC notes that “executions against stub quotes represented a significant portion of broken trades on May 6.”18

Quote Movement Bands

The SRO rule amendments require market makers to maintain continuous two-sided quotations throughout the trading day that are within a specified percentage band of the national best bid and offer (“NBBO”). The amendments establish two separate bands: one for stocks subject to the individual circuit breaker pilot program (i.e., stocks included in the S&P 500, stocks included in the Russell 1000 and certain exchange-traded products) (the “Circuit Breaker Band”), and one for securities that are not subject to the single-stock circuit breakers (the “Non-Circuit Breaker Band”).19 With respect to stocks within the Circuit Breaker Band, a must enter quotes that are not more than 8% away from the NBBO. A quote entered at or within 8% of the NBBO may move further away from the NBBO before it must be adjusted.

16 Stub Quotes Release at 2. 17 Id. at 3. 18 Id. 19 Id. at 4.

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Once the quote is 9.5% away from the NBBO, however, the market maker must adjust it so that it is at or within 8% of the NBBO. The Circuit Breaker Band is wider during times that the circuit breakers are not in effect, namely before 9:45 a.m. and after 3:35 a.m. on trading days. During those times, market makers must enter quotes that are no further than 20% away from the NBBO and must adjust those quotes back to 20% if they drift more than 1.5%, i.e., to 21.5%, away from the NBBO.20

For securities in the Non-Circuit Breaker Band, market makers must enter quotes that are no more than 30% away from the NBBO. If the quotes drift more than 1.5%, i.e., to 31.5%, away from the NBBO, the market maker must adjust the quote so that it is not further than 30% away from the NBBO.21

Additional SRO Market Maker Rule Amendments

The SROs proposed additional rule amendments relating to market makers. The Financial Industry Regulatory Authority, Inc. (“FINRA”) proposed an amendment to state explicitly that market makers have a duty to assist in maintaining fair and orderly markets. The New York Stock Exchange LLC (“NYSE”) and NYSE Amex LLC (“NYSE Amex”) proposed amendments to their rules to state explicitly that market makers have a duty to maintain continuous two-side quotes with displayed size of at least one round lot.22

BATS Exchange, Inc. (“BATS”), NASDAQ OMX BS, Inc. (“BX”) and The NASDAQ Stock Market LLC (“Nasdaq”) proposed amendments to their rules to adopt functionality that would automatically update market makers’ quotes on their exchanges. The BATS functionality is optional. BX and Nasdaq functionality will automatically create a quote to comply with the bands described above for each issue in which a market maker is registered as such. BX and Nasdaq would adjust one of the automated quotes if it drifts within 4% of the NBBO (or one- quarter of the applicable percentage necessary to trigger an individual stock trading pause, if greater), or if it drifts within the applicable percentage necessary to trigger an individual stock trading pause, minus 0.5%. If the preceding occurs, BX or Nasdaq would adjust and display a quote for the market maker at the appropriate percentage away from the NBBO. Other quotes entered directly by market makers would be allowed to move freely towards the NBBO. If a quote entered automatically is executed, BX or Nasdaq would refresh the market maker’s quote on the executed side of the market away form the NBBO, or at the last reported sale in the absence of an NBBO.23

20 Stub Quotes Release at 4. In the absence of an NBBO, the bands set out above apply, but the market maker must use the consolidated last sale. 21 Id. at 4-5. A market maker may voluntarily quote at price level closer to the NBBO than are required under the amended rules. 22 Id. at 5. 23 Id. at 5-6.

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Finally, NYSE Arca, Inc. (“NYSE Arca”) has proposed amending its “Q Order” type. NYSE Arca would eliminate the “Standard Q,” which is an order that has a price of $0.01 for the bid and two times the previous day’s close for the offer. Market makers utilizing Q Order functionality would continue to be subject to market maker quoting obligations.24

* * * * * * * * * * * * * * * If you have any questions regarding this memorandum, please contact Roger D. Blanc (212-728- 8206, [email protected]), Martin R. Miller (212-728-8690, [email protected]), Matthew B. Comstock (202-303-1257, [email protected]) or the Willkie attorney with whom you regularly work.

Willkie Farr & Gallagher LLP is headquartered at 787 Seventh Avenue, New York, NY 10019- 6099 and has an office located at 1875 K Street, NW, Washington, DC 20006-1238. Our New York telephone number is (212) 728-8000 and our facsimile number is (212) 728-8111. Our Washington, DC telephone number is (202) 303-1000 and our facsimile number is (202) 303- 2000. Our website is located at www.willkie.com.

November 22, 2010

Copyright © 2010 by Willkie Farr & Gallagher LLP.

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24 Stub Quotes Release at 6.

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