[Federal Register Volume 59, Number 53 (Friday, March 18, 1994)]
[Unknown Section]
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From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-6323]


[[Page Unknown]]

[Federal Register: March 18, 1994]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33758; File No. SR-NASD-92-12, Amendment No. 6]

 

Self-Regulatory Organizations; Notice of Proposed Rule Change by 
the National Association of Securities Dealers, Inc., Relating to 
Amendments to the NASD's Proposed Short Sale Rule

March 11, 1994.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on March 8, 
1994, the National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') Amendment No. 6 to the proposed rule change 
as described in Items I, II, and III below, which Items have been 
prepared by the NASD.\1\ The Commission is publishing this notice to 
solicit comments on the proposed rule change, as amended, from 
interested persons.
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    \1\On January 14, 1994, the NASD submitted Amendment No. 5 to 
this filing. Amendment No. 6 supersedes and replaces Amendment No. 
5, which was not published for comment.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The NASD is amending its proposed short sale rule or ``bid test'' 
applicable to stocks traded on the Nasdaq National Market by expanding 
the options market makers' exemption from the rule to include certain 
short sales effected by index options market makers. Specifically, for 
an eighteen-month pilot period, the proposal provides that an NASD 
member shall be permitted, consistent with its quotation obligations, 
to execute a short sale for the account of an index options market 
maker that would otherwise be in contravention of the NASD's short sale 
rule so long as: (1) The short sales are hedges of existing or 
contemporaneously established index options positions and (2) the 
dollar value of all stock sold short to hedge the offsetting stock 
index options position(s) does not exceed the aggregate current index 
value of the offsetting index options position(s).
    The NASD also is proposing four other amendments to the NASD's 
short sale rule. First, the NASD proposes to amend the filing to 
provide that all market maker exemptions from the rule will be uniform 
in duration. Specifically, under the proposal, the exemptions afforded 
qualified Nasdaq market makers, Nasdaq warrant market makers, and 
qualified options market makers will all expire eighteen months after 
the effective date of the NASD's short sale rule. Prior to the 
termination of the eighteen-month period, the NASD will evaluate 
whether these exemptions should be extended, modified, approved on a 
permanent basis, or terminated. Second, with respect to the trading 
activity of options market makers and warrant market makers, the 
amendment clarifies that transactions unrelated to normal options/
warrant market making activity, such as index arbitrage or risk 
arbitrage that in either case is independent of an options/warrant 
market maker's market making functions, will not be considered a 
hedging transaction for purposes of the options/warrant market maker 
exemption from the NASD's short-sale rule. Third, consistent with Rule 
10a-1 under the Act, the amendment expands the exemption from the 
NASD's short-sale rule for certain transactions in special arbitrage 
accounts and special international arbitrage accounts to include short-
sales effected by non-members. Prior to this amendment, only NASD 
members would be able to avail themselves of these two exemptions from 
the rule. Fourth, the NASD proposes to amend the options and warrant 
market maker exemptions to provide that an NASD member would not be in 
violation of the NASD's short sale rule if it executed an order for the 
account of an options or warrant market maker in the good faith belief 
that the order was in full compliance with the NASD's short sale rule 
and it was subsequently determined that the order was either not 
entitled to the exemption or it was incorrectly marked long. The NASD 
also proposes to make some minor stylistic modifications and 
grammatical corrections to the short sale rule and amend the section 
numbers for the rule. The text of the proposed rule change is available 
at the Office of the Secretary of the NASD and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in sections 
(A), (B), and (C) below of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the proposed Rule Change

    On November 19, 1993, the NASD submitted Amendment No. 4 to its 
proposed short sale rule or ``bid test'' applicable to stocks traded on 
the Nasdaq National Market to provide for an eighteen-month pilot 
program that would afford equity options market makers with a limited 
exemption from the rule if the short sales were effected to hedge 
options positions established as a result of bona fide market making 
activity.\2\ This amendment reflected the NASD's efforts to strike a 
reasonable balance between the needs of equity options market makers to 
effectively hedge their long options positions through short 
sales\3\and the NASD's need to implement a meaningful short sale rule 
for the Nasdaq Stock Market (``Nasdaq'') that does not contain broad 
and sweeping exemptions that eviscerate the rule's effectiveness.
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    \2\See Securities Exchange Act Release No. 33289 (December 3, 
1993), 58 FR 64994 (December 12, 1993).
    \3\The options exchanges and options market makers have 
consistently argued, among other things, that the absence of an 
exemption from the NASD's short sale rule for options market makers 
will have an adverse impact on the liquidity and pricing of options 
on Nasdaq securities and that it is inconsistent with the Act to 
afford Nasdaq market makers an exemption from the rule and not 
options market makers. See Securities Exchange Act Release No. 31729 
(January 13, 1993), 58 FR 5791 (``Amendment No. 3 Notice''). See 
also, e.g., letter to Jonathan G. Katz, Secretary, SEC, from the 
American, New York, Pacific and Philadelphia Stock Exchanges, and 
the Chicago Board Options Exchange dated February 18, 1993.
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    Recently, however, the options exchanges have maintained that it is 
equally important for the efficiency of the marketplace that index 
options market makers be able to avail themselves of an exemption from 
the NASD's short sale rule for hedging purposes. Accordingly, the NASD 
is proposing another amendment to its short sale rule to accommodate 
the hedging needs of index options market makers. In particular, the 
NASD proposes to modify the equity options market maker exemption to 
include short sales effected by index options market makers.
    Specifically, under the proposed index options market maker 
exemption, an NASD member will be permitted, consistent with its 
quotation obligations, to execute a short sale for the account of an 
options market maker that would otherwise be in contravention of the 
NASD's short sale rule so long as: (1) The short sale is an ``exempt 
hedge transaction''; and (2) the options market maker is registered 
with a ``qualified options exchange''\4\ as a ``qualified options 
market maker'' on a ``qualified stock index.'' An ``exempt hedge 
transaction'' is defined to be a short sale in a Nasdaq National Market 
security that was effected to hedge, and in fact serves to hedge, an 
existing offsetting stock index options position or an offsetting stock 
index options position that was created in a transaction(s) 
contemporaneous with the short sale, provided certain conditions are 
satisfied. These conditions are as follows: (a) The security sold short 
must be a component security of the index underlying such index option; 
(b) the index underlying such offsetting index options position must be 
a ``qualified stock index''; and (c) the dollar value of all exempt 
short sales effected to hedge the offsetting stock index options 
position(s) does not exceed the aggregate current index value of the 
offsetting options position(s).
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    \4\As with the equity option market maker exemption, a 
``qualified options exchange'' is defined to be a national 
securities exchange that has received SEC approval of rules and 
procedures governing: (1) The designation of options market makers 
as qualified options market makers; (2) the surveillance of its 
market makers utilization of the exemption; and (3) authorization of 
the NASD to withdraw, suspend, or modify the designation of a 
qualified options market maker in the event that the options 
exchange determines that the qualified options market maker has 
failed to comply with the terms of the exemption and the exchange 
believes that such action is warranted in light of the substantial, 
willful, or continuing nature of the violation.
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    A ``qualified stock index'' is defined to be a stock index that 
includes one or more Nasdaq National Market securities, provided that 
more than 10% of the weight of the index is accounted for by Nasdaq 
National Market securities. The amendment also provides that a 
qualified stock index shall be reviewed as of the end of each calendar 
quarter, and the index shall cease to qualify if the value of the index 
represented by one or more Nasdaq National Market securities is less 
than 8% at the end of any subsequent calendar quarter. In this 
connection, the NASD has proposed the 10% minimum requirement for 
qualified stock indexes to help ensure that exempted short sales 
effected by index options market makers are in fact the result of 
legitimate hedging needs.
    Thus, an index options market maker would become a ``qualified 
options market maker'' for certain classes of stock index options only 
if it has received an appointment as such from a qualified options 
exchange. In this regard, the rule is designed to ensure that only 
those index options market makers who regularly engage in making 
markets in options classes overlying indexes containing Nasdaq-listed 
securities are designated as qualified options market makers. 
Specifically, before an options exchange can become a qualified options 
exchange, it must have rules in place to identify and designate as 
qualified options market makers those market makers who regularly 
engage in market making activities in particular options classes.
    As with the equity options market maker exemption, the NASD also 
has proposed that the index options market maker exemption shall only 
be in effect for an eighteen-month pilot period. Throughout this 
eighteen-month period, the NASD will review and analyze with the 
options exchanges whether the exemption is resulting in destabilizing 
trading in Nasdaq stocks.
    In addition, the NASD notes that the Intermarket Surveillance Group 
Agreement, which provides for the sharing of surveillance information 
between the exchanges and the NASD, may assist in evaluating possibly 
manipulative activity and other possibly destabilizing short selling 
activity by qualified options market makers and other options market 
makers in Nasdaq securities.
    The NASD also is proposing four other amendments to its short-sale 
rule. First, the NASD proposes to amend its short sale rule to provide 
that all market maker exemptions from the rule are uniform in duration. 
Specifically, under the proposal, the exemptions afforded qualified 
Nasdaq market makers, Nasdaq warrant market makers, and qualified 
options market makers all will expire eighteen months after the 
effective date of the NASD's short sale rule. Previously, only the 
options market maker exemption was proposed on a pilot basis. With all 
of the market maker exemptions expiring simultaneously, the NASD 
believes it will be better able to evaluate and respond to the market 
impacts, if any, resulting from these exemptions. Accordingly, prior to 
the termination of the eighteen-month pilot period, the NASD will 
evaluate whether these exemptions should be extended, modified, 
approved on a permanent basis, or terminated.
    Second, the NASD is clarifying that transactions by options market 
makers and warrant market makers unrelated to their normal options/
warrant market making activity, such as index arbitrage or risk 
arbitrage that in either case is independent of an options/warrant 
market maker's market making functions, will not be considered a 
hedging transaction for purposes of the options/warrant market maker 
exemption from the NASD's short-sale rule. Amendment No. 4 to the short 
sale rule provided that Nasdaq market makers will not be able to avail 
themselves of an exemption from the short sale rule for ``transactions 
unrelated to normal market making activity, such as index arbitrage and 
risk arbitrage that is independent from a member's market making 
functions * * *''. Thus, this amendment merely extends to options and 
warrant market makers the same restriction that already applies to 
Nasdaq market makers.\5\
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    \5\The NASD also would like to correct an error that was made in 
the filing for Amendment No. 4 concerning the entitlement of a 
Nasdaq market maker to an exemption from the NASD's short sale rule 
when the risk arbitrage department of a firm takes over the firm's 
market making functions after the announcement of a merger or 
acquisition. Specifically, the filing stated that ``registered 
Nasdaq market makers that qualify for the exemption according to the 
standards of Sections 46 and 47 would relinquish their market making 
exemption if the risk arbitrage department of the firm took over the 
market making functions after the announcement of a merger or 
acquisition.'' Instead, the filing should have stated that the firm 
would not have to relinquish its market maker exemption if the risk 
arbitrage department continued to engage in bona fide market making 
and the firm continued to qualify for an exemption for that issue 
under sections 46 and 47 of the NASD's Rules of Fair Practice. To 
the extent that the risk arbitrage department effected risk 
arbitrage transactions unrelated to bona fide market making 
activity, however, the exemption would not be available for those 
transactions. (As discussed below, the NASD proposes to renumber 
Sections 46 and 47 upon approval of this filing.)
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    Third, the NASD proposes to amend its short sale rule to track 
provisions of SEC Rule 10a-1(e) (7) and (8) concerning short sales 
effected by special arbitrage accounts and special international 
arbitrage accounts (``arbitrage accounts''). Currently, the NASD's 
short sale rule only affords NASD members an exemption from the rule 
for certain short sales effected in arbitrage accounts. The exemptions 
from the SEC's short sale rule afforded by Rule 10a-1(e) (7) and (8), 
however, are available to any person and are not limited to members of 
an exchange or the NASD. Thus, the NASD is proposing to replace the 
word ``member'' with the word ``person'' in the exemptions for 
arbitrage accounts so that the NASD's short sale rule better tracks 
comparable provisions of SEC Rule 10a-1.
    Fourth, to clarify that the onus for determining entitlement to an 
exemption falls squarely on options and warrant market makers, the NASD 
proposes to add new Sections (h)(2)(f) and (i)(4) to the short sale 
rule to provide that an NASD member will not be in violation of the 
NASD's short-sale rule if the member executes a short sale for the 
account of an options or warrant market maker that is in contravention 
of the options or warrant market maker exemptions, provided that the 
member did not know or have reason to know that the options or warrant 
market maker's short sale was in contravention of these exemptions.
    The NASD also is proposing several minor changes to its short sale 
rule and the accompanying rule governing the designation of Primary 
Nasdaq Market Makers. First, the NASD proposes to replace references to 
Nasdaq/NMS securities in these rules with the term Nasdaq National 
Market securities to ensure uniformity and avoid confusion. Second, 
because another NASD rule has been designated as Section 46, the same 
section number proposed for the short sale rule, the NASD proposes to 
delete the section numbers for short sale rule and the accompanying 
rule governing Primary Nasdaq Market Makers. Once this filing is 
approved, these Sections will be numbered sequentially with the next 
available section numbers. Third, the NASD proposes two minor 
amendments to the first paragraph of Interpretation C to the short sale 
rule to correct grammatical mistakes.
    The NASD believes the proposed rule change is consistent with 
sections 15A(b)(6) and 11A(c)(1)(F) of the Act. Section 15A(b)(6) 
requires that the rules of a national securities association be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in regulating, clearing, 
settling, processing information with respect to, and facilitating 
transactions in securities, and to remove impediments to and perfect 
the mechanism of a free and open market. Section 11A(c)(1)(F) assures 
equal regulation of all markets for qualified securities and all 
exchange members, brokers, and dealers effecting transactions in such 
securities. Specifically, as noted in prior filings regarding the 
NASD's short sale rule, approval of the proposed short sale rule would 
result in equivalent short sale regulation in the exchange and Nasdaq 
markets and would work to prevent fraud and manipulation with respect 
to short sales in the Nasdaq market. Moreover, the NASD believes that 
affording index options market makers with an exemption from the rule 
for legitimate hedging transactions associated with their bona fide 
options market making activity will serve to minimize the potential 
adverse impacts, if any, on the options markets resulting from adoption 
of the NASD's short sale rule. In addition, in light of the safeguards 
proposed in conjunction with the index options market maker exemption 
(e.g., the requirement that the short sales be hedges of existing or 
contemporaneously established index options positions and the 
limitation of the exemption to index options market makers on indexes 
with a substantial Nasdaq component), the NASD does not believe that 
the index options market maker exemption will subsume or eviscerate the 
effectiveness of the NASD's short sale rule.
    In addition, as with the exemption for equity options market 
makers, the NASD believes it is reasonable and appropriate to approve 
the index options market maker exemption on an eighteen-month pilot 
basis. As noted in prior NASD filings concerning the NASD's short sale 
rule, in the absence of a comparable short sale rule for the options 
markets, it is not entirely clear to the NASD that abusive short 
sellers will not be able to circumvent the NASD's short sale rule 
through the use of the index options markets. Specifically, if index 
options market makers are not required to adhere to the NASD's short 
sale rule, the NASD believes it is possible that market participants 
would aggressively buy puts or sell calls on indexes with a large 
Nasdaq component confident in the knowledge that the options market 
makers likely to bear the other side of the contract would almost 
surely employ their short sale exemption to sell into the bid on 
Nasdaq. Accordingly, the NASD believes it would be prudent and 
consistent with the maintenance of fair and orderly markets to approve 
the index options market maker exemption on an eighteen-month pilot 
basis. During the term of the pilot, the NASD, in cooperation with the 
options exchanges, will conduct a thorough analysis of the market 
impacts, if any, resulting from short sales effected pursuant to the 
exemption. Depending on the results of the study, the NASD will 
consider whether to seek permanent approval of the exemption, modify 
the exemption, or withdraw the exemption. In this connection, it is the 
NASD's intention to not modify or withdraw the exemption unless it can 
be shown that the exemption is causing demonstrable harm to Nasdaq. 
Moreover, should it become clear during the term of the pilot that the 
index options market marker exemption is having an adverse impact on 
Nasdaq, the NASD will endeavor to make a good faith effort to work with 
the options exchanges to correct or rectify the concerns associated 
with the operation of the exemption before seeking to withdraw the 
pilot.
    The NASD also believes that approving the exemption for qualified 
Nasdaq market makers on an eighteen-month pilot basis is consistent 
with the maintenance of fair and orderly markets. While the NASD 
continues to believe that Nasdaq market makers regularly performing an 
effective market making function must be permitted the flexibility to 
sell short when necessary to adjust quickly to market movements and 
that there are more compelling reasons to provide Nasdaq market makers 
with an exemption from the short sale rule than options market makers, 
the NASD, nevertheless, believes it is appropriate to thoroughly 
examine whether the Nasdaq market maker exemption is causing any 
adverse market impacts before adopting the exemption on a permanent 
basis. In addition, approving the Nasdaq market maker exemption on an 
interim basis is consistent with the proposed pilot exemption for 
options market makers. Finally, with respect to the other proposed 
amendments discussed in this filing, the NASD believes they will serve 
to reduce investor confusion concerning the application and operation 
of the NASD's short sale rule, thereby promoting efficient and fair 
markets.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purpose of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the NASD consents, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the proposed rule change that are filed with the 
Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to the file number in the caption 
above and should be submitted by April 8, 1994.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-6323 Filed 3-17-94; 8:45 am]
BILLING CODE 8010-01-M