[Federal Register Volume 59, Number 88 (Monday, May 9, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11075]


[[Page Unknown]]

[Federal Register: May 9, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34000; File No. SR-NASD-93-61]

 

Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc; Order Instituting Proceedings to Determine Whether to 
Disapprove Rule Change Relating to the SelectNet Service

May 3, 1994.

I. Introduction

    On November 1, 1993, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities 
and Exchange Commission (``Commission'' or ``SEC''), pursuant to 
section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') and 
Rule 19b-4 thereunder, a proposed rule change to modify the operational 
features of the SelectNet service.\1\ The NASD is proposing to install 
a price validation screen that will prohibit entry of orders into 
SelectNet priced away from the inside market on Nasdaq. If approved, 
the NASD will amend the SelectNet User Guide to clarify that orders 
entered into SelectNet during normal market hours (9:30 a.m. to 4 p.m.) 
will be prohibited by the system if the orders are priced outside the 
best bid or offer in the Nasdaq system, unless unusual market 
conditions, such as locked, crossed, one-side, or no-quote markets 
exist in a security.
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    \1\The NASD originally filed the proposed rule change on October 
25, 1993 pursuant to section 19(b)(3)(A) of the Act. On October 29, 
1993, the Commission issued an Order of Summary Abrogation 
abrogating the NASD's October 25th rule change. The Commission's 
Order of Summary Abrogation suggested that the procedures provided 
by section 19(b)(2) of the Act provide a more appropriate mechanism 
for determining whether the NASD's rule change is consistent with 
the Act. Thus, on November 1, 1993, the NASD refiled its rule change 
under section 19(b)(2).
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    Notice of the proposed rule change appeared in the Federal Register 
on November 9, 1993.\2\ Three comments opposing the NASD's proposal 
were received in response to the Commission release. The substance of 
these comments is discussed in detail below.
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    \2\Securities Exchange Act Release No. 33141 (Nov. 3, 1993), 58 
FR 59504 (Nov. 9, 1993).
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II. Description of SelectNet's Prohibition Against Entering Orders 
Outside the Inside Nasdaq Market

    In response to the difficulties experienced in the Nasdaq market 
during the market break of October 1987, the NASD developed an 
auxiliary service, the Order Confirmation Transaction Service 
(``OCT''), to process orders during market extremes by providing an 
alternative method of negotiating trades when traditional telephone 
negotiation is difficult or infeasible. The Commission originally 
approved OCT in January 1988.\3\ OCT, renamed SelectNet in 1990, 
currently operates from 9 a.m. to 5:15 p.m. Eastern Time,\4\ and 
increases communications capacity by enabling eligible firms to enter 
electronic messages. SelectNet supports the continuous, orderly 
operation of the Nasdaq Stock Market during difficult or unusual market 
conditions. Since in inception, the NASD has enhanced SelectNet in an 
effort to provide greater flexibility in the automated execution of 
orders and to facilitate market maker's and order entry firms' 
(collectively referred to as ``participants'') use of SelectNet.\5\
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    \3\Securities Exchange Act Release No. 25263 (Jan. 11, 1988), 53 
FR 1430 (Jan. 19, 1988) (order approving SelectNet, previously 
referred to as the Order Confirmation Transaction Service, on a 
Temporary accelerated basis). See also, Securities Exchange Act 
Release No. 25523 (Mar. 28, 1988), 53 FR 10965 (Apr. 4, 1988) (order 
extending temporary approval of SelectNet); Securities Exchange Act 
Release No. 25690 (May 11, 1988), 53 FR 17523 (May 17, 1988) (order 
granting permanent approval of SelectNet).
    \4\Securities Exchange Act Release No. 30581 (Apr. 14, 1992), 57 
FR 14596 (Apr. 21, 1992).
    \5\Securities Exchange Act Release No. 28636 (Nov. 21, 1990), 55 
FR 49732 (Nov. 30, 1990).
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    The service currently allows participants to broadcast orders to 
all market makers in a security or direct order to a specific market 
maker. In addition, market makers can broadcast to all participants 
watching a particular security (a feature known as ``all call''). To 
enter an order in SelectNet, a participant enters the normal trade 
information (i.e., security symbol, side, size, and price). In 
addition, the participant may provide that an order or counter-offer 
will be in effect for anywhere from 3 to 99 minutes, specify a day 
order, or indicate whether price and/or size are negotiable or whether 
a specific minimum quantity is acceptable.\6\ Participants may accept, 
counter or decline a SelectNet order. In the event that a participant 
elects to counter an offer, the service allows negotiations to be 
conducted between the participants by exchanging counter-offers until 
an agreement is reached.
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    \6\The identity of a participant entering an order is anonymous 
when broadcasting an order, unless the participant elects to 
identify itself; once the order is executed, each participant to the 
transaction learns of the identity of the other. In contrast, the 
recipient of a directed order is provided with the identity of the 
participant who sent the order.
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A. The NASD's Basis for the Prohibition

    The NASD seeks to amend the SelectNet operating manual\7\ to 
prohibit entry of orders in SelectNet priced outside the inside Nasdaq 
market during normal market hours (:30 a.m. to 4 p.m.), unless unusual 
market conditions, such as locked, crossed, one-sided, or no-quote 
markets exist in a security. The NASD had represented that it is 
proposing to prohibit entry of orders priced outside the inside Nasdaq 
market to eliminate a large number of what it believes to be erroneous 
transactions occurring through the service.
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    \7\The current SelectNet rules are contained in the SelectNet 
User Guide, but are not included in the NASD Manual. See SelectNet 
User Guide (Nov. 1990). The NASD has represented that it will update 
these rules and submit, by March 31, 1994, a rule filing, pursuant 
to section 19(d) of the Act and Rule 19b-4 thereunder, to 
incorporate the SelectNet rules into the NASD Manual. Letter from 
Beth E. Weimer, Associate General Counsel, NASD, to Selwyn 
Notelovitz, Branch Chief, SEC (Jan. 14, 1994). To date, the 
Commission has not received this filing.
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    The NASD believes that these orders are put into SelectNet in two 
ways: (1) as errors, where the party intended to place the order at or 
within the inside bid and offer and mistyped the trade information into 
SelectNet, ignored the reverse colored warning screen and instructed 
the computer to override the warning, or (2) as a ``concerted attempt 
to trick'' recipients of the orders into executing obviously erroneous 
trades.\8\
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    \8\For example, if the inside market in a Nasdaq security is 20 
bid, 20\1/4\ offer, and order entry firm may place an order to buy 
stock priced at 19\1/8\. According to the NASD, traders 
traditionally deal in fractions, frequently not even stating the 
integer amount of a price when transacting business over the 
telephone, and an order priced at 19\1/8\ could be read or 
interpreted as 20\1/8\. Thus, the market maker would accept the 
order, believing that it was executing an order priced within the 
spread, at 20\1/8\. Instead, the market maker would have executed 
the order a full point below the price it thought it was getting, 
and \7/8\ of a point below the best bid.
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    In support of its position, the NASD included in its filing with 
the Commission part of the results of an analysis of SelectNet orders 
and trades during September 1993. According to the NASD, the analysis 
demonstrates that, on average, over 1,000 orders a day are placed in 
SelectNet at prices outside the inside Nasdaq market. According to the 
NASD, this resulted, on average, in more than 100 executions a day at 
prices the NASD has concluded, without input from the parties of the 
transactions, are erroneous and wholly unrelated to current market 
prices. The NASD further represented that during September 1993 it 
received, in total, 46 requests to reverse trades as clearly 
erroneous,\9\ notwithstanding the daily average of 100 executions at 
prices outside the inside Nasdaq market.
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    \9\Letter from Robert E. Aber, Vice president and General 
Counsel, NASD, to Selwyn Notelovitz, Branch Chief, SEC (Jan. 14, 
1994).
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    Subsequently, the NASD provided the Commission with more specific 
information concerning the NASD's analysis of SelectNet orders and 
trades during September 1993.\10\ This information indicated that 
during the month, 34,957 (on average, 1.665/day) orders were entered in 
SelectNet outside the inside Nasdaq Market and that 2,802 (on average, 
133/day) of these orders were executed. In addition, this information 
indicated that during September 1993 the NASD received 44 requests to 
deem trades clearly erroneous where the trade occurred outside the 
inside Nasdaq Market. This information further indicated that the NASD 
granted 32 of these requests.
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    \10\Letter from Beth E. Weimer, Associate General Counsel, NASD, 
to Selwyn Notelovitz, Branch Chief, SEC (Mar. 7, 1994). In its 
letter to the Commission, the NASD requested confidential treatment 
of the information accompanying its letter. The NASD requested this 
treatment pursuant to 17 CFR 204.24b-2 and Exemption 4 of the 
Freedom of Information Act (5 U.S.C. Sec. 552(b)(4)).
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B. Exceptions to the Prohibition

    The NASD has determined to allow entry of orders on SelectNet 
outside the inside Nasdaq market under three circumstances. Any order 
entered during an exception period, described below, will remain active 
in SelectNet even after the exception period has passed.
1. Pre-Opening and Post-Closing Exception
    Because the inside Nasdaq market during non-market periods might 
not reflect current market conditions and, therefore, may be one-sided 
or may simply reflect the closing bid and offer on Nasdaq, the 
prohibition of entering orders outside the inside Nasdaq market will 
only be in effect during normal market hours (i.e., 9:30 a.m. until 4 
p.m.)
2. Exception for Locked, Crossed, One-Sided Quote or No Quote Markets
    If the market in a security becomes locked or crossed or 
experiences a one-sided quote or no quote, the NASD will allow entry or 
orders outside the inside Nasdaq market. In the event of these unusual 
market conditions, SelectNet will be programmed to lift the prohibition 
automatically for that security until the unusual condition no longer 
exists.
3. Exception for Emergency Conditions or Extraordinary Market 
Conditions
    Under Article VII, Section 3 of the NASD By-Laws,\11\ the NASD will 
retain authority to lift the prohibition during an emergency or when 
extraordinary market conditions exist.\12\
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    \11\NASD Manual, By-Laws, Art. VII, Sec. 3, (CCH) 1182A.
    \12\``Emergency conditions'' include unexpected events such as a 
declaration of war, a presidential assassination or an electrical 
black-out. ``Extraordinary market conditions'' include market breaks 
(such as October 1987), market declines and any other occasions 
where the market is experiencing highly volatile trading conditions 
such that prompt intervention is necessary for the market's 
continued efficient operation. Securities Exchange Act Release No. 
26072 (Sept. 12, 1988), 53 FR 36143 (Sept. 16, 1988) (order 
approving rule to provide the NASD Board of Governors and a proposed 
committee the authority to take action during an emergency or under 
extraordinary market conditions). See also, Securities Exchange Act 
Release No. 33292 (Dec. 6, 1993), 58 FR 65214 (Dec. 13, 1993) (NASD 
Policy Statement on Market Closings in the event of an emergency or 
extraordinary market conditions).
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III. Comment Letters

    The Commission received three comments letters in response to the 
NASD's proposed rule change.\13\ Two of these commenters opposed 
approval of the NASD's proposed rule change. Without explicitly 
opposing the NASD's proposed change, the third commenter generally 
criticized the SelectNet Service and used its response to the NASD's 
filing to support its continuing contention that SelectNet is a 
``quotation driven trading system'' rather than a communication system. 
The NASD responded to the issues raised by the commenters in a letter 
dated January 14, 1994.\14\
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    \13\Letter from James E. Buck, Senior Vice President and 
Secretary, New York Stock Exchange (``NYSE''), to Jonathan Katz, 
Secretary, SEC (Nov. 30, 1993). The NYSE's letter also referred to 
another pending NASD proposed rule change which would include 
exchange listed securities in SelectNet (File No. SR-NASD-92-16). 
The focus of the NYSE's letter concerned SR-NASD-92-16 and SelectNet 
in general.
    \14\Letter from Robert E. Aber, Vice President and General 
Counsel, NASD, to Selwyn J. Notelovitz, Branch Chief, SEC (Jan. 14, 
1994).
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    One commenter opposing the proposal argued that there are 
legitimate risk management and trading strategies that involve entering 
orders outside the inside Nasdaq market.\15\ Another commenter opposing 
the proposal argued that entering orders outside the inside market is 
typical practice when dealing with large retail orders and during 
volatile market conditions.\16\ This commenter took further exception 
with the NASD's assertion that it must review and reverse as clearly 
erroneous many of the orders executed outside the inside Nasdaq market, 
offering examples of instances where the NASD refused to reverse a 
trade executed outside the inside Nasdaq market. In addition, this 
commenter argued that the NASD's proposed prohibition is not necessary 
because SelectNet includes a feature that alerts participants who 
accept orders priced outside the inside market and requires 
confirmation of the participant's acceptance of such orders.
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    \15\Letter from Harold S. Bradley, Vice President and Director 
of Trading, Investors Research Corporation, to Jonathan G. Katz, 
Secretary, SEC (Dec. 8, 1993).
    \16\Letter from Simon S. Kogan to Margaret McFarland, Deputy 
Secretary, SEC (Dec. 1, 1993).
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    In response, the NASD acknowledged that legitimate bases exist for 
entering orders outside the inside Nasdaq market.\17\ Nonetheless, the 
NASD has determined that on balance, the benefits of the prohibition 
outweigh the costs. The NASD argued that erroneous trades are costly to 
the industry and, when reported to the tape, mislead and confuse 
issuers and investors. Moreover, the NASD pointed out that the 
alternative of negotiating a trade outside the inside Nasdaq market 
over the telephone remains.
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    \17\Letter from Robert E. Aber, Vice President and General 
Counsel, The Nasdaq Stock Market, Inc., to Selwyn Notelovitz, Branch 
Chief, SEC (Jan. 14, 1994).
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IV. Proceedings to Determine Whether to Disapprove SR-NASD-93-61 
and Grounds for Disapproval Under Consideration

    The NASD's proposal is presented as an effort to prevent market 
makers from inadvertently executing SelectNet orders at prices outside 
the inside market. Nevertheless, prohibiting the entry of SelectNet 
orders at prices outside the inside market may be neither the most 
effective means of accomplishing this objective nor the least 
restrictive. Accordingly, the Commission is interested in the reasons 
market participants may have for entering SelectNet orders outside the 
inside market, and whether there may be less restrictive means of 
preventing erroneous trades.
    The Commission, therefore, is instituting proceedings pursuant to 
Section 19(b)(2)(B) of the Act to determine whether the proposed rule 
change should be disapproved. Institution of disapproval proceedings 
appears appropriate at this time in view of the legal and policy issues 
raised by the proposal. Institution of disapproval proceedings, 
however, does not indicate that the Commission has formulated any 
conclusions with respect to any of the issues involved and the 
Commission seeks and encourages interested persons to comment on the 
proposed rule change. The sections of the Act applicable to the 
proposed rule change include:

 Section 15A(b)(6), which requires that the rules of a national 
securities association, among other things, 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(a)(1)(B), which sets forth the Congressional 
finding that new data processing and communications techniques create 
the opportunity for more efficient and effective market operations.
 Section 11A(a)(1)(C), which sets forth the Congressional 
finding that it is in the public interest to assure economically 
efficient execution of securities transactions.
 Section 11A(a)(2), which directs the Commission to facilitate 
the establishment of a national market system for securities in 
accordance with the findings set forth in Sections 11A(a)(1) (B) and 
(C).

    With respect to the proposal, the Commission specifically requests 
that commenters address, if applicable, the following items:
    (a) The NASD acknowledges that legitimate bases exist for entering 
SelectNet orders at prices outside the inside market. These could 
include: (i) Communicating limit orders to market makers; (ii) 
negotiating large block transactions; (iii) obtaining executions in 
fast markets; or (iv) exploring the level of market interest at the 
prices quoted in Nasdaq. The Commission invites comment on the 
circumstances in which a market maker or customer would use SelectNet 
to enter orders outside the inside market.
    (b) The NASD submitted data indicating that during the month of 
September 1993, although approximately 130 trades are executed daily 
(2,730 per month) through SelectNet outside the inside market, it 
received a total of only 44 requests to reverse trades as clearly 
erroneous and granted 32 of these requests. One commenter opposed to 
the proposal submitted copies of two NASD decisions upholding trades 
executed through SelectNet outside the inside market. As such, the 
Commission invites commenters to discuss whether such decisions reflect 
aberrations based on special circumstances or reflect legitimate use of 
SelectNet and of the Nasdaq market. The Commission also invites 
SelectNet users to discuss whether they cancel executions outside the 
inside by agreement with the other party (and therefore not reflected 
in the NASD's data) and/or if they choose not to cancel/seek reversal 
for other reasons (e.g., determination that cancelling/reversing is not 
worth the administrative cost).
    (c) The Commission invites suggestions for alternative means to 
prevent erroneous SelectNet executions, such as the development by 
member firms of facilities for preventing inadvertent executions.
    (d) The extent, if any, to which investors may be confused by 
reports to the type of trades effected outside the inside Nasdaq market 
using SelectNet.
    (e) The potential benefits of the proposal and whether those 
benefits outweigh any costs or burdens imposed on members and/or public 
customers.
    (f) Order delivery systems exist in and among other markets. The 
rules of some of these systems, such as the Intermarket Trading System 
(ITS), prohibit limit orders and create a conclusive presumption that 
an order executed outside the inside bid or offer is an obvious error. 
Other systems, on the other hand, such as the New York Stock Exchange's 
SuperDot System, allow limit orders and have no restrictions on the 
price of orders. The Commission invites commenters to discuss the 
distinctions among these systems with respect to the issues raised by 
the NASD.

V. Procedure: Request for Written Comments

    The Commission requests that interested persons provide written 
submissions of their views, data and arguments with respect to the 
concerns identified above as well as any other relevant concerns. In 
particular, the Commission invites the written views of interested 
persons concerning whether the proposed rule change is inconsistent 
with the provisions of the Act and the rules and regulations 
thereunder, specifically sections 15A(b)(6), 11A(a)(1) (B), and (C). 
Although there do not appear to be any issues relevant to approval or 
disapproval which would be facilitated by an oral presentation of 
views, arguments and data, the Commission will consider, pursuant to 
Rule 19b-4, any request for an opportunity to make an oral 
presentation.\18\
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    \18\Section 19(b)(2) of the Act, as amended by the Securities 
Acts Amendments of 1975, Pub. L. 94-29 (June 4, 1975), grants the 
Commission flexibility to determine what type of proceeding--either 
oral or notice and opportunity for written comments--is appropriate 
for consideration of a particular proposal by a self-regulatory 
organization. See Securities Acts Amendments of 1975, Senate Comm. 
on Banking, Housing & Urban Affairs, S. Rep. No. 75, 94th Cong., 1st 
Sess. 30 (1975).
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    Interested persons are invited to submit written data, views and 
arguments regarding the proposed rule change by June 8, 1994. Section 
19(b)(2) of the Act requires that proceedings to determine whether to 
disapprove a proposed rule change be concluded within 180 days of the 
date of publication of notice of the filing of the proposed rule 
change, unless the Commission finds good cause to extend the time for 
the conclusion of such proceedings. To provide ample opportunity for 
commenters to submit views and for the Commission to give consideration 
of these views, the Commission finds good cause to extend the time for 
the conclusion of the proceedings.
    Persons desiring to submit written data, views and arguments should 
file six copies thereof with the Secretary of the Commission, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549. Reference should be made to File No. SR-NASD-93-61.
    Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change which are filed 
with the Commission, and all written communications relating to the 
proposed rule change between the Commission and any person, other than 
those which may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying at the Commission's Public Reference Room. Copies of the filing 
and of any subsequent amendments also will be available at the 
principal office of the NASD.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-11075 Filed 5-6-94; 8:45 am]
BILLING CODE 8010-01-M