[Federal Register Volume 59, Number 129 (Thursday, July 7, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16372]
[[Page Unknown]]
[Federal Register: July 7, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34277; File No. SR-NASD-92-12]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Temporary Approval and Notice of Filing
and Order Granting Accelerated Approval of Amendment No. 8 of Proposed
Rule Change Creating a Short Sale Bid-Test for Nasdaq National Market
Securities
June 29, 1994.
I. Introduction
On July 22, 1992, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') filed with the Securities and
Exchange Commission (``SEC'' or ``Commission'') a proposed rule change
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'')\1\ and Rule 19b-4 thereunder.\2\ The rule change creates, on
a temporary basis for eighteen months, a short sale rule or ``bid-
test'' for Nasdaq Stock Market (``Nasdaq'') National Market
Securities\3\ that will prohibit short sales at or below the current
inside bid as shown on the Nasdaq screen when that bid is lower than
the previous inside bid. The rule provides certain exemptions,
including an exemption for qualified Nasdaq market makers, options
market makers, and warrant market makers. The rule also provides
exemptions similar to those provided under the Commission's short sale
rule, Rule 10a-1.\4\ Further, the NASD has submitted three
interpretations regarding ``bona fide'' market making activity, the
prices at which ``legal'' short sales may be effected, and examples of
conduct that will be deemed to be in violation of the rule; these
interpretations are part of the proposed rule change.
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\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1994).
\3\Nasdaq includes both Nasdaq SmallCap Market and Nasdaq
National Market securities. In July 1993, the NASD began referring
to Nasdaq National Market System or Nasdaq NMS securities as Nasdaq
National Market securities.
\4\17 CFR 240.10a-1.
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Notice of the proposed rule change and subsequent amendments
appeared in the Federal Register.\5\ The Commission received 397
comments in response to the release, 122 in support and 275 in
opposition.\6\ In addition to amending the proposal several times, the
NASD responded to issues raised by the commenters in a letter dated
June 24, 1993.\7\ For the reasons discussed below, the Commission is
approving the proposal, effective September 6, 1994, on a temporary
basis through March 5, 1996.
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\5\The NASD amended the proposed rule change eight times since
it was originally filed with the Commission on April 9, 1992. The
first two amendments were included in the Commission's original
notice. Securities Exchange Act Release No. 31003 (Aug. 6, 1992), 57
FR 36421 (Aug. 13, 1992). The NASD submitted Amendment No. 3 on
December 23, 1992, Securities Exchange Act Release No. 31729 (Jan.
13, 1993), 58 FR 5791 (Jan. 22, 1993), Amendment No. 4 on November
19, 1993, Securities Exchange Act Release No. 33289 (Dec. 3, 1993),
58 FR 64994 (Dec. 10, 1993), Amendment No. 5 on January 14, 1994,
Amendment No. 6 on March 8, 1994, Securities Exchange Act Release
No. 33758 (Mar. 11, 1994), 59 FR 13016 (Mar. 18, 1994) (Amendment
No. 6 replaced Amendment No. 5, which was not published for
comment), and Amendment No. 7 on May 16, 1994, Securities Exchange
Act Release No. 34092 (May 20, 1994), 59 FR 27634 (May 27, 1994). On
June 29, 1994, the NASD submitted Amendment No. 8 requesting
approval of the rule on a temporary basis for eighteen months beyond
the effective date of the rule and amending Interpretation C to
clarify that moving a bid up or down and then moving it back to the
original bid simply to create an up bid or down bid to facilitate or
preclude short selling will be considered a manipulative act and a
violation of the rule.
\6\A list of comment letters received in connection with the
publication of the rule change is available for inspection in the
Commission's Public Reference Room.
\7\Letter from Richard Ketchum, Executive Vice President and
Chief Operating Officer, NASD, to Jonathan G. Katz, Security, SEC
(June 24, 1993).
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II. Description of the Rule
A. Background
The opportunity for short selling can add to market liquidity and
pricing efficiency, while at the same time can raise general anti-
manipulation concerns. Currently, neither the Commission nor the NASD
imposes any general restriction on short selling of OTC securities.
This contrasts with short sale restrictions on exchange-listed
securities that have been in place since 1938. In general, the
Commission's short sale rule, Rule 10a-1, provides that short sales of
securities may be effected only at a price above the price at which the
immediately preceding sale was effected (``plus-tick'') or at a price
equal to the last sale if the last preceding transaction at a different
price was at a lower price (``zero-plus-tick'').
The NASD proposes to add two sections to Article III of the Rules
of Fair Practice establishing a short sale rule based on a ``bid-test''
for Nasdaq National Market securities.\8\ The first section will
prohibit members from effecting short sales at or below the bid for
themselves or their customers when the current inside or best bid is
below the previous bid, unless one of the exemptions applies. The
second section provides a definition of ``primary Nasdaq market maker''
which, beginning one year after the effective date of the rule, sets
forth the criteria a market maker must satisfy to be exempt from the
rule. In addition, the NASD submitted three interpretations setting
forth: (a) what will constitute ``bona fide market making activity;''
(b) the prices at which ``legal'' short sales may be effected; and (c)
situations that will be deemed to be indirect violations of the rule.
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\8\The rule will be in effect during normal, domestic market
hours (9:30 a.m. to 4 p.m. Eastern Time).
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The proposed rule also contains a limited exemption from the short
sale prohibition for market makers. In addition, in response to
concerns raised by commenters, the NASD submitted a number of
amendments providing limited exemptions for options market makers and
warrant market makers satisfying certain requirements, and clarifying
that bona fide market making includes, under certain conditions, risk
arbitrage activity. The exemptions are designed to allow short selling
where necessary to conduct efficient and effective market making
activities without allowing unrestricted short selling. During the
eighteen-month period of effectiveness of the rule, the NASD will study
the impact of the rule and its exemptions and, prior to the rule's
expiration, the NASD will evaluate whether the rule and its exemptions
should be extended, modified, approved on a permanent basis, or
terminated. If the NASD decides to extend, modify or approve on a
permanent basis any part or all of the rule, it must obtain Commission
approval pursuant to Section 19(b) of the Act.\9\
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\9\15 U.S.C. Sec. 78s (b)(1).
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B. The General Rule and Exemptions
The NASD's bid-test rule will prohibit NASD members from effecting
a short sale in a security at or below the current inside bid when this
bid is below the preceding best bid.\10\ This prohibition applies
equally to trades for customers and to trades for the member's own
account.\11\ The rule, however, sets forth ten exemptions. Seven of
these exemption mirror the exceptions provided under the Commission's
short sale rule.\12\ The three additional exemptions provide an
exemption for bona fide market making activity by qualified market
makers, hedge transactions by options market makers registered as
qualified options market makers, and hedge transactions resulting in
fully hedged positions by warrant market makers registered as market
makers for the warrant.
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\10\As set forth in Interpretation B, the NASD has determined
that in order to effect a ``legal'' short sale when the current best
bid is lower than the preceding best bid the short sale must be
executed at a price of at least \1/16\th point above the current
inside bid. The last sale report of such a trade would, therefore,
be above the inside bid by at least \1/16\th point. Moreover, the
NASD believes that requiring short sales to be a minimum increment
of \1/16\th point above the bid ensures that transactions are not
effected at prices inconsistent with the underlying purpose of the
rule.
\11\In Interpretation C, the NASD provides examples of
circumstances under which a member would be deemed to be in
violation of the rule. For example, if a market maker moves its bid
up or down and then moves it back to the original bid simply to
create an up bid or down bid to facilitate or preclude short
selling, the NASD would consider this a manipulative act and a
violation of the rule. In addition, if a market maker agrees to an
arrangement proposed by a member or a customer where the market
maker raises its bid in the Nasdaq system in order to effect a short
sale for the other party and is protected against any loss on the
trade or on any other executions effected at its new bid price, the
market maker would be deemed to be in violation of the rule.
Similarly, a market maker would be deemed in violation of the rule
if it entered into an arrangement with a member or a customer
whereby it used its exemption from the rule to sale short at the bid
at successively lower prices, accumulating a short position, and
subsequently offsetting those sales through a transaction at a
prearranged price, for the purpose of avoiding compliance with the
rule, and with the understanding that the market maker would be
guaranteed by the member or customer against losses on the trades.
The NASD believes that members' activities to circumvent the rule
through indirect actions such as executions with other members or
through facilitation of customer orders while being protected from
loss are antithetical to the purposes of the rule. Accordingly, the
NASD will consider any such activity as a violation of this section.
\12\In particular, the NASD's exceptions found in XX(c)(2), (3),
(4), (5), (6), (7) and (8) parallel 17 CFR 240.10a-1(e)(1), (2),
(3), (4), (7), (8) and (10), respectively. The NASD's proposal does
not include the Commission's exemptions found in 17 CFR 240.10a-
1(e)(5), (6), (11), (12) and (13); 17 CFR 240.10a-1(e)(9) is
reserved for future use.
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1. The Qualified Market Maker Exemption
The NASD received substantial comment from its members that
application of a short sale rule to market makers would dramatically
reduce their ability to adjust inventory positions quickly, thereby
lessening liquidity throughout the marketplace. Thus, the NASD provided
an exemption for qualified market makers satisfying certain criteria.
To be exempt from the provisions of the rule, a market maker must be
conducting bona fide market making activity\13\ and satisfy the
criteria for a qualified market maker. The rule sets forth certain
criteria for becoming a qualified market maker, which criteria change
after the first year of the effectiveness of the rule. Under both the
criteria applicable to the first year and those applicable to the last
six months of the rule, general qualifications standards apply. The
rule then sets forth separate criteria for becoming a qualified market
maker for securities subject to a secondary offering,\14\ an initial
public offering, or a merger or acquisition.
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\13\A market maker executing a transaction on an agency basis
would not be exempt from the rule with respect to that transaction.
As indicated above, the NASD submitted three interpretations of
the short sale rule. Interpretation A states, among other things,
the factors the NASD will consider when determining whether certain
market making activity may not be deemed bona fide market making
activity and, therefore, ineligible for the qualified market maker
exemption.
First, the interpretation reiterates the express exclusion from
the exemption for activity unrelated to market making functions,
such as index arbitrage and risk arbitrage that is independent from
a member's market making functions. The interpretation does,
however, allow short sales of a security of a company involved in a
merger or acquisition of the sale is made to hedge the purchase or
prospective purchase (based on communicated indications of interest)
of other security of a company involved in the merger or
acquisition, which purchase was made, or is to be made, in the
course of bona fide market making activity. Short sales made to
hedge any such purchases or prospective purchases must be reasonably
consistent with the exchange ratio (or exchange ratio formula)
specified by the terms of the merger or acquisition.
Similarly, the interpretation provides that bona fide market
making activity would exclude speculative selling strategies that
are disproportionate to the usual market making patterns of the
member in that security. Furthermore, the interpretation indicates
that the NASD does not anticipate that a firm could properly take
advantage of its market maker exemption to effectuate such
speculative or investment short selling decisions. Disproportionate
short selling in a market making account to effectuate such
strategies will be viewed by the NASD as inappropriate activity that
does not represent bona fide market making and would therefore be in
violation of the rule.
\14\For secondary offerings, the NASD concluded that the time
period after the announcement of the offering is so sensitive to
short selling pressure that it established special time frames and
eligibility criteria for primary market makers. In these situations,
the stock of the issuer is currently being traded and the
``overhang'' on the market of the new stock coming into the market
from the offering makes the security particularly susceptible to
short selling abuse. Such short selling can adversely affect the
capitalization of the issuer, particularly of smaller issuers, whose
securities often have less liquid secondary markets. The NASD
believes that the heightened requirements should address the
concerns about short selling by newly registered market makers in
secondary offerings.
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During the first year of the eighteen-month pilot period, a
qualified market maker is defined as a market maker that has maintained
quotations in the subject security continuously for the preceding 20
business days.\15\ During the last six months of the eighteen-month
pilot period, a qualified market maker is defined as a market maker
satisfying the criteria for a primary Nasdaq market maker. To qualify
as a primary Nasdaq market maker, market makers must satisfy at least
two of the following three standards: (1) The market maker must be at
the best bid or best offer as shown in the Nasdaq system no less than
35 percent of the time; (2) the market maker must maintain a spread no
greater than 102 percent of the average dealer spread; or (3) no more
than 50 percent of the market maker's quotation updates may occur
without being accompanied by a trade execution of at least one unit of
trading.\16\ Alternatively, recognizing that overall volume is also
indicative of quality market making, the NASD has proposed a
supplemental criterion for becoming a primary market maker. Under the
supplemental criterion, a market maker must satisfy one of the three
criteria set forth above and account for 1\1/2\ times its proportionate
share\17\ of volume in the stock.\18\
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\15\During the first year of the effectiveness of the rule, the
separate criteria for becoming a qualified market maker for
securities subject to a secondary offering, an initial public
offering, or a merger or acquisition are:
(i) For secondary offerings, the offering has become effective
and the market maker has been registered in and maintained
quotations without interruption in the subject security for 40
calendar days (between January 1, 1994 and May 31, 1994, the average
time between filing and effective dates for secondary offerings
reviewed by the NASD's Corporate Financing department was 34
business (48 calendar) days);
(ii) For initial public offerings, the market maker may register
in the offering and immediately become a qualified market maker; and
(iii) After a merger or acquisition has been publicly announced,
a qualified market maker in one of the two affected securities may
immediately register as a qualified market maker in the other merger
or acquisition security.
\16\During the last six months of the eighteen-month exemption
period, the separate criteria for becoming a qualified market maker
for securities subject to a secondary offering, an initial public
offering, or a merger or acquisition are:
(a) For secondary offerings:
(i) the secondary offering has become effective and the market
maker has satisfied the qualification criteria in the time period
between registering in the security and the offering becoming
effective; or
(ii) the market maker has satisfied the qualification criteria
for 40 calendar days.
(b) For initial public offerings:
(i) the market maker may register in the offering and
immediately become a primary Nasdaq market maker if it is a primary
Nasdaq market maker in 80% of the securities in which it has
registered; provided however, that if, at the end of the first
review period, the primary Nasdaq market maker has withdrawn on an
unexcused basis from the security or has not satisfied the
qualification criteria, it shall not be afforded a primary Nasdaq
market maker designation on any subsequent initial public offerings
for the next 10 business days; or
(ii) the market maker registers in the stock as a regular Nasdaq
market maker and satisfies the qualification criteria for the next
review period.
(c) After a merger or acquisition has been publicly announced, a
primary Nasdaq market maker in one of the two affected securities
may immediately register as a primary Nasdaq market maker in the
other merger or acquisition security.
\17\The rule provides that the NASD may change from time to time
the proportionate volume necessary for a market maker to satisfy
this test. If the NASD elects to change this criterion, the Act
requires it to file a proposed rule change with the Commission.
\18\For example, if there are 10 market makers in a stock, each
has a proportionate share of 10 percent. Thus, a market maker
seeking to qualify as a primary market maker under the alternative
criteria must, in addition to satisfying one of the three criteria
under the standard approach, account for at least 15 percent of the
overall volume. For example, if a market maker maintains its bid or
offer at the inside quote at least 35 percent of the time, but
maintains a 1 point spread in the stock when the other dealers
averaged a \3/4\ point spread and changed its quote three times on
average for every trade, then the market maker would have to meet
the proportionate volume test to qualify as a primary market maker.
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Compliance with the criteria will be tracked through the Nasdaq
system, which will enable market makers to review their status in each
criterion in each stock, and will also provide members with notice of
their compliance with the standards at set intervals.\19\ The NASD will
monitor market makers for compliance with the primary market maker
standards on a monthly review period. A market maker failing to satisfy
the qualification criteria remains a market maker in the security,\20\
but is subject to the short sale limitations. The NASD will establish
review procedures for market makers seeking reconsideration of their
failure to satisfy the primary market maker standards. Because the
primary market maker standards are objective, however, the NASD will
limit requests for reconsideration to consideration of system failures,
excused withdrawals, or related activity in derivative or convertible
securities or derivative pricing mechanisms, as seen with foreign
securities or ADRs, that may affect a market maker's compliance with
the criteria.
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\19\A market maker satisfying the criteria will be designated as
a primary market maker in the Nasdaq system, with ``primary'' or
``P'' designation displayed on the Nasdaq Workstation screen. In
addition, to assist market participants' compliance with the
proposed rule, indication of a market maker's primary market maker
designation will be available through vendor services.
\20\The requirements for registration as a Nasdaq market maker
are set forth in the NASD Manual. NASD Manual, Schedules to the By-
Laws, Schedule D, Part V, Sec. 1, (CCH) 1818. These requirements
are not affected by the NASD's bid-test proposal.
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2. The Options Market Maker Exemption
The rule also provides an exemption for certain transactions by
options market makers registered as qualified options market makers in
stock options or qualified stock index options. With certain
restrictions, the exemption permits members to execute short sales for
the account of qualified options market makers that would otherwise be
prohibited by the rule. To be eligible for the exemptions, the short
sale must satisfy the criteria for an ``exempt hedge transaction'' and
the market maker must be designated a qualified options market maker.
The rule provides separate definitions of ``exempt hedge
transaction'' for market making in stock options and stock index
options. For stock options, the term means a short sale of an
underlying security to hedge an existing offsetting options position or
an offsetting options position that was created ``contemporaneous with
the short sale.''\21\ For stock index options, an exempt hedge
transaction means a short sale to hedge an existing offsetting stock
index options position or an offsetting stock index options position
that was created contemporaneously with the short sale, provided that:
(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'';\22\ and (c)
the dollar value of all exempt short sales effected to hedge the
offsetting stock index options position does not exceed the aggregate
current index value of the offsetting options position.
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\21\``Contemporaneous with the short sale'' includes
transactions occurring simultaneously as well as transactions
occurring within the same brief period of time. Thus, the short sale
can precede, as well as follow, the option transaction.
\22\The rule defines a ``qualified stock index'' as 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 rule further provides
that a qualified stock index shall be reviewed by the NASD 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.
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To be designated a qualified options market maker, the market maker
must have received an appointment as such pursuant to the rules of a
``qualified options exchange.'' \23\ In addition, when establishing the
short position, the options market maker must receive, or be eligible
to receive, good-faith margin pursuant to Section 220.12 of Regulation
T under the Act.
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\23\A ``qualified options exchange'' is a national securities
exchange with Commission approved 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
limit the designation of a qualified options market maker where the
options exchange finds substantial, willful, or continuing
violations of the rule. See e.g., File Nos. SR-CBOE-94-10, SR-Phlx-
94-9, SR-Amex-94-21 and SR-PSE-94-16 filed with the Commission on
March 31, 1994, June 1, 1994, June 13, 1994 and June 16, 1994,
respectively. The NYSE has informed the Commission that it sent its
filing on June 27, 1994 under the file number SR-NYSE-94-22.
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As discussed more fully below, options market maker short sale
transactions unrelated to normal options market making activity (e.g.,
index arbitrage and risk arbitrage) are not exempt. Nonetheless, the
rule provides that a member would not violate the short sale rule if it
executed an order for the account of an options market maker with the
good-faith belief that the order was in full compliance with the rule,
even though a subsequent determination was made that the order was
either not entitled to the exemption or was incorrectly marked
``long.''
3. The Warrant Market Maker Exemption
The rule also extends an exemption to registered warrant market
makers, with restrictions similar to those imposed on qualified options
market makers. To be eligible for this exemption, the warrant market
maker must be registered as a market maker in the warrant and the short
sale must be an ``exempt hedge transaction'' that results in a fully
hedged position. The rule defines the term ``exempt hedge transaction''
as a short sale to hedge an existing offsetting warrant position or an
offsetting warrant position that was created contemporaneous with the
short sale.\24\
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\24\The phrase contained in the proposed rule ``contemporaneous
with the short sale'' is meant to include transactions occurring
simultaneously as well as transactions occurring within the same
brief period of time.
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Short sales unrelated to normal warrant market making activity
(e.g., index arbitrage and risk arbitrage) would not be exempt. As with
short sales executed on behalf of options market makers, a member who
executes a short sale on behalf of a warrant market maker will not be
deemed to violate the short sale rule if it executed the order with the
good-faith belief that the order was in full compliance with the rule,
even though a subsequent determination was made that the order was
either not entitled to the exemption or was incorrectly marked
``long.''
4. The Exemptions Mirroring Rule 10a-1
The rule also incorporates the exemptions in the Commission's short
sale rule that are relevant to trading in Nasdaq.\25\ In addition, the
Commission recently proposed an amendment to Rule 10a-1 to codify an
interpretation with respect to liquidating index arbitrage
positions.\26\ The NASD has requested that if approved by the
Commission, it intends to conform its rule to the Commission's rule and
will file the proposed rule change with the Commission.\27\
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\25\Specifically, the rule exempts: (1) A broker-dealer from a
sale that is for an account in which it has no interest and that is
marked long; (2) Any sale by a market maker to offset odd-lot orders
of customers; (3) Any sale by a market maker to liquidate a long
position, which is less than a round lot, provided the sale does not
change the dealer's position by more than one unit of trading (100
shares); (4) Certain short same arbitrage transactions, in special
arbitrage accounts, by a person who owns another security or
presently will be entitled to acquire an equivalent number of
securities of the sale class as the securities sold (provided the
sale, or purchase which the sale offsets, is made for the bona fide
purpose of profiting from a current price difference between the
security sold and the security owned) and that the right of
acquisition was originally attached to the security or was issued to
all holders of any class of securities of the issuer; (5)
Transactions made as part of an international arbitrage opportunity,
whereby the seller must have a bona fide purpose to profit from the
price difference between a security on an international market
outside the jurisdiction of the U.S. and a security listed as a
Nasdaq National Market security (for the purposes of this section, a
depository receipt (e.g., ADR) for a security shall be deemed the
same as the security represented by the receipt); (6) Short sales by
an underwriter or any member of the distribution syndicate in
connection with the over-allotment of securities, or any lay-off
sale by a person with a distribution of securities pursuant to a
rights offering (17 CFR 240.10b-8) or a standby underwriting
commitment; and (7) Liquidations of blocks acquired by a market
maker acting in the capacity of a block positioner even if the block
positioner does not have a net long position in the security if and
to the extent that its net short position in such security is the
subject of one or more offsetting positions created in the course of
bona fide arbitrage, risk arbitrage, or bona fide hedge activities.
\26\Securities Exchange Act Release No. 30772 (June 3, 1992), 57
FR 26891 (June 16, 1992).
\27\Securities Exchange Act Release No. 31003 (Aug. 6, 1992), 57
FR 36421 (Aug. 13, 1992) (publication of the Commission's original
notice of SR-NASD-92-12).
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III. Comments
As indicated above, the Commission received a total of 397 comment
letters on the NASD's proposed short sale bid-test, with 275 opposing
approval of the rule change and 122 supporting approval.\28\ In
addition to amending the proposal several times, the NASD responded to
issues raised by the commenters in a letter dated June 24, 1993.\29\
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\28\A list of comment letters received in connection with the
publication of the rule change is available for inspection in the
Commission's Public Reference Room.
\29\Letter from Richard Ketchum, Executive Vice President and
Chief Operating Officer, NASD, to Jonathan G. Katz, Secretary, SEC
(June 24, 1993).
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Commenters in support of the proposed short sale bid-test are
mostly issuers whose securities trade on Nasdaq.\30\ Many of these
issuers report that they have experienced short selling ``abuse'' and
several commenters provide what they believe are specific examples of
``piling-on'' and manipulation. These commenters make four principal
arguments in favor of the proposal: (1) The short sale rule is
necessary to reduce intra-day volatility on Nasdaq; (2) the proposal
will reduce market manipulation that threatens the integrity of the
Nasdaq market; (3) short selling abuse undervalues stock prices; and
(4) the proposed rule will provide more equal regulation of short
selling between the exchange and Nasdaq markets.
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\30\The Commission received approximately 120 letters from
issuers and issuer trade groups.
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Commenters opposing the rule change make three principal arguments
that remain relevant after consideration of the NASD's amendments: (1)
The NASD has failed to provide sufficient evidence of the need for a
short sale rule or demonstrate the appropriateness of a bid-test; (2)
the ``primary'' market maker qualification standards will have negative
effects on both market makers and the Nasdaq market; and (3) the
proposed rule is inconsistent with the requirements of the Act.
A. The Need for a Short Sale Bid-Test
Commenters argue that the NASD has failed to provide sufficient
evidence demonstrating the need for short sale regulation in the form
of a bid-test. Indeed, many argue that there is no need for additional
short sale restrictions. They argue that instead of adding another
layer of regulation to the OTC market, the NASD should enforce existing
anti-fraud rules more stringently and increase surveillance over market
participants. Commenters further believe that the NASD proposed the
rule with the primary purpose of eliminating a competitive disadvantage
vis-a-vis the exchanges. They argue that the NASD is simply responding
to issuer misconception of the effect of the Commission's short sale
rule, which applies only to exchange-listed securities. They believe
that issuers incorrectly conclude that manipulative short selling is
substantially diminished because of the restrictions on short selling
on exchanges. Finally, these commenters believe the NASD has not
adequately balanced the benefits of short selling, such as increased
liquidity and more accurate pricing of securities, against the costs
that its rule will impose.
Commenters also argued against the NASD's proposal on the basis
that there are less restrictive alternatives. For example, the NASD
could limit short selling in a given security only when the security
has experienced a certain percentage decrease during the trading day.
Many of these commenters further argued that the NASD's proposal would
create long periods of short sale prohibition in some of the less
liquid Nasdaq National Market securities. Commenters also opposed the
rule due to concerns that it could encourage Market makers to
manipulate bids to guard against short selling. Finally, several
commenters cited economic studies such as that of Irving M. Pollack to
support their arguments that short selling restrictions in the form of
a bid-test are unnecessary.\31\
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\31\In 1986, the NASD retained former Commissioner Irving M.
Pollack to conduct a study of short selling in the OTC market.
Irving M. Pollack, Short-Sale Regulation of Nasdaq Securities (July
1986) (``Pollack Report'').
In general, the Pollack Report recommended against a formal
short sale rule for Nasdaq and found that the preponderance of short
selling is done for legitimate purposes by market professionals. The
report also found that short positions in Nasdaq stocks generally
are smaller overall in relation to average daily volume and share
outstanding than is true of exchange-listed securities, and that
Nasdaq stocks have lower average short-interest percentages. Pollack
Report at 65. The same finding was made by the NASD based on later
data. NASD, Reports of the special Committee of the Regulatory
Review Task Force on the Quality of Markets 32 (1988). See also J.
Randall Woolridge and Amy Dickinson, Short Selling and Common Stock
Prices, Fin. Analysts J. 20 (Jan.-Feb. 1994) (analysis of overall
market data and selected individual securities traded on exchanges
and in the OTC market indicating that there is an insignificant
relationship between changes in short positions and stock prices).
The Pollack Report also concluded that, unless accompanied by a
violation of delivery and settlement requirements or by fraudulent
or manipulative conduct, short selling is not improper or abusive.
Since the study found that there was no current evidence of problems
that would support consideration of tick-test type restrictions, the
study did not explore the varieties of tick-tests and their
feasibility for the market. The study identified, however, the
build-up of short to clearing (i.e., naked short) positions as
having the potential to create serious problems in a lengthy bear
market or in times of market stress. Pollack Report at 63-64.
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In response to the commenters' belief that a short sale rule for
the Nasdaq market is unnecessary, the NASD stated that notwithstanding
the implementation of the Pollack Report recommendations, it remains
concerned about short-term volatility and inaccurate pricing of Nasdaq
securities often associated with short selling. In addition, the NASD
cited to over one hundred comment letters submitted by issuers claiming
that they have experienced short selling problems, some recounting
specific instances alleging that participants sold short on the basis
of rumors or inaccurate reports. The NASD, therefore, indicated its
belief that its proposal is a reasonable approach to solving these
problems and is consistent with the Act.
B. Effect of Primary Market Maker Qualification Standards on Nasdaq
Market Makers and the Market
Many commenters indicated their believe that most short selling is
done by market makers and, therefore, if the NASD does impose a bid-
test restriction on short selling, there should be no exemptions. Many
market making firms and others criticized the NASD's primary market
maker qualification standards, which goes into effect one year after
the effective date of the rule. They argued that the criteria will
unfairly discriminate among market makers and create two tiers of
market makes and, thus, will fragment the market making community and
restrict the ability of non-primary market makers to use short sales as
a risk management technique.
Some commenters also believe that requiring market makers to
maintain the inside bid or offer will result in dealers following the
lead of other dealers in the issue, thus creating additional
volatility. Additionally, commenters stated that the requirements that
no more than 50% of a market maker's quotation updates occur without
being accompanied by an execution appears to be in direct conflict with
a market maker reflecting a customer's order in its quote. In addition,
some commenters believed that this requirement would prevent market
makers from updating quotes in response to significant external events
and amounts to a penalty on efficient pricing policies.
Some commenters also strongly opposed the interim, first year 20-
day qualification criteria, stating that it is overly restrictive and
disadvantageous to market makers that want to add new stocks. They
believed that the inability to short a stock at the bid price will
seriously impede market makers' capital commitment to these issues and
recommended that the 20-day test be a stand-by provision, to be
implemented only when abuses of the market maker exemption have been
uncovered. On the other hand, at least one commenter believed that
immediate implementation of the permanent qualification standards may
have the effect of improving the quality of the market and, thus, is
preferable to the 20-day registration standard.
In response to these comments, the NASD stated that the
qualification standards are designed to limit the exemption to those
market participants that add depth and liquidity to the market. This
approach, according to the NASD, will ensure that the exemption is
available only to those market makers that consistently add value to
the market.
Responding to the concern that the primary market maker criteria
may have negative effects on market makers and the Nasdaq market, the
NASD indicated that it believes that the specific qualification
criteria can be met successfully by both small and large market makers.
The NASD further noted that market making firms have direct control
over whether they meet the primary market maker qualification
standards. In particular, they have control over the amount of time at
which they are at the inside bid or offer, their spread in comparison
to the average spread, quotation updates accompanied by reported
transactions and accounting for 1\1/2\ times of proportionate share of
overall volume.
C. Consistency With the Requirements of the Act
Many commenters on the proposed rule change believed that it is
inconsistent with the requirements of the Act. In particular,
commenters believed that the rule proposal is at odds with the Act's
requirements that the NASD's rules: (a) Promote just and equitable
principles of trade, remove impediments to and perfect the mechanism of
a free and open market, and protect investors and the public
interest;\32\ and (b) not impose a burden on competition not necessary
or appropriate in furtherance of the purposes of the Act.\33\
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\32\15 U.S.C. Sec. 78o-3(b)(6).
\33\15 U.S.C. Sec. 78o-(b)(9).
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Beyond the commenters' concern that the rule will unfairly
discriminate among market makers (discussed in the previous section),
commenters argued that the bid-test will create inequitable principles
of trade by disadvantaging non-exempt market participants. Further,
they believed that the bid-test adds an unnecessary and poorly designed
impediment to an otherwise free and open market by restricting the
ability of participants to determine the natural market price of
securities. Finally, commenters asserted that the proposal will not
protect investors or the public interest because, as drafted, the rule
fails to restrict manipulative short selling, while at the same time it
exempts market makers which are the most active class of short sellers.
Notwithstanding the NASD's assertion that the proposal furthers
Congress' goal of fair competition among brokers and dealers and among
markets, commenters argued that the proposal is inconsistent with
Section 11A(a)(1)(C).\34\ These commenters asserted that the bid-test
is anti-competitive in that it creates unfair advantages for certain
market participants at the expense of other market participants.
Specifically, they argued that the rule provides unfair advantages to
qualified market makers at the expense of non-exempt market
participants. Further, commenters stated that the purpose of the rule
is to enhance the NASD's competitive status at the expense of other
markets and that this goal is directly at odds with the requirements of
the Act.
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\34\ Section 11A(a)(1)(C) sets forth, among other things,
Congress' finding that it is in the public interest to assure fair
competition among brokers and dealers, among exchange markets, and
between exchange markets and markets other than exchange markets. 15
U.S.C. 78k(a)(1)(C).
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The NASD argued that its proposal complies with Section 15A(b)(6)
because, similar to Rule 10a-1, it is designed to prevent fraudulent
and manipulative acts. In addition, the NASD argued, because the
immediate beneficiaries of short sale regulation are the shareholders
who own stock, the NASD believes the proposal ensures an environment
designed to protect investors and the public interest. The NASD also
asserted that the rule is consistent with Section 15A(b)(9) because,
although the proposal does impose burdens on members and their
customers, these burdens are appropriate for maintaining the integrity
of the market for shareholders.
The NASD responded to the commenters' unequal regulation argument
by asserting that, for the purposes of Section 3(a)(36) of the Act,
NASD members and non-members are not within the same ``class.'' Thus,
granting members of the NASD an exemption to the rule while not
granting investors or non-members an equivalent exemption cannot be
deemed unequal regulation. The NASD further pointed out that Congress
did not ban all forms of discrimination between members of the same
class. The Act only bans unfair discrimination and the NASD asserts
that to grant an exemption to those member firms that add liquidity and
otherwise improve the market is not unfair.
The NASD also addressed the unequal regulation argument by
asserting that the exemption for certain Nasdaq market makers is
appropriate even though exchange specialists do not have a similar
exemption under Rule 10a-1 because of the inherent differences between
the competitive dealer market and the auction markets. In particular,
the NASD pointed out that: (a) Exchange specialists have a monopoly
over the securities in which they trade; (b) dealers generally do not
have an informational advantage over other dealers; and (c) dealers do
not have the ability to close their markets because of sudden
volatility or an order imbalance.
IV. Discussion
Under Section 19(b) of the Act, the Commission must approve a
proposed NASD rule change if it finds that the proposal is consistent
with the requirements of the Act and the rules and regulations
thereunder that govern the NASD.\35\ In evaluating a given proposal,
the Commission must examine the record before it and all relevant
factors and necessary information.\36\ Section 15A of the Act addresses
with some specificity requirements applicable to NASD rules, and those
standards are particularly significant in the Commission's
determination of whether the NASD's proposal is consistent with the
Act.\37\
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\35\15 U.S.C. 78s(b).
\36\In the Securities Acts Amendments of 1975, Congress directed
the Commission to use its authority under the Act, including its
authority to approve SRO rule changes, to foster the establishment
of a national market system and promote the goals of economically
efficient securities transactions, fair competition, and best
execution. Congress granted the Commission ``broad, discretionary
powers'' and ``maximum flexibility'' to develop a national market
system and to carry out these objectives. Furthermore, Congress gave
the Commission ``the power to classify markets, firms, and
securities in any manner it deems necessary or appropriate in the
public interest or for the protection of investors and to facilitate
the development of subsystems within the national market system.''
S. Rep. No. 75, 94th Cong., 1st. Sess., at 7 (1975).
\37\See 15 U.S.C. Sec. 78o-3.
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The Commission has determined to approve the NASD's proposal. The
Commission believes that the rule change is consistent with the
requirements of the Act and the rules and regulations thereunder
applicable to the NASD, including the requirements of Sections
15A(b)(6), 15A(b)(9) and 15A(b)(11) of the Act.\38\ Section 15A(b)(6)
requires, among other things, that the NASD's rules be designed to
prevent fraudulent and manipulative acts and practices, to promote just
and equitable principles of trade, and to protect investors and the
public interest.\39\ Sections 15A(b)(9) and (11) require that the
NASD's rule be designed not to impose any burden on competition not
necessary or appropriate in furtherance of the Act\40\ and to produce
fair and informative quotations, to prevent fictitious or misleading
quotations, and to promote orderly procedures for collecting,
distributing and publishing quotations.\41\ In addition, the Commission
believes that the rule change will further the goals of Section 11A in
that it will promote efficient and effective market operations and
economically efficient execution of investor orders in the best market
and assure fair competition between the exchange markets and the OTC
market and among brokers and dealers.\42\
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\38\Id 78o-3(b)(6), (9) and (11).
\39\Id 78o-3(b)(6).
\40\Id 78o-3(b)(9).
\41\Id 78o-3(b)(11).
\42\Id 78k-1(a)(1)(C).
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A. Background of Short Sale Regulation
The Commission believes that the disparate regulation of short
selling in Nasdaq and exchange markets may no longer be warranted or
justified by valid regulatory purposes. Short selling of exchange-
listed securities has been the subject of Commission regulation since
1938.\43\ On a number of occasions, the Commission has sought comment
on and considered whether to extend short sale regulation similar to
Rule 10a-1 to securities traded solely in the OTC market. In the
process of designating certain OTC securities as National Market
securities, the Commission discussed issues related to the eventual
inclusion of qualified OTC securities in additional national market
system facilities.\44\ In response, the NASD stated that ``short
selling regulations prior to and during a distribution of [National
Market] Securities would be appropriate but that it is not necessary,
at this time, to impose across-the-board short sales regulations on
transactions in [National Market] Securities.''\45\ In 1985, the
Commission again sought comment on whether short sales in Nasdaq
National Market securities should be regulated, and if so, how such
regulation should occur.\46\ Commenters generally opposed the adoption
of a tick-test for Nasdaq National Market securities. The Commission
did not act on these requests for comments.\47\
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\43\17 CFR 240.10a-1. Congress granted the Commission plenary
power to regulate short sales in listed securities to ``purge the
markets of the abuses connected with these practices.'' See Stock
Exchange Practices, Report of the Senate Comm. on Banking and
Currency, S. Rep. No. 1455, 73d Cong., 2d Sess. 55 (1934). See also
H.R. Rep. No. 1383, 73d Cong., 2d Sess. 11 (1934). Following a
Commission inquiry into the effects of concentrated short selling in
the 1937 market break, the Commission in 1938 adopted Rule 10a-1.
This rule prohibited all short sales in securities listed on a
national securities exchange below the last sale price, or at the
last sale price if the last preceding trade at a different price was
at a higher price, subject to certain exceptions. See Securities
Exchange Act Release No. 1548 (Jan. 24, 1938), 3 FR 213. In that
release, the Commission also adopted Rule 3b-3. For a detailed
discussion of the development of Rule 10a-1, see 7 Louis Loss & Joel
Seligman, Securities Regulation 3198-3221 (1991).
\44\Securities Exchange Act Release No. 18590 (Mar. 24, 1982),
47 FR 13617 (Mar. 31, 1982). The primary effect of designating OTC
securities as National Market securities is that transactions in
these securities must be reported in a real-time system in
accordance with the Commission's last sale reporting rule, and
quotations for these securities must be firm as to the quoted price
and size. 17 CFR 240.11Aa3-1 and 17 CFR 240.11Ac1-1.
\45\Letter from William Broka, Secretary, NASD, to George A.
Fitzsimmons, Secretary, SEC (July 31, 1981).
\46\Securities Exchange Act Release No. 22127 (June 21, 1985),
50 FR 26584 (June 27, 1985).
\47\The Commission did, however, adopt Rule 10b-21 to address
the concern expressed by the NASD and other commenters about the
practice of short selling immediately prior to a public offering of
securities with the covering purchases being made from the
securities in the offering. 17 CFR 240.10b-21. In particular, Rule
10b-21 prohibits a person who effects short sales of an equity
security between the filing of a registration statement and the time
at which sales of such equity security may be commenced, from
covering those short sales with offered securities purchased from an
underwriter or other broker or dealer participating in the offering.
The Commission originally adopted Rule 10b-21 on a temporary basis
(Rule 10b-21(T)). Securities Exchange Act Release No. 26028 (Aug.
25, 1988), 53 FR 33455 (Aug. 31, 1988). The Commission subsequently
adopted the rule on a permanent basis. Securities Exchange Act
Release No. 33702 (Mar. 2, 1994) 59 FR 10984 (Mar. 9, 1994).
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In 1986, the Pollack Report made a number of recommendations
regarding short selling in Nasdaq stocks, but recommended against a
formal short selling rule for Nasdaq.\48\ Since 1986 the NASD has
adopted a number of the recommendations for short sale regulation
contained in the Pollack Report. The NASD now requires each member to
mark all sale transactions either ``long'' or ``short;''\49\ requires
each member, prior to accepting a short sale from a customer, to make
an affirmative determination that it will receive delivery of the
security from the customer or that it can borrow the security on the
customer's behalf;\50\ requires each member, with certain exceptions,
to make an affirmative determination that it can borrow the security
before effecting a short sale for its own account;\51\ imposes
mandatory buy-in requirements for cash or guaranteed delivery for
Nasdaq securities where the buyer is a customer other than another NASD
member, upon failure of a clearing corporation to effect delivery
pursuant to a buy-in notice;\52\ requires each member to report to the
NASD, as of the 15th of each month, aggregate short positions in all
customer and proprietary accounts in Nasdaq securities;\53\ and
requires a short seller's broker to close-out securities for cash or
guaranteed delivery when delivery has not occurred within 10 business
days after normal settlement date.\54\
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\48\See supra note 31 and accompanying text.
\49\NASD Manual, Rules of Fair Practice, Art. 3, Sec. 21(b)(i),
(CCH) 2171. Securities Exchange Act Release No. 23572 (Aug. 28,
1986), 51 FR 31865 (Sept. 5, 1986) (approval of File No. SR-NASD-86-
17).
\50\NASD Manual, Rules of Fair Practice, Art. 3, Sec. 1, Prompt
Receipt and Delivery Interpretation (b)(2)(A), (CCH) 2151.04.
Securities Exchange Act Release No. 23572 (Aug. 28, 1986), 51 FR
31865 (Sept. 5, 1986) (approval of File No. SR-NASD-88-17). On May
26, 1994, the NASD filed a proposed rule change to amend the
definition of ``affirmative determination'' to require a member to
maintain a written record identifying, among other things, the
location and deliverability of the securities or the identity of the
individual and firm who offered assurance that the securities will
be delivered or available for borrowing by the settlement date. See
File No. SR-NASD-94-31.
\51\NASD Manual, Rules of Fair Practice, Art. 3, Sec. 1, Prompt
Receipt and Delivery Interpretation (b)(2)(B), (CCH) 2151.04.
Securities Exchange Act Release No. 28186 (July 5, 1990), 55 FR
28703 (July 12, 1990) (approval of File No. SR-NASD-89-5). See also
supra note 50 concerning NASD proposal to amend the definition of
``affirmative determination.''
\52\NASD Manual, Uniform Practice Code, Sec. 59(j), (CCH)
3559. Securities Exchange Act Release No. 26694 (Apr. 4, 1989) 54 FR
14404 (Apr. 11, 1989) (approval of File No. SR-NASD-87-10).
\53\NASD Manual, Rules of Fair Practice, Art. III, Sec. 41 (CCH)
2200A. Securities Exchange Act Release No. 23855 (Dec. 1, 1986),
51 FR 44170 (Dec. 8, 1986) (approval of File No. SR-NASD-86-30).
\54\NASD Manual, Uniform Practice Code, Sec. 71, (CCH) 3571.
Securities Exchange Act Release No. 32632 (July 14, 1993), 58 FR
39072 (July 21, 1993) (File No. SR-NASD-90-30).
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The NASD also encouraged adoption of Rule 10b-21,\55\ which
prohibits a person who effects a short sale of an equity security
between the filing of a registration statement and the time at which
sales of such equity security may be commenced from covering the short
sale with offered securities purchased from an underwriter or other
broker or dealer participating in the offering.\56\
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\55\See supra note 47.
\56\17 CFR 240.10b-21.
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B. The NASD's Initiative
1. The Need for a Short Sale Rule for the OTC Market
The Commission is reluctant to approve regulations that are likely
to hinder efficient price discovery. The Commission's experience with
Rule 10a-1 demonstrates that limited short sale rule restrictions have
not interfered with the efficient operation of the exchange markets,
while reducing the potential for abusive short selling practices. In
addition, investors derive a certain measure of confidence from short
selling limitations.
Over the past twenty years, the enhancements to, and growth of, the
OTC market have led to increased expectations by investors, issuers and
broker-dealers of Nasdaq securities generally, and Nasdaq National
Market securities, in particular. Today, these participants expect
safeguards in Nasdaq comparable to the exchange markets. The NASD
believes that implementation of the principal Pollack Report
recommendations have not adequately provided these safeguards.
The NASD and commenters have presented evidence, albeit anecdotal,
of continuing problems of short selling in the OTC market. In addition,
the Commission recognizes that without a short sale rule for Nasdaq,
the NASD is competitively disadvantaged. The exchange markets can and
do attract issuers and investors with claims that their markets protect
against potential short selling abuse. In 1975, Congress specifically
found that the interests of the public, the protection of investors and
the maintenance of fair and orderly markets are furthered by fair
competition between the exchange markets and the OTC market.\57\ Thus,
recognizing the potential for problems associated with short selling,
the changing expectations of Nasdaq market participants and the
competitive disparity between the exchange markets and the OTC market,
the Commission believes that regulation of short selling of Nasdaq
National Market securities is consistent with the Act.
---------------------------------------------------------------------------
\57\15 U.S.C. 78k-1(a)(1)(C)(ii).
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2. The Design of the Proposed Restrictions
Having determined that some regulation of short selling of Nasdaq
National Market securities is consistent with the Act, the Commission
must determine whether the proposed design of that regulation is
consistent with the Act. The Commission's tick-test restricts short
selling based on the most recent sale price in the particular security.
This is a logical approach in the auction market environment where,
generally, transactions in a given security are executed at one
location and, consequently, are typically reported sequentially.
Notwithstanding the advances over the past fifteen years in trade
reporting of Nasdaq securities, the NASD is not convinced that a tick-
test would be appropriate for Nasdaq short sale regulation. In Nasdaq,
the average security has more than ten market makers. With many trades
occurring over the telephone and transaction reporting occurring up to
ninety seconds after execution, the sequence in which trades are
reported may not always reflect the sequence in which the trades
occurred. Thus, the NASD believes that differences between trade
reporting in the auction markets and the competing dealer market
warrant consideration of a different, although analogous, approach to
short sale regulation.
The NASD's rule also differs from the Commission's short sale rule
by providing, under certain circumstances, a market maker exemption;
under the Commission's rule, which generally applies only to the
auction markets, specialists do not enjoy an exemption. The NASD
believes that a market maker exemption is justified, considering the
inherent differences between its competing dealer market and the
auction markets. In particular, unlike competing market makers,
specialists have a monopoly over the securities in which they trade and
are able to call trading halts in response to excessive volatility or
order imbalances.
The Commission believes that the NASD's short sale bid-test,
including the market maker exemptions, is a reasonable approach to
short sale regulation of Nasdaq National Market securities and reflects
the realities of its market structure. The Commission believes,
however, that experience with the NASD's bid-test may raise issues that
require reconsideration of some or all elements of the proposal. The
Commission is sensitive to commenters' concerns about efficiency and
liquidity in the market. The Commission acknowledges, based in large
part on the arguments raised by commenters, that there will be
opportunities for market makers to control short selling by moving
their bids.\58\ The Commission is also concerned that the bid-test may
restrict non-abusive short-selling for lengthy periods of time when the
bid is stable after a down-bid.\59\
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\58\We note, however, that the rule includes a provision
(conditioning market maker exemption on at least 50% of quote
updates being accompanied by executions) that could discourage
market makers from lowering their bids to limit short selling.
\59\The Commission notes that facilities for exposure of
customer limit orders in Nasdaq would alleviate the restrictiveness
of the rule by increasing opportunities for customers to trade
between the quotes. Increased transparency would also limit the
ability of market makers to restrict short selling by lowering their
bids. In this regard, the Commission's Division of Market Regulation
recently recommended that the NASD encourage the display of limit
orders in Nasdaq stocks that are better than the best Nasdaq quote.
See Division of Market Regulation, Market 2000: An Examination of
Current Equity Market Developments at IV-6 (January 1994) (``Market
2000 Report'').
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In addition, questions remain about whether market maker exemptions
from these restrictions are necessary on an ongoing basis. It is worth
noting that specialists and other market makers do not enjoy similar
exemptions from the Commission's short sale rule for listed securities
under Rule 10a-1. With respect to the market maker exemption,
commenters have raised concerns about one of the conditions of the
proposed exemption, which requires that at least 50% of a market
maker's quote updates be accompanied by an execution. The Commission
acknowledges that this requirement may decrease pricing efficiency by
discouraging market makers from updating their quotes in response to
external events. Moreover, the Commission is concerned that this
requirement could discourage market makers from exposing customer
orders in their quotes. The Commission has long encouraged the display
of customer orders with prices better than the interdealer quotes,\60\
and will scrutinize the effects of this requirement on transparency for
customer orders.
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\60\See e.g., Market 2000 Report, at IV-6 (the NASD should
``consider encouraging the display of limit orders in Nasdaq stocks
that are better than the best Nasdaq quote * * *'').
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During the eighteen-month temporary approval period for the
proposal, the Commission and the NASD will have an opportunity to study
the effects of the bid-test and market marker exemptions, and to
determine whether the bid-test and exemptions are practicable and
necessary on an ongoing basis.\61\ The Commission expects the NASD to
monitor the effects of its short sale rule on a continuing basis during
the first 12 months of effectiveness, and expects a full report as soon
as practicable thereafter. In particular, the NASD's study should
address the following issues:
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\61\This 18-month pilot period also enables the Commission and
the NASD to consider other alternatives to the rule. See e.g. supra
Comment section of this order.
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Effectis on Amount of Short-Selling: As noted, the bid-
test will lead to prohibitions of short selling for longer time
intervals than would a transaction price tick-test. The study should
provide data on the length of these intervals. In addition, the study
should evaluate the amount of non-market maker short selling permitted
under the rule, the extent of short selling by market makers exempt
from the rule, and any incidents of perceived ``abusive short
selling.''
Spreads and Volatility: The NASD has asserted that
``abusive short selling'' has increased volatility and spreads in
Nasdaq stocks. The study should evaluate the effects of the rule on
spreads and volatility.
Potential Bid Manipulation: As noted, the rule provides
market makers with the opportunity to control short selling by moving
their bids. The study should evaluate whether the behavior of bid
prices has been significantly altered by the rule. Specifically, the
study should compare the average time that short sales are prohibited
after the rule is in place relative to the average time short sales
would have been prohibited in the period prior to effectiveness, had
the rule been in place.
Minimum Increment for Allowable Sales Above the Bid: The
study should review the effects of permitting short selling based on a
minimum bid increment of 1/16.\62\
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\62\In this regard, the Commission notes that various
proprietary trading systems may allow for finer pricing intervals.
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V. Conclusion
For the reasons discussed above, the Commission has determined that
the NASD's proposed short sale rule is designed to prevent manipulative
acts and practices and protect investors and the public interest, and
that these goals, on balance, outweigh any negative effects the rule
may have on the market for Nasdaq National Market securities.
Accordingly, the Commission finds that the rule change is
consistent with the Act and the rules and regulations thereunder
applicable to the NASD and, in particular, Sections 15A(b)(6),
15A(b)(9), and 15A(b)(11). In addition, the Commission finds that the
rule change is consistent with the Congressional objectives for the
equity markets, set out in Section 11A, of achieving more efficient and
effective market operations, fair competition among brokers and
dealers, and the economically efficient execution of investor orders in
the best market.
It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act,
that the instant rule change SR-NASD-92-12 be, and hereby is, approved,
effective September 6, 1994, on a temporary eighteen-month basis
through March 5, 1996.
By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 94-16372 Filed 7-6-94; 8:45 am]
BILLING CODE 8010-01-M