[Federal Register Volume 60, Number 21 (Wednesday, February 1, 1995)]
[Notices]
[Pages 6327-6330]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-2388]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35275; File No. SR-NASD-94-68]


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. 2 of Proposed 
Rule Change to Extend the Interim SOES Rules

January 25, 1995.

I. Introduction

    On December 1, 1994, 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 NASD proposes to 
extend through March 27, 1995 certain of the prior changes to its Small 
Order Execution System (``SOES'') that are scheduled to expire today. 
The currently effective prohibition on short selling in SOES would not 
be extended.

    \1\15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1994).
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    Specifically, the NASD proposes to extend changes that: (1) Reduced 
the maximum size order eligible for execution through SOES from 1,000 
shares to 500 shares; (2) reduced the minimum exposure limit for 
``unpreferenced'' SOES orders from five times the maximum order size to 
two times the maximum order size, and eliminated the exposure limits 
for ``preferenced orders''; and (3) implemented an automated function 
for updating market maker quotations when the market maker's exposure 
limit has been exhausted (collectively referred to hereinafter as the 
``Amended Interim SOES Rules'').
    In 1993, the Commission approved these changes to the SOES rules 
(as well as a short selling prohibition) on a one-year pilot basis.\3\ 
Approval on a pilot basis was intended to permit the Commission to 
reconsider the effects of the rules in light of experience with the 
rules' operation in the marketplace.\4\ The NASD now seeks extension of 
certain of these rules.

    \3\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58 
FR 69419 (Dec. 30, 1993) (approving the Interim SOES Rules on a one-
year pilot basis effective January 7, 1994). See also Securities 
Exchange Act Release No. 33424 (Jan. 5, 1994) (order denying stay 
and granting interim stay through January 25, 1994) and Securities 
Exchange Act Release No. 33635 (Feb. 17, 1994) (order denying 
renewed application for stay).
    \4\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58 
FR 69419 (Dec. 30, 1993).
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    The NASD originally sought extension of the Amended Interim SOES 
Rules through May 1, 1995. Notice of that proposed rule change appeared 
in the Federal Register on December 16, 1994.\5\ The Commission 
received comments from 58 commenters, with 12 supporting the proposal 
and 46 opposing it. On January 23, 1995, the NASD amended its proposal 
to request extension of the Amended Interim SOES Rules until March 27, 
1995, rather than [[Page 6328]] until May 1, 1995.\6\ For the reasons 
discussed below, this order approves the proposed rule change until 
March 27, 1995.

    \5\The NASD amended the proposed rule change twice since it was 
originally filed with the Commission on December 1, 1994. The first 
amendment was included in the Commission's original notice. 
Securities Exchange Act Release No. 35077 (Dec. 9, 1994), 59 FR 
65105 (Dec. 16, 1994).
    \6\Letter from T. Grant Callery, Vice President & General 
Counsel, NASD, to Mark Barracca, Branch Chief, SEC (Jan. 23, 1995).
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II. Description of the Proposed Rule Change

    As noted above, the NASD has proposed to extend three of the four 
Interim SOES Rules that became effective January 25, 1994. The proposal 
does not include extending the short sale prohibition beyond January 
25, 1995; thus, effective January 26, 1995, short sales in compliance 
with the NASD's short sale rule applicable to the Nasdaq market as a 
whole will be permitted in SOES.\7\ The following restrictions will be 
effective until March 27, 1995:

    \7\NASD Manual, Rules of Fair Practice, Sec. 48, CCH 2200H.
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    (1) SOES Maximum Order Size: The maximum size order eligible for 
SOES execution will be 500 shares for the highest tier of Nasdaq 
National Market securities.\8\

    \8\Market makers must continue to display a size of 1,000 shares 
in their quotations for these securities, and to be firm for a 
minimum of 1,000 shares at their published quotation, for any 
negotiated transaction through SelectNet or over the telephone. See 
NASD Manual, Schedules to the By-Laws, Schedule D, Part VI, Sec. 
2(a)--(b), CCh 1819.
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    (2) SOES Minimum Exposure Limit: The market maker's SOES minimum 
exposure limit will be two times the maximum order size. The rule 
change continues the application of the minimum exposure limit to 
unpreferenced orders only, so that preferenced orders will not count 
toward depletion of the minimum exposure limit.
    (3) Automated Quotation Updates: The NASD proposes to continue 
providing an automated quotation update function for marker makers 
using SOES, at their election, on an issue-by-issue basis. If the 
automated update function is not used, when a market maker depletes its 
exposure limit in SOES, the market maker's quotation is closed to SOES 
executions until the market maker updates its quote and reestablishes 
its exposure limit. If used, the function updates a market maker's 
quotation in any Nasdaq security when its exposure limit has been 
exhausted, and reestablishes the original quotation size and exposure 
limit, thereby preventing closed quotations. Market makers electing to 
use the feature can set the fractional interval of the quotation update 
for each security and set their exposure limit at the maximum order 
size for that security that is, 500 shares for the highest tier of 
Nasdaq National Market securities.
    In light of the NASD's implementation of short sale prohibitions on 
September 6, 1994,\9\ the NASD will terminate the prohibition against 
short selling through SOES. Thus, beginning January 26, 1995, short 
sales in compliance with the NASD's short sale rule will be permitted 
through SOES.

    \9\Securities Exchange Act Release No. 34277 (June 29, 1994), 59 
FR 34885 (July 7, 1994) (approval of the NASD's short sale rule, 
effective September 6, 1994).
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III. Comments

    Commenters supporting and opposing the proposal stated reasons 
similar to those put forth in response to the NASD's original proposal 
to adopt the Interim SOES Rules.\10\ Commenters supporting the proposal 
argue that the Amended Interim SOES Rules will limit the exposure of 
market makers to multiple executions, which should produce narrower 
spreads and more liquid markets. Those opposing extension of the rules 
argue that market makers have ample opportunity to update their quotes 
in order to avoid multiple SOES executions. They contend that two 
studies submitted by proponents of the rules fail to show any increase 
in market quality as a result of the rules. They also argue that the 
SOES immediate automatic execution feature provides them the only 
meaningful access to the Nasdaq market because, they allege, market 
makers do not honor their quoted prices on the telephone or through 
SelectNet. These commenters assert that they cannot obtain quote-based 
trade executions except through SOES and that the Interim SOES Rules 
have thereby restricted their access to Nasdaq and the ability of 
certain customers to receive executions at quoted prices. These 
commenters argue that the Interim SOES Rules thus produce unfair 
discrimination and an inappropriate burden on competition.

    \10\These comments addressed the proposal to extend the Interim 
SOES Rules through May 1, 1995, as originally filed. As amended, 
those rules would now expire March 27, 1995. See supra note 5.
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IV. Discussion

    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.\11\ In 
evaluating a given proposal, the Commission examines the record before 
it and relevant factors and information.\12\ After balancing the 
advantages and disadvantages of extension, the Commission believes that 
limited extension of the Amended Interim SOES Rules through March 27, 
1995 meets the above standards and is necessary and appropriate in the 
public interest and for the protection of investors. As discussed in 
more detail below, the Commission does not believe that, on the basis 
of the information before it, an extension of the Amended Interim SOES 
Rules beyond 60 days is justified under the applicable statutory 
standard. Nevertheless, because much information has been made 
available only recently, the Commission has determined that it is 
appropriate to provide this brief phase-out period (until March 27, 
1995), which will enable the market to make an orderly transition.\13\

    \11\15 U.S.C. Sec. 78s(b). The Commission's statutory role is 
limited to evaluating the rules as proposed against the statutory 
standards. See S.Rep. No. 75, 94th Cong., 1st. Sess., at 13 (1975).
    \12\In the 1975 Amendments, 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).
    \13\The Commission does not believe that further extension of 
these restrictions without changes to benefit public investors would 
be appropriate.
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    Because the Interim SOES Rules were approved only for a pilot 
period, the Commission noted in its approval order that it expected to 
revisit the issues presented by the NASD's proposal.\14\ In 
[[Page 6329]] approving the Interim SOES Rules, the Commission noted 
its concern over the lack of reliable statistical analysis. The 
Commission approved the rules, however, among other reasons, because of 
the rules' limited duration and because of the agency's commitment to 
monitor the rules' effects.\15\ The Commission stated that extension of 
the Interim SOES Rules or other similar modifications upon expiration 
of the Interim SOES Rules would ``require an independent consideration 
under Section 19 of the Act.''\16\

    \14\Both proponents of and opponents to the 1994 Interim SOES 
Rules argued that imposing the rules would affect the Nasdaq market. 
Opponents argued that the rules would heighten volatility and widen 
spreads. E.g., Letters to Jonathan G. Katz, Secretary, SEC, from 
Michael Frey, President, A.J. Michaels & Co., at 7 (May 11, 1993); 
Douglas P. Ralston, President, Shearman, Ralston Inc., at 1 and 6 
(May 10, 1993); and Harvey L. Pitt, counsel for Dina Securities, 
Inc., at 15 (June 11, 1993). The NASD and its supporters, on the 
other hand, argued that placing certain restrictions on the use of 
SOES, for example, lowering the maximum order size, would act to 
decrease volatility and narrow spreads. Securities Exchange Act 
Release No. 32143 (Apr. 14, 1993), 58 FR 21484 (Apr. 21, 1993) 
(notice of the NASD's proposed Interim SOES Rules, File No. SR-NASD-
93-16). The Commission's December 1993 SOES order describes in some 
detail the order size reduction, the minimum order exposure limit 
reductions, and the automated quotation update feature that the NASD 
proposes to extend. See Securities Exchange Act Release No. 33377 
(Dec. 23, 1993), 58 FR 69419 (Dec. 30, 1993). That order also 
discusses the NASD's rationale for these changes to the SOES rules 
and the Commission's rationale for approving them for a one-year 
period.
    \15\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 
58 FR 69419 (Dec. 30, 1993).
    \16\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 
58 FR 69419 (Dec. 30, 1993) (footnote omitted). The Commission's 
order further stated that ``[t]he NASD should consider whether 
additional criteria for evaluating the effectiveness of the 
modifications are appropriate, and should include in its assessment 
of the modifications all factors that it deems relevant in 
evaluating the effects of the modifications [and] . . . [i]f an 
assessment is not feasible, the NASD should provide a reasoned 
explanation supporting that determination.'' Id.
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    In connection with its extension request, the NASD submitted an 
econometric study conducted by the NASD's Economic Research 
Department\17\ and commissioned a consulting economist to provide an 
assessment of the effect of the Interim SOES Rules.\18\ In summary, the 
NASD's Economic Research Department found that since implementation of 
the Interim SOES Rules: (a) Spreads in Nasdaq securities have declined; 
and (b) volatility of Nasdaq securities appears to be unchanged, except 
for brief, market-wide period of volatility in March and April 1994. 
The commissioned study reported that while percentage quoted spreads 
increased a statistically insignificant amount, percentage quoted 
spreads, adjusted for other determining factors, declined by a 
statistically significant, but economically insignificant, amount. From 
this data, the author concluded that the Interim SOES Rules did not 
harm market quality.

    \17\Securities Exchange Act Release No. 35080 (Dec. 9, 1994), 59 
FR 65109 (Dec. 16, 1994). The NASD's Economic Research Department 
examined Nasdaq bid-ask spreads in specific stocks and price 
volatility on two sample days each month from November 1993 (three 
months prior to the effective date of the rules) through August 
1994.
    \18\Letter from John F. Olson, Counsel for the NASD, Gibson, 
Dunn & Crutcher, to Jonathan Katz, Secretary, SEC (Dec. 30, 1994) 
(submitting in connection with File No. SR-NASD-94-68 analysis 
entitled the Association Between the Interim SOES Rules and Nasdaq 
Market Quality prepared by Dean Furbush, Ph.D., Economists 
Incorporated (Dec. 30, 1994)). This analysis compared sample days in 
the three months prior to and three months after the effective date 
of the Interim SOES Rules.
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    An evaluation of the empirical data submitted by the NASD does not 
persuasively demonstrate that the quality of the market improved 
subsequent to the adoption of the Interim Rules. The evidence in both 
studies shows that spreads declined, but the results were only 
marginally significant, and the size of the reduction is too small to 
be important. Nevertheless, the Commission believes that these studies 
demonstrate that the Interim Rules have operated for one year with no 
apparent significant negative implications for overall market quality.
    The absence of negative implications for market quality must be 
considered in conjunction with other effects of the Interim SOES Rules 
on the investing public. Commenters opposed to the Interim SOES Rules 
argue that the restrictions impose a burden on the ability of some 
customers to obtain execution of transactions in size in the Nasdaq 
market. They contend that, to the extent that the Interim Rules 
restrict their access to SOES, their ability to obtain executions is 
limited because they cannot effectively trade over the telephone and 
through SelectNet. In support of these arguments, they refer to a large 
number of complaints alleging that market makers have refused to fill 
trades now ineligible for SOES execution at their quoted prices. In 
addition, they have provided anecdotal information that certain SOES 
order entry firms have suffered serious drops in daily trading volume 
since approval of the Interim Rules. The Commission takes such 
allegations seriously, and is reviewing them as part of its obligation 
to oversee the securities markets.
    As indicated above, the Commission has determined to approve the 
Amended Interim Rules through March 27, 1995. In light of the balance 
of factors described above, the Commission does not believe that 
further extension of this proposal would be appropriate.\19\ The short 
extension the Commission has determined to approve will permit the 
market to make an orderly transition to operation in a changed 
environment. The Commission believes that such a measure is appropriate 
in the public interest. Moreover, the Commission notes that the Amended 
Interim Rules, unlike the rules currently in effect, will permit the 
entry of short sale orders. The Commission believes this will 
ameliorate during the phase-out period the burdens associated with the 
Interim SOES Rules by expanding the types of orders that are eligible 
for automatic execution.

    \19\Of course, a different proposal that modified the Amended 
Interim Rules to provide additional public benefits would require an 
independent Commission determination.
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    The Commission notes that subsequent to approval of the Interim 
SOES Rules in December 1993, the NASD submitted a proposal to replace 
SOES with the Nasdaq Primary Retail Order View and Execution System 
(``NPROVE''). As currently proposed, NPROVE would 
differ from SOES in two general ways:

     NPROVE would provide a facility for automated 
routing and execution of small orders, allowing market makers a 15 
second opportunity to decline an order (if consistent with the Firm 
Quote Rule, permitting a brief period for quote updates). SOES 
generally provides immediate execution of orders against an assigned 
market maker at the best bid or offer and thereafter notifies the 
affected market maker; and
     NPROVE would provide an opportunity for public 
limit orders to interact with other limit orders and incoming market 
orders, and for execution of market orders at prices superior to the 
best market maker quotes. SOES provides limited opportunity for such 
interaction.

    In light of comments received as recently as January 9, 1995 
concerning NPROVE, as well as other developments in the Nasdaq 
market,\20\ the Commission believes that the NASD's NPROVE 
proposal warrants further assessment. Among other matters, commenters 
have raised concerns about the NASD's ability to monitor sufficiently 
market maker compliance with the Firm Quote Rule and the potential for 
significant order queues to develop. Before further Commission action 
on NPROVE, the Commission believes that the NASD should address 
such issues, including the potential for queuing during periods of 
market stress, whether there are restrictions on access to the system 
inconsistent with the purposes of the Act, and whether there are 
adequate mechanisms to ensure effective oversight of market makers' 
compliance with the Firm Quote Rule.

    \20\As has been widely disclosed, the Commission is conducting 
an inquiry into certain practices in the Nasdaq market and the 
Antitrust Division of the Department of Justice recently has made 
public an inquiry into whether Nasdaq market makers are violating 
federal antitrust laws. Although not tied directly to the 
Commission's consideration of the instant proposal, the Commission 
expects that these inquiries may provide valuable information that 
will affect future reform efforts and ultimately improve the quality 
of the Nasdaq market. In addition, the NASD has formed a committee 
headed by former U.S. Senator Warren Rudman to review the 
effectiveness of the operation and surveillance of Nasdaq and the 
governance of the NASD and Nasdaq.
[[Page 6330]]

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2. 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. Sec. 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 SR-NASD-94-68 and should be submitted by February 22, 1995.

VI. Conclusion

    The Commission, in the exercise of the authority delegated to it by 
Congress, and in light of its experience regulating securities markets 
and market participants, has determined that a temporary extension of 
the Amended Interim SOES Rules will provide an orderly phase-out period 
and is consistent with maintaining investor protection and fair and 
orderly markets, and that these goals, on balance, outweigh any 
temporary anti-competitive effects on order entry firms and their 
customers.
    For the reasons discussed in this order, pursuant to Section 
19(b)(2) of the Act,\21\ the Commission finds good cause for approving 
the proposed rule change, as amended, prior to the 30th day after 
publication of Amendment No. 2 in the Federal Register. The proposed 
amendment shortens the date that the Amended Interim SOES Rules would 
expire from May 1, 1995 to March 27, 1995, and will facilitate 
maintenance of fair and orderly markets. Prior to Amendment No. 2, the 
proposed rule change was published in the Federal Register for the full 
statutory period.

    \21\15 U.S.C. Sec. 78s(b)(2).
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    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-94-68 be, and hereby is, approved, 
effective January 26, 1995, extending the Interim SOES Rules, exclusive 
of the short sale prohibition, through March 27, 1995.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 95-2388 Filed 1-31-95; 8:45 am]
BILLING CODE 8010-01-M