[Federal Register Volume 61, Number 151 (Monday, August 5, 1996)]
[Notices]
[Pages 40693-40699]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-19836]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37492; File No. SR-NASD-96-30]
Self-Regulatory Organizations; Notice of Filing and Order
Granting Partial Accelerated Approval of Proposed Rule Change by
National Association of Securities Dealers, Inc. Relating to an
Extension and Permanent Approval of the NASD's Short Sale Rule
July 29, 1996.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on July 24, 1996, the National Association of Securities Dealers, Inc.
(``NASD'' or ``Association'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC'') the proposed rule change as
described in Items I, II, and III below, which Items have been prepared
by the NASD. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons. As
discussed below, the Commission has also granted accelerated approval
to a portion of the proposal.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The NASD is proposing to implement its short sale rule (``Rule'')
on a permanent basis. With this filing, the NASD is also proposing a
three-month extension of the pilot program for the short sale rule so
that the effectiveness of the Rule does not lapse while the Commission
considers the NASD's request for permanent approval of the Rule.
The text of the proposed rule change with respect to the proposal
to implement the short sale rule on a permanent basis is as follows
(additions are in italics and deletions are bracketed):
NASD Rule 3350
* * * * *
(k)(3)[(A) Until February 1, 1996, the term ``qualified market
maker'' shall mean a registered Nasdaq market maker that has
maintained, without interruption, quotations in the subject security
for the preceding 20 business days. Notwithstanding the 20-day period
specified in this subsection, after an offering in a stock has been
publicly announced, a registration statement has been filed, or a
merger or acquisition involving two issues has been announced, no
market maker may register in the stock as a qualified market maker
unless it meets the requirements set forth below:
(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;
(ii) For initial public offerings, the market maker may register in
the offering and immediately become a qualified market maker; provided,
however, that if the market maker withdraws on an unexcused basis from
the security within the first 20 days of the offering, it shall not be
designated as a qualified market maker on any subsequent initial public
offerings for the next 10 business days;
(iii) After a merger or acquisition involving an exchange of stock
has been publicly announced and not yet consummated or terminated, a
market maker may immediately register in either or both of the two
affected securities as a qualified market maker pursuant to the same-
day registration procedures in Rule 4611; provided, however, that if
the market maker withdraws on an unexcused basis from any stock in
which it has registered pursuant to this subsection within 20 days of
so registering, it shall not be designated as a qualified market maker
pursuant to this subparagraph (3) for any subsequent merger or
acquisition announced within three months subsequent to such unexcused
withdrawal.
(B) For purposes of this subparagraph (3), a market maker will be
deemed to have maintained quotations without interruption if the market
maker is registered in the security and has continued publication of
quotations in the security through the Nasdaq on a continuous basis;
provided, however, that if a market maker is granted an excused
withdrawal pursuant to the requirements of Rule 4619, the 20 business
day standard will be considered uninterrupted and will be calculated
without regard to the period of the excused withdrawal. Beginning
February 1, 1996, t]The term ``qualified market maker'' shall mean a
registered Nasdaq market maker that meets the criteria for a Primary
Nasdaq Market Maker as set forth in Rule 4612.
[(1) This section shall be in effect until August 3, 1996.]
The text of the proposed rule change with respect to the proposal
to extend the short sale rule for a three-month period is as follows
(additions are italics and deletions are bracketed):
NASD Rule 3350
* * * * *
(1) This section shall be in effect until [August 3, 1996] November
4, 1996.
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the NASD included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item V below. The NASD has prepared summaries, set forth in Sections A,
B, and C below, of the most significant aspects of such statements.
[[Page 40694]]
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Background and Description of the NASD's Short Sale Rule
On June 29, 1994, the SEC approved the NASD's short sale rule
applicable to short sales \3\ in Nasdaq National Market (``NNM'')
securities on an eighteen-month pilot basis through March 5, 1996.\4\
The NASD's short sale rule prohibits member firms from effecting short
sales at or below the current inside bid as disseminated by Nasdaq
whenever that bid is lower than the previous inside bid.\5\ The Rule is
in effect during normal domestic market hours (9:30 a.m. to 4:00 p.m.,
Eastern Time).
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\3\ A short sale is a sale of a security which the seller does
not own or any sale which is consummated by the delivery of a
security borrowed by, or for the account of, the seller. To
determine whether a sale is a short sale, members must adhere to the
definition of a ``short sale'' contained in Rule 3b-3, 17 CFR
240.3b-3, which rule is incorporated into Nasdaq's short sale rule
by NASD Rule 3350(k)(1).
\4\ See Securities Exchange Act Release No. 34277 (June 29,
1994), 59 FR 34885 (July 7, 1994) (``Short Sale Rule Approval
Order''). The termination date for the pilot program was
subsequently extended until August 3, 1996 due to delays in
implementation of the NASD's Primary Market Maker Standards. See
Securities Exchange Act Release Nos. 36171 (August 30, 1995), 60 FR
46651; and 36532 (November 30, 1995), 60 FR 62519.
\5\ Nasdaq calculates the inside bid or best bid from all market
makers in the security (including bids on behalf of exchanges
trading Nasdaq securities on an unlisted trading privileges basis),
and disseminates symbols to denote whether the current inside bid is
an ``up bid'' or a ``down bid.'' Specifically, an ``up bid'' is
denoted by a green ``up'' arrow and a ``down bid'' is denoted by a
red ``down'' arrow. Accordingly, absent an exemption from the rule,
a member can not effect a short sale at or below the inside bid for
a security in its proprietary account or a customer's account if
there is a red arrow next to the security's symbol on the screen. In
order to effect a ``legal'' short sale on a down bid, the short sale
must be executed at a price at least a \1/16\th of a point above the
current inside bid. Conversely, if the security's symbol has a
green, up arrow next to it, members can effect short sales in the
security without any restrictions.
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i. Market Maker Exemption
In order to ensure that market maker activities that provide
liquidity and continuity to the market are not adversely constrained
when the short sale rule is invoked, the Rule provides an exemption to
``qualified'' Nasdaq market makers. Even if a market maker is able to
avail itself of the qualified market maker exemption, it can only
utilize the exemption from the short sale rule for transactions that
are made in connection with bona fide market making activity. If a
market maker does not satisfy the requirements for a qualified market
maker, it can remain a market maker in the Nasdaq system, although it
can not take advantage of the exemption from the Rule.
From September 4, 1994 through February 1, 1996, Nasdaq market
makers who maintained a quotation in a particular NNM security for 20
consecutive business days without interruption were exempt from the
Rule for short sales in that security, provided that the short sales
were made in connection with bona fide market making activity (``the
20-day'' test). Since February 1, 1996 until the present, the ``20-
day'' test has been replaced with a four-part quantitative test known
as the Nasdaq Primary Market Maker (``PMM'') Standards.
Under the PMM Standards, a market maker must satisfy at least two
of the following four criteria to be eligible for an exemption from the
short sale rule: (1) the market maker must be at the best bid or best
offer as shown on Nasdaq 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; (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; or (4) the market
maker executes 1\1/2\ times its ``proportionate'' volume in the
stock.\6\ If a market maker is a PMM for a particular stock, there is a
``P'' indicator next to its quote in that stock. In addition, market
makers are able to review their status as PMMs through their Nasdaq
Workstation. The review period for satisfaction of the PMM performance
standards is one calendar month. If a PMM has not satisfied the
threshold standards after a particular review period, the PMM
designation will be removed on the next business day following notice
of failure to satisfy the standards. Market makers may requalify for
designation as a PMM by satisfying the threshold standards in the next
review period.
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\6\ Specifically, the proportionate volume test requires a
market maker to account for volume of at least one-and-a-half times
its proportionate share of overall volume in the security for the
review period. For example, if a security has 10 market makers, each
market maker's proportionate share volume is 10 percent. Therefore,
the proportionate share volume is one-and-a-half times 10, or 15
percent of overall volume.
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The ability of a member firm to achieve and maintain PMM status in
80 percent of the NNM issues in which it is registered can also have
the following corollary effects:
a. Existing NNM Securities: If a member firm is a PMM in 80 percent
or more of the securities in which it has registered, the firm may
immediately become a PMM (i.e., a qualified market maker) in a NNM
security by registering and entering quotations in that issue. If the
member firm is not a PMM in at least 80 percent of its stocks, it may
become a PMM in that stock if it registers in the stock as a regular
Nasdaq market maker and satisfies the PMM qualification standards for
the next review period.
b. Initial Public Offerings (``IPOs''): If a member firm has
obtained PMM status in 80 percent or more of the stocks in which it has
registered, the firm may immediately become a PMM in an IPO by
registering and entering quotations in the issue. However, if the firm:
(1) withdraws from the IPO on an unexcused basis any time during the
calendar month in which the IPO commenced trading on Nasdaq or (2)
fails to meet the PMM standards for the month in which the IPO
commenced trading on Nasdaq,\7\ then the firm is precluded from
becoming a PMM in any other IPO for ten business days following the
unexcused withdrawal of failure to meet the PMM standards (``10-day
rule'').\8\
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\7\ On June 20, 1996, the NASD submitted a rule filing to the
SEC that clarified the applicable PMM review period for IPOs listed
during the last five business days of a month. See Securities
Exchange Act Release No. 37426 (July 11, 1996), 61 FR 37521 (File
SR-NASD-96-25).
\8\ The PMM rule also has provisions applicable to secondary
offerings. Specifically, unless a market maker is registered in a
security prior to the time a secondary offering in that stock has
been publicly announced or a registration statement has been filed,
it cannot become a PMM in the stock unless: (1) the secondary
offering has become effective and the market maker has satisfied the
PMM standards between the time the market maker registered in the
security and the time the offering became effective or (2) the
market maker has satisfied the PMM standards for 40 calendar days.
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c. Merger and Acquisition Situations: after a merger or acquisition
is announced, a market maker that is a PMM in one stock may immediately
become a PMM in the other stock by registering and entering quotations
in that issue.
ii. Options Market Maker Exemption
In an effort to not constrain the legitimate hedging needs of
options market makers, the NASD's short sale rule also contains a
limited exception for standardized options market makers. Specifically,
under the Rule, an NASD member may execute a short sale for the account
of an equity option market maker or an index option market maker that
would otherwise be in contravention of the NASD's short sale rule so
long as: (1) the short sale is an ``exempt hedge transaction''; \9\ and
(2)
[[Page 40695]]
the options market maker is registered with a ``qualified options
exchange'' \10\ as a ``qualified options market maker'' \11\ in a stock
options class overlying a NNM security or in an options class overlying
a ``qualified stock index.'' \12\
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\9\ For equity option market makers, an ``exempt hedge
transaction'' is defined to be a short sale that was effected to
hedge, and in fact serves to hedge, an existing offsetting options
position or an offsetting options position that was created in a
transaction(s) contemporaneous with the short sale, provided that
when establishing the short position the options market maker
receives, or is eligible to receive, good faith margin pursuant to
Section 220.12 of Regulation T under the Act. For index option
market makers, an ``exempt hedge transaction'' is defined to be a
short sale in a NNM security that was effected to hedge, and in fact
serves to hedge, an existing offsetting stock index options position
or an offsetting stock index options position that was created in a
transaction(s) contemporaneous with the short sale, provided that:
(1) the security sold short must be a component security of the
index underlying such index option; (2) the index underlying such
offsetting index options position is a ``qualified stock index'';
and (3) the dollar value of all exempt short sales effected to hedge
the offsetting stock index options position(s) does not exceed the
aggregate current index value of the offsetting options position(s).
\10\ A ``qualified options exchange'' is defined to be a
national securities exchange that has received SEC approval of its
rules and procedures governing: (1) the designation of options
market makers as qualified options market makers; (2) the
surveillance of its market makers' utilization of the exemption; and
(3) authorization of the NASD to withdraw, suspend, or modify the
designation of a qualified options market maker in the event that
the options exchange determines that the qualified options market
maker has failed to comply with the terms of the exemption and the
exchange believes that such action is warranted in light of the
substantial, willful, or continuing nature of the violation. All
national securities exchanges that trade standardized options are
``qualified options exchanges.''
\11\ An options market maker is a ``qualified options market
maker'' if it has been appointed as such by a qualified options
exchange.
\12\ A ``qualified stock index'' is defined to be a stock index
that includes one or more NNM securities, provided that more than
10% of the weight of the index is accounted for by NNM securities.
In addition, qualified stock indexes are reviewed as of the end of
each calendar quarter, and an index would cease to qualify if the
value of the index represented by one or more NNM securities was
less than 8 percent at the end of any subsequent calendar quarter.
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iii. Warrant Market Maker Exemption
The Rule also contains an exemption for warrant market makers
similar to the one available for options market makers. To be eligible
for the exemption, a warrant market maker must be registered as a
market maker in the warrant and the short sale must be an ``exempt
hedge transaction'' \13\ that results in a fully hedged position. Any
short sale by a warrant market maker unrelated to normal warrant market
making activity, such as index arbitrage or risk arbitrage that in
either case is independent of a warrant market maker's market making
functions, is not considered an ``exempt hedge transaction'', however.
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\13\ An ``exempt hedge transaction'' is a short sale in an NNM
security that was effected to hedge, and in fact serves to hedge, an
existing offsetting warrant position that was created in a
transaction contemporaneous with the short sale.
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iv. Exemptions Comparable to Those Contained in Rule 10a-1
The NASD's short sale rule also incorporates seven exemptions
contained in Rule 10a-1 \14\ that are relevant to trading on Nasdaq.
Specifically the rule exempts:
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\14\ 17 CFR 240.10a-1.
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Sales by a broker-dealer for an account in which it has no
interest and that is marked long;
Any sale by a market maker to offset odd-lot orders of
customers;
Any sale by any person, for an account in which he has an
interest, if such person owns the security sold and intends to deliver
such securities as soon as possible without undo inconvenience or
expense;
Sales by a member to liquidate a long position which is
less than a round lot, provided the sale does not change the member's
position by more than one unit of trading (100 shares);
Short sales effected by a person in a special arbitrage
account;\15\
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\15\ In order to fall within this exemption, the person
effecting the short sale must then own another security by virtue of
which the person is, or presently will be, entitled to acquire an
equivalent number of securities of the same class of securities sold
short, provided the short sale, or the purchase which such sale
offsets, is effected for the bona fide purpose of profiting from a
current difference between the price of the security sold short and
the security owned, and such right of acquisition was originally
attached to or represented by another security or was issued to all
the holders of any such class of securities of the issuer.
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Short sales effected by a person in a special
international arbitrage account; \16\ and
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\16\ In order to fall within this exemption, the short sale must
be effected for the bona fide purpose of profiting from a current
difference between the price of such security on a securities market
not within or subject to the jurisdiction of the United States and a
securities market subject to the jurisdiction of the United States,
provided the person at the time of such sale knows or, by virtue of
information currently received, has reasonable grounds to believe
that an offering enabling a person to cover such sale is then
available to the person in such foreign securities market and
intends to accept such offer immediately.
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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 such a person in connection with a
distribution of securities rights pursuant to Rule 10b-18 \17\ or a
standby underwriting commitment.
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\17\ 17 CFR 240.10b-18.
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The Rule also provides that a member not currently registered as a
Nasdaq market maker in a security that has acquired the security while
acting in the capacity of a block positioner shall be deemed to own
such security for the purposes of the Rule notwithstanding that such
member may not have a net long position in such security if and to the
extent that such member's short position in such security is subject to
one or more offsetting positions created in the course of bona fide
arbitrage, risk arbitrage, or bona fide hedge activities. In addition,
the NASD has recognized that SEC staff interpretations to Rule 10a-1
dealing with the liquidation of index arbitrage positions \18\ and an
``international equalizing exemption'' \19\ are equally applicable to
the NASD's short sale rule.
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\18\ In 1986, the SEC took a ``no action'' position that, under
certain conditions, permits broker-dealers not to aggregate certain
short positions when liquidating index arbitrage positions involving
long stock. This no-action position was clarified in a later SEC
Release and the SEC has proposed to amend Rule 10a-1 to incorporate
this interpretation. See Securities Exchange Act Release No. 30772
(June 3, 1992) 57 FR 24415.
\19\ Specifically, the NASD has interpreted its short sale rule
to provide that any person can sell a foreign security, or a
depositary share or depositary receipt relating to such a security,
on a down bid at the opening, provided the inside bid is equal to or
above the last reported sale price (adjusted for current exchange
rates and ADR multiples) of the security in the principal foreign
market for that security.
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v. Interpretations to the NASD's Short Sale Rule
In conjunction with the adoption of the short sale rule, the NASD
also issued three Interpretations by the NASD Board of Governors
dealing with the Rule. Interpretation A to the Rule clarifies some of
the factors that will be taken into consideration when reviewing market
making activity that may not be deemed to be bona fide market making
activity and, therefore, not exempt from the Rule's application.\20\
Interpretation B defines a ``legal'' short sale on a down bid as one
that is executed at a price of at least a \1/16\th of a point above the
current inside bid. Finally, Interpretation C clarifies some of the
circumstances under which
[[Page 40696]]
a member would be deemed to be in violation of the Rule.\21\
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\20\ Specifically, Interpretation A provides that bona fide
market making activity does not include activity that is unrelated
to market making functions, such as index arbitrage and risk
arbitrage that is independent from a member's market making
functions. Similarly, the Interpretation states that bona fide
market making would exclude activity that is related to speculative
selling strategies of the member or investment decisions of the firm
and is disproportionate to the usual market making patterns or
practices of the member in that security. In addition, the
Interpretation provides guidance with respect to what constitutes
bona fide market making in the context of a merger or acquisition
situation.
\21\ Specifically, the Interpretation contains the following
non-exhaustive list of activities that would be considered to be
manipulative acts and violations of the rule: (a) in instances where
the current best bid is below the preceding best bid, if a market
maker alone at the inside best bid were to lower its bid and then
raise it to create an ``up bid'' for the purpose of facilitating a
short sale; (b) if a market maker with a long stock position were to
raise its bid above the inside bid and then lower it to create a
``down bid'' for the purpose of precluding market participants from
selling short; (c) if a market maker agrees to an arrangement
proposed by a member or a customer whereby 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; and (d) if a market
maker entered into an arrangement with a member or a customer
whereby it used its exemption from the rule to sell short at the bid
at successively lower prices, accumulating a short position, and
subsequently offset 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.
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2. Proposal To Adopt the Short Sale Rule on a Permanent Basis
When the Commission approved the NASD's short sale rule on a
temporary basis, it made specific findings that the Rule was consistent
with Sections 11A, 15A(b)(6), 15A(b)(9), and 15A(b)(11) of the Act.
Specifically, the Commission stated that, ``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.'' \22\ In addition, the Commission stated that
it ``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.'' \23\ Nevertheless, in light of the Commission's
concerns with adverse comments made about the Rule and the Commission's
own concerns with the structure and impact of the Rule,\24\ the
Commission determined to approve the Rule on a temporary basis to
afford the NASD and the SEC an opportunity to study the effects of the
Rule and its exemptions. In particular, before considering any NASD
proposal to extend, modify, permanently implement or terminate the
Rule, the Commission requested that the NASD examine: (1) the effects
of the Rule on the amount of short selling; (2) the length of time that
the Rule is in effect (i.e., the duration of down bid situations); (3)
the amount of non-market maker short selling permitted under the Rule;
(4) the extent of short selling by market makers exempt from the Rule;
(5) whether there have been any incidents of perceived ``abuse short
selling''; (6) the effects of the Rule on spreads and volatility; (7)
whether the behavior of bid prices has been significantly altered by
the Rule; and (8) the effect of permitting short selling based on a
minimum increment of \1/16\th.
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\22\ See Short Sale Rule Approval Order, supra note 3, 59 FR at
34891.
\23\ Id. 59 FR at 34892.
\24\ When the NASD's short sale rule was first considered by the
Commission, the SEC received 397 comment letters on the proposal,
with 275 comments opposed to the Rule and 122 comments in favor of
the Rule. Those comment letters opposed to the Rule argued that: (1)
the NASD had failed to provide sufficient evidence of the need for a
short sale rule or demonstrate the appropriateness of a short sale
rule based on a ``bid'' test instead of a ``tick'' test; (2) the PMM
standards will have negative effects on both market makers and the
Nasdaq market; and (3) the short sale rule is inconsistent with the
requirements of the Act.
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Accordingly, in response to the Commission's requests and concerns,
the NASD's Economic Research Department has prepared a study on the
economic impact of the NASD's short sale rule that addresses these
issues.\25\ This study examined market activity both before and after
implementation of the Rule and found that the Rule has had its intended
effect of diminishing short selling at the bid in declining markets,
while still allowing short sales to occur at prices slightly above the
bid in down bid situations. Specifically, among other things, the Short
Sale Study found that:
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\25\ The Economic Impact of the Nasdaq Short Sale Rule, NASD
Economic Research Department (July 1996) (``Short Sale Study''). A
copy of the Short Sale Study is available in the Commission's Public
Reference Room in File No. SR-NASD-96-30.
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The Rule appears to dramatically reduce the amount of the
short selling on down-bids, without having the undesirable effect of
driving away all non-exempt short sales on down bids;
Stocks with large down-bid percentages (i.e., the average
percentage of time during the trading day that the Rule is invoked) are
not associated with economically-large reductions in market quality, as
measured by relative displayed spreads, percent bid range, and trading
activity;
For stocks with large monthly increases in short interest,
implementation of the Rule has been associated with lower bid price
volatility and narrower dollar spreads;
The Rule does not appear to have reduced overall sales at
the bid by non-exempt sellers (long and short sales combined). Thus,
since short sales at the bid on down bids by non-exempt short sellers
are prohibited,\26\ the results illustrate that short sales at the bid
have been replaced by long sales at the bid during down-bids for these
securities; Apparent ``unnatural'' bid price movement occurred
extremely infrequently (0.6 percent or fewer of all bid changes
evaluated in the study), indicating that market makers are not
attempting to move bids to invoke or deactivate the Rule;
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\26\ Specifically, the Short Sale Study found that only 2.8
percent of short sales by non-exempt short sellers occur at or below
the inside bid in down-bid situations. Since the short sale rule
prohibits short sales at the bid on down bids, this figure should
theoretically be zero. Reasons why this figure is 2.8 percent
include, among others, improper alignment of trades and their
corresponding inside quotes, potential reporting errors, and
violations of the Rule.
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On a stock-by-stock basis, the percentage of volume
accounted for by short sales increases as the stock experiences larger
price declines as opposed to price increases or no price changes,
suggesting that speculative short selling is more apt to occur when
stock prices are falling; and
Exempt short sales generally are executed above the bid,
indicating that market makers are not abusing the exemption.
Specifically, in a down-bid environment, 7.5 percent of exempt short
sales are executed at or below the bid, while the comparable figure
during an up-bid environment is 8.7 percent.
The interviews conducted in conjunction with the Study also
indicate that the Rule has been effective in promoting the integrity of
the Nasdaq market. Specifically, most market participants interviewed
stated that the Rule has had the effect of slowing down the ``piling
on'' of short sales in a declining market, thereby contributing to
greater market stability. At the same time, market participants
indicated that the Rule does not unduly constrain them from effecting
short sales in a declining market, although they say it does take them
longer to execute short sales in a falling market. Most market
participants interviewed also stated that the exemptions from the Rule
are warranted and have not been abused. In particular, most market
participants interviewed reiterated the importance of retaining the
market maker exemption and stated that there is no need to change the
PPM standards. Similarly, the American Stock Exchange and the Chicago
Board Options Exchange, the two largest standardized options markets in
the United States, both stated that the options market maker exemption
has performed well and that the exchanges have not detected any abuses
of the exemption by their members. In sum, the NASD believes
[[Page 40697]]
that the market participant interviews corroborate and provide further
support for the empirical findings made in the quantitative portion of
the Short Sale Study. Namely, that the NASD's short sale rule has been
effective in accomplishing what the NASD intended the rule to
accomplish (i.e., reducing speculative short selling at the bid in
declining markets) without causing unnecessary disruptions elsewhere in
the marketplace. Accordingly, the NASD believes the Short Sale Study
reaffirms and substantiates the statutory findings made by the
Commission when it approved the NASD's short sale rule on a temporary
basis.
Thus, the NASD believes experience with the NASD's short sale rule
since its implementation in September 1994 warrants permanent approval
of the Rule. Specifically, the NASD believes experience with the Rule
illustrates and substantiates the benefits to investors and the
integrity of Nasdaq that the NASD believed would result from the rule.
Namely, that wit the Rule in place purchasers of NNM securities have
greater assurance that they can liquidate their positions in a
declining market without predatory short sellers exacerbating downward
pressure on stocks and reducing overall liquidity. I sum, the NASD
continues to believe that its short sale rule strikes a reasonable
balance between the needs to prevent abuse short selling and reduce the
exposure of the Nasdaq market to manipulative and excessive intra-day
volatility, on the one hand, and the need to not distort the pricing
efficiency and liquidity provided by appropriate short selling activity
on the other.
Based on experience with the short sale rule, the NASD also
believes the Rule should be permanently approved in its present form.
Specifically, given the geographically dispersed nature of Nasdaq's
competing dealer market structure, the NASD continues to believe that
it is appropriate for its short sale rule to be based on a ``bid'' test
\27\ instead of a ``tick'' test \28\ (as is the case with Rule 10a-1).
When the NASD's short sale rule was first considered by the Commission
in 1994, the SEC and commentators expressed concern that structuring
the Rule as a ``bid'' test instead of a ``tick'' test could result in
the Rule being in effect for longer periods of time in comparison to a
``tick'' test. The SEC also expressed concern that market markers could
control the amount of short selling by simple adjusting their bids.
Based on the findings of the Short Sale Study, however, the NASD
believes these concerns are no longer valid. First, while the Study
clearly found that the Rule is having its intended effect of inhibiting
the execution of non-exempt short sales at the bid in a declining
market, the Study also found that market participants are nevertheless
readily able to effect short sales at prices slightly above ``down''
bids.\29\ Similarly, several market participants interviewed in
conjunction with the preparation of the Study stated that the Rule has
not adversely impacted their ability to effect short sales, just that
it takes them longer to effect such short sales. Second, the Study's
finding that apparent ``unnatural'' quote movements have occurred very
infrequently indicates that market makers are not adjusting their
quotes to facilitate or constrain short selling activity.\30\
Accordingly, the NASD continues to believe that a ``bid'' test short
sale rule is the most appropriate for Nasdaq's competing dealer market.
Moreover, the NASD notes that SEC approval of the NASD's proposed
NAqcess system and its accompanying ``equivalent protection rules,''
\31\ along with the SEC's own proposed rule governing the display of
customers limit orders,\32\ would substantially increase the ability of
non-exempt short sellers to receive executions at prices at least a \1/
16\th of a point above the bid in down bid situations, thereby
minimizing the impact of the Rule on legitimate short selling activity.
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\27\ The NASD's short sale rule is commonly referred to as a
``bid'' test because it is activated based upon movements in the
inside bid on Nasdaq.
\28\ Rule 10a-1 is commonly referred to as a ``tick'' test
because it is activated based on movements in the last sale prices
of securities.
\29\ See Short Sale Study, supra note 25.
\30\ See Short Sale Study, supra note 25.
\31\ See Securities Exchange Act Release No. 37302 (June 11,
1996), 61 FR 31574.
\32\ See Securities Exchange Act Release No. 36310 (September
29, 1995), 60 FR 52792.
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In addition, based on the Short Sale Study's finding that the
amount of exempt short selling occurring at or below the bid is
virtually the same in both down-bid and up-bid situations and the fact
that market makers do not appear to be adjusting their quotes to
constrain or facilitate short selling, the NASD can find no basis to
conclude that the market maker exemption should be modified. The NASD
continues to believe that an exemption from the rule for bona fide
market making activity by market makers who provide liquidity and
continuity to the market is essential for the maintenance of fair and
orderly markets on Nasdaq. In this connection, the NASD also believes
the current primary market maker standards represent a reasoned,
balanced approach to confine the use of the exemption to those market
participants truly adding liquidity and depth to the market. The NASD
also believes the qualification criteria do not impose standards that
are unattainable by both small and large market makers because the
standards are designed to assess market maker performance in the
activities they have direct control over (although the proportional
volume standard is the only standard that a market maker may have less
control over).\33\
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\33\ The NASD also continues to believe that it is appropriate
and consistent with the Act for the NASD's short sale rule to exempt
certain qualified market makers while Rule 10a-1 does not provide an
exemption for exchange specialists other than the limited exemption
contained in Rule 10a-1(e)(6) for specialists on regional exchanges.
Specifically, the NASD believes the following differences between
the dealer and auction markets warrant the retention of the market
maker exemption from the Rule: (1) exchange specialists have a
monopoly over the securities in which they trade; (2) dealers
generally do not have an informational advantage over other dealers;
and (3) dealers do not have the ability to close their markets
because of sudden volatility or an order imbalance.
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The NASD also notes that retention of the NASD's short sale rule
has significant competitive implications. Indeed, in the Short Sale
Rule Approval Order, the Commission stated that it ``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 the claim that their markets protect against potential
short selling abuse.'' \34\ Given that experience with the NASD's short
sale rule over the past two years illustrates that the Rule provides
investors and the marketplace with protections against predatory short
selling comparable to Rule 10a-1, the NASD believes the competitive
disadvantages highlighted by the Commission would become severe if the
NASD's short sale rule were not permanently approved. In particular,
without permanent approval of the NASD's short sale rule, Nasdaq could
potentially loose issuers to other marketplaces simply because those
markets have a short sale rule in place which is very similar to the
NASD's short sale rule. Moreover, aside from these serious competitive
concerns, the NASD believes it should be allowed to continue to
implement a rule that affords investors the same protections against
abusive short selling activity when trading NNM securities that they
receive when trading exchange-listed securities by virtue of Rule 10a-
1.
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\34\ Short Sale Rule Approval Order, supra note 4, 60 FR at
34891.
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In this connection, even if the Commission were to conclude that
the
[[Page 40698]]
NASD's short sale rule has had no impact on market quality, the NASD
believes the Commission's approval of New York Stock Exchange
(``NYSE'') Rule 80A\35\ illustrates that the Commission would still
have a sufficient basis to approve the Rule on a permanent basis. When
NYSE Rule 80A was proposed, the Commission received considerable
adverse comment to the effect that there was no casual relationship
between index arbitrage and market volatility and that activation of
the rule during turbulent market conditions could have disastrous
effects on related options and futures markets and actually exacerbate
market volatility. Despite these comments, the Commission approved the
proposal on a one-year pilot basis noting that ``the NYSE proposal
represents a modest step, proposed on a pilot basis, to attempt to
address the issue of market volatility.'' \36\ After the one year
pilot, the NYSE prepared a report that, in the SEC's words, found that
``the standard measures of NYSE market quality appear largely
unaffected by Rule 80A. Specifically, the NYSE Report indicated that:
(1) quotes on the NYSE did not widen after the 50 DJIA point trigger
was reached; and (2) the imposition of Rule 80A did not have any
negative effect on price continuity and depth in the market.\37\ In
addition, in approving Rule 80A on a permanent basis, the SEC noted
that the rule ``represents a modest but useful step by the NYSE to
attempt to address the issue of market volatility,'' \38\ that the rule
``has not been disruptive to the marketplace'',\39\ and that there was
a ``lack of evidence of any harmful effects of Rule 80A.''\40\ In sum,
the SEC discussion of the statutory basis for approval of NYSE Rule 80A
focused in large part on the fact that Rule 80A did not have any
adverse impacts on market quality on the NYSE and that, as a result,
the NYSE should be given the latitude to take reasonable steps to
address excessive volatility in its marketplace. Accordingly, the NASD
believes the SEC should afford the NASD the same regulatory flexibility
that it afforded the NYSE and permit the NASD to permanently implement
a short sale rule reasonably designed to enhance the quality of Nasdaq
and minimize the effects of abusive short selling practices.
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\35\ Rule 80A provides that when the Dow Jones Industrial
Average declines or advances by 50 points or more, all index
arbitrage orders to sell or buy must be executed in a market
stabilizing manner.
\36\ See Securities Exchange Act Release No. 28282 (July 30,
1990), 55 FR 31468, 31472 (Order approving File Dos. SR-NYSE-90-5
and 90-11).
\37\ See Securities Exchange Act Release No. 29854 (October 24,
1994), 56 FR 55963 (October 30, 1994) (order approving file SR-NYSE-
91-21) (``Rule 80A Approval Order'').
\38\ Id. 56 FR at 55967.
\39\ Id.
\40\ Id. 56 FR at 55967-68.
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The NASD believes the proposed rule change is consistent with
Section 15A(b)(6), 15A(b)(9), 15A(b)(11), and 11A of the Act. Section
15A(b)(6) requires that the rules of a national securities association
be designed to prevent fraudulent and manipulative acts and practices,
to promote just and equitable principles of trade, to foster
cooperation and coordination with persons engaged in regulating,
clearing, settling, processing information with respect to, and
facilitating transactions in securities, and to remove impediments to
and perfect the mechanism of a free and open market. Specifically, the
NASD believes its short sale rule is consistent with Section 15A(b)(6)
of the Act because the Rule is premised on the same antimanipulation
and investor protection concerns that underlie the SEC's own short sale
rule, Rule 10a-1. In particular, as with Rule 10a-1, the NASD's short
sale rule promotes just and equitable principles of trade by permitting
long sellers access to market prices at any time, while constraining
the execution of potentially abusive and manipulative short sales at or
below the bid in a declining market. In addition, as with Rule 10a-1,
the NASD's short sale rule removes impediments to a free and open
market for long sellers and helps to assure liquidity at bid prices
that might otherwise be usurped by short sellers. Lastly, because the
immediate beneficiaries of the Rule are shareholders of NNM companies,
the Rule is designed to protect investors and the public interest. At
the same time, given that the NASD's short sale rule does not constrain
short sales in a raising market or prohibit the execution of short
sales in a declining market above bid prices, the NASD believes the
Rule does not diminish the important pricing efficiency and liquidity
benefits that legitimate short selling activity provides.
Section 15A(b)(9) provides that the Association's rules may not
impose any burden on competition that is not necessary or appropriate
in furtherance of the purposes of the Act. While the NASD's short sale
rule does impose compliance burdens on market participants and
conditions the execution of short sales in a declining market, the NASD
believes these burdens and restrictions are necessary in furtherance of
the protection of investors and the integrity of the Nasdaq market.
Specifically, by implementing a short sale that is designed to protect
investors and issuers from predatory short selling practices, reduce
the exposure of Nasdaq to manipulation and extreme intraday volatility,
and afford investors in Nasdaq securities the same protections against
abusive short selling that investors in exchange-listed securities
presently receive, the NASD believes its proposal is consistent with
the Act and that any burdens or competition resulting from the Rule do
not outweigh the overall benefits to investors that the Rule provides.
Section 15A(b)(11) empowers the NASD to adopt rules governing the
form and content of quotations relating to securities in the Nasdaq
market. Such rules must be designed to produce fair and informative
quotations, prevent fictitious and misleading quotations, and promote
orderly procedures for collecting and distributing quotations.
Specifically, by minimizing the extreme intra-day price volatility
associated with abusive short selling activity, the NASD believes its
short sale rule prevents misleading quotations and promotes more
orderly quotation movements, particularly in a declining market. In
addition, the NASD believes its primary market maker standards provide
an incentive for market makers to improve the quality of their
quotations.
The NASD also believes that the proposed rule change is consistent
with the significant national market system objectives contained in
Section 11A of the Act. Specifically, Section 11A(a)(1)(C) provides
that it is in the public interest and appropriate for the protection of
investors and the maintenance of fair and orderly markets to assure,
among other things, (i) the economically efficient execution of
securities transactions; (ii) fair competition among brokers and
dealers; and (iii) the practicality of brokers executing investors
orders in the best market. Specifically, by minimizing the
destabilizing influences of abusive short selling activity, the NASD
believes all of these objectives will be advanced. Similarly, Section
11A(c)(1)(F) assures the ``equal regulation of all markets for
qualified securities and all exchange members, brokers, and dealers
effecting transactions in such securities.'' Because approval of the
NASD's proposal would result in equivalent short sale regulation in the
exchange and Nasdaq markets, the NASD believes its proposal is
consistent with Section 11A(c)(1)(F).
In addition, the NASD notes that the SEC cited the NASD's adoption
of a short sale rule as a basis to question whether its recently
proposed Rule 105 of Regulation M is necessary at all.
[[Page 40699]]
Specifically, in proposing Rule 105, which liberalizes current Rule
10b-21 \41\ government short sales in connection with a secondary
offering, the SEC stated:
\41\ 17 CFR 240.10b-21.
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Since the adoption of Rule 10b-21, several additional regulatory
measures have been implemented that may lessen the effects of short
selling in connection with an offering. These initiatives, which
include permitting passive market making during offerings of Nasdaq
securities and implementing a short sale rule for the Nasdaq market,
may reduce the need for Rule 105. (Footnote omitted).\42\
\42\ See Securities Exchange Act Release No. 37094 (April 11,
1996), 61 FR 17108, 17126.
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The NASD believes it would be inconsistent for the SEC to not
permanently approve the NASD's short sale rule and yet approve another
SEC rule that liberalizes current Rule 10b-21 or eliminate it
altogether because of, among other things, the presence of the NASD's
short sale rule.
Lastly, the NASD believes that extending the effectiveness of the
short sale rule for an additional three-month period while the SEC
reviews the NASD's proposal for permanent approval of the Rule would
avoid the confusion in the marketplace that would result if the Rule
were to lapse for three months and then be reinstated later. Finally,
the NASD believes that extending the pilot period for the short sale
Rule will help to ensure that future regulatory action taken with
respect to the Rule is based on a greater knowledge and understanding
of the Rule.
B. Self-Regulatory Organization's Statement on Burden on Competition
As discussed above in Section II. A., the NASD believes that the
proposed rule change will not result in any burden on competition that
is not necessary or appropriate in furtherance of the purposes of the
Act. The NASD believes the primary market makers of all sizes to
qualify as primary market makers. Moreover, it is important to note
that market makers that do not meet the standards are still permitted
to remain registered market makers in the Nasdaq system. In addition,
without a short sale rule for the Nasdaq market, Nasdaq would be
adversely impacted in its ability to compete for listing with exchange
markets.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
The NASD requests that the Commission find good cause pursuant to
Section 19(b)(2) for approving that part of the proposed rule change
that requests a three month extension of the pilot program for the Rule
prior to the 30th day after publication in the Federal Register. With
regard to the request for permanent approval of the Rule, within 35
days of the date of publication of this notice in the Federal Register
or within such longer period (i) as the Commission may designate up to
90 days of such date if it finds such longer period to be appropriate
and publishes its reasons for so finding or (ii) as to which the NASD
consents, the Commission will:
A. By order approve such proposed rule change, or
B. Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Commission's Findings and Order Granting Partial Accelerated
Approval of Proposed Rule Change
The Commission finds that the proposal to extend the short sale
rule for a three-month period is consistent with the Act and the rules
and regulations promulgated thereunder. Specifically, the Commission
finds that the proposed rule change is consistent with Section
15A(b)(6) which requires that the NASD rules be designed, among other
things, to facilitate securities transactions and protect investors and
the public interest. Further, the Commission finds good cause to
approve a temporary three-month extension of short sale rule pilot
prior to the 30th day after the date of publication of notice of filing
in that accelerated approval will avoid disrupting the market while the
Commission considers the NASD's request for permanent approval.
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549. Copies
of the submission, all subsequent amendments, all written statements
with respect to the proposed rule change that are filed with the
commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
NASD. All submissions should refer to the file number in the caption
above and should be submitted by August 26, 1996.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the portion of the proposed rule change (SR-NASD-96-30) providing
a three-month extension of the NASD's pilot short sale rule is approved
until November 4, 1996.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\43\
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\43\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-19836 Filed 8-2-96; 8:45 am]
BILLING CODE 8010-01-M