[Federal Register Volume 62, Number 171 (Thursday, September 4, 1997)]
[Notices]
[Pages 46787-46791]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-23391]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38985; File No. SR-NASD-97-53]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
Trading in Exchange-Listed Securities in the Third Market

August 27, 1997.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on July 28, 1997, the 
National Association of Securities Dealers, Inc. (``NASD''), through 
its wholly-owned subsidiary, The Nasdaq Stock Market, Inc. 
(``Nasdaq''), filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by Nasdaq. 
The Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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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 amend several rules governing the trading 
in exchange-listed securities in the over-the-counter market. 
Specifically, the NASD is proposing to amend rules of the NASD to: (1) 
Codify permissible uses of computer-generated quote systems with 
respect to exchange-listed securities; (2) eliminate the excess spread 
rule for market makers in exchange-listed securities; (3) reduce the 
minimum quotation size applicable to market makers in exchange-listed 
securities to one unit of trading (i.e., 100 shares), regardless of 
whether the CQS market maker \2\ is displaying a customer's limit order 
or quoting for its own proprietary account; (4) extend exemptive 
provisions of the NASD's limit order protection rule applicable to 
Nasdaq-listed securities (the ``Manning Rule'') to exchange-listed 
securities; and (5) reduce from 1000 to 100 the number of shares that 
the Computer Assisted Execution System (``CAES'') will execute 
automatically. Below is the text of the proposed rule change. Proposed 
new language is underlined; proposed deletions are in brackets.
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    \2\ Quotations and quotation sizes in reported securities may be 
entered into the Consolidated Quotations Service (CQS) through The 
Nasdaq Stock Market only by an Association member registered with it 
as a CQS market maker. See NASD rule 6320.
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6330. Obligations of CQS Market Makers

    (a) No Change.
    (b) [CQS market makers shall be required to input a minimum 
quotation size of 200 or 500 shares in each reported security (as 
established and published from time to time by the Association) 
depending on trading characteristics of the security; provided that a 
CQS market maker may input a quotation size less than such minimum 
quotation size to display a limit order in compliance with SEC Rule 
11Ac1-4. A limit order displayed in a] A CQS market maker's quotation 
[pursuant to SEC Rule 11Ac1-4] must be for at least one normal unit of 
trading [or a multiple thereof].
    [(c) Excess Spreads.
    A market maker shall not enter quotations in CQS securities that 
exceed the parameters for maximum allowable spreads as approved by the 
Association's Board of Governors and that may be published from time to 
time by the Association. The maximum allowable spreads for CQS 
securities shall be 125 percent of the average of the three (3) 
narrowest market maker spreads in each security, which average spread 
calculations shall include quotations from national securities 
exchanges (if the number of CQS market makers in a security plus the 
number of national securities exchanges trading that security is less 
than three (3), the maximum allowable spread will be 125 percent of the 
average spread); provided, however, that the maximum allowable spread 
shall never be less than \1/4\ of a point.]
    (d) redesignated as paragraph (c)
    (d) Computer-Generated Quotations.
    (1) General Prohibition--Except as provided below, this rule 
prohibits the

[[Page 46788]]

automatic updating or tracking of inside quotations in CQS by computer-
generated quote systems. This ban is necessary to offset the negative 
impact on the capacity and operation of Nasdaq systems regarding 
certain systems that track changes to the inside quotation and 
automatically react by generating another quote to keep the market 
maker's quote away from the best market, without any cognizable human 
intervention.
    (2) Exceptions to the General Prohibition--Automated updating of 
quotations is permitted when: (1) the update is in response to an 
execution in the security by that firm (such as execution of an order 
that partially fills a market maker's quotation size); (2) it requires 
a physical, cognizable entry (such as a manual entry to the market 
maker's internal system which then automatically forwards the update to 
a Nasdaq system); (3) the update is to reflect the receipt, execution, 
or cancellation of a customer limit order; (4) it is used to expose a 
customer's market or marketable limit order for price improvement 
opportunities; or (5) it is used to equal or improve either or both 
sides of the national best bid or offer (``NBBO''), or add size to the 
NBBO.
* * * * *

6440. Trading Practices

    (a)-(e) No Change
    (f)(1) No Change
    (f)(2) No Change
    (3) The provisions of this paragraph shall not apply:
    (A) No Change
    (B) No Change
    (C) No Change
    (D) to any purchase or sale for which a member has negotiated 
specific terms and conditions applicable to the acceptance of limit 
orders that are:
    (i) for customer accounts that meet the definition of an 
``institutional account'' as that term is defined in Rule 3110(c)(4); 
or
    (ii) for 10,000 shares or more, unless such orders are less than 
$100,000 in value.

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 statutory basis for, the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. Nasdaq has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organizations' Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In light of the implementation of the Commission's Order Execution 
Rules,\3\ and the impending implementation of the ``1% Rule'' \4\ to 
all exchange-listed securities, the NASD is proposing the following 
amendments to the rules governing trading in exchange-listed securities 
in the over-the-counter market, the so-called ``third market.''
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    \3\ See Securities Exchange Act Release No. 37619A (September 6, 
1997), 61 FR 48290 (September 12, 1997) (``Adopting Release''). The 
Commission adopted Rule 11Ac1-4 (``Limit Order Display Rule'') and 
amendments to Rule 11Ac1-1 (``Quote Rule'') (collectively ``Order 
Execution Rules'').
    \4\ An amendment to the Quote Rule expanded the quotation 
requirements of substantial OTC market makers and exchange 
specialists to require that they publicly disseminate continuous 
two-sided quotations for any exchange-listed security for which they 
account for one percent or more of the trading volume (commonly 
referred to as the ``1% Rule''). See Adopting Release. While the 
amendments to the Quote Rule extended the quotation requirement to 
all exchange-listed securities, the Commission, by exemptive order, 
has provided relief from compliance with the 1% Rule, with respect 
to non-19c-3 securities, until September 30, 1997. See Exchange Act 
Release No. 38870 (July 24, 1997), 62 FR 40732 (July 30, 1997). 
Therefore, currently, OTC market makers and exchange specialists 
publicly disseminate quotations only when they are responsible for 
one percent or more of the trading volume in a 19c-3 security.
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a. Permissibility of the Use of Certain Automated Quotation Generation 
Systems
    The plan governing the Intermarket Trading System (``ITS Plan'') 
currently provides that exchange specialists and CQS market makers may 
use ``automated quotation tracking systems,'' provided that the 
quotations generated by such systems are for 100 shares or less (``100-
Share Autoquoting Limitation''). Despite the ITS Plan's allowance of 
100-share autoquotes, the NASD prohibits CQS market makers from using 
autoquote systems to effect automated quote updates or to track the 
inside market. In addition, the NASD requires CQS market makers to 
maintain a minimum quotation size of 500 shares, with the exception of 
displaying a customer limit order, which also effectively prohibits CQS 
market makers from autoquoting.
    In expanding the 1% Rule, the Commission recognized that it raised 
an issue with respect to the ability of NASD members to autoquote. The 
Commission stated that ``a total prohibition on the use of computer 
generated quotes is not appropriate'' and that ``[s]uch an approach 
excessively limits the use of sophisticated trading strategies that 
rely on automation in the quotation process for their success, and it 
also may act as a competitive disadvantage to market makers and 
specialists that would otherwise rely on technology to meet their 
quotation obligations more efficiently.'' \5\ While the Commission 
noted that it ``recognizes traditional concerns related to the 
accessibility of computer generated quotes and the impact of such 
quotes on system capacity, it believes that more can and should be done 
in this area.'' \6\ The Commission stressed that more should be done 
particularly ``given the enhanced quotation obligations that will be 
imposed on some market participants under the revised Quote Rule.'' \7\ 
The Commission, therefore, urged the ``NASD, ITS Participants, and 
other interested market participants to develop revised standards that 
would permit the use of computer generated quotes that contribute value 
to the market.'' \8\
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    \5\ See Adopting Release at Section III.B.3.c.i.
    \6\ Id.
    \7\ Id.
    \8\ Id.
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    Accordingly, the NASD is proposing to explicitly accommodate 
computer-generated quotations that add value to the market and do not 
raise quotation accessibility concerns or compromise the capacity or 
integrity of Nasdaq. Specifically, the proposed rule change amends NASD 
Rule 6330 to permit computer-generated quotations in exchange-listed 
securities that generate proprietary quotes for 100 shares or more if 
such quote systems equal or improve either or both sides of the NBBO. 
For example, if a CQS market marker utilized a computer-generated 
quotation program to match the best offer (bid) and the market 
responsible to the best offer (bid) subsequently increased (decreased) 
its offer (bid) price, the CQS market maker could not use the program 
to track such inferior price. Thus, if the best offer is 20\1/4\, a CQS 
market maker could use the program to improve its offer to 20\1/4\. If 
the market responsible for the 20\1/4\ offer moved to 20\3/8\, however, 
the CQS market maker could not use the program to move its offer to 
20\3/8\.
    In addition, the proposed rule change amends Rule 6330 to permit 
computer-generated quotations that add size to the NBBO, or are used to 
expose a customer's market or marketable limit order for price 
improvement

[[Page 46789]]

opportunities. These uses would be in addition to three other forms of 
computer-enhanced quotation maintenance programs referenced in the 
NASD's Autoquote Policy which are also being incorporated into Rule 
6330 with respect to exchange-listed securities.\9\ With the exception 
of these types of computer-generated quotation and maintenance systems, 
all other types of computer-generated quotations would continue to be 
prohibited. Thus, market makers could not use computer-generated 
quotations to track away from the inside market (``autoquoting 
away'').\10\
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    \9\ See NASD IM-4613. Specifically, these three forms are: (1) 
Quotations updates in response to an execution in the security by 
that firm (such as execution of an order that partially fills a 
market maker's quotation size); (2) quotation updates that require a 
physical entry (such as manual entry to the market maker's internal 
system which then automatically forwards the update to Nasdaq); and 
(3) quotation updates that reflect the receipt, execution, or 
cancellation of a customer limit order.
    \10\ To the extent that approval of the proposed amendments to 
Rule 6330 would result in NASD rules permitting computer-generated 
quotations in CQS securities to a greater degree than that permitted 
under Section 8(d)(ii) of the ITS Plan, the NASD requests that the 
Commission's order approving these amendments to Rule 6330 
specifically provide that adherence to Rule 6330 supersedes 
adherence to Section 8(d)(ii) of the ITS Plan until such time as the 
ITS Plan is amended to contain similar provisions.
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    In approving this proposal, the NASD was fully cognizant of and 
carefully considered the views of some industry participants that 
prohibiting autoquoting away would subject CQS market makers to a 
competitive disadvantage vis-a-vis specialists on regional 
exchanges.\11\ The NASD also considered contrary arguments raised by 
some industry participants that permitting autoquoting away would 
undermine the integrity of the third market and facilitate the 
generation of inaccessible market maker quotes. After considering these 
views, the NASD remains concerned with the potential adverse impacts on 
market integrity and Nasdaq system capacity that restricted autoquoting 
away could cause. Specifically, the NASD believes that the potential 
increase in the number of OTC market makers and corresponding quote 
changes in the third market due to the expansion of the 1% Rule, 
coupled with more CQS market makers registering and electing to quote 
in conjunction with the SEC's Limit Order Display Rule, creates a 
market environment where unfettered autoquoting away would subject 
Nasdaq systems to capacity constraints that would compromise the 
integrity of The Nasdaq Stock Market and the protection of investors. 
In addition, the NASD is concerned by the prior experience with 
unlimited autoquoting by regional exchange specialists. Unlimited 
autoquoting away from the market creates ephemeral quotations which can 
appear to be at the best price for a few seconds only to disappear 
before an order realistically can be routed to the quote. In short, the 
NASD believes that unlimited computer-generated quotations would 
diminish the positive impact on quotation transparency obtained from 
the Commission's expansion of the 1% Rule.
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    \11\ See letter from David E. Shaw, Chairman, D.E. Shaw & Co., 
Inc. to Alfred R. Berkeley, III, President, The Nasdaq Stock Market, 
dated June 2, 1997, attached as Exhibit 2 (``D.E. Shaw Letter'').
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    The NASD continues to believe that autoquoting away should not be 
fostered as a policy matter. The NASD, however, is extremely concerned 
with the competitive implications on CQS market makers raised by the 
prospect that while they are prohibited from autoquoting away, 
specialists on regional exchanges will continue to do so. Accordingly, 
the NASD and Nasdaq Boards considered alternatives designed to provide 
CQS market markers with the ability to update their quotes in an 
efficient and cost effective manner while minimizing the impact on the 
operation and capacity of Nasdaq systems that collect, process, and 
disseminate quotation changes. Ultimately, as discussed in more detail 
below, the NASD voted to eliminate the excess spread rule applicable to 
CQS market makers in conjunction with prohibiting autoquoting away. The 
NASD believes that the elimination of the excess spread rule for CQS 
securities in conjunction with the retention of the NASD's ban on 
autoquoting away is a prudent, balanced, and rational approach to the 
resolution of an issue critically important to the preservation of the 
integrity and efficiency of Nasdaq. As noted above, the NASD believes 
that allowing autoquoting away will have a profound adverse impact on 
the quality of the third market and the operational soundness of 
Nasdaq. However, in light of the competitive implications to CQS market 
makers, the NASD proposes to enhance the quotation flexibility of CQS 
market makers by eliminating the excess spread rule for CQS securities. 
The NASD trusts that eliminating the excess spread rule for CQS 
securities will nullify any competitive advantages that specialists on 
regional exchanges, who can autoquote away, may have over CQS market 
makers who can not. Thus, as a policy matter, not a capacity matter, 
the NASD believes this to be a compromise solution that is more 
beneficial to the market place than allowing unfettered computer-
generated quotations.
b. Elimination of the Excess Spread Rule
    The NASD's excess spread rule applicable to CQS securities 
currently provides that a CQS market maker shall not enter a quotation 
spread in excess of 125 percent of the average of the three narrowest 
market marker spreads in such security, which average spread 
calculation shall include quotations from national securities 
exchanges.
    As discussed above, the analysis of the proposed elimination of the 
CQS excess spread rule was joined with the NASD's analysis of whether 
to permit autoquoting away. The NASD determined that the potential 
adverse competitive consequences on highly automated CQS market making 
firms who are prohibited from autoquoting away could be minimized if 
the excess spread rule was eliminated. Specifically, by eliminating the 
excess spread rule for CQS securities, the NASD believes that CQS 
market makers will have more flexibility in quoting, Nasdaq capacity 
will not be needlessly consumed by processing voluminous quote updates 
away from the market, and the competitiveness of the third market will 
not be compromised.
    The NASD continues to believe that an excess spread rule provides 
important benefits for the competitiveness and integrity of the market 
in instances where Nasdaq is the primary market. On the other hand, in 
the third market, where Nasdaq is not the primary market, the NASD 
believes that imposition of an excess spread rule may unduly hamper 
Nasdaq's ability to compete with the primary market and other markets 
because it may constrain the number of CQS market makers. Because 
Nasdaq is not the primary market for issues traded in the third market, 
the NASD does not find it inconsistent to eliminate the excess spread 
rule for exchange-trade securities while maintaining an excess spread 
rule for Nasdaq securities. Accordingly, the NASD is proposing to 
eliminate the excess spread rule for CQS market makers.
c. Changes to the Minimum Quote Size Rule for CQS Market Makers
    NASD Rule 6330(b) presently provides that a CQS market maker must 
display a minimum quotation size of 500 shares (``500 Share Quote 
Rule''), with the exception of displaying a customer limit order, which 
may be for less than 500 shares.
    In an environment where CQS market makers were the only market 
participants who could impact quotes in

[[Page 46790]]

the third market, it was believed to be desirable and appropriate to 
impose a minimum quotation size requirement to ensure an acceptable 
level of market liquidity and depth. However, now that the SEC's Limit 
Order Display Rule permits investors to directly impact quoted prices 
in the third market by having their limit orders displayed publicly, 
the NASD believes it is appropriate to treat CQS market makers in a 
manner equivalent to exchange specialists and not subject them to 
minimum quote size requirements. In sum, the NASD believes the 
increased order-driven nature of the third market brought about the 
SEC's Limit Order Display Rule obviates the justification for the 500 
Share Quote Rule. Accordingly, the NASD is proposing to amend the 500 
Share Quote Rule to permit a CQS market maker to post quotations 
commensurate with their own freely-determined trading interest, 
provided, however, that the quotations must be for at least one normal 
unit of trading.
d. Modifications to CAES
    CAES is an automated system operated by Nasdaq that allows NASD 
members to direct both agency and principal orders (in stocks in which 
they make a market) in exchange-listed securities to CAES for automated 
execution in the third market. All CQS market makers must be CAES 
market makers.
    The implementation of the SEC's Limit Order Display Rule has 
exacerbated a shortcoming in the design of the current CAES system. 
Specifically, while CAES volume is minimal, CAES permits other CQS 
market makers to send preferenced orders of up to 1,000 shares to a CQS 
market maker for automatic execution at the best bid or offer among CQS 
market makers. CAES will execute such orders regardless of whether the 
CQS market maker is at the best bid or offer (``BBO''), regardless of 
whether the quote driving the BBO is for less than 1,000 shares, and 
regardless of whether the CQS market maker wants to accept preferenced 
orders from the order entry firm or market maker. Thus, since the 
implementation of the Order Execution Rules has required market makers 
to display customer limit orders, CQS market makers are not only 
obligated to execute trades up to 1,000 shares at another market 
maker's quote, they must now also execute trades at superior-priced 
limit orders displayed by any other CQS market maker, even if such 
limit orders are only for 100 shares. In addition, because Nasdaq no 
longer quotes,\12\ CAES executes orders at the best bid or offer price 
in the third market instead of the national best bid or offer 
(``NBBO''). As a result, when there are no CQS market makers at the 
NBBO, CAES is providing inferior executions to customer orders.
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    \12\ See Exchange Act Release No. 37663, September 10, 1996 (61 
FR 48725) (order approving File No. SR-NASD-96-26).
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    In order to facilitate the best execution of customer orders and 
not subject CQS market makers to automatic executions at prices other 
than their posted quotes, the NASD believes it is imperative that CAES 
be appropriately modified. Accordingly, the NASD has established a two-
step process to amend the operation of CAES--one a short-term solution 
and the other a long-term solution.
    In the short term, and as part of the instant filing, the NASD is 
proposing to amend the operation of CAES so that it automatically 
executes orders up to 100 shares instead of 1,000 shares. This 
eliminates much of a market maker's exposure, although it does not 
completely address the core deficiencies with CAES noted above.
    As a long-term solution, the NASD plans a future proposal to amend 
the operation of CAES so that: (1) It only accepts priced orders; and 
(2) orders will only be executed against a market maker if the market 
maker's quote is equal to or better than the price of the order (i.e., 
if a market maker's bid was 20 it would be obligated to execute orders 
to sell priced equal to 20 or below).
e. Modifications to the Limit Order Protection Rule Applicable to COS 
Securities
    NASD Rule 6440 provides that no member shall trade ahead of a 
customer limit order. Unlike the limit order protection rule applicable 
to Nasdaq securities (the ``Manning Rule''), however, the limit order 
rule applicable to CQS securities does not on its face permit a member 
to negotiate special terms and conditions with a customer that would 
enable the firm to trade ahead of, or at the same price as, the limit 
order price. Specifically, under the Manning Rule, member firms may 
attach terms and conditions with respect to the handling of limit 
orders that are either: (1) For institutional accounts; \13\ or (2) 
limit orders that are for 10,000 shares or greater, regardless of 
whether they are for institutional accounts, provided that the order is 
$100,000 or more in value.
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    \13\ Institutional limit orders are orders for institutional 
accounts. NASD Rule 3110(c) defines an institutional account as an 
account for: (1) Banks, savings and loan associations, insurance 
companies, or registered investment companies; (2) investment 
advisers registered under Section 203 of the Investment Advisers Act 
of 1940; and (3) any other entity (whether a natural person, 
corporation, partnership, trust, or otherwise) with total assets of 
at least $50 million.
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    The NASD believes there is no basis to differentiate between limit 
orders in Nasdaq securities and limit orders in exchange-listed 
securities with respect to the protections afforded under NASD rules. 
Accordingly, the NASD is proposing to extend the ``terms and 
conditions'' language of the Manning Rule to the CQS limit order 
protection rule.
    The NASD believes that the proposed rule change is consistent with 
the provisions of Sections 11A(a)(1)(D), 11A(a)(2) and 15A(b)(6) of the 
Act. Section 11A(a)(1)(D) of the Act states that the linking of all 
markets for qualified securities through communications and data 
processing facilities will foster efficiency, enhance competition, 
increase the information available to brokers, dealers and investors, 
facilitate the offsetting of investor's orders and contribute to best 
execution of such orders, and subsection (a)(2) thereunder directs the 
Commission to facilitate the establishment of a national market system 
for qualified securities. 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, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and in general to 
protect investors and the public interest. The proposed rule change 
will enhance the national market system for exchange-listed securities 
and will further the implementation of the Commission's Order Execution 
Rules with respect to exchange-listed securities, thereby benefitting 
all market participants and investors.

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

    Nasdaq does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

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

    Written comments were neither solicited nor received.

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 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, 450 Fifth Street, N.W., Washington, 
D.C. 20549. 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 September 25, 1997.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-23391 Filed 9-3-97; 8:45 am]
BILLING CODE 8010-01-M