[Federal Register Volume 62, Number 193 (Monday, October 6, 1997)]
[Notices]
[Pages 52170-52173]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-26359]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39140; File No. SR-NASD-97-65]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change by the National 
Association of Securities Dealers, Inc. Extending the Pilot Program of 
the NASD's Short Sale Rule

September 26, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 \2\ thereunder, notice is hereby given 
that on September 4, 1997, 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 
and to grant accelerated approval of the proposed rule change.
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    \1\ 15 U.S.C. Sec. 78s(b)(1)(1994).
    \2\ 17 CFR 240.19b-4 (1997).
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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 Rule 3350 to extend the pilot 
program of the NASD's short sale rule from October 1, 1997 until 
January 15, 1998. Below is the text of the proposed rule change. 
Proposed new language is in italics; proposed deletions are in 
brackets.
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[[Page 52171]]

NASD Rule 3350

    (1) This section shall be in effect until January 15, 1998 (October 
1, 1997).
* * * * *

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. Nasdaq has prepared summaries, set forth in Sections A, 
B, and C below, of the most significant aspects of such statements.

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 rule applicable to short 
sales \3\ in Nasdaq National Market (``NNM'') securities on an 
eighteen-month pilot basis through March 5, 1996.\4\ The termination 
date for the pilot program for the Rule was subsequently extended until 
October 1, 1997.\5\
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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 of the Act, 
which rule is incorporated into Nasdaq's Rule by NASD Rule 
3350(k)(1).
    \4\ Securities Exchange Act Release No. 34277 (June 29, 1994), 
59 FR 34885 (July 7, 1994) [File No. SR-NASD-92-12] (``Short Sale 
Rule Approval Order'').
    \5\ The Rule was extended on several occasions. Securities 
Exchange Act Release No. 36532 (November 30, 1995), 60 FR 62519 
(December 6, 1995) [File No. SR-NASD-95-58]; See also Securities 
Exchange Act Release No. 36171 (August 30, 1995), 60 FR 46651 
(September 7, 1995) [File No. SR-NASD-95-35]. The most recent 
extension of the pilot program through October 1, 1997, was approved 
by the SEC to afford the NASD a better opportunity to examine the 
effectiveness of the Rule and the impact of the market maker 
exemption from the Rule. Securities Exchange Act Release No. 37917 
(November 1, 1996), 61 FR 57934 (November 8, 1996) [File No. SR-
NASD-96-41]. In this connection, in order to enhance its ability to 
examine the impact of the market maker exemption, the NASD received 
SEC approval of its proposal to require market makers to mark their 
ACT reports to denote when they have relied on the market maker 
exemption. Securities Exchange Act Release No. 38240 (February 5, 
1997), 62 FR 6290 (February 11, 1997) [File No. SR-NASD-96-52].
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    The 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.\6\ The Rule is in effect 
during normal domestic market hours (9:30 a.m. to 4:00 p.m., Eastern 
Time). To ensure that market maker activities that provide liquidity 
and continuity to the market are not adversely constrained when the 
Rule is invoked, the Rule provides an exemption to ``qualified'' Nasdaq 
market makers (i.e., those market makers that meet the Primary Market 
Maker (``PMM'') standards). Even if a market maker is able to avail 
itself of the qualified market maker exemption, it can only utilize the 
exemption from the Rule for transactions that are made in connection 
with bona fide market making activity. If a market maker does not 
satisfy the requirements to be 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.
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    \6\ 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. 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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    Since the Rule has been in effect, there have been three methods 
used to determine whether a market maker is eligible for the market 
maker exemption. Specifically, 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 the short sales were made in connection with bona 
fide market making activity (the ``20-day'' test). From February 1, 
1996 until February 14, 1997, the ``20-day'' test was replaced with a 
four-part quantitative test known as the Nasdaq PMM Standards.\7\ On 
February 14, 1997, the PMM standards were waived for all NNM securities 
due to the effects of the SEC's Order Handling Rules and corresponding 
NASD rule change and system modifications on the operation of the four 
quantitative standards.\8\ For example, among other effects, the 
requirement that market makers display customer limit orders adversely 
affected the ability of market makers to satisfy the ``102% Average 
Spread Standard.'' Nasdaq is presently in the process of formatting 
revised PMM standards that focus principally on whether a market maker 
is a ``net'' provider of liquidity.
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    \7\ Under the PMM Standards, a market maker was required to 
satisfy at least two of the following four criteria each month to be 
eligible for an exemption from the 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. If a PMM did not satisfy the 
threshold standards after a particular review period, the market 
maker lost its designation as a PMM (i.e., the ``P'' next to its 
market maker identification was removed). Market makers could 
requalify for designation as a PMM by satisfying the threshold 
standards in the next review period.
    \8\ Securities Exchange Act Release No. 38294 (February 14, 
1997), 62 FR 8289 (February 24, 1997) [File No. SR-NASD-97-07].
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    Furthermore, in an effort to not constrain the legitimate hedging 
needs of options market makers, the Rule contains a limited exception 
for standardized options market makers. The Rule also contains an 
exemption for warrant market makers similar to the one available for 
options market makers. The Rule also incorporates seven exemptions 
contained in Rule 10a-1 under the Act (``Rule 10a-1'') that are 
relevant to trading on Nasdaq.\9\
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    \9\ See NASD Rule 3350(c) (2)-(8). 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 and an 
``international equalizing exemption'' are equally applicable to the 
NASD's Rule.
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2. Proposal To Extend the Short Sale Rule
    When the Commission approved the 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 NNM securities in consistent with the Act.'' \10\ In 
addition, the Commission stated that it ``believes that the NASD's 
short sale bid-test, including the market

[[Page 52172]]

maker exemption, is a reasonable approach to short sale regulation of 
Nasdaq National Market securities and reflects the realities of its 
market structure.'' \11\ However, 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,\12\ 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.\13\ To address these concerns, in July 1996 and in August 
1997, the NASD's Economic Research Department prepared two separate 
studies on the economic impact of the Rule, which concluded, among 
other things, that the Rule had no adverse impact on the market.\14\ 
Accordingly, on August 8, 1997, the NASD submitted a proposed rule 
change that requested permanent approval of the Rule.
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    \10\ Short Sale Rule Approval Order, supra note 4, at 34891.
    \11\ Id. at 34892.
    \12\ When the NASD's 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 commenters opposed to the Rule argued that: (1) The 
NASD had failed to provide sufficient evidence of the need for the 
Rule or demonstrate the appropriateness of the Rule based on a 
``bid'' test instead of ``tick'' test; (2) the PMM standards will 
have negative effects on both market makers and the Nasdaq market; 
and (3) the Rule is inconsistent with the requirements of the Act.
    \13\ 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 
``abusive 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 1/16th.
    \14\ In July 1996, the NASD's Economic Analysis Department 
completed a study on the economic impact of the Rule, which 
concluded that the Rule has had no adverse impact on the market. The 
Economic Impact of the Nasdaq Short Sale Rule, NASD Economic 
Research Department (July 23, 1996) (``July 1996 Short Sale 
Study''). In the same month, NASD submitted a proposal to adopt the 
Rule on a permanent basis. Securities Exchange Act Release No. 37942 
(July 29, 1996), 61 FR 40693 (SR-NASD-96-30). Because the NASD 
believed additional quantitative analysis was necessary to evaluate 
the effects of the Rule, the NASD withdrew this rule filing. In 
August 1997, the NASD's Economic Analysis Department completed a 
second study on the economic impact of the Rule, which further 
concluded that the Rule has had no adverse impact on the market. The 
Nasdaq Stock Market Short Sale Rule: Analysis of Market Quality 
Effects and The Market Maker Exemption, NASD Economic Research 
Department (August 7. 1997) (``August 1997 Short Sale Study'').
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    The NASD notes that while the short sale pilot is set to expire on 
October 1, 1997, Nasdaq currently is working diligently to develop 
effective PMM standards, which the NASD plans to file shortly with the 
Commission. The NASD notes that any PMM standards it might propose are 
integrally related to the Rule, that is, changes to PMM standards may 
have an impact on the Rule because it will define the parameters under 
which market makers qualify for PMM status and thus may execute 
``legal'' short sales. Therefore, the NASD believes that any PPM 
standards that the NASD may propose may have an impact on whether the 
Commission ultimately grants the NASD's request for permanent approval 
of the Rule. Accordingly, in light of these factors and expiration of 
the Rule on October 1, 1997, the NASD is proposing to extend the Rule's 
pilot until January 15, 1998. The NASD believes this extension will 
afford the NASD time to formulate and submit to the Commission revised 
PMM standards and will allow the Commission to review on a 
contemporaneous basis these two integrally related proposed rule 
changes (i.e., the short sale and PMM rules).
    The NASD believes the proposed rule change is consistent with 
Sections 15A(b)(6) 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 that extending 
the pilot period for the Rule will ensure continuity in regulation 
while the Commission considers the proposed PMM standards and permanent 
approval of the Rule.
    The NASD also believes the proposed rule change is consistent with 
Section 15A(b)(6) of the Act because the Rule is premised on the same 
anti-manipulation and investor protection concerns that underlie the 
SEC's own short sale rule, Rule 10a-1 under the Act (``Rule 10a-1''). 
In particular, as with Rule 10a-1, the NASD believes its 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, Nasdaq believes 
its 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, Nasdaq believes its Rule 
is designed to protect investors and the public interest. At the same 
time, given that the Rule does not constrain short sales in a raising 
market or prohibit the execution of short sales in a declining market 
above bid prices, Nasdaq believes the Rule does not diminish the 
important pricing efficiency and liquidity benefits that legitimate 
short selling activity provides.

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

    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.

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 its proposal to extend the effectiveness of 
the Rule until January 15, 1998, be approved on an accelerated basis 
prior to October 1, 1997.

IV. Commission's Findings and Order Granting Accelerated Approval of 
the Proposed Rule Change

    The Commission finds that the NASD's proposed rule change seeking 
to extend the pilot of the Rule through January 15, 1998, 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) of the Act which requires that the 
NASD rules be designed, among other things, to facilitate securities 
transaction and to protect investors and the public interest. The 
Commission believes that the proposed rule change is consistent with 
the Act because extension of the pilot will allow the Commission and 
the NASD to consider the potential problems associated with short 
selling, the changing expectations of Nasdaq market participants and 
the potential for competitive disparity between the exchange markets 
and the OTC market. This extension also will afford NASD time to 
formulate and submit to the Commission revised PMM

[[Page 52173]]

standards and will allow the Commission to review on a contemporaneous 
basis these two integrally related rules (i.e., the short sale and PMM 
rules).
    The Commission also finds good cause for approving the proposed 
rule change prior to the 30th day after the date of publication of 
notice of filing thereof. The Commission believes that it is 
appropriate to approve on an accelerated basis the extension through 
January 15, 1998, of the pilot program of the Rule to ensure the 
continuous operation of the Rule and to allow the NASD and the 
Commission time to review the operation of the Rule, which is set to 
expire on October 1, 1997.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. People 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. Sec. 552, will be available for inspection and copying in 
the Commission's Public Reference Room. Copies of the filing will also 
be available for inspection and copying at the NASD's principal 
offices. All submissions should refer to File No. SR-NASD-97-65 and 
should be submitted by October 27, 1997.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change, SR-NASD-97-65 be, and hereby is, 
approved through January 15, 1998.\15\

    \15\ See also companion release Securities Exchange Act Release 
No. 39139.
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    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12) (1997).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-26359 Filed 10-3-97; 8:45 am]
BILLING CODE 8010-01-M