[Federal Register Volume 63, Number 14 (Thursday, January 22, 1998)]
[Notices]
[Pages 3370-3372]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-1422]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39551; File No. SR-NASD-97-94]


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 and the Amendment to the Definition of 
``Legal'' Short Sale

January 14, 1998.
    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 December 23, 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 extend until April 15, 1998, the pilot 
program of the NASD's short sale rule (``Rule'') and the recently-
approved amendment to the definition of ``legal'' short sale.\3\ Below 
is the text of the proposed rule change. Proposed new language is in 
italics; proposed deletions are in brackets.
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    \3\ The NASD has requested permanent approval of its short sale 
rule. Securities Exchange Act Release No. 38979 (Aug. 26, 1997), 62 
FR 46537 (Sept. 3, 1997) [File No. SR-NASD-97-58]. In response to 
its solicitation of comments on the filing (SR-NASD-97-58), the 
Commission has received 352 comment letters to date, which will be 
considered in connection with the Commission's determination on SR-
NASD-97-58.
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* * * * *

NASD Rule 3350

    (1) This section shall be in effect until April 15, 1998 [January 
15, 1998].
* * * * *

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 \4\ in Nasdaq National Market (``NNM'') securities on an 
eighteen-month pilot basis through March 5, 1996.\5\ The termination 
date for the pilot program for the Rule was subsequently extended until 
January 15, 1998.\6\
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    \4\ 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).
    \5\ 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'').
    \6\ The Rule was extended on several occasions. See Securities 
Exchange Act Release No. 39140 (Sept. 26, 1997), 62 FR 52170 (Oct. 
6, 1997) [File No. SR-NASD-97-65]; Securities Exchange Act Release 
No. 37917 (Nov. 1, 1996), 61 FR 57934 (Nov. 8, 1996) [File No. SR-
NASD-96-41]; Securities Exchange Act Release No. 36171 (Aug. 30, 
1995), 60 FR 46651 (Sept. 7, 1995) [File No. SR-NASD-95-35]. The 
most recent extension of the pilot program through January 15, 1998, 
was to allow Nasdaq and the NASD to develop more meaningful primary 
market maker standards.
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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.\7\ 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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    \7\ 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 1/16th 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 that 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. \8\ 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

[[Page 3371]]

four quantitative standards.\9\ 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.''
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    \8\ 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.
    \9\ Securities Exchange Act Release No. 38294 (February 14, 
1997), 62 FR 8289 (February 24, 1997) [File No. SR-NASD-97-07]. On 
October 3, 1997, the waiver of PMMs was extended until April 1, 
1998. Securities Exchange Act Release No. 39198 (Oct. 3, 1997), 62 
FR 53365 (Oct. 14, 1997) [SR-NASD-97-3].
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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.\10\
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    \10\ 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.
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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 is consistent with the Act.'' \11\ In 
addition, the Commission stated that it ``believes that the NASD's 
short sale bid-test, including the market maker exemption, is a 
reasonable approach to short sale regulation of Nasdaq National Market 
securities and reflects the realities of its market structure.'' \12\ 
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,\13\ the Commission determined to 
approve the Rule on a temporary basis to afford the NASD and the SEC an 
opportunity study the effects of the Rule and its exemptions.\14\ 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.\15\ Accordingly, on 
August 8, 1997, the NASD submitted a proposed rule change that 
requested permanent approval of the Rule.\16\ Additionally, on August 
14, 1997, the NASD and Nasdaq submitted a proposed rule change to amend 
the definition of ``legal'' short sale in the Rule.\17\
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    \11\ Short Sale Rule Approval Order, supra note 5, at 34891.
    \12\ Id. at 34892.
    \13\ 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.
    \14\ 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 \1/16\th.
    \15\ 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 (Aug. 5, 1996) [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'').
    \16\ Securities Exchange Act Release No. 38979 (Aug. 26, 1997), 
62 FR 46537) (Sept. 3, 1997) [File No. SR-NASD-97-58].
    \17\ Securities Exchange Act Release No. 38975 (Aug. 26, 1997), 
62 FR 46535 (Sept. 3, 1997) [File No. SR-NASD-97-59].
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    On September 26, 1997, the Commission approved an extension of the 
Rule until January 15, 1998, to allow Nasdaq, to develop, and receive 
the required board approval for, more meaningful PMM standards.\18\ On 
the same day, the Commission also approved on a temporary basis until 
January 15, 1998, the proposed amendment to the definition of ``legal'' 
short sale.\19\ During its September 1997 meeting, the Nasdaq Board of 
Directors approved revised PMM standards, which were forwarded to, and 
approved by, the NASD Board of Governors at its October 9, 1997 
meeting.
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    \18\ See Securities Exchange Act Release No. 39140 (Sept. 26, 
1997), 62 FR 52170 (Oct. 6, 1997) [File No. SR-NASD-97-65].
    \19\ Securities Exchange Act Release No. 39139 (Sept. 26, 1997), 
62 FR 52169 (Oct. 6, 1997) [File No. SR-NASD-97-59]. The amendment 
provides that a ``legal'' short sale can be effected on a down bid: 
at a price of \1/16\th above the bid when the inside spread is \1/
16\th or greater; or at a price equal to or greater than the offer 
price when the inside spread is less than \1/16\th.
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    The NASD has had ongoing discussions with Commission staff 
regarding the PMM standards. In light of the foregoing, the NASD and 
Nasdaq are requesting an extension of the Rule until April 15, 1998. 
The extension of time also will allow the NASD and Nasdaq to provide 
Commission staff with additional information about the practical 
effects and the operation of the revised PMM standards, and to explore 
other options to PMM standards, such as a customer facilitation 
exemption for market makers. The NASD and Nasdaq also are requesting an 
extension to April 15, 1998, of the amendment to the definition of 
``legal'' short sale, which previously was approved on a temporary 
basis until January 15, 1998.
    The NASD believes the proposed rule change is consistent with 
Section 25A(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. 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

[[Page 3372]]

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 and the amendment to the definition of a ``legal'' short sale 
until April 15, 1998, be approved on an accelerated basis prior to 
January 15, 1998.

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 and the amendment to the definition of 
``legal'' short sale through April 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 transactions 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 and the amendment to the definition of a 
``legal'' short sale for a short period of time 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 over-the-counter market. This extension also 
will afford the NASD time to submit to the Commission revised PMM 
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). Once the NASD develops reasonable PMM standards, the Commission 
will be in a better position to evaluate the need for a short sale rule 
as well as the appropriateness of an exemption for PMMs.
    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 of the 
pilot program of the Rule and the amendment to the definition of 
``legal'' short sale through April 15, 1998, because it will ensure the 
continuous operation of the Rule and the amendment to the definition of 
``legal'' short sale, while the NASD addresses the Commission's 
questions and concerns, provides Commission staff with additional 
information about the practical effects and the operation of the 
revised PMM standards, and explores other options to PMM standards, 
such as a customer facilitation exemption for market makers.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. People making whiten 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-97-94 and 
should be submitted by February 11, 1998.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change, SR-NASD-97-94 be, and hereby is approved 
through April 15, 1998.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12)(1997).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-1422 Filed 1-21-98; 8:45 am]
BILLING CODE 8010-01-M