[Federal Register Volume 65, Number 84 (Monday, May 1, 2000)]
[Notices]
[Pages 25401-25408]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-10725]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42713; Form Type 34-36 MR; File No. 79-9]


Notice of Application and Order Temporarily Granting Application 
for a Conditional Exemption by the National Association of Securities 
Dealers, Inc. Relating to the Acquisition and Operation of a Software 
Development Company by the Nasdaq Stock Market, Inc

April 24, 2000
    Pursuant to Rule 0-12 \1\ under the Securities Exchange Act of 1934 
(``Exchange Act''), notice is hereby given that on March 3, 2000, the 
National Association of Securities Dealers, Inc. (``NASD'') and the 
Nasdaq Stock Market, Inc. (``Nasdaq'') filed with the Securities and 
Exchange Commission (``Commission'') an application for a conditional 
exemption under Section 36(a)(1) of the Exchange Act \2\ relating to 
Nasdaq's acquisition and operation of a software development company. 
In addition, the NASD requested that, if the Commission determined to 
solicit comment on the application for a permanent exemption, the 
Commission grant a temporary conditional exemption for a period of one 
year.
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    \1\ 17 CFR 240.0-12.
    \2\ 15 U.S.C. 78mm(a)(1).
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    The Commission is publishing this notice to solicit comments from 
interested persons on the NASD's application for a permanent exemption. 
For the reasons discussed below, the Commission also is issuing an 
order at this time approving the NASD's request for a temporary 
conditional exemption for a period of one year from the date of this 
release. The Commission will make a final determination concerning the 
request for a permanent exemption after reviewing the comments 
submitted in response to this notice and prior to the expiration of the 
temporary exemption.
    The text of the NASD's application is set forth in section 1 
below,\3\ followed by the Commission's solicitation of comments on the 
NASD's request for a permanent exemption in section II and the 
Commission's order granting the NASD's request for a temporary 
exemption in section III.
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    \3\ The NASD filed its application on March 3, 2000. 
Subsequently, Nasdaq completed its acquisition of the assets of the 
software development company.
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I. NASD's Application for Exemption

    On behalf of the NASD and Nasdaq, pursuant to Section 36 of the 
Securities Exchange Act of 1934 and Rule 0-12 thereunder, we are 
writing to apply for an exemption from Section 19(b) of the Exchange 
Act, to (1) permit Nasdaq to acquire and operate a software development 
company, Financial Systemware, Inc. (``FSI''), to market certain 
financial services software, ``OTC Tools'' and related software 
(``Software''), and to expand the products and services offered by FSI 
to include service bureau and back-office functions for NASD broker-
dealers, without filing proposed rule changes pursuant to Rule 19b-4 
under the Exchange Act of before making or implementing any 
modifications to the Software, or with respect to each new software 
product or service offered by FSI (provided those new software products 
and services are offered in a manner that is not inconsistent with the 
presentation contained in this letter), and (2) permit FSI to determine 
prices for such software products and services based on competitive 
market factors without filing proposed rule changes pursuant to Rule 
19b-4 under the Exchange Act.

A. Background

    The NASD is a national securities association registered under 
Section 15A of the Exchange Act. As a national securities association, 
the NASD is a self-regulatory organization (``SRO'') as defined by 
Section 3(a)(26) of the Exchange Act. Though its subsidiaries, NASD 
Regulation, Inc., the American Stock Exchange, Inc. and Nasdaq, the 
NASD develops rules and regulations, conducts regulatory review of its 
members' business activities, and designs and operates marketplace 
facilities and services.
    The NASD also has three other subsidiaries: (1) Nasdaq 
International, Ltd., which provides services to domestic and foreign 
companies, (2) Securities Dealers Insurance Co., Inc., which provides 
reinsurance services in connection with a fidelity bond program for 
NASD members, and (3) Securities Dealers Risk Purchasing Group, which 
provides professional liability insurance to NASD members.
    The NASD sets the overall strategic direction and policy agenda of 
the whole organization, oversees the effectiveness of its subsidiaries 
and ensures that the organization's statutory and self-regulatory 
obligations are fulfilled.
    Subject to receiving the exemptive relief requested herein, Nasdaq 
plans to acquire the assets of FSI, whose primary line of business is 
the development and distribution of a financial services software 
product called ``OTC Tools.'' OTC Tools is designed for and marketed

[[Page 25402]]

to NASD broker-dealers that use Nasdaq Workstation II terminals. OTC 
Tools is a Microsoft Windows-based software product that enhances and 
simplifies a user's interactions with, and use of, the Nasdaq 
Workstation II terminal, but does not change or alter the current 
features of Nasdaq, SelectNet or SOES (i.e., the facilities of the 
NASD).
    Currently, the Software which is being commercially marketed to 
NASD broker-dealers, offers a variety of features to assist them in 
efficiently managing their quotes, monitoring and executing incoming 
orders, continually checking for closed, locked or crossed markets, and 
monitoring the depth of the market. There is a high level of effective 
competition in providing these types of software products and services 
to market participants. For example, Automatic Securities Clearance, 
through its BRASS service, provides order-management services and 
software to a large number of NASD member firms that are in many 
respects similar to the Software. Other firms, such as Eagle Trading, 
ADP, TCAM and Royal Blue, offer order handling packages that compete 
with those offered by FSL. Similarly, many NASD member firms have 
developed internal order management and order-routing software that 
provides independent functions comparable to those provided by the 
Software.
    Given the NASD's complex infrastructure and the dramatic 
acceleration of technological changes that are impacting the securities 
markets, the NASD and Nasdaq believe that they must have the capability 
to respond quickly to the technological needs of NASD members. The NASD 
and Nasdaq believe that the acquisition of FSI will greatly improve 
Nasdaq's ability to provide such rapid solutions to its members' 
technological needs. Nasdaq also plans to expand the products and 
services offered by FSI to include service bureau and back-office 
functions \4\ for NASD broker-dealers.
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    \4\ For example, FSI may perform for its customers, service 
bureau and back-office functions, including ACT trade reporting, 
trade comparison, and position and account management functions 
(e.g., profit and loss calculations).
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B. Basis for Relief Sought and Anticipated Benefits to Investors

    Section 19(b)(1) of the Exchange Act requires an SRO,\5\ including 
the NASD (as a registered securities association under Section 15A of 
the Exchange Act), to file with the Commission its proposed rule 
changes accompanied by a concise general statement of the basis and 
purpose of the proposed rule change. Once a proposed rule change has 
been filed, the Commission is required to publish notice of it and 
provide an opportunity for public comment. The proposed rule change may 
not take effect unless approved by the Commission by order, or unless 
the rule change is within the class of rule changes that are effective 
upon filing pursuant to Section 19(b)(3)(a).\6\
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    \5\ Section 3(a)(26) of the Exchange Act defines the term 
``self-regulatory organization'' to mean ``any national securities 
exchange, registered securities association, registered clearing 
agency, and, for purposes of Section 19(b) and other limited 
purposes, the Municipal Securities Rulemaking Board (``MSRB'').''
    \6\ Under Section 19(b)(3)(A) of the Exchange Act and rule 19b-
4(e) thereunder, a proposed rule change may take effect upon filing 
without the notice and approval procedures required by Section 
19(b)(2) if the proposed rule change comes within prescribed 
statutory categories, including rule changes that (1) constitute a 
stated policy, practice, or interpretation with respect to the 
meaning, administration, or enforcement of an existing rule of the 
SRO, (2) establish or change a due, fee, or other charge imposed by 
the SRO, (3) are concerned solely with the administration of the 
SRO, or (4) are matters which the Commission may, consistent with 
the public interest and the purposes of this subsection, specify by 
rule.
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    Section 19(b)(1) of the Exchange Act defines the term ``proposed 
rule change'' to mean ``any proposed rule or rule change in, addition 
to, or deletion from the rules of [a] self-regulatory organization.'' 
Pursuant to Section 3(a)(27) and 3(a)(28) of the Exchange Act, the term 
``rules of a self-regulatory organization'' means (1) the constitution, 
articles of incorporation, bylaws and rules, or instruments 
corresponding to the foregoing, of an SRO, and (2) such stated 
policies, practices and interpretations of an SRO (other than the MSRB) 
as the Commission, by rule, may determine to be necessary or 
appropriate in the public interest or for the protection of investors 
to be deemed to be rules. The Commission has exercised this rulemaking 
authority by adopting Rule 19b-4(b) under the Exchange Act, which 
defines the term ``stated policy, practice, or interpretation.''
    Rule 19b-4(b) defines the term ``stated policy, practice, or 
interpretation to mean generally ``any material aspect of the operation 
of the facilities of the self-regulatory organization \7\ or any 
statement made available to the membership, participants, or specified 
persons thereof that establishes or changes any standard, limit, or 
guideline with respect to rights and obligations of specified persons 
or the meaning, administration, or enforcement of an existing rule.'' 
(Emphasis added.)
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    \7\ The term ``facilities of the self-regulatory organization'' 
is not defined in the Exchange Act. The term ``facility'' is defined 
in Section 3(a)(2) of the Exchange Act, but only with respect to an 
exchange (as defined in Section 3(a)(1), to ``include * * * its 
premises, tangible or intangible property whether on the premises or 
not, any right to use such premises or property or any service 
thereof for the purpose of effecting or reporting a transaction on 
an exchange (including, among other things, any system of 
communication to or from the exchange, by ticker or otherwise, 
maintained by or with the consent of the exchange), and any right of 
the exchange to the use of any property or service.''
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    To the extent that the software or related services (or portions 
thereof) offered by FSI to Nasdaq member firms would be a ``facility'' 
of an SRO, Section 19(b) of the Exchange Act, and rule 19b-4, would, 
absent an exemption, require the NASD to file proposed rule changes 
with the Commission in certain instances where FSI seeks to modify the 
Software or the fees it charges for providing it. Technology 
applications for broker-dealers and market makers develop and change 
very rapidly, and FSI needs to be able to move quickly to modify 
existing products and develop new software products. If FSI were 
required to follow the procedures for rule filings and approvals each 
time the Software is modified or enhanced, the delays and 
administrative difficulties associated with the rule filing process 
would put FSI at a significant competitive disadvantage relative to 
other software developers that are not affiliated with an SRO. 
Moreover, the NASD and Nasdaq would not be able to provide NASD broker-
dealers with the type of timely and effective software development that 
users desire and have indicated they need. Thus, in this competitive 
software market, the delays and administrative difficulties associated 
with the rule filing process would, in the NASD's view, put FSI at such 
a competitive disadvantage so as to render the acquisition of FSI or 
the rights to the software impracticable.
    As noted above, because of the NASD's complex infrastructure and 
the dramatic acceleration of technological changes that are impacting 
the securities markets, the NASD believes that it must have the 
capability to respond quickly to the technological needs of its 
members. The NASD believes that the acquisition of FSI by Nasdaq will 
greatly improve Nasdaq's ability to provide such rapid solutions to its 
members' technological needs. If, however, the NASD and Nasdaq cannot 
as a practical matter compete in the software market, the result would 
be the inhibition of the development of more efficient and effective 
market operations and economically efficient execution of securities 
transactions--each a stated Congressional goal under Section 11A of the 
Exchange Act, which directs the Commission to facilitate the 
development of a national market

[[Page 25403]]

system. Furthermore, as more efficient means are developed for NASD 
broker-dealers to manage and monitor their quotations, order flow, 
executions and positions, the cost savings derived from these 
efficiencies can be passed on to investors through reduced spreads and 
transactions costs, as well as through increased liquidity in the over-
the-counter market. Absent full and effective competition in the 
software market, the incentive to develop new and beneficial software 
for market maker use is reduced, thereby reducing the opportunity to 
pass along the benefits to investors.

C. Discussion

    The Commission has general exemptive authority pursuant to Section 
36 of the Exchange Act, and Rule 0-12 thereunder, in pertinent part, to 
exempt any person from any Exchange Act provision or rule, to the 
extent that such exemption is necessary or appropriate, in the public 
interest, and is consistent with the protection of investors. In order 
for the NASD and Nasdaq to compete effectively in providing software 
and service bureau functions to NASD broker-dealers, the NASD 
respectfully requests that the Commission exercise its general 
exemptive authority and exempt the NASD from the requirements of 
Sections 19(b) to (1) permit it to operate FIS and offer software to 
market makers (and other NASD member firms) without filing proposed 
rule changes with respect to making or implementing any modifications 
to the Software, or with respect to each new software product or 
service offered by FSI to (provided those new software products and 
services are offered in a manner that is not inconsistent with the 
representations contained in this letter), and (2) permit FSI determine 
prices for such software products and services based on competitive 
market factors without filing proposed rule changes. In particular, the 
NASD requests an exemption form Section 19(b) of the Exchange Act with 
respect to any rule filings that would otherwise be required under that 
Section and the rules and regulations thereunder.
    Given the rapid advances in technology, the increasing reliance of 
the financial industry on automation and the degree of competition in 
the supply of technological solutions, we believe that in certain 
circumstances, including those presented in this request, a policy 
distinction can be made between essential or core SRO services and 
ancillary non-essential or optional services such as those offered by 
FSI to permit the latter category of services to be offered by an SRO 
on a fully competitive basis without compliance with the notice and 
comment process while at the same time ensuring that those services are 
offered in a way that is consistent with the goals and requirements of 
the Exchange Act.
    As noted above, OTC Tools offers a variety of features to assist 
NASD broker-dealers in efficiently managing their quotes, monitoring 
and executing incoming orders, continually checking of closed, locked 
or crossed markets, and monitoring the depth of the market. These 
functions to be performed by OTC Tools are not central to the core 
functionality of Nasdaq's marketplace. Rather the functions involved 
are supplemental to, and independent of, the primary functions of 
Nasdaq.
    Moreover, the NASD and Nasdaq believe that the exemption requested 
is consistent with the purposes of the Exchange Act, particularly the 
protection of investors, the maintenance of fair and orderly markets, 
and the fostering of competition. This segment of the financial 
software market is highly competitive. As discussed above, there are a 
number of other firms that offer competing products to OTC Tools. The 
NASD and Nasdaq purpose that Nasdaq will operate FSI as a stand-alone 
business, capitalized separately and not subsidized by NASD members or 
other revenues of the NASD or Nasdaq.\8\
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    \8\ The NASD, of course, reserves the right to provide capital 
to FSI adequate for it to compete effectively in the market place 
and to develop and market new products and services.
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    In addition, the NASD and Nasdaq would take appropriate steps to 
ensure that FSI would not have any information advantage regarding 
planned developments and changes to Nasdaq that would not also be 
available to other competing vendors. Finally, the core functions of 
Nasdaq would not be altered as a result of the acquisition, and the 
NASD and Nasdaq will take all reasonable steps necessary to ensure that 
market makers and order-entry firms will continue to have the ability 
to trade effectively through Nasdaq's essential facilities without 
using the Software.

D. Conditions

    As described in Exchange Act Rule 0-12, in connection with a 
request for exemption from any provision of the Exchange Act, the 
applicant is required to state any conditions or limitations it 
believes would be appropriate for the protection of investors. As a 
general matter, the NASD and Nasdaq believe the request submitted 
herein is appropriate because it deals with nonessential services of 
the NASD and provides the benefit of optional technological innovation 
designed to improve the productivity of NASD member firms. The 
following limitations on the exemptive relief requested are, in the 
view of NASD and Nasdaq, not objectionable to further this objective 
and to ensure that the operation of FSI is generally consistent with 
the requirements of the Exchange Act applicable to SROs.
    Continued Presence of Competition--As indicated above, at the time 
of this application, there is a high level of effective competition in 
providing software to market makers. Automatic Securities Clearance, 
through its BRASS service, for example, provides order-management 
services and software that are in many respects similar to the Software 
to a large number of NASD member firms. Other firms, such as Eagle 
Trading, ADP, TCAM and Royal Blue, offer order handling packages that 
compete with those offered by FSI. Similarly, many NASD member firms 
have developed internal order management and order management and 
order-routing software that provides independent functions comparable 
to those provided by the Software. Moreover, the software industry in 
general, and the financial software industry in particular, have low 
barriers to entry, so that, as the markets evolve and technology is 
increasingly brought to bear on securities trading, new entrants can, 
in our view, emerge, NASD and Nasdaq understand that the Commission may 
reconsider at a later date its decision to grant the exemptive relief 
requested herein in the event that effective competition for these 
software products and services no longer exists.
    Independent Functionally of Nasdaq and Other NASD-Sponsored 
Services--NASD and Nasdaq believe that providing the Software to NASD 
member firms does not, and will not, affect the basic functionality of 
the Nasdaq system. In acquiring FSI and providing the software to NASD 
member firms, the core functions of Nasdaq (currently provided through 
the Nasdaq Workstation II terminal system) will not be changed. Nasdaq 
and other NASD-sponsored systems (such as the Automated Confirmation 
Transaction Service) operate and will continue to operate independently 
of the Software. Use of the Software is not, and will not in the 
future, be necessary to access Nasdaq or any other NASD market-related 
facility, and NASD members that do not use the Software will be able to 
enter and change quotes, route orders, effect transactions and perform 
all market functions in Nasdaq. The NASD

[[Page 25404]]

and Nasdaq believe that requiring full Nasdaq core functionality 
without use of the Software is an appropriate condition to the grant of 
the exemptive relief requested.
    Full Public Access to Nasdaq through the Application Programming 
Interface (``API'') \9\ will Continue--As the Commission is aware, the 
Nasdaq system is an open architecture system and Nasdaq has provided an 
API that enables firms to have access to the Nasdaq system through 
their own software or computer system. The NASD and Nasdaq are fully 
committed to maintaining the API to provide for fair and equitable 
access to the system and to encourage the development of software by 
NASD member firms and competing software vendors. Thus, we believe that 
conditioning the exemptive relief on continued free and open access to 
Nasdaq through the API is appropriate in light of the commitment of the 
NASD and Nasdaq to maximum competition in offering services to NASD 
members.
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    \9\ API provides an electronic interface between a subscriber's 
computer system and the Nasdaq Workstation II system, Through the 
use of the API, a subscriber may build its own workstation 
presentation software to integrate the Nasdaq Workstation II service 
into the subscriber's existing presentation facilities. The API 
allows a subscriber to emulate the Nasdaq Workstation II 
presentation software with equivalent functionality, capacity 
utilization and through-put capability, in addition to providing 
enhanced capability to develop customized internal presentations for 
use in support of a subscriber's activities. API also allows a 
subscriber to operate a quote-update facility to assist solely in 
complying with the Commission's Order Handling Rules. Generally, a 
subscriber establishes an API ``linkage,'' such as Nasdaq 
Workstation II substitute or quote update facility, which in turn 
connects to a service delivery platform via an API server.
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    Fair Access to Information on Nasdaq Developments--As a fourth 
condition consistent with the statutory objective and our stated 
objective of maintaining a competitive software market, the NASD and 
Nasdaq, as noted above, agree not to provide FSI an information 
advantage concerning Nasdaq core facilities, particularly changes and 
improvements to the system, that is not available to the industry 
generally or to vendors of financial software for market makers and 
order entry firms, and will prevent FSI from having any advance 
knowledge of proposed changes or modifications to core Nasdaq 
facilities. This is appropriate to avoid giving FSI any informational 
advantage in the development and enhancement of software products for 
the Nasdaq market.
    In this regard, FSI will not share employees with the NASD, Nasdaq 
or any other NASD affiliate, and will be housed in office space from 
that of the NASD or Nasdaq. In addition, FSI will be notified of any 
change or improvements to the Nasdaq system in the same manner that 
other competing vendors are notified of such changes or improvements. 
For example, in addition to mailings and Web site disclosure of changes 
to Nasdaq or to Nasdaq technical specifications, Nasdaq currently meets 
at least quarterly with all vendors to discuss proposed modifications 
to the System and changes that are in the pipeline (subject to 
Commission approval, where needed). FSI will be treated, for purposes 
of these mailings, disclosures and meetings, the same as any third 
party vendor and will not receive any information regarding planned or 
actual changes to Nasdaq in advance of other vendors. Conversely, FSI 
will not disclose any system or design specifications, or any other 
information to any employees with the NASD, Nasdaq or any other NASD 
affiliate that would give FSI and unfair advantage over its 
competitors.

E. Conclusion

    For the reason set forth above, the NASD hereby requests that the 
Commission grant an exemption from Sections 19(b), and the rules and 
regulations thereunder, to (1) permit the Nasdaq to operate FSI and 
offer software to market makers (and other NASD member firms) without 
filing proposed rule changes with respect to making or implementing any 
modifications to the Software, or with respect to each new software 
product or service offered by FSI (provided those new software products 
services are offered in a manner that is not inconsistent with the 
representations contained in this letter), and (2) permit FSI to 
determine prices for such software products and services based on 
competitive market factors without filing proposed rule changes. If the 
Commission believes that notice of this request and an opportunity for 
public comment is necessary, the NASD requests that the Commission 
grant the relief requested, on a temporary basis, for a period of one 
year, and that thereafter, following the conclusion of any such notice 
and comment period, the Commission grant the requested relief on a 
permanent basis.

II. Solicitation of Comments

    Section 36(b) of the Exchange Act provides that the Commission 
shall, by rule or regulation, determine the procedures under which an 
exemptive order shall be granted. Exchange Act Rule 0-12(g) provides 
that the Commission, in its sole discretion, may choose to publish in 
the Federal Register a notice of an application for an exemption under 
Section 36 and to allow any person to submit information that relates 
to the action requested in the application. The Commission has 
determined that, prior to taking final action on the NASD's application 
for a permanent exemption, it would be helpful to offer the public an 
opportunity to submit information concerning the permanent exemption 
and the conditions on which the exemption is based. Accordingly, 
interested persons are invited to submit written data, views, and 
arguments concerning the NASD's application for an exemption. Persons 
making written submissions should file six copies thereof with the 
Secretary, Securities and Exchange Commission, 450 Fifth Street NW., 
Washington DC 20549-0609. All submissions should refer to Form Type 34-
36 MR; File No. 79-9 and should be submitted by July 31, 2000. Comment 
letters received will be available for public inspection and copying in 
the Commission's Public Reference Room.

III. Order Granting Temporary Conditional Exemption

    The Commission has determined to grant the NASD's request for a 
temporary conditional exemption for a period of one year from the date 
of this release. The Commission finds that the temporary conditional 
exemption from the provisions of Section 19(b) is necessary or 
appropriate in the public interest and is consistent with the 
protection of investors. In particular, the exemption could help 
promote efficiency and competition in the market to provide enhanced 
software services to broker-dealers who interact with the NASD's 
facilities, while upholding the regulatory objectives of the Exchange 
Act. After the end of the public comment period set forth in section II 
above and prior to expiration of the temporary exemption, the 
Commission will make a final determination concerning the NASD's 
application for a permanent exemption.\10\
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    \10\ The Commission's approval of the NASD's request for a 
temporary conditional exemption should not be interpreted as 
suggesting that the Commission is predisposed to approving the 
NASD's application for a permanent exemption subject to the same 
conditions.
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    As discussed further below, the NASD, as a registered self-
regulatory organization, operates a number of facilities used by 
broker-dealers that effect transactions in securities in the over-the-
counter market, particularly securities that are qualified for 
inclusion in Nasdaq. These facilities, which

[[Page 25405]]

include the automated quotations network that is the heart of Nasdaq, 
order delivery and execution systems, and a transaction reporting 
system, are made available to broker-dealer subscribers primarily 
through the Nasdaq Workstation II (``NWII'') service. The NASD has 
adopted an open architecture system that provides an API between the 
NWII system and a subscriber's computer system. The API allows broker-
dealers to employ specialized software that supplements the NWII 
service and enhances their interaction with the NASD's facilities, 
thereby facilitating their trading and other proprietary activities. 
Currently, a number of companies independent of the NASD offer this 
type of software product for sale to broker-dealers. Nasdaq has 
acquired one of these companies--FSI.
    Certain of the functions offered through FSI's products, when 
considered together with the other services offered by the NASD and its 
affiliates,\11\ could cause such products to be considered part of the 
NASD's facilities. Consequently, changes to the products or the fees 
charged for the products could trigger the proposed rule change 
requirements of Section 19(b), which includes filings with the 
Commission, public notice and comment on those filings, and Commission 
review and approval of the proposed rule change. These requirements 
could significantly hamper the ability of FSI to compete effectively in 
a rapidly changing technology market to provide specialized software to 
broker-dealers. The requested temporary conditional exemption would 
allow FSI to modify its products, offer new products, and set fees for 
its products without going through the proposed rule change procedures 
of Section 19(b).
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    \11\ The companies that currently offer the enhanced software 
products for broker-dealers are not owned by an SRO. When considered 
alone, their activities do not fall within the definition of a 
facility of an SRO, and they therefore are not subject to the 
proposed rule change requirements of Section 19(b).
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    In granting the Commission broad exemptive authority in Section 36, 
Congress intended to incorporate flexibility into the Exchange Act 
regulatory scheme to reflect a rapidly changing marketplace. Congress 
particularly intended for the Commission to use this flexibility to 
promote efficiency and competition. The Commission believes that the 
NASD's requested temporary conditional exemption will help achieve 
these goals, while upholding the regulatory objectives of the Exchange 
Act. In particular, the exemption could facilitate vigorous competition 
in the market to provide enhanced software services to broker-dealers 
by allowing FSI to compete on a more equal footing with companies that 
are not subject to the regulatory requirements applicable to an SRO. 
The exemption is subject to four principal conditions to help assure 
that FSI will not obtain an unfair competitive advantage because of its 
ownership by Nasdaq.
    The Commission believes that granting a temporary conditional 
exemption is warranted because (1) the products of FSI will not be 
required for broker-dealers to access the NASD's fundamentally 
important or core services, including quotation collection and 
dissemination, order routing and execution, and transaction reporting, 
and (2) the opportunity for fair competition will be preserved in the 
market to provide enhanced software services to broker-dealers who use 
the NASD's facilities. Under these circumstances, the Commission 
believes that competitive forces, rather than the regulatory 
protections provided by the proposed rule change process, can be relied 
on to uphold the objectives of the Exchange Act in an efficient manner 
during the one-year period of the temporary exemption. Fair and 
vigorous competition, by creating incentives for companies to provide 
superior software products at fair prices, can serve the interests of 
broker-dealers, and ultimately those of their investor customers.

A. The NASD's Facilities and Its Open Architecture System

    The NASD currently operates a number of facilities for broker-
dealers that effect transactions in securities traded in the OTC 
markets. These facilities include (1) an automated quotations system, 
(2) the SelectNet order delivery system,\12\ (3) the Small Order 
Execution System (``SOES''), and (4) the Automated Confirmation 
Transaction Service (``ACT'').
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    \12\ The Commission recently approved a proposed rule change by 
the NASD to establish a revised order delivery and execution 
system--the Nasdaq National Market Execution System. Securities 
Exchange Act Release No. 42344 (Jan. 18, 2000), 65 FR 3987. After 
implementation of the system, SelectNet will be re-established as a 
non-liability system for purposes for order delivery and negotiation 
only.
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    At its heart, Nasdaq is a telecommunications network for the 
centralized collection and dissemination of quotations from market 
makers and electronic communications networks (``ECNs''). This service 
allows broker-dealers to enter, retrieve, monitor, and adjust 
quotations throughout the trading day. The NASD's SelectNet facility 
offers broker-dealers the ability to automate the negotiation and 
execution of trades and eliminates the need for verbal contact between 
trading desks. It allows Nasdaq subscribers to direct orders for the 
purchase and sale of Nasdaq stocks to specified market makers or ECNs, 
or to broadcast orders for Nasdaq stocks to all market makers and ECNs. 
SelectNet also identifies incoming and outgoing orders and allows 
traders to see subsequent messages and negotiation results. The NASD's 
SOES facility automatically executes small agency orders routed to 
market makers, reports completed trades for public dissemination, and 
sends information with respect to those trades to clearing corporations 
for comparison and settlement. Finally, the NASD's ACT facility is an 
automated service that speeds the post-execution steps of price and 
volume reporting and the comparison and clearing of securities 
transactions.
    Access to the NASD's facilities is made available primarily through 
the NASD's NWII service. In addition, the NASD has adopted an open 
architecture system that provides full public access to its facilities 
through API. The API provides an electronic interface between a 
subscriber's computer system and the NWII system. Through the use of 
the API, a subscriber may employ its own workstation presentation 
software to integrate the NWII services into its presentation 
capabilities. The API thereby allows a subscriber to develop customized 
internal presentations for use in support of the subscriber's 
activities. In sum, fundamentally important or core NASD services are 
provided through the NWII system, while subscribers also are able to 
develop or purchase customized software that enhances the NWII services 
and responds to their individual needs.
    Many broker-dealers have taken advantage of the API and employ 
software to enhance the NASD services provided through the NWII system. 
Some broker-dealers have developed such software internally. In 
addition, a number of companies independent of the NASD have developed 
this type of software and offered it for sale to broker-dealers. For 
example, the promotional materials of one company states that its 
product ``provides fully integrated and enhanced Nasdaq Workstation II 
features,`` including automated management of quotations, automated ACT 
reporting, and automated SelectNet order entry and order acceptance. 
Other competing companies make similar

[[Page 25406]]

assertions concerning the ability of their products to enhances the 
interaction of broker-dealers with the NASD's facilities, as well as to 
facilitate a wide array of other broker-dealer proprietary activities.
    The Nasdaq has acquired one of these companies--FSI. FSI is a 
software development company that offers a product called OTC Tools. 
OTC Tools includes a variety of features to assist NASD members in 
conducting their proprietary activities, including efficiently managing 
their quotes, monitoring and executing incoming orders, continually 
checking for closed, locked, or crossed markets, and monitoring the 
depth of the market.\13\ To enable FSI to modify its products, offer 
new products, and set fees for its products as freely and quickly as 
its competitors that are not owned by an SRO, the NASD has requested a 
temporary conditional exemption from the proposed rule change 
provisions of Section 19(b).
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    \13\ For example, the current version of OTC Tools enables a 
user (1) to maintain a pre-configured maximum market spread in 
specific securities when making adjustments in a quotation at one 
side of the market; (2) to capture and execute incoming SelectNet 
orders in several different fashions by combining multiple keystroke 
or mouse functions; (3) to send, with a single point-and-click 
feature, multiple SelectNet preferenced orders to preset market 
makers or ECNs; and (4) to monitor SelectNet broadcast orders for 
electronic execution based on the user's pre-configured order 
selection file.
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B. Proposed Rule Change Provisions of Section 19(b)

    Section 10(b) requires that every SRO file with the Commission 
copies of any proposed rule or any proposed change in, addition to, or 
deletion from the rules of such SRO, accompanied by a concise general 
statement of the basis and purpose of such proposed rule change. The 
Commission is required to publish notice of the filing of a proposed 
rule change and to give interested persons an opportunity to submit 
written data, views, and arguments. Section 19(b) provides that the 
Commission shall approve an SRO's proposed rule change if it is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to the SRO.
    The term ``rules of a self-regulatory organization'' is defined in 
Section 3(a)(28) of the Exchange Act to include the rules of an 
association of broker-dealers that is a registered securities 
association, and the term ``rules of an association'' is defined in 
Section 3(a)(27) to include such of the stated policies, practices, and 
interpretations of the association as the Commission determines by rule 
to be necessary or appropriate in the public interest or for the 
protection of investors. In Exchange Act Rule 19b-4,\14\ the Commission 
has defined ``stated policy, practice, or interpretation'' to include 
any material aspect of the operation of the facilities of a self-
regulatory organization. The term ``facility'' when used with respect 
to an exchange\15\ is defined very broadly in Section 3(a)(2) to 
include, among other things, any tangible or intangible property of the 
exchange and any right to the use of such property or any service 
thereof for the purpose of effecting or reporting a transaction on an 
exchange (including any system of communication to or from the 
exchange).
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    \14\ 17 CFR 240.19b-b
    \15\ The Commission has found that Nasdaq falls within the 
definition of ``exchange'' under Section 3(a)(1) of the Act. 
Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 63 FR 
70844 (``ATS Release''), at nn. 58-61 and accompanying text.
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    Certain aspects of the software products that enhance a broker-
dealer's interaction with the NASD's facilities could, when considered 
together with the other services offered by the NASD and its 
affiliates, fall within the Exchange Act definition of a facility and 
therefore require the filing of a proposed rule change for material 
changes in the software and the fees charged for the software. The NASD 
has requested a temporary conditional exemption from this requirement 
under Section 36 of the Exchange Act.

C. Commission's Exemptive Authority Under Section 36

    Section 36(a)(1) of the Exchange Act grants the Commission broad 
authority to exempt any person from any provision of the Act to the 
extent that such exemption is necessary or appropriate in the public 
interest and is consistent with the protection of investors. In 
enacting Section 36, Congress indicated that it expected that ``the 
Commission will use this authority to promote efficiency, competition 
and capital formation.'' \16\ It particularly intended to give the 
Commission sufficient flexibility to respond to changing market and 
competitive conditions.
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    \16\ H.R. Rep. No. 104-622, 104th Cong., 2nd Sess. 38 (1996).

    The Committee recognizes that the rapidly changing marketplace 
dictates that effective regulation requires a certain amount of 
flexibility. Accordingly, the bill grants the SEC general exemptive 
authority under both the Securities Act and the Securities Exchange 
Act. This exemptive authority will allow the Commission the 
flexibility to explore and adopt new approaches to registration and 
disclosure. It will also enable the Commission to address issues 
relating to the securities markets more generally. For example, the 
SEC could deal with the regulatory concerns raised by the recent 
proliferation of electronic trading systems, which do not fit neatly 
into the existing regulatory framework.\17\
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    \17\ S. Rep. No. 104-293, 104th Cong., 2nd Sess. 15 (1996).

    At the same time that it added Section 36 to the Exchange Act, 
Congress enacted Section 3(f), which charges the Commission, when it is 
engaged in rulemaking itself or reviewing an SRO rule and is required 
to consider whether an action is necessary or appropriate in the public 
interest, also to consider whether the action will promote efficiency, 
competition, and capital formation.
    Section 36 and Section 3(f) reaffirm a fundamental and long-
established principle of the Exchange Act--investor interests are best 
served by a regulatory structure that facilitates fair and vigorous 
competition among market participants. Congress emphasized this 
principle, for example, when it amended the Exchange Act in 1975:

    In 1936, this Committee pointed out that a major responsibility 
of the SEC in the administration of the securities laws is to 
`create a fair field of competition.' This responsibility continues 
today. * * * The objective would be to enhance competition and to 
allow economic forces, interacting within a fair regulatory field, 
to arrive at appropriate variations in practices and services. It 
would obviously be contrary to this purpose to compel elimination of 
differences between types of markets or types of firms that might be 
competition-enhancing. \18\
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    \18\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 8 (1975).

    In recent years, the Commission has exercised its Section 36 
exemptive authority by seeking to enhance competition as a means to 
meet the objectives of the Exchange Act. For example, it exempted 
alternative trading systems from many of the requirements that 
otherwise would apply to an ``exchange,'' including registration and 
the filing of proposed rule changes, when such requirements were not 
necessary or appropriate to further the Exchange Act's objectives. In 
adopting this exemption, the Commission stated that it ``believes that 
its regulation of markets should both accommodate traditional market 
structures and provide sufficient flexibility to ensure that new 
markets promote fairness, efficiency, and transparency.'' \19\
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    \19\ ATS Release, note 15 above, section I.
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    In addition, the Commission has used its exemptive authority to 
revise the proposed rule change requirements of

[[Page 25407]]

Section 19(b) to meet the changing needs of the SROs in a competitive 
international marketplace. For example, the Commission amended Rule 
19b-4 in 1998 to streamline the requirements for introduction of new 
derivative securities products.\20\ At the same time, the Commission 
adopted rule 19b-5 to help reduce impediments to competitive innovation 
by SROs by exempting them from the requirement to file proposed rule 
changes for pilot trading systems for a two-year period. In adopting 
this exemption, the Commission noted that ``excessive regulation of 
traditional exchanges, alternating trading systems, or other markets 
hinders these exchanges' ability to compete and survive in the global 
arena'' and found that the exemption from Section 19(b) for pilot 
trading programs ``responds to the SROs' need for a more balanced 
competitive playing field.'' \21\
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    \20\ Securities Exchange Act Release No. 40761 (Dec. 8, 1998), 
63 FR 70952.
    \21\ ATS Release, note 15 above, section VI.A.
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D. Temporary Conditional Exemptions for FSI

    The NASD has requested a temporary conditional exemption that would 
allow FSI to modify its products, offer new products, and set fees for 
its products without filing proposed rule changes under Section 19(b). 
The exemption would be subject to four principal conditions: (1) the 
continued presence or effective competition in the market to provide 
software products that enhance a broker-dealer's interaction with the 
NASD's facilities; (2) the independent functionality of the NASD's 
facilities; (3) continued full public access to the NASD's facilities 
through the API; and (4) fair access to information concerning the 
NASD's facilities and systems.
    The Commission believes that the requested temporary conditional 
exemption could help promote efficiency and competition, while 
upholding the regulatory objectives of the Exchange Act. Nasdaq's 
ownership of a software company whose products facilitate a broker-
dealer's interaction with the NASD's facilities could promote 
efficiency and competition in at least two ways. First, Nasdaq's 
detailed knowledge of the needs of NASD members could lead FSI to 
develop products with features that more closely respond to those needs 
and that increase the efficiency of broker-dealer operations. Second, 
Nasdaq ownership could help assure that software is developed and made 
available that will meet the needs of the wide variety of broker-
dealers that are NASD members, both large and small. Thus, the 
existence of a Nasdaq-owned company offering enhanced software products 
could act as a spur to competition and thereby help generate better 
software products for broker-dealers.
    Given the pace of change in software technology and market 
conditions, the Commission believes at this point that the procedural 
requirements of Section 19(b) could significantly hamper the ability of 
FSI to compete effectively with companies that are not subject to the 
same regulatory requirements. A software company needs to act rapidly 
and nimbly in developing and pricing its products. If FSI were required 
to comply with the proposed rule change requirements, it necessarily 
would be subject to greater expense, delay, and uncertainty in offering 
products and setting prices than its competitors. Although the 
requirements of Section 19(b) serve vital regulatory functions, 
particularly with respect to the fundamentally important or core 
services of an SRO, the Commission does not believe at this point that 
they are necessary to further the public interest in the context of the 
limited services to be provided by FSI.
    In reviewing a proposed rule change under Section 19(b) the 
Commission focuses on the particular section of the Exchange Act that 
sets forth substantive requirements for the SRO's rules. For a national 
securities association such as the NASD, Section 15A of the Exchange 
Act requires, among other things, that its rules (1) provide for the 
equitable allocation of reasonable dues, fees, and other charges among 
members using any facility or system which the association operates or 
controls (subparagraph (b)(5)); (2) be designed to promote just and 
equitable principles of trade, 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, and not be 
designed to permit unfair discrimination between customers, issuers, or 
broker-dealers (subparagraph (b)(7)); and (3) not impose any burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act (subparagraph (b)(9)).
    The four principal conditions of the requested temporary exemption 
will help assure that these regulatory objectives are upheld during the 
one-year period of the exemption without requiring Commission review 
and approval of FSI's products and fees.\22\ First, the products of FSI 
will not be necessary for broker-dealers to access the NASD's 
fundamentally important or core services, including quotation 
collection and dissemination, order routing and execution, and trade 
reporting.\23\ The NASD and Nasdaq have agreed to maintain an 
independent functionality for the NASD's market-related facilities--
that is, FSI's products nor enhance software products of any kind will 
be necessary for a broker-dealer to obtain access to the NASD's 
fundamentally important or core services. The basic software products 
necessary to obtain such access (currently provided through the NWII 
service) will be provided separately from FSI.
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    \22\ The Commission reserves the right to modify, by order, the 
terms and scope of the exemption from the proposed rule change 
requirements if it determines such modification is appropriate for 
the protection of investors or in the public interest.
    \23\ This approach is consistent with the Commission's decision 
in an administrative proceeding that included a denial of access 
claim under Section 19(d) of the Exchange Act. In the Matter of the 
Application of Morgan Stanley & Co., Admin. Proc. File No. 3-9289 
(Dec. 17, 1997) (``In those cases in which we have found a denial of 
access, an SRO had denied or limited the applicant's ability to 
utilize one of the fundamentally important services offered by the 
SRO. The services at issue were not merely important to the 
applicant but were central to the function of the SRO.'').
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    In addition, for broker-dealers who wish to employ software 
products that enhance their interaction with the NASD's facilities, the 
exemption is conditioned on the continued existence of effective 
competition in the market to provide such type of products. This 
condition will assure that broker-dealers have a variety of viable 
software products from which to choose. To maintain an opportunity for 
fair competition, the NASD and Nasdaq have agreed to continue to 
provide open architecture systems that enable full public access to the 
NASD's facilities through the API. The NASD and Nasdaq also have agreed 
not to provide an unfair information advantage to FSI. FSI will not be 
given information that is not available to the industry generally or to 
other companies competing to provide enhanced software products to 
broker-dealers. In particular, the NASD and Nasdaq will prevent FSI 
from having any advance private knowledge of proposed changes or 
modifications to the NASD's facilities. To help meet this condition, 
FSI will not share employees with the NASD or any NASD affiliate and 
will be housed in office space separate from that of the NASD and 
Nasdaq.
    Given these conditions, the Commission does not believe that the 
regulatory protections offered by Commission review and approval of

[[Page 25408]]

proposed rule changes are necessary or appropriate to further the 
Exchange Act's regulatory objectives during the one-year period of the 
temporary exemption. Access to the NASD's fundamentally important and 
core services will be independently maintained by the NASD and fully 
subject to the Exchange Act's regulatory scheme, including the proposed 
rule change requirements of Section 19(b). Fair competition will be 
maintained in the market to provide enhanced software products to 
broker-dealers. Under these circumstances, the Commission believes at 
this point that competitive forces can be relied upon to produce 
software products at fair prices that meet the needs of broker-dealers. 
In sum, the Commission believes that FSI will neither be unnecessarily 
hampered in its competition to provide software services to broker-
dealers nor given an unfair competitive advantage because of its 
ownership by Nasdaq.
    For the reasons discussed above, the Commission finds that the 
temporary conditional exemption requested by the NASD is necessary or 
appropriate in the public interest and is consistent with the 
protection of investors.
    It Is Therefore Ordered, pursuant to Section 36(a)(1) of the 
Act,\24\ that the NASD's application for a temporary conditional 
exemption (Form Type 34-36 MR; File No. 79-9) is granted for a period 
of one year until April 24, 2001.
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    \24\ 15 U.S.C. 78mm(a)(1).

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-10725 Filed 4-28-00; 8:45 am]
BILLING CODE 8010-01-M