[Federal Register Volume 66, Number 23 (Friday, February 2, 2001)]
[Notices]
[Pages 8823-8827]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-2850]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43893; File No. SR-NASD-01-09]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Implementation of Decimal Pricing in the Nasdaq Market

January 26, 2001.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on January 25, 2001, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary, the Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change as described in Items I, II and III below, which Items have been 
prepared by Nasdaq. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq proposes to modify several NASD rules to support the 
implementation of decimal pricing in the Nasdaq market as outlined in 
the Decimals Implementation Plan For the Equities and Options Markets 
(``Implementation Plan'' or ``Plan'') submitted to the Commission on 
July 24, 2000. Nasdaq will implement these rule changes pursuant to the 
Plan starting on March 12, 2001 for each security converted to decimal 
pricing under the Plan. Securities not trading in decimal increments 
will continue to be governed by the current fractional versions of 
these rules. The text of the proposed rule change is below.
    Proposed new language is in italics.
* * * * *

[[Page 8824]]

IM-2110-2. Trading Ahead of Customer Limit Order

    (a) General Application.
    To continue to ensure investor protection and enhance market 
quality, the Association's Board of Governors is issuing an 
interpretation to the Rules of the Association dealing with member 
firms' treatment of their customer limit orders in Nasdaq securities. 
This interpretation, which is applicable from 9:30 a.m. to 6:30 p.m. 
Eastern Time, will require members acting as market makers to handle 
their customer limit orders with all due care so that market makers do 
not ``trade ahead'' of those limit orders. Thus, members acting as 
market makers that handle customer limit orders, whether received from 
their own customers or from another member, are prohibited from trading 
at prices equal or superior to that of the limit order without 
executing the limit order. Such orders shall be protected from 
executions at prices that are superior but not equal to that of the 
limit order. In the interests of investor protection, the Association 
is eliminating the so-called disclosure ``safe harbor'' previously 
established for members that fully disclosed to their customers the 
practice of trading ahead of a customer limit order by a market-making 
firm.
    Rule 2110 of the Association's Rules states that:
    A member, in the conduct of his business, shall observe high 
standards of commercial honor and just and equitable principles of 
trade.
    Rule 2320, the Best Execution Rule, states that:
    In any transaction for or with a customer, a member and persons 
associated with a member shall use reasonable diligence to ascertain 
the best inter-dealer market for the subject security and buy or sell 
in such a market so that the resultant price to the customer is as 
favorable as possible to the customer under prevailing market 
conditions.

Interpretation

    The following interpretation of Rule 2110 has been approved by the 
Board:
    A member firm that accepts and holds an unexecuted limit order from 
its customer (whether its own customer or a customer of another member) 
in a Nasdaq security and that continues to trade the subject security 
for its own market-making account at prices that would satisfy the 
customer's limit order, without executing that limit order, shall be 
deemed to have acted in a manner inconsistent with just and equitable 
principles of trade, in violation of Rule 2110, provided that, until 
September 1, 1995, customer limit orders in excess of 1,000 shares 
received from another member firm shall be protected from the market 
maker's executions at prices that are superior but not equal to that of 
the limit order, and provided further, that a member firm may negotiate 
specific terms and conditions applicable to the acceptance of limit 
orders only with respect to limit orders that are: (a) for customer 
accounts that meet the definition of an ``institutional account'' as 
that term is defined in Rule 3110(c)(4); or (b) 10,000 shares or more, 
unless such orders are less than $100,000 in value. Nothing in this 
interpretation, however, requires members to accept limits orders from 
any customer.
    By rescinding the safe harbor position and adopting this 
interpretation, the Association wishes to emphasize that members may 
not trade ahead of their customer limit orders in their market-making 
capacity even if the member had in the past fully disclosed the 
practice to its customers prior to accepting limit order. The 
Association believes that, pursuant to Rule 2110, members accepting and 
holding unexecuted customer limit orders owe certain duties to their 
customers and the customers of other member firms that may not be 
overcome or cured with disclosure of trading practices that include 
trading ahead of the customer's order. The terms and conditions under 
which institutional account or appropriately sized customer limit 
orders are accepted must be made clear to customers at the time the 
order is accepted by the firm so that trading ahead in the firm's 
market making capacity does not occur. For purposes of this 
interpretation, a member that controls or is controlled by another 
member shall be considered a single entity so that if a customer's 
limit order is accepted by one affiliate and forwarded to another 
affiliate for execution, the firms are considered a single entity and 
the market making unit may not trade ahead of that customer's limit 
order.

As Outlined in NASD Notice to Members 97-57, the Minimum Amount of 
Price Improvement Necessary in Order for a Market Maker to Execute an 
Incoming Order on a Proprietary Basis When Holding an Unexecuted Limit 
Order for a Nasdaq Security Trading in Fractions, and Not Be Required 
To Execute the Held Limit Order, Is as Follows:

     If actual spread is greater than \1/16\ of a point, a firm 
must price improve an incoming order by at least a \1/16\. For stocks 
priced under $10 (which are quoted in \1/32\ increments) the firm must 
price improve by at least \1/64\.
     If actual spread is the minimum quotation increment, a 
firm must price improve an incoming order by one-half the minimum 
quotation increment.
    For Nasdaq securities authorized for trading in decimals pursuant 
to the Decimals Implementation Plan For the Equities and Options 
Markets, the minimum amount of price improvement necessary in order for 
a market maker to execute an incoming order on a proprietary basis in a 
security trading in decimals when holding an unexecuted limit order in 
that same security, and not be required to execute the held limit 
order, is $0.01.
    The Association also wishes to emphasize that all members accepting 
customer limit orders owe those customers duties of ``best execution'' 
regardless of whether the orders are executed through the member's 
market making capacity or sent to another member for execution. As set 
out above, the Best Execution Rule requires members to use reasonable 
diligence to ascertain the best inter-dealer market for the security 
and buy or sell in such a market so that the price to the customer is 
as favorable as possible under prevailing market conditions. The 
Association emphasizes that order entry firms should continue to 
routinely monitor the handling of their customers' limit order 
regarding the quality of the execution received.
    (b) No Change.
    IM-3350. Short Sale Rule.
    (a)(1) through (a)(3) No Change.
    (b)(1) Rule 3350 requires that no member shall effect a short sale 
for the account of a customer or for its own account in a Nasdaq 
National Market security at or below the current best (inside) bid when 
the current best (inside) bid as displayed by The Nasdaq Stock Market 
is below the preceding best (inside) bid in the security. The 
Association has determined that in order to effect a ``legal'' short 
sale when the current best bid is lower than the preceding best bid the 
short sale must be executed at a price of a least \1/16\th point above 
the current inside bid when the current inside spread is \1/16\th point 
or greater. The last sale report for such a trade would, therefore, be 
above the inside bid by at least \1/16\th point. If the current spread 
is less than \1/16\th point, however, the short sale must be executed 
at a price equal to or greater than the current inside offer price.
    (2) Moreover, the Association believes that requiring short sales 
to be a minimum increment of \1/16\th point above the bid when the 
current spread is \1/16\th or greater and equal to or greater

[[Page 8825]]

than the offer when the current spread is less than \1/16\th ensures 
that transactions are not effected at prices inconsistent with the 
underlying purpose of the Rule. It would be inconsistent with Rule 3350 
for a member or customer to cause the inside spread for an issue to 
narrow when the current best is lower than the preceding best bid 
(e.g., lowering its offer to create an inside spread less than \1/
16\th) for the purpose of facilitating the execution of a short sale at 
a price less than \1/16\th above the inside bid.
    (3) For Nasdaq National Market securities trading in decimals 
pursuant to the Decimals Implementation Plan for Equity and Options 
Markets, the Association has determined that in order to effect a 
``legal'' short sale in such securities when the current bid is lower 
than the preceding bid the short sale must be executed at least $0.01 
above the current inside bid. The last sale report for such a trade 
would, therefore, be above the inside bid by at least $0.01.
    (c)(1) through (c)(3) No Change.
    4632. Transaction Reporting.
    (a) through (c) No Change.
    (d) Procedures for Reporting Price and Volume.
    Members which are required to report pursuant to paragraph (b) 
above shall transmit last sale reports for all purchases and sales in 
designated securities in the following manner:
    (1) No Change.
    (2) No Change.
    (3)(A) For principal transactions, except as provided below, report 
each purchase and sale transaction separately and report the number of 
shares and the price. For principal transactions which are executed at 
a price which includes a mark-up, mark-down or service charge, the 
price reported shall exclude the mark-up, mark-down or service charge. 
Such reported price shall be reasonably related to the prevailing 
market, taking into consideration all relevant circumstances including, 
but not limited to, market conditions with respect to the security, the 
number of shares involved in the transaction, the published bids and 
offers with size at the time of the execution (including the reporting 
firm's own quotation), the cost of execution and the expenses involved 
in clearing the transaction.
    Example:
    BUY as principal 100 shares from another member at 40 (no mark-down 
included);
    REPORT 100 shares at 40.
    Example:
    BUY as principal 100 shares from a customer at 39\7/8\ which 
includes a \1/8\ mark-down from prevailing market at 40;
    REPORT 100 shares at 40.
    Example:
    BUY as principal 100 shares from a customer at 39.90 which includes 
a $0.10 mark-down from prevailing market at 40;
    REPORT 100 shares at 40.
    Example:
    SELL as principal 100 shares to a customer at 40\1/8\, which 
includes a \1/8\ mark-up from the prevailing market of 40;
    REPORT 100 shares at 40.
    Example:
    SELL as principal 100 shares to a customer at 40.10, which includes 
a $0.10 mark-up from the prevailing market of 40;
    REPORT 100 shares at 40.
    Example:
    BUY as principal 10,000 shares from a customer at 39\3/4\, which 
includes a \1/4\ mark-down or service charge from the prevailing market 
at 40;
    REPORT 10,000 shares at 40.
    Example:
    BUY as principal 10,000 shares from a customer at 39.75, which 
includes a $0.75 mark-down or service charge from the prevailing market 
of 40;
    REPORT 10,000 shares at 40.
    (B) No Change.
    (e) through (f) No Change.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, Nasdaq 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 IV below. Nasdaq has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of such statements.

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

1. Purpose
    On June 8, 2000, the Commission ordered the exchanges and the NASD 
to submit a decimal pricing phase-in plan no later than July 24, 2000. 
Under the Plan, the NASD is to fully convert the Nasdaq market to 
decimal pricing no later than April 9, 2001. Before full 
implementation, Nasdaq is also to commence a decimal pricing pilot 
program for 10-15 Nasdaq issues on or before March 12, 2001. Recently, 
Nasdaq also determined to add a second decimal phase-in of 
approximately 100+ additional Nasdaq securities on March 26, 2001.
    In preparation for decimal pricing, the NASD proposes to amend 
certain of its rules that contain fractions through the addition of 
language and decimal-based values so as to govern trading activity in 
securities that transition from fractional to decimal pricing under the 
Plan. After Nasdaq's full implementation of decimal pricing, Nasdaq 
will automatically remove, where appropriate, any remaining fractional 
references in its rules.\3\
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    \3\ Obviously, many NASD Rules and interpretations do not 
contain, and are not enforced based on, any particular fractional 
value. Nothing in Nasdaq's move to decimal pricing should be 
construed as relieving NASD members from their ongoing obligation to 
comply with all current NASD Rules.
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    Specifically, Nasdaq is proposing to amend the following: IM-2110-2 
(Trading Ahead of Customer Limit Order); IM-3350 (Short Sale Rule) and 
NASD Rule 4632 (Transaction Reporting). A summary of the proposed 
changes is provided below:

IM-2210-2. Trading Ahead of Customer Limit Order

    NASD IM-2110-2 (``Manning Interpretation'' or ``Interpretation'') 
is amended to add language indicating that the minimum amount of price 
improvement that an NASD member holding an unexecuted limit order in a 
decimal-priced Nasdaq National Market (``NNM'') or SmallCap security 
must provide when executing an incoming order in that same security to 
avoid a violation of the Interpretation is $0.01. The Interpretation is 
also amended to incorporate the price improvement standard for NMS and 
SmallCap securities trading in fractions currently contained in NASD 
Notice to Members 97-57 (``NTM 97-57'').
    The Manning Interpretation is designed to ensure that customer 
limit orders are executed in a fair manner and at similar prices at 
which a firm has indicated it is willing to trade for its own account. 
To provide customers with the greatest opportunity to have their orders 
executed, NASD's Manning Interpretation requires NASD member firms to 
provide a minimum level of price improvement to incoming orders in NMS 
and SmallCap securities if the firm chooses to trade as principal with 
those incoming orders at prices superior to customer limit orders they 
currently hold. If a firm fails to provide the minimum level of price 
improvement to the incoming order, the firm must

[[Page 8826]]

execute its held customer limit orders. Generally, if a firm fails to 
provide the requisite amount of price improvement and also fails to 
execute its held customer limit orders, it is in violation of the 
Manning Interpretation. Currently, the minimum price improvements 
necessary to avoid a Manning violation, as outlined in NTM 97-57, are:
     If actual spread is greater than \1/16\ of a point = Firm 
must price improve incoming order by at least a \1/16\. For stocks 
priced under $10, (which are quoted in 32nds) the firm must price 
improve by at least \1/64\.
     If actual spread is the minimum quotation increment = Firm 
must price improve incoming order by one-half the minimum quotation 
increment.
    In a decimal environment, Nasdaq is proposing the following Manning 
price improvement standards for NNM and SmallCap securities:
     A firm must always price improve an incoming order by at 
least $0.01.\4\
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    \4\ Pursuant to the terms of the Implementation Plan, the 
minimum quotation increment for Nasdaq securities (both National 
Market and SmallCap) at the outset of decimal pricing is $0.01. As 
such, Nasdaq will only display priced quotations to two places 
beyond the decimal point (to the penny). Quotations submitted to 
Nasdaq that do not meet this standard will be rejected by Nasdaq 
systems. See Securities Exchange Act Release No. 43876 (January 23, 
2001) (SR-NASD-01-07).
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    Please note that for securities quoting in decimals, there would no 
longer be any differentiation between the amount of price improvement 
required and the price of a particular security.
    Nasdaq chose to propose the $0.01 price improvement standard for 
securities quoting in decimals, taking the view that the current \1/16\ 
price improvement values contained in NTM 97-57 discussing the 
Interpretation generally approximate today's minimum quotation 
increment for most Nasdaq securities.\5\ One exception to this approach 
is in the area of Manning price improvement when the spread equals the 
minimum quote increment. Recognizing that retaining Manning's current 
``\1/2\ the spread'' price improvement alternative standard when the 
spread equals the minimum quote increment would result in a firm being 
able to price ahead of a customer order for \1/2\ a penny ($0.005), 
Nasdaq has determined to strengthen that standard and propose a rule 
that would always require at least a penny price improvement before 
executing ahead of a held customer limit order. Nasdaq believes that 
given the size of the new decimal quotation increment, uniform price 
improvement of a penny, particularly for stocks that are already 
trading with a penny spread, is an appropriate price improvement 
standard for the initiation of decimal pricing.
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    \5\ Originally, Nasdaq's Manning Interpretation required that 
firm price improve an incoming order by the then minimum trade 
reporting increment of \1/64\th. See NASD NTM 94-43 (June 5, 1995). 
In response to changing market conditions, including a move to a \1/
16\ minimum quote increment, Nasdaq adopted the current \1/16\ price 
improvement standard. See NASD NTM 97-57 (September 1997); 
Securities Exchange Act Release No. 39049 (September 10, 1997), 62 
FR 48912 (September 17, 1997) (SR-NASD-97-66).
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    As contemplated in the Plan, Nasdaq and NASD Regulation will 
closely monitor the protection of customer limit orders during the 
implementation of decimal pricing in the Nasdaq market and will analyze 
and evaluate trading activity to determine if future changes to the 
price improvement standard are warranted.

IM-3350. Short Sale Rule

    The Interpretative Material is amended to add language indicating 
that when the current best bid in a decimalized NNM security is lower 
than the preceding best bid in that security, a ``legal'' short sale 
must be executed at a price at least $0.01 above the current bid.
    NASD's Short Sale Rule requires that no member execute a short sale 
in an NNM security for a customer or proprietary account at or below 
the current best bid (unless operating pursuant to an exemption to the 
rule) when the current best bid is below the preceding best bid in the 
security. Under the current rule, a valid short sale in an NNM security 
must be executed at the following specified amounts above the current 
bid in a down market:
     Spread \1/16\ or greater = Legal Short Sale must be 
executed at least \1/16\ above current inside bid.
     Spread less than \1/16\ = Legal Short Sale must be 
executed at price equal or greater than current inside offer.
    In a decimal environment, Nasdaq proposes the following standard 
for ``legal'' short sales:
     A valid short sale on a down bid would have to be executed 
at least $0.01 above the current inside bid.
    Nasdaq chose to propose the $0.01 price improvement standard for 
legal short sales in decimalized securities in a down market taking the 
view that the current \1/16\th values contained in the short sale rule 
generally approximate today's minimum \1/16\th quotation increment for 
most Nasdaq securities.
    As contemplated in the Plan, Nasdaq and NASD Regulation will 
closely monitor the operation of the short sale rule in Nasdaq's 
decimal environment and will analyze and evaluate trading activity to 
determine if the short sale price improvement standard adopted here 
adequately advances the market quality goals of the rule.

Rule 4632  Transaction Reporting

    The Rule is amended to provide alternative reporting examples for 
securities trading in decimals.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act \6\ in that it is 
designed to promote just and equitable principles of trade, foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to and 
facilitating transactions in securities, perfect the mechanism of a 
free and open market and a national market system, and protect 
investors and the public interest.
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    \6\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

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

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

    Written comments were neither solicited nor received.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the Exchange consents, the Commission will:
    A. by order approve such proposed rule change, or
    B. institute proceedings to determine whether the proposed rule 
change should be disapproved.
    Nasdaq has requested accelerated approval of the proposed rule 
change. While the Commission will not grant accelerated approval at 
this time, the Commission will consider granting accelerated approval 
of the proposal at the close of an abbreviated comment period of 15 
days from the date of publication of the proposal in the Federal 
Register.

[[Page 8827]]

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
Association. All submissions should refer to file number SR-NASD-01-09 
and should be submitted by February 20, 2001.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-2850 Filed 2-1-01; 8:45 am]
BILLING CODE 8010-01-M