[Federal Register Volume 66, Number 47 (Friday, March 9, 2001)]
[Notices]
[Pages 14235-14237]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-5797]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44030; File No. SR-NASD-01-09]


Self-Regulatory Organizations; Order Granting Accelerated 
Approval of Proposed Rule Change by the National Association of 
Securities Dealers, Inc. Regarding Trading Ahead of Customer Limit 
Orders and Short Sales on a Pilot Basis and Transaction Reporting 
Pursuant to Decimal Pricing in the Nasdaq Market

March 2, 2001.

I. Introduction

    On January 25, 2001, the National Association of Securities 
Dealers, Inc. (NASD or Association), through its subsidiary, the Nasdaq 
Stock Market, Inc. (Nasdaq), filed with the Securities and Exchange 
Commission (Commission or SEC), pursuant to section 19(b)(1) of the 
Securities Exchange Act of 1934 (Act) \1\ and Rule 19b-4 thereunder,\2\ 
a proposed rule change that would modify several NASD rules to support 
the implementation of decimal pricing in the Nasdaq market. Notice of 
the proposed rule change appeared in the Federal Register on February 
2, 2001.\3\ The Commission received no comments on the proposed rule 
change. This order approves the proposed rule changes regarding trading 
ahead of customer limit orders and short sales on a pilot basis ending 
on Friday, March 1, 2002, and grants approval for the proposed rule 
change concerning transaction reporting pursuant to decimal pricing in 
the Nasdaq Market.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 43893 (January 26, 
2001), 66 FR 8823.
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II. Description of the Proposal

    In preparation for decimal pricing, the NASD proposes to amend 
certain of its rules that contain references to fractions through the 
addition of language and decimal-based values so as to govern trading 
activity in securities when they transition from fractional to decimal 
pricing.\4\ After Nasdaq's full implementation of decimal pricing, 
Nasdaq will automatically remove, where appropriate, any remaining 
references to fractions in NASD rules.\5\ 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.
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    \4\ Nasdaq will implement these rule changes starting on March 
12, 2001, for each security converted to decimal pricing. Securities 
not trading in decimal increments will continue to be governed by 
the current versions of these proposed rules.
    \5\ Many NASD Rules and interpretations do not contain, and are 
not enforced based on, any particular value, fractional or 
otherwise. 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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IM-2110-2. Trading Ahead of Customer Limit Order

    Nasdaq is amending NASD IM-2110-2 and the related interpretation of 
IM-2110-2 (Manning Interpretation or Interpretation) \6\ to add 
language that the minimum amount of price improvement that an NASD 
member holding an unexecuted customer 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 being 
amended to incorporate the price improvement standard for NMS and 
SmallCap securities trading in fractions currently contained in NASD's 
NTM 97-57.
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    \6\ See Securities Exchange Act Release No. 39049 (September 10, 
1997), 62 FR 48912 (order approving Interpretation). The 
Interpretation was announced to the NASD membership in NASD's Notice 
to Members 97-57 (September 1997) (NTM 97-57).
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    According to Nasdaq, 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 execute the customer limit orders it holds. Generally, if a firm 
trades for its own account and 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 equal to or greater than \1/16\th of a 
point: Firm must price improve incoming order by at least a \1/16\th.
     If actual spread is the minimum quotation increment: Firm 
must price improve incoming order by one-half the minimum quotation 
increment.\7\
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    \7\ For stocks priced under $10 (which are quoted in \1/32\nd 
increments) the firm must price improve by at least \1/64\th. Nasdaq 
notes that, for securities quoted in decimals, under the proposal 
there would no longer by any differentiation in the amount of price 
improvement required based on the price of a particular security.
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    In a decimal environment, Nasdaq is proposing the following Manning 
Interpretation price improvement standards for NNM and SmallCap 
securities:
     A firm must always price improve an incoming order by at 
least $0.01.\8\
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    \8\ Pursuant to the terms of the Decimals Implementation Plan 
(Implementation Plan) submitted to the Commission on July 24, 2000, 
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 
Nadaq that do not meet this standard will be rejected by Nasdaq 
systems. See Securities Exchange Act Release No. 43876 (January 23, 
2001), 66 FR 8251.

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[[Page 14236]]

    Nasdaq chose to propose the $0.01 price improvement standard for 
securities quoting in decimals, taking the position that the current 
\1/16\th price improvement values contained in NTM 97-57 discussing the 
Interpretation generally approximate the existing minimum quotation 
increment for most Nasdaq securities.\9\ One exception to this approach 
is price improvement when the spread equals the minimum quotation 
increment. Recognizing that retaining the Interpretation's current 
``one-half 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 one-half a penny ($0.005), 
Nasdaq proposes to strengthen that standard by requiring 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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    \9\ Originally, Nasdaq's Manning Interpretation required that 
member firms price improve an incoming order by the then minimum 
trade reporting increment of \1/64\th. See NASD's Notice To Members 
95-43 (June 1995). In response to changing market conditions, 
including a move to a \1/16\th minimum quotation increment, Nasdaq 
adopted the current \1/16\th price improvement standard. See NTM 97-
57. See also Securities Exchange Act Release No. 39049 (September 
10, 1997), 62 FR 48912.
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    As contemplated in the Implementation Plan, Nasdaq and NASD 
Regulation will 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

    Nasdaq proposes to amend IM-3350 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 best 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 bid context:
     Spread \1/16\th or greater: Legal Short Sale must be 
executed at least \1/16\th above current best (inside) bid.
     Spread less than \1/16\th: Legal Short Sale must be 
executed at price equal or greater than current best (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 best (inside) bid.
    Nasdaq believes that the current \1/16\th increment contained in 
the short sale rule generally approximates the current minimum \1/16\th 
quotation increment for most Nasdaq securities. Nasdaq believes that 
short sale regulation should reflect the minimum quotation increment 
once trading commences in a decimals environment, i.e., where there is 
a down bid in a security a legal short sale must be executed at a price 
at least $0.01 above the current best bid.
    As contemplated in the Implementation Plan, Nasdaq and NASD 
Regulation will 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

    Nasdaq proposes to amend Rule 4632 to provide alternative reporting 
examples for securities trading in decimals.\10\
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    \10\ Supra note 3.
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III. Discussion

    The Commission has reviewed carefully the proposed rule change, and 
finds that it is consistent with the Act and the rules and regulations 
promulgated thereunder.\11\ Specifically, the Commission finds that 
approval of the proposed rule change is consistent with section 
15A(b)(6) of the Act.\12\
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    \11\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition and capital 
formation. 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78o-3(b)(6).
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    The Commission finds that the proposed amendment to the 
Interpretation to IM-2110-2 is consistent with section 15A(b)(6) of the 
Act,\13\ in that it is designed to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of trade, 
and to remove impediments to and perfect the mechanism of a free and 
open market and a national market system, and, in general, to protect 
investors and the public interest. The proposal is intended to ensure 
that customer limit orders are executed fairly, and to require firms to 
provide price improvement of at least $0.01 before trading ahead of 
customer limit orders that they hold.
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    \13\ Id.
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    Regarding Nasdaq's proposed amendment to IM-3350, the Commission 
finds that the proposal is consistent with section 15A(b)(6) of the 
Act,\14\ in that it is designed to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of trade, 
and 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. Nasdaq is setting the $0.01 
increment standard for legal short sales in securities quoting in 
decimals to mirror current operation of this rule for most Nasdaq 
securities quoting in fractions.
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    \14\ Id.
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    The Commission believes the proposed amendments to the Manning 
Interpretation and IM-3350 are a reasonable approach during the initial 
stages of the Nasdaq conversion to decimal pricing. However, we believe 
that the amendments should be reexamined once Nasdaq decimal trading 
behavior can be analyzed. As a result, the Commission is approving the 
amendment on a one-year pilot program basis. The primary purpose of 
pilot program is to allow Nasdaq, participants, and the Commission to 
examine the operation of the Interpretation and the Short Sale Rule. 
Ninety days prior to the end of the pilot period, Nasdaq must submit to 
the Commission a study analyzing the operation of these rules as 
amended.\15\ The study must include, but is not limited to, an analysis 
of whether the rules are effective in achieving their

[[Page 14237]]

investor protection and market quality goals with a $0.01 minimum 
increment.\16\ The Commission finds that the proposed amendments are 
appropriate during the pilot period.\17\
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    \15\ Requiring this study does not alleviate NASD of its 
obligations to provide any other reports required to be submitted to 
the Commission as a part of its conversion to decimal pricing. 
Specifically, NASD has agreed, pursuant to the Implementation Plan, 
to perform a detailed statistical analysis of quoting and trading 
activity that will be used to form the basis for a study or studies 
on systems capacity, liquidity, and trading behavior. This report is 
required to be delivered to the Commission no later than 60 days 
after the full implementation of decimals. Securities Exchange Act 
Release No. 42914 (June 8, 2000), 65 FR 38010.
    \16\ We note that concerns have been raised recently about the 
effect of a penny increment on trading behavior. See Norris, Big 
Board Will Study Effects of Decimal Trading, The New York Times, 
Feb. 17, 2001, at C1. We also note that the NASD has previously 
expressed concerns that transactions based on very small price 
changes could undermine the operation of the Short Sale Rule in a 
fractional pricing context. See Securities Exchange Act Release No. 
31003 (August 6, 1992), 57 FR 36421, 36426 (Amended Notice Proposing 
NASD Short Sale Rule). The Commission will separately study the 
effect of decimal pricing on the operation of self-regulatory 
organization and Commission rules containing provisions that are 
designed to give public orders precedence over member orders, e.g., 
Exchange Act Rule 11a1-1(T). In addition, we will study the effect 
of decimal pricing on the operation of short sale rules.
    \17\ Approving the amendment on a one-year pilot basis does not 
prevent Nasdaq from proposing a rule change regarding the 
Interpretation and the Short Sale Rule before the end of the one-
year pilot should Nasdaq believe it is appropriate.
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    With regard to the amendments to NASD Rule 4632, the Commission 
finds that providing alternative reporting examples for securities 
quoting in decimals is consistent with the Act in general, and in 
particular with section 15A(b)(6).\18\ By providing examples of trade 
reporting for securities quoting in decimals, Nasdaq clarifies how 
trade reporting will operate in a decimals environment, which should 
help 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.
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    \18\ Id.
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    The Commission finds good cause for approving the proposed rule 
change prior to the 30th day after the date of publication of notice of 
the filing in the Federal Register. Notice of the proposal indicated 
that the Commission would consider granting accelerated approval of the 
proposed rule change after a 15-day comment period.\19\ The Commission 
received no comments on the proposal. Given the absence of comments, 
and Nasdaq's resolve to begin decimal pricing in certain Nasdaq 
securities on March 12, 2001, the Commission finds good cause to 
approve the proposal on an accelerated basis to ensure that the 
amendments are approved in advance of March 12, 2001.
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    \19\ Supra note 3.
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IV. Conclusion

    For the above reasons, the Commission finds that the proposed rule 
change is consistent with the provisions of the Act, in general, and 
with section 15A(b)(6),\20\ in particular.
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    \20\ 15 U.S.C. 78o-3(b)(6).
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-NASD-01-09), be and hereby 
is approved on a pilot basis for the proposed rule changes to IM-2110-2 
and the related Interpretation to IM-2110-2, and IM-3350 on a pilot 
basis ending on Friday, March 1, 2002;
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    \21\ 15 U.S.C. 78s(b)(2).
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    It is further ordered, pursuant to section 19(b)(b) of the Act,\22\ 
that the proposed rule change (SR-NASD-01-09), be and hereby is 
approved as to the amendment to NASD Rule 4632.
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    \22\ Id.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-5797 Filed 3-8-01; 8:45 am]
BILLING CODE 8010-01-M