[Federal Register Volume 66, Number 131 (Monday, July 9, 2001)]
[Notices]
[Pages 35817-35819]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-17003]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44497; File No. SR-NASD-98-26]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 10 to a Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Extension of Short Sale Rule and Continued Suspension of Primary 
Market Maker Standards

June 29, 2001.
    On June 15, 2001, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its subsidiary, the Nasdaq 
Stock Market Inc. (``Nasdaq''), submitted to the Securities and 
Exchange Commission (``SEC'' or ``Commission''), pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Exchange Act'') \1\ 
and Rule 19b-4 thereunder,\2\ a proposed rule to change to: (1) 
Continue to suspend the current Primary Market Maker (``PMM'') 
standards until March 1, 2002, and (2) extend the NASD's Short Sale 
Rule pilot until March 1, 2002 (``Amendment No. 10'').\3\ Amendment No. 
10 to the proposed rule change, SR-NASD-96-28, is described in Items I 
and II below, which Items have been prepared by the Nasdaq. The 
Commission is publishing this notice and order to solicit comments on 
amendment No. 10 from interested persons and to approve the amendment 
on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letters from Edward S. Knight, Executive Vice President 
and General Counsel, Nasdaq, to Belinda Blaine, Associate Director, 
Division of Market Regulation (``Division''), Commission, dated June 
14, 2001; and Mary Dunbar, Vice President, Nasdaq, to Anitra Cassas, 
Special Counsel, Division, dated June 29, 2001. The current 
suspension and extension would expire on June 30, 2001. See 
Securities Exchange Act Release No. 43368 (September 27, 2000), 65 
FR 59478 (October 5, 2000).''
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    In the current amendment, Nasdaq is proposing to extend the Short 
Sale Rule pilot and the suspension of the existing PMM standards from 
June 30, 2001 until March 1, 2002. The proposed rule language, as 
amended, follows. Additions are italicized; deletions are bracketed.
NASD Rule 3350
    (a)-(k) No Changes.
    (l) This Rule shall be in effect until [June 30, 2001] March 1, 
2002.

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

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

(1) Background on the NASD's Short Sale Rule
    Section 10(a) of the Exchange Act \4\ gives the Commission plenary 
authority to regulate short sales of securities registered on a 
national securities exchange, as needed to protect investors. Although 
the Commission has regulated short sales since 1938, that regulation 
has been limited to short sales of exchange-listed securities. In 1992, 
Nasdaq, believing that short-sale regulation is important to the 
orderly operation of securities markets, proposed a short sale rule for 
trading of its National Market securities that incorporates the 
protections provided by Rule 10a-1 of the Exchange Act.\5\ On June 29, 
1994, the Commission approved the NASD's short sale rule, Rule 3350 
(``Short Sale Rule''), applicable to short sales \6\ in Nasdaq National 
Market (``NNM'') securities on an eighteen-month pilot basis through 
March 5, 1996.\7\ The NASD and the Commission have extended NASD Rule 
3350 numerous times, most recently, until June 30, 2001.\8\
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    \4\ 15 U.S.C. 78j(a).
    \5\ 17 CFR 240.10a-1.
    \6\ A short sale is a sale of a security the seller does not own 
or any sale which is consummated by the delivery of a security 
borrowed by, or for the account of, the seller. To determine whether 
a sale is a short sale, members must adhere to the definition of a 
``short sale'' contained in Rule 3b-3 of the Exchange Act, which is 
incorporated into Nasdaq's short sale rule by NASD Rule 3350(k)(1).
    \7\ See Securities Exchange Act Release No. 34277 (June 29, 
1994), 59 FR 34885 (July 7, 1994) (``Short Sale Rule Approval 
Order'').
    \8\ See supra, note 3.
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    Nasdaq's short-sale rule employs a ``bid'' test rather than a tick 
test because Nasdaq trades are not necessarily reported to the tape in 
chronological order. Nasdaq's short sale rule prohibits short sales at 
or below the inside bid when the current inside bid is below the 
previous inside bid. Nasdaq calculates the inside bid from all market 
makers in the security (including bids on exchanges trading Nasdaq 
securities on an unlisted trading privileges basis), and disseminates 
symbols to denote whether the current inside bid is an ``up-bid'' or a 
``down-bid.'' To effect a ``legal'' short-sale on a down-bid, the 
short-sale must be executed at a price at least .01 above the current 
inside bid.\9\ The rule is in effect from 9:30 a.m. E.T. until 4 p.m. 
E.T. each trading day.
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    \9\ In light of the industry conversion to decimal pricing, 
Nasdaq recently amended the increment standard for legal short sales 
from 1/16th to $0.01. The Commission approved the amendment to IM-
3350 on a pilot basis, ending March 1, 2002. Securities Exchange Act 
Release No. 44030 (March 2, 2001), 66 FR 14235 (March 9, 2001).
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    To reduce the compliance burdens on its members, Nasdaq's short 
sale rule also incorporates seven exemptions contained in Rule 10a-1 
under the Exchange Act that are relevant to trading on Nasdaq.\10\ In 
addition, in an effort to not constrain the legitimate hedging needs of 
options market makers, the NASD's short sale rule contains a limited 
exception for standardized options market makers. The Rule also 
contains an exemption for warrant market makers similar to the one 
available for options market makers.
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    \10\ See NASD Rule 3350(c)(2)-(8). The Rule also provides that a 
member not currently registered as a Nasdaq market maker in a 
security, and that has acquired the security while acting in the 
capacity of a block positioner shall be deemed to own such security 
for the purposes of the Short Sale Rule, notwithstanding that such 
member may not have a net long position in such security if and to 
the extent that such member's short position in such security is 
subject to one or more offsetting positions created in the course of 
bona fide arbitrage, risk arbitrage, or bona fide hedge activities. 
In addition, the NASD has recognized that SEC staff interpretations 
to Rule 10a-1 under the Exchange Act dealing with the liquidation of 
index arbitrage positions and an ``international equalizing 
exemption'' are equally applicable to the NASD's short sale rule. 
See NASD Rule 3350(f).

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[[Page 35818]]

(2) Background on the NASD's Primary Market Maker Standards
    To ensure that market maker activities that provide liquidity and 
continuity to the market are not adversely constrained when the short 
sale rule is invoked, NASD Rule 3350(c)(1) provides an exemption for 
``qualified'' Nasdaq market makers (i.e., market makers that meet the 
PMM standards). Presently, NASD Rule 4612 provides that a member 
registered as a Nasdaq market maker pursuant to NASD Rule 4611 may be 
deemed a PMM if that member meets certain threshold standards.
    Since NASD Rule 3350 has been in effect, there have been two 
methods used to determine whether a market maker is eligible for the 
PMM exemption. Specifically, from September 4, 1994 through February 1, 
1996, Nasdaq market makers that maintained a quotation in a particular 
NNM security for 20 consecutive business days without interruption were 
exempt from Rule 3350 for short sales in that security, provided the 
short sales were made in connection with bona fide market making 
activity (``the 20-day'' test).\11\ From February 1, 1996 until 
February 14, 1997, the ``20-day'' test was replaced with a four-part 
quantitative test known as the PMM standards.\12\
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    \11\ See Short Sale Rule Approval Order, supra note 7.
    \12\ Id. Under the PMM standards, a market maker was required to 
satisfy at least two of the following four criteria each month to be 
eligible for an exemption from the short sale rule: (1) The market 
maker must be at the best bid or best offer as shown on Nasdaq no 
less than 35 percent of the time; (2) the market maker must maintain 
a spread no greater than 102 percent of the average dealer spread; 
(3) no more than 50 percent of the market maker's quotation updates 
may occur without being accompanied by a trade execution of at least 
one unit of trading; or (4) the market maker executes 1\1/2\ times 
its ``proportionate'' volume in the stock. If a PMM did not satisfy 
the threshold standards after a particular review period, the market 
maker lost its designation as a PMM (i.e., the ``P'' next to its 
market maker identification was removed). Market makers could re-
qualify for designation as a PMM by satisfying the threshold 
standards in the next review period.
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    Beginning on February 14, 1997, the PMM standards were suspended 
for all NNM securities due to the impact of the SEC's Order Handling 
Rules, and corresponding NASD rule change and system modifications on 
the operation of the four quantitative standards.\13\ For example, the 
requirement that market makers display customer limit orders adversely 
affected the ability of market makers to satisfy the ``102% Average 
Spread Standard.'' Since that time all market makers have been 
designated as PMMs.
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    \13\ See Securities Exchange Act Release Nos. 38294 (February 
14, 1997), 62 FR 8289 (February 24, 1997) (order granting temporary 
accelerated approval of suspension of PMM standards until October 1, 
1997; File No. SR-NASD-97-07); 39198 (October 3, 1997), 62 FR 53365 
(October 14, 1997) (order granting temporary accelerated approval of 
continuing suspension until April 1, 1998; File No. SR-NASD-97-73); 
39819 (March 30, 1998), 63 FR 16841 (April 6, 1998) (order granting 
temporary accelerated approval of continuing suspension until May 1, 
1998; File No. SR-NASD-98-26); 39936 (April 30, 1998); 63 FR 25253 
(May 7, 1998) (order granting temporary accelerated approval of 
continuing suspension until July 1, 1998; Amendment No. 3 to File 
No. SR-NASD-98-26); 40140 (June 26, 1998), 63 FR 36464 (July 6, 
1998) (order granting temporary accelerated approval of continuing 
suspension until October 1, 1998; Amendment No. 4 to File No. SR-
NASD-98-26); 40485 (September 25, 1998), 63 FR 52780 (October 1, 
1998) (order granting temporary accelerated approval of continuing 
suspension until March 31, 1999; Amendment No. 5 to File No. SR-
NASD-98-26); 41195 (March 19, 1999), 64 FR 14778 (March 26, 1999) 
(order granting temporary accelerated approval of continuing 
suspension until June 30, 1999; Amendment No. 6 to File No. SR-NASD-
98-26); 41568 (June 28, 1999), 64 FR 36416 (July 6, 1999) (order 
granting temporary accelerated approval of continuing suspension 
until December 31, 1999; Amendment No. 7 to File No. SR-NASD-98-26); 
42219 (December 9, 1999), 64 FR 70753 (December 17, 1999) (granting 
temporary accelerated approval of continuing suspension until 
September 30, 2000; Amendment No. 8 to File No. SR-NASD-98-26).
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    In March 1998, Nasdaq proposed PMM standards that received 
substantially negative comments.\14\ In light of those comments, Nasdaq 
staff convened an advisory subcommittee to develop PMM standards 
(``Subcommittee'') in August 1998. The Subcommittee met nine times and 
formulated new PMM standards. On December 9, 1998, the NASD/Nasdaq 
staff met with the Commission staff and the Subcommittee to receive 
informal feedback on the new PMM standards. At the conclusion of the 
meeting, Commission staff noted the progress made by the Subcommittee 
and requested time to digest and more carefully analyze the proposed 
new PMM standards.
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    \14\ See Securities Exchange Act Release 39819 (March 30, 1998), 
63 FR 16841 (April 6, 1998).
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    On July 29, 1999, members of the Nasdaq staff conducted a 
conference call with members of the Commission staff to receive 
feedback on the PMM standards that Nasdaq presented at the December 9, 
1998 meeting. During the meeting, the Commission staff suggested that 
Nasdaq modify several of the proposed standards and analyze the impact 
of those modifications on the primary market maker determination. On 
September 27, 1999, Nasdaq reported that the NASD Economic Research 
staff had analyzed data based on the Commission's suggested revisions, 
and concluded that the Commission's modified standards produced 
unfavorable results.\15\
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    \15\ See letter from John F. Malitzis, Assistant General 
Counsel, Nasdaq, to Richard Strasser, Assistant Director, Division, 
Commission, dated September 27, 1999.
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    The Commission notes that it intends to propose amendments to Rule 
10a-1 under the Exchange Act, which applies to exchanges. The 
Commission recently noticed for public comment Nasdaq's application for 
registration as a national securities exchange under Section 6 of the 
Exchange Act.\16\
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    \16\ See Securities Exchange Act Release No. 44396 (June 7, 
2001), 66 FR 31952 (June 13, 2001).
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(3) Current Amendment
    Nasdaq believes that it is in the best interest of investors to 
extend the short sale regulation pilot program. In the Short Sale 
Approval Order, the Commission stated that ``recognizing the potential 
for problems associated with short selling, the changing expectations 
of Nasdaq market participants and the competitive disparity between the 
exchange markets and the OTC market, the Commission believes that 
regulation of short selling of Nasdaq National Market securities is 
consistent with the Act.'' \17\ In addition, the Commission stated that 
it ``believes that the NASD's short sale bid-test, including the market 
maker exemptions, is a reasonable approach to short sale regulation of 
Nasdaq National Market securities and reflects the realities of its 
market structure.'' \18\ Nasdaq believes the benefits that the 
Commission recognized when it first approved NASD Rule 3350 apply with 
equal force today.
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    \17\ See Short Sale Rule Approval Order, supra note 8.
    \18\ Id.
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    Similarly, Nasdaq believes the concerns that caused the Commission 
to waive the PMM standards in February 1997 continue to exist today. 
Nasdaq and the Commission agreed to waive the PMM standards to avoid 
frustrating operation of the Commission's Order Handling Rules, in 
light of market factors that were not apparent at the time the Order 
Handling Rules were implemented.\19\ Nasdaq has worked to

[[Page 35819]]

address those concerns to the Commission's satisfaction, including 
convening a special subcommittee on PMM issues, proposing two different 
sets of PMM standards, and being continuously available and responsive 
to Commission staff to discuss this issue. Despite these efforts, the 
Commission and Nasdaq have been unable to establish satisfactory PMM 
standards. Nasdaq believes that re-instating the PMM standards set 
forth in NASD Rule 4612 would be extremely disruptive to the market and 
harmful to investors.
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    \19\ Nasdaq stated at the time that it believed the 
implementation of the Order Handling Rules created the following 
three issues: (1) many market makers voluntarily chose to display 
customer limit orders in their quotes although the Limit Order 
Display Rule does not yet require it; (2) SOES decrementation for 
all Nasdaq stocks significantly affected market makers' ability to 
meet several of the primary market maker standards; and (3) with the 
inability to meet the existing criteria for a larger number of 
securities, a market maker may be prevented from registering as a 
primary market maker in an initial public offering because it fails 
to meet the 80% primary market maker test contained in Rule 
4612(g)(2)(B). See Securities Exchange Act Release No. 38294 
(February 14, 1997), 62 FR 8289 (February 24, 1997).
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    Nasdaq also notes that the Commission has signaled to the 
securities industry that it is considering fundamental changes to Rule 
10a-1 of the Exchange Act that could impact the manner in which Nasdaq 
and the other markets regulate short sales. On October 20, 1999, the 
Commission issued a Concept Release on Short Sales in which it sought 
comment on, among other things, revising the definition of short sale, 
extending short sale regulation to non-exchange listed securities, and 
eliminating short sale regulation altogether.\20\ Nasdaq believes it 
would be inappropriate for Nasdaq to alter its regulation of short 
sales while the Commission is considering changing Rule 10a-1.
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    \20\ See Securities Exchange Act Release No. 42037 (October 20, 
1999), 64 FR 57996 (October 28, 1999).
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III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 10, including whether the proposed 
Amendment 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 NASD. All submissions should refer to File No. 
SR-NASD-98-26 and should be submitted by July 30, 2001.

IV. Commission's Findings and Order Granting Accelerated Approval 
of the Amendment

    After careful consideration, the Commission finds, for the reasons 
set forth below, that the extension of the Short Sale Rule pilot and 
the suspension of the existing PMM standards until March 1, 2002 is 
consistent with the requirements of the Act and the rules and 
regulations thereunder. In particular, the extension is consistent with 
section 15A(b)(6) \21\ of the Act, which requires that the NASD's rules 
be designed, among other things, to remove impediments to and perfect 
the mechanism of a free and open market and a national market system 
and to promote just and equitable principles of trade.
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    \21\ 15 U.S.C. 78o-3(b)(6).
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    The Commission finds that continuation of the Short Sale Rule pilot 
and the continued suspension of the current PMM standards will maintain 
the status quo while the Commission is considering amending Rule 10a-1 
under the Exchange Act. However, this extension of the pilot and 
continued suspension of the current PMM standards is subject to 
modification or revocation should the Commission amend Rule 10a-1 in 
such a manner as to deem the extension or suspension unnecessary or in 
conflict with any adopted amendments.\22\
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    \22\ Absent an exemption, Rule 10a-1 of the Exchange Act would 
apply to Nasdaq upon Commission approval of their exchange 
registration.
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    The Commission finds good cause for approving the extension of the 
Short Sale Rule pilot and the suspension of existing PMM standards 
prior to the 30th day after the date of publication of notice of the 
filing in the Federal Register. It could be disruptive to the Nasdaq 
market and confusing to market participants to reintroduce the previous 
PMM standards while new PMM standards are being developed, and while 
the Commission is considering amending Rule 10a-1 under the Exchange 
Act.
    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\23\ that Amendment No. 10 to the proposed rule change, SR-NASD-98-
26, which extends the NASD Short Sale Rule pilot and the suspension of 
the current PMM standards to March 1, 2002, is approved on an 
accelerated basis.\24\
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    \23\ 15 U.S.C. 78s(b)(2).
    \24\ In approving Amendment No. 10, the Commission has 
considered its impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\
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    \25\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 01-17003 Filed 7-6-01; 8:45 am]
BILLING CODE 8010-01-M