[Federal Register Volume 67, Number 47 (Monday, March 11, 2002)]
[Notices]
[Pages 10953-10955]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-5782]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45499, File No. SR-NASD-98-26 Amend. No. 12]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing and Order Granting Accelerated Approval 
to Amendment No. 12 to a Proposed Rule Change Relating to an Extension 
of the NASD Short Sale Rule and Continued Suspension of Primary Market 
Maker Standards Set Forth in NASD Rule 4612

March 4, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ notice is hereby given that on February 28, 2002, the 
National Association of Securities Dealers, Inc., through its 
subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq'') filed with the 
Securities and Exchange Commission (``Commission'' or ``SEC'') the 
proposed rule change as described in Items I and II 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).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq is proposing to extend the pilot program of the NASD short 
sale rule (``Rule 3350'') from March 1, 2002 until December 15,2002. 
Nasdaq is also seeking to continue the suspension of the effectiveness 
of the Primary Market Maker (``PMM'') standards currently set forth in 
NASD Rule 4162 also from March 1, 2002 until December 15,2002. The text 
of the proposed rule change is as follows. Additions are italicized; 
deletions are bracketed.

NASD Rule 3350

* * * * *
    (l) This section shall be in effect until December 15,2002 [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. 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. Background and Description of the NASD's Short Sale Rule

    Section 10(a) of the Act 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 under the Act. On June 29, 1994, the SEC approved Rule 
3350 applicable to short sales \2\ in Nasdaq National Market (``NNM'') 
securities on an eighteen-month pilot basis through March 5,1996.\3\ 
The NASD and the Commission have extended Rule 3350 numerous times, 
most recently, until March 1, 2002. Rule 3350 employs a ``bid'' test 
rather than a tick test because Nasdaq trades are not necessarily 
reported to the tape in chronological order. The 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 for 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. Rule 3350 is in effect from 9:30 a.m. 
until 4 p.m. each trading day.
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    \2\ A short sale is a sale of a security that the seller does 
not own or any sale that 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 under the Act, 
which is incorporated into Nasdaq's short sale rule by NASD Rule 
3350(k)(1).
    \3\ See Securities Exchange Act Release No. 34277 (June 29, 
1994), 59 FR 34885 (July 7, 1994) (``Short Sale Rule Approval 
Order'').
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    To reduce the compliance burdens on its members, Rule 3350 also 
incorporates seven exemptions contained in Rule 10a-1 under the Act, 
that are relevant to trading on Nasdaq.\4\ For example, in an effort to 
not constrain the legitimate hedging needs of options market makers, 
Rule 3350 also 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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    \4\ 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 that has acquired the security while acting in the capacity 
of a block positioner shall be deemed to own such security for the 
purposes of the Rule notwithstanding that such member may not have a 
net long position in such security if and to the extent that such 
member's short position in such security is subject to one or more 
offsetting positions created in the course of bona fide arbitrage, 
risk arbitrage, or bona fide hedge activities. In addition, the NASD 
has recognized that SEC staff interpretations to Rule 10a-1 under 
the Act dealing with the liquidation of index arbitrage positions 
and an ``international equalizing exemption'' are equally applicable 
to the NASD's short sale rule.
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B. Background of the Primary Market Maker Standards

    To ensure that market maker activities that provide liquidity and 
continuity to the market are not adversely constrained when the Rule is 
invoked, Rule 3350 provides an exemption for ``qualified'' Nasdaq 
market makers (i.e., market makers that meet the PMM standards). 
Presently, NASD Rule 4612 provides

[[Page 10954]]

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 Rule 3350 has been in effect, there have been three methods 
used to determine whether a market maker is eligible for the market 
maker exemption. Specifically, from September 4, 1994 through February 
1, 1996, Nasdaq market makers that maintained a quotation in a 
particular NNM security for 20 consecutive business days were exempt 
from the Rule for short sales in that security, provided the short 
sales were made in connection with bona fide market making activity 
(``the 20-day'' test). From February 1, 1996 until the February 14, 
1997, the ``20-day'' test was replaced with a four-part quantitative 
test known as the PMM standards.\5\
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    \5\ 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 that 35 percent of the time; (2) the market maker must maintain 
a spread no greater than 102 percent of the average dealer spread; 
(3) no more than 50 percent of the market maker's quotation updates 
may occur without being accompanied by a trade execution of at least 
one unit of trading; or (4) the market maker executes 1\1/2\ times 
its ``proportionate'' volume in the stock. If a PMM did not satisfy 
the threshold standards after a particular review period, the market 
maker lost its designation as a PMM (i.e., the ``P'' next to its 
market maker identification was removed). Market makers could 
requalify for designation as a PMM by satisfying the threshold 
standards in the next review period.
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    On February 14, 1997, the PMM standards were waived for all NNM 
securities due to the effects of the SEC's Order Handling Rules and 
corresponding NASD rule change and system modifications on the 
operation of the four quantitative standards.\6\ For example, among 
other effects, the requirement that market makers display customer 
limit orders adversely affected the ability of market makers to satisfy 
the ``102% Average Spread Standard''. Since that time all market makers 
have been designated as PMMs.
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    \6\ See Securities Exchange Act Release No. 38294 (February 17, 
1997), 62 FR 8289 (February 24, 1997).
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    In March 1998, Nasdaq proposed PMM standards that received 
substantially negative comments.\7\ In light of those comments, Nasdaq 
staff convened an advisory subcommittee to develop new PMM standards 
(``Subcommittee'') in August 1998. The Subcommittee met nine times and 
formulated new PMM standards. NASD/Nasdaq staff requested to meet with 
the Commission staff and the Subcommittee to receive informal feedback 
on the new PMM standards. This meeting occurred on December 9, 1998. 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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    \7\ See Securities Exchange Act Release No. 39189 (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 requested 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 recommended 
revisions, and concluded that the Commission's modified standards 
produced unfavorable results. Nasdaq requested that the Commission 
comment on the outcome of this test ``as we intend to communicate your 
comments to the Subcommittee in an effort to resume the process of 
developing new standards.'' \8\
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    \8\ See Letter, dated September 27, 1999 from John F. Malitzis, 
Assistant General Counsel, Nasdaq, to Richard Strasser, Assistant 
Director, Division of Market Regulation, SEC.
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    Nasdaq suspended development of PMM standards in late-1999 after 
the Commission signaled the securities industry that it is considering 
fundamental changes to Rule 10a-1 under the Act, changes that could 
affect the manner in which Nasdaq and the other markets regulate short 
sales. In October 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. Nasdaq believed that it would be inappropriate for Nasdaq 
to dramatically alter its regulation of short sales while the 
Commission is considering fundamentally changing Rule 10a-1 under the 
Act. At the request of the staff of the Division of Market Regulation, 
Nasdaq has resumed development of PMM standards and has been working 
with the Commission staff toward that goal.

C. Proposal To Extend the Short Sale Rule and Suspend the PMM Standards

    Nasdaq believes that it is in the best interest of investors to 
extend the short sale regulation pilot program. When the Commission 
approved the NASD's short sale rule on a pilot basis, it made specific 
findings that the Rule was consistent with sections 11A, 15A(b)(6), 
15A(b)(9), and 15A(b)(11) of the Act. Specifically, the Commission 
stated that, ``recognizing the potential for problems associated with 
short selling, the changing expectations of Nasdaq market participants 
and the competitive disparity between the exchange markets and the OTC 
market, the Commission believes that regulation of short selling of 
Nasdaq National Market securities is consistent with the Act.'' \9\ 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.'' \10\ 
Nasdaq believes the benefits that the Commission recognized when it 
first approved Rule 3350 apply with equal force today.
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    \9\ See Short Sale Rule Approval Order, supra note 3.
    \10\ Id.
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    Similarly, 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 for three reasons that 
were discovered only after the Order Handling Rules were 
implemented.\11\ Through late-1999, Nasdaq worked diligently to 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 were unable to establish satisfactory PMM 
standards. At the request of Commission staff, Nasdaq has begun 
developing PMM standards suitable to today's rapidly changing 
marketplace. 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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    \11\ 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 did not require it at that time; (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).

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[[Page 10955]]

D. Self-Regulatory Organization's Statement on Burden on Competition

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

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

    Comments were neither solicited nor received.

III. 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 the filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to the file number in the caption 
above and should be submitted by April 1, 2002.

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 December 15,2002 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) \12\ 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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    \12\ 15 U.S.C. 78o-3(b)(6).
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    The Commission finds that the continuation of the Short Sale Rule 
Pilot and the continued suspension of the PMM standards will maintain 
the status quo while the Commission is considering amending Rule 10a-1 
under the Act. This extension of the pilot and continued suspension of 
the PMM standards is subject to modification or revocation should the 
Commission amend Rule 10a-1 under the Act in a manner as to deem the 
extension or suspension unnecessary or in conflict with any adopted 
amendments.\13\
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    \13\ Absent an exemption, Rule 10a-1 under the Act would apply 
to Nasdaq on Commission approval of its 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 disrupt the Nasdaq market and 
confuse market participants to reintroduce the previous PMM standards 
while new PMM standards are being developed, and while the Commission 
considers amending Rule 10a-1 under the Act.
    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\14\ that Amendment No. 12 to the proposed rule change, SR-NASD-98-
26, which extends the NASD Short Sale Rule Pilot and suspends the PMM 
standards through December 15,2002, is approved on an accelerated 
basis.\15\
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    \14\ 15 U.S.C. 78s(b)(2).
    \15\ In approving Amendment No. 12, 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.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 02-5782 Filed 3-8-02; 8:45 am]
BILLING CODE 8010-01-U