[Federal Register Volume 67, Number 204 (Tuesday, October 22, 2002)]
[Notices]
[Pages 64944-64948]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-26781]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46663; File No. SR-NASD-2002-40]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 2 and 3 to Proposed Rule Change, by NASD, Relating to 
NASD Rules 1022, 1032, 2210, 3010, 3370, IM-1022-1, and IM-1022-2 and 
New Rules 2865 and IM-2210-7

October 15, 2002.

I. Introduction

    On March 22, 2002, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Exchange Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposal to adopt new rules and amend existing rules 
to provide for the trading of security futures. Notice of the proposed 
rule change and Amendment No. 1 thereto was published for comment in 
the Federal Register on July 18, 2002.\3\ The Commission received two 
comment letters regarding the proposed rule change.\4\ On September 5, 
2002, NASD filed Amendment No. 2 to the proposed rule change.\5\ On 
September 26, 2002, NASD filed Amendment No. 3 to the proposed rule 
change.\6\ This order approves the proposed rule change, accelerates 
approval of Amendment Nos. 2 and 3, and solicits comments from 
interested persons on those amendments.
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    \1\ 15 U.S.C. 78s(b)(1)
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 46186 (July 11, 2002), 
67 FR 47412.
    \4\ Letter from Jonathan Barton, Chairman, Steering Committee on 
Securities Futures of the Futures Industry Association and the 
Securities Industry Association, Inc. (``SIA/FIA Committee''), to 
Jonathan Katz, Secretary, Commission, dated August 9, 2002; Letter 
from Richard G. DuFour, Executive Vice President, Chicago Board 
Options Exchange (``CBOE''), to Jonathan Katz, Secretary, 
Commission, dated August 21, 2002.
    \5\ See letter from Gary L. Goldsholle, Associate General 
Counsel, NASD, to Katherine England, Assistant Director, Division of 
Market Regulation, Commission, dated September 5, 2002.
    \6\ See letter from Gary L. Goldsholle, Associate General 
Counsel, NASD, to Katherine England, Assistant Director, Division of 
Market Regulation, Commission, dated September 26, 2002.
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II. Description of the Proposed Rule Change

    The rule change modifies existing NASD rules and adopts new rules 
to accommodate the trading of security futures (i.e., futures on 
individual stocks and narrow-based stock indices).\7\ A description of 
the rule change follows.
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    \7\ See e.g., Section 3(a)(55) of the Act, 15 U.S.C. 78c(a)(55).
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A. New Security Futures Rule 2865

    Under the rule change, NASD is adopting Rule 2865 as its security 
futures rule. The new rule is based on NASD's existing options rule, 
Rule 2860. Some aspects of Rule 2865 are substantially similar to 
corresponding provisions of Rule 2860. However, several provisions of 
Rule 2865 are tailored specifically to security futures.
Delivery of Security Futures Risk Disclosure Statement
    Rule 2865(b)(1) will require every member to deliver the security 
futures risk disclosure statement to each customer at or prior to the 
time the customer's account is approved for trading security futures. 
The disclosure statement will discuss the risks of security futures, 
how they trade, margin, effects of leverage, settlement procedures, 
customer account protections, and the tax consequences of trading 
security futures.\8\
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    \8\ See Securities Exchange Act Release No. 46612, (October 7, 
2002) (file No. SR-NASD-2002-128).
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Discretionary Accounts
    Rule 2865(b)(18) establishes discretionary account procedures for 
security futures that are similar to those for options. These 
procedures will require that the written authorization of the customer 
required by NASD Rule 2510 specifically authorize security futures 
trading in the account. Under the rule change, a discretionary account, 
even if it is permitted to trade options, cannot trade security futures 
unless a new written discretionary account authorization specifically 
authorizing security futures trading is on file.
Statements of Account
    Rule 2865(b)(15) will require members to deliver a customer account 
statement no less frequently than each month where there has been an 
entry during the preceding month with respect to a security futures 
contract, and quarterly to all customers that have

[[Page 64945]]

an open security futures position or money balance. The statement must 
provide specific information regarding the customer's position, 
including the market price, mark-to-market value and nominal value of 
each security futures position as well as the mark-to-market price and 
market value of other security positions, the total value of all 
positions, the outstanding debit or credit balance, and account 
equity.\9\
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    \9\ Amendment No. 2 modified the originally proposed wording of 
these requirements.
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Opening of Accounts
    Rule 2865(b)(16) establishes specific procedures for members to 
follow in order to approve a customer account to trade security 
futures. These procedures include review by an appropriately qualified 
principal (a Registered Options and Security Futures Principal or a 
Limited Principal--General Securities Sales Supervisor), specific 
guidance as to information the member must ask the customer to provide, 
and a requirement for the member to furnish the security futures risk 
disclosure statement at or before the time the member accepts an order 
from the customer to purchase or sell a security future.
Suitability
    Rule 2865(b)(19) establishes a heightened suitability standard for 
security futures, similar to that required for options. The rule 
provides that if an associated person recommends a security futures 
transaction, the associated person must have a reasonable basis to 
believe ``that the customer has such knowledge and experience in 
financial matters that the customer may reasonably be expected to be 
capable of evaluating the risks of the recommended transaction, and is 
financially able to bear the risks of the recommended position in the 
security future.'' This standard would extend to trading strategies as 
well as individual trades.
Trading Ahead
    Rule 2865(b)(25) will require members to exercise due care to avoid 
trading ahead of customer orders in the same security futures contract. 
A member must exercise this due care when the member has gained 
knowledge of or reasonably should have gained knowledge of the 
customer's order prior to transmitting the member's order for a 
proprietary account or in any account in which the member or an 
associated person has an interest.
Security Futures Transactions and Reports by Market Makers in Listed 
Securities
    Rule 2865(b)(24) will require members that are off-board market 
makers in securities listed on a national securities exchange to 
regularly report security futures transactions involving 50 or more 
contracts on such listed securities that are for the benefit of the 
member or are for the benefit of certain associated persons of the 
member.

B. Front Running Policy

    NASD will amend its front running policy, IM-2110-3, to apply to 
security futures in the same manner that it applies to options. Under 
the rule change, when a member has material, non-public market 
information concerning an imminent block transaction in a stock, the 
member will not be able to trade the security future overlying that 
stock in its proprietary account, other accounts in which it has an 
interest, or discretionary accounts. Once the material, non-public 
market information has been made publicly available, however, the 
restrictions would no longer apply.

C. Qualifications, Registration and Supervision of Registered Persons

1. Registration Procedures and Examinations
    The securities industry has a wide array of qualification 
examinations that registered persons can take to qualify to engage in 
various aspects of the securities business. To accommodate the 
introduction of security futures, the rule change modifies several NASD 
registration categories, and permits the ``grandfathering'' of persons 
already registered in those categories. The following registration 
categories will be broadened to include security futures activities:
    [sbull] Registered Options Principal (Series 4), which becomes 
Registered Options and Security Futures Principal.
    [sbull] Limited Principal--General Securities Sales Supervisor 
(Series 9/10).
    [sbull] General Securities Representative (Series 7).
    [sbull] Limited Representative--Options (Series 42), which becomes 
Limited Representative--Options and Security Futures.
    NASD is working with other self-regulatory organizations to develop 
new and revised qualification examinations that will test applicants on 
topics related to security futures. NASD anticipates that new and 
revised qualification examinations for the associated registration 
categories will be completed six months after retail trading in 
security futures begins. For registered representatives wishing to 
engage in a security futures business, a new Series 43 examination will 
be offered. Thereafter, new applicants may choose to take only the 
Series 7, or, if they wish to engage in security futures business, both 
the Series 7 and Series 43. Further, because some existing registrants 
may actually wish to take revised qualification examinations, NASD is 
modifying its registration categories to allow it to accept other 
examinations that address security futures, such as the revised Series 
3 (containing questions on security futures).
    For persons who are or become registered in one of these categories 
before the implementation of new examinations, the rule change 
institutes a firm-element continuing education requirement. Under the 
rule change, NASD will require each such person to complete this 
program prior to conducting a business in security futures. Thus, these 
registrants may be ``grandfathered'' so that they will not have to 
retake any expanded examinations. These grandfathering procedures will 
lapse on December 31, 2006. After that date, registrants who have 
passed an examination that does not include security futures, and who 
have not already completed this firm-element continuing education 
program, will be required to retake an examination to function in a 
registration category with respect to security futures.
2. Other Personnel--Related Changes
    The rule change amends other NASD rules relating to the hiring, 
registration, and supervision of personnel. NASD is amending Rule 
1060(a) to exempt from registration with NASD persons associated with a 
member whose functions are related solely and exclusively to 
transactions in security futures, provided that they are registered 
with a registered futures association. In addition, NASD is modifying 
Rule 3010(e) to require members, when reviewing a job applicant's 
employment experience that includes experience with a broker-dealer 
registered pursuant to Section 15(b)(11) of the Act,\10\ to review a 
copy of Commodity Futures Trading Commission (``CFTC'') Form 8-T: 
Notice of Termination of Associated Person, NFA Associate, Branch 
Office

[[Page 64946]]

Manager, Designated Supervisor or Principal.\11\
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    \10\ 15 U.S.C. 78o(b)(11).
    \11\ NASD also is modifying NASD Rule 3010(e) to reflect that 
members may now review Form U-5s through an internet connection to 
the WebCRD system, rather than by otherwise obtaining actual copies 
of such documents.
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    The rule change amends Rule 3050, which requires associated persons 
who seek to open accounts or place securities orders with an NASD firm 
that is not their employer to notify both their employer firm and the 
executing firm before doing so. Specifically, NASD is broadening the 
scope of this rule to cover accounts with broker-dealers registered 
pursuant to Section 15(b)(11) of the Act.
    NASD also is modifying its ``Taping Rule'' (Rule 3010(b)(2)), which 
requires members who employ certain amounts of personnel who have 
worked at disciplined firms to adopt special supervisory procedures, 
including the tape-recording of all telephone calls with customers or 
prospective customers. The rule change broadens the scope of the Taping 
Rule to include Futures Commission Merchants (``FCMs'') and Introducing 
Brokers (``IBs'') within the group of intermediaries that can 
potentially meet the definition of a ``disciplined firm.'' The rule 
change borrows NFA's definition of a disciplined firm.

D. Advertising Rule for Security Futures

    Under the rule change, NASD will regulate communications with the 
public regarding security futures through amendments to its existing 
rules and the addition of Interpretive Material to Rule 2210 (the 
``Advertising Rule''). Among other things, the rule change specifies 
that advertisements and sales literature concerning security futures 
must be approved by ``a principal qualified to supervise security 
futures activities.'' \12\ A General Securities Principal (Series 24) 
would not be authorized to approve advertisements and sales literature 
concerning security futures.
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    \12\ NASD Rule 2210(b)(1). As originally proposed, this approval 
would have been required to be performed by a Registered Options and 
Security Futures Principal. In Amendment No. 2, however, NASD 
altered this by supplying the quoted language.
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    The rule change establishes a pre-use filing requirement for 
advertisements concerning security futures. In general, a member will 
be required to file a security futures advertisement with NASD's 
Advertising/Investment Companies Regulation Department at least 10 days 
before its use. The Department will review the advertisement and then 
either approve it, disapprove it, or specify changes that the firm must 
make before using the communication.
    While communications regarding security futures will be subject to 
the general requirements of NASD's advertising rule, the rule change 
also establishes several specific requirements on the content of 
communications regarding security futures. IM-2210-7(d) will require 
that any statement referring to the potential advantages of security 
futures be balanced with a statement, in the same degree of 
specificity, of the corresponding risks. All communications regarding 
security futures must include a warning that they are not suitable for 
all investors. In addition, all such communications must state that, 
upon request, the firm will provide documents that support any claims, 
comparisons, recommendations, statistics, or other technical data used 
in the communication. Moreover, communications that are not accompanied 
or preceded by the security futures risk disclosure statement may not 
contain statements of historical performance or projections, must be 
limited to general descriptions of security futures, and must contain 
contact information for obtaining a copy of the disclosure statement.

E. Short Sales

    Transactions in security futures are excluded from the short sale 
provisions of Section 10(a) of the Act.\13\ To harmonize NASD's rules 
with Section 10(a), NASD is amending the affirmative determination 
provisions of NASD Rule 3370 to exclude transactions in security 
futures from the application of the rule. In addition, NASD is amending 
the definition of ``bona fide fully hedged'' positions to include 
certain long single stock futures positions in connection with short 
positions in the underlying stock.
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    \13\ 15 U.S.C. 78j(a)(2).
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III. Summary of Comments and Response to Comments

    As noted above, the Commission received two comment letters 
regarding the proposed rule change.\14\ The SIA/FIA Committee expressed 
the view that, to the greatest extent possible, NASD should make 
proposed Rule 2865 a comprehensive stand alone rule for security 
futures products. The SIA/FIA Committee also noted its concern with 
respect to cases where an NASD member may also be a member of an 
exchange trading security futures. In such an instance of dual 
membership, the SIA/FIA Committee argued that the NASD's rules should 
make clear that the particular exchange's trading rules would take 
precedence with respect to orders executed on that exchange. In 
addition, the SIA/FIA Committee urged the NASD to defer to NFA 
qualifications and rules to the greatest extent possible for dual 
registrant firms for customers whose transactions will be booked in 
futures accounts.
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    \14\ See n. 4, supra.
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    The SIA/FIA Committee also detailed five specific areas of concern. 
First, the SIA/FIA Committee expressed concern with the proposed 
amendments to NASD Rule 1022, which sets out the various principal 
registration types and would establish the qualifying examinations that 
must be taken to attain those principal registration types with respect 
to security futures. The SIA/FIA Committee asserted that the proposed 
NASD rule would apply examination requirements too broadly across 
varying types of securities futures activities and is ambiguous as to 
the application of examination requirements to other activities.
    Second, the SIA/FIA Committee maintained that the intermarket 
front-running interpretation now applicable to trading in the options 
and cash markets should not be extended to security futures due to the 
unique nature of security futures trading. In addition, the SIA/FIA 
Committee urged that actual knowledge of the processing of a block 
trade should be a component of a front-running violation.
    Third, the SIA/FIA Committee expressed the view that further 
harmonization between the NASD and NFA rules was necessary with regard 
to the proposed communications rules. The SIA/FIA Committee stated that 
there should be no material regulatory differences in what FCMs on the 
one hand and broker-dealers, on the other hand, can say to current or 
prospective customers and when and how it can be said.
    Fourth, the SIA/FIA Committee articulated a number of concerns 
regarding proposed NASD Rule 2865. The SIA/FIA Committee argued that 
Rule 2865(b)(12), dealing with confirmations, should be deleted due to 
the Commission's final action with respect to SEC Rule 10b-10.\15\ In 
addition, the SIA/FIA Committee stated that language in proposed Rule 
2865(b)(15), regarding account statements, indicating that security 
futures have a market value should be deleted, because security futures 
will have a mark-to-market price, rather than a market value as such. 
The SIA/FIA

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Committee also suggested deleting language in the same provision 
regarding margin computation. In Rule 2865(b)(16)(B) and (D), the SIA/
FIA Committee recommended conforming the language to more closely match 
the analogous NFA rule on minimum net equity requirements. The SIA/FIA 
Committee also noted that it does not believe that there should be a 
requirement for customers to acknowledge receipt of the risk disclosure 
statement for options, and therefore that a conforming amendment should 
be made in proposed Rule 2260(b)(16)(D). The SIA/FIA Committee also 
expressed concern with regard to proposed Rule 2865(b)(17), and 
requested that the NASD clarify that, with respect to customer 
complaints, the maintenance of a separate record for security futures 
complaints is unnecessary. The SIA/FIA Committee requested that NASD 
incorporate IM-2310-3, regarding suitability obligations to 
institutional customers, into Rule 2865(b)(19), either directly or by 
reference. The SIA/FIA Committee also asserted that the audit trail 
requirements of proposed Rule 2865 would impose undue burdens on the 
industry and should be eliminated in favor of internal surveillance 
tools. Finally, with respect to Rule 2865(b)(24), the SIA/FIA Committee 
recommended that the NASD adopt a conforming Interpretive Memorandum 
regarding the prohibition against trading ahead of customer orders when 
the member is aware or reasonably should be aware of such order.
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    \15\ See Securities Exchange Act Release No. 46471 (September 6, 
2002), 67 FR 58302 (September 13, 2002).
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    Fifth, the SIA/FIA Committee requested that NASD modify its 
proposed amendments to Rule 3370. Specifically, the Committee suggested 
rule language that would apply the affirmative determination obligation 
of the Rule to members that hold a security futures position unless the 
member had assurances that the position would be liquidated prior to 
expiration.
    In its comment letter, CBOE raised three concerns about the 
proposed rule change with regard to discretionary accounts. First, the 
CBOE stated its belief that the proposed NASD rule does not 
sufficiently mirror the comparable CBOE and New York Stock Exchange, 
Inc. (``NYSE'') rules regarding the review and acceptance of security 
futures discretionary accounts by principals qualified to supervise 
security futures activities and specifically delegated the authority to 
review and accept such discretionary accounts.
    In addition, CBOE expressed concern about the confirmations 
provision in the proposed rule change, which required that initial and 
maintenance margin be disclosed on the confirmation, but did not 
require that the purchase price of such transaction be included. CBOE 
stated that the purpose of the confirmation is to disclose to the 
customer the terms of the transaction, not the required margin.
    Finally, CBOE expressed concern with the characterization of 
security futures products having an equity value under proposed Rule 
2865(b)(15)(B). The CBOE stated its belief that the rule should clarify 
that security futures contracts, aside from their accrued profit or 
loss, have zero value for equity purposes.
    The NASD responded to the commenters in Amendment No. 2. NASD 
stated that it believed that several of the SIA/FIA Committee's 
comments would have eased restrictive aspects of the proposed rules. 
NASD stated further that it believed that the proposed rule change 
would further the goal of investor protection by using the NASD's 
options rules as the basis for the majority of its security futures 
rules.
    However, NASD did agree to make several changes in response to the 
commenters' suggestions. Specifically, NASD responded to the 
commenters' concern with respect to confirmations by eliminating NASD's 
proposed confirmation requirement. The NASD also addressed the SIA/FIA 
Committee's comment with respect to Rule 2865(b)(15)(B) by eliminating 
the provision, which pertained to margin equity requirements.
    In addition, NASD noted in Amendment No. 2 that it did not agree to 
make the changes requested by CBOE regarding discretionary accounts. 
NASD stated that it would consider amending both its options and 
security futures rules once CBOE's proposed rule change regarding 
discretionary accounts has been approved. In addition, the NASD amended 
the account statement requirement to provide that the market price, 
mark-to-market value and nominal value of security futures must be 
disclosed on customer account statements.
    Finally, NASD stated that it intends to clarify the following 
issues through a Notice to Members: The application of the NASD's best 
execution rule, Rule 2320, to security futures; that the Series 55 
qualification will not be needed for associated persons to trade 
security futures; that NASD intends to recognize the Series 30 
qualification as acceptable for an associated person in a firm 
registered as a broker/dealer and either a futures commission merchant 
or introducing broker to supervise security futures; that the 
suitability obligations to institutional customers interpretation, IM-
2310-3, will apply to security futures; and when the trading ahead of 
customer orders requirement, Rule 2865(b)(25), will apply.

IV. Discussion

    After careful review, and consideration of all comments received, 
the Commission finds that the proposed rule change is consistent with 
the Act and the rules and regulations thereunder applicable to a 
national securities association.\16\ In particular, the Commission 
finds that the proposal is consistent with the requirements of Section 
15A(b)(6) of the Act,\17\ which requires, among other things, that the 
rules of a registered national securities association be designed to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade and, in general, to protect investors 
and the public interest.
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    \16\ In approving the proposal, the Commission has considered 
the rule's impact on efficiency, competition, and capital formation. 
15 U.S.C. 78c(f).
    \17\ 15 U.S.C. 78o(b)(6).
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    The Commission notes that the rules NASD has proposed for security 
futures are modeled after its rules governing options. The system of 
joint regulation of security futures established by the Commodity 
Futures Modernization Act is intended to prevent competitive advantages 
from arising solely out of differences between securities regulation 
and futures regulation. In addition, NASD's rules reflect the risks to 
investors that apply specifically to options transactions.
    The Commission believes that the rule change should promote just 
and equitable principles of trade by preventing regulatory disparities 
from occurring between options and security futures. In addition, the 
Commission believes that by recognizing the specific risks of security 
futures, the rule changes should protect investors that trade security 
futures.

V. Amendment Nos. 2 and 3

    The Commission finds good cause to approve Amendment Nos. 2 and 3 
to the proposed rule change prior to the thirtieth day after the date 
of publication of notice thereof in the Federal Register.
    In Amendment No. 2, NASD made a series of changes to the originally 
proposed rule text that clarified or corrected the text without 
changing the substance of requirements. In Amendment No. 3, NASD 
amended its filing to state that NASD would make the rule changes 
effective on the date approved by the Commission.

[[Page 64948]]

    The Commission believes that these amendments merely serve to 
clarify certain provisions of the proposed rules, and make technical 
changes that do not raise substantive issues. Accordingly, the 
Commission believes that there is good cause, consistent with Section 
19(b) of the Act,\18\ to approve Amendment Nos. 2 and 3 on an 
accelerated basis.
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    \18\ 15 U.S.C. 78s(b).
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VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 2 and 3, including whether they are 
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 at the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the Exchange. All 
submissions should refer to File No. SR-NASD-2002-40 and should be 
submitted by November 12, 2002.

VII. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change, as amended, is consistent with the requirements of the Act 
and the rules and regulations thereunder.
    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\19\ that the proposed rule change (SR-NASD-2002-40), as amended, 
is approved.
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    \19\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-26781 Filed 10-21-02; 8:45 am]
BILLING CODE 8010-01-P