[Federal Register Volume 67, Number 247 (Tuesday, December 24, 2002)]
[Notices]
[Pages 78534-78537]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32315]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46999; File No. SR-NASD-98-26 Amendment No. 13]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of a Proposed Rule Change by National 
Association of Securities Dealers, Inc. Relating to Extension of Short 
Sale Rule and Continued Suspension of Primary Market Maker Standards 
Set Forth in NASD Rule 4612

December 13, 2002.
    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 December 13, 2002, 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 (``SEC'' or ``Commission'') the proposed rule change as 
described in Items I and II below, which Items have been prepared by 
the Nasdaq.
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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 is proposing to extend the pilot program of the NASD short 
sale rule from December 15, 2002 until June 15, 2003. 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 December 15, 2002 until June 15, 2003. Finally, Nasdaq is 
proposing to modify the method used to calculate the bid tick indicator 
used by members to determine whether a short sale is permitted. The 
text of the proposed rule change is as follows. Additions are in 
italics; deletions are bracketed.

NASD Rule 3350

    (a)
    (b)(1) With respect to trades executed on or reported to the ADF, 
[N]o 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 national best (inside) bid when the current national best 
(inside) bid is below the preceding national best (inside) bid in the 
security.
    (2) With respect to trades executed on or reported to Nasdaq, 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 displayed in the Nasdaq National Market 
Execution System when the current best (inside) bid is below the 
preceding best (inside) bid in the security.
    (b)-(k) No Change.
    (l) This section shall be in effect until June 15, 2003 [December 
15, 2002].

IM-3350. Short Sale Rule

    (a) No Change.
    (b) (1) With respect to trades executed on or reported to the ADF, 
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 national best (inside) bid when 
the current national best (inside) is below the proceeding national 
best (inside) bid in the security. NASD 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 at 
least $0.01 above the current inside bid when the current inside spread 
is $0.01 or greater. The last sale report for such a trade would, 
therefore, be above the inside bid by at least $0.01.
    (2) With respect to trades executed on or reported to Nasdaq, 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 displayed in the 
Nasdaq National Market Execution System when the current best (inside) 
bid is below the proceeding best (inside) bid in the security. Nasdaq 
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 at least $0.01 above the current inside 
bid when the current inside spread is $0.01 or greater. The last sale 
report for such a trade would, therefore, be above the inside bid by at 
least $0.01.
    (c) No Change.

[[Page 78535]]

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

1. 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 SEC Rule 10a-1. On June 29, 1994, the SEC approved the NASD's short 
sale rule (the ``Rule'') applicable to short sales \3\ in Nasdaq 
National Market (``NNM'') securities on an eighteen-month pilot basis 
through March 5, 1996.\4\ The NASD and the Commission have extended 
Rule 3350 numerous times, most recently, until December 15, 2002.
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    \3\ 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 reason of, the seller. To determine 
whether a sale is a short sale members must adhere to the definition 
of a ``sort sale'' contained in SEC Rule 3b-3, which is incorporated 
into Nasdaq's short sale rule by NASD Rule 3350(k)(1).
    \4\ See Securities Exchange Act Release No. 34277 (June 29, 199) 
(``Short Sale Rule Approval Order'').
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    The Rule 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. The Rule is in 
effect from 9:30 a.m. until 4 p.m. each trading day.
    To reduce the compliance burdens on its members, the Rule also 
incorporates seven exemptions contained in SEC Rule 10a-1 that are 
relevant to trading on Nasdaq.\5\ For example, in an effort to not 
constrain the legitimate hedging needs of options market makers, the 
Rule 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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    \5\ 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 bone fide hedge activities. In addition, the NASD 
has recognized that SEC staff interpretations to SEC Rule 10a-1 
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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2. 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 short 
sale rule is invoked, Rule 3350 provides an exemption for ``qualified'' 
market makers (i.e., market makers that meet the PMM standards). 
Presently, NASD Rule 4612 provides that a member registered as a market 
maker pursuant to NASD Rule 4611 may be deemed a PMM if that member 
meets certain threshold standards.
    Since the Rule has been in effect, Nasdaq has used three methods 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 without interruption 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.\6\
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    \6\ 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 not 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'' volumn 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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    On February 14, 1997, the PMM standards were waived for all NNM 
securities due to the impacts of the SEC's Order Handling Rules and 
corresponding NASD rule change and system modifications on the 
operation of the four quantitative standards.\7\ For example, among 
other impacts, 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 Nasdaq Market 
Makers have been deemed to be PMMs.
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    \7\ See Securities Exchange Act Release No. 34-38294 (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.\8\ 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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    \8\ See Securities Exchange Act Release 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

[[Page 78536]]

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.''\9\
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    \9\ See Letter, dated September 27, 1999 from John F. Malitzis, 
Assistant General Counsel, Nasdaq, to Richard Strasser, Assistant 
Director, Division of Market Regulations, SEC.
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    Nasdaq suspended development of PMM standards in late-1999 after 
the Commission signaled to the securities industry that it is 
considering fundamental changes to Rule 10a-1, changes that could 
impact 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 a 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. 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 towards that goal.
3. 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,\10\ 15A(b)(6), 
\11\ 15A(b)(9), \12\ and 15A(b)(11) \13\ 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.''\14\ 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.''\15\ The benefits that the Commission recognized when it 
first approved Rule 3350 apply with equal force today.
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    \10\ 15 U.S.C. 78k-1.
    \11\ 15 U.S.C. 78o-3(b)(6).
    \12\ 15 U.S.C. 78o-3(b)(9).
    \13\ 15 U.S.C. 78o-3(b)(11).
    \14\ See Short Sale Rule Approval Order, supra note 4.
    \15\ 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.\16\ 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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    \16\ 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).
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4. Proposal To Modify Bid Tick Indicator
    Nasdaq would like to modify the method it uses to calculate the 
last bid by having it refer to the ``Nasdaq Inside'' which is comprised 
of quotations from all participants in Nasdaq execution systems (e.g., 
SuperMontage), rather than referring to the National Best Bid and Offer 
(``NBBO''). As explained in more detail below, this change is necessary 
to maintain a fair and orderly market within Nasdaq.
    Historically, the NBBO only included Nasdaq market makers. In 1996, 
when the Chicago Stock Exchange began trading Nasdaq-listed issues, the 
NBBO and thus the Nasdaq bid-tick indicator became inclusive of other 
exchanges even though those exchanges are not subject to NASD Rule 
3350. Due to Chicago's participation in Nasdaq systems and their 
willingness to be linked into Nasdaq execution systems, the NBBO and 
the best bid and offer in Nasdaq were identical and there was no need 
to calculate a separate best bid for Nasdaq.
    Recently, several markets have begun trading Nasdaq securities 
pursuant to unlisted trading privileges. As a result, the NBBO is 
regularly different from the best bid that is accessible to Nasdaq 
market participants using Nasdaq execution systems. It is possible for 
a market without a short sale rule to affect the direction of the short 
sale arrow and accordingly have an impact on NASD members' short sale 
rule obligation in Nasdaq. This is inequitable since those markets 
currently impose no short selling obligations on their own members. 
Nasdaq has a compelling interest in resolving this issue in order to 
maintain a fair and orderly market within Nasdaq.
    The separation of Nasdaq's market systems from the systems it 
operates as the exclusive securities information processor for Nasdaq 
securities has enabled Nasdaq to calculate an independent Nasdaq Inside 
Price (``Nasdaq Inside'') and a last bid change based upon that Nasdaq 
Inside. The Nasdaq Inside is comprised of the best bid and offer quote 
from among all participants in the Nasdaq National Market Execution 
System (commonly known as ``SuperMontage'')--including all Nasdaq 
market participants as well as UTP exchanges that choose to participate 
in SuperMontage.
    Given this new capability and the presence of markets with no short 
sale rules, Nasdaq proposes to modify the short sale rule to refer to 
the Nasdaq Inside rather than the NBBO. It is damaging to the Nasdaq 
market and its participants to restrict the short sales of Nasdaq firms 
based upon the quotations of markets with no short sale rule. 
Additionally, this approach is similar to the approach that the SEC has 
adopted under the short sale rule that applies to the listed markets 
where a primary exchange (e.g., NYSE) is permitted to look only to 
transactions occurring on the primary exchange in determining its 
members' short sale rule obligations.
    Nasdaq currently has the ability to calculate and apply the Nasdaq-
based bid tick indicator to SuperMontage, and it will implement the 
proposed rule change immediately with respect to SuperMontage. With 
respect to trades executed outside Nasdaq execution systems and 
reported to Nasdaq, Nasdaq anticipates that it will have the ability to 
display the Nasdaq-based bid tick indicator to market participants on

[[Page 78537]]

January 13, 2003.\17\ Nasdaq participants will then have up to 90 
calendar days to transition from the NBBO-based bid tick to the Nasdaq-
based bid tick for trades executed outside Nasdaq execution systems and 
reported to Nasdaq. In the event that Nasdaq is unable to display the 
Nasdaq-based bid tick indicator at that time, Nasdaq will inform the 
Commission and delay implementation of this transition period. In 
addition, Nasdaq is working with the NASD to ensure a continued high 
level of short sale compliance during that transition period.
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    \17\ At that time, Nasdaq anticipates that the quotations of 
exchanges that lack a hard-wired linkage to Nasdaq will be removed 
from the Nasdaq Quotation Data Service (``NQDS'') data feed. Nasdaq 
is currently analyzing alternative methods for calculating the 
Nasdaq-based bid tick indicator in the event the removal from NQDS 
of quotations of exchanges that lack hard-wired linkages is delayed.
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B. 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.

C. 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 such 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 January 14, 2003.

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 until 
June 15, 2003, the suspension of the existing PMM standards until June 
15, 2003 and the modification of the method used to calculate the bid 
tick indicator used by members to determine the permissibility of a 
short sale are consistent with the requirements of the Act and the 
rules and regulations thereunder. In particular, the proposal is 
consistent with Section 15A(b)(6)\18\ 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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    \18\ 15 U.S.C. 78o-3(b)(6).
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    The Commission finds that the continuation of the Short Sale Rule 
Pilot, the continued suspension of the PMM standards, and the 
modification of the method used to calculate the bid tick indicator 
will maintain the status quo while the Commission is considering 
amending Rule 10a-1 under the Act. This extension of the pilot, 
continued suspension of the PMM standards, and modification of the bid 
tick test is subject to modification or revocation should the 
Commission amend Rule 10a-1 under the Act in a manner as to deem the 
extension, suspension, or modification unnecessary or in conflict with 
any adopted amendments.\19\
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    \19\ 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, the suspension of existing PMM standards, and 
the modification of the method used to calculate the bid tick indicator 
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,\20\ that Amendment No. 13 to the proposed rule change, SR-NASD-98-
26, which extends the NASD Short Sale Rule Pilot through June 15, 2003, 
suspends the PMM standards through June 15, 2003, and modifies the 
method used to calculate the bid tick indicator is approved on an 
accelerated basis.\21\
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    \20\ 15 U.S.C. 78s(b)(2).
    \21\ In approving Amendment No. 13, 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.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-32315 Filed 12-23-02; 8:45 am]
BILLING CODE 8010-01-P