[Federal Register Volume 67, Number 247 (Tuesday, December 24, 2002)]
[Notices]
[Pages 78537-78540]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32316]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47003; File No. SR-NASD-2002-59]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to a New Trade Report Modifier To Be Attached to Trades Whose Prices 
Exceed Certain Parameters

December 16, 2002.

I. Introduction

    On April 29, 2002, the National Association of Securities Dealers, 
Inc. (``NASD''), through its subsidiary, the Nasdaq Stock Market, Inc. 
(``Nasdaq''), filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a 
proposed rule change to create a new trade report modifier to be 
attached to trades whose prices exceed certain parameters. The proposed 
rule change was published for comment in the Federal Register on June 
14, 2002.\3\ The Commission received two comment letters regarding the 
proposal.\4\ Nasdaq responded to the commenters on November 30, 
2002.\5\

[[Page 78538]]

This order approves the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 46056 (June 10, 
2002), 67 FR 40975.
    \4\ See letter from Michael T. Dorsey, Senior Vice President, 
Director of Legislative and Regulatory Affairs, Knight Trading 
Group, to Commission, dated July 19, 2002 (``Knight Letter'') and 
letter from Cindy D. Foster, Vice President, Compliance, SunGard 
Trading Systems, to Jonathan G. Katz, Secretary, Commission, dated 
July 5, 2002 (``SunGard Letter'').
    \5\ See letter from Edward S. Knight, Executive Vice President, 
General Counsel, Nasdaq, to Jonathan G. Katz, Secretary, Commission, 
dated November 20, 2002 (responding to the comment letters received 
regarding the proposed rule change) (``Nasdaq Response Letter'').
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II. Background

    Trades reported to Nasdaq using the Automated Confirmation 
Transaction (``ACT'') Service are subject to procedures that identify 
trades executed at prices away from the current market. This process 
helps to ensure a fair and orderly market by preventing such trades 
from being disseminated to the public as last sale reports and/or by 
detecting trades that are reported at erroneous prices.
    The process differs slightly depending on whether a trade is 
executed using a Nasdaq system, which then automatically reports the 
trade to ACT (e.g., SelectNet), or the trade is submitted to ACT 
directly by a member. ACT rejects a trade that is submitted directly by 
a member if the price reported is outside established parameters. The 
member has an opportunity to resubmit the trade, which then will be 
subject to a different set of parameters. If the price is rejected 
after this second process, the member must call Nasdaq's MarketWatch 
Department to explain why the execution price was so far away from the 
current market. If the MarketWatch staff determines, on the basis of 
its conversation with the member, that there is an adequate rationale 
for such price, the staff would submit the trade to ACT.\6\ In such 
circumstances, the trade is normally being reported more than 90 
seconds after the trade was executed, and so the MarketWatch staff 
would report the trade with the .SLD modifier attached, which indicates 
a late trade report.\7\ Trades reported with a .SLD modifier are not 
included in the last sale calculation, but are included in the 
calculation of the high and low price for the security.
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    \6\ If the MarketWatch staff believes the price would be 
misleading to the market, the trade report would be submitted for 
clearing purposes only. Nasdaq believes that the number of instances 
in which the staff submits the report only for clearing purposes is 
very limited. The staff estimates that this occurs less than 10 
times a year. In addition, the staff can refer the transaction to 
NASD Regulation for further investigation.
    \7\ NASD rules require that trades be marked late, using the 
.SLD modifier, if they are reported more than 90 seconds after 
execution. See e.g., NASD Rule 4632.
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    Trades executed using Nasdaq systems, however, are subject to a 
different process due to the manner in which such trades are 
transmitted to ACT. The information passed to ACT from a Nasdaq system 
does not include the exact location, or terminal, within a member from 
which an order/execution emanates. Therefore, such trades are not 
subject to the second validation process which allows members to 
resubmit a trade report after it is rejected initially, since the exact 
location within a member to which a reject message can be sent is 
unknown. To compensate for this difference and to prevent such trades 
from being included in the last sale calculation, Nasdaq automatically 
attaches the .SLD modifier to any trades executed using a Nasdaq system 
whose prices exceed the initial parameters. Nasdaq also includes 
another modifier with these trade reports to indicate that the .SLD 
modifier has been attached by a Nasdaq system. This other modifier 
ensures that members would not be cited for late trade reporting on the 
basis of these trades.
    Nasdaq believes that the process described above has worked well in 
promoting a fair and orderly market because it has prevented certain 
anomalous prices from being included in the last sale calculation, 
which is used for many purposes including as a measure of the current 
market for a security; a determinant of the execution price of certain 
types of orders (e.g., market on close orders); and in determining 
index values. Nasdaq believes this process has helped provide more 
accurate information about the prices at which individual securities 
are trading, and for that matter, the market, or a segment of the 
market, if such securities are components of indices designed to 
measure the entire market or a particular segment.

III. Description of the Proposed Rule Change

    Under the proposed rule change, Nasdaq has identified a means of 
further improving the current process. Presently, the .SLD modifier 
prevents a trade report from being included in the last sale 
calculation, but it does not prevent such a report from being included 
in the calculation of the high and low price of a security. As such, a 
trade that has been excluded from the last sale calculation because its 
price exceeds the parameters, nevertheless, may set the high or low 
price for a security. Nasdaq believes that these trades should not 
establish the high or low price for a security because the high and low 
prices are also used as a measure of a security's performance, or could 
trigger certain actions.
    Therefore, Nasdaq proposed to create a new modifier that would 
exclude such trades from the high/low calculations, as well as the last 
sale calculation.\8\ This new modifier tentatively would be known as 
the ``Out of Range,'' or .OR , modifier and would be used instead of 
the .SLD modifier in the circumstances described above. Under the 
proposed rule change, members would not have the ability to append this 
modifier to trade reports. Nasdaq proposed that only Nasdaq staff and 
Nasdaq systems would append this modifier, and only for transactions in 
Nasdaq National Market System, SmallCap Market, and OTC Bulletin Board 
securities. For example, if a trade executed using SelectNet exceeds 
the price parameters, ACT automatically would append the .OR modifier 
to the trade report instead of the .SLD modifier. Similarly, the Nasdaq 
MarketWatch staff would append the .OR modifier to reports they submit. 
Nasdaq believes that the number of trade reports that contain the .SLD 
modifier either attached by ACT or the Nasdaq MarketWatch staff because 
the price is outside the parameters is very small.\9\ Nasdaq believes 
that the current proposal to create a new modifier would not affect 
this number since all that is being changed is the modifier that is 
being attached, and Nasdaq is not proposing to modify the price 
parameters.
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    \8\ Nasdaq recognizes that trades whose prices exceed the price 
parameters nevertheless may be valid transactions that the parties 
want to settle. As such, these trades are transmitted to The 
Depository Trust and Clearing Corporation for clearing and 
settlement.
    \9\ Nasdaq estimates that, on a daily average, less than .002% 
of trades executed on Nasdaq are reported with the .SLD modifier due 
to the trade being executed at a price that exceeds the price 
parameters.
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    Nasdaq recognized that, in certain circumstances, members may 
believe that they have executed a trade at a price that provides 
valuable information to the market, even though the price is outside 
the parameters. To ensure that such trades are not inappropriately 
withheld from the last sale and high/low calculations, members would be 
able to contact the Nasdaq MarketWatch staff to request that the .OR 
modifier be removed from the trade report. The member must explain the 
facts and circumstances surrounding the trade and why the price was 
reasonable, as measured against the market at the time of execution. If 
the MarketWatch staff agrees with the explanation, it can remove the 
.OR modifier from the trade report.
    The process for developing and implementing the modifier, which 
will include testing with market data vendors, will take several 
months. Nasdaq would continue to utilize the .SLD modifier in the 
manner described until the new modifier can be implemented.

[[Page 78539]]

IV. Summary of Comments and Nasdaq's Response

    As noted above, the Commission received two comment letters 
regarding the proposal.\10\ Nasdaq filed a response letter to address 
concerns raised by the commenters.\11\
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    \10\ See Knight Letter and SunGard Letter, supra note 4.
    \11\ See Nasdaq Response Letter, supra note 5.
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    One commenter commended Nasdaq for its proposal as promoting a fair 
and orderly market for Nasdaq stocks through improved transparency.\12\ 
This commenter supported the new modifier as a better indication of the 
trading activity then occurring in the marketplace. This commenter also 
suggested that Nasdaq create additional modifiers to address other 
unique execution scenarios, such as ``market on close'' orders. Nasdaq 
has indicated that it is presently examining several additional 
modifiers to address some of this commenter's concerns.\13\
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    \12\ See Knight Letter, supra note 4.
    \13\ See Nasdaq Response Letter, supra note 5.
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    The other commenter supported Nasdaq's proposal, but believed that 
the proposal should not be approved absent providing the same relief to 
members effecting transactions and transaction reports outside Nasdaq 
systems who experience similar problems with rejected trades.\14\ This 
commenter believed that the process of having a member telephone Nasdaq 
MarketWatch, after ACT has rejected a trade for the second time, in 
order to enter the transaction and then append the .SLD, delays a 
trader's operations and could harm the execution of pending customer 
orders, especially in today's highly automated marketplace.
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    \14\ See SunGard Letter, supra note 4.
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    This commenter offered two methods that it believed would result in 
better use of member, market, and regulatory resources and further 
prevent any degrading of the execution of customer orders. First, the 
commenter suggested that Nasdaq adopt a new modifier that would be 
appended to transaction reports that followed the second rejection of 
ACT. Under this method, Nasdaq and NASD surveillance could then monitor 
the proper use of such modifier and, on a post-report review process 
during the day, contact members about those transactions that appear 
problematic. Alternatively, this commenter suggested that Nasdaq 
systems be programmed to automatically append a .SLD modifier and a .OR 
as it would with transactions executed and reported by Nasdaq systems. 
Transaction reports which evidence a delay between the execution and 
transaction report or a delay of the re-submission could still be 
rejected, and Nasdaq could then review these transactions on post-
review basis.
    In response, Nasdaq stated that its proposal complies with Section 
15A(b)(6) of the Act \15\ to protect investors and the public interest 
because it would result in the public dissemination of information that 
reflects more accurately the current trading in a particular 
security.\16\ Furthermore, to the extent a security is a component of 
an index, the index would reflect more accurately the value of the 
market, or segment of market the index is designed to measure. Nasdaq 
also stated that this commenter offered no statutory analysis that 
would contradict Nasdaq's compliance with the Act and support the 
commenter's request to delay approval of the proposed rule change.
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    \15\ 15 U.S.C. 78o-3(b)(6).
    \16\ See Nasdaq Response Letter, supra notes.
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    Furthermore, with respect to the commenter's suggestions, Nasdaq 
does not believe that it would be feasible to permit members to use the 
.OR modifier. Under the proposal, trades reported with a .OR modifier 
would not be included in the calculation of last sale, high price and 
low price of the security. Nasdaq notes that these calculations provide 
investors and market participants with important information about the 
prices at which a security is trading, and generally promote 
transparency and accurate price discovery. Therefore, Nasdaq believes 
that this ability to append the .OR modifier and thus prevent it from 
being included in these calculations must be strictly controlled. If 
members were permitted to append the .OR modifier, Nasdaq notes that 
the potential for mistake or purposely misusing the .OR modifier to 
withhold certain trade prices would have to be considered. Moreover, 
there is presently no automated, real-time means to surveil members for 
the proper use of the .OR modifier. Nasdaq believes this surveillance 
would be necessary to ensure that mistakenly marked trades are 
identified and then publicly disseminated at, or near, the time of the 
trade, which is when the information is useful. This risk of error, 
misuse, and surveillance complications also would limit the usefulness 
of any other modifier Nasdaq would create for use by members that would 
operate in the same manner as the .OR modifier.
    Finally, Nasdaq states that it recognizes the challenges faced by 
members reporting trades in a fast-moving market and would continue to 
examine how it can address some of the concerns raised by this 
commenter. However, Nasdaq believes that the proposed solution should 
not create additional surveillance burdens for members and Nasdaq that 
outweigh the benefits of the proposal, or worse, that the benefits are 
exceeded by the potential for new areas of abuse. Nasdaq believes that 
developing a solution that strikes a balance among these factors is a 
lengthy process, and that delaying approval of its current proposal 
until a broader solution can be implemented would unnecessarily delay 
the benefits the .OR modifier currently can provide to investors and 
market participants.

V. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
association.\17\ In particular, the Commission finds that the proposal 
is consistent with Section 15A(b)(6) of the Act,\18\ in that it is 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in regulating, clearing, 
settling, processing information with respect to, and facilitating 
transactions in securities, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, and, 
in general, to protect investors and the public interest.
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    \17\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \18\ 15 U.S.C. 78o-3(b)(6).
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    Specifically, the Commission finds that Nasdaq's proposal appears 
to be a reasonable effort to improve the information disseminated to 
investors. The Commission believes that the proposed modifier may be a 
practical method in identifying with specificity trades that fail price 
validation and may prevent these trades from impacting the last sale 
calculation and the high and low price for the security. The Commission 
also believes that the corresponding result of the proposal may be 
trades, or other actions, executed at prices more reflective of the 
current market when the price of an execution, or other action, is 
based on the last sale, the high price or low price of a security, or 
the value of an index. Furthermore, the Commission believes that the 
proposal and Nasdaq's Response Letter appears to reasonably address the 
concerns raised by the commenters. Nasdaq has noted that it

[[Page 78540]]

would continue examining several additional modifiers and solutions to 
address other unique scenarios, such as ``market on close'' orders, and 
issues raised by the commenters.\19\
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    \19\ See Nasdaq Response Letter, supra notes.
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VI. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change is consistent with the requirements of the Act and rules 
and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\20\ that the proposed rule change (SR-NASD-2002-59) is approved.
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    \20\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\21\
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    \21\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-32316 Filed 12-23-02; 8:45 am]
BILLING CODE 8010-01-P