[Federal Register Volume 68, Number 120 (Monday, June 23, 2003)]
[Notices]
[Pages 37183-37186]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-15773]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48035; File No. SR-NASD-98-26]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Amendment Nos. 14 and 15 to a Proposed 
Rule Change by the National Association of Securities Dealers, Inc. 
Relating to an Extension of the Short Sale Rule and Continued 
Suspension of the Primary Market Maker Standards Set Forth in NASD Rule 
4612

June 16, 2003.
    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 March 19, 1998, 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 (``Commission'') the proposed rule change as described in 
Items I and II below, which Items have been prepared by the Nasdaq. The 
NASD subsequently filed several amendments to the proposed rule change. 
On June 11, 2003, the NASD filed Amendment No. 14 to the proposed rule 
change.\3\ On June 16, 2003, the NASD filed Amendment No. 15 to the 
proposed rule change.\4\ The Commission is publishing this notice to 
solicit comments on the proposed rule change, as amended, and to grant 
accelerated approval of the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Mary M. Dunbar, Vice-President and Deputy 
General Counsel, NASD, to Kathy England, Assistant Director, 
Division of Market Regulation (``Division''), Commission, dated June 
10, 2003 (``Amendment No. 14'').
    \4\ See letter from Mary M. Dunbar, Vice-President and Deputy 
General Counsel, NASD, to Kathy England, Assistant Director, 
Division, Commission, dated June 10, 2003 (``Amendment No. 15'').
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Nasdaq is proposing to extend the pilot program of the NASD 
short sale rule from June 15, 2003, until December 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 June 15, 2003, until December 15, 2003. The text of 
the proposed rule change is below. Proposed new language is italicized; 
deletions are [bracketed]. NASD Rule 3350

[[Page 37184]]

    (a)-(k) No Change.
    (l) This section shall be in effect until [December 15, 2003 [June 
15, 2003]].
* * * * *

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

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The NASD 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. Purpose

Background and Description of the NASD's Short Sale Rule

    Section 10(a) of the Act \5\ gives the Commission plenary authority 
to regulate short sales of securities registered on a national 
securities exchange, as needed to protect investors. Although the 
Commission has regulated short sales since 1938, that regulation has 
been limited to short sales of exchange-listed securities. In 1992, 
Nasdaq, believing that short-sale regulation is important to the 
orderly operation of securities markets, proposed a short sale rule for 
trading of its National Market securities that incorporates the 
protections provided by Rule 10a-1 of the Act.\6\ On June 29, 1994, the 
Commission approved the NASD's short sale rule (the ``Rule'') 
applicable to short sales \7\ in Nasdaq National Market (``NNM'') 
securities on an eighteen-month pilot basis through March 5, 1996.\8\ 
The NASD and the Commission have extended NASD Rule 3350 numerous 
times, most recently, until June 15, 2003.
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    \5\ 15 U.S.C. 78j.
    \6\ 17 CFR 240.10a-1.
    \7\ 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 of the Act, 
which is incorporated into Nasdaq's short sale rule by NASD Rule 
3350(k)(1).
    \8\ See Securities Exchange Act Release No. 34277 (June 29, 
1994), 59 FR 34885 (July 7, 1994), (SR-NASD-92-12), (``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 Rule 10a-1 of the Act,\9\ 
and other exemptions that are relevant to trading on Nasdaq.\10\ 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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    \9\ 17 CFR 240.10a-1.
    \10\ See NASD Rule 3350(c)(2)-(8). The Rule also provides that a 
member not currently registered as a Nasdaq market maker in a 
security 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 Commission staff interpretations to Rule 10a-1 
of 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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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, NASD Rule 3350 provides an exemption for 
``qualified'' market makers (i.e., market makers that meet the PMM 
standards). 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.\11\
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    \11\ 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 or trading; or (4) the market maker executes 1\1/2\ times 
its ``proportionate'' volume in the stock. If a PMM did not satisfy 
the threshold standards after a particular review period, the market 
maker lost its designation as a PMM (i.e. the ``P'' next to its 
market maker identification was removed). Market makers could re-
qualify for designation as a PMM by satisfying the threshold 
standards in the next review period.
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    On February 14, 1997, the PMM standards were waived for all NNM 
securities due to the impacts of the Commission's Order Handling Rules 
and corresponding NASD rule change and system modifications on the 
operation of the four quantitative standards.\12\ 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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    \12\ See Securities Exchange Act Release No. 38294 (February 17, 
1997), 62 FR 8289 (February 24, 1997), (SR-NASD-97-07).
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    In March 1998, Nasdaq proposed PMM standards that received 
substantially negative comments.\13\ 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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    \13\ See Securities Exchange Act Release No. 39819 (March 30, 
1998), 63 FR 16841 (April 6, 1998), (SR-NASD-97-73).
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    On July 29, 1999, members of the Nasdaq staff conducted a 
conference

[[Page 37185]]

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.'' \14\
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    \14\ See Letter, dated September 27, 1999 from John F. Malitzis, 
Assistant General Counsel, Nasdaq, to Richard Strasser, Assistant 
Director, Division of Market Regulation, Commission.
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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 of the Act,\15\ 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 of the Act.\16\ At the request of the Division, Nasdaq has 
resumed development of PMM standards and has been working with the 
Commission staff towards that goal.
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    \15\ 17 CFR 240.10a-1.
    \16\ 17 CFR 240.10a-1.
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    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,\17\ 
15A(b)(6),\18\ 15A(b)(9),\19\ and 15A(b)(11) \20\ 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.'' \21\ 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.'' \22\ The benefits that the Commission recognized 
when it first approved NASD Rule 3350 apply with equal force today.
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    \17\ 15 U.S.C. 78k-1.
    \18\ 15 U.S.C. 78o-3.
    \19\ Id.
    \20\ Id.
    \21\ See Short Sale Rule Approval Order, supra note 8.
    \22\ 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.\23\ 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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    \23\ 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 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 NASD Rule 
4612(g)(2)(B).
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2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of section 15A of the Act,\24\ in general and with 
section 15A(b)(6) of the Act,\25\ in particular, in that it is designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, remove impediments to a free 
and open market and a national market system, and, in general, to 
protect investors and the public interest.
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    \24\ 15 U.S.C. 78o-3.
    \25\ 15 U.S.C. 78o-3(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Nasdaq does not believe that the proposed rule change will 
impose any burden on competition.

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

    The Nasdaq neither solicited nor received written comments with 
respect to the proposed rule change.

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 file number SR-NASD-98-26 and 
should be submitted by July 14, 2003.

IV. Commission's Findings and Order Granting Accelerated Approval of 
Proposed Rule Change as a Pilot Program

    After careful consideration, the Commission finds, for the reasons 
set forth below, that the extension of the Short Sale Rule Pilot until 
December 15, 2003, and the suspension of the existing PMM standards 
until December 15, 2003, are consistent with the requirements of the 
Act and the rules and regulations thereunder. In particular, the 
extension is consistent

[[Page 37186]]

with section 15A(b)(6) \26\ 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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    \26\ 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 
of the Act.\27\ 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 of the Act \28\ in a manner as to deem the 
extension or suspension unnecessary or in conflict with any adopted 
amendments.\29\
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    \27\ 17 CFR 240.10a-1.
    \28\ Id.
    \29\ Absent an exemption, Rule 10a-1 under the Act would apply 
to Nasdaq on Commission approval of its exchange registration.
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    Accordingly, 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 of the Act.\30\
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    \30\ 17 CFR 240.10a-1.
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\31\ that Amendment Nos. 14 and 15 to the proposed rule change, SR-
NASD-98-26, which extends the NASD Short Sale Rule Pilot through 
December 15, 2003, and suspends the PMM standards through December 15, 
2003, is approved on an accelerated basis.\32\
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    \31\ 15 U.S.C. 78s(b)(2).
    \32\ In approving Amendment Nos. 14 and 15, 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.\33\
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    \33\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary
[FR Doc. 03-15773 Filed 6-20-03; 8:45 am]
BILLING CODE 8010-01-P