[Federal Register Volume 70, Number 122 (Monday, June 27, 2005)]
[Notices]
[Pages 36985-36992]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3329]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51890; File No. SR-NASD-00-23]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
2 to Proposed Rule Change by National Association of Securities 
Dealers, Inc. Relating to Amendments To Order Audit Trail System Rules

June 21, 2005.
    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 April 19, 2000, the National Association of Securities Dealers, Inc. 
(``NASD'') filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') a proposed rule change relating to its Order Audit 
Trail System (``OATS''). On September 5, 2000, NASD filed Amendment No. 
1 to the proposed rule change. The proposed rule change, as amended by 
Amendment No. 1, was published for comment in the Federal Register on 
October 3, 2000.\3\ The Commission received 13 comment letters from 12 
commenters in response to the publication.\4\
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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. 43344 (September 26, 
2000), 65 FR 59038.
    \4\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Harold M. Golz, Krys Boyle Freedman & Sawyer, P.C. on behalf of 
Rocky Mountain Securities & Investments, Inc., dated October 20, 
2000; Mitchell M. Almy, President, Mitchell Securities Corporation 
of Oregon, dated October 20, 2000; Joanne Ferrari, Compliance 
Manager, Weeden & Co., dated October 23, 2000; Bonnie K. Wachtel, 
CEO and Wendie L. Wachtel, COO, Wachtel & Co., Inc., dated October 
24, 2000 and March 26, 2001; Laurence Storch, Storch & Brenner, LLP, 
dated October 24, 2000; Allen Thomas, Vice President, A.G. Edwards & 
Sons, Inc., dated October 24, 2000; Stuart J. Kaswell, Senior Vice 
President and General Counsel, Securities Industry Association, Ad 
Hoc Committee, dated October 24, 2000; W. Leo McBlain, Chairman and 
Thomas J. Jordan, Executive Director, Financial Information Forum, 
dated October 24, 2000; Thomas F. Guinan, Senior Vice President, 
Pershing Division of Donaldson, Lufkin & Jenrette Securities 
Corporation, dated October, 24, 2000; Paul A Merolla, Senior Vice 
President and General Counsel, Instinet Corporation, dated October 
25, 2000; Richard E. Schell, Vice President and Assistant General 
Counsel, First Options of Chicago, dated October 25, 2000; Jill W. 
Ostergaard, Vice President, Morgan Stanley Dean Witter, dated 
October 27, 2000.

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[[Page 36986]]

    On June 10, 2005, NASD filed Amendment No. 2 to the proposed rule 
change. Amendment No. 2 is described in Items I, II, and III below, 
which Items have been prepared by NASD. The Commission is publishing 
this notice to solicit comments on Amendment No. 2 to the proposed rule 
change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is proposing amendments to its OATS rules. The text of the 
proposed rule change follows. Proposed new language is in italics; 
proposed deletions are in brackets.
* * * * *

6951. Definitions

    For purposes of Rules 6950 through 6957:
    (a) Through (m) No Change.
    (n) ``Reporting Member'' shall mean a member that receives or 
originates an order and has an obligation to record and report 
information under Rules 6954 and 6955. A member shall not be considered 
a Reporting Member in connection with an order, if the following 
conditions are met:
    (1) The member engages in a non-discretionary order routing 
process, pursuant to which it immediately routes, by electronic or 
other means, all of its orders to a single receiving Reporting Member;
    (2) The member does not direct and does not maintain control over 
subsequent routing or execution by the receiving Reporting Member;
    (3) The receiving Reporting Member records and reports all 
information required under Rules 6954 and 6955 with respect to the 
order; and
    (4) The member has a written agreement with the receiving Reporting 
Member specifying the respective functions and responsibilities of each 
party to effect full compliance with the requirements of Rules 6954 and 
6955.
* * * * *

6954. Recording of Order Information

    (a) No Change.
    (b) Order Origination and Receipt.
    Unless otherwise indicated, the following order information must be 
recorded under this Rule when an order is received or originated. For 
purposes of this Rule, the order origination or receipt time is the 
time the order is received from the customer.
    (1) through (18) No Change.
    (c) Order Transmittal.
    Order information required to be recorded under this Rule when an 
order is transmitted includes the following.
    (1) When a Reporting Member transmits an order to a[nother] 
department within the member, [other than to the trading department,] 
the Reporting Member shall record:
    (A) Through (C) No Change.
    (D) An identification of the department and nature of the 
department to which the order was transmitted, [and]
    (E) The date and time the order was received by that department, 
(F) the number of shares to which the transmission applies, and
    (G) Any special handling requests.[;]
    (2) Through (6) No Change.
    (d) No Change.
* * * * *

6955. Order Data Transmission Requirements

    (a) Through (c) No Change.
    (d) Exemptions.
    (1) Pursuant to the Rule 9600 Series, the staff, for good cause 
shown after taking into consideration all relevant factors, may exempt, 
subject to specified terms and conditions, a member from the order data 
transmission requirements of this Rule for manual orders, if such 
exemption is consistent with the protection of investors and the public 
interest, and the member meets the following criteria:
    (A) The member and current control affiliates and associated 
persons of the member have not been subject within the last five years 
to any final disciplinary action, and within the last ten years to any 
disciplinary action involving fraud;
    (B) The member has annual revenues of less than $2 million;
    (C) The member does not conduct any market making activities in 
Nasdaq Stock Market equity securities;
    (D) The member does not execute principal transactions with its 
customers (with limited exception for principal transactions executed 
pursuant to error corrections); and
    (E) The member does not conduct clearing or carrying activities for 
other firms.
    (2) An exemption provided pursuant to this paragraph (d) shall not 
exceed a period of two years. At or prior to the expiration of a grant 
of exemptive relief under this paragraph (d), a member meeting the 
criteria set forth in paragraph (d)(1) may request, pursuant to the 
Rule 9600 Series, a subsequent exemption, which will be considered at 
the time of the request, consistent with the protection of investors 
and the public interest.
    (3) This paragraph shall be in effect until [five years from the 
effective date of the proposed rule change].
* * * * *

9600. Procedures for Exemptions

9610. Application

(a) Where To File
    A member seeking an exemption from Rule 1021, 1022, 1070, 2210, 
2320, 2340, 2520, 2710, 2720, 2810, 2850, 2851, 2860, Interpretive 
Material 2860-1, 3010(b)(2), 3020, 3210, 3230, 3350, 6955, 8211, 8212, 
8213, 11870, or 11900, Interpretive Material 2110-1, or Municipal 
Securities Rulemaking Board Rule G-37 shall file a written application 
with the appropriate department or staff of NASD and provide a copy of 
the application to the Office of General Counsel of NASD.
    (b) and (c) No Change.
* * * * *

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

    In its filing with the Commission, 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 IV below. 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

Rule Filing History

    On April 19, 2000, NASD filed with the Commission proposed rule 
change SR-NASD-00-23, proposed amendments to the OATS rules (the 
``original filing''). On September 5, 2000, NASD filed with the 
Commission Amendment No. 1 to SR-NASD-00-23, which proposed to make 
certain changes to the original filing. On September 26, 2000, the 
Commission published for comment the proposed rule change in the 
Federal Register.\5\ Based on comments received in response to the 
publication of the proposed rule change in the Federal Register and 
discussions with the staff of the SEC, NASD is filing this Amendment 
No. 2 to SR-NASD-00-23

[[Page 36987]]

to make certain changes as described herein.\6\
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    \5\ See supra note 3.
    \6\ NASD withdrew and separately proposed a portion of one of 
the proposed changes in SR-NASD-00-23, specifically the proposed 
change to require that electronic communications networks (``ECNs'') 
that electronically receive routed orders capture and report a 
routed order identifier. Because such change was proposed separately 
in SR-NASD-2004-137 and subsequently approved by the Commission (see 
Securities Exchange Act Release No. 50409 (September 17, 2004), 69 
FR 57113 (September 23, 2004), it is not addressed herein.)
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    Specifically, Amendment No. 2 would: (1) Provide that members are 
required to capture and report both the time the order is received by 
the member from the customer and the time the order is received by the 
member's trading desk or trading department,\7\ if those times are 
different;\8\ (2) exclude certain members from the definition of 
``Reporting Member'' for those orders that meet specified conditions 
and are recorded and reported to OATS by another member; and (3) permit 
NASD to grant exemptive relief from the OATS reporting requirements in 
certain circumstances to members that meet specified criteria.
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    \7\ The terms ``trading desk'' and ``trading department'' are 
used interchangeably in this rule filing.
    \8\ Members currently are required to capture and report the 
time the order is received by the member from the customer.
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Background

    On March 6, 1998, the SEC approved NASD Rules 6950 through 6957 
(``OATS Rules'').\9\ OATS provides a substantially enhanced body of 
information regarding orders and transactions that improves NASD's 
ability to conduct surveillance and investigations of member firms for 
potential violations of NASD rules and the federal securities laws. 
OATS is designed, at a minimum, to: (1) Provide an accurate, time-
sequenced record of orders and transactions, beginning with the receipt 
of an order at the first point of contact between the broker/dealer and 
the customer or counterparty and further documenting the life of the 
order through the process of execution; and (2) provide for market-wide 
synchronization of clocks used in connection with the recording of 
market events.
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    \9\ See Securities Exchange Act Release No. 39729, 63 FR 12559 
(March 13, 1998).
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    The OATS Rules generally impose obligations on member firms to 
record in electronic form and report to NASD on a daily basis certain 
information with respect to orders originated or received by NASD 
members relating to securities listed on Nasdaq. OATS captures this 
order information reported by NASD members and integrates it with quote 
and transaction information to create a time-sequenced record of orders 
and transactions. This information is critical to NASD staff in 
conducting surveillance and investigations of member firms for 
violations of federal securities laws and NASD rules.
    The OATS requirements were implemented in three phases. All members 
were required to synchronize their computer system clocks and all 
mechanical clocks that record times for regulatory purposes by August 
7, 1998, and July 1, 1999, respectively. In addition, electronic orders 
received at the trading department of a market maker and those received 
by ECNs were required to be reported to OATS as of March 1, 1999 
(``Phase One''). Additional information relating to market maker and 
ECN electronic orders and all other electronic orders were required to 
be reported to OATS by August 1, 1999 (``Phase Two''). Pursuant to Rule 
6957(c), the OATS Rules will apply to all manual orders effective 120 
days after Commission approval of SR-NASD-00-23 (``Phase Three'').\10\
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    \10\ The original effective date for Phase Three was July 31, 
2000. NASD filed a proposed amendment with the SEC for immediate 
effectiveness to extend the implementation date of Phase Three to 
120 days after SEC approval of SR-NASD-00-23. See Securities 
Exchange Act Release No. 43654 (December 1, 2000), 65 FR 77405 
(December 11, 2000).
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    Since the implementation of OATS, NASD staff has reviewed OATS 
activities with the goal of identifying ways in which to improve OATS 
and enhance its effectiveness as a regulatory tool. In this regard, 
NASD identified several changes to OATS that it believed would enhance 
NASD's automated surveillance for compliance with trading and market 
making rules such as Interpretive Material (IM) 2110-2, (commonly 
referred to as the ``NASD's Limit Order Protection Interpretation''), 
the SEC's Order Handling Rules and a member firm's best execution 
obligations. NASD proposed these changes in SR-NASD-00-23 and Amendment 
No. 1 thereto. Provided below is a description of each of the proposed 
changes, a summary of the comments received in response to the SEC's 
publication of the proposed changes, and NASD's response, as 
applicable.

Proposed Definition of Time of Receipt

    NASD Rule 6954 requires certain identifying information be recorded 
at various critical points during the life of an order, thereby 
assisting NASD in carrying out its regulatory responsibilities. In 
particular, NASD Rule 6954(b)(16) requires that members record and 
report the date and time the order is originated or received by a 
Reporting Member (``time of receipt''). The OATS Rules, which currently 
only apply to electronic orders, require that the time of receipt for 
an electronic order be the time an order is received by a firm's 
electronic order handling system. Once the OATS Rules are fully phased 
in, members will be required to record and report OATS information for 
manual orders. The time of receipt for manual orders is the time the 
order is received by the member from the customer, whether that is at a 
trading desk or at another location.
    In the original filing, NASD proposed that the time of receipt for 
manual orders be the time the order is received by the member firm's 
trading desk or trading department for execution or further routing 
purposes. NASD also proposed to codify the staff's position that the 
time of receipt for electronic orders is the time the order is captured 
by a member's electronic order-routing or execution system.
    NASD amended its original filing and proposed in Amendment No. 1 
that the time of receipt for manual orders of less than 10,000 shares 
be the time the order is received by the member's trading desk or 
trading department for execution or routing purposes. For manual orders 
that are 10,000 shares or greater, the time of receipt would continue 
to be the time the order is received by the member from the 
customer.\11\
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    \11\ Because certain order handling rules may apply differently 
to block orders of 10,000 shares or greater, Amendment No. 1 defined 
the time of receipt differently depending on the size of the order. 
For example, members may attach terms and conditions to certain 
block orders of 10,000 shares or greater for purposes of the NASD's 
Limit Order Protection Interpretation, and such orders are excepted 
from the SEC's limit order display rule unless a customer expressly 
requests otherwise.
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Comments on Proposed Definition of Time of Receipt

    Commenters opposed having two definitions of time of receipt for 
manual orders. Specifically, commenters opposed the requirement that 
the time of receipt for a manual order of 10,000 shares or greater be 
the time the order is received by the member from the customer, rather 
than the time the order is received at the member's trading desk or 
trading department for execution or routing purposes. Commenters 
asserted that eliminating the time a 10,000 share or greater order is 
received by the trading desk for OATS purposes would impede NASD 
surveillance capabilities while, conversely, the inclusion of the 
customer order receipt time for these orders would not improve 
significantly

[[Page 36988]]

NASD's ability to oversee and enforce sales practice violations. 
Further, commenters noted that NASD, where necessary, can obtain from 
members the customer order receipt time from members, which is required 
to be maintained under Rule 17a-3(a)(6) of the Act.\12\ In addition, 
commenters indicated that the two differing definitions of receipt time 
would create unnecessary costs and burdens for members in establishing 
automated systems to capture OATS data at branch locations, as well as 
confusion for salespersons in the branches and trading desk personnel 
of firms, and would lead to inadvertent mistakes and delays in 
executions.
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    \12\ 17 CFR 240.17a-3(a)(6).
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    NASD agrees with commenters that having two differing definitions 
of time of receipt based solely on the size of the order would create 
burdens for members. However, because NASD believes that it is critical 
to NASD automated surveillance systems that OATS capture the time that 
an order is received by the trading desk, and have an electronic record 
of when orders, especially larger orders, are received at a firm to 
enable the staff to perform surveillance to detect violations such as 
frontrunning, NASD staff has determined that OATS should capture both 
the time the order is received by the member from the customer and the 
time the order is received by the member's trading desk or trading 
department, if those times are different.
    Given that orders may be routed to multiple locations within a firm 
prior to reaching the trading desk (or even routed outside the firm 
directly from a desk other than the trading desk), NASD is proposing to 
capture the various receipt times (customer receipt time, trading desk 
receipt time, etc.) by expanding the OATS order transmittal 
requirements that apply to intra-firm routes to include orders routed 
to the trading department.\13\ Specifically, if an order is not 
received immediately at the trading department, members would be 
required to capture information relating to the transfer of that order 
to the trading department under the order transmittal requirements of 
NASD Rule 6954(c). To the extent that the time of receipt of the order 
from the customer and receipt of the order by the trading department 
are the same, no Desk Report would be required, given that the New 
Order Report would accurately capture the time of receipt at the 
trading department.
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    \13\ NASD Rule 6954(c) currently requires that certain 
information be recorded when an order is transmitted to a department 
within a firm, other than the trading department. In furtherance of 
this provision, the OATS Reporting Technical Specifications requires 
that this information be reported to OATS via a ``Desk Report.'' 
When the OATS Rules originally were adopted in 1998, the OATS 
reporting framework was based on NASD staff's understanding that 
most electronic orders received by members were transferred to the 
trading department for execution and that such transfer was 
instantaneous with receipt of the order. Members had indicated that 
the ``routine'' order flow from point of receipt to the trading 
department would generate a significant number of OATS Desk Reports, 
and that reporting that information to OATS would be very burdensome 
and provide little additional information, since the transfer was 
instantaneous. As a result, Desk Reports only were required in those 
instances where orders were transmitted to departments other than 
the trading department (e.g., block desk, arbitrage desk). Since 
that time, member order routing and handling systems have changed 
and a larger percentage of orders are not routed immediately to the 
trading desk. Therefore, NASD staff believes the exclusion for 
orders routed to the trading department no longer makes sense and 
may result in gaps in the audit trail.
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    The proposed rule change would apply equally to both electronic and 
manual orders. In other words, the time of receipt for purposes of 
order origination would always be the time the order is received from 
the customer. The proposed rule change also would require that members 
provide information on the nature of the department to which an order 
was transmitted, the number of shares to which the transmission 
applies, and any special handling requests. As with other technical 
requirements relating to OATS, NASD will specify in the OATS Reporting 
Technical Specifications how firms should report this information.
    By proposing this change, NASD will capture the complete lifecycle 
of an order within a firm, even in those situations where an order is 
held at the sales trading or other desk within a member firm, and then 
later routed to the trading desk. Although NASD staff understands that 
this requirement may impose additional costs on member firms, NASD 
believes that it is critical to NASD's surveillance systems and 
regulatory program that OATS capture the full lifecycle of an order 
within a firm and, in particular, both the time that an order is 
received from the customer and the time the order is received by the 
trading desk. In recognition of the technological burdens that may be 
imposed on members as a result of this proposal, NASD staff proposes to 
provide an implementation date that is 120 days from Commission 
approval of the proposed change.

Exclusion From the Definition of ``Reporting Member''

    Certain NASD members engage in non-discretionary order routing 
processes whereby, immediately after receipt of a customer order, the 
member routes the order, by electronic or other means, to another 
member (``receiving Reporting Member'') for further routing or 
execution at the receiving Reporting Member's discretion. Currently, 
the OATS rules require both the member with which the order originated 
and the receiving Reporting Member to create and report new order 
reports and possibly route reports. This results in the receipt of 
duplicative information by OATS. Therefore, NASD proposed in the 
original filing that the OATS rules be amended to require, in such 
instances, that only the receiving Reporting Member report OATS data. 
Under the proposed rule change, a member would not be required to 
report OATS data regarding an order, if the following conditions are 
met:
    (1) The member engages in a non-discretionary order routing 
process, pursuant to which it immediately routes, by electronic or 
other means, all of its orders to a single receiving Reporting Member; 
\14\
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    \14\ If any delay results in the routing of an order due to 
systems problems or other reasons, the member with which the order 
originated would be required to report OATS data.
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    (2) The member does not direct or maintain control over subsequent 
routing or execution by the receiving Reporting Member;
    (3) The receiving Reporting Member records and reports all 
information required under NASD Rules 6954 and 6955 with respect to the 
order; and
    (4) The member has a written agreement with the receiving Reporting 
Member specifying the respective functions and responsibilities of each 
party to effect full compliance with the requirements of NASD Rules 
6954 and 6955.
    In addition to eliminating the reporting of duplicative information 
to OATS, the NASD believes that proposed rule change will reduce the 
regulatory burdens on members, particularly smaller members, that route 
all their orders to another receiving Reporting Member by means of a 
non-discretionary order routing process, for execution or further 
routing purposes.\15\
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    \15\ This exclusion would not change a member's requirement to 
capture and retain the time an order was received from a customer 
under SEC Rule 17a-3(a)(6).
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Comments on the Exclusion From the Definition of ``Reporting Member''

    Commenters suggested that the exclusion from the definition of 
``Reporting Member'' for members that use a non-discretionary order 
routing process as described in the proposed rule change be expanded to 
allow for an

[[Page 36989]]

additional exclusion for members that regularly route all of a 
particular type of order or class of securities to a single receiving 
Reporting Member pursuant to a contractual arrangement. For example, if 
a firm regularly routes to a receiving Reporting Member all 
transactions in margin accounts and the receiving Reporting Member 
otherwise has total execution discretion and meets the other 
requirements set forth in the proposed rule change, the firm should be 
excluded from reporting these orders under the OATS rules. A commenter 
noted that such an exclusion could be limited to no more that two or 
three such relationships. One commenter also suggested an order-by-
order exclusion.
    NASD amended its original filing and proposed in Amendment No. 1 
that the time of receipt for manual orders of less than 10,000 shares 
be the time the order is received by the member's trading desk or 
trading department for execution or routing purposes. For manual orders 
that are 10,000 shares or greater, the time of receipt would continue 
to be the time the order is received by the member from the 
customer.\11\
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    \11\ Because certain order handling rules may apply differently 
to block orders of 10,000 shares or greater, Amendment No. 1 defined 
the time of receipt differently depending on the size of the order. 
For example, members may attach terms and conditions to certain 
block orders of 10,000 shares or greater for purposes of the NASD's 
Limit Order Protection Interpretation, and such orders are excepted 
from the SEC's limit order display rule unless a customer expressly 
requests otherwise.
---------------------------------------------------------------------------

Comments on Proposed Definition of Time of Receipt

    Commenters opposed having two definitions of time of receipt for 
manual orders. Specifically, commenters opposed the requirement that 
the time of receipt for a manual order of 10,000 shares or greater be 
the time the order is received by the member from the customer, rather 
than the time the order is received at the member's trading desk or 
trading department for execution or routing purposes. Commenters 
asserted that eliminating the time a 10,000 share or greater order is 
received by the trading desk for OATS purposes would impede NASD 
surveillance capabilities while, conversely, the inclusion of the 
customer order receipt time for these orders would not improve 
significantly NASD's ability to oversee and enforce sales practice 
violations. Further, commenters noted that NASD, where necessary, can 
obtain from members the customer order receipt time from members, which 
is required to be maintained under Rule 17a-3(a)(6) of the Act.\12\ In 
addition, commenters indicated that the two differing definitions of 
receipt time would create unnecessary costs and burdens for members in 
establishing automated systems to capture OATS data at branch 
locations, as well as confusion for salespersons in the branches and 
trading desk personnel of firms, and would lead to inadvertent mistakes 
and delays in executions.
---------------------------------------------------------------------------

    \12\ 17 CFR 240.17a-3(a)(6).
---------------------------------------------------------------------------

    NASD agrees with commenters that having two differing definitions 
of time of receipt based solely on the size of the order would create 
burdens for members. However, because NASD believes that it is critical 
to NASD automated surveillance systems that OATS capture the time that 
an order is received by the trading desk, and have an electronic record 
of when orders, especially larger orders, are received at a firm to 
enable the staff to perform surveillance to detect violations such as 
frontrunning, NASD staff has determined that OATS should capture both 
the time the order is received by the member from the customer and the 
time the order is received by the member's trading desk or trading 
department, if those times are different.
    Given that orders may be routed to multiple locations within a firm 
prior to reaching the trading desk (or even routed outside the firm 
directly from a desk other than the trading desk), NASD is proposing to 
capture the various receipt times (customer receipt time, trading desk 
receipt time, etc.) by expanding the OATS order transmittal 
requirements that apply to intra-firm routes to include orders routed 
to the trading department.\13\ Specifically, if an order is not 
received immediately at the trading department, members would be 
required to capture information relating to the transfer of that order 
to the trading department under the order transmittal requirements of 
NASD Rule 6954(c). To the extent that the time of receipt of the order 
from the customer and receipt of the order by the trading department 
are the same, no Desk Report would be required, given that the New 
Order Report would accurately capture the time of receipt at the 
trading department.
---------------------------------------------------------------------------

    \13\ NASD Rule 6954(c) currently requires that certain 
information be recorded when an order is transmitted to a department 
within a firm, other than the trading department. In furtherance of 
this provision, the OATS Reporting Technical Specifications requires 
that this information be reported to OATS via a ``Desk Report.'' 
When the OATS Rules originally were adopted in 1998, the OATS 
reporting framework was based on NASD staff's understanding that 
most electronic orders received by members were transferred to the 
trading department for execution and that such transfer was 
instantaneous with receipt of the order. Members had indicated that 
the ``routine'' order flow from point of receipt to the trading 
department would generate a significant number of OATS Desk Reports, 
and that reporting that information to OATS would be very burdensome 
and provide little additional information, since the transfer was 
instantaneous. As a result, Desk Reports only were required in those 
instances where orders were transmitted to departments other than 
the trading department (e.g., block desk, arbitrage desk). Since 
that time, member order routing and handling systems have changed 
and a larger percentage of orders are not routed immediately to the 
trading desk. Therefore, NASD staff believes the exclusion for 
orders routed to the trading department no longer makes sense and 
may result in gaps in the audit trail.
---------------------------------------------------------------------------

    The proposed rule change would apply equally to both electronic and 
manual orders. In other words, the time of receipt for purposes of 
order origination would always be the time the order is received from 
the customer. The proposed rule change also would require that members 
provide information on the nature of the department to which an order 
was transmitted, the number of shares to which the transmission 
applies, and any special handling requests. As with other technical 
requirements relating to OATS, NASD will specify in the OATS Reporting 
Technical Specifications how firms should report this information.
    By proposing this change, NASD will capture the complete lifecycle 
of an order within a firm, even in those situations where an order is 
held at the sales trading or other desk within a member firm, and then 
later routed to the trading desk. Although NASD staff understands that 
this requirement may impose additional costs on member firms, NASD 
believes that it is critical to NASD's surveillance systems and 
regulatory program that OATS capture the full lifecycle of an order 
within a firm and, in particular, both the time that an order is 
received from the customer and the time the order is received by the 
trading desk. In recognition of the technological burdens that may be 
imposed on members as a result of this proposal, NASD staff proposes to 
provide an implementation date that is 120 days from Commission 
approval of the proposed change.

Exclusion From the Definition of ``Reporting Member''

    Certain NASD members engage in non-discretionary order routing 
processes whereby, immediately after receipt of a customer order, the 
member routes the order, by electronic or other means, to another 
member (``receiving Reporting Member'') for further routing or 
execution at the receiving Reporting Member's discretion. Currently, 
the OATS rules require both the member with which the order originated 
and the receiving Reporting Member to create and report new order 
reports and possibly route reports. This results in

[[Page 36990]]

the receipt of duplicative information by OATS. Therefore, NASD 
proposed in the original filing that the OATS rules be amended to 
require, in such instances, that only the receiving Reporting Member 
report OATS data. Under the proposed rule change, a member would not be 
required to report OATS data regarding an order, if the following 
conditions are met:
    (1) The member engages in a non-discretionary order routing 
process, pursuant to which it immediately routes, by electronic or 
other means, all of its orders to a single receiving Reporting Member; 
\14\
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    \14\ If any delay results in the routing of an order due to 
systems problems or other reasons, the member with which the order 
originated would be required to report OATS data.
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    (2) The member does not direct or maintain control over subsequent 
routing or execution by the receiving Reporting Member;
    (3) The receiving Reporting Member records and reports all 
information required under NASD Rules 6954 and 6955 with respect to the 
order; and
    (4) The member has a written agreement with the receiving Reporting 
Member specifying the respective functions and responsibilities of each 
party to effect full compliance with the requirements of NASD Rules 
6954 and 6955.
    In addition to eliminating the reporting of duplicative information 
to OATS, the NASD believes that proposed rule change will reduce the 
regulatory burdens on members, particularly smaller members, that route 
all their orders to another receiving Reporting Member by means of a 
non-discretionary order routing process, for execution or further 
routing purposes.\15\
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    \15\ This exclusion would not change a member's requirement to 
capture and retain the time an order was received from a customer 
under SEC Rule 17a-3(a)(6).
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Comments on the Exclusion From the Definition of ``Reporting Member''

    Commenters suggested that the exclusion from the definition of 
``Reporting Member'' for members that use a non-discretionary order 
routing process as described in the proposed rule change be expanded to 
allow for an additional exclusion for members that regularly route all 
of a particular type of order or class of securities to a single 
receiving Reporting Member pursuant to a contractual arrangement. For 
example, if a firm regularly routes to a receiving Reporting Member all 
transactions in margin accounts and the receiving Reporting Member 
otherwise has total execution discretion and meets the other 
requirements set forth in the proposed rule change, the firm should be 
excluded from reporting these orders under the OATS rules. A commenter 
noted that such an exclusion could be limited to no more that two or 
three such relationships. One commenter also suggested an order-by-
order exclusion.
    Other commenters stated that it is inequitable to provide an 
exclusion to correspondent firms that send all their order flow to 
their clearing firm, but not other kinds of order entry firms. The 
commenters generally argued that this proposed exclusion is unfair to 
other firms with different business models and is likely to hasten the 
decision by some firms to entrust all of their order flow with one 
executing party.
    As discussed above, the proposed exclusion from the definition of 
Reporting Member is directed at those members that use a non-
discretionary order routing process whereby, immediately after receipt 
of its customer orders, the member routes all its orders, by electronic 
or other means, to a single receiving Reporting Member for further 
routing or execution at the receiving Reporting Member's discretion. 
This proposed exclusion is not limited to correspondent/clearing 
relationships, but applies to any relationship that meets the proposed 
conditions.
    The goal of the proposed rule is to eliminate the reporting of 
duplicative information to OATS where all of the OATS data of one 
member would be captured by the receiving Reporting Member. If the 
proposed rule were to permit deviations from this as commenters 
suggest, the exclusion would, in effect, permit an exclusion for almost 
any category of orders that are routed to another firm. Without the 
condition that all orders be routed to one firm, NASD will not have the 
ability to easily identify which receiving Reporting Member is 
providing the OATS order information that corresponds to the orders 
initially received by the member. Therefore, NASD does not believe any 
further changes to this proposed rule as described by commenters are 
appropriate. However, NASD is proposing an amendment to the rule text 
to clarify that, to qualify for the proposed exclusion to the 
definition of ``Reporting Member,'' the member must route all of its 
orders to a single receiving Reporting Member.

Recording and Reporting a Routed Order Identifier

    OATS has the capability of tracking the history of an order by 
linking such orders across firms through the use of a routed order 
identifier. If the order does not contain a routed order identifier, 
the order cannot be linked systematically to subsequent actions, such 
as further routing or execution by other firms or Nasdaq systems. In 
this regard, the complete history of a significant percentage of orders 
may not be tracked because the OATS rules do not require a receiving 
Reporting Member to capture and report a routed order identifier if the 
order is routed to it manually.

Comments on Recording and Reporting a Routed Order Identifier

    Several commenters opposed the proposed requirement that members be 
required to capture and report a transmitting member's unique 
identifier for all manually routed orders. Commenters stated that 
members should not be responsible for capturing accurately on a manual 
basis the routed order identifier from other firms. Errors will be 
frequent and carried on to the next firm to which the order is routed. 
Further, commenters indicated that this would impose a significant 
increase in numeric data that must be captured for a limited amount of 
heightened surveillance ability.
    Commenters further noted that the proposed requirement would lead 
to delays in order communication and executions and ultimately harm 
public investors. Because orders that are transmitted manually may not 
be entered into a firm's system and no systematic order identifier 
generated, commenters indicated that the proposed requirement would 
pose serious operational and logistical problems. Commenters also 
argued that NASD could effectively link or match together routed orders 
with new orders of the firm they are routed to, without the routed 
order identifier information.
    As discussed above, the use of a routed order identifier reported 
through OATS permits NASD to track the history of orders routed between 
firms on an automated basis. If the order does not contain a routed 
order identifier, the order cannot be linked systematically on an 
automated basis to subsequent actions, such as further routing or 
execution by other firms. In the case of manually routed orders, 
however, NASD does not believe that the benefits provided by such an 
identifier clearly outweigh the related costs to members. NASD notes in 
particular the commenters' concerns that requiring routed order 
identifiers for manually routed orders creates potential delays in the 
handling and execution of customer orders and creates the likelihood of 
high levels of data errors. Further, while NASD will not be able to 
track the history of manual orders between firms

[[Page 36991]]

on an automated basis without a routed order identifier, the staff can 
create, on an order by order basis, a process that links manual orders 
to subsequent events with an acceptable level of accuracy. Therefore, 
the staff has concluded that the costs imposed by this proposed 
requirement relating to manually routed orders as described by 
commenters are not outweighed by the incremental benefits to NASD 
regulatory data and surveillance systems.

Exemptive Relief

    Finally, NASD proposed in Amendment No. 1 new paragraph (d) of NASD 
Rule 6955 and an amendment to NASD Rule 9610(a) to permit NASD to grant 
exemptive relief to certain members from the reporting requirements of 
the OATS rules under the procedures set forth in the NASD Rule 9600 
series. Specifically, members that meet the following criteria would be 
eligible to request an exemption to the OATS reporting requirements for 
manual orders:
    (1) The member and current control affiliates and associated 
persons of the member have not been subject within the last five years 
to any disciplinary action, and within the last ten years to any 
disciplinary action involving fraud;
    (2) The member has annual revenues of less than $2 million;
    (3) The member does not conduct any market making activities in 
Nasdaq Stock Market equity securities;
    (4) The member does not execute principal transactions with its 
customers (with limited exceptions for error corrections); and
    (5) The member does not conduct clearing or carrying activities for 
other firms.
    Under the proposed rule change, any exemptive relief granted would 
expire no later than two years from the date the member receives the 
exemptive relief. At or prior to the expiration of a grant of exemptive 
relief, members meeting the specified criteria may request a subsequent 
exemption. In addition, under the proposed rule change, NASD's 
exemptive authority shall be in effect for five years from the 
effective date of the proposed rule change.
    The proposed exemptive authority would provide NASD the ability to 
grant relief to members meeting the specified criteria in situations 
where, for example, reporting of such information would be unduly 
burdensome for the member or where temporary relief from the rules (in 
the form of additional time to achieve compliance) would permit the 
member to avoid unnecessary expense or hardship.

Comments on Exemptive Relief

    Commenters generally supported the proposed rule change that would 
provide NASD with the authority to exempt certain members from OATS 
reporting for manual orders, but opposed many of the conditions placed 
on members in order for them to request exemptive relief. For example, 
several commenters suggested changes to the proposed condition that 
requires that members requesting exemptive relief not have been subject 
within the last five years to any disciplinary action, and within the 
last ten years to any disciplinary action involving fraud. Commenters 
indicated that the five and ten year disciplinary action test should 
commence from the date the disciplinary action is initiated, rather 
than when the disciplinary action is finalized. Commenters indicated 
that the date of initiation of the disciplinary action is the date most 
closely linked to the conduct that is triggering the sanction and that 
members should not be discouraged from seeking a hearing or other 
recourse due to the proposed condition on obtaining exemptive relief 
for OATS purposes. One commenter suggested a de minimis exception for 
single disciplinary action incurring a fine of not more than $10,000, 
while another commenter suggested that NASD be provided discretion to 
consider a firm's overall disciplinary history in determining whether 
to grant an exemption.
    One commenter suggested that exemptive relief be available for 
market makers that conduct principal trades. Another commenter 
recommended eliminating the condition restricting firms that clear for 
others from obtaining exemptive relief where the introducing firm is 
not a reporting member under NASD Rule 6951 (except the exclusion that 
another member report its trades) and/or the introducing firm obtains 
an exemption under NASD Rule 6955.
    One commenter noted that the five-year ``sunset'' provision on 
NASD's ability to grant exemptions should be extended indefinitely, 
noting that there currently is no reason to believe the rationale for 
providing NASD exemptive authority will be any different in five years. 
Moreover, the procedural impediments necessary for NASD to request that 
its exemptive authority be extended would be very burdensome.
    Another commenter stated that exemptive relief should be provided 
from all OATS reporting requirements for any NASD member that: (1) 
Carries no accounts for customers; (2) provides execution services in 
Nasdaq equity securities only to other dealers who are acting as market 
makers or proprietary traders and not on behalf of a customer; and (3) 
does not itself (other than in an error account) engage in market 
making or proprietary trading.
    NASD is not proposing any changes to this exemptive provision at 
this time. However, if the rule change is approved, NASD staff intends 
to review and analyze closely the application of such conditions to 
exemptive authority and determine whether it would be appropriate to 
seek changes to these conditions, including the types of changes 
suggested by commenters.

Clarifying Change to Rule Language

    NASD also is amending proposed NASD Rule 6955(d)(1)(A) to clarify 
that this condition on members that may request exemptive relief under 
the proposed rule only applies to final disciplinary actions within the 
last five years and does not include minor rule violations pursuant to 
Rule 19d-1(c)(2) of the Act.\16\
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    \16\ 17 CFR 240.19d-1(c)(2).
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    The effective date of the proposed rule change will be 120 days 
following Commission approval. NASD will announce the effective date of 
the proposed rule change in a Notice to Members to be published no 
later than 60 days following Commission approval.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\17\ which requires, among 
other things, that NASD rules must 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. NASD believes that the proposed rule change will 
enhance NASD's ability to conduct surveillance and investigations of 
member firms for violations of NASD's and other applicable rules.
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    \17\ 15 U.S.C. 78o3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

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

    Written comments on the proposed rule change were solicited by the 
Commission in response to SR-NASD-

[[Page 36992]]

00-23, which proposed several changes relating to OATS requirements. 
The Commission received 13 comment letters from 12 commenters in 
response to the Federal Register publication of SR-NASD-00-23. The 
comments are summarized above.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. 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. Comments may be submitted by any of 
the following methods:

Electronic Comments:

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-NASD-00-23 on the subject line.

Paper Comments:

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE, 
Washington, DC 20549-9303.
    All submissions should refer to File Number SR-NASD-00-23. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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, 100 F Street, 
NE, Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of NASD.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to the File Number SR-NASD-00-23 
and should be submitted on or before July 18, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. E5-3329 Filed 6-24-05; 8:45 am]
BILLING CODE 8010-01-P