[Federal Register Volume 71, Number 14 (Monday, January 23, 2006)]
[Notices]
[Pages 3550-3566]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-664]



[[Page 3550]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53128; File No. 10-131]


In the Matter of the Application of the Nasdaq Stock Market LLC 
for Registration as a National Securities Exchange; Findings, Opinion, 
and Order of the Commission

January 13, 2006.

I. Introduction

    On March 15, 2001, The Nasdaq Stock Market, Inc. (``Nasdaq''), a 
subsidiary of the National Association of Securities Dealers, Inc. 
(``NASD''), submitted to the Securities and Exchange Commission 
(``Commission'') a Form 1 application (``Form 1'') under the Securities 
Exchange Act of 1934 (``Exchange Act''), seeking registration as a 
national securities exchange pursuant to section 6 of the Exchange 
Act.\1\ Notice of the application was published for comment in the 
Federal Register on June 13, 2001.\2\ On November 13, 2001, December 5, 
2001, and January 8, 2002, Nasdaq submitted Amendment Nos. 1,\3\ 2,\4\ 
and 3,\5\ respectively, to its Form 1. The Commission received 82 
comment letters in response to the Original Notice and Amendment Nos. 
1, 2, and 3.
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    \1\ 15 U.S.C. 78f.
    \2\ See Exchange Act Release No. 44396 (June 7, 2001), 66 FR 
31952 (``Original Notice''). The Commission extended the comment 
period for the Original Notice for 30 days. See Exchange Act Release 
No. 44625 (July 31, 2001), 66 FR 41056 (August 6, 2001).
    \3\ See letter to Annette Nazareth, Director, Division of Market 
Regulation (``Division''), Commission, from Edward S. Knight, 
Executive Vice President and General Counsel, Nasdaq, dated November 
13, 2001 (``Amendment No. 1'').
    \4\ See letter to Jonathan G. Katz, Secretary, Commission, from 
Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated December 5, 2001 (``Amendment No. 2'').
    \5\ See letter to Annette Nazareth, Director, Division, 
Commission, from Edward S. Knight, Executive Vice President and 
General Counsel, Nasdaq, dated January 8, 2002 (``Amendment No. 
3'').
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    On August 15, 2005, and September 23, 2005, Nasdaq submitted 
Amendment Nos. 4 \6\ and 5 \7\ respectively, to its Form 1. In 
Amendment Nos. 4 and 5, Nasdaq proposed, among other things, a new 
corporate structure whereby Nasdaq would become a holding company with 
two subsidiaries. Nasdaq requested that the Commission grant 
registration as a national securities exchange to one of its proposed 
subsidiaries--The Nasdaq Stock Market LLC (``Nasdaq Exchange'' or 
``Exchange'').\8\ The Commission published notice of Amendment Nos. 4 
and 5 on October 11, 2005.\9\ In response to the October 2005 Notice, 
the Commission received 15 comment letters.\10\ On December 13, 2005, 
Nasdaq submitted a response to comment letters received on Amendment 
Nos. 4 and 5.\11\ On January 13, 2006, Nasdaq submitted Amendment No. 6 
to its Form 1.\12\
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    \6\ See letter to Robert L.D. Colby, Deputy Director, Division, 
Commission, from Edward S. Knight, Executive Vice President and 
General Counsel, Nasdaq, dated August 15, 2005 (``Amendment No. 
4''). Amendment No. 4 supersedes and replaces the Original Notice 
and Amendment Nos. 1, 2, and 3.
    \7\ See letter to Robert L.D. Colby, Deputy Director, Division, 
Commission, from Edward S. Knight, Executive Vice President and 
General Counsel, Nasdaq, dated September 23, 2005 (``Amendment No. 
5'').
    \8\ The other subsidiary of Nasdaq would be The Trade Reporting 
Facility LLC, which would operate the proposed NASD Trade Reporting 
Facility (``TRF''), which the NASD submitted to the Commission for 
approval. See Exchange Act Release No. 52049 (July 15, 2005), 70 FR 
42398 (July 22, 2005) (``NASD Proposal''). As described in the NASD 
Proposal, the TRF would be available to NASD members for the 
reporting of trades executed in the internal systems of NASD 
members.
    \9\ See Exchange Act Release No. 52559 (October 4, 2005), 70 FR 
59097 (``October 2005 Notice''). Complete copies of Nasdaq's 
Amendment Nos. 4 and 5 to its Form 1 are available in the 
Commission's Public Reference Room, File No. 10-131. Portions of 
Nasdaq's Form 1, as amended by Amendment Nos. 4 and 5, including the 
Nasdaq Exchange's proposed rules, are available on the Commission's 
Internet Web site (http://www.sec.gov).
    \10\ See letters from Steven I. Weissman, P.A., dated October 9, 
2005 and December 18, 2005 (``Weissman Letters''); Brad Smith et 
al., International Association of Small Broker Dealers and Advisors, 
received October 12, 2005 (``SBDA Letter''); Representative Ginny 
Brown-Waite et al., House Financial Services Committee, Members of 
Congress, dated October 31, 2005 (``House Financial Services 
Committee Letter''); Michael J. Simon, International Securities 
Exchange, Inc., dated November 3, 2005 (``ISE Letter''); Carolyn 
McCarthy, Member of Congress, dated November 3, 2005 (``Carolyn 
McCarthy Letter''); James T. Brett, Managing Director, J.P. Morgan 
Securities, Inc., dated November 4, 2005 (``J.P. Morgan Letter''); 
Michael Santucci, President, Kimberly Unger, Executive Director, and 
Stephen J. Nelson, Co-Chair STANY Trading Issues Committee, The 
Security Traders Association of New York, Inc., dated November 8, 
2005 (``STANY Letter''); Vito Fossella, Member of Congress, dated 
November 8, 2005 (``Vito Fossella Letter''); Jeffrey W. Rubin, 
Partner, Hogan & Hartson L.L.P., dated November 9, 2005 (``Nissan 
Letter''); Senator Chuck Hagel et al., United States Senate, dated 
November 9, 2005 (``Senator Chuck Hagel et al. Letter''); Kevin J.P. 
O'Hara, Chief Administrative Officer and General Counsel, 
Archipelago Holdings, Inc., dated November 10, 2005 (``Arca 
Letter''); Mary Yeager, Assistant Secretary, New York Stock 
Exchange, Inc., dated November 10, 2005 (``NYSE Letter''); Kim Bang, 
Bloomberg L.P., dated November 17, 2005 (``Bloomberg Letter''); and 
James A. Duncan, Chairman, and John C. Giesea, President/CEO, 
Security Traders Association, dated November 17, 2005 (``STA 
Letter'').
    \11\ See letter to Jonathan G. Katz, Secretary, Commission, from 
Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated December 13, 2005 (``Nasdaq Response Letter'').
    \12\ See letter to Robert L.D. Colby, Acting Director, Division, 
Commission, from Edward S. Knight, Nasdaq Exchange, dated January 
13, 2006 (``Amendment No. 6''). Amendment No. 6, among other things, 
revises the proposed rules of the Nasdaq Exchange to reflect the 
NASD rule changes filed and approved by the Commission since Nasdaq 
filed Amendment No. 4, including, for example, the rules that govern 
executions on the INET system and Rule 2111, which would prohibit 
Nasdaq Exchange members and persons associated with Nasdaq Exchange 
members from trading ahead of a customer's market order. See 
Exchange Act Release No. 52226 (August 9, 2005), 70 FR 48219 (August 
16, 2005). See Nasdaq Exchange Rule 4950 Series. See Exchange Act 
Release No. 52902 (December 7, 2005), 70 FR 73810 (December 13, 
2005) (``INET Order''). In addition, in Amendment No. 6, Nasdaq 
proposes: (1) A new Rule 4305, which is a transitional listing rule 
for securities included on Nasdaq, as a facility of the NASD, the 
day prior to the Nasdaq Exchange commencing operations as a national 
securities exchange; (2) a new Rule 4720 that sets forth the timing 
on consolidating the Nasdaq Exchange's three trading systems; (3) a 
new Rule 4121, regarding trading halts; (4) amendments to Exchange 
By-Law Article III, section 5(e) to clarify the responsibilities of 
the Regulatory Oversight Committee; (5) a new Rule 0150 requiring 
the Nasdaq Exchange to contract out those regulatory functions 
subject to the Regulatory Contract, supra notes 107--112 and 
accompanying text, to the NASD, an affiliate of NASD, or an 
independent self-regulatory organization, unless Nasdaq Exchange 
obtains prior Commission approval to do otherwise; and (6) to amend 
Rules 1002(e) and 1014(a)(15) to require that members maintain 
membership in another registered securities association that is not 
registered solely under section 15A(k) of the Exchange Act or 
another registered exchange that is not registered solely under 
section 6(g) of the Exchange Act.
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    Nasdaq's original proposal raised significant regulatory concerns. 
As originally proposed, Nasdaq's exchange would have expanded what has 
traditionally been recognized as an exchange. In particular, commenters 
noted that Nasdaq's original application proposed to operate an 
exchange without intra-market priority rules.\13\ Intra-market priority 
rules require orders in the same securities directed to an exchange to 
interact with each other. By contrast, Nasdaq had proposed to permit 
members to report transactions on the Nasdaq exchange without providing 
price protection to orders displayed in Nasdaq. Commenters argued that 
if the Commission approved these rules, it would have to reverse its 
longstanding position that exchanges have a central limit order book 
with priority over dealer trades on the exchange, and permit other 
exchanges to adopt similar rules.\14\ Commenters also took issue with 
Nasdaq's broad definition of what it proposed to be a

[[Page 3551]]

``Nasdaq transaction.''\15\ In particular, Nasdaq proposed to include 
as a ``Nasdaq transaction'' certain transactions reported to Nasdaq 
that were executed otherwise than by using the systems of the Nasdaq 
exchange. In addition, Nasdaq members not required to report such 
transactions to Nasdaq would be permitted to do so. A number of 
commenters expressed significant concern about Nasdaq's proposal to 
permit Nasdaq members to report, to the Nasdaq exchange, trades that 
had always been considered over-the-counter (``OTC'') market 
trades.\16\
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    \13\ See letters from Cameron Smith, General Counsel, The Island 
ECN, Inc., dated August 26, 2001 (``Island Letter''); Jeffrey T. 
Brown, Vice President, Regulation and General Counsel, Cincinnati 
Stock Exchange, dated August 28, 2001 (``CSE Letter''); James E. 
Buck, Senior Vice President, New York Stock Exchange, dated August 
27, 2001 (``NYSE August 2001 Letter''); and Darla C. Stuckey, 
Corporate Secretary, New York Stock Exchange, dated February 14, 
2002 (``NYSE February 2002 Letter'').
    \14\ See CSE Letter and Island Letter, supra note 13; and letter 
from Edward J. Joyce, President, Chief Operating Officer, Chicago 
Board Options Exchange, dated August 27, 2001 (``CBOE Letter'').
    \15\ See CSE Letter, Island Letter, NYSE August 2001 Letter, and 
NYSE February 2002 Letter, supra note 13; and letters from George W. 
Mann, Jr., Senior Vice President and General Counsel, Boston Stock 
Exchange, dated July 20, 2001; Sol Reicher, Co-Chairman, Amex 
Specialists Associations, John Hawkey, Chairman, Amex Floor Brokers 
Association, and Ross Moore, Chairman, Amex Options Market Maker 
Association, writing on behalf of The Member Associations of the 
American Stock Exchange, dated July 30, 2001 (``Member Associations 
of the American Stock Exchange Letter''); Stuart J. Kaswell, Senior 
Vice President and General Counsel, Securities Industry Association, 
dated August 30, 2001 (representing the interests of some of its 
members) (``SIA Letter''); Douglas M. Atkin, President, Chief 
Executive Officer, Instinet, dated August 28, 2001 (``Instinet 
Letter''); Kevin M. Foley, Bloomberg L.P. and Bloomberg Tradebook 
LLC, dated August 28, 2001 (``Bloomberg 2001 Letter''); and Meyer S. 
Frucher, Chairman and Chief Executive Officer, Philadelphia Stock 
Exchange, dated September 4, 2001 and February 25, 2002 (``Phlx 
Letters'').
    \16\ See NYSE August 2001 Letter and NYSE February 2002 Letter, 
supra note 13; and Instinet Letter, Member Associations of the 
American Stock Exchange Letter, Phlx Letters, SIA Letter, supra note 
15.
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    Nasdaq proposes in Amendment Nos. 4 and 5 to address these concerns 
by limiting Nasdaq Exchange transactions to only those trades that are 
executed in the Exchange's systems and to amend its Exchange systems to 
require executions to occur pursuant to price priority rules. Trades 
that are executed otherwise than on the Nasdaq Exchange or any other 
national securities exchange would continue to be reported to the NASD 
either to its Alternative Display Facility (``ADF'') or its proposed 
TRF.\17\
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    \17\ See NASD Proposal, supra note 8.
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    In response to the October 2005 Notice, the Commission received 
several comments in support of Nasdaq's amended application to register 
the Nasdaq Exchange as a national securities exchange.\18\ Specific 
concerns raised by other commenters are discussed below.\19\
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    \18\ See Carolyn McCarthy Letter, House Financial Services 
Committee Letter, ISE Letter, J.P. Morgan Letter, NYSE Letter (with 
proviso), Senator Chuck Hagel et al. Letter, STA Letter, STANY 
Letter, Vito Fossella Letter, supra note 10.
    \19\ The Commission received two comments not directly related 
to the Nasdaq Exchange's registration. One commenter voiced concern 
about the NASD's responsibility over the Over-the-Counter Bulletin 
Board. See SBDA Letter, supra note 10. In response, Nasdaq noted 
that the issue of the NASD's regulatory responsibility over the 
Over-the-Counter Bulletin Board has already been addressed by the 
Commission. See Nasdaq Response Letter, supra note 11. Another 
commenter alleged that Nasdaq violated Section 17(b) of the 
Securities Act of 1933 by allegedly ``touting'' Nasdaq-listed 
companies. See Weissman Letters, supra note 10. Nasdaq responded by 
noting that this issue is currently in litigation. See Nasdaq 
Response Letter, supra note 11.
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II. Statutory Standards

    Under sections 6(b) and 19(a) of the Exchange Act,\20\ the 
Commission shall by order grant a registration as a national securities 
exchange if it finds that the exchange is so organized and has the 
capacity to carry out the purposes of the Exchange Act and can comply, 
and can enforce compliance by its members and persons associated with 
its members, with the provisions of the Exchange Act, the rules and 
regulations thereunder, and the rules of the exchange. The rules of the 
exchange, among other things, must be adequate to insure fair dealing 
and to protect investors, and may not impose any burden on competition 
not necessary or appropriate in furtherance of the purposes of the 
Exchange Act.
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    \20\ 15 U.S.C. 78f(b) and 78s(a).
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    As discussed in greater detail below, the Commission finds that 
Nasdaq's application for exchange registration meets the requirements 
of the Exchange Act and the rules and regulations thereunder. Further, 
the Commission finds that the proposed rules of the Nasdaq Exchange as 
proposed in Amendment Nos. 4 and 5 \21\ and further amended by 
Amendment No. 6 \22\ are consistent with section 6 of the Exchange Act 
in that, among other things, they are designed to: (1) Assure fair 
representation of an exchange's members in the selection of its 
directors and administration of its affairs and provide that, among 
other things, one or more directors shall be representative of 
investors and not be associated with the exchange, or with a broker or 
dealer; (2) prevent fraudulent and manipulative acts and practices, 
promote just and equitable principles of trade, foster cooperation and 
coordination with persons engaged in regulating, clearing, settling, 
processing information with respect to, and facilitating transactions 
in securities, remove impediments to and perfect the mechanisms of a 
free and open market and a national market system; and (3) protect 
investors and the public interest. The Commission also believes that 
the rules of the Nasdaq Exchange are consistent with 11A of the 
Exchange Act. Finally, the Commission finds that the proposed rules of 
the Nasdaq Exchange do not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act.\23\
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    \21\ See Amendment No. 4 and Amendment No. 5, supra notes 6 and 
7.
    \22\ See Amendment No. 6, supra note 12.
    \23\ 15 U.S.C. 78f(b)(8).
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III. Discussion

A. Corporate Structure

    Prior to 2000, Nasdaq was a wholly-owned subsidiary of the NASD. In 
2000, the NASD began restructuring its relationship with Nasdaq. As the 
result of a two-phase private placement of Nasdaq shares, a public 
offering completed in January 2005, and other dispositions by the NASD 
of Nasdaq shares, the NASD's ownership interest in Nasdaq has been 
reduced to about 26%.\24\ Notwithstanding its minority ownership 
interest in Nasdaq, the NASD has retained control of Nasdaq through its 
ownership of one outstanding share of Series D preferred stock, which 
gives the NASD the right to cast one vote more than one-half of all 
votes entitled to be cast at an election by all holders of capital 
stock of Nasdaq. This share of Series D preferred stock allows the NASD 
to continue to retain control over Nasdaq.\25\ The Series D preferred 
share will expire when Nasdaq ceases to operate pursuant to the NASD's 
Plan of Allocation and Delegation of Functions by the NASD to 
Subsidiaries (``Delegation Plan'').
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    \24\ As of December 6, 2005, the NASD had beneficial ownership 
of 22,138,996 shares of the common stock of Nasdaq. This includes 
17,590,968 shares of common stock underlying warrants and 4,548,028 
shares of common stock held by the NASD. Of the 17,590,968 shares 
underlying warrants, 6,849,849 of the shares of common stock 
underlying warrants have been exercised by the holders of such 
warrants. The NASD, however, retains the right to vote these shares 
pursuant to a voting trust agreement. Upon approval of the 
application to register the Nasdaq Exchange as a national securities 
exchange, the NASD's beneficial ownership of shares underlying the 
exercised warrants will terminate. See Amendment No. 4, Exhibit K, 
supra note 6.
    \25\ See Exchange Act Release No. 53022 (December 23, 2005), 70 
FR 77433 (December 30, 2005). In this filing, Nasdaq replaced a 
Preferred B share that had provided the NASD with control over 
Nasdaq with the Preferred D share.
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    As noted above, Nasdaq proposes to convert to a holding company 
(``Nasdaq Holding Company''),\26\ which would have two subsidiaries: 
(1) The Nasdaq Exchange; and (2) The Trade Reporting Facility LLC, 
which would operate the proposed new NASD TRF. Nasdaq filed its 
corporate documents for the proposed Nasdaq Holding Company and 
proposed Exchange. According to Nasdaq, it plans to transfer all or

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substantially all of its assets and liabilities to the subsidiaries of 
the Nasdaq Holding Company.
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    \26\ Current Nasdaq shareholders will receive shares in the 
holding company, making it the publicly-traded company.
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1. Self-Regulatory Function of the Exchange; Relationship between 
Nasdaq Holding Company and the Nasdaq Exchange; Jurisdiction Over 
Nasdaq Holding Company
    Although Nasdaq Holding Company will not itself carry out 
regulatory functions, its activities with respect to the operation of 
the Exchange must be consistent with, and not interfere with, the 
Exchange's self-regulatory obligations. The proposed Nasdaq Holding 
Company corporate documents include certain provisions that are 
designed to maintain the independence of the Nasdaq Exchange's self-
regulatory function from the Nasdaq Holding Company, enable the 
Exchange to operate in a manner that complies with the federal 
securities laws, including the objectives of sections 6(b) and 19(g) of 
the Exchange Act, and facilitate the ability of the Exchange and the 
Commission to fulfill their regulatory and oversight obligations under 
the Exchange Act.\27\ For example, the Nasdaq Holding Company submitted 
to the Commission's jurisdiction with respect to activities relating to 
the Nasdaq Exchange,\28\ and agreed to provide the Commission with 
access to its books and records.\29\ Nasdaq Holding Company also agreed 
to keep confidential non-public information relating to the self-
regulatory function \30\ of the Exchange and not to use such 
information for any non-regulatory purpose.\31\ In addition, the board 
of directors of the Nasdaq Holding Company, as well as its officers, 
employees, and agents are required to give due regard to the 
preservation of the independence of the Exchange's self-regulatory 
function.\32\ Finally, the Nasdaq Holding Company By-Laws require that 
any changes to the Nasdaq Holding Company Certificate of Incorporation 
and By-Laws be submitted to the Board of Directors of the Nasdaq 
Exchange (``Exchange Board''), and, if the Exchange Board determines 
that such amendment is required to be filed with the Commission 
pursuant to section 19(b) of the Exchange Act, such change shall not be 
effective until filed with, or filed with and approved by, the 
Commission.\33\ The Commission believes that these provisions are 
consistent with the Exchange Act.\34\
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    \27\ See Nasdaq Holding Company By-Laws Article XI, section 
11.3; Article XII, sections 12.1, 12.2, 12.3, 12.4, and 12.5.
    \28\ See Nasdaq Holding Company By-Laws Article XII, section 
12.3.
    \29\ See Nasdaq Holding Company By-Laws Article XII, section 
12.1(b).
    \30\ This requirement to keep confidential non-public 
information relating to the self-regulatory function shall not limit 
the Commission's ability to access and examine such information or 
limit the ability of directors, officers, or employees of the Nasdaq 
Holding Company from disclosing such information to the Commission. 
See Nasdaq Holding Company By-Laws Article XII, section 12.1(b).
    \31\ See Nasdaq Holding Company By-Laws Article XII, section 
12.1(b).
    \32\ See Nasdaq Holding Company By-Laws Article XII, section 
12.1(a).
    \33\ See Nasdaq Holding Company Restated Certificate of 
Incorporation Article Eighth.B. and Nasdaq Holding Company By-Laws 
Article XI, section 11.3.
    \34\ The Commission notes that it is in the process of reviewing 
issues related to new ownership structures of SROs and has proposed 
rules relating to the governance and ownership of SROs, including 
limiting the restrictions on ownership and voting to members of an 
SRO or a facility of an SRO. See Exchange Act Release No. 50699 
(November 18, 2004), 69 FR 71126 (December 18, 2004).
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    The Commission also believes that under section 20(a) of the 
Exchange Act \35\ any person with a controlling interest in the Nasdaq 
Holding Company would be jointly and severally liable with and to the 
same extent that Nasdaq Holding Company is liable under any provision 
of the Exchange Act, unless the controlling person acted in good faith 
and did not directly or indirectly induce the act or acts constituting 
the violation or cause of action. In addition, section 20(e) of the 
Exchange Act \36\ creates aiding and abetting liability for any person 
who knowingly provides substantial assistance to another person in 
violation of any provision of the Exchange Act or rule thereunder. 
Further, section 21C of the Exchange Act \37\ authorizes the Commission 
to enter a cease-and-desist order against any person who has been ``a 
cause of'' a violation of any provision of the Exchange Act through an 
act or omission that the person knew or should have known would 
contribute to the violation.
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    \35\ 15 U.S.C. 78t(a).
    \36\ 15 U.S.C. 78t(e).
    \37\ 15 U.S.C. 78u-3.
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2. Changes in Control of the Nasdaq Exchange; Ownership and Voting 
Limitations
    The Nasdaq Holding Company's Restated Certificate of Incorporation 
imposes limits on direct and indirect changes in control, which are 
designed to prevent any shareholder from exercising undue control over 
the operation of the Exchange and to ensure that the Exchange and the 
Commission are able to carry out their regulatory obligations under the 
Exchange Act. Specifically, no person who beneficially owns shares of 
common stock, preferred stock, or notes in excess of five percent of 
the securities generally entitled to vote may vote the shares in excess 
of five percent.\38\ This five percent voting limitation does not 
apply, however, to the NASD or its affiliates until such time as the 
NASD beneficially owns five percent or less of Nasdaq's outstanding 
stock or notes. In addition, the Nasdaq Holding Company Board may 
approve exemptions from the five percent voting limitation for any 
person that is not a broker-dealer, an affiliate of a broker-dealer, or 
a person subject to a statutory disqualification under section 3(a)(39) 
of the Exchange Act.\39\ Any such exemption from the five percent 
voting limitation would not be effective until approved by the 
Commission pursuant to section 19 of the Exchange Act.\40\
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    \38\ See Nasdaq Holding Company Restated Certificate of 
Incorporation Article Fourth.C.
    \39\ 15 U.S.C. 78c(a)(39). See Nasdaq Holding Company Restated 
Certificate of Incorporation Article Fourth.C.6.
    \40\ See Nasdaq Holding Company By-Laws Article XII, Section 
12.5.
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    The Nasdaq Exchange's proposed rules also prohibit Exchange members 
and persons associated with Exchange members from beneficially owning 
more than 20 percent of the then-outstanding voting securities of the 
Nasdaq Holding Company.\41\ Members that trade on an exchange 
traditionally have ownership interests in such exchange. As the 
Commission has noted in the past, however, a member's interest in an 
exchange could become so large as to cast doubt on whether the exchange 
can fairly and objectively exercise its self-regulatory 
responsibilities with respect to that member.\42\ A member that is a 
controlling shareholder of an exchange might be tempted to exercise 
that controlling influence by directing the exchange to refrain from, 
or the exchange may hesitate to, diligently monitor and surveil the 
member's conduct or diligently enforce its rules and the Federal 
securities laws with respect to conduct by the member that violates 
such provisions.
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    \41\ See Nasdaq Exchange Rule 2130.
    \42\ See Exchange Act Release Nos. 51149 (February 8, 2005), 70 
FR 7531 (February 14, 2005) (SR-CHX-2004-26); 49718 (May 17, 2004), 
69 FR 29611 (May 24, 2004) (SR-PCX-2004-08); 49098 (January 16, 
2004), 69 FR 3974 (January 27, 2004) (SR-Phlx-2003-73); and 49067 
(January 13, 2004), 69 FR 2761 (January 20, 2004) (SR-BSE-2003-19).
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    The Commission believes that these ownership and voting 
restrictions are consistent with the Exchange Act. These ownership 
limitations should minimize the potential that a person could 
improperly interfere with or restrict the ability of the Commission or 
the

[[Page 3553]]

Exchange to effectively carry out their regulatory oversight 
responsibilities under the Exchange Act.
3. The Nasdaq Exchange
    Nasdaq has applied to the Commission to register its wholly-owned 
subsidiary, the Nasdaq Exchange, as a national securities exchange. As 
part of its exchange application, Nasdaq has filed the proposed Nasdaq 
Exchange Limited Liability Company Agreement (``Exchange LLC 
Agreement'') and Exchange By-Laws. In these documents, among other 
things, Nasdaq establishes the composition of the Exchange Board and 
the Exchange committees.
    a. The Nasdaq Exchange Board of Directors
    The Exchange Board will be the governing body of the Nasdaq 
Exchange and possess all of the powers necessary for the management of 
the business and affairs of the Nasdaq Exchange and the execution of 
its responsibilities as an SRO. Under the Exchange By-Laws:
     Twenty percent of the directors on the Exchange Board will 
be ``Member Representative Directors;'' \43\
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    \43\ See Exchange LLC Agreement, Section 9(a). ``Member 
Representative Director'' means a Director ``who has been elected or 
appointed after having been nominated by the Member Nominating 
Committee or by a Nasdaq [Exchange] Member * * *.'' See Exchange By-
Laws Article I(q).
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     The number of ``Non-Industry Directors'' \44\ will equal 
or exceed the sum of the number of ``Industry Directors'' \45\ and 
``Member Representative Directors;'' \46\
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    \44\ ``Non-Industry Director'' means a ``Director (excluding 
Staff Directors) who is (i) a Public Director; (ii) an officer or 
employee of an issuer of securities listed on the national 
securities exchange operated by the [Exchange]; or (iii) any other 
individual who would not be an Industry Director.'' See Exchange By-
Laws Article I(v).
    \45\ Generally, an ``Industry Director'' is, among other things, 
a Director that is or has been an officer, director, employee, or 
owner of a broker-dealer. In addition, persons who have a consulting 
or employment relationship with the Exchange, its affiliates, or the 
NASD are considered ``Industry.'' See Exchange By-Laws Article I(l).
    \46\ See Exchange By-Laws Article III, section 2(a).
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     The Exchange Board will include at least one ``Public 
Director;'' \47\
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    \47\ See id. Nasdaq proposes that the Audit Committee would 
include at least two Public Directors and the Regulatory Oversight 
Committee (``ROC'') would include at least three Public Directors. 
Accordingly, the Exchange Board would also have to include at least 
three Public Directors. See Exchange By-Laws Article III, section 
5(e) and (d). ``Public Director'' means a ``Director who has no 
material business relationship with a broker or dealer, the 
[Exchange] or its affiliates, or the NASD.'' See Exchange By-Laws 
Article I(y). Public Directors that serve on the ROC must also 
satisfy independence requirements applicable to Nasdaq Exchange 
issuers set forth in Exchange Rule 4200. See Nasdaq Exchange By-Laws 
Article III, section 5(e).
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     The Exchange Board will include at least one issuer 
representative (or at least two if the Exchange Board consists of ten 
or more members); \48\ and
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    \48\ See Exchange By-Laws Article III, section 2(a).
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     Up to two officers of the Nasdaq Exchange (``Staff 
Directors'') may be elected to the Exchange Board.\49\
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    \49\ These Staff Directors will be considered ``neutral'' and 
not as either Industry or Non-Industry Directors. See Exchange By-
Laws Article I(l). See also Exchange Act Release No. 44280 (May 8, 
2001), 66 FR 26892 (May 15, 2001) (SR-NASD-2001-06) (approving 
amendment to NASD By-Laws to allow for the treatment of staff 
Governors as ``neutral'' for purposes of Industry/Non-Industry 
balancing on the NASD Board of Governors).
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    On December 14, 2005, Nasdaq Holding Company elected the initial 
directors of the Exchange Board pursuant to the Exchange LLC 
Agreement.\50\ The initial Exchange Board is the current Board of 
Directors of the Nasdaq Holding Company who were elected pursuant to 
the procedures set forth in the current Nasdaq By-Laws. The initial 
Exchange Board is balanced: the number of Non-Industry Directors 
exceeds the number of Industry Directors and there are four Public 
Directors and four issuer representatives. These Directors were 
selected by the Nasdaq Nominating Committee, and elected by a majority 
vote of the Board of Governors of the NASD, which includes 
representatives of NASD members. No Nasdaq Exchange members 
participated in the selection of directors for the initial board 
because the Exchange does not yet have members. In light of these 
circumstances, and Nasdaq's representation that it expects to elect a 
new Exchange Board at the same time the Nasdaq Holding Company holds 
its annual meeting in Spring 2006, the Commission believes that the 
initial Exchange Board is consistent with the Exchange Act.
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    \50\ See Exchange LLC Agreement, section 9 and Schedule C.
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    For subsequent boards, the Exchange Board will appoint a Nominating 
Committee and a Member Nominating Committee. The Member Nominating 
Committee will nominate candidates for each Member Representative 
Director position on the Exchange Board, as well as nominate candidates 
for appointment by the Exchange Board for each vacant or new position 
on a committee that is to be filled with a Member Representative under 
the Exchange By-Laws. Additional candidates may be added to the list of 
candidates for the Member Representative Director positions if a Nasdaq 
Exchange Member submits a timely and duly executed written nomination 
to the Secretary of the Nasdaq Exchange.\51\ These candidates, together 
with those nominated by the Member Nominating Committee, will then be 
presented to Exchange members for election.\52\ The Nominating 
Committee will nominate candidates for all other vacant or new Director 
positions on the Exchange Board, the Nasdaq Listing and Hearing Review 
Council, and the Nasdaq Review Council.
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    \51\ See Exchange By-Laws Article II, section 1(c).
    \52\ See Exchange By-Laws Article II.
---------------------------------------------------------------------------

    The Commission believes that the requirement in the Exchange By-
Laws that twenty percent of the directors be ``Member Representative 
Directors'' and the means by which they are elected by members provides 
for the fair representation of members in the selection of directors 
and the administration of the Exchange consistent with the requirement 
in section 6(b)(3) of the Exchange Act.\53\ This requirement helps to 
ensure that members have a voice in the use of self-regulatory 
authority, and that an exchange is administered in a way that is 
equitable to all those who trade on its market or through its 
facilities.
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    \53\ 15 U.S.C. 78f(b)(3).
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    The Commission has previously stated its belief that the inclusion 
of public, non-industry representatives on exchange oversight bodies is 
critical to an exchange's ability to protect the public interest.\54\ 
Further, public representatives help to ensure that no single group of 
market participants has the ability to systematically disadvantage 
other market participants through the exchange governance process. The 
Commission believes that public directors can provide unique, unbiased 
perspectives, which should enhance the ability of the Exchange Board to 
address issues in a non-discriminatory fashion and foster the integrity 
of the Nasdaq Exchange. The Commission believes that the Nasdaq 
Exchange Board satisfies the requirements in section 6(b)(3) of the 
Exchange Act,\55\ which requires that one or more directors be 
representative of issuers and investors and not be associated with a 
member of the exchange, or with a broker or dealer.\56\
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    \54\ See Regulation of Exchanges and Alternative Trading 
Systems, Exchange Act Release No. 40760 (December 8, 1998), 63 FR 
70844 (December 22, 1998) (``Regulation ATS Release'').
    \55\ 15 U.S.C. 78f(b)(3).
    \56\ See also In the Matter of National Association of 
Securities Dealers, Inc., Order Instituting Public Proceedings 
Pursuant to section 19(h)(1) of the Securities Exchange Act of 1934, 
Making Findings and Imposing Remedial Sanctions, Exchange Act 
Release No. 37538 (August 8, 1996), Administrative Proceeding File 
No. 3-9056 (``1996 Settlement Order''). Simultaneously with issuing 
this Order, the Commission also published a Report pursuant to 
section 21(a) of the Exchange Act regarding the NASD and the Nasdaq 
market. See Report and Appendix to Report Pursuant to section 21(a) 
of the Securities Exchange Act of 1934 Regarding the NASD and The 
Nasdaq Stock Market (August 8, 1996). As a subsidiary of the NASD, 
Nasdaq is currently bound by the 1996 Settlement Order settling an 
enforcement action against the NASD. In conjunction with the Nasdaq 
Exchange's application to register as an exchange, Nasdaq submitted 
a letter to the Commission affirming that the Nasdaq Exchange will 
comply with the 1996 Settlement Order except as specified. See 
letter to Robert L.D. Colby, Deputy Director, Division, Commission, 
from Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated January 11, 2006. Consistent with the 1996 Settlement 
Order, the Exchange Board structure has at least fifty percent 
independent public and non-industry membership.

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[[Page 3554]]

b. The Nasdaq Exchange Committees
    In the Exchange By-Laws, the Nasdaq Exchange has proposed to 
establish several committees. Specifically, the Exchange has proposed 
to establish the following committees that would be composed solely of 
directors: An Executive Committee,\57\ a Finance Committee,\58\ a 
Management Compensation Committee,\59\ an Audit Committee,\60\ and a 
ROC.\61\ In addition, the Exchange has proposed to establish these 
other committees that are not required to be composed solely of 
directors: a Nasdaq Listing and Hearing Review Committee,\62\ a Nasdaq 
Review Council (``NRC''),\63\ a Nominating Committee,\64\ a Member 
Nominating Committee,\65\ a Quality of Markets Committee,\66\ a Market 
Operations Review Committee,\67\ an Arbitration and Mediation 
Committee,\68\ and a Market Regulation Committee.\69\ The Commission 
believes that the Exchange's proposed committees should enable it to 
carry out its responsibilities under the Exchange Act.
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    \57\ See Exchange By-Laws Article III, section 5(a).
    \58\ See Exchange By-Laws Article III, section 5(b).
    \59\ See Exchange By-Laws Article III, section 5(c).
    \60\ See Exchange By-Laws Article III, section 5(d).
    \61\ See Exchange By-Laws Article III, section 5(e).
    \62\ See Exchange By-Laws Article V.
    \63\ See Exchange By-Laws Article VI.
    \64\ See Exchange By-Laws Article III, section 6(b).
    \65\ Id.
    \66\ See Exchange By-Laws Article III, section 6(c).
    \67\ See Exchange By-Laws Article III, section 6(d).
    \68\ See Exchange By-Laws Article III, section 6(e).
    \69\ See Exchange By-Laws Article III, section 6(f).
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    The Exchange has proposed that the composition of certain 
committees be consistent with the 1996 Settlement Order. These 
committees include the Nominating Committee, the Quality of Markets 
Committee, the Arbitration and Mediation Committee,\70\ the Market 
Regulation Committee,\71\ the NRC,\72\ the Management Compensation 
Committee, and the Audit Committee.\73\ Each of these committees is 
compositionally balanced as they each must be composed of at least 50 
percent Non-Industry members. The Commission believes that these 
committees' compositional balance is consistent with the 1996 
Settlement Order.
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    \70\ The Exchange By-Laws provide that the Arbitration and 
Mediation Committee shall consist of no fewer than 10 and no more 
than 25 members, and shall have at least 50 percent Non-Industry 
members. See Exchange By-Laws Article III, section 5(e)(ii). The 
Arbitration and Mediation Committee may be maintained on the 
Exchange's behalf by a regulatory services provider (e.g., the 
NASD). See Exchange By-Laws Article III, section 5(e). (``The Board 
shall appoint an Arbitration and Mediation Committee, or shall cause 
the [Exchange] to enter into an agreement with a self-regulatory 
organization that provides regulatory services pursuant to which 
such self-regulatory organization shall appoint an Arbitration and 
Mediation Committee on the Company's behalf.''). In the event that a 
regulatory services provider appoints an Arbitration and Mediation 
Committee on the Nasdaq Exchange's behalf, it must comply with the 
compositional and other requirements set forth in the Exchange By-
Laws with respect to such committee.
    \71\ The Market Regulation Committee is the successor to the 
Market Surveillance Committee. See Exchange Act Release Nos. 38545 
(April 24, 1997), 62 FR 25226 (May 8, 1997); and 38908 (August 7, 
1997), 62 FR 43385 (August 13, 1997).
    \72\ The Nasdaq Exchange will not maintain a National Business 
Conduct Committee. Its appellate level disciplinary body, the NRC, 
however, is composed of a majority of Non-Industry Directors 
consistent with the 1996 Settlement Order. See Exchange By-Laws 
Article VI, section 2. The NRC will be appointed by the Exchange 
Board and will, among other things, preside over appeals or reviews 
of disciplinary proceedings, statutory disqualification proceedings, 
and membership proceedings. See Exchange By-Laws Article VI, section 
1.
    \73\ Consistent with the 1996 Settlement Order, the Audit 
Committee is composed of a majority of Non-Industry Directors and is 
chaired by a Public Director. See Exchange By-Laws Article III, 
section 5(d).
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B. Regulation of the Nasdaq Exchange

    As a prerequisite for the Commission's approval of an exchange's 
application for registration, an exchange must be organized and have 
the capacity to carry out the purposes of the Exchange Act.\74\ 
Specifically, an exchange must be able to enforce compliance by its 
members, and persons associated with its members, with the federal 
securities laws and the rules of the exchange.\75\
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    \74\ See section 6(b)(1) of the Exchange Act; 15 U.S.C. 
78f(b)(1).
    \75\ Id. See also section 19(g) of the Exchange Act; 15 U.S.C. 
78s(g).
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1. Membership
    Nasdaq proposes that the criteria for membership in the Nasdaq 
Exchange be substantially the same as the criteria currently applicable 
to firms applying for membership in the NASD.\76\ Unlike the NASD 
rules, however, the Nasdaq Exchange's proposed rules require a broker-
dealer to be a member of at least one other SRO before applying for 
membership in the Exchange and to remain a member of another SRO.\77\
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    \76\ See Nasdaq Exchange Rule 1010 Series. The Nasdaq Exchange's 
proposed membership By-Laws and rules essentially mirror the NASD's 
By-Laws and Rule 1010 series. In Amendment No. 6, Nasdaq updated 
proposed Nasdaq Exchange Rule IM-1000-2 to reflect a proposed rule 
change, which clarified the scope of the relief provided to 
registered representatives called into active military duty. See 
Exchange Act Release No. 52980 (December 19, 2005), 70 FR 76477 
(December 27, 2005).
    \77\ See Nasdaq Exchange Rules 1002(e) and 1014(a)(15). In 
Amendment No. 6, Nasdaq amended these rules to amend Rules 1002(e) 
and 1014(a)(15) to require that members maintain membership in 
another registered securities association that is not registered 
solely under section 15A(k) of the Exchange Act or another 
registered exchange that is not registered solely under section 6(g) 
of the Exchange Act. See supra note 12. NASD membership is required, 
in particular, for applicants that will transact business with the 
public. See also section 15(b)(8) of the Exchange Act and Rule 15b9-
1 thereunder. 15 U.S.C. 78o(b)(8); 17 CFR 240.15b9-1.
---------------------------------------------------------------------------

    Current NASD members will be able to apply through an expedited 
process to become a Nasdaq Exchange member, and to register with the 
Exchange all of their associated persons whose registrations were 
approved with the NASD, by submitting a Waive-in Membership Application 
Form and a Membership Agreement.\78\ All of the firm's associated 
persons who are registered in categories recognized by Exchange rules 
would become registered persons of a Nasdaq Exchange member firm.
---------------------------------------------------------------------------

    \78\ See Nasdaq Exchange Rule 1013(a)(6)(C).
---------------------------------------------------------------------------

    Broker-dealers that are not members of the NASD and new broker-
dealers that are not yet members of another SRO may apply for 
membership in the Nasdaq Exchange and comply with the Exchange Rule 
1010 Series. Firms that apply to become both NASD and Exchange members 
simultaneously may file one full membership application with the NASD 
in compliance with the NASD Rule 1010 Series.\79\ New broker-dealers 
that wish to become members of the Nasdaq Exchange and an SRO other 
than the NASD must submit a complete application form with all of the 
information required of new applicants in Exchange Rule 1013(a)(2).\80\ 
The Nasdaq Exchange will consider the application for membership in the 
Exchange after its membership in the other SRO has been approved.
---------------------------------------------------------------------------

    \79\ See Nasdaq Exchange Rule 1013(a)(6)(A).
    \80\ See Nasdaq Exchange Rule 1013(a)(6)(B).
---------------------------------------------------------------------------

    The Exchange has contracted with NASD Regulation (``NASDR''), the 
NASD's wholly-owned subsidiary, to which the NASD has delegated the 
performance of certain of its regulatory obligations,\81\ to perform 
certain

[[Page 3555]]

regulatory functions on its behalf (the ``Regulatory Contract'').\82\ 
Under the Regulatory Contract, NASDR will perform certain membership 
functions for the Nasdaq Exchange. Specifically, NASDR will accept and 
review all applications for membership in the Exchange, and receive and 
process membership applications through the Central Registration 
Depository (``CRD'') system pursuant to the Exchange's membership 
rules.\83\ NASDR will evaluate the applications and make 
recommendations to the Exchange about whether they should be approved 
or denied. The Nasdaq Exchange will make the ultimate decision on 
whether to accept a broker-dealer as a member.\84\
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    \81\ See Delegation Plan.
    \82\ The Nasdaq Exchange and NASDR have requested confidential 
treatment for their contractual agreement pursuant to section 
24(b)(2) of the Exchange Act and Rule 24b-2 thereunder. 15 U.S.C. 
78x(b)(2); and 17 CFR 240.24b-2. Nasdaq has represented to the 
Commission that it will assign the Regulatory Contract to the Nasdaq 
Exchange.
    \83\ See Nasdaq Exchange Rule 1013. See also Exchange By-Laws 
Article VI, Section 2.
    \84\ In Amendment No. 6, Nasdaq proposed to modify Nasdaq 
Exchange Rule 3230(h) to reflect an NASD proposed rule change 
relating to reporting requirements for members that are clearing 
firms. See Exchange Act Release No. 52352 (August 26, 2005), 70 FR 
52460 (September 2, 2005).
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    Appeals of staff denials of membership will be heard by the 
NRC.\85\ Decisions of this committee will be final, but may be called 
for review by the Exchange Board.\86\ This process is consistent with 
the current process by which the NASD Board of Directors may call for 
review membership decisions made by the NASD's National Adjudicatory 
Council.
---------------------------------------------------------------------------

    \85\ See Nasdaq Exchange Rule 1015. See also Exchange By-Laws 
Article VI, Section 2.
    \86\ See Nasdaq Exchange Rules 1015(j)(3) and 1016.
---------------------------------------------------------------------------

    The Nasdaq Exchange also proposes to require that all broker-dealer 
applicants include an original Nasdaq Exchange-approved fingerprint 
card for each associated person of the applicant subject to section 
17(f)(2) of the Exchange Act and Rule 17f-2 thereunder \87\ for whom a 
fingerprint card has not been filed with another SRO.\88\ The Nasdaq 
Exchange's rules also permit the Exchange to make the registration of a 
person effective pending receipt of a fingerprint card.\89\ Section 
17(f)(2) of the Exchange Act and Rule 17f-2(a) thereunder \90\ states 
that every member of a national securities exchange shall require that 
each of its partners, directors, officers and employees be 
fingerprinted, and shall submit such fingerprints, or cause the 
fingerprints, to be submitted to the Attorney General of the United 
States for identification and appropriate processing. Exchange Act Rule 
17f-2(c) \91\ permits a national securities exchange to file a 
fingerprint plan with the Commission that will facilitate the 
submission of fingerprints to the Attorney General. Because the 
Exchange's rules contemplate that the Exchange will facilitate the 
submission of fingerprints to the Attorney General on behalf of its 
members as permitted by Exchange Act Rule 17f-2(c), as a condition to 
the operation of the Nasdaq Exchange, a fingerprint plan must be filed 
by the Nasdaq Exchange under Exchange Act Rule 17f-2 and declared 
effective by the Commission.
---------------------------------------------------------------------------

    \87\ 15 U.S.C. 78q(f)(2); and 17 CFR 240.17f-2.
    \88\ See Nasdaq Exchange Rule 1013(a)(2)(B).
    \89\ See Nasdaq Exchange Rule 1140(c)(2).
    \90\ 15 U.S.C. 78q(f)(2); and 17 CFR 240.17f-2(a).
    \91\ 17 CFR 240.17f-2(c).
---------------------------------------------------------------------------

    The Commission finds that the Nasdaq Exchange's membership rules 
are consistent with section 6 of the Exchange Act,\92\ specifically 
section 6(b)(2) of the Exchange Act,\93\ which requires that a national 
securities exchange have rules that provide that any registered broker 
or dealer may become a member and any person may become associated with 
an exchange member. The Commission notes that pursuant to section 6(c) 
of the Exchange Act, an exchange must deny membership to non-registered 
broker-dealers and registered broker-dealers that do not satisfy 
certain standards, such as financial responsibility or operational 
capacity. As a registered exchange, the Nasdaq Exchange must 
independently determine if an applicant satisfies the standards set 
forth in the Exchange Act, regardless of whether an applicant is a 
member of another SRO.\94\
---------------------------------------------------------------------------

    \92\ 15 U.S.C. 78f. The Commission notes that it is not 
approving the Nasdaq NTS Access Order Form and Nasdaq Services 
Agreement.
    \93\ 15 U.S.C. 78f(b)(2).
    \94\ In response to the Original Notice, the Securities Industry 
Association submitted a comment noting that the Nasdaq Exchange 
should be clear about its membership application process and the 
process for the registration of associated persons of Nasdaq 
Exchange members. See SIA Letter, supra note 15.
---------------------------------------------------------------------------

2. Regulatory Independence--the Chief Regulatory Officer and Regulatory 
Oversight Committee
    Nasdaq proposes to create an Exchange Board committee, the ROC, 
that would be composed of independent directors. The ROC would consist 
of three members, each of whom must be a Public Director and 
``independent director'' as defined by Nasdaq Exchange Rule 4200.\95\ 
The ROC would be responsible for monitoring the adequacy and 
effectiveness of the Exchange's regulatory program, assessing the 
Exchange's regulatory performance, assisting the Exchange Board in 
reviewing the Exchange's regulatory plan and the overall effectiveness 
of the Exchange's regulatory functions.\96\
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    \95\ Nasdaq Exchange Rule 4200(a)(15) sets forth the director 
independence listing standards applicable to Nasdaq-listed issuers. 
See also Amendment No. 6, supra note 12.
    \96\ See Exchange By-Laws Article III, section 5(e).
---------------------------------------------------------------------------

    The ROC would also meet with the Chief Regulatory Officer (``CRO'') 
in executive session at regularly scheduled meetings and at any time 
upon request of the CRO or any member of the ROC.\97\ The ROC would 
also be informed about the CRO's compensation, promotion, or 
termination (including reasons).\98\ Finally, the regulatory budget 
would be presented to the ROC so that its members may inquire as to the 
adequacy of resources available for the Nasdaq Exchange's regulatory 
program.\99\
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    \97\ See Exchange By-Laws Article IV,section 7.
    \98\ See Exchange By-Laws Article III, section 5(e).
    \99\ Id.
---------------------------------------------------------------------------

    Nasdaq proposes that its CRO have general supervision of the 
regulatory operations of the Exchange, including overseeing 
surveillance, examination, and enforcement functions.\100\ The CRO also 
would administer any regulatory services agreement with another SRO to 
which the Nasdaq Exchange is a party.\101\ The CRO would be an 
Executive Vice President or Senior Vice President that reports directly 
to the Chief Executive Officer.\102\ The CRO may also serve as the 
Nasdaq Exchange's General Counsel.\103\
---------------------------------------------------------------------------

    \100\ See Exchange By-Laws Article IV, section 7.
    \101\ Id.
    \102\ Id.
    \103\ Id.
---------------------------------------------------------------------------

    In addition, the Nasdaq Exchange has created an independent 
regulatory department, Nasdaq Regulation, for the purpose of 
functionally separating its regulatory functions from its business 
lines. Nasdaq Regulation will carry out many of the Nasdaq Exchange's 
regulatory functions, including administering its membership and 
disciplinary rules.\104\
---------------------------------------------------------------------------

    \104\ See Exchange Rules 1011(c) and 9120(w). See also Report of 
Investigation Pursuant to section 21(a) of the Securities Exchange 
Act of 1934 Regarding the Nasdaq Stock Market Inc., as Overseen By 
Its Parent, The National Association of Securities Dealers, Inc., 
Exchange Act Release No. 51163 (February 9, 2005). The Commission 
issued this report as a result of an investigation that uncovered a 
regulatory failure between the NASD and Nasdaq. In this report, the 
Commission stated that ``[i]n carrying out their regulatory 
responsibilities, SROs must ensure that they effectively manage the 
inherent conflicts between their role as a market and their role as 
a regulator.'' Id. In response, the NASD and Nasdaq took several 
remedial steps, including the creation of the Nasdaq Regulation.

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[[Page 3556]]

    In the October 2005 Notice, the Commission requested comment on 
whether the Nasdaq Exchange's proposed regulatory structure, including 
the ROC and CRO, insulate its regulatory functions from its market and 
other commercial interests so that it could carry out its regulatory 
obligations. In response, the Commission received two comment 
letters.\105\ Both commenters supported the Exchange's proposed 
regulatory structure.
---------------------------------------------------------------------------

    \105\ ISE Letter and STA Letter, supra note 10.
---------------------------------------------------------------------------

    The Commission believes that, in this context, the Exchange's 
proposal is consistent with the statutory requirements. In addition, 
the Commission believes that the Nasdaq Exchange's proposal is 
consistent with the 1996 Settlement Order.\106\
---------------------------------------------------------------------------

    \106\ See 1996 Settlement Order, supra note 56.
---------------------------------------------------------------------------

3. The Regulatory Contract
    Although the Exchange will be an SRO with all of the attendant 
regulatory obligations under the Exchange Act, it has entered into the 
Regulatory Contract with NASDR, under which NASDR will perform certain 
regulatory functions on its behalf.\107\ Notwithstanding the Regulatory 
Contract, the Exchange will retain ultimate legal responsibility for 
the regulation of its members and its market. This contract is intended 
to reflect the current relationship that Nasdaq and NASDR have and 
accordingly, NASDR will be performing for the Nasdaq Exchange the same 
regulatory functions it currently performs for Nasdaq as a facility of 
the NASD.
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    \107\ In Amendment No. 6, Nasdaq proposed Rule 0150, which 
provides that the regulatory functions performed by NASD will 
continue to be performed by NASD, an affiliate of NASD, or an 
independent self-regulatory organization, unless Nasdaq Exchange 
obtains prior Commission approval to do otherwise.
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    In addition to performing certain membership functions for the 
Nasdaq Exchange,\108\ NASDR will perform certain disciplinary and 
enforcement functions for the Exchange. Generally, NASDR will 
investigate members, issue complaints, and conduct hearings pursuant to 
the Exchange's rules. Appeals of disciplinary hearings, however, will 
be handled by the NRC.\109\
---------------------------------------------------------------------------

    \108\ See supra text accompanying note 82.
    \109\ See Exchange By-Laws Article VI, section 1.
---------------------------------------------------------------------------

    The Commission has previously stated that it would consider whether 
it would be consistent with the public interest for an exchange to 
contract with another SRO to perform certain regulatory functions.\110\ 
In this case, the Commission believes that it is consistent with the 
Exchange Act and the public interest to allow the Exchange to contract 
with NASDR to perform membership, disciplinary, and enforcement 
functions. Membership, discipline, and enforcement are fundamental 
elements to a regulatory program, and constitute core self-regulatory 
functions. It is essential to the public interest and the protection of 
investors that these functions are carried out in an exemplary manner, 
and the Commission believes that NASDR has the expertise and experience 
to perform these functions on behalf of the Nasdaq Exchange.\111\
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    \110\ See, e.g., Regulation ATS Release, supra note 54. See also 
Exchange Act Release No. 50122 (July 29, 2004), 69 FR 47962 (August 
6, 2004) (``Amex Order'').
    \111\ In response to the Original Notice, some commenters raised 
general concerns over the ability of NASDR to be a fair and 
impartial regulator of the Nasdaq Exchange given the historical 
relationship between Nasdaq and NASDR and the fact that the Nasdaq 
Exchange is a ``customer'' of the NASD's for regulatory services. 
See Instinet Letter; Member Associations of the American Stock 
Exchange Letter; and SIA Letter, supra note 15; and letters from 
William O'Brien, Senior Vice President & General Counsel, The Brut 
ECN, L.L.C., dated July 30, 2001; and W. Hardy Callcott, Senior Vice 
President and General Counsel, Charles Schwab, dated August 30, 
2001. Other commenters, however, believed that exchange status for 
Nasdaq would permit the NASD to provide regulatory services without 
the perception or potential for a conflict of interest. See letters 
from Robert M. Funk, Executive Director, American Shareholders 
Association, dated July 17, 2001; Grover G. Norquist, President, 
Americans for Tax Reform, dated July 17, 2001; Congressman Patrick 
J. Tiberi, Ohio, dated July 20, 2001; Congressman Steven C. 
LaTourette, Ohio, dated July 25, 2001; Congressman E. Clay Shaw, 
Florida, dated July 25, 2001; Senator Richard J. Durbin, Illinois, 
dated July 27, 2001; Barry S. Porter, Chairman, The Nasdaq Stock 
Market Issuer Affairs Committee and 22 representatives of the Nasdaq 
Issuer Affairs Committee, dated August 8, 2001; Glenn R. Oxner, 
Executive Vice President, Scott & Stringfellow, Inc., dated August 
14, 2001; Congressional Delegation from Maryland, including 
Constance A. Morella, Roscoe Bartlett, Wayne Gilchrest, and Robert 
L. Ehrlich, Jr., dated August 15, 2001; Congressman Charles A. 
Gonzalez, Texas, dated August 21, 2001; Congressman Chip Pickering, 
Mississippi, dated August 21, 2001; Congressman Jerry Weller, 
Illinois, letters dated August 23, 2001 and August 31, 2001; Mathew 
Ng, Assistant General Counsel & Assistant Secretary, Oracle 
Corporation, dated August 29, 2001; Congressional Delegation from 
Connecticut, including Nancy Johnson, James Maloney and Christopher 
Shays, dated September 18, 2001; and Congressman Mark Foley, 
Florida, dated September 21, 2001.
---------------------------------------------------------------------------

    At the same time, the Commission believes that, unless relieved by 
the Commission of its responsibility,\112\ the Nasdaq Exchange bears 
the responsibility for self-regulatory conduct and primary liability 
for self-regulatory failures, not the SRO retained to perform 
regulatory functions on the Exchange's behalf. In performing these 
functions, however, NASDR may nonetheless bear liability, in 
appropriate circumstances, for causing or aiding and abetting the 
failure of the Exchange to perform its regulatory functions.\113\ 
Accordingly, although NASDR will not act on its own behalf under its 
SRO responsibilities in carrying out these regulatory services for the 
Nasdaq Exchange, NASDR also may have secondary liability if, for 
example, the Commission finds that the contracted functions are being 
performed so inadequately as to cause a violation of the Federal 
securities laws by the Nasdaq Exchange.
---------------------------------------------------------------------------

    \112\ See section 17(d)(1) of the Exchange Act and Rule 17d-2 
thereunder. 15 U.S.C. 78q(d)(1); and 17 CFR 240.17d-2. See also 
infra notes 114-117 and accompanying text. The Commission is not 
approving the Regulatory Contract.
    \113\ For example, if failings by NASDR have the effect of 
leaving the Exchange in violation of any aspect of the Exchange's 
self-regulatory obligations, the Exchange would bear direct 
liability for the violation, while NASDR may bear liability for 
causing or aiding and abetting the violation.
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4. Rule 17d-2 Agreements
    Section 19(g)(1) of the Exchange Act\114\ requires every SRO to 
examine its members and persons associated with its members and to 
enforce compliance with the federal securities laws and the SRO's own 
rules, unless the SRO is relieved of this responsibility pursuant to 
section 17(d) of the Exchange Act.\115\ Section 17(d) was intended, in 
part, to eliminate unnecessary multiple examinations and regulatory 
duplication with respect to members of more than one SRO (``common 
members''). Rule 17d-2 of the Exchange Act\116\ permits SROs to propose 
joint plans allocating regulatory responsibilities concerning common 
members. These agreements, which must be filed with and approved by the 
Commission, generally cover such regulatory functions as personnel 
registration, branch office examinations, and sales practices. 
Commission approval of a 17d-2 plan relieves the specified SRO of those 
regulatory responsibilities allocated by the plan to another SRO. Many 
existing SROs have entered into such agreements.\117\
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    \114\ 15 U.S.C. 78s(g)(1).
    \115\ 15 U.S.C. 78q(d).
    \116\ 17 CFR 240.17d-2.
    \117\ See, e.g., Exchange Act Release Nos. 13326 (Mar. 3, 1977), 
42 FR 13878 (Mar. 14, 1977) (NYSE/Amex); 13536 (May 12, 1977), 42 FR 
26264 (May 23, 1977) (NYSE/BSE); 14152 (Nov. 9, 1977), 42 FR 59339 
(Nov. 16, 1977) (NYSE/CSE); 13535 (May 12, 1977), 42 FR 26269 (May 
23, 1977) (NYSE/CHX); 13531 (May 12, 1977), 42 FR 26273 (May 23, 
1977) (NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1, 1977) 
(NYSE/Phlx); 15191 (Sep. 26, 1978), 43 FR 46093 (Oct. 5, 1978) 
(NASD/BSE, CSE, CHX and PSE); 16858 (May 30, 1980), 45 FR 37927 
(June 5, 1980) (NASD/BSE, CSE, CHX and PSE); and 42815 (May 23, 
2000), 65 FR 34762 (May 31, 2000) (NASD/ISE).
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    Nasdaq has represented to the Commission that the Nasdaq Exchange

[[Page 3557]]

and the NASD intend to file a Rule 17d-2 agreement with the Commission 
covering common members of the Nasdaq Exchange and the NASD. The Nasdaq 
Exchange represented that this agreement would allocate to the NASD 
regulatory responsibility, with respect to common members, the 
following:
    (1) The NASD will receive and process in the CRD applications, 
reports, information, filings, fingerprint cards, and notices generally 
relating to the status of an associated person of a common member, and 
registration as a principle or representative of any type, or any other 
type of employee of a common member required to register or pass a 
qualification examination under the Nasdaq Exchange rules.
    (2) The NASD will receive and process notices, filings, or 
registrations for the branch offices of common members of the Nasdaq 
Exchange and the NASD, including notices, filings, or registrations to 
designate offices of supervisory jurisdiction.
    (3) The NASD will examine common members of the Nasdaq Exchange and 
the NASD for compliance with Federal securities laws, rules and 
regulations, and rules of the Nasdaq Exchange that have been certified 
by the Nasdaq Exchange as identical or substantially similar to the 
NASD rules.
    (4) The NASD will investigate common members of the Nasdaq Exchange 
and the NASD for apparent violations of Federal securities laws, rules 
or regulations, or Nasdaq Exchange rules that has been certified by the 
Nasdaq Exchange as identical or substantially identical to an NASD 
rule.
    (5) The NASD will enforce compliance with Federal securities laws, 
rules and regulations, and rules of the Nasdaq Exchange that have been 
certified by Nasdaq as identical or substantially similar to the NASD 
rules.
    Because the Nasdaq Exchange anticipates entering into this 17d-2 
agreement, it has not made provisions to fulfill the regulatory 
obligations that would be undertaken by the NASD under this agreement 
with respect to common members of the Nasdaq Exchange and the NASD. 
Accordingly, the Commission is conditioning the operation of the Nasdaq 
Exchange on approval by the Commission of a 17d-2 agreement between the 
Nasdaq Exchange and the NASD that allocates the above specified matters 
to the NASD.\118\
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    \118\ Alternatively, the Nasdaq Exchange could demonstrate that 
it has the ability to fulfill its regulatory obligations.
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5. Discipline and Oversight of Members
    As a prerequisite for the Commission approval of an exchange's 
application for registration, an exchange must be organized and have 
the capacity to carry out the purposes of the Exchange Act. 
Specifically, an exchange must be able to enforce compliance by its 
members and persons associated with its members with Federal securities 
laws and the rules of the exchange.\119\ As noted above, pursuant to 
the Regulatory Contract, NASDR will perform many of the initial 
disciplinary processes on behalf of the Exchange.\120\ For example, 
NASDR will investigate claims of securities laws violations, issue 
complaints, and conduct hearings pursuant to Nasdaq Exchange 
rules.\121\ Appeals from disciplinary decisions will be heard by the 
NRC. Thereafter, the NRC may affirm, reverse, or otherwise modify the 
decision of the Hearing Panel, and must submit a proposed written 
decision to the Exchange Board, which will become final unless the 
matter is called for review by any Director.\122\ After review, the 
Exchange Board may affirm, reverse, modify, and increase or reduce any 
sanction, or impose any other fitting sanction.\123\
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    \119\ 15 U.S.C. 78f(b)(1).
    \120\ In response to the Original Notice, the Securities 
Industry Association submitted a comment generally supporting this 
arrangement for the regulation of Nasdaq Exchange members. See SIA 
Letter, supra note 15.
    \121\ NASDR will appoint Hearing Panels pursuant to Nasdaq 
Exchange rules. In Amendment No. 6, Nasdaq proposed a new 
transitional rule, 9231(b)(1)(D), allowing persons who served on the 
NASD National Adjudicatory Council, or a disciplinary subcommittee 
thereof, prior to the date that Nasdaq commenced operating as a 
national securities exchange to sit on Hearing Panels. The 
Commission believes that proposed Nasdaq Exchange Rule 9231(b)(1)(D) 
is consistent with the Exchange Act. Allowing persons who previously 
served on the NASD National Adjudicatory Council, or a disciplinary 
subcommittee thereof, to act as Panelists in the Nasdaq Exchange 
disciplinary hearings will facilitate a seamless transition from the 
current NASD disciplinary process to the Nasdaq Exchange 
disciplinary process.
    \122\ Nasdaq Exchange Rules 9349 and 9351(a).
    \123\ Nasdaq Exchange Rule 9351.
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    The Nasdaq Exchange's By-Laws and rules provide that it has 
disciplinary jurisdiction over its members so that it can enforce its 
members' compliance with its rules and the Federal securities 
laws.\124\ The Exchange's rules also permit it to sanction members for 
violations of its rules and violations of the Federal securities laws 
by, among other things, expelling or suspending members, limiting 
members' activities, functions, or operations, fining or censuring 
members, or suspending or barring a person from being associated with a 
member.\125\ The Nasdaq Exchange's rules also provide for the 
imposition of fines for minor rule violations in lieu of commencing 
disciplinary proceedings.\126\ Accordingly, as a condition to the 
operation of the Nasdaq Exchange, a Minor Rule Violation Plan 
(``MRVP'') filed by the Nasdaq Exchange under Exchange Act Rule 19d-
1(c)(2) must be declared effective by the Commission.\127\
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    \124\ See generally Nasdaq Exchange By-Laws Article IX; Nasdaq 
Exchange Rule Series, 0100, 1000, 9000.
    \125\ See Nasdaq Exchange Rule 8300.
    \126\ See Nasdaq Exchange Rule 9216 and IM-9216. Minor Nasdaq 
Exchange rule violations include, for example, failing to file 
timely reports of short positions, failure to timely submit 
amendments to Forms BD or U-4, failing to submit trading data as 
requested, or failing to have a principal approve advertisements or 
sales literature prior to its use. See Nasdaq Exchange Rule IM-9216. 
In Amendment No. 6, Nasdaq updated proposed Nasdaq Exchange Rule IM-
9216 to reflect a NASD proposed rule change, which expanded the list 
of violations appropriate for disposition as minor rule violations. 
See Exchange Act Release No. 52294 (August 18, 2005), 70 FR 49700 
(August 24, 2005). The Commission finds that this proposed rule 
change is consistent with section 6(b)(5), (b)(6) and (b)(7) of the 
Exchange Act for the same reasons that the Commission approved these 
rule changes under section 15A(b)(6), (b)(7) and (b)(8).
    \127\ 17 CFR 240.19d-1(c)(2).
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    The Nasdaq Exchange will operate MarketWatch, a real-time 
surveillance department.\128\ MarketWatch will perform this real-time 
intraday surveillance over all Nasdaq Exchange-listed companies and all 
Nasdaq Exchange market participants. More specifically, MarketWatch 
will oversee the complete and timely disclosure of Nasdaq Exchange 
issuers' material information to determine if a trading halt is 
necessary to maintain an orderly market for the release of material 
news. In addition, MarketWatch, through its automated detection system, 
will monitor the trading activity of each security and will generate a 
price and volume alert to aid in the assessment of unusual market 
activity. MarketWatch will also coordinate and execute the release of 
initial public offerings; administer market participants' excused 
withdrawals and passive market making requests; and handle the clearly

[[Page 3558]]

erroneous trade adjudication process.\129\ If MarketWatch observes any 
activity that may involve a violation of Commission or Nasdaq Exchange 
rules, MarketWatch will immediately refer the activity to NASDR's 
Market Regulation Department for further investigation and potential 
disciplinary action.\130\
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    \128\ See Amendment No. 5, Exhibit E, supra note 7. Nasdaq 
currently operates MarketWatch pursuant to the Delegation Plan, and 
MarketWatch will continue to operate in the same manner upon the 
Nasdaq Exchange's operation as an exchange. In Amendment No. 6, 
Nasdaq proposed to add Nasdaq Exchange Rule 4121, which provided 
that, in accordance with the standing request of the Commissions, 
the Nasdaq Exchange would halt domestic trading if other major 
securities markets initiated market-wide trading halts in response 
to extraordinary market conditions.
    \129\ In Amendment No. 6, Nasdaq proposed to modify Nasdaq 
Exchange Rule 11890(b) to reflect a proposed rule change approved by 
the Commission for the NASD. The proposed rule change clarified the 
time frames under which an officer of the NASD must initiate action 
to declare a transaction null and void. See Exchange Act Release No. 
52508 (September 26, 2005), 70 FR 57346 (September 30, 2005).
    \130\ The INET ECN currently operates as a facility of the NASD. 
See infra note 137 and accompanying text. Nasdaq represents that 
until September 30, 2006, INET will report its trading activity to 
the National Stock Exchange (``NSX''). As a result, surveillance and 
disciplinary actions are currently handled by INET and NSX. Trading 
activity on INET will become subject to Nasdaq Exchange Rule 11890 
on or before February 6, 2006, and clearly erroneous matters will be 
administered by MarketWatch pursuant to the same rules and processes 
as trading activity through The Nasdaq Market Center and Brut. INET 
will cease reporting its trading activity to NSX at or prior to the 
end of September 2006, when Nasdaq's trading systems are integrated 
onto a single platform. See infra note 144 and accompanying text. At 
that time, Nasdaq MarketWatch will assume the same functions for 
INET trading as for the Nasdaq Market Center and Brut.
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    The Commission finds that the Nasdaq Exchange's By-Laws and rules 
concerning its disciplinary and oversight programs are consistent with 
the requirements of sections 6(b)(6) and 6(b)(7) \131\ of the Exchange 
Act in that they provide fair procedures for the disciplining of 
members and persons associated with members. The Commission further 
finds that the rules of the Exchange provide it with the ability to 
comply, and with the authority to enforce compliance by its members and 
persons associated with its members, with the provisions of the 
Exchange Act, the rules and regulations thereunder, and the rules of 
the Nasdaq Exchange.\132\
---------------------------------------------------------------------------

    \131\ 15 U.S.C. 78f(b)(6) and (7).
    \132\ 15 U.S.C. 78f(b)(1).
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6. Order Audit Trail System
    Under the Nasdaq Exchange rules, Nasdaq Exchange members will be 
required to comply with the NASD's Order Audit Trail System (``OATS'') 
requirements. Because Exchange members will report order information to 
OATS pursuant to the Nasdaq Exchange rules, the Exchange will have the 
right of access to OATS data for regulatory purposes. In the October 
2005 Notice, the Commission specifically requested comment on the 
extent to which the Nasdaq Exchange should be able to use OATS data for 
non-regulatory purposes and whether it should have access to OATS data 
regarding: (1) All orders its members receive, including those orders 
that are routed to markets other than the Exchange; and (2) reports of 
executions by its members that are reported to the new TRF.
    The Commission received two comment letters addressing these 
issues.\133\ One commenter stated that it was its understanding that 
the Nasdaq Exchange's sole use of OATS information would be for 
regulatory purposes and if that understanding were incorrect, it 
objects to the Exchange's access to such information for non-regulatory 
purposes.\134\ A second commenter argued that the Nasdaq Exchange 
should not have access to OATS data regarding orders and executions by 
its members that are executed off the Exchange and that the Exchange 
should not be permitted to use OATS data for non-regulatory 
purposes.\135\ This commenter, however, said that if the Exchange is 
permitted to use OATS data for non-regulatory purposes, access to such 
data for non-regulatory purposes should be granted to other markets or 
any other person who requests the data.\136\
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    \133\ See Bloomberg Letter and STA Letter, supra note 10.
    \134\ See STA Letter, supra note 10.
    \135\ See Bloomberg Letter, supra note 10.
    \136\ See Bloomberg Letter, supra note 10. Nasdaq responded to 
commenters' concerns by reaffirming its commitment not to use OATS 
data for commercial purposes. Nasdaq, however, believes that its use 
of OATS data by Nasdaq's Department of Economic Research to study 
public policy issues, such as sub-penny trading and decimalization, 
does not constitute a commercial use of the data. The Commission 
believes that any non-regulatory use of the data would have a 
commercial benefit. See Nasdaq Response Letter, supra note 11.
---------------------------------------------------------------------------

    The Commission shares commenters' concerns about the use by the 
Nasdaq Exchange of OATS information for non-regulatory purposes, 
particularly since it includes information about members' trading 
activities on competitors of the Exchange. The Nasdaq Exchange's OATS 
rules would require Exchange members to report, on a daily basis, 
extensive information with respect to the handling of orders for Nasdaq 
securities, including when all or portions of orders are executed on 
markets other than the Nasdaq Exchange. A member's failure to provide 
this information could give rise to disciplinary action by the Exchange 
pursuant to its authority as a self-regulatory organization under the 
Exchange Act. Because this information is obtained from members through 
the exercise of the Exchange's regulatory powers, the Commission does 
not believe it should be used for non-regulatory purposes, unless the 
NASD makes available such OATS data to other market participants on the 
same terms as it is provided to the Nasdaq Exchange.

C. Trading System

1. Trading Rules
    In Amendment No. 4, Nasdaq proposed that only trades executed on 
the Nasdaq Exchange systems would be considered exchange trades. 
Currently, the Nasdaq systems that would be the Exchange's systems are 
the Nasdaq Market Center, formerly known as SuperMontage, Brut, and 
INET.\137\
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    \137\ Nasdaq acquired Brut in September 2004 and the rules 
governing the execution of transactions on Brut were approved by the 
Commission in March 2005. Brut is a price/time priority system. See 
Exchange Act Release No. 51326 (March 7, 2005), 70 FR 12521 (March 
14, 2005) (``Brut Order''). In addition, on December 8, 2005, Nasdaq 
purchased INET ECN, and the rules governing the trading on INET were 
approved by the Commission in December 2005. See INET Order, supra 
note 12. In Amendment No. 6, Nasdaq proposed to add Nasdaq Exchange 
Rules 4950 et seq., governing the operation of INET, including its 
rules requiring orders to be executed in price/time priority.
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    The Nasdaq Exchange's proposed Nasdaq Market Center rules require 
price priority.\138\ The rules, with limited exceptions, also require 
time priority.\139\ Accordingly, the Nasdaq Exchange's proposed Nasdaq 
Market Center rules differ from current NASD rules governing the Nasdaq 
Market Center as follows:
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    \138\ In Amendment No. 6, Nasdaq proposed to add two order types 
that are consistent with its priority rules and were previously 
approved by the Commission for the NASD: proactive limit orders and 
reverse pegged orders. See respectively, Exchange Act Release Nos. 
52511 (September 27, 2005), 70 FR 57636 (October 3, 2005) (relating 
to proactive limit orders) and 52449 (September 15, 2005), 70 FR 
55647 (September 22, 2005) (relating to reverse pegged orders).
    \139\ Because ERISA may restrict the ability of a Nasdaq Quoting 
Market Participant or Order Entry Firm that is trading for a managed 
account, pursuant to Exchange rules, these members may append an 
anti-internalization qualifier (``AIQ'') to its quote or order to 
prevent an order from trading with the entering firms' own trading 
interest.
    In addition, Nasdaq Market Center Participants may submit 
``Auto-Ex Orders,'' which would only trade with the quotes and 
orders of automatic execution participants that do not charge a 
separate quote-access fee. An Auto-Ex Order would cancel instead of 
locking or trading through the price of an order-delivery or quote-
access fee charging participant's quote or order. Order delivery and 
quote-access charging participants would not retain time priority 
over the quotes and orders of automatic execution participants that 
do not charge a separate quote-access fee when such quotes and 
orders trade with Auto-Ex Orders.
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    (1) The Exchange's rules do not include the priority rule that 
first executes an incoming order against the submitting member's own 
interest reflected in the Nasdaq Market Center at

[[Page 3559]]

the best price, irrespective of whether the member has time priority; 
\140\ and
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    \140\ See NASD Rule 4710(b)(1)(B)(ii)(a).
---------------------------------------------------------------------------

    (2) The Exchange's rules do not permit preferenced orders by 
members, which permit trades to occur outside of time priority.\141\
---------------------------------------------------------------------------

    \141\ Currently, NASD rules permit the use of preferenced 
orders, which permit NASD members to direct orders to a particular 
contra party for execution. If the contra party is at the best 
price, the system executes the order against the preferenced party, 
irrespective of whether the preferenced party has time priority. See 
NASD Rule 4701(aa).
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    In addition to the Nasdaq Market Center, Nasdaq currently owns and 
operates two other trading systems--the Brut Facility \142\ and the 
INET Facility.\143\ Nasdaq proposes to integrate its three execution 
systems into a single trading platform with an integrated quote/order 
book operated in accordance with a unified price priority execution 
algorithm prior to the end of September 2006.\144\ Nasdaq has also 
represented that upon completion of this systems integration there will 
be a single integrated book where all orders interact with each other. 
If the Nasdaq Exchange satisfies each of the conditions required for it 
to begin operating as an exchange set forth in this Order prior to 
completing integration of the three systems, the Nasdaq Exchange may 
temporarily operate as many as three separate trading facilities, each 
of which trades the same securities, but do not fully interact with 
each other.\145\
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    \142\ See Brut Order, supra note 137.
    \143\ See INET Order, supra note 137.
    \144\ See Amendment No. 6, Nasdaq Exchange Rule 4720.
    \145\ As of the date of this Order, the Nasdaq INET Facility is 
a wholly-separate platform that posts its top-of-file quotes through 
the facilities of the National Stock Exchange (``NSX''). Nasdaq and 
Brut are partially integrated. Brut displays its entire book in the 
Nasdaq Market Center. Accordingly, all quotes and orders resident in 
the Nasdaq Market Center, including Brut's entire depth of the book, 
interact with incoming orders based on the Nasdaq Market Center's 
order execution algorithm. Orders sent directly to the Brut system, 
however, do not interact with quotes and orders resident in the 
Nasdaq Market Center; they interact solely with quotes and orders 
displayed in Brut.
---------------------------------------------------------------------------

    The Commission believes that it is beneficial for orders in the 
same securities directed to an exchange to interact with each other. 
Such interaction promotes efficient exchange trading and protects 
investors by assuring that orders are executed pursuant to a single set 
of priority rules that are consistently and fairly applied. For 
example, consolidating the limit orders received by an exchange within 
a single trading facility affords an opportunity for such orders to be 
executed in accordance with price priority, which may not be available 
when an exchange's orders are directed among multiple trading 
facilities.
    Nasdaq's operation of three trading facilities is due to recent 
acquisitions by Nasdaq. Nasdaq has represented that it is in the 
process of combining these three trading systems into one system, which 
Nasdaq proposes to complete by September 30, 2006.\146\ Both Brut and 
INET were operating as alternative trading systems prior to Nasdaq's 
acquisition, and are important trading markets with participants that 
rely on their continuing availability. The Commission believes that it 
is in the public interest for Brut and INET to be available while 
Nasdaq is integrating them together with its Nasdaq Market Center and, 
thus, for this limited period of time it is consistent with the 
Exchange Act for the Nasdaq Exchange to operate as many as three 
separate trading system until September 30, 2006.\147\
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    \146\ See Nasdaq Exchange Rule 4720.
    \147\ Pursuant to the Brut Order and the INET Order, Brut and 
INET are subject to all NASD rules applicable to their broker-dealer 
activities, including those requiring participation in market 
surveillance and audit trail programs conducted by the NASD and 
Nasdaq. Similarly, Brut and INET will be subject to all applicable 
Nasdaq Exchange broker-dealer rules as of the operation date of the 
Exchange.
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2. Trade Reporting Facility
    In a separate filing with the Commission, the NASD proposes to 
establish a new Trade Reporting Facility to provide NASD members with a 
mechanism for reporting transactions in all exchange-listed securities 
executed otherwise than on an exchange.\148\ In commenting on Nasdaq's 
application for exchange registration, several commenters criticized 
this NASD proposal.\149\ These commenters contend, among other things, 
that because of the affiliation between the Nasdaq Exchange and the 
limited liability company that will operate the TRF, the Trade 
Reporting Facility would not really be a facility of the NASD, but 
instead would be a facility of the Nasdaq Exchange. At such time as the 
Commission considers the TRF proposal, it will take these comments into 
account.
---------------------------------------------------------------------------

    \148\ See NASD Proposal, supra note 8.
    \149\ See Arca Letter and NYSE Letter, supra note 10.
---------------------------------------------------------------------------

3. Market Maker Obligations
    Nasdaq Exchange members may register as Nasdaq Market Makers or 
ITS/CAES Market Makers.\150\ As market makers, these members must 
engage in a course of dealings for their own account to assist in the 
maintenance, insofar as reasonably practicable, of fair and orderly 
markets.\151\ In addition, Nasdaq Market Makers and ITS/CAES Market 
Makers, among other things, must maintain continuous two-sided quotes, 
that are firm, with a minimum quotation increment of $0.01. The 
Commission believes that these requirements are consistent with the 
Exchange Act because they should help to ensure that Nasdaq Market 
Makers and ITS/CAES Market Makers perform their obligations in a manner 
that promotes just and equitable principles of trade.
---------------------------------------------------------------------------

    \150\ See Nasdaq Exchange Rules 4611 and 5220.
    \151\ See Amendment No. 6, supra note 12 and Nasdaq Exchange 
Rules 4613 and 5221.
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4. Section 11 of the Exchange Act
    Section 11(a)(1) of the Exchange Act \152\ prohibits a member of a 
national securities exchange from effecting transactions on that 
exchange for its own account, the account of an associated person, or 
an account over which it or its associated person exercises discretion 
(collectively, ``covered accounts'') unless an exception applies. Rule 
11a2-2(T) \153\ under the Exchange Act, known as the ``effect versus 
execute'' rule, provides exchange members with an exemption from the 
section 11(a)(1) prohibition. Rule 11a2-2(T) permits an exchange 
member, subject to certain conditions, to effect transactions for 
covered accounts by arranging for an unaffiliated member to execute the 
transactions on the exchange. To comply with Rule 11a2-2(T)'s 
conditions, a member (i) must transmit the order from off the exchange 
floor; (ii) may not participate in the execution of the transaction 
once it has been transmitted to the member performing the execution; 
\154\ (iii) may not be affiliated with the executing member; and (iv) 
with respect to an account over which the member has investment 
discretion, neither the member nor its associated person may retain any 
compensation in connection with effecting the transaction except as 
provided in the Rule.
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    \152\ 15 U.S.C. 78k(a)(1).
    \153\ 17 CFR 240.11a2-2(T).
    \154\ The member may, however, participate in clearing and 
settling the transaction.
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    In a letter to the Commission,\155\ Nasdaq requested that the 
Commission concur with Nasdaq's conclusion that Nasdaq Exchange members 
that enter orders into Nasdaq Market Center, Brut, and INET 
(collectively ``Nasdaq

[[Page 3560]]

Execution Systems'') satisfy the requirements of Exchange Act Rule 
11a2-2(T). For reasons set forth below, the Commission believes that 
Nasdaq Exchange members entering orders into the Nasdaq Execution 
Systems would satisfy the conditions of the Rule.
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    \155\ See letter to Nancy Morris, Secretary, Commission, and 
Elizabeth King, Associate Director, Division, Commission, from 
Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated January 12, 2006 (``Nasdaq 11(a) Letter'').
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    The Rule's first condition is that orders for covered accounts be 
transmitted from off the exchange floor. The Nasdaq Execution Systems 
receive orders electronically through remote terminals or computer-to-
computer interfaces. In the context of other automated trading systems, 
the Commission has found that the off-floor transmission requirement is 
met if a covered account order is transmitted from a remote location 
directly to an exchange's floor by electronic means.\156\ Since the 
Nasdaq Execution Systems receive orders electronically through remote 
terminals or computer-to-computer interfaces, the Commission believes 
that the Nasdaq Execution Systems satisfy the off-floor transmission 
requirement.
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    \156\ See, e.g., Exchange Act Release Nos. 49068 (January 13, 
2004), 69 FR 2775 (January 20, 2004) (order approving the Boston 
Options Exchange as an options trading facility of the Boston Stock 
Exchange); 44983 (October 25, 2001), 66 FR 55225 (November 1, 2001) 
(order approving Archipelago Exchange (``ArcaEx'') as electronic 
trading facility of the Pacific Exchange (``PCX'') (''ArcaEx 
Order'')); 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991) 
(regarding NYSE's Off-Hours Trading Facility); 15533 (January 29, 
1979), 44 FR 6084 (January 31, 1979) (regarding the American Stock 
Exchange (``Amex'') Post Execution Reporting System, the Amex 
Switching System, the Intermarket Trading System, the Multiple 
Dealer Trading Facility of the Cincinnati Stock Exchange, the PCX 
Communications and Execution System, and the Philadelphia Stock 
Exchange's (``Phlx'') Automated Communications and Execution System 
(``1979 Release'')); and 14563 (March 14, 1978), 43 FR 11542 (March 
17, 1978) (regarding the NYSE's Designated Order Turnaround System 
(``1978 Release'')).
---------------------------------------------------------------------------

    Second, the rule requires that the member not participate in the 
execution of its order. Nasdaq represented that at no time following 
the submission of an order is a member able to acquire control or 
influence over the result or timing of an order's execution.\157\ 
According to Nasdaq, the execution of a member's order is determined 
solely by what orders, bids, or offers are present in the system at the 
time the member submits the order. Accordingly, the Commission believes 
that a Nasdaq Exchange member does not participate in the execution of 
an order submitted into the Nasdaq Execution Systems.
---------------------------------------------------------------------------

    \157\ See Nasdaq 11(a) Letter, supra note 155. The member may 
only cancel or modify the order, or modify the instructions for 
executing the order, but only from off the Exchange floor. Id. The 
Commission has stated that the non-participation requirement is 
satisfied under such circumstances so long as such modifications or 
cancellations are also transmitted from off the floor. See Exchange 
Act Release No. 14563 (March 14, 1978), 43 FR 11542 (March 17, 1978) 
(stating that the ``non-participation requirement does not prevent 
initiating members from canceling of modifying orders (or the 
instructions pursuant to which the initiating member wishes orders 
to be executed) after the orders have been transmitted to the 
executing member, provided that any such instructions are also 
transmitted from off the floor'').
---------------------------------------------------------------------------

    Third, Rule 11a2-2(T) requires that the order be executed by an 
exchange member who is unaffiliated with the member initiating the 
order. The Commission has stated that the requirement is satisfied when 
automated exchange facilities, such as the Nasdaq Execution Systems, 
are used.\158\
---------------------------------------------------------------------------

    \158\ In considering the operation of automated execution 
systems operated by an exchange, the Commission noted that while 
there is no independent executing exchange member, the execution of 
an order is automatic once it has been transmitted into the systems. 
Because the design of these systems ensures that members do not 
possess any special or unique trading advantages in handling their 
orders after transmitting them to the exchange, the Commission has 
stated that executions obtained through these systems satisfy the 
independent execution requirement of Rule 11a2-2(T). See 1979 
Release, supra note 156.
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    Fourth, in the case of a transaction effected for an account with 
respect to which the initiating member or an associated person thereof 
exercises investment discretion, neither the initiating member nor any 
associated person thereof may retain any compensation in connection 
with effecting the transaction, unless the person authorized to 
transact business for the account has expressly provided otherwise by 
written contract referring to section 11(a) of the Exchange Act and 
Rule 11a2-2(T).\159\ Nasdaq represented that Nasdaq Exchange members 
trading for covered accounts over which they exercise investment 
discretion must comply with this condition in order to rely on the 
rule's exemption.\160\
---------------------------------------------------------------------------

    \159\ 17 CFR 240.11a2-2(T)(a)(2)(iv). In addition, Rule 11a2-
2(T)(d) requires a member or associated person authorized by written 
contract to retain compensation, in connection with effecting 
transactions for covered accounts over which such member or 
associated person thereof exercises investment discretion, to 
furnish at least annually to the person authorized to transact 
business for the account a statement setting forth the total amount 
of compensation retained by the member in connection with effecting 
transactions for the account during the period covered by the 
statement. See 17 CFR 240.11a2-2(T)(d). See also 1978 Release, supra 
note 156 (stating ``[t]he contractual and disclosure requirements 
are designed to assure that accounts electing to permit transaction-
related compensation do so only after deciding that such 
arrangements are suitable to their interests'').
    \160\ See Nasdaq 11(a) Letter, supra note 155.
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5. Short Sale Rule
a. Background
    Section 10(a) of the Exchange Act \161\ gives the Commission 
plenary authority over short sales \162\ of securities registered on a 
national securities exchange as necessary or appropriate in the public 
interest or for the protection of investors. The Commission adopted 
Rule 10a-1 in 1938 in order to restrict short selling in a declining 
market.\163\ Paragraph (a) of Rule 10a-1 generally covers short sales 
in securities registered on, or admitted to unlisted trading privileges 
on, a national securities exchange if trades of the securities are 
reported pursuant to an ``effective transaction reporting plan'' and 
information as to such trades is made available in accordance with such 
plan on a real-time basis to vendors of market transaction 
information.\164\ Paragraph (b) applies to short sales on national 
exchanges in securities that are not covered by paragraph (a).
---------------------------------------------------------------------------

    \161\ 15 U.S.C. 78j(a).
    \162\ A ``short sale'' is defined in Rule 200(a) of Regulation 
SHO as ``any sale of a security which the seller does not own or any 
sale which is consummated by the delivery of a security borrowed by, 
or for the account of, the seller.'' 17 CFR 242.200(a).
    \163\ See Exchange Act Release No. 1548 (January 24, 1938), 3 FR 
213 (January 26, 1938). In addition to section 10(a) of the Exchange 
Act, and Rule 10a-1 thereunder, Regulation SHO, which became 
effective on September 7, 2004, also governs the regulation of short 
sales. See Exchange Act Release No. 50103 (July 28, 2004), 69 FR 
48008 (August 6, 2004) (``Adopting Release''). Regulation SHO 
adopted the following provisions: (i) Rule 200--Definitions and 
Marking Requirements; (ii) Rule 202T--Pilot Program; and (iii) Rule 
203--Locate and Delivery Requirements. Pursuant to the terms of 
Regulation SHO, the Commission approved an order establishing a one-
year pilot program (``Pilot Program'') suspending the provisions of 
Rule 10a-1(a) under the Exchange Act and any short sale price test 
of any exchange or national securities association for short sales 
of certain securities for certain time periods. See Exchange Act 
Release No. 50104 (July 28, 2004), 69 FR 48032 (August 6, 2004). The 
Commission decided to defer consideration of proposed Rule 201, 
which would have replaced the current ``tick'' test of Rule 10a-1(a) 
with a new uniform bid test. See Exchange Act Release No. 48709 
(October 28, 2003), 68 FR 62972 (November 6, 2003) (``Proposing 
Release''). The Commission will consider any further action on the 
price test after the completion of the Pilot Program. Therefore, 
Rule 10a-1's tick test currently applies to short sales of 
securities registered on, or admitted to unlisted trading privileges 
on, a national securities exchange.
    \164\ Rule 10a-1 uses the term ``effective transaction reporting 
plan'' as defined in Rule 600 of Regulation NMS under the Exchange 
Act, 17 CFR 242.600. 17 CFR 240.10a-1(a)(1)(i).
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    Rule 10a-1(a)(1) provides that, subject to certain exceptions, an 
exchange-registered security may only be sold short: (1) At a price 
above the price at which the immediately preceding sale was effected 
(plus tick), or (2) at the last sale price if it is higher than the 
last different price (zero-plus tick). Conversely, short sales are not 
permitted on minus ticks or zero-minus ticks, subject to narrow 
exceptions. The operation of these provisions is commonly described as 
the ``tick test.''

[[Page 3561]]

b. Nasdaq Securities
    Current short sale regulations apply different price tests to 
securities trading in different markets. Rule 10a-1's ``tick test,'' 
which is based on the sale price reported pursuant to an effective 
transaction reporting plan, applies to short sales of securities 
registered on, or admitted to unlisted trading privileges on, a 
national securities exchange. In 1994, the Commission granted temporary 
approval to the NASD to apply its own short sale rule to Nasdaq 
National Market securities on a pilot basis.\165\ Specifically, NASD 
Rule 3350 prohibits short sales at or below the current best (inside) 
bid when the current best (inside) bid is below the previous best 
(inside) bid in a security. Once Nasdaq operates as an exchange, Nasdaq 
National Market securities and Nasdaq Capital Market securities \166\ 
will be exchange-registered securities reported pursuant to an 
effective transaction reporting plan and therefore subject to Rule 10a-
1.\167\
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    \165\ See Exchange Act Release No. 34277 (June 29, 1994), 59 FR 
34885 (July 7, 1994). The NASD's short sale rule was originally 
approved on an eighteen-month pilot basis. The NASD has proposed and 
the Commission has approved, extensions of NASD Rule 3350 several 
times, most recently, until December 15, 2006. See Exchange Act 
Release No. 53093 (January 10, 2006). In Amendment No. 6, Nasdaq 
proposed to modify Nasdaq Exchange Rules 3350(k)(2) and 3350(l) to 
reflect the changes made to NASD Rule 3350.
    \166\ Nasdaq Capital Market securities were formerly known as 
``Nasdaq SmallCap Market securities.'' See Exchange Act Release No. 
52489 (September 21, 2005), 70 FR 56948 (September 29, 2005).
    \167\ Nasdaq plans to request relief from the registration 
requirements of section 12(b) of the Exchange Act for certain 
issuers who are currently exempt grandfathered foreign private 
issuers (Rule 12g3-2(b) of the Exchange Act) and insurance companies 
(section 12(g)(2)(G) of the Exchange Act). If granted, such 
securities would trade on Nasdaq even though they would not be 
registered pursuant to section 12(b) of the Exchange Act. However, 
such securities would remain subject to Nasdaq Exchange Rule 3350.
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    In the Regulation SHO Proposing Release,\168\ the Commission 
considered Nasdaq's request for an exemption from Rule 10a-1 in 
conjunction with its exchange registration to allow Nasdaq to apply 
Rule 3350 to Nasdaq exchange-listed securities, as well as other market 
developments \169\ in proposing a uniform bid test using the 
consolidated best bid as the reference point for permissible short 
sales.\170\ After considering comments to the Regulation SHO Proposing 
Release regarding the proposed uniform bid test, the Commission decided 
to defer consideration of a new uniform bid test and instead adopted 
Rule 202T of Regulation SHO.\171\ Rule 202T is a temporary rule that 
excludes designated securities from the operation of the ``tick'' test 
of Rule 10a-1(a) and any short sale price test rule of any exchange or 
national securities association for a designated period of time.\172\ 
The Commission believes that conducting a Pilot Program pursuant to 
Rule 202T of Regulation SHO is an important component of evaluating the 
overall effectiveness of price test restrictions on short sales.\173\ 
The empirical data obtained from the Pilot Program will help the 
Commission assess whether it is necessary or appropriate to amend, or 
possibly remove, the short sale price tests for some population of 
securities.\174\ The Commission will consider any further action on the 
adoption of a price test after the completion of the Pilot Program. In 
order to promote efficient regulation and to avoid unnecessarily 
burdening markets with the imposition of costs associated with 
implementing a price test that may be temporary, the Commission 
believes that, as discussed below, it is necessary and appropriate in 
the public interest and consistent with the protection of investors to 
maintain the status quo for the price test to apply to short sales in 
Nasdaq National Market securities, and to continue to not apply to 
short sales in Nasdaq Capital Market securities.
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    \168\ See Exchange Act Release No. 48709 (October 28, 2003), 68 
FR 62972 (November 6, 2003).
    \169\ 68 FR at 62979.
    \170\ Id.
    \171\ 17 CFR 242.202T.
    \172\ See Exchange Act Release No. 50104 (July 28, 2004), 69 FR 
48032 (August 6, 2004). See also Exchange Act Release No. 50747 
(November 29, 2004), 69 FR 70480 (December 6, 2004).
    \173\ See Exchange Act Release No. 50104 (July 28, 2004), 69 FR 
48032 (August 6, 2004).
    \174\ Id.
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c. Request for exemption from Rule 10a-1
    Nasdaq has requested \175\ an exemption from Rule 10a-1 to continue 
regulating short sales of Nasdaq National Market securities under the 
bid test of Nasdaq Exchange Rule 3350.\176\ Nasdaq has also requested 
an exemption from Rule 10a-1 for Nasdaq Capital Market securities, as 
current NASD Rule 3350 is inapplicable to such securities. The 
requested exemption would therefore allow Nasdaq Capital Market 
securities to continue to trade without being subject to a price test. 
Nasdaq proposes to continue all current exemptions to NASD Rule 3350 in 
its Rule 3350, including the exemption for qualified market makers in 
connection with bona fide market making.\177\
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    \175\ See letter to James A. Brigagliano, Division, Commission, 
from Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated January 4, 2006 (``Short Sale Letter'').
    \176\ The Nasdaq Exchange's short sale rule is identical to the 
NASD's short sale rule.
    \177\ Nasdaq's request states that, unlike exchange specialists, 
dealers in Nasdaq securities have no monopoly-like position in the 
securities they trade, nor do they have an inherent informational 
advantage over any other dealer. Additionally, they have no ability 
to close their market because of sudden volatility or an order 
imbalance. Given these differences, it believes that treating market 
makers and exchange specialists identically is not appropriate. See 
letter to James A. Brigagliano, Division, Commission, from Edward S. 
Knight, Executive Vice President and General Counsel, Nasdaq, dated 
January 4, 2006. Allowing Nasdaq to maintain the market maker 
exemption would also be consistent with the CBOE's position 
expressed in its comment letter. The CBOE stated that there is a 
critical need to maintain an exemption for options market makers 
until, at a minimum, the Commission makes a final determination 
concerning the future framework and provision of Rule 10a-1. See 
CBOE Letter, supra note 14.
---------------------------------------------------------------------------

    Nasdaq represents that its requested exemption would serve the 
public interest and protect investors by enabling Nasdaq to continue 
regulating short sales under Nasdaq Rule 3350 as it does today under 
NASD Rule 3350.\178\ In addition, Nasdaq represents, among other 
things, that (i) its short sale rule would continue to prohibit the 
same conduct as Commission Rule 10a-1; (ii) Nasdaq would continue to 
vigorously and effectively enforce those prohibitions; and (iii) it is 
imperative that Nasdaq preserve its current structure to the greatest 
extent possible to avoid needless confusion during Nasdaq's transition 
to exchange status.\179\
---------------------------------------------------------------------------

    \178\ See Short Sale Letter, supra note 175.
    \179\ Id.
---------------------------------------------------------------------------

    Commenters generally supported the Commission granting an exemption 
to Nasdaq from Rule 10a-1 to allow the Nasdaq Exchange to apply its own 
bid test once it becomes a national securities exchange.\180\ One 
commenter in particular noted that it is important for Nasdaq to retain 
the NASD short sale rule when it becomes an exchange for the following 
reasons, among others: (i) Because depriving market makers of the 
market maker exception would significantly hinder their ability to 
quickly adjust inventory risk positions; and (ii) because options 
market makers and block facilitators widely use the NASD short sale 
rule's options hedge exceptions as a risk management tool, the 
unavailability of the NASD short sale rule's exception may result in 
less

[[Page 3562]]

willingness to commit capital to customer orders.\181\
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    \180\ See letter from Thomas N. McManus, Executive Director and 
Counsel, Morgan Stanley Dean Witter, dated September 4, 2001 
(``Morgan Stanley Letter''). See also SIA Letter, supra note 15; and 
letters from Robert M. Funk, Executive Director, American 
Shareholders Association, dated July 17, 2001; Grover G. Norquist, 
President, Americans for Tax Reform, dated July 17, 2001; 
Congressman Patrick J. Tiberi, Ohio, dated July 20, 2001; and 
Congressman Jerry Weller, Illinois, dated August 23, 2001 and August 
31, 2001.
    \181\ See Morgan Stanley Letter, supra note 180.
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    A few commenters, on the other hand, believed that Nasdaq should 
not be granted an exemption from Rule 10a-1, noting, among other 
things, that from a regulatory, fairness and competitive perspective, 
Nasdaq should be required to comply with all Commission rules 
applicable to a national securities exchange, including the 
Commission's short sale rule.\182\ One commenter, in particular, stated 
that the Commission should either propose amendments to Rule 10a-1 to 
apply to all exchanges equally, including Nasdaq, or require Nasdaq to 
amend its proposed rules to be consistent with the short sale 
regulatory regime applied to all other exchanges.\183\
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    \182\ See NYSE August 2001 Letter, supra note 13. See also CSE 
Letter, supra note 13; SIA Letter, supra note 15.
    \183\ See CSE Letter, supra note 13.
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d. Response
    The Commission appreciates the concerns expressed by such 
commenters; however, as discussed above, the Commission believes that 
it is important to maintain the status quo of short sale regulation 
during the Pilot Program in order to avoid unnecessarily burdening the 
markets. Moreover, it is important to maintain the integrity of the 
data obtained by the Commission during this period on the impact of 
short selling in the absence of a price test. This data will, among 
other things, assist in (i) determining the extent to which a price 
test is necessary to further the objectives of short sale regulation; 
(ii) the effects of relatively unrestricted short selling on market 
volatility, price efficiency, and liquidity; and (iii) whether a short 
sale price test should be removed, in part or in whole, for some or all 
securities, or if retained, should be applied to additional securities. 
Investor protection will be enhanced because the Commission's 
determination with respect to the short sale price test will be based 
on sound empirical data obtained from the Pilot Program.
    Based upon the representations and facts Nasdaq has presented in 
its request for exemption, as discussed above, and as necessary and 
appropriate in the public interest and consistent with the protection 
of investors, in particular the necessity and importance of maintaining 
the status quo during the Pilot Program, pursuant to section 36 of the 
Exchange Act,\184\ the Commission hereby grants a temporary exemption 
\185\ from Rule 10a-1 to permit the Nasdaq Exchange to apply Nasdaq 
Exchange Rule 3350 to short sales in Nasdaq National Market securities 
occurring on the Nasdaq Exchange and to allow Nasdaq Capital Market 
securities to be exempt from the application of the tick test.\186\ The 
exemptions from Rule 10a-1 will expire upon termination of the Pilot 
Program or at such other time the Commission determines that such 
exemptions are no longer necessary or appropriate in the public 
interest or consistent with the protection of investors.\187\
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    \184\ 15 U.S.C. 78mm(a)(1).
    \185\ Granting a temporary exemption to Nasdaq from Rule 10a-1 
is consistent with certain comments received on the Nasdaq Exchange 
Application. See SIA Letter, supra note 15.
    \186\ As exchange-registered securities reported pursuant to an 
effective transaction reporting plan, Rule 10a-1 applies to Nasdaq 
securities, as defined in Rule 600 of Regulation NMS, wherever they 
are traded. See 17 CFR 240.10a-1(a)(1)(i). Therefore, short sales in 
Nasdaq securities effected on any national securities exchange that 
trades Nasdaq securities on a unlisted trading privileges (``UTP'') 
basis or in the OTC market are subject to Rule 10a-1 unless 
exempted. It may be appropriate for the Nasdaq short sale rule to 
apply uniformly to all Nasdaq National Market securities, wherever 
they are traded. 15 U.S.C. 78mm(a)(1). The Commission is therefore 
prepared to consider an appropriate exemptive request from Rule 10a-
1 for any exchange trading Nasdaq National Market securities UTP to 
apply an analogue of Nasdaq Exchange Rule 3350, so that short sales 
in Nasdaq National Market securities would be treated consistently 
whether they occurred on Nasdaq or in another venue. Likewise, the 
Commission is prepared to consider an appropriate exemption from 
Rule 10a-1 for any exchange trading Nasdaq Capital Market securities 
UTP so that such securities would be exempt from the tick test 
wherever traded. This would be consistent with at least one 
commenter's position that if Nasdaq is granted an exemption from 
Rule 10a-1, other registered exchanges must equally be granted such 
an exemption. See CSE Letter, supra note 13.
    \187\ The Pilot Program is currently scheduled to end on April 
28, 2006. See Exchange Act Release No. 50747 (November 29, 2004), 69 
FR 70480 (December 6, 2004). However, the Commission may from time 
to time approve further orders affecting the Pilot Program, 
including extension of the duration of the Pilot Program.
---------------------------------------------------------------------------

    Because Nasdaq proposes to continue to maintain the exemption from 
its Rule 3350 for qualified market makers in connection with bona fide 
market making, the exemptions from Rule 10a-1 are subject to the 
following conditions: \188\
---------------------------------------------------------------------------

    \188\ This exemption from Rule 10a-1 is strictly limited to the 
application of Rule 10a-1 to transactions in Nasdaq securities. The 
exemption does not affect any other provisions of the Federal 
securities laws, and is subject to modification or revocation at any 
time the Commission determines that such action is necessary or 
appropriate in furtherance of the purposes of the Federal securities 
laws. Further, this exemption is subject to modification or 
revocation should the Commission amend Rule 10a-1 in such a manner 
as to render the exemption unnecessary or in conflict with any 
adopted amendments. In addition, Nasdaq is directed to the anti-
fraud and anti-manipulation provisions of the Federal securities 
laws, including sections 9(a) and 10(b) of the Exchange Act, and 
Rule 10b-5 thereunder. Responsibility for these and any other 
applicable provisions of the federal securities laws must rest with 
those relying on the relief granted herein.
---------------------------------------------------------------------------

    (1) The Nasdaq Exchange is required to surveil member firms in 
order to monitor whether firms claiming the bona fide market maker 
exception in Nasdaq Exchange Rule 3350 are engaged in bona fide market 
making activity; and
    (2) The Nasdaq Exchange will issue a Notice to Members or other 
appropriate communication to its members to provide further 
clarification to Nasdaq market makers regarding what activity would not 
be deemed ``bona fide market making activity'' for purposes of claiming 
the exception to Nasdaq Exchange Rule 3350's bid test.

D. Section 11A of the Exchange Act

    Section 11A of the Exchange Act and the rules thereunder form the 
basis of our national market system and impose requirements on 
exchanges to implement its objectives. Specifically, national 
securities exchanges are required, under Rule 601 of Regulation 
NMS,\189\ to file transaction reporting plans regarding transactions in 
listed equity and Nasdaq securities that are executed on its 
facilities. Currently registered exchanges satisfy this requirement by 
participating in the Consolidated Transaction Association Plan (``CTA 
Plan''), for listed equities and the Joint Self-Regulatory Organization 
Plan Governing the Collection, Consolidation and Dissemination of 
Quotation and Transaction Information for Nasdaq-Listed Securities 
Traded on Exchanges on an Unlisted Trading Privileges Basis (``Nasdaq 
UTP Plan'') for Nasdaq securities.\190\ Before the Nasdaq Exchange can 
begin operating as an exchange, it must join these plans as a 
participant in its own right. Currently, the transactions executed in 
Nasdaq trading facilities are reported to these plans as OTC trades 
pursuant to the NASD's participation in the plans. The NASD's continued 
participation in these plans is necessary for it to fulfill its 
obligations under section 11A of the Exchange Act and Rules 601 and 
603.
---------------------------------------------------------------------------

    \189\ 17 CFR 242.601.
    \190\ These plans also satisfy the requirement in Rule 603 that 
national securities exchanges and national securities associations 
act jointly pursuant to an effective national market system plan to 
disseminate consolidated information, including a national best bid 
and offer, and quotations for and transactions in NMS stocks. See 17 
CFR 242.603.
---------------------------------------------------------------------------

    National securities exchanges are required, under Rule 602 of 
Regulation NMS,\191\ to collect bids, offers, quotation sizes and 
aggregate quotation sizes from those members who are responsible broker 
or dealers. National securities

[[Page 3563]]

exchanges must then make this information available to vendors at all 
times when the exchange is open for trading. The current exchanges 
satisfy this requirement by participating in the Consolidated Quotation 
System Plan (``CQ Plan'') for listed equity securities and the Nasdaq 
UTP Plan for Nasdaq securities. Before the Nasdaq Exchange can begin 
operating as an exchange it also must join the CQ Plan as a participant 
in its own right. As with transaction reports, quotations posted in 
Nasdaq trading facilities are currently provided to the CQ Plan and 
Nasdaq UTP Plan pursuant to the NASD's participation in the plans. The 
NASD must remain a member of these plans for OTC quotations in 
exchange-listed and Nasdaq securities so that it can continue to 
fulfill its obligations under sections 15A(b)(11) \192\ and 11A of the 
Exchange Act and Rules 602 and 603.
---------------------------------------------------------------------------

    \191\ 17 CFR 242.602.
    \192\ 15 U.S.C. 78o-3(b)(11).
---------------------------------------------------------------------------

    An integral part of our national market system is the means by 
which quotations are accessible across the competing exchanges and the 
NASD.\193\ Currently, the registered exchanges and the NASD are linked 
for the purpose of accessing quotations in exchange-listed securities 
via the Intermarket Trading System (``ITS''). The ITS Plan contains the 
rules pursuant to which its participants interact and contains the 
current trade-through rule.\194\ Currently, the NASD is a member of the 
ITS Plan and as a participant complies with, and enforces compliance by 
its members, with the terms of the ITS Plan.\195\ Accordingly, most OTC 
transactions in non-Nasdaq exchange-listed securities regulated by the 
NASD are subject to the requirements of the ITS Plan. The NASD plans to 
remain a member of the ITS Plan for the purpose of providing access to 
OTC quotations communicated by its members through NASD facilities and 
to provide its members access to exchanges' quotations. The NASD's 
Nasdaq facility currently is the means by which the NASD and its 
members comply with obligations under the ITS Plan. Accordingly, the 
NASD must have the means to satisfy these obligations prior to 
completing the spin-off of its subsidiary as an independent national 
securities exchange. For this reason, the Commission is conditioning 
the operation of the Nasdaq Exchange, which will automatically 
terminate the NASD's control of Nasdaq,\196\ on the NASD representing 
to the Commission that control of Nasdaq through the Preferred D share 
is no longer necessary.
---------------------------------------------------------------------------

    \193\ See section 11A(a)(1)(D) of the Exchange Act; 15 U.S.C. 
78k-1(a)(1)(D). In this section, Congress found that the ``[t]he 
linking of all markets for qualified securities through 
communications and data processing facilities will foster 
efficiency, enhance competition, increase the information available 
to brokers, dealers, and investors, facilitate the offsetting of 
investors' orders, and contribute to best execution of such 
orders.''
    \194\ In June 2005, the Commission adopted Regulation NMS, which 
included the new Rule 611 that will supersede the trade-through rule 
found in the ITS Plan. Rule 611 requires a trading center to 
establish, maintain and enforce written policies and procedures that 
are reasonably designed to prevent trade-throughs of protected 
quotations in NMS stocks. Rule 611 became effective on August 29, 
2005; compliance with this rule shall begin starting on June 29, 
2006. 17 CFR 242.611.
    \195\ 17 CFR 242.608(c).
    \196\ See supra note 25 and accompanying text.
---------------------------------------------------------------------------

    To provide access to quotes and orders in non-Nasdaq exchange-
listed securities displayed on the Nasdaq Exchange, the Nasdaq Exchange 
must become a member of the ITS Plan prior to its operation as a 
national securities exchange for trading such securities. Although 
required participation in the ITS Plan is of limited duration,\197\ the 
Commission believes that it is necessary until the full implementation 
of Rule 611 that the Nasdaq Exchange join the ITS Plan to ensure that 
the Commission's policy of protecting limit orders and providing price 
protection across markets is maintained. Further, the Nasdaq Exchange 
participation in the ITS Plan should ensure that regulatory 
requirements are consistent across the markets for exchange-listed 
securities.\198\ Nasdaq has proposed to adopt ITS rules that are 
similar to the current NASD ITS Rules. The Commission notes that the 
Nasdaq Exchange may have to amend its ITS rules to reflect its 
participation in the ITS Plan. Any changes to its rules to implement 
its participation in the ITS Plan must be filed with and approved by 
the Commission prior to its commencement of operations as a national 
securities exchange.
---------------------------------------------------------------------------

    \197\ See supra note 194.
    \198\ See section 11A(a)(1)(ii) of the Exchange Act; 15 U.S.C. 
78k-1(a)(1)(ii).
---------------------------------------------------------------------------

    The NASD currently fulfills its obligations under Rules 602 and 
603, the CTA Plan, CQ Plan, Nasdaq UTP Plan, and section 15A(b)(11) of 
the Exchange Act \199\ through NASD facilities that are owned by the 
NASD's subsidiary, Nasdaq. The NASD also operates the ADF for 
collecting quotations and trade reports in Nasdaq securities but not 
exchange-listed securities. With respect to non-Nasdaq exchange-listed 
securities, the only means currently available to the NASD to fulfill 
these statutory and regulatory obligations is through NASD facilities 
owned by Nasdaq. Accordingly, the Commission believes that, until the 
NASD has alternative means to satisfy these obligations, it cannot 
complete its separation from Nasdaq and Nasdaq cannot cease to operate 
as a facility of the NASD. For this reason, the Commission is 
conditioning the operation of the Nasdaq Exchange, which will 
automatically terminate the NASD's control of Nasdaq,\200\ on the NASD 
representing to the Commission that control of Nasdaq through the 
Preferred D share is no longer necessary.
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    \199\ 15 U.S.C. 78o-3(b)(11). Section 15A(b)(11) requires the 
rules of the NASD to include provisions governing the form and 
content of quotations relating to securities sold OTC that may be 
distributed or published by any NASD member or person associated 
with such member, and the persons to whom such quotations may be 
supplied.
    \200\ See supra note 25 and accompanying text.
---------------------------------------------------------------------------

    In the Original Notice, the Commission noted that the registration 
of the Nasdaq Exchange has implications for the NASD and its ability to 
satisfy its statutory and regulatory obligations.\201\ The Commission 
further stated that the NASD must have an operational quotation and 
transaction reporting facility upon the registration of the Nasdaq 
Exchange. The Commission received comments on the Original Notice and 
Amendment Nos. 1, 2, and 3 that raised significant concerns about how 
the NASD would continue to satisfy its statutory and regulatory 
obligations.\202\ In particular, one commenter expressed concern about 
Nasdaq's registration as an exchange because it ``will eliminate the 
only non-exchange facilities that exist for trading NMS securities.'' 
\203\ Therefore, this commenter believed that the Commission should 
withhold approval of Nasdaq's exchange registration until a viable NASD 
quotation display and trade reporting facility is in place because, 
without such a facility, market makers and electronic communication 
networks would essentially be mandated to become a member of the Nasdaq 
Exchange to meet their regulatory obligations. Similarly, another 
commenter noted that for several decades, Nasdaq has been the arm of 
the NASD through which broker-dealers satisfy their regulatory 
obligations for OTC transactions in NMS stocks. This commenter believed 
that Nasdaq's exchange application could not be reconciled with the 
requirements of the Exchange Act until after the NASD has in place 
operational facilities

[[Page 3564]]

to permit OTC trading to continue to flourish in the U.S.\204\
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    \201\ See Original Notice, supra note 2.
    \202\ See e.g., Bloomberg 2001 Letter, Instinet Letter, Phlx 
Letters, SIA Letter, supra note 15; and letters from Barry S. 
Porter, Chairman, The Nasdaq Stock Market Issuer Affairs Committee, 
dated August 8, 2001; and Senator Zell Miller, U.S. Senate, dated 
August 16, 2001.
    \203\ See SIA Letter, supra note 15.
    \204\ See Instinet Letter, supra note 15.
---------------------------------------------------------------------------

    The Commission agrees with these commenters and is conditioning the 
operation of the Nasdaq Exchange upon the ability of the NASD to 
satisfy its statutory and regulatory obligations. The Commission does 
not believe that it would be consistent with the Exchange Act to allow 
the NASD to separate from the facilities by which it satisfies its 
regulatory obligations without having alterative means to do what the 
Exchange Act and the rules thereunder require. Accordingly, the Nasdaq 
Exchange may not begin operating as a national securities exchange and 
cease to operate as a facility of the NASD until NASD has the means to 
fulfill its regulatory obligations.
    Finally, national securities exchanges must make available certain 
order execution information pursuant to Rule 605 of Regulation 
NMS.\205\ Current exchanges have standardized the required disclosure 
mechanisms by participating in the Order Execution Quality Disclosure 
Plan.\206\ The Nasdaq Exchange must join this plan before it begins 
operations as an exchange.
---------------------------------------------------------------------------

    \205\ 17 CFR 242.605.
    \206\ See Exchange Act Release No. 44177 (April 12, 2001), 66 FR 
19814 (April 17, 2001).
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E. Listing Requirements

1. Registration Under Section 12(b) of the Exchange Act
    Once the Nasdaq Exchange begins operations as a national securities 
exchange, a security will be considered for listing on the Nasdaq 
Exchange only if such security is registered pursuant to section 12(b) 
of the Exchange Act \207\ or such security is subject to an 
exemption.\208\ An issuer may register a security pursuant to section 
12(b) by submitting to the Nasdaq Exchange a listing application that 
provides certain required information.\209\ The Exchange will review 
the listing application and, if the listing application is approved, 
will certify to the Commission that it has approved the security for 
listing and registration.\210\ Registration of the security will become 
effective thirty days after the receipt of such certification by the 
Commission or within a shorter period of time as the Commission may 
determine.\211\ Once registration is effective the security is eligible 
for listing on the Nasdaq Exchange.\212\
---------------------------------------------------------------------------

    \207\ 15 U.S.C. 78l(b). Nasdaq has notified Commission staff of 
its intent to request appropriate regulatory relief to facilitate 
the efficient registration of its issuers' securities under section 
12(b) of the Exchange Act. The Commission expects that any such 
process would include a notice by Nasdaq to the general public and 
an appropriate notice to issuers, and an opportunity for issuers to 
opt out of the process.
    \208\ 15 U.S.C. 78l(c); Nasdaq Exchange Rules 4310(a) and 
4320(a). Certain issuers currently listed on Nasdaq are not required 
to register under section 12(g) of the Exchange Act because of 
exemptions provided to foreign private issuers, Rule 12(g)3-2(b), 
and insurance companies, section 12(g)(2)(G). These issuers, 
however, are not similarly exempt from section 12(b) of the Exchange 
Act. The Commission received one comment letter submitted on behalf 
of Nissan Motor Co., Ltd., whose shares (in the form of American 
Depositary Shares) are listed on Nasdaq but are exempt from 
registration under section 12(g). See Nissan Letter, supra note 10. 
Nissan requests that its current exemption from registration be 
continued, or alternatively that it and other similarly situated 
foreign private issuers be given a transition period after Nasdaq 
begins operating as an exchange within which to evaluate whether to 
register under section 12(b). In its response to this comment, 
Nasdaq stated that it expects to submit a formal request to the 
Commission pursuant to which Nasdaq will seek a three-year exemption 
period for issuers such as Nissan.
    \209\ 15 U.S.C. 78l(b); Nasdaq Exchange Rules 4310(b) and 
4320(b).
    \210\ See Nasdaq Exchange Rules 4310(b), 4320(b), and 4410(b); 
15 U.S.C. 78l(d).
    \211\ 15 U.S.C. 78l(d).
    \212\ See Nasdaq Exchange Rules 4310(b), 4320(b), and 4410(b); 
15 U.S.C. 78l(d).
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2. Initial and Continuing Listing Standards
    Nasdaq proposes that its initial and continuing listing standards 
be largely the same as current NASD listing rules.\213\ Nasdaq also 
proposes a transitional listing rule that would automatically qualify 
for initial listing any security trading on the Nasdaq facility of the 
NASD on the day prior to the Nasdaq Exchange's first day of operation 
as an independent exchange.\214\ The Commission believes that these 
rules are consistent with the requirements of the Exchange Act because 
they would enable current Nasdaq securities to continue trading once 
the Nasdaq Exchange begins operations as a national securities exchange 
thus providing a continuous market for investors for these securities.
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    \213\ In Amendment No. 6, Nasdaq proposed to modify their 
listing standards to reflect proposed rule changes approved by the 
Commission for the NASD as follows: SR-NASD-2004-125 clarifies and 
increases the transparency of the procedures associated with denying 
companies initial or continued listing on Nasdaq, see Exchange Act 
Release No. 52342 (August 26, 2005), 70 FR 52456 (September 2, 
2005); SR-NASD-2005-153 amends the procedures for review of listing 
determinations to allow for electronic delivery of documents, see 
Exchange Act Release No. 53067 (January 6, 2006); SR-NASD-2004-162 
establishes a fee and notice requirements for substitution listing 
events for all Nasdaq issuers, except dual listed companies, see 
Exchange Act Release No. 52712 (November 1, 2005), 70 FR 67511 
(November 7, 2005); SR-NASD-2005-136 permits Nasdaq to issue public 
reprimand letters to listed companies for certain rule violations 
when a determination is made that delisting is not an appropriate 
sanction, see Exchange Act Release No. 52899 (December 6, 2005), 70 
FR 74392 (December 15, 2005); and SR-NASD-2005-082 clarifies the 
listing standards applicable to companies in bankruptcy proceedings, 
see Exchange Act Release No. 52603 (October 13, 2005), 70 FR 61163 
(October 20, 2005). The Commission finds that these changes are 
consistent with section 6(b)(5) of the Exchange Act for the same 
reasons that the Commission approved them under section 15A(b)(6) of 
the Exchange Act.
    \214\ See Amendment No. 6, supra note 12 and Nasdaq Exchange 
Rule 4305.
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3. Corporate Governance Standards
    In 2003, the Commission approved a proposal to revise the NASD 
rules by adding new corporate governance standards for listed issuers, 
as contained in NASD Rules 4200 and 4350.\215\ These changes, which 
were applied to Nasdaq-listed issuers through the NASD as a national 
securities association, established enhanced requirements for audit 
committees of Nasdaq-listed issuers, as mandated by the Sarbanes-Oxley 
Act of 2002.\216\ In addition, these changes established new 
requirements relating to the independence of the listed issuer's board 
of directors and key board committees and required issuers to adopt 
codes of conduct for directors, officers and employees. The corporate 
governance listing standards proposed for the Nasdaq Exchange are the 
same as those previously approved by the Commission for the NASD 
pursuant to section 10A(m) of the Exchange Act and Rule 10A-3 and 
pursuant to section 15A(b)(6) of the Exchange Act.\217\
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    \215\ See Exchange Act Release No. 48745 (November 4, 2003), 68 
FR 64154 (November 12, 2003) (approving changes to the corporate 
governance listing standards of the Nasdaq Stock Market, Inc. and 
the NYSE).
    \216\ The Sarbanes Oxley Act, Public Law 107-204, 116 Stat. 745 
(2002), established, among other provisions, section 10A(m) of the 
Exchange Act, 15 U.S.C. 78j-1(m), which relates to standards for 
audit committees. Rule 10A-3 under the Exchange Act, which was 
adopted pursuant to section 10A(m) of the Exchange Act, directed 
each national securities exchange and national securities 
association to prohibit the listing of any security of an issuer 
that is not in compliance with the audit committee requirements 
specified in the Rule. 17 CFR 240.10A-3.
    \217\ 15 U.S.C. 78f(b)(5). Subsequent to the Commission's 
approval of changes to the corporate governance listing standards 
for Nasdaq-listed issuers, the NASD refined those standards. See 
Exchange Act Release Nos. 49060 (January 12, 2004), 69 FR 2954 
(January 21, 2004); 49901 (June 22, 2004), 69 FR 38944 (June 29, 
2004); 49903 (June 22, 2004), 69 FR 38941 (June 29, 2004); 50573 
(October 20, 2004), 69 FR 62493 (October 26, 2004); 51221 (February 
17, 2005), 70 FR 9122 (February 24, 2005); and 51420 (March 23, 
2005), 70 FR 15968 (March 29, 2005). In Amendment No. 6, Nasdaq 
proposed to modify Nasdaq Exchange Rule 4350(k) to reflect a 
proposed rule change approved by the Commission for the NASD. This 
proposed rule change requires each listed issuer to be audited by an 
independent accountant that is registered as a public accounting 
firm with the Public Company Accounting Oversight Board. See 
Exchange Act Release No. 52896 (December 6, 2005), 70 FR 74074 
(December 14, 2005). The Commission finds that this proposed rule 
change is consistent with section 6(b)(5) of the Exchange Act for 
the same reasons that the Commission approved this rule change under 
section 15A(b)(6).

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[[Page 3565]]

    The Commission finds that the proposed corporate governance listing 
standards contained in the Nasdaq Exchange's proposed rules are 
consistent with section 6(b)(5) of the Exchange Act and satisfy the 
requirements of the section 10A(m) of the Exchange Act and Rule 10A-3 
thereunder. The Commission believes that the Nasdaq Exchange's 
corporate governance listing standards are designed to promote 
independent and objective review and oversight of the accounting and 
auditing practices of listed issuers and to enhance audit committee 
independence, authority, and responsibility by implementing the 
standards set forth in Rule 10A-3. Moreover, in the Commission's view, 
the listing standards should help safeguard the interests of 
shareholders and foster greater transparency, accountability, and 
objectivity in the oversight by, and the decision making processes of, 
the boards and key board committees of Nasdaq-listed issuers. The 
Nasdaq Exchange's listing standards also should help promote compliance 
with high standards of conduct by the issuers' directors, management, 
and personnel.

F. Unlisted Trading Privileges

    Rule 602 of Regulation NMS requires the NASD to collect, process 
and make available to vendors the best bid, best offer, and quotation 
sizes in NMS securities \218\ communicated off an exchange by members 
acting in the capacity of an OTC market maker. The NASD satisfies this 
obligation today through its operation of the Nasdaq facility though 
which NASD members quote and report trades in exchange-listed 
securities. In offering this quote and trade reporting facility for 
exchange-listed securities, the NASD does not have rules that comply, 
in all respects, to section 12(f) of the Exchange Act and Rule 12f-5 
thereunder because those provisions apply only to exchanges.\219\
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    \218\ An NMS security is any security for which transaction 
reports are collected, processed, and made available pursuant to an 
effective transaction reporting plan, or an effective national 
market system plan for reporting transactions in listed options. 17 
CFR 242.600(b)(46).
    \219\ See also section 15A(b)(11) of the Exchange Act.
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    Once registered as an exchange, the Nasdaq Exchange will be 
permitted by section 12(f) of the Exchange Act to extend unlisted 
trading privileges to securities listed and registered on other 
exchanges, subject to Commission rules. Exchange Act Rule 12f-5 
requires an exchange that extends unlisted trading privileges to 
securities to have in effect a rule or rules providing for transactions 
in the class or type of security to which the exchange extends unlisted 
trading privileges.\220\ The Commission notes that the Nasdaq Exchange 
does not have in effect rules that comply with Rule 12f-5 for all 
exchange-listed securities currently quoted on the Nasdaq facility of 
the NASD.\221\ Accordingly, to continue trading such securities, the 
Nasdaq Exchange would have to file a proposed rule change with the 
Commission and obtain Commission approval of such rules.
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    \220\ 17 CFR 240.12f-5. See also Exchange Act Release No. 35737 
(April 21, 1995), 60 FR 20891 (April 28, 1995) (adopting Rule 12f-
5).
    \221\ For example, the Nasdaq Exchange does not have rules that 
comply with Rule 12f-5 for certain exchange-traded funds whose 
holdings are primarily unregistered foreign securities (such as 
those formerly known as World Equity Benchmark Shares or WEBS), 
exchange-traded funds whose holdings are concentrated in a few 
securities, exchange-traded funds that provide a leveraged 
performance (such as xtraShares Trust Ultra Funds and Short Funds), 
and certain commodity or foreign currency based derivative 
securities (such as streetTracks Gold Shares (GLD), iShares Comex 
Gold Trust Shares (IAU), and Euro Currency Shares (FXE)).
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IV. Exemption From Section 19(b) of the Exchange Act With Regard to 
NASD Rules Incorporated by Reference

    Nasdaq proposes to incorporate by reference many NASD rules as 
Exchange rules. Thus, for certain Exchange rules, Exchange members will 
comply with an Exchange rule by complying with the NASD rule 
referenced.\222\ In connection with its proposal to incorporate NASD 
rules by reference, Nasdaq requested, pursuant to Rule 240.0-12,\223\ 
an exemption under section 36 of the Exchange Act from the rule filing 
requirements of section 19(b) of the Exchange Act for changes to those 
Nasdaq Exchange rules that are effected solely by virtue of a change to 
a cross-referenced NASD rule.\224\ Nasdaq proposes to incorporate by 
reference categories of rules (rather than individual rules within a 
category) that are not trading rules. In addition, the Nasdaq Exchange 
agrees to provide written notice to its members whenever a proposed 
rule change to an NASD rule that is incorporated by reference is 
proposed.
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    \222\ Nasdaq proposed to incorporate by reference the following 
NASD rules: Article IV, Section 8 of the NASD By-Laws; IM-1000- 
1032; 1120; 2111; IM-2110-2; 2210; IM-2210-1; 2211; 2212; 2240; 
2250; 2260; IM-2260; 2270; 2310; IM-2310-2; IM-2310-3; 2330; IM-
2330; 2340; 2341; 2360; 2361; 2370; 2430; 2510; 2520; 2810; 2830; 
3010; IM-3010; 3011; 3012; 3013; IM-3013; 3020; 3030; 3040; 3050; 
3060; 3070; 3080; IM-3110; 3120; 3130; IM-3130; 3150; 3510; 6953; 
6954; 6955; 6957; the 10000 series; 11860; and 11870. In Amendment 
No. 6, Nasdaq proposed that the Nasdaq Exchange incorporate by 
reference recent amendments to the ``Manning Rule,'' NASD IM-2110-2, 
and NASD Rule 2111, to reflect proposed rule changes approved by the 
Commission for the NASD. The amendments to NASD IM-2110-2 prohibit a 
Nasdaq Exchange member from trading for its own account in a Nasdaq 
or exchange-listed security at a price that is better than an 
unexecuted customer limit order in that security, unless the Nasdaq 
Exchange member immediately executes the customer limit order at the 
price at which the Nasdaq Exchange member traded for its own account 
or better. See Exchange Act Release No. 52210 (August 4, 2005), 70 
FR 46897 (August 11, 2005). NASD Rule 2111 extends the Manning Rule 
to customer market orders. See Exchange Act Release No. 52226 
(August 9, 2005), 70 FR 48219 (August 16, 2005). In addition, as a 
result of these proposed rule changes, in Amendment No. 6 Nasdaq 
proposed to delete certain provisions of Rule 6440(f) to reflect an 
NASD proposed rule change approved by the Commission. See Exchange 
Act Release No. 52722 (November 2, 2005), 70 FR 68120 (November 9, 
2005). The Commission finds that these proposed rule changes are 
consistent with Section 6(b)(5) of the Exchange Act for the same 
reasons that the Commission approved these rule changes under 
section 15A(b)(6).
    \223\ See 17 CFR 240.0-12.
    \224\ See letter to Nancy Morris, Secretary, Commission, from 
Edward S. Knight, Executive Vice President and General Counsel, 
Nasdaq, dated January 13, 2006. This letter supersedes and replaces 
prior similar exemptive requests. See letters to Jonathan G. Katz, 
Secretary, Commission, from Edward S. Knight, Executive Vice 
President and General Counsel, Nasdaq, dated December 8, 2005 and 
May 6, 2002.
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    Using its authority under section 36 of the Exchange Act, the 
Commission previously exempted certain SROs from the requirement to 
file proposed rule changes under section 19(b) of the Exchange 
Act.\225\ Each such exempt SRO agreed to be governed by the 
incorporated rules, as amended from time to time, but is not required 
to file a separate proposed rule change with the Commission each time 
the SRO whose rules are incorporated by reference seeks to modify its 
rules.
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    \225\ See Exchange Act Release No. 49260 (February 17, 2004), 69 
FR 8500 (February 24, 2004).
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    In addition, each SRO incorporated by reference only regulatory 
rules (i.e., margin, suitability, arbitration), not trading rules, and 
incorporated by reference whole categories of rules (i.e., did not 
``cherry-pick'' certain individual rules within a category). Each 
exempt SRO had reasonable procedures in place to provide written notice 
to its members each time a change is proposed to the incorporated rules 
of another SRO in order to provide its members with notice of a 
proposed rule change that affects their interests, so that they would 
have an opportunity to comment on it.
    The Commission is granting Nasdaq's request for exemption, pursuant 
to section 36 of the Exchange Act, from the rule filing requirements of 
section 19(b) of the Exchange Act with respect to the rules that the 
Nasdaq Exchange proposes to incorporate by reference.

[[Page 3566]]

This exemption is conditioned upon the Nasdaq Exchange providing 
written notice to its members whenever the NASD proposes to change a 
rule that the Nasdaq Exchange has incorporated by reference. The 
Commission believes that this exemption will promote more efficient use 
of Commission and SRO resources by avoiding duplicative rule filings 
based on simultaneous changes to identical rule text sought by more 
than one SRO. Consequently, the Commission grants Nasdaq's exemption 
request for the Nasdaq Exchange.

V. Conclusion

    It is ordered that the application of the Nasdaq Stock Market LLC 
for registration as a national securities exchange be, and hereby is, 
granted.
    It is further ordered that operation of the Nasdaq Exchange is 
conditioned on the satisfaction of the requirements below.
    A. Participation in National Market System Plans. The Nasdaq 
Exchange must join the CTA Plan, the CQ Plan, the Nasdaq UTP Plan, the 
ITS Plan, and the Order Execution Quality Disclosure Plan.
    B. The NASD's Ability to Fulfill its Statutory and Regulatory 
Obligations. The NASD must represent to the Commission that control of 
Nasdaq through the Preferred D share is no longer necessary because the 
NASD can fulfill through other means its obligations with respect to 
non-Nasdaq exchange listed securities under Section 15A(b)(11) of the 
Exchange Act, Rules 602 and 603 of Regulation NMS, and the national 
market system plans in which the NASD participates.
    C. Intermarket Surveillance Group. The Exchange must join the 
Intermarket Surveillance Group.
    D. Minor Rule Violation Plan. A MRVP filed by the Nasdaq Exchange 
under Exchange Act Rule 19d-1(c)(2) must be declared effective by the 
Commission.\226\
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    \226\ 17 CFR 240.19d-1(c)(2).
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    E. Fingerprint Plan. A fingerprint plan filed by the Nasdaq 
Exchange under Exchange Act Rule 17f-2 must be declared effective by 
the Commission.\227\
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    \227\ 17 CFR 240.17f-2(c).
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    F. 17d-2 Agreement. An agreement pursuant to Exchange Act Rule 17d-
2 \228\ between the NASD and the Nasdaq Exchange that allocates to the 
NASD regulatory responsibility for those matters specified above \229\ 
must be approved by the Commission, or the Nasdaq Exchange must 
demonstrate that it independently has the ability fulfill all of its 
regulatory obligations.
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    \228\ 17 CFR 240.17d-2.
    \229\ See supra text accompanying notes 114-117.

    By the Commission (Chairman Cox and Commissioners Glassman, 
Atkins, Campos, and Nazareth).
Nancy M. Morris,
Secretary.
 [FR Doc. E6-664 Filed 1-20-06; 8:45 am]
BILLING CODE 8010-01-P