[Federal Register Volume 71, Number 200 (Tuesday, October 17, 2006)]
[Notices]
[Pages 61112-61115]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-17167]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54585; File No. SR-NASD-2005-101]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Notice of 
Filing and Order Granting Accelerated Approval to Amendment No. 1 
Thereto Relating to Expansion of OATS Reporting Requirements to OTC 
Equity Securities

October 10, 2006.

I. Introduction

    On August 25, 2005, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission'') pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ the 
proposed rule change relating to expansion of the Order Audit Trail 
System (``OATS'') reporting requirements to OTC equity securities. The 
proposed rule change was published for comment in the Federal Register 
on October 18, 2005.\3\ The Commission received three comment letters 
on the proposal.\4\ NASD filed Partial Amendment No. 1 to the proposed 
rule change on September 21, 2006 (``Amendment No. 1'').\5\ This order 
approves the proposed rule change, grants accelerated approval to 
Amendment No. 1, and solicits

[[Page 61113]]

comments from interested persons on Amendment No. 1.
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    \1\ 15 U.S.C. 78s(b)(l).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 52581 (October 11, 
2006), 70 FR 60592 (the ``Notice'').
    \4\ Two comment letters were specific to this proposal. See 
letters to Jonathan G. Katz, Secretary, Commission, from John 
Polanin Jr., Chair, SIA Self-Regulation and Supervisory Practices 
Committee, dated December 2, 2005 (``SIA Letter'') and from Phylis 
M. Esposito, Executive Vice President, Chief Strategy Officer, 
Ameritrade, Inc., dated November 8, 2005 (``Ameritrade Letter''). 
One comment letter expressed general opposition to OATS. See letter 
filed via the Commission's Web Comment Form, from Rich Bertematti, 
dated September 7, 2006 (``Bertematti Letter''). In addition, NASD 
received comment letters about the proposed rule change following 
publication in NASD's Notice to Members 04-80 (November 2004). NASD 
addressed those comment letters in the Notice.
    \5\ In Amendment No. 1, NASD proposes to (1) amend NASD Rule 
6955(b)(2) to clarify that members will not be required to comply 
with OATS reporting obligations with respect to an OTC equity 
security until a symbol has been assigned to the security; (2) 
exclude direct participation programs (``DPPs'') from the proposed 
definition of ``OTC equity security;'' (3) extend the implementation 
period; and (4) make technical changes necessary in light of the 
commencement of The NASDAQ Stock Market LLC (``Nasdaq'') as a 
national securities exchange. NASD also responded to comment letters 
received.
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II. Description of the Proposed Rule Change

    NASD Rules 6950 through 6957 impose obligations on member firms to 
record in electronic form and report to NASD on a daily basis certain 
information with respect to orders originated, received, transmitted, 
modified, canceled or executed by NASD members relating to equity 
securities listed and traded on Nasdaq. OATS captures this order 
information and integrates it with quote and transaction information to 
create a time-sequenced record of orders, quotes and transactions. NASD 
believes this information is critical to its conducting surveillance 
and investigations of member firms for violations of NASD rules and 
Federal securities laws.
    To enhance the effectiveness of OATS as a regulatory tool, NASD 
proposes to amend NASD Rules 6951, 6952, and 6955 to require members to 
record and report to OATS order information relating to OTC equity 
securities.\6\ Currently, the OATS requirements do not apply to OTC 
equity securities and as a result, NASD is unable to recreate, on an 
automated basis, an order and transaction audit trail for these 
securities. NASD believes that expanding OATS requirements to these 
securities would enhance its ability to review and examine for member 
compliance with certain trading rules, including, but not limited to, 
NASD's rules governing best execution and interpositioning,\7\ limit 
order protection,\8\ and offers at stated prices.\9\
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    \6\ NASD proposes to define ``OTC equity security'' as any 
equity security that: (1) Is not listed on a national securities 
exchange; or (2) is listed on one or more regional stock exchanges 
and does not qualify for dissemination of transaction reports via 
the facilities of the Consolidated Tape.
    \7\ NASD Rule 2320.
    \8\ NASD Rule 6541.
    \9\ NASD Rule 3320.
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    In addition, NASD proposes two technical changes that are necessary 
given the commencement of Nasdaq as a national securities exchange.

III. Summary of Comments

    The Commission received comment letters in response to the 
publication of the notice in the Federal Register.\10\ The primary 
issues two of the commenters raised concern the scope of a member's 
obligations to record and report OATS information relating to OTC 
equity securities and the timing of the proposed rule change.
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    \10\ See supra, note 4.
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A. Scope of a Member's OATS Obligations Relating to OTC Equity 
Securities

1. Comments Relating to the Issuance of a Security Symbol
    One of the commenters requested clarification of the definition and 
scope of ``OTC equity security'' and suggested that the appropriate 
scope of OATS reporting should include only those securities currently 
subject to Automated Confirmation Transaction (``ACT'') Service 
reporting requirements.\11\ NASD responded that it does not believe 
that the scope of the proposed definition of ``OTC equity security'' 
should be limited as suggested by this commenter and stated that, as 
originally proposed, members should be required to record and report 
OATS information for all OTC equity securities. However, to address the 
situation where an OTC equity security does not have a symbol assigned 
to it at the time an OATS order event occurs, NASD proposed a 
clarifying change in Amendment No. 1 whereby, pursuant to NASD Rule 
6955(b)(2), members would not be required to comply with their OATS 
reporting obligations with respect to an OTC equity security until a 
symbol has been assigned to that security.\12\ NASD explained that 
members would still have an obligation to immediately record all other 
applicable OATS information in accordance with the provisions of NASD 
Rule 6954, irrespective of whether the security has a symbol assigned 
to it at the time the order is originated or received.\13\ NASD 
represented to the Commission that it would detail these obligations 
under NASD Rules 6954 and 6955 in a Notice to Members and the revised 
OATS Technical Specifications,\14\ both of which NASD will publish 
following this approval of the proposed rule change.
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    \11\ See SIA Letter, supra note 4, at 4.
    \12\ In proposing this exception from the reporting obligations, 
NASD emphasized that members should be diligent in their efforts to 
obtain a symbol, as necessary, for securities they wish to trade so 
that they can comply with their trade reporting obligations under 
NASD Rule 6620. NASD Rule 6620(c)(1) requires that each trade report 
include the symbol of the OTC equity security; trade reports that do 
not contain this information are rejected by the system. In 
addition, NASD noted that members have an obligation to report 
trades within ninety seconds of execution or on a next-day basis, as 
applicable under Rule 6620(a).
    \13\ NASD stated that it does not believe that members should 
face any technological difficulties in recording OATS information 
for an OTC equity security that does not have a symbol assigned to 
it, but the extended implementation period should allow sufficient 
time to address any such problems.
    \14\ NASD states that since OATS Phase III has been implemented, 
it does not expect any significant changes to the OATS Technical 
Specifications as a result of this proposed rule change. NASD 
anticipates that the only such change would be expansion of the list 
of securities that are OATS reportable.
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2. Comments Relating to DPPs
    One commenter stated that DPPs should not be OATS reportable 
because they are ``effectively subscriptions, not trades'' and sold 
through a process that is not captured in automated systems within the 
firm.\15\ Additionally, this commenter stated that the volume for these 
securities is low, and OATS reporting may discourage the sale of such 
products.\16\ In response to the concerns raised by this commenter, 
NASD proposed in Amendment No. 1 to exclude DPPs from the definition of 
``OTC equity security.'' NASD stated, however, that it would continue 
to monitor member activities relating to DPPs and may determine, at a 
later date, that applying OATS requirements to DPPs is appropriate. If 
that situation arises, NASD represented that it would submit a proposed 
rule change.
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    \15\ See SIA Letter, supra note 4, at 4-5.
    \16\ Id.
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3. Additional Comments
    One commenter stated that members should not be required to 
identify the type of security (e.g., Nasdaq, OTCBB, Pink Sheets) in 
OATS reports and suggested that NASD provide a list of all OATS 
reportable securities, so that members do not have to rely on third 
party vendors for this information.\17\ NASD responded that it will not 
require at this time that members identify the type of security as part 
of their OATS obligations. In addition, NASD stated it would provide a 
list of OTC equity securities that are subject to the OATS requirements 
on the OATS Web site.\18\
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    \17\ See Ameritrade Letter, supra note 4, at 2.
    \18\ This list can currently be found under the Symbol Directory 
at http://www.nasdaqtrader.com/trader/symboldirectory/symbol.stm.
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    This same commenter also suggested that OATS should be capable of 
recognizing stocks that have had symbol changes and suggested that 
using the CUSIP number instead of the security symbol may be 
appropriate.\19\ NASD responded by stating that a change to CUSIP 
number rather than security symbol would be costly and burdensome and 
is unnecessary because NASD's OATS system is able to track symbol 
changes (e.g., where an ``E'' is appended to the symbol of an OTCBB 
issuer that is delinquent in its SEC filings).
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    \19\ See Ameritrade Letter, supra note 4, at 2.
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    One commenter stated that it understands OATS reporting is not 
required for OTC options, derivatives or

[[Page 61114]]

swaps, and with respect to foreign securities, trades effected by NASD 
members in the U.S. would be reportable, while trades effected by a 
foreign affiliate of a member would not be reportable.\20\ NASD 
confirmed that the commenter's understanding relating to the proposed 
OATS reporting requirements on this point is correct. NASD stated that, 
in addition, with respect to non-member foreign affiliates of members, 
OATS obligations do not apply, provided that the order is never 
received or held by the member, for example, where the order originates 
with a foreign affiliate and is not routed to the member. NASD 
clarified that, with respect to orders received by members for foreign 
securities that otherwise meet the definition of an OTC equity 
security, members would have an OATS obligation, irrespective of 
whether the order is ultimately effected inside or outside the United 
States. If, for example, a member receives an order in a foreign 
security and routes that order to a foreign exchange for handling and 
execution, the member would need to record and report to OATS the 
receipt of that order and the route to the foreign exchange.
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    \20\ See SIA Letter, supra note 4, at 4. This commenter also 
suggested that NASD exclude from the requirements of Rule 6620 
transactions executed on a foreign exchange that is an ``affiliate 
member'' of the Intermarket Surveillance Group. Id. NASD has stated 
that Rule 6620 is not at issue in this rule filing.
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    Finally, this commenter also stated that an audit trail is not 
necessary for all markets and that NASD should be required to make the 
case that the accretive value of an order audit trail to the 
surveillance of the OTC market outweighs the imposition of additional 
costs and burdens on member firms.\21\ NASD responded that it does not 
agree that it has to meet that standard and, rather, that the standards 
it must satisfy in any proposed rule change are set forth in Sections 
15A \22\ and 19(b) of the Act.\23\ NASD believes it has made the 
requisite showing. NASD also responded that while it recognizes that 
the proposed rule change may impose additional costs and burdens on 
member firms, OATS reporting of OTC equity securities is important to 
NASD's surveillance systems and regulatory program. In recognition of 
the potential additional burden on members, however, as discussed in 
greater detail below, NASD proposed to extend the implementation period 
of the proposed rule change.
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    \21\ See SIA Letter, supra note 4, at 4.
    \22\ 15 U.S.C. 78o-3.
    \23\ 15 U.S.C. 78s(b).
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B. Timing of Proposed Rule Change

    One commenter stated that NASD should allow a minimum of six months 
for implementation of the changes necessary for OATS reporting of OTC 
equity securities.\24\ Another commenter stated that OATS for OTC 
equity securities should not be implemented until the industry can 
properly devote the personnel and technical resources necessary to 
achieve compliance.\25\ This commenter also stated that OTC markets are 
manual by nature, and expanding OATS reporting to OTC equity securities 
at this time could render obsolete all of the work that has been put 
into production for OATS Phase III compliance.\26\
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    \24\ See Ameritrade Letter, supra note 4, at 2.
    \25\ See SIA Letter, supra note 4, at 2.
    \26\ See SIA Letter, supra note 4, at 3.
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    NASD responded that while it does not agree that the proposed 
expansion of OATS reporting to OTC equity securities would have a 
negative impact on the work done relating to OATS Phase III, it does 
acknowledge the technological burdens that may be imposed on members as 
a result of this proposal, as well as the fact that members have a 
number of regulatory initiatives requiring technological and system 
changes. Accordingly, in Amendment No. 1, NASD proposed an 
implementation date of six months following publication of revised OATS 
Technical Specifications incorporating the proposed rule change, which 
will be published no later than sixty days following Commission 
approval of the proposed rule change.\27\ NASD believes that the 
extended implementation period will provide members sufficient time to 
make any adjustments necessary to implement OATS reporting for OTC 
equity securities, especially since, according to NASD, the technical 
specifications for OATS reporting of OTC equity securities would be 
substantially similar to the technical specifications that have been in 
place since July of 2006 for OATS Phase III.
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    \27\ The initial rule text as published in the notice proposed 
an implementation date of 120 days from publication of the OATS 
Reporting Technical Specifications.
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    In addition, one commenter suggested that NASD implement certain 
operational and/or procedural regulations relating to the OTC 
marketplace, such as expansion of the trade-through protections and 
limit order display requirements, prior to implementation of OATS 
reporting requirements and that until such time, best execution 
standards for NMS stocks and OTC stocks will remain unequal.\28\ In 
response to this comment, NASD noted that it already has order handling 
and trading rules in effect that apply to the OTC marketplace, 
including, but not limited to, Rule 2320 (Best Execution and 
Interpositioning) and Rule 6541 (Limit Order Protection). NASD further 
stated that OATS reporting is necessary to enhance NASD's ability to 
review and examine for member compliance with these and other rules.
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    \28\ See Ameritrade Letter, supra note 4, at 3.
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    Finally, NASD responded to a commenter that expressed general 
opposition to OATS and asserted that OATS is a mechanism for NASD to 
generate income through fines.\29\ The commenter further claimed that 
there has been no evidence that OATS has helped the investing public or 
assisted in any way in improving the capital markets.\30\ In addition, 
the commenter noted the burdens that OATS imposes on members, and in 
particular, small firms.\31\ NASD responded that it is aware of the 
costs and technological burdens associated with the proposed rule 
change, and in recognition proposed an extended implementation period 
in Amendment No. 1.
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    \29\ See Bertematti Letter, supra note 4, at 1.
    \30\ Id.
    \31\ Id.
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IV. Discussion and Commission Findings

    The Commission has reviewed carefully the proposed rule change, the 
comment letters, and NASD's response to the comments. The Commission 
finds that the proposed rule change, as amended, is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities association,\32\ particularly 
Section 15A(b)(6) of the Act,\33\ which, among other things, requires 
that the rules of a national securities association be designed to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade, to foster cooperation and 
coordination with persons engaged in regulating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and, in general, to 
protect investors and the public interest.
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    \32\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \33\ 15 U.S.C. 78o-3(b)(6).
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    As discussed above, NASD currently requires member firms to record 
and report order information for transactions in Nasdaq Stock Market 
equity securities. NASD's OATS uses this

[[Page 61115]]

information for integration with trade and quotation information to 
provide NASD with an accurate time-sequenced record of orders and 
transactions to detect for possible violations of NASD rules and other 
securities laws and regulations. NASD recognizes that the trading in 
OTC equity securities is often more manual than Nasdaq Stock Market 
equity securities, and while this may result in additional burdens on 
member firms to capture this data electronically, NASD believes that 
reporting information related to OTC equity securities is critical to 
its surveillance program. The Commission believes that it is consistent 
with the Act for NASD to expand the OATS reporting requirements to 
include OTC equity securities to assist it in detecting possible fraud 
or manipulation in the trading of such securities in order to help 
protect investors.
    In addition, the Commission believes that the technical changes 
proposed by NASD, which NASD has noted are needed in light of Nasdaq's 
operation as a national securities exchange, are not only consistent 
with the Act, but also necessary to clarify NASD's rules.

V. Solicitation of Comments Concerning Amendment No. 1

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether Amendment No. 1 
to the proposed rule change is consistent with the Act. Comments may be 
submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-NASD-2005-101 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-NASD-2005-101. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room. Copies of the filing 
also will be available for inspection and copying at the principal 
office of NASD. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
NASD-2005-101 and should be submitted on or before November 7, 2006.

VI. Accelerated Approval of Amendment No. 1

    The Commission finds good cause for approving Amendment No. 1 to 
the proposed rule change prior to the thirtieth day after publication 
for comment in the Federal Register pursuant to Section 19(b)(2) of the 
Act.\34\ As discussed in greater detail above, in Amendment No. 1, NASD 
proposed revisions to clarify that member firms do not need to comply 
with the OATS reporting obligations with respect to an OTC equity 
security until a symbol has been assigned to that security. In 
addition, in response to a comment letter, it proposed to exclude DPPs 
from the definition of OTC equity security. Because two commenters 
raised issues specific to the timing of the proposed rule change, NASD 
also proposed an extended implementation period in Amendment No. 1. 
Finally, NASD proposed two technical changes in Amendment No. 1 that 
are necessary to reflect the commencement of Nasdaq as a national 
securities exchange.
    Since the changes proposed in Amendment No. 1 address commenter 
concerns and make changes that the Commission believes will help 
clarify the proposed rule change and should assist firms by providing 
greater guidance, as well as time for testing systems to help ensure 
compliance with the rule, and it does not raise any new issues of 
regulatory concern, the Commission finds good cause to accelerate 
approval of Amendment No. 1, consistent with Section 15A(b)(6) of the 
Act \35\ and Section 19(b) of the Act.\36\
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    \34\ 15 U.S.C. 78s(b)(2).
    \35\ 15 U.S.C. 78o-3(b)(6).
    \36\ 15 U.S.C. 78s(b).
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VII. Conclusion

    It is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\37\ that the proposed rule change (File No. SR-NASD-2005-101), as 
amended, be and hereby is, approved, and that Amendment No. 1 is 
approved on an accelerated basis.
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    \37\ 15 U.S.C. 78s(b)(2).
    \38\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\38\
Jill M. Peterson,
Assistant Secretary.
[FR Doc. E6-17167 Filed 10-16-06; 8:45 am]
BILLING CODE 8011-01-P