Self-Regulatory Organizations; National Association of Securities Dealers, Inc; Order Instituting Proceedings to Determine Whether to Disapprove Rule Change Relating to the SelectNet Service

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34000; File No. SR-NASD-93-61]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc; Order Instituting Proceedings to Determine Whether to

Disapprove Rule Change Relating to the SelectNet Service

May 3, 1994.

I. Introduction

On November 1, 1993, the National Association of Securities

Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities

and Exchange Commission (``Commission'' or ``SEC''), pursuant to

section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') and

Rule 19b-4 thereunder, a proposed rule change to modify the operational

features of the SelectNet service.\1\ The NASD is proposing to install

a price validation screen that will prohibit entry of orders into

SelectNet priced away from the inside market on Nasdaq. If approved,

the NASD will amend the SelectNet User Guide to clarify that orders

entered into SelectNet during normal market hours (9:30 a.m. to 4 p.m.)

will be prohibited by the system if the orders are priced outside the

best bid or offer in the Nasdaq system, unless unusual market

conditions, such as locked, crossed, one-side, or no-quote markets

exist in a security.

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\1\The NASD originally filed the proposed rule change on October

25, 1993 pursuant to section 19(b)(3)(A) of the Act. On October 29,

1993, the Commission issued an Order of Summary Abrogation

abrogating the NASD's October 25th rule change. The Commission's

Order of Summary Abrogation suggested that the procedures provided

by section 19(b)(2) of the Act provide a more appropriate mechanism

for determining whether the NASD's rule change is consistent with

the Act. Thus, on November 1, 1993, the NASD refiled its rule change

under section 19(b)(2).

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Notice of the proposed rule change appeared in the Federal Register

on November 9, 1993.\2\ Three comments opposing the NASD's proposal

were received in response to the Commission release. The substance of

these comments is discussed in detail below.

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\2\Securities Exchange Act Release No. 33141 (Nov. 3, 1993), 58

FR 59504 (Nov. 9, 1993).

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II. Description of SelectNet's Prohibition Against Entering Orders

Outside the Inside Nasdaq Market

In response to the difficulties experienced in the Nasdaq market

during the market break of October 1987, the NASD developed an

auxiliary service, the Order Confirmation Transaction Service

(``OCT''), to process orders during market extremes by providing an

alternative method of negotiating trades when traditional telephone

negotiation is difficult or infeasible. The Commission originally

approved OCT in January 1988.\3\ OCT, renamed SelectNet in 1990,

currently operates from 9 a.m. to 5:15 p.m. Eastern Time,\4\ and

increases communications capacity by enabling eligible firms to enter

electronic messages. SelectNet supports the continuous, orderly

operation of the Nasdaq Stock Market during difficult or unusual market

conditions. Since in inception, the NASD has enhanced SelectNet in an

effort to provide greater flexibility in the automated execution of

orders and to facilitate market maker's and order entry firms'

(collectively referred to as ``participants'') use of SelectNet.\5\

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\3\Securities Exchange Act Release No. 25263 (Jan. 11, 1988), 53

FR 1430 (Jan. 19, 1988) (order approving SelectNet, previously

referred to as the Order Confirmation Transaction Service, on a

Temporary accelerated basis). See also, Securities Exchange Act

Release No. 25523 (Mar. 28, 1988), 53 FR 10965 (Apr. 4, 1988) (order

extending temporary approval of SelectNet); Securities Exchange Act

Release No. 25690 (May 11, 1988), 53 FR 17523 (May 17, 1988) (order

granting permanent approval of SelectNet).

\4\Securities Exchange Act Release No. 30581 (Apr. 14, 1992), 57

FR 14596 (Apr. 21, 1992).

\5\Securities Exchange Act Release No. 28636 (Nov. 21, 1990), 55

FR 49732 (Nov. 30, 1990).

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The service currently allows participants to broadcast orders to

all market makers in a security or direct order to a specific market

maker. In addition, market makers can broadcast to all participants

watching a particular security (a feature known as ``all call''). To

enter an order in SelectNet, a participant enters the normal trade

information (i.e., security symbol, side, size, and price). In

addition, the participant may provide that an order or counter-offer

will be in effect for anywhere from 3 to 99 minutes, specify a day

order, or indicate whether price and/or size are negotiable or whether

a specific minimum quantity is acceptable.\6\ Participants may accept,

counter or decline a SelectNet order. In the event that a participant

elects to counter an offer, the service allows negotiations to be

conducted between the participants by exchanging counter-offers until

an agreement is reached.

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\6\The identity of a participant entering an order is anonymous

when broadcasting an order, unless the participant elects to

identify itself; once the order is executed, each participant to the

transaction learns of the identity of the other. In contrast, the

recipient of a directed order is provided with the identity of the

participant who sent the order.

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A. The NASD's Basis for the Prohibition

The NASD seeks to amend the SelectNet operating manual\7\ to

prohibit entry of orders in SelectNet priced outside the inside Nasdaq

market during normal market hours (:30 a.m. to 4 p.m.), unless unusual

market conditions, such as locked, crossed, one-sided, or no-quote

markets exist in a security. The NASD had represented that it is

proposing to prohibit entry of orders priced outside the inside Nasdaq

market to eliminate a large number of what it believes to be erroneous

transactions occurring through the service.

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\7\The current SelectNet rules are contained in the SelectNet

User Guide, but are not included in the NASD Manual. See SelectNet

User Guide (Nov. 1990). The NASD has represented that it will update

these rules and submit, by March 31, 1994, a rule filing, pursuant

to section 19(d) of the Act and Rule 19b-4 thereunder, to

incorporate the SelectNet rules into the NASD Manual. Letter from

Beth E. Weimer, Associate General Counsel, NASD, to Selwyn

Notelovitz, Branch Chief, SEC (Jan. 14, 1994). To date, the

Commission has not received this filing.

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The NASD believes that these orders are put into SelectNet in two

ways: (1) as errors, where the party intended to place the order at or

within the inside bid and offer and mistyped the trade information into

SelectNet, ignored the reverse colored warning screen and instructed

the computer to override the warning, or (2) as a ``concerted attempt

to trick'' recipients of the orders into executing obviously erroneous

trades.\8\

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\8\For example, if the inside market in a Nasdaq security is 20

bid, 20\1/4\ offer, and order entry firm may place an order to buy

stock priced at 19\1/8\. According to the NASD, traders

traditionally deal in fractions, frequently not even stating the

integer amount of a price when transacting business over the

telephone, and an order priced at 19\1/8\ could be read or

interpreted as 20\1/8\. Thus, the market maker would accept the

order, believing that it was executing an order priced within the

spread, at 20\1/8\. Instead, the market maker would have executed

the order a full point below the price it thought it was getting,

and \7/8\ of a point below the best bid.

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In support of its position, the NASD included in its filing with

the Commission part of the results of an analysis of SelectNet orders

and trades during September 1993. According to the NASD, the analysis

demonstrates that, on average, over 1,000 orders a day are placed in

SelectNet at prices outside the inside Nasdaq market. According to the

NASD, this resulted, on average, in more than 100 executions a day at

prices the NASD has concluded, without input from the parties of the

transactions, are erroneous and wholly unrelated to current market

prices. The NASD further represented that during September 1993 it

received, in total, 46 requests to reverse trades as clearly

erroneous,\9\ notwithstanding the daily average of 100 executions at

prices outside the inside Nasdaq market.

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\9\Letter from Robert E. Aber, Vice president and General

Counsel, NASD, to Selwyn Notelovitz, Branch Chief, SEC (Jan. 14,

1994).

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Subsequently, the NASD provided the Commission with more specific

information concerning the NASD's analysis of SelectNet orders and

trades during September 1993.\10\ This information indicated that

during the month, 34,957 (on average, 1.665/day) orders were entered in

SelectNet outside the inside Nasdaq Market and that 2,802 (on average,

133/day) of these orders were executed. In addition, this information

indicated that during September 1993 the NASD received 44 requests to

deem trades clearly erroneous where the trade occurred outside the

inside Nasdaq Market. This information further indicated that the NASD

granted 32 of these requests.

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\10\Letter from Beth E. Weimer, Associate General Counsel, NASD,

to Selwyn Notelovitz, Branch Chief, SEC (Mar. 7, 1994). In its

letter to the Commission, the NASD requested confidential treatment

of the information accompanying its letter. The NASD requested this

treatment pursuant to 17 CFR 204.24b-2 and Exemption 4 of the

Freedom of Information Act (5 U.S.C. Sec. 552(b)(4)).

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B. Exceptions to the Prohibition

The NASD has determined to allow entry of orders on SelectNet

outside the inside Nasdaq market under three circumstances. Any order

entered during an exception period, described below, will remain active

in SelectNet even after the exception period has passed.

1. Pre-Opening and Post-Closing Exception

Because the inside Nasdaq market during non-market periods might

not reflect current market conditions and, therefore, may be one-sided

or may simply reflect the closing bid and offer on Nasdaq, the

prohibition of entering orders outside the inside Nasdaq market will

only be in effect during normal market hours (i.e., 9:30 a.m. until 4

p.m.)

2. Exception for Locked, Crossed, One-Sided Quote or No Quote Markets

If the market in a security becomes locked or crossed or

experiences a one-sided quote or no quote, the NASD will allow entry or

orders outside the inside Nasdaq market. In the event of these unusual

market conditions, SelectNet will be programmed to lift the prohibition

automatically for that security until the unusual condition no longer

exists.

3. Exception for Emergency Conditions or Extraordinary Market

Conditions

Under Article VII, Section 3 of the NASD By-Laws,\11\ the NASD will

retain authority to lift the prohibition during an emergency or when

extraordinary market conditions exist.\12\

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\11\NASD Manual, By-Laws, Art. VII, Sec. 3, (CCH) 1182A.

\12\``Emergency conditions'' include unexpected events such as a

declaration of war, a presidential assassination or an electrical

black-out. ``Extraordinary market conditions'' include market breaks

(such as October 1987), market declines and any other occasions

where the market is experiencing highly volatile trading conditions

such that prompt intervention is necessary for the market's

continued efficient operation. Securities Exchange Act Release No.

26072 (Sept. 12, 1988), 53 FR 36143 (Sept. 16, 1988) (order

approving rule to provide the NASD Board of Governors and a proposed

committee the authority to take action during an emergency or under

extraordinary market conditions). See also, Securities Exchange Act

Release No. 33292 (Dec. 6, 1993), 58 FR 65214 (Dec. 13, 1993) (NASD

Policy Statement on Market Closings in the event of an emergency or

extraordinary market conditions).

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III. Comment Letters

The Commission received three comments letters in response to the

NASD's proposed rule change.\13\ Two of these commenters opposed

approval of the NASD's proposed rule change. Without explicitly

opposing the NASD's proposed change, the third commenter generally

criticized the SelectNet Service and used its response to the NASD's

filing to support its continuing contention that SelectNet is a

``quotation driven trading system'' rather than a communication system.

The NASD responded to the issues raised by the commenters in a letter

dated January 14, 1994.\14\

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\13\Letter from James E. Buck, Senior Vice President and

Secretary, New York Stock Exchange (``NYSE''), to Jonathan Katz,

Secretary, SEC (Nov. 30, 1993). The NYSE's letter also referred to

another pending NASD proposed rule change which would include

exchange listed securities in SelectNet (File No. SR-NASD-92-16).

The focus of the NYSE's letter concerned SR-NASD-92-16 and SelectNet

in general.

\14\Letter from Robert E. Aber, Vice President and General

Counsel, NASD, to Selwyn J. Notelovitz, Branch Chief, SEC (Jan. 14,

1994).

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One commenter opposing the proposal argued that there are

legitimate risk management and trading strategies that involve entering

orders outside the inside Nasdaq market.\15\ Another commenter opposing

the proposal argued that entering orders outside the inside market is

typical practice when dealing with large retail orders and during

volatile market conditions.\16\ This commenter took further exception

with the NASD's assertion that it must review and reverse as clearly

erroneous many of the orders executed outside the inside Nasdaq market,

offering examples of instances where the NASD refused to reverse a

trade executed outside the inside Nasdaq market. In addition, this

commenter argued that the NASD's proposed prohibition is not necessary

because SelectNet includes a feature that alerts participants who

accept orders priced outside the inside market and requires

confirmation of the participant's acceptance of such orders.

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\15\Letter from Harold S. Bradley, Vice President and Director

of Trading, Investors Research Corporation, to Jonathan G. Katz,

Secretary, SEC (Dec. 8, 1993).

\16\Letter from Simon S. Kogan to Margaret McFarland, Deputy

Secretary, SEC (Dec. 1, 1993).

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In response, the NASD acknowledged that legitimate bases exist for

entering orders outside the inside Nasdaq market.\17\ Nonetheless, the

NASD has determined that on balance, the benefits of the prohibition

outweigh the costs. The NASD argued that erroneous trades are costly to

the industry and, when reported to the tape, mislead and confuse

issuers and investors. Moreover, the NASD pointed out that the

alternative of negotiating a trade outside the inside Nasdaq market

over the telephone remains.

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\17\Letter from Robert E. Aber, Vice President and General

Counsel, The Nasdaq Stock Market, Inc., to Selwyn Notelovitz, Branch

Chief, SEC (Jan. 14, 1994).

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IV. Proceedings to Determine Whether to Disapprove SR-NASD-93-61

and Grounds for Disapproval Under Consideration

The NASD's proposal is presented as an effort to prevent market

makers from inadvertently executing SelectNet orders at prices outside

the inside market. Nevertheless, prohibiting the entry of SelectNet

orders at prices outside the inside market may be neither the most

effective means of accomplishing this objective nor the least

restrictive. Accordingly, the Commission is interested in the reasons

market participants may have for entering SelectNet orders outside the

inside market, and whether there may be less restrictive means of

preventing erroneous trades.

The Commission, therefore, is instituting proceedings pursuant to

Section 19(b)(2)(B) of the Act to determine whether the proposed rule

change should be disapproved. Institution of disapproval proceedings

appears appropriate at this time in view of the legal and policy issues

raised by the proposal. Institution of disapproval proceedings,

however, does not indicate that the Commission has formulated any

conclusions with respect to any of the issues involved and the

Commission seeks and encourages interested persons to comment on the

proposed rule change. The sections of the Act applicable to the

proposed rule change include:

Section 15A(b)(6), which requires that the rules of a national

securities association, among other things, 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, clearing, settling, processing

information with respect to, and facilitating transactions in

securities, and to remove impediments to and perfect the mechanism of a

free and open market.

Section 11A(a)(1)(B), which sets forth the Congressional

finding that new data processing and communications techniques create

the opportunity for more efficient and effective market operations.

Section 11A(a)(1)(C), which sets forth the Congressional

finding that it is in the public interest to assure economically

efficient execution of securities transactions.

Section 11A(a)(2), which directs the Commission to facilitate

the establishment of a national market system for securities in

accordance with the findings set forth in Sections 11A(a)(1) (B) and

(C).

With respect to the proposal, the Commission specifically requests

that commenters address, if applicable, the following items:

(a) The NASD acknowledges that legitimate bases exist for entering

SelectNet orders at prices outside the inside market. These could

include: (i) Communicating limit orders to market makers; (ii)

negotiating large block transactions; (iii) obtaining executions in

fast markets; or (iv) exploring the level of market interest at the

prices quoted in Nasdaq. The Commission invites comment on the

circumstances in which a market maker or customer would use SelectNet

to enter orders outside the inside market.

(b) The NASD submitted data indicating that during the month of

September 1993, although approximately 130 trades are executed daily

(2,730 per month) through SelectNet outside the inside market, it

received a total of only 44 requests to reverse trades as clearly

erroneous and granted 32 of these requests. One commenter opposed to

the proposal submitted copies of two NASD decisions upholding trades

executed through SelectNet outside the inside market. As such, the

Commission invites commenters to discuss whether such decisions reflect

aberrations based on special circumstances or reflect legitimate use of

SelectNet and of the Nasdaq market. The Commission also invites

SelectNet users to discuss whether they cancel executions outside the

inside by agreement with the other party (and therefore not reflected

in the NASD's data) and/or if they choose not to cancel/seek reversal

for other reasons (e.g., determination that cancelling/reversing is not

worth the administrative cost).

(c) The Commission invites suggestions for alternative means to

prevent erroneous SelectNet executions, such as the development by

member firms of facilities for preventing inadvertent executions.

(d) The extent, if any, to which investors may be confused by

reports to the type of trades effected outside the inside Nasdaq market

using SelectNet.

(e) The potential benefits of the proposal and whether those

benefits outweigh any costs or burdens imposed on members and/or public

customers.

(f) Order delivery systems exist in and among other markets. The

rules of some of these systems, such as the Intermarket Trading System

(ITS), prohibit limit orders and create a conclusive presumption that

an order executed outside the inside bid or offer is an obvious error.

Other systems, on the other hand, such as the New York Stock Exchange's

SuperDot System, allow limit orders and have no restrictions on the

price of orders. The Commission invites commenters to discuss the

distinctions among these systems with respect to the issues raised by

the NASD.

V. Procedure: Request for Written Comments

The Commission requests that interested persons provide written

submissions of their views, data and arguments with respect to the

concerns identified above as well as any other relevant concerns. In

particular, the Commission invites the written views of interested

persons concerning whether the proposed rule change is inconsistent

with the provisions of the Act and the rules and regulations

thereunder, specifically sections 15A(b)(6), 11A(a)(1) (B), and (C).

Although there do not appear to be any issues relevant to approval or

disapproval which would be facilitated by an oral presentation of

views, arguments and data, the Commission will consider, pursuant to

Rule 19b-4, any request for an opportunity to make an oral

presentation.\18\

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\18\Section 19(b)(2) of the Act, as amended by the Securities

Acts Amendments of 1975, Pub. L. 94-29 (June 4, 1975), grants the

Commission flexibility to determine what type of proceeding--either

oral or notice and opportunity for written comments--is appropriate

for consideration of a particular proposal by a self-regulatory

organization. See Securities Acts Amendments of 1975, Senate Comm.

on Banking, Housing & Urban Affairs, S. Rep. No. 75, 94th Cong., 1st

Sess. 30 (1975).

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Interested persons are invited to submit written data, views and

arguments regarding the proposed rule change by June 8, 1994. Section

19(b)(2) of the Act requires that proceedings to determine whether to

disapprove a proposed rule change be concluded within 180 days of the

date of publication of notice of the filing of the proposed rule

change, unless the Commission finds good cause to extend the time for

the conclusion of such proceedings. To provide ample opportunity for

commenters to submit views and for the Commission to give consideration

of these views, the Commission finds good cause to extend the time for

the conclusion of the proceedings.

Persons desiring to submit written data, views and arguments should

file six copies thereof with the Secretary of the Commission,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549. Reference should be made to File No. SR-NASD-93-61.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change which are filed

with the Commission, and all written communications relating to the

proposed rule change between the Commission and any person, other than

those which may be withheld from the public in accordance with the

provisions of 5 U.S.C. 552, will be available for inspection and

copying at the Commission's Public Reference Room. Copies of the filing

and of any subsequent amendments also will be available at the

principal office of the NASD.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-11075 Filed 5-6-94; 8:45 am]

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