Self-Regulatory Organizations; Notice of Proposed Rule Change by the National Association of Securities Dealers, Inc., Relating to Amendments to the NASD's Proposed Short Sale Rule

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33758; File No. SR-NASD-92-12, Amendment No. 6]

Self-Regulatory Organizations; Notice of Proposed Rule Change by

the National Association of Securities Dealers, Inc., Relating to

Amendments to the NASD's Proposed Short Sale Rule

March 11, 1994.

Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on March 8,

1994, the National Association of Securities Dealers, Inc. (``NASD'' or

``Association'') filed with the Securities and Exchange Commission

(``Commission'' or ``SEC'') Amendment No. 6 to the proposed rule change

as described in Items I, II, and III below, which Items have been

prepared by the NASD.\1\ The Commission is publishing this notice to

solicit comments on the proposed rule change, as amended, from

interested persons.

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\1\On January 14, 1994, the NASD submitted Amendment No. 5 to

this filing. Amendment No. 6 supersedes and replaces Amendment No.

5, which was not published for comment.

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I. Self-Regulatory Organization's Statement of the Terms of

Substance of the Proposed Rule Change

The NASD is amending its proposed short sale rule or ``bid test''

applicable to stocks traded on the Nasdaq National Market by expanding

the options market makers' exemption from the rule to include certain

short sales effected by index options market makers. Specifically, for

an eighteen-month pilot period, the proposal provides that an NASD

member shall be permitted, consistent with its quotation obligations,

to execute a short sale for the account of an index options market

maker that would otherwise be in contravention of the NASD's short sale

rule so long as: (1) The short sales are hedges of existing or

contemporaneously established index options positions and (2) the

dollar value of all stock sold short to hedge the offsetting stock

index options position(s) does not exceed the aggregate current index

value of the offsetting index options position(s).

The NASD also is proposing four other amendments to the NASD's

short sale rule. First, the NASD proposes to amend the filing to

provide that all market maker exemptions from the rule will be uniform

in duration. Specifically, under the proposal, the exemptions afforded

qualified Nasdaq market makers, Nasdaq warrant market makers, and

qualified options market makers will all expire eighteen months after

the effective date of the NASD's short sale rule. Prior to the

termination of the eighteen-month period, the NASD will evaluate

whether these exemptions should be extended, modified, approved on a

permanent basis, or terminated. Second, with respect to the trading

activity of options market makers and warrant market makers, the

amendment clarifies that transactions unrelated to normal options/

warrant market making activity, such as index arbitrage or risk

arbitrage that in either case is independent of an options/warrant

market maker's market making functions, will not be considered a

hedging transaction for purposes of the options/warrant market maker

exemption from the NASD's short-sale rule. Third, consistent with Rule

10a-1 under the Act, the amendment expands the exemption from the

NASD's short-sale rule for certain transactions in special arbitrage

accounts and special international arbitrage accounts to include short-

sales effected by non-members. Prior to this amendment, only NASD

members would be able to avail themselves of these two exemptions from

the rule. Fourth, the NASD proposes to amend the options and warrant

market maker exemptions to provide that an NASD member would not be in

violation of the NASD's short sale rule if it executed an order for the

account of an options or warrant market maker in the good faith belief

that the order was in full compliance with the NASD's short sale rule

and it was subsequently determined that the order was either not

entitled to the exemption or it was incorrectly marked long. The NASD

also proposes to make some minor stylistic modifications and

grammatical corrections to the short sale rule and amend the section

numbers for the rule. The text of the proposed rule change is available

at the Office of the Secretary of the NASD and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the NASD included statements

concerning the purpose of and basis for the proposed rule change and

discussed any comments it received on the proposed rule change. The

text of these statements may be examined at the places specified in

Item IV below. The NASD has prepared summaries, set forth in sections

(A), (B), and (C) below of the most significant aspects of such

statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the proposed Rule Change

On November 19, 1993, the NASD submitted Amendment No. 4 to its

proposed short sale rule or ``bid test'' applicable to stocks traded on

the Nasdaq National Market to provide for an eighteen-month pilot

program that would afford equity options market makers with a limited

exemption from the rule if the short sales were effected to hedge

options positions established as a result of bona fide market making

activity.\2\ This amendment reflected the NASD's efforts to strike a

reasonable balance between the needs of equity options market makers to

effectively hedge their long options positions through short

sales\3\and the NASD's need to implement a meaningful short sale rule

for the Nasdaq Stock Market (``Nasdaq'') that does not contain broad

and sweeping exemptions that eviscerate the rule's effectiveness.

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\2\See Securities Exchange Act Release No. 33289 (December 3,

1993), 58 FR 64994 (December 12, 1993).

\3\The options exchanges and options market makers have

consistently argued, among other things, that the absence of an

exemption from the NASD's short sale rule for options market makers

will have an adverse impact on the liquidity and pricing of options

on Nasdaq securities and that it is inconsistent with the Act to

afford Nasdaq market makers an exemption from the rule and not

options market makers. See Securities Exchange Act Release No. 31729

(January 13, 1993), 58 FR 5791 (``Amendment No. 3 Notice''). See

also, e.g., letter to Jonathan G. Katz, Secretary, SEC, from the

American, New York, Pacific and Philadelphia Stock Exchanges, and

the Chicago Board Options Exchange dated February 18, 1993.

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Recently, however, the options exchanges have maintained that it is

equally important for the efficiency of the marketplace that index

options market makers be able to avail themselves of an exemption from

the NASD's short sale rule for hedging purposes. Accordingly, the NASD

is proposing another amendment to its short sale rule to accommodate

the hedging needs of index options market makers. In particular, the

NASD proposes to modify the equity options market maker exemption to

include short sales effected by index options market makers.

Specifically, under the proposed index options market maker

exemption, an NASD member will be permitted, consistent with its

quotation obligations, to execute a short sale for the account of an

options market maker that would otherwise be in contravention of the

NASD's short sale rule so long as: (1) The short sale is an ``exempt

hedge transaction''; and (2) the options market maker is registered

with a ``qualified options exchange''\4\ as a ``qualified options

market maker'' on a ``qualified stock index.'' An ``exempt hedge

transaction'' is defined to be a short sale in a Nasdaq National Market

security that was effected to hedge, and in fact serves to hedge, an

existing offsetting stock index options position or an offsetting stock

index options position that was created in a transaction(s)

contemporaneous with the short sale, provided certain conditions are

satisfied. These conditions are as follows: (a) The security sold short

must be a component security of the index underlying such index option;

(b) the index underlying such offsetting index options position must be

a ``qualified stock index''; and (c) the dollar value of all exempt

short sales effected to hedge the offsetting stock index options

position(s) does not exceed the aggregate current index value of the

offsetting options position(s).

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\4\As with the equity option market maker exemption, a

``qualified options exchange'' is defined to be a national

securities exchange that has received SEC approval of rules and

procedures governing: (1) The designation of options market makers

as qualified options market makers; (2) the surveillance of its

market makers utilization of the exemption; and (3) authorization of

the NASD to withdraw, suspend, or modify the designation of a

qualified options market maker in the event that the options

exchange determines that the qualified options market maker has

failed to comply with the terms of the exemption and the exchange

believes that such action is warranted in light of the substantial,

willful, or continuing nature of the violation.

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A ``qualified stock index'' is defined to be a stock index that

includes one or more Nasdaq National Market securities, provided that

more than 10% of the weight of the index is accounted for by Nasdaq

National Market securities. The amendment also provides that a

qualified stock index shall be reviewed as of the end of each calendar

quarter, and the index shall cease to qualify if the value of the index

represented by one or more Nasdaq National Market securities is less

than 8% at the end of any subsequent calendar quarter. In this

connection, the NASD has proposed the 10% minimum requirement for

qualified stock indexes to help ensure that exempted short sales

effected by index options market makers are in fact the result of

legitimate hedging needs.

Thus, an index options market maker would become a ``qualified

options market maker'' for certain classes of stock index options only

if it has received an appointment as such from a qualified options

exchange. In this regard, the rule is designed to ensure that only

those index options market makers who regularly engage in making

markets in options classes overlying indexes containing Nasdaq-listed

securities are designated as qualified options market makers.

Specifically, before an options exchange can become a qualified options

exchange, it must have rules in place to identify and designate as

qualified options market makers those market makers who regularly

engage in market making activities in particular options classes.

As with the equity options market maker exemption, the NASD also

has proposed that the index options market maker exemption shall only

be in effect for an eighteen-month pilot period. Throughout this

eighteen-month period, the NASD will review and analyze with the

options exchanges whether the exemption is resulting in destabilizing

trading in Nasdaq stocks.

In addition, the NASD notes that the Intermarket Surveillance Group

Agreement, which provides for the sharing of surveillance information

between the exchanges and the NASD, may assist in evaluating possibly

manipulative activity and other possibly destabilizing short selling

activity by qualified options market makers and other options market

makers in Nasdaq securities.

The NASD also is proposing four other amendments to its short-sale

rule. First, the NASD proposes to amend its short sale rule to provide

that all market maker exemptions from the rule are uniform in duration.

Specifically, under the proposal, the exemptions afforded qualified

Nasdaq market makers, Nasdaq warrant market makers, and qualified

options market makers all will expire eighteen months after the

effective date of the NASD's short sale rule. Previously, only the

options market maker exemption was proposed on a pilot basis. With all

of the market maker exemptions expiring simultaneously, the NASD

believes it will be better able to evaluate and respond to the market

impacts, if any, resulting from these exemptions. Accordingly, prior to

the termination of the eighteen-month pilot period, the NASD will

evaluate whether these exemptions should be extended, modified,

approved on a permanent basis, or terminated.

Second, the NASD is clarifying that transactions by options market

makers and warrant market makers unrelated to their normal options/

warrant market making activity, such as index arbitrage or risk

arbitrage that in either case is independent of an options/warrant

market maker's market making functions, will not be considered a

hedging transaction for purposes of the options/warrant market maker

exemption from the NASD's short-sale rule. Amendment No. 4 to the short

sale rule provided that Nasdaq market makers will not be able to avail

themselves of an exemption from the short sale rule for ``transactions

unrelated to normal market making activity, such as index arbitrage and

risk arbitrage that is independent from a member's market making

functions * * *''. Thus, this amendment merely extends to options and

warrant market makers the same restriction that already applies to

Nasdaq market makers.\5\

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\5\The NASD also would like to correct an error that was made in

the filing for Amendment No. 4 concerning the entitlement of a

Nasdaq market maker to an exemption from the NASD's short sale rule

when the risk arbitrage department of a firm takes over the firm's

market making functions after the announcement of a merger or

acquisition. Specifically, the filing stated that ``registered

Nasdaq market makers that qualify for the exemption according to the

standards of Sections 46 and 47 would relinquish their market making

exemption if the risk arbitrage department of the firm took over the

market making functions after the announcement of a merger or

acquisition.'' Instead, the filing should have stated that the firm

would not have to relinquish its market maker exemption if the risk

arbitrage department continued to engage in bona fide market making

and the firm continued to qualify for an exemption for that issue

under sections 46 and 47 of the NASD's Rules of Fair Practice. To

the extent that the risk arbitrage department effected risk

arbitrage transactions unrelated to bona fide market making

activity, however, the exemption would not be available for those

transactions. (As discussed below, the NASD proposes to renumber

Sections 46 and 47 upon approval of this filing.)

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Third, the NASD proposes to amend its short sale rule to track

provisions of SEC Rule 10a-1(e) (7) and (8) concerning short sales

effected by special arbitrage accounts and special international

arbitrage accounts (``arbitrage accounts''). Currently, the NASD's

short sale rule only affords NASD members an exemption from the rule

for certain short sales effected in arbitrage accounts. The exemptions

from the SEC's short sale rule afforded by Rule 10a-1(e) (7) and (8),

however, are available to any person and are not limited to members of

an exchange or the NASD. Thus, the NASD is proposing to replace the

word ``member'' with the word ``person'' in the exemptions for

arbitrage accounts so that the NASD's short sale rule better tracks

comparable provisions of SEC Rule 10a-1.

Fourth, to clarify that the onus for determining entitlement to an

exemption falls squarely on options and warrant market makers, the NASD

proposes to add new Sections (h)(2)(f) and (i)(4) to the short sale

rule to provide that an NASD member will not be in violation of the

NASD's short-sale rule if the member executes a short sale for the

account of an options or warrant market maker that is in contravention

of the options or warrant market maker exemptions, provided that the

member did not know or have reason to know that the options or warrant

market maker's short sale was in contravention of these exemptions.

The NASD also is proposing several minor changes to its short sale

rule and the accompanying rule governing the designation of Primary

Nasdaq Market Makers. First, the NASD proposes to replace references to

Nasdaq/NMS securities in these rules with the term Nasdaq National

Market securities to ensure uniformity and avoid confusion. Second,

because another NASD rule has been designated as Section 46, the same

section number proposed for the short sale rule, the NASD proposes to

delete the section numbers for short sale rule and the accompanying

rule governing Primary Nasdaq Market Makers. Once this filing is

approved, these Sections will be numbered sequentially with the next

available section numbers. Third, the NASD proposes two minor

amendments to the first paragraph of Interpretation C to the short sale

rule to correct grammatical mistakes.

The NASD believes the proposed rule change is consistent with

sections 15A(b)(6) and 11A(c)(1)(F) of the Act. Section 15A(b)(6)

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, 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(c)(1)(F) assures

equal regulation of all markets for qualified securities and all

exchange members, brokers, and dealers effecting transactions in such

securities. Specifically, as noted in prior filings regarding the

NASD's short sale rule, approval of the proposed short sale rule would

result in equivalent short sale regulation in the exchange and Nasdaq

markets and would work to prevent fraud and manipulation with respect

to short sales in the Nasdaq market. Moreover, the NASD believes that

affording index options market makers with an exemption from the rule

for legitimate hedging transactions associated with their bona fide

options market making activity will serve to minimize the potential

adverse impacts, if any, on the options markets resulting from adoption

of the NASD's short sale rule. In addition, in light of the safeguards

proposed in conjunction with the index options market maker exemption

(e.g., the requirement that the short sales be hedges of existing or

contemporaneously established index options positions and the

limitation of the exemption to index options market makers on indexes

with a substantial Nasdaq component), the NASD does not believe that

the index options market maker exemption will subsume or eviscerate the

effectiveness of the NASD's short sale rule.

In addition, as with the exemption for equity options market

makers, the NASD believes it is reasonable and appropriate to approve

the index options market maker exemption on an eighteen-month pilot

basis. As noted in prior NASD filings concerning the NASD's short sale

rule, in the absence of a comparable short sale rule for the options

markets, it is not entirely clear to the NASD that abusive short

sellers will not be able to circumvent the NASD's short sale rule

through the use of the index options markets. Specifically, if index

options market makers are not required to adhere to the NASD's short

sale rule, the NASD believes it is possible that market participants

would aggressively buy puts or sell calls on indexes with a large

Nasdaq component confident in the knowledge that the options market

makers likely to bear the other side of the contract would almost

surely employ their short sale exemption to sell into the bid on

Nasdaq. Accordingly, the NASD believes it would be prudent and

consistent with the maintenance of fair and orderly markets to approve

the index options market maker exemption on an eighteen-month pilot

basis. During the term of the pilot, the NASD, in cooperation with the

options exchanges, will conduct a thorough analysis of the market

impacts, if any, resulting from short sales effected pursuant to the

exemption. Depending on the results of the study, the NASD will

consider whether to seek permanent approval of the exemption, modify

the exemption, or withdraw the exemption. In this connection, it is the

NASD's intention to not modify or withdraw the exemption unless it can

be shown that the exemption is causing demonstrable harm to Nasdaq.

Moreover, should it become clear during the term of the pilot that the

index options market marker exemption is having an adverse impact on

Nasdaq, the NASD will endeavor to make a good faith effort to work with

the options exchanges to correct or rectify the concerns associated

with the operation of the exemption before seeking to withdraw the

pilot.

The NASD also believes that approving the exemption for qualified

Nasdaq market makers on an eighteen-month pilot basis is consistent

with the maintenance of fair and orderly markets. While the NASD

continues to believe that Nasdaq market makers regularly performing an

effective market making function must be permitted the flexibility to

sell short when necessary to adjust quickly to market movements and

that there are more compelling reasons to provide Nasdaq market makers

with an exemption from the short sale rule than options market makers,

the NASD, nevertheless, believes it is appropriate to thoroughly

examine whether the Nasdaq market maker exemption is causing any

adverse market impacts before adopting the exemption on a permanent

basis. In addition, approving the Nasdaq market maker exemption on an

interim basis is consistent with the proposed pilot exemption for

options market makers. Finally, with respect to the other proposed

amendments discussed in this filing, the NASD believes they will serve

to reduce investor confusion concerning the application and operation

of the NASD's short sale rule, thereby promoting efficient and fair

markets.

B. Self-Regulatory Organization's Statement on Burden on Competition

The NASD believes that the proposed rule change will not result in

any burden on competition that is not necessary or appropriate in

furtherance of the purpose of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing

for Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the NASD consents, the Commission will:

A. By order approve such proposed rule change, or

B. Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. Copies

of the submission, all subsequent amendments, all written statements

with respect to the proposed rule change that are filed with the

Commission, and all written communications relating to the proposed

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

that may be withheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

NASD. All submissions should refer to the file number in the caption

above and should be submitted by April 8, 1994.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\6\

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\6\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-6323 Filed 3-17-94; 8:45 am]

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