Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Granting Temporary Approval and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 2 of Proposed Rule Change to Extend the Interim SOES Rules

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35275; File No. SR-NASD-94-68]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc.; Order Granting Temporary Approval and Notice of Filing

and Order Granting Accelerated Approval of Amendment No. 2 of Proposed

Rule Change to Extend the Interim SOES Rules

January 25, 1995.

I. Introduction

On December 1, 1994, the National Association of Securities

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

and Exchange Commission (``SEC'' or ``Commission'') a proposed rule

change pursuant to Section 19(b)(1) of the Securities Exchange Act of

1934 (``Act'')\1\ and Rule 19b-4 thereunder.\2\ The NASD proposes to

extend through March 27, 1995 certain of the prior changes to its Small

Order Execution System (``SOES'') that are scheduled to expire today.

The currently effective prohibition on short selling in SOES would not

be extended.

\1\15 U.S.C. Sec. 78s(b)(1) (1988).

\2\17 CFR 240.19b-4 (1994).

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Specifically, the NASD proposes to extend changes that: (1) Reduced

the maximum size order eligible for execution through SOES from 1,000

shares to 500 shares; (2) reduced the minimum exposure limit for

``unpreferenced'' SOES orders from five times the maximum order size to

two times the maximum order size, and eliminated the exposure limits

for ``preferenced orders''; and (3) implemented an automated function

for updating market maker quotations when the market maker's exposure

limit has been exhausted (collectively referred to hereinafter as the

``Amended Interim SOES Rules'').

In 1993, the Commission approved these changes to the SOES rules

(as well as a short selling prohibition) on a one-year pilot basis.\3\

Approval on a pilot basis was intended to permit the Commission to

reconsider the effects of the rules in light of experience with the

rules' operation in the marketplace.\4\ The NASD now seeks extension of

certain of these rules.

\3\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58

FR 69419 (Dec. 30, 1993) (approving the Interim SOES Rules on a one-

year pilot basis effective January 7, 1994). See also Securities

Exchange Act Release No. 33424 (Jan. 5, 1994) (order denying stay

and granting interim stay through January 25, 1994) and Securities

Exchange Act Release No. 33635 (Feb. 17, 1994) (order denying

renewed application for stay).

\4\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58

FR 69419 (Dec. 30, 1993).

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The NASD originally sought extension of the Amended Interim SOES

Rules through May 1, 1995. Notice of that proposed rule change appeared

in the Federal Register on December 16, 1994.\5\ The Commission

received comments from 58 commenters, with 12 supporting the proposal

and 46 opposing it. On January 23, 1995, the NASD amended its proposal

to request extension of the Amended Interim SOES Rules until March 27,

1995, rather than [[Page 6328]] until May 1, 1995.\6\ For the reasons

discussed below, this order approves the proposed rule change until

March 27, 1995.

\5\The NASD amended the proposed rule change twice since it was

originally filed with the Commission on December 1, 1994. The first

amendment was included in the Commission's original notice.

Securities Exchange Act Release No. 35077 (Dec. 9, 1994), 59 FR

65105 (Dec. 16, 1994).

\6\Letter from T. Grant Callery, Vice President & General

Counsel, NASD, to Mark Barracca, Branch Chief, SEC (Jan. 23, 1995).

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II. Description of the Proposed Rule Change

As noted above, the NASD has proposed to extend three of the four

Interim SOES Rules that became effective January 25, 1994. The proposal

does not include extending the short sale prohibition beyond January

25, 1995; thus, effective January 26, 1995, short sales in compliance

with the NASD's short sale rule applicable to the Nasdaq market as a

whole will be permitted in SOES.\7\ The following restrictions will be

effective until March 27, 1995:

\7\NASD Manual, Rules of Fair Practice, Sec. 48, CCH 2200H.

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(1) SOES Maximum Order Size: The maximum size order eligible for

SOES execution will be 500 shares for the highest tier of Nasdaq

National Market securities.\8\

\8\Market makers must continue to display a size of 1,000 shares

in their quotations for these securities, and to be firm for a

minimum of 1,000 shares at their published quotation, for any

negotiated transaction through SelectNet or over the telephone. See

NASD Manual, Schedules to the By-Laws, Schedule D, Part VI, Sec.

2(a)--(b), CCh 1819.

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(2) SOES Minimum Exposure Limit: The market maker's SOES minimum

exposure limit will be two times the maximum order size. The rule

change continues the application of the minimum exposure limit to

unpreferenced orders only, so that preferenced orders will not count

toward depletion of the minimum exposure limit.

(3) Automated Quotation Updates: The NASD proposes to continue

providing an automated quotation update function for marker makers

using SOES, at their election, on an issue-by-issue basis. If the

automated update function is not used, when a market maker depletes its

exposure limit in SOES, the market maker's quotation is closed to SOES

executions until the market maker updates its quote and reestablishes

its exposure limit. If used, the function updates a market maker's

quotation in any Nasdaq security when its exposure limit has been

exhausted, and reestablishes the original quotation size and exposure

limit, thereby preventing closed quotations. Market makers electing to

use the feature can set the fractional interval of the quotation update

for each security and set their exposure limit at the maximum order

size for that security that is, 500 shares for the highest tier of

Nasdaq National Market securities.

In light of the NASD's implementation of short sale prohibitions on

September 6, 1994,\9\ the NASD will terminate the prohibition against

short selling through SOES. Thus, beginning January 26, 1995, short

sales in compliance with the NASD's short sale rule will be permitted

through SOES.

\9\Securities Exchange Act Release No. 34277 (June 29, 1994), 59

FR 34885 (July 7, 1994) (approval of the NASD's short sale rule,

effective September 6, 1994).

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III. Comments

Commenters supporting and opposing the proposal stated reasons

similar to those put forth in response to the NASD's original proposal

to adopt the Interim SOES Rules.\10\ Commenters supporting the proposal

argue that the Amended Interim SOES Rules will limit the exposure of

market makers to multiple executions, which should produce narrower

spreads and more liquid markets. Those opposing extension of the rules

argue that market makers have ample opportunity to update their quotes

in order to avoid multiple SOES executions. They contend that two

studies submitted by proponents of the rules fail to show any increase

in market quality as a result of the rules. They also argue that the

SOES immediate automatic execution feature provides them the only

meaningful access to the Nasdaq market because, they allege, market

makers do not honor their quoted prices on the telephone or through

SelectNet. These commenters assert that they cannot obtain quote-based

trade executions except through SOES and that the Interim SOES Rules

have thereby restricted their access to Nasdaq and the ability of

certain customers to receive executions at quoted prices. These

commenters argue that the Interim SOES Rules thus produce unfair

discrimination and an inappropriate burden on competition.

\10\These comments addressed the proposal to extend the Interim

SOES Rules through May 1, 1995, as originally filed. As amended,

those rules would now expire March 27, 1995. See supra note 5.

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IV. Discussion

The Commission must approve a proposed NASD rule change if it finds

that the proposal is consistent with the requirements of the Act and

the rules and regulations thereunder that govern the NASD.\11\ In

evaluating a given proposal, the Commission examines the record before

it and relevant factors and information.\12\ After balancing the

advantages and disadvantages of extension, the Commission believes that

limited extension of the Amended Interim SOES Rules through March 27,

1995 meets the above standards and is necessary and appropriate in the

public interest and for the protection of investors. As discussed in

more detail below, the Commission does not believe that, on the basis

of the information before it, an extension of the Amended Interim SOES

Rules beyond 60 days is justified under the applicable statutory

standard. Nevertheless, because much information has been made

available only recently, the Commission has determined that it is

appropriate to provide this brief phase-out period (until March 27,

1995), which will enable the market to make an orderly transition.\13\

\11\15 U.S.C. Sec. 78s(b). The Commission's statutory role is

limited to evaluating the rules as proposed against the statutory

standards. See S.Rep. No. 75, 94th Cong., 1st. Sess., at 13 (1975).

\12\In the 1975 Amendments, Congress directed the Commission to

use its authority under the Act, including its authority to approve

SRO rule changes, to foster the establishment of a national market

system and promote the goals of economically efficient securities

transactions, fair competition, and best execution. Congress granted

the Commission ``broad, discretionary powers'' and ``maximum

flexibility'' to develop a national market system and to carry out

these objectives. Furthermore, Congress gave the Commission ``the

power to classify markets, firms, and securities in any manner it

deems necessary or appropriate in the public interest or for the

protection of investors and to facilitate the development of

subsystems within the national market system.'' S. Rep. No. 75, 94th

Cong., 1st Sess., at 7 (1975).

\13\The Commission does not believe that further extension of

these restrictions without changes to benefit public investors would

be appropriate.

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Because the Interim SOES Rules were approved only for a pilot

period, the Commission noted in its approval order that it expected to

revisit the issues presented by the NASD's proposal.\14\ In

[[Page 6329]] approving the Interim SOES Rules, the Commission noted

its concern over the lack of reliable statistical analysis. The

Commission approved the rules, however, among other reasons, because of

the rules' limited duration and because of the agency's commitment to

monitor the rules' effects.\15\ The Commission stated that extension of

the Interim SOES Rules or other similar modifications upon expiration

of the Interim SOES Rules would ``require an independent consideration

under Section 19 of the Act.''\16\

\14\Both proponents of and opponents to the 1994 Interim SOES

Rules argued that imposing the rules would affect the Nasdaq market.

Opponents argued that the rules would heighten volatility and widen

spreads. E.g., Letters to Jonathan G. Katz, Secretary, SEC, from

Michael Frey, President, A.J. Michaels & Co., at 7 (May 11, 1993);

Douglas P. Ralston, President, Shearman, Ralston Inc., at 1 and 6

(May 10, 1993); and Harvey L. Pitt, counsel for Dina Securities,

Inc., at 15 (June 11, 1993). The NASD and its supporters, on the

other hand, argued that placing certain restrictions on the use of

SOES, for example, lowering the maximum order size, would act to

decrease volatility and narrow spreads. Securities Exchange Act

Release No. 32143 (Apr. 14, 1993), 58 FR 21484 (Apr. 21, 1993)

(notice of the NASD's proposed Interim SOES Rules, File No. SR-NASD-

93-16). The Commission's December 1993 SOES order describes in some

detail the order size reduction, the minimum order exposure limit

reductions, and the automated quotation update feature that the NASD

proposes to extend. See Securities Exchange Act Release No. 33377

(Dec. 23, 1993), 58 FR 69419 (Dec. 30, 1993). That order also

discusses the NASD's rationale for these changes to the SOES rules

and the Commission's rationale for approving them for a one-year

period.

\15\Securities Exchange Act Release No. 33377 (Dec. 23, 1993),

58 FR 69419 (Dec. 30, 1993).

\16\Securities Exchange Act Release No. 33377 (Dec. 23, 1993),

58 FR 69419 (Dec. 30, 1993) (footnote omitted). The Commission's

order further stated that ``[t]he NASD should consider whether

additional criteria for evaluating the effectiveness of the

modifications are appropriate, and should include in its assessment

of the modifications all factors that it deems relevant in

evaluating the effects of the modifications [and] . . . [i]f an

assessment is not feasible, the NASD should provide a reasoned

explanation supporting that determination.'' Id.

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In connection with its extension request, the NASD submitted an

econometric study conducted by the NASD's Economic Research

Department\17\ and commissioned a consulting economist to provide an

assessment of the effect of the Interim SOES Rules.\18\ In summary, the

NASD's Economic Research Department found that since implementation of

the Interim SOES Rules: (a) Spreads in Nasdaq securities have declined;

and (b) volatility of Nasdaq securities appears to be unchanged, except

for brief, market-wide period of volatility in March and April 1994.

The commissioned study reported that while percentage quoted spreads

increased a statistically insignificant amount, percentage quoted

spreads, adjusted for other determining factors, declined by a

statistically significant, but economically insignificant, amount. From

this data, the author concluded that the Interim SOES Rules did not

harm market quality.

\17\Securities Exchange Act Release No. 35080 (Dec. 9, 1994), 59

FR 65109 (Dec. 16, 1994). The NASD's Economic Research Department

examined Nasdaq bid-ask spreads in specific stocks and price

volatility on two sample days each month from November 1993 (three

months prior to the effective date of the rules) through August

1994.

\18\Letter from John F. Olson, Counsel for the NASD, Gibson,

Dunn & Crutcher, to Jonathan Katz, Secretary, SEC (Dec. 30, 1994)

(submitting in connection with File No. SR-NASD-94-68 analysis

entitled the Association Between the Interim SOES Rules and Nasdaq

Market Quality prepared by Dean Furbush, Ph.D., Economists

Incorporated (Dec. 30, 1994)). This analysis compared sample days in

the three months prior to and three months after the effective date

of the Interim SOES Rules.

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An evaluation of the empirical data submitted by the NASD does not

persuasively demonstrate that the quality of the market improved

subsequent to the adoption of the Interim Rules. The evidence in both

studies shows that spreads declined, but the results were only

marginally significant, and the size of the reduction is too small to

be important. Nevertheless, the Commission believes that these studies

demonstrate that the Interim Rules have operated for one year with no

apparent significant negative implications for overall market quality.

The absence of negative implications for market quality must be

considered in conjunction with other effects of the Interim SOES Rules

on the investing public. Commenters opposed to the Interim SOES Rules

argue that the restrictions impose a burden on the ability of some

customers to obtain execution of transactions in size in the Nasdaq

market. They contend that, to the extent that the Interim Rules

restrict their access to SOES, their ability to obtain executions is

limited because they cannot effectively trade over the telephone and

through SelectNet. In support of these arguments, they refer to a large

number of complaints alleging that market makers have refused to fill

trades now ineligible for SOES execution at their quoted prices. In

addition, they have provided anecdotal information that certain SOES

order entry firms have suffered serious drops in daily trading volume

since approval of the Interim Rules. The Commission takes such

allegations seriously, and is reviewing them as part of its obligation

to oversee the securities markets.

As indicated above, the Commission has determined to approve the

Amended Interim Rules through March 27, 1995. In light of the balance

of factors described above, the Commission does not believe that

further extension of this proposal would be appropriate.\19\ The short

extension the Commission has determined to approve will permit the

market to make an orderly transition to operation in a changed

environment. The Commission believes that such a measure is appropriate

in the public interest. Moreover, the Commission notes that the Amended

Interim Rules, unlike the rules currently in effect, will permit the

entry of short sale orders. The Commission believes this will

ameliorate during the phase-out period the burdens associated with the

Interim SOES Rules by expanding the types of orders that are eligible

for automatic execution.

\19\Of course, a different proposal that modified the Amended

Interim Rules to provide additional public benefits would require an

independent Commission determination.

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The Commission notes that subsequent to approval of the Interim

SOES Rules in December 1993, the NASD submitted a proposal to replace

SOES with the Nasdaq Primary Retail Order View and Execution System

(``NPROVE''). As currently proposed, NPROVE would

differ from SOES in two general ways:

NPROVE would provide a facility for automated

routing and execution of small orders, allowing market makers a 15

second opportunity to decline an order (if consistent with the Firm

Quote Rule, permitting a brief period for quote updates). SOES

generally provides immediate execution of orders against an assigned

market maker at the best bid or offer and thereafter notifies the

affected market maker; and

NPROVE would provide an opportunity for public

limit orders to interact with other limit orders and incoming market

orders, and for execution of market orders at prices superior to the

best market maker quotes. SOES provides limited opportunity for such

interaction.

In light of comments received as recently as January 9, 1995

concerning NPROVE, as well as other developments in the Nasdaq

market,\20\ the Commission believes that the NASD's NPROVE

proposal warrants further assessment. Among other matters, commenters

have raised concerns about the NASD's ability to monitor sufficiently

market maker compliance with the Firm Quote Rule and the potential for

significant order queues to develop. Before further Commission action

on NPROVE, the Commission believes that the NASD should address

such issues, including the potential for queuing during periods of

market stress, whether there are restrictions on access to the system

inconsistent with the purposes of the Act, and whether there are

adequate mechanisms to ensure effective oversight of market makers'

compliance with the Firm Quote Rule.

\20\As has been widely disclosed, the Commission is conducting

an inquiry into certain practices in the Nasdaq market and the

Antitrust Division of the Department of Justice recently has made

public an inquiry into whether Nasdaq market makers are violating

federal antitrust laws. Although not tied directly to the

Commission's consideration of the instant proposal, the Commission

expects that these inquiries may provide valuable information that

will affect future reform efforts and ultimately improve the quality

of the Nasdaq market. In addition, the NASD has formed a committee

headed by former U.S. Senator Warren Rudman to review the

effectiveness of the operation and surveillance of Nasdaq and the

governance of the NASD and Nasdaq.

[[Page 6330]]

V. Solicitation of Comments

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

arguments concerning Amendment No. 2. 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. Sec. 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 SR-NASD-94-68 and should be submitted by February 22, 1995.

VI. Conclusion

The Commission, in the exercise of the authority delegated to it by

Congress, and in light of its experience regulating securities markets

and market participants, has determined that a temporary extension of

the Amended Interim SOES Rules will provide an orderly phase-out period

and is consistent with maintaining investor protection and fair and

orderly markets, and that these goals, on balance, outweigh any

temporary anti-competitive effects on order entry firms and their

customers.

For the reasons discussed in this order, pursuant to Section

19(b)(2) of the Act,\21\ the Commission finds good cause for approving

the proposed rule change, as amended, prior to the 30th day after

publication of Amendment No. 2 in the Federal Register. The proposed

amendment shortens the date that the Amended Interim SOES Rules would

expire from May 1, 1995 to March 27, 1995, and will facilitate

maintenance of fair and orderly markets. Prior to Amendment No. 2, the

proposed rule change was published in the Federal Register for the full

statutory period.

\21\15 U.S.C. Sec. 78s(b)(2).

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Accordingly, the Commission finds that the rule change is

consistent with the Act and the rules and regulations thereunder

applicable to the NASD and, in particular, Sections 15A(b)(6),

15A(b)(9), and 15A(b)(11). In addition, the Commission finds that the

rule change is consistent with the Congressional objectives for the

equity markets, set out in Section 11A, of achieving more efficient and

effective market operations, fair competition among brokers and

dealers, and the economically efficient execution of investor orders in

the best market.

It is Therefore Ordered, pursuant to Section 19(b)(2) of the Act,

that the instant rule change SR-NASD-94-68 be, and hereby is, approved,

effective January 26, 1995, extending the Interim SOES Rules, exclusive

of the short sale prohibition, through March 27, 1995.

By the Commission.

Jonathan G. Katz,

Secretary.

[FR Doc. 95-2388 Filed 1-31-95; 8:45 am]

BILLING CODE 8010-01-M