Self-Regulatory Organizations; Notice of Proposed Rule Change by the National Association of Securities Dealers, Inc. Amending Rule 11890 Regarding Clearly Erroneous Transactions

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38196; File No. SR-NASD-96-51]

Self-Regulatory Organizations; Notice of Proposed Rule Change by

the National Association of Securities Dealers, Inc. Amending Rule

11890 Regarding Clearly Erroneous Transactions

January 22, 1997.

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 December

17, 1996, the National Association of Securities Dealers, Inc.

(``NASD'' or ``Association'') filed with the Securities and Exchange

Commission (``Commission'' or ``SEC'') the proposed rule change as

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

by the NASD and The Nasdaq Stock Market, Inc. (``Nasdaq''). On January

17, 1997, the NASD and Nasdaq submitted to the Commission Amendment No.

1 to the proposed rule change.\1\ The Commission is publishing this

notice to solicit comments on the proposed rule change from interested

persons.

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\1\ See letter from Robert E. Aber, Vice President and General

Counsel, Nasdaq, to Katherine A. England, Assistant Director, SEC,

dated January 17, 1997. Amendment No. 1 corrects typographical

errors in the text of the proposed rule change.

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

of the Proposed Rule Change

Pursuant to Section 19(b)(1) under the Act and Rule 19b-4

thereunder, the NASD and Nasdaq are submitting this rule filing to

amend Rule 11890, the rule related to clearly erroneous transactions.

The proposed amended language for Rule 11890 is set forth below. [new

text is italicized; deleted text is bracketed].

11890. Clearly Erroneous [Trades] Transactions

(a) Authority to [Declare] Review Transactions [Void]

(1) [In circumstances in which the Association deems it necessary

to maintain a fair and orderly market and to protect investors and the

public interest, the Association may, pursuant to the procedures set

forth in paragraph (b) below, declare any transaction arising out of

the use or operation of any automated quotation, execution, or

communication system owned or operated by the Association or any

subsidiary thereof and approved by the Commission, null and void on the

grounds that one or more of the terms of the transaction are clearly

erroneous.

(2)] For the purposes of this Rule, the terms of a transaction are

clearly erroneous when there is an obvious error in any term, such as

price, number of shares or other unit of trading, or identification of

the security.

(2) Officers of The Nasdaq Stock Market, Inc. (``Nasdaq'')

designated by the President of Nasdaq shall, pursuant to the procedures

set forth in paragraph (b) below, have the authority to review any

transaction arising out of the use or operation of any automated

quotation, execution, or communication system owned or operated by

Nasdaq and approved by the Commission. A Nasdaq officer shall review

transactions with a view toward maintaining a fair and orderly market

and the protection of investors and the public interest. Based upon

this review, the Officer shall decline to act upon a disrupted

transaction if the officer believes that the transaction under dispute

is not clearly erroneous, or, if the officer determines the transaction

in dispute is clearly erroneous, he or she shall declare that the

transaction is null and void or modify one or more terms of the

transaction. When adjusting the terms of a transaction, the Nasdaq

officer shall seek to adjust the price and/or size of the transaction

to achieve an equitable rectification of the error that would place the

parties to a transaction in the same position, or as close as possible

to the same position, that they would have been in had the error not

occurred. Nasdaq shall promptly provide oral notification of a

determination to the parties involved in a disputed transaction and

thereafter issue a written confirmation of the determination.

(b) Procedures for Reviewing [Declaring a] Transactions [Void]

(1) Any member or person associated with a member that seeks to

have a transaction reviewed [declared null and void] pursuant to

paragraph (a) hereof, shall submit a written complaint, via facsimile

or otherwise, to Nasdaq Market Operations in accordance with the

following time parameters:

(A) for transactions occurring prior to 10:00 a.m., Eastern Time,

complaints must be submitted 10:30 a.m., Eastern Time; and

(B) for transactions occurring on or after 10:00 a.m., Eastern

Time, complaints must be submitted within thirty minutes.

[notify an officer of the Association designated by the President of

the transaction during Nasdaq operating hours on the same business day

the transaction occurs, and shall provide such official all facts and

information necessary for a determination under paragraph (a).

Information communicated orally shall be confirmed promptly in

writing.]

(2) Once a complaint has been received in accord with subparagraph

(b)(1) above:

(A) the complainant shall have up to thirty (30) minutes, or such

longer period as specified by Nasdaq staff, to submit any supporting

written information concerning the complaint necessary for a

determination under paragraph (a)(2), via facsimile or otherwise;

(B) the counterparty to the trade shall be verbally notified of the

complaint by Nasdaq staff and shall have up to thirty (30) minutes, or

such longer period as specified by Nasdaq staff, to submit any

supporting written information concerning the complaint necessary for a

determination under paragraph (a)(2), via facsimile or otherwise; and

(C) either party to a disputed trade may request the written

information provided by the other party pursuant to this subparagraph.

(3) Notwithstanding paragraph (b)(2) above, once a party to a

disputed trade communicates that it does not intend to submit any

further information concerning a complaint, the party may not

thereafter provide additional information unless requested to do so by

Nasdaq staff. If both parties to a disputed trade indicate that they

have no further information to provide concerning the complaint before

their respective thirty-minute information submission period has

elapsed, then the matter may be immediately presented to a Nasdaq

officer for a determination pursuant to paragraph (a)(2) above.

(4) Each member and/or person associated with a member involved in

the transaction shall provide the Association with any information

requested by the Association in order to resolve the matter on a timely

basis notwithstanding the time parameters set forth in paragraph (b)(2)

above.

(5) Once a party has applied to Nasdaq for review, the transaction

shall be reviewed and a determination rendered, unless both parties to

the transaction agree to withdraw the application for review prior to

the time a decision is rendered pursuant to paragraph (a)(2).

[[Page 4369]]

[(2) An officer of the Association designated by the President

shall review the information submitted and determine whether the

transaction in dispute is clearly erroneous and detrimental to the

maintenance of a fair and orderly market and the protection of

investors and the public interest and may declare that the transaction

be null and void. The official may decline to act upon a disputed

transaction if he or she believes that action is unnecessary or

inappropriate. The Association shall immediately issue a written

determination of the matter, setting forth the actions taken and the

reasons therefor.]

(c) Procedures for Reviewing Transactions Executed During System

Disruptions or Malfunctions

In the event of a disruption or malfunction in the use or operation

of any automated quotation, execution, or communications system owned

or operated by Nasdaq and approved by the Commission, Nasdaq, acting

through an officer designated by the President of Nasdaq pursuant to

paragraph (a)(2), may, on its own motion pursuant to the standards set

forth in paragraph (a), declare transactions arising out of the use or

operation of such systems during the period of such disruption or

malfunction null and void or modify the terms of these transactions;

provided that, in the absence of extraordinary circumstances, a Nasdaq

officer must take action pursuant to this paragraph within thirty (30)

minutes of detection of the erroneous transaction(s), but in no event

later than 6:00 p.m., Eastern Time, on the next trading day following

the date of the trade at issue. When Nasdaq takes action pursuant to

this subparagraph, the member firms involved in the transaction shall

be notified as soon as is practicable and shall have a right to appeal

such action in accordance with paragraph (d)(1) below.

(d) [(3)] Review by the Market Operations Review Committee (``MORC'')

(1) A member or person associated with a member may appeal a

determination made under paragraphs (a)(2) or (c) [the determination

under subparagraph (2)] to the MORC [Market Operations Review

Committee] provided such appeal is made in writing, via facsimile or

otherwise, within [four market hours of] thirty (30) minutes after the

member or person associated with a member receives verbal notification

of such determination. [For the purposes of this Rule, ``market'' hours

shall mean those hours the Nasdaq market is open in the United States,

Eastern Time.] Once a written appeal has been received, the

counterparty to the trade will be notified of the appeal and both

parties shall be able to submit any additional supporting written

information, via facsimile or otherwise, up until the time the appeal

is considered by the Committee. Either party to a disputed trade may

request the written information provided by the other party during the

appeal process. An appeal to the Committee shall not operate as a stay

of the determination made pursuant to paragraph (a)(2) above. Once a

party has appealed a determination to the Committee, the determination

shall be reviewed and a decision rendered, unless both parties to the

transaction agree to withdraw the appeal prior to the time a decision

is rendered by the Committee. Upon consideration of the record, and

after such hearings as it may in its discretion order, the Committee,

pursuant to the standards set forth in paragraph (a), shall affirm,

modify, reverse, [dismiss,] or remand the determination made under

[sub]paragraph (a)(2) or (c) above.

(2) [(4)] The decision of the Committee shall be final and binding

upon any member or person associated with a member and shall constitute

final Association action on the matter in issue. Any adverse

determination by a Nasdaq officer pursuant to paragraph (a)(2) or (c)

or any adverse decision by the Committee pursuant to paragraph (d)(1)

shall be rendered without prejudice as to the rights of the parties to

the transaction to submit their dispute to arbitration.

* * * * *

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 and Nasdaq 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 and Nasdaq have 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

The NASD and Nasdaq have determined to amend Rule 11890, the NASD's

rule governing the review and resolution of erroneous transaction

complaints. In general, the proposed amendments provide greater

specificity regarding declarations of erroneous transactions. As

explained in more detail below, the proposed amendments would:

Provide Nasdaq officials the authority to efficiently and

expeditiously adjust the price and size of erroneous transactions

(currently Nasdaq officials may only nullify, affirm, or decline to act

with respect to an allegedly erroneous transaction);

Shorten the time period to submit erroneous transactions

complaints from same day submission to submission within 30 minutes of

the transaction;

Clarify the procedures by which the parties to an

allegedly erroneous transaction may submit written information

concerning the transaction;

Provide Nasdaq officials the requisite authority to cancel

or adjust erroneous transactions on their own motion;

Discourage regulatory arbitrage by prohibiting a member

from withdrawing an erroneous transaction complaint unless the other

party to the trade agrees to withdraw the matter;

Shorten the time period to appeal an erroneous transaction

determination from four ``market'' hours to thirty minutes; and

Clarify that an appeal of an erroneous transaction

determination does not operate as a stay of the determination.

A. Background

In April 1990, the SEC approved an NASD proposal to add Section 70

to the Uniform Practice Code (now NASD rule 11890) to permit the NASD

to declare clearly erroneous transactions null and void if they arise

out of the use or operation of any automated quotation, execution, or

communication system owned or operated by the NASD. Previously, the

NASD had no authority to cancel a transaction, even if one or more

terms of the transaction clearly was in error. For example, one of the

catalysts for adopting Rule 11890 was that a member had complained that

a trade executed over Nasdaq's SelectNet service was ten points away

from the inside quotation, clearly an error, but the contra party

refused to cancel the trade. With the adoption of rule 11890, the NASD

now has the ability to resolve disputes involving obvious errors in an

expeditious manner, akin to an exchange floor governor ruling.\2\

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\2\ See, e.g., New York Stock Exchange Rule 75.

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[[Page 4370]]

Briefly, the current procedures for canceling a clearly erroneous

trade require one party to contact the NASD on trade day and in writing

state the basis for the requested action. Thereafter, an officer of

Nasdaq: (1) advises the contra party to the trade that the transaction

is in dispute; (2) obtains additional information concerning the

transaction, if necessary; (3) reviews the trade information; and (4)

makes a determination as to whether the trade should stand or be

broken. If either party wishes to appeal the staff determination, it

may seek review by the MORC.

While the current Erroneous Transaction procedures have served as a

vehicle to correct or cancel erroneous transactions, experience with

the operation of Rule 11890 has shown that the Rule can be improved to

enhance the fairness and expediency with which erroneous transaction

complaints are resolved. Experience with the Rule also has revealed

shortcomings in the scope of Nasdaq's authority to take action with

respect to clearly erroneous transactions. In particular, there have

been instances in the past where it would have been appropriate for

Nasdaq to declare a series of transactions erroneous even though the

parties to the transactions were immediately unaware of any error. The

proposed changes to the rule are intended to eliminate the shortcomings

and to provide additional capabilities to resolve clearly erroneous

transactions.

B. Proposed Changes to Rule 11890

(i) Authority of Nasdaq Officers to Adjust the Terms of Erroneous

Transactions: While Nasdaq officers and the MORC both have the

authority to nullify, affirm, or decline to act with respect to an

allegedly erroneous transaction, only the MORC can presently adjust the

terms of an erroneous transaction. In order to enhance the efficiency

with which erroneous transaction disputes are resolved, it is

appropriate to grant Nasdaq officers the requisite authority with

respect to allegedly erroneous transactions that the MORC possesses.

Accordingly, the NASD and Nasdaq propose that Rule 11890 be amended to

afford Nasdaq officers the authority to adjust the terms of a clearly

erroneous transaction. In particular, the NASD and Nasdaq believe

Nasdaq officers should be able to adjust the price and/or size of a

transaction to achieve an equitable correction of an error that would

place the parties to the transaction in the same position, or as close

as possible to the same position, that they would have been in had the

error not occurred.

(ii) Time Parameters For the Submission of Erroneous Transaction

Complaints: Rule 11890 presently provides that a member can submit an

erroneous transaction complaint ``during Nasdaq operating hours on the

same business day the transaction occurs. . . .'' Because members can

file erroneous transaction complaints any time during the trading day,

however, the rule has been used by some firms to seek to cancel trades

that were not erroneous at the time of execution, but which became

unprofitable due to subsequent market movement. For example, when a

trade occurs on SelectNet at 10:00 a.m. and a party does not complain

of an error until 5:00 p.m., the complainant has had the opportunity to

watch for positive or negative market movements, prior to requesting

NASD action. If the market moves in a direction that is unfavorable to

the trade, the member will contact the NASD to cancel the trade after

the close of the market, leaving the other side of the transaction at

risk, without giving adequate notice of the disputed trade in close

proximity to the time of execution.\3\

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\3\ In essence, the rule grants a free call option when a

potential complainant sold stock and a free put option when the

potential complainant bought stock.

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Accordingly, the NASD and Nasdaq believe that Rule 11890 should be

amended to require the timely submission of notifications of allegedly

erroneous transactions. The NASD and Nasdaq are proposing two different

time periods depending upon the time of day when the allegedly

erroneous transaction occurred to take into account the peak trading

period that occurs at the market's opening. Because of the pace and

volume of trades that occur in the first half hour of trading each

morning, the proposal establishes a separate timeframe for reporting

clearly erroneous transactions that occur between 9:30 and 10:00. Thus,

notifications would be required according to the following time table:

(a) for transactions occurring prior to 10:00 a.m., Eastern Time,

complaints must be submitted by 10:30 a.m., Eastern Time; and

(b) for transactions occurring at or after 10:00 a.m., Eastern

Time, complaints must be submitted within thirty minutes.

In addition, the NASD proposes to amend Rule 11890 to clarify

several procedural aspects concerning the submission of erroneous

transaction complaints. Specifically, the amendments would clarify

that:

(a) a complaint will not be deemed to have been submitted until

Market Operations receives a written complaint, via facsimile or

otherwise;

(b) once a timely complaint is received, a complainant will have up

to thirty minutes to submit any supporting written information

concerning the complaint, via facsimile or otherwise;

(c) once a timely complaint is received, the counter-party will be

notified by Market Operations of the complaint and afforded a thirty-

minute period to submit any supporting written information concerning

the disputed trade, via facsimile or otherwise;

(d) either party to a disputed trade may request the written

information submitted by the other party;

(e) notwithstanding the thirty-minute period to submit information,

once a party to a disputed trade communicates that it has no further

information to provide, it may not thereafter provide additional

information unless requested to do so by the staff; and

(f) if both parties to a disputed trade indicate that they have no

further information to provide concerning the complaint before their

respective thirty-minute information submission period has elapsed,

then the matter may be immediately presented to a Nasdaq officer for a

determination.

(iii) Authority of Nasdaq to Cancel or Adjust Clearly Erroneous

Trades on its Own Motion: Presently, only members can seek to have an

allegedly erroneous transaction nullified. There have been occasions,

however, where Nasdaq system malfunctions have caused erroneous trades.

Accordingly, in order to promote fair and orderly markets, the NASD and

Nasdaq believe it would be appropriate to provide designated Nasdaq

officials the authority to cancel or modify the terms of transactions

in the event of a disruption or malfunction in the use or operation of

any automated quotation, execution, or communication system owned or

operated by Nasdaq.\4\ Under this provision, the NASD and Nasdaq also

believe such senior officials should be authorized to cancel or adjust

an erroneous transaction on their own motion within thirty minutes of

detection of the erroneous transaction, absent extraordinary

circumstances, but in no event later than 6:00 p.m. on the next trading

day after the date of the trade(s) in dispute. As with any other

erroneous transaction determination, members would have the right to

appeal such actions to the MORC.

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\4\ A list of the Nasdaq officials that have the authority to

cancel or modify the terms of a transaction shall be maintained by

the Nasdaq Corporate Secretary.

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(iv) Withdrawal of Erroneous Transaction Complaints: Rule 11890

[[Page 4371]]

currently permits a member to withdraw an erroneous transaction

complaint at any time. Because there are no restrictions on when a

complaint can be withdrawn, market participants have in the past

withdrawn their complaints when the market moved in their favor

subsequent to filing the complaint. Accordingly, in order to facilitate

the maintenance of fair and orderly markets and the equitable

resolution of erroneous transaction disputes, the NASD and Nasdaq

believe that Rule 11890 should be amended to prohibit the withdrawal of

a complaint or an appeal of an erroneous transaction determination

unless both parties to the trade agree to withdraw the matter.

(v) Time Parameter to Appeal Erroneous Transaction Determinations:

Presently, members have four ``market'' hours to appeal an erroneous

transaction determination. This period of time is too long in that it

unduly extends the period of time that both parties to the trade are

subject to market risk. Accordingly, the NASD has proposed that, once a

member has received verbal notification of an erroneous transaction

determination from the staff, it shall have thirty minutes to appeal

the determination. The NASD and Nasdaq also propose that Rule 11890

should be amended to clarify that once a written appeal has been

received, the counter-party to the trade will be notified of the appeal

and both parties will be able to submit any additional supporting

written information up until the time the appeal is considered by the

Committee. In addition, the NASD and Nasdaq believe that the Rule

should be amended to provide that either party to a disputed trade may

request the written information provided by the other party during the

appeal process.

(vi) Clarification of the Appeal Process for Erroneous Transaction

Determinations: In order to clarify the current operation of the appeal

process for erroneous transaction determinations, Rule 11890(b)(3)

should be amended to provide that:

(a) an appeal of an erroneous transaction determination does not

operate as a stay of the initial ruling; and

(b) any decisions by the MORC or the staff are rendered without

prejudice as to the rights of the parties to seek arbitration of the

disputed transactions.

In proposing these rule changes, the NASD and Nasdaq believe that

the process for resolving erroneous transaction complaints will become

fairer, more efficient, and more timely, thereby promoting the

maintenance of fair and orderly markets and exposing the parties to an

allegedly erroneous transaction to less market risk. In addition,

allowing Nasdaq officials to cancel or adjust erroneous transactions on

their own motion in the event a disturbance or malfunction with a

Nasdaq system will serve to protect the interests of investors.

Accordingly, the NASD and Nasdaq believe that the proposed rule change

is consistent with the provisions of Section 15A(b)(6) in that it

promotes the protection of investors and the public interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

The NASD and Nasdaq do not believe that the proposed rule change

will result in any burden on competition that is not necessary or

appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the

Proposed Rule Change Received from Members, Participants, or Others

Written 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 self-regulatory organization 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, N.W., Washington, D.C. 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 File No. SR-NASD-96-51 and should

be submitted by February 19, 1997.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-2099 Filed 1-28-97; 8:45 am]

BILLING CODE 8010-01-M