Self-Regulatory Organizations; Notice of Filing and Order Granting Temporary Accelerated Approval of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Rule 4612, Primary Nasdaq Market Maker Standards Through October 1, 1997

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38294; File No. SR-NASD-97-07]

Self-Regulatory Organizations; Notice of Filing and Order

Granting Temporary Accelerated Approval of Proposed Rule Change by the

National Association of Securities Dealers, Inc. Relating to Rule 4612,

Primary Nasdaq Market Maker Standards Through October 1, 1997

February 14, 1997.

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

(``Act''),\1\ notice is hereby given that on January 31, 1997, the

Nasdaq Stock Market, Inc. (``Nasdaq'') filed with the Securities and

Exchange Commission (``SEC'' or ``Commission'') the proposed rule

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

prepared by Nasdaq. The Commission is publishing this notice to solicit

comments on the proposed rule change from interested persons and to

grant accelerated approval to the proposal.

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

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

of the Proposed Rule Change

Pursuant to the provisions of Section 19(b)(1) under the Act,

Nasdaq, a wholly owned subsidiary of the National Association of

Securities Dealers, Inc. (``NASD'' or ``Association''), is herewith

filing a proposed rule change to temporarily suspend the use of the

Primary Nasdaq Market Maker qualification criteria found in Rule 4612

(a) and (b) of the Nasdaq Market Maker Requirements of the NASD Rules

for all Nasdaq National Market securities for the remainder of the

current pilot period of the Nasdaq Short Sale Rule or until such

earlier time when new primary market maker qualification criteria can

be devised and adopted.

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

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, 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. Nasdaq 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

After the first week of trading under the new SEC rules regarding a

Nasdaq market maker's order handling obligations, i.e., Rule 11Ac1-4

(the customer limit order display rule) and amended Rule 11Ac1-1

(amendments to the firm quote rule regarding the display of priced

orders entered by market makers or specialists into electronic

communications networks (``ECNs'')),\2\ Nasdaq has re-evaluated its

existing qualification criteria in the primary market maker standards

rule, Rule 4612 (a) and (b), in those stocks that are not subject to

the primary market maker standard suspension approved in SR-NASD-96-

55.\3\ In that rule filing, Nasdaq noted that because of the potential

changes in quotation and trading activity in Nasdaq securities when the

new SEC Rules became effective, the existing numerical criteria used to

qualify a registered market maker as a primary market maker would be

significantly affected. Because the precise effects on market maker

quotes and trades were not possible to predict until Nasdaq could

develop practical experience with new patterns of activity under the

new rules, Nasdaq believed that it should attempt to minimize the

possible harmful unintended consequences that could occur by leaving

the current standards in place. Accordingly, Nasdaq proposed, and the

SEC approved, that the existing standards would be temporarily

suspended on the same schedule for the phase in of the SEC Rules

requirements.

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\2\ See Securities Exchange Act Release No. 37619A (September 6,

1996); 61 FR 48290 (September 12, 1996) (Order Handling Rules

Adopting Release).

\3\ See Securities Exchange Act Release No. 38175 (January 23,

1997); 62 FR 3548.

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However, based upon trading experience in the first week of trading

under the new SEC and NASD Rules, Nasdaq believes that the primary

market maker standards should be suspended immediately for all National

Market securities and all registered market makers in those securities

should be designated as primary market makers. Nasdaq bases this

proposed rule change on three factors that were not readily apparent at

the time it filed SR-NASD-96-55: (1) many market makers have

voluntarily chosen to display customer limit orders in their quotes

even though the SEC's Limit Order Display Rule does not yet require it;

(2) SOES decrementation for all Nasdaq stocks has significantly

affected market maker ability to meet several of the primary market

maker standards; and (3) with the inability to meet the existing

criteria for a larger number of securities, a market maker may be

prevented from registering as a primary market maker in an initial

public offering because it fails to meet the 80% primary market maker

test contained in Rule 4612(g)(2)(B).

Under existing Rule 4612, a registered Nasdaq Market Maker may be

deemed to be a Primary Market Maker in National Market securities if

the market maker meets two of three criteria: (1) the market maker

maintains the best bid or best offer as shown on Nasdaq no less than

35% of the time; (2) a market maker maintains a spread no greater than

102% of the average dealer spread; and (3) no more than 50% of a market

maker's quotation changes occur without a trade execution. In addition,

if a registered market maker meets only one of the above criteria, it

may nevertheless qualify as a primary market maker if the market maker

accounts for volume at least 1\1/2\ times its proportionate share of

overall volume in the stock. The review period for meeting any of these

criteria is one calendar month. Nasdaq notifies a market maker at the

beginning of the new calendar month if it does not meet the tests, and

one business day following the notification, Nasdaq withdraws the ``p''

designator.

The changes to market maker quotation and trading activities have

been dramatic in the first week of trading in the new environment. To

provide their customers with the greater transparency, many market

makers have begun to display customer limit orders in all Nasdaq

securities, not only those subject to the phase-in of the Limit Order

Display Rule, Rule 11Ac1-4. With the voluntary display of customer

limit orders in stocks not yet subject to Rule 11Ac1-4, Nasdaq market

makers are changing their quotes when they are in

[[Page 8290]]

receipt of customer limit orders that improve upon their current

quotations. Because more dealer quotes are now being driven not merely

by the market maker's proprietary interests, but also the interests of

customers that place limit orders with the market maker, Nasdaq

believes that a market maker's ability to meet the 102% of average

dealer spread test may be more difficult to meet. For example, because

a quote of a market maker driven by a customer limit order is

indistinguishable from that of a quote driven by a customer order, it

is impossible to tell when market maker quote changes are being driven

by customer interests that are entered and then subsequently canceled

without any execution. In addition, the test regarding the percentage

of time in which the market maker's quote is at the inside will also be

driven to some extent by customer limit order interest.

Moreover, the SOES decrementation feature is having a significant

impact on individual market maker quotations. Under the new SOES rules,

which apply to all securities, when SOES executes against a quotation,

whether it is on behalf of a customer or not, Nasdaq's system decreases

the quotation size. If the quote is decreased to zero, and the market

maker has the Nasdaq auto-refresh feature turned on, the market maker's

quote is changed pursuant to that execution, However, because the auto-

refresh moves only one side of the market maker's quote, the market

maker's quote is spread wider than many market makers want. Therefore,

market makers then change the quote to a narrower spread. While Nasdaq

believes that narrower spreads are beneficial for investors overall, in

this instance, the quote movement without a corresponding trade causes

the market maker to exceed the 50% quote to trade ratio established in

the primary market maker standards. If the market maker, on the other

hand, chooses not to narrow its quote after the auto-refresh, that

market maker runs the risk that it may not meet the 102% of the average

spread test. Finally, Nasdaq notes that if a market maker fails to meet

the standards and falls below the test regarding being a primary market

maker in 80% or more of the securities for which it is registered as a

market maker, it will not be allowed to register as a primary market

maker in an initial public offering, even if it is an underwriter of

that security and may be required to play an important liquidity

providing role in that stock's initial trading activity.

Nasdaq believes that it is in the public investor's best interests

to temporarily suspend the operation of the primary market maker

standards that currently exist. If the standards are not suspended, the

significant shift in the patterns of quotation and executions that

Nasdaq is beginning to experience is going to cause primary market

makers operating under the existing standards to lose that status. Loss

of the designation would mean that market makers without the designator

would not be permitted to avail themselves of the short sale exemption

for primary market makers. If a significant number of registered market

makers were to lose the short sale exemption, or if a single market

maker that handled a significant portion of the order flow in a

security were to lose the exemption, liquidity in that particular stock

could be seriously harmed.

Therefore, as of February 3, 1997, any registered market maker

would be able to avail itself of the short sale exemption for qualified

market makers found in Rule 3350(c)(1). In seeking to temporarily

suspend the use of the primary market maker qualification criteria,

Nasdaq believes that the suspension of the criteria is an appropriate

balance between the need for limitations on the market maker short sale

exemption and the potential for loss of liquidity and market disruption

in a period when new patterns and practices of trading are first being

developed. Nasdaq believes that the period of time in which the new SEC

Rules are first being implemented may be a period of uncertainty for

market makers and investors alike and that the prudent course of action

would be to identify and eliminate as many potential areas for

increasing that uncertainty as possible. Nasdaq has identified this

issue as a critical area of uncertainty and believes that the

suspension of the market maker qualification standards on a temporary

basis is an appropriate market quality response. This relief will

enable Nasdaq market makers to better satisfy investor liquidity

demands and could help to promote pricing efficiency.

Nasdaq also plans to develop new standards as soon as practicable

so that Nasdaq can obtain experience with the manner in which the new

SEC Rules affect market makers. The plan is to analyze the data from

January and February and discuss the practices among staff and with the

Quality of Markets Committee.

Nasdaq believes that the proposed rule change is consistent with

Section 15A(b)(6) of the Act in that it is designed to prevent

fraudulent and manipulative acts and facilities transactions in

securities. In particular, this temporary amendment to the existing

rule should provide market makers with certainty regarding whether they

are entitled to an exemption under the rule which should promote market

efficiency and enhance the orderliness of the market during a

transition period. It should also help in reducing investor confusion

at this time and thereby promote efficient and fair markets.

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

Nasdaq does 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. Commission's Findings and Order Granting Temporary Accelerated

Approval of Proposed Rule Change

The Commission has reviewed carefully Nasdaq's proposed rule change

and believes, for the reasons set forth below, that the proposed rule

change is consistent with the requirements of the Act and the rules and

regulations thereunder applicable to the NASD and, in particular, the

requirements of Section 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 the Act, of achieving more efficient and effective market

operation, fair competition among brokers and dealers, and economically

efficient execution of investor orders in the best market. In

particular, this temporary amendment to the existing rule should avoid

frustrating the operation of the Order Handling Rules in light of the

existence of market factors not readily apparent at the time the NASD

requested more limited relief with respect to the suspension of primary

market maker standards.\4\ The Commission is approving the rule change

on a pilot basis through October 1, 1997. During this time, however,

the Commission expects that, as with the NASD's excess spread rule,\5\

the NASD must develop

[[Page 8291]]

new primary market maker standards well before the expiration of the

pilot.

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\4\ Id.

\5\ As with the primary market maker standards, there is also a

dealer spread test that is part of the NASD's ``excess spread

rule,'' Rule 4613(d). The Commission recently approved a proposed

rule change on a pilot basis through July 1, 1997, providing that a

registered market maker in a security listed on the Nasdaq stock

market shall be precluded from being a registered market maker in

that issue for twenty business days if its average spread in the

security over the course of any full calendar month exceeds 150

percent of the average of all dealer spreads in such issue for the

month. See Securities Exchange Act Release No. 38180 (January 16,

1997), 62 FR 3725. Although the Commission approved the proposed

rule change on a temporary basis to facilitate compliance with the

Commission's Order Handling Rules, the Commission stated that during

this time period, the NASD should monitor the effects of the pilot,

as well as study alternative methods that would enhance market

making performance while completely fulfilling the NASD's obligation

regarding the excess spread rule before the August 8, 1997, deadline

contained in the Commission's Order Instituting Public Proceedings

Pursuant to Section 19(h)(1) of the Securities Exchange Act of 1934,

Making Findings and Imposing Remedial Sanctions, Securities Exchange

Act Release No. 37538 (August 8, 1996).

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Nasdaq has requested that the Commission find good cause pursuant

to Section 19(b)(2) for approving the proposed rule change prior to the

30th day after publication in the Federal Register. The Commission

finds good cause for approving the proposed rule change prior to the

30th day after the date of publication of notice of filing thereof in

that accelerated approval will accommodate the Order Handling Rules,

which went into effect January 20, 1997.\6\

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\6\ The Division of Market Regulation issued an interim no-

action letter to the NASD and Nasdaq with respect to the enforcement

of the NASD's primary market maker standards during the

consideration of this proposed rule change. The approval of this

rule change supersedes that no-action position. See Letter from

Howard Kramer, Associate Director, Division of Market Regulation,

SEC, to Eugene A. Lopez, Assistant General Counsel, Nasdaq, dated

February 3, 1997.

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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 File No. SR-NASD-97-07 and should

be submitted by March 17, 1997.

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\7\ that the proposed rule change be, and hereby is, approved on an

accelerated basis, effective February 14, 1997 through October 1, 1997.

\7\ 15 U.S.C. 78s(b)(2).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\8\

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\8\ 17 U.S.C. 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-4445 Filed 2-21-97; 8:45 am]

BILLING CODE 8010-01-M