[Federal Register Volume 62, Number 209 (Wednesday, October 29, 1997)]
[Notices]
[Pages 56217-56219]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28627]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39266; File No. SR-NASD-97-42)]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to Proposed Rule Change to Amend 
NASD Rule 2320(g) to Provide Authority to the Staff of NASD Regulation 
to Grant Exemptions From Such Provision

October 22, 1997.

I. Introduction

    On June 17, 1997, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') submitted to the Securities and 
Exchange commission (``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Exchange Act'') \1\ and Rule 
19b-4 thereunder,\2\ a proposed rule change to amend NASD Rule 2320(g) 
to provide the staff of NASD Regulation authority to grant exemptions 
from such provision.
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    \1\ 15 U.S.C. 78s(b)(1)
    \2\ 17 CFR 240.19b-4.
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    Notice of the proposed rule change, together with the substance of 
the proposal, was published for comment in Securities Exchange Act 
Release No. 38936 (August 14, 1997), 62 FR 44503 (August 21, 1997). Two 
comment letters were received on the proposal.\3\
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    \3\ See letter from Leonard Mayer, President, Mayer & 
Schweitzer, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
September 12, 1997 (``Mayer letter''), and letter from Paul 
Chalmers, Senior Vice President, International Trading, Canaccord 
Capital, to Jonathan G. Katz, Secretary, Commission, dated September 
17, 1997 (``Canaccord letter'').
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II. Description

    NASD Rule 2320(g) (``The Three Quote Rule'' or ``Rule'') was 
adopted on May 2, 1998 \4\ as an amendment to the NASD's best execution 
interpretation \5\ under Article III, Section 1 of the NASD's Rules of 
Fair Practice.\6\ The Three Quote Rule was adopted in connection with 
the NASD's efforts to develop a nationwide automated market 
surveillance program for non-Nasdaq, over-the-counter (``OTC'') 
securities, commonly referred to as ``pink sheet'' stocks, and was 
designed to create a standard to help assure that members would fulfill 
their best execution responsibilities to customers in non-Nasdaq 
securities, especially transactions involving relatively illiquid 
securities with non-transparent prices.
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    \4\ See Securities Exchange Act Release No. 25637 (May 2, 1988), 
53 FR 16488 (May 9, 1988).
    \5\ ``Interpretation of the Board of Governors--Execution of 
Retail Transactions in the Over-the-Counter Market.''
    \6\ The best execution interpretation in Article III, Section 1 
of the NASD's Rules of Fair Practice was converted into NASD Rule 
2320 in connection with the NASD's Manual revision project. See 
Securities Exchange Act Release No 36698 (January 11, 1996), 61 FR 
1419 (January 19, 1996.)
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    The Rule expanded a member's best execution obligation to customers 
by setting forth additional requirements for customer transactions in 
non-Nasdaq securities. In particular, the Rule requires members that 
execute transactions in non-Nasdaq securities on behalf of customers to 
contact a minimum of three dealers (or all dealers if there are three 
or less) to obtain quotations to enable them to determine the best 
inter-dealer market. Each member is generally required to use 
reasonable diligence to ascertain this best inter-dealer market for a 
security, and to buy or sell in that market so that the resultant price 
to the customer is as favorable as possible under prevailing market 
conditions.\7\
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    \7\ See NASD Rule 2320(a).
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    Concurrent with these activities, the Commission also approved 
Schedule H to the NASD's By-Laws, which established an electronic 
system of mandatory price and volume reporting for the OTC non-Nasdaq 
securities.\8\ On May 1, 1990, the Commission issued an order approving 
the operation of the NASD's OTC Bulletin Board Display Service (``OTC 
Bulletin Board'') for a pilot term of one year.\9\ The NASD introduced 
the OTC Bulletin Board to allow NASD eligible members to enter, update 
and retrieve quotation information on a real-time basis in non-Nasdaq 
securities.\10\
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    \8\ Schedule H of the By-laws required NASD members executing 
principal transactions in non-Nasdaq securities to report price and 
volume data for the days on which their sales or purchases exceeded 
50,000 shares or $10,000. In 1993, member obligations under Schedule 
H were modified or eliminated as a result of the NASD adopting real-
time reporting of transactions for non-Nasdaq securities. See 
Securities Exchange Act Release No. 32647 (July 16, 1993), 58 FR 
39262 (July 22, 1993).
    \9\ On March 31, 1997, the SEC granted permanent approval of the 
OTC Bulletin Board. See Securities Exchange Act Release No. 38456 
(March 31, 1997), 62 FR 16635 (April 7, 1997).
    \10\ See Securities Exchange Act Release No. 27975 (May 1, 
1990), 55 FR 19123 (May 8, 1990).
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    Since the establishment of the OTC Bulletin Board, significant 
market, regulatory and technology related improvements have occurred in 
the non-Nasdaq marketplace.\11\ In

[[Page 56218]]

particular, the NASD has implemented enhancements to the OTC Bulletin 
Board to increase the reliability of information contained therein. 
Most recently, in July 1993, the Commission approved an NASD rule 
change to implement real-time trade reporting for members' OTC 
transactions in certain non-Nasdaq equity securities,\12\ and in April 
1994, the NASD commenced realtime dissemination of transaction reports 
through the Nasdaq network and the networks of commercial vendors, 
providing member firms and their customers access to last-sale price 
and volume information for these securities throughout the business 
day.
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    \11\ These changes include: requiring that all priced quotations 
entered by market makers in domestic securities be firm for at least 
one trading unit (see Securities Exchange Act Release No. 29261 (May 
31, 1991), 56 FR 29297 (June 26, 1991)); calculating inside quotes 
for individual securities and disseminating this information through 
vendors; and establishing larger minimum-size requirements for 
market makers' quotes in domestic securities.
    \12\ See Securities Exchange Act Release No. 32647 (July 16, 
1993), 58 FR 39262 (July 22, 1993).
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    The OTC Bulletin Board meets the requirements of an ``automated 
quotation system'' as the characteristics of such system Ware described 
in Section 17B of the Exchange Act.\13\ As such, the OTC Bulletin Board 
has assisted NASD broker-dealers in complying with certain disclosure 
regulations under Section 15(g) of the Exchange Act (``the Penny Stock 
Rules'').\14\ The OTC Bulletin Board was also designed to help deter 
fraudulent and manipulative trading practices in penny stocks, \15\ in 
part through real-time transaction reporting. Technological 
improvements to the OTC Bulletin Board have enhanced the NASD's 
surveillance capabilities to, among other things, permit computerized 
analyses of market markers' quotation entries and reported 
transactions.
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    \13\ On October 15, 1990, the Securities Enforcement Remedies 
and Penny Stock Reform Act of 1990 (``Reform Act'') was signed into 
law. Among other things, the Reform Act amended the Exchange Act by 
adding Section 17B, which requires the Commission to facilitate the 
development of one or more automated quotation systems for the 
collection and dissemination of information for penny stocks.
    \14\ See Rules 15g-1 through 15g-9 under the Exchange Act, 17 
CFR 240.15g-1 through 240.15g-9.
    \15\ ``Penny Stock'' is defined under Rule 3a51-1 of the 
Exchange Act, 17 CFR 240.3a51-1.
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    The proposed change to Rule 2320(g) will provide for general 
exemptive authority under the Rule. The NASD Regulation staff, upon 
written request and taking into consideration all relevant factors, 
will be able to exempt from Rule 2320 any transaction or class of 
transactions, either unconditionally or on specified terms, if the 
exemption is consistent with the purposes of the Rule, protection of 
investors and the public interest. The decision may be appealed to the 
National Business Conduct Committee (``NBCC''). NASD Regulation has not 
yet determined whether any particular class of transactions should be 
exempted.
    The NASD noted in its filing that the staff could consider, in 
determining whether to grant an exemptive request: (1) The number of 
firms publishing firm quotations and the period of time during which 
such quotations were published; (2) the size of the customer order in 
relation to the minimum size of the market makers' quotations; (3) the 
transaction volume of the security in question; and (4) the number of 
dealers publishing quotations through an electronic quotation medium in 
comparison to dealers in the security that do not publish such quotes. 
The NASD also stated that it expects the range of circumstances in 
which exemptions may be granted would be limited to those circumstances 
in which it can be shown that the Three Quote Rule would, in fact, 
hinder a member's best execution obligation.
    The Office of the General Counsel of NASD Regulation (``the 
Office'') will be responsible for strict compliance with discharging 
this exemptive authority. Member broker-dealers will be instructed to 
submit all requests for exemptions to the Office and will be required 
to limit the requests to actual contemplated transactions or 
situations. The NASD Regulation staff will not provide exemptions in 
response to hypothetical situations or transactions. The request should 
be detailed and include all relevant information necessary for the 
staff to reach a determination on the request. If a particular 
exemption involves a particular class of transactions or class of 
customers that may be relevant to other member broker-dealers, the NASD 
Regulation staff will also publish such results to the membership 
through a Notice to Members or similar publication or broadcast. NASD 
Regulation staff determinations will be subject to review by the NBCC.

III. Summary of Comments

    The Commission received two comment letters on the proposal, both 
of which supported the proposal. One commenter supported the ability of 
the NASD Regulation staff to have discretionary authority to grant, 
where appropriate, exemptions from the Three Quote Rule both for a 
particular fact situation or as to a class of securities or 
transactions.\16\ Both commenters agreed that in certain situations the 
Three Quote Rule may hinder, rather than help, a firm in meeting its 
best execution obligations. One commenter stated that, in particular, 
the exemption should be available for foreign securities and agreed 
with the reasoning in the proposing release.\17\
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    \16\ See Mayer letter, supra note 3.
    \17\ See Canaccord letter, supra note 3.
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IV. Discussion

    The Commission believes that the proposed rule change is consistent 
with Sections 15A(b)(6) \18\ and 15A(b)(9) \19\ of the Exchange 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, and to 
remove impediments to and perfect the mechanism of a free and open 
market and a national market system and in general to protect investors 
and the public interest. Section 15A(b)(9) requires that rules of an 
association not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act.\20\
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    \18\ 15 U.S.C. 78o-3(b)(6).
    \19\ 15 U.S.C. 78O-3(b)(9).
    \20\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
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    The Commission believes that the proposed rule change is consistent 
with the Exchange Act because it will give NASD Regulation the 
authority to grant exemptions from the Three Quote Rule in situations 
where complying with the rule would hinder, rather than assist, best 
execution. The Commission believes that providing general exemptive 
authority under the Rule is appropriate in order to provide flexibility 
to respond to changing market conditions and to particular fact 
situations,\21\ as well as instances when certain classes of 
transactions or certain securities on OTC Bulletin Board may warrant an 
exemption from the Three Quote Rule.
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    \21\ In its proposal, the NASD stated that some member broker-
dealers who are active in the non-Nasdaq market claim that adherence 
to the three quote requirement may, in certain situations, have a 
negative impact on a member's ability to satisfy its best execution 
obligations, due to time delays involved in contacting and 
collecting quotations from three separate dealers. In addition, the 
NASD noted that some members question whether the Three Quote Rule 
should continue to apply to all customer transactions in non-Nasdaq 
securities in light of the technological and regulatory improvements 
to the non-Nasdaq marketplace and to the OTC Bulletin Board, over 
the past seven years. However, there are many non-Nasdaq securities 
that only trade in the Pink Sheets.
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    The Commission notes that one situation where exemptive relief 
might be applied would be trading in certain foreign securities.\22\ In 
some

[[Page 56219]]

circumstances the foreign exchange market may constitute the best 
market for the securities that are listed on that market, and the time 
delay involved in contacting three dealers in advance of a customer 
transaction could hinder obtaining the best execution for the customer.
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    \22\ The Three Quote Rule applies to transactions in all non-
Nasdaq securities. A non-Nasdaq security is defined in NASD Rule 
6710 as ``any equity security that is neither included in the Nasdaq 
Stock Market nor traded on any national securities exchange * * *. 
Therefore, the rule by its terms applies to transactions effected on 
any foreign exchange. The term ``national securities exchange'' is 
not defined in NASD rules, but the requirements to qualify are set 
forth in Sections 6(a) and 19(a) of the Exchange Act.
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    The Commission believes that the exemptive process provided by the 
rule change is reasonable under the Exchange Act. The Commission 
stresses that the NASD Regulation staff would not be able to grant an 
exemption (either for a particular market maker in a particular 
security, or for all market makers in a particular security or a class 
of securities) unless a market maker can demonstrate that adherence to 
the Rule could serve as an impediment to satisfying its best execution 
obligations with regard to a particular situation. The NASD Regulation 
Staff will not provide exemptions in response to hypothetical 
situations. The Commission also notes that if a particular exemption 
involves a particular class of transactions or class of customers that 
may be relevant to other member broker-dealers. The NASD Regulation 
staff will also publish such results to the membership through a Notice 
to Members or similar publication or broadcast. Further, the Commission 
notes that the grant of an exemption to the Three Quote Rule should not 
in any way limit a member's best execution obligation. Finally, the 
NASD Regulation staff determinations are subject to review by the 
NBCC.\23\
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    \23\ After the NASD gains experience with this exemptive 
authority, the Commission expects the NASD to codify, to the extent 
possible, exceptions to the Rule. In particular, the NASD should 
amend the rule to incorporate exemptions provided to broad classes 
or types of transactions.
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\24\ that the proposed rule change (SR-NASD-97-42) is 
approved.
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    \24\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\
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    \25\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 97-28627 Filed 10-28-97; 8:45 am]
BILLING CODE 8010-01-M