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[Federal Register Volume 63, Number 146 (Thursday, July 30, 1998)]
[Notices]
[Pages 40748-40759]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-20313]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40260; File No. 4-208]
RIN 3235-AH49

Intermarket Trading System (``ITS'') Plan; Proposed Amendments to 
Expand the ITS/Computer Assisted Execution System Linkage to all Listed 
Securities and to Eliminate the Unanimous Vote Provision

AGENCY: Securities and Exchange Commission.

ACTION: Proposed amendments to national market system plan.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing amendments to the plan governing the operation of the 
Intermarket Trading System (``ITS Plan'' or ``Plan'') that was approved 
pursuant to Rule 11Aa3-2 under the Securities Exchange Act of 1934, as 
amended (``Exchange Act'' or ``Act''). The proposed amendments expand 
the ITS/Computer Assisted Execution System (``CAES'') linkage to all 
listed securities, including non-Rule 19c-3 securities. The amendments 
to the Plan also eliminate the requirement that amendments to the ITS 
Plan be approved by a unanimous vote of all Participants; instead, a 
two-thirds supermajority of the Participants would be required for 
amendments.

DATES: Comments should be submitted by August 31, 1998.

ADDRESSES: All comments should be submitted in triplicate and addressed 
to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 
Mail Stop 6-9, 450 Fifth Street, NW., Washington, DC 20549. Comments 
also may be submitted electronically at the following E-mail address: 
[email protected]. All comments should refer to File No. 4-208; 
this file number should be included in the subject line if E-mail is 
used. Comment letters will be available for public inspection and 
copying at the Commission's Public Reference Room at the same address. 
Electronically submitted comment letters will be posted on the 
Commission's web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT:
Katherine A. England, Assistant Director at (202) 942-0154; Elizabeth 
Prout Lefler, Special Counsel at (202) 942-0170; Heather A. Seidel, 
Attorney at (202) 942-4165; or Christine Richardson, Attorney at (202) 
942-0748, Office of Market Supervision, Division of Market Regulation, 
Securities and Exchange Commission, Mail Stop 10-1, 450 Fifth Street, 
NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to 
the ITS Plan \1\ to expand the NASD's ITS/CAES linkage to all listed 
securities. The Commission is also proposing amendments to the Plan to 
eliminate the unanimous vote requirement for amendments to the ITS 
Plan. The amendments, published by the Commission on its own initiative 
pursuant to Rule 11Aa3-2 under the Exchange Act,\2\ are necessary to

[[Page 40749]]

encourage the statutory goals of efficient execution of securities 
transactions and opportunities for best execution of customer orders. 
They also address features of governance requirements of the ITS Plan 
that discourage intermarket competition. The Commission is proposing 
these amendments only after the ITS Participants have been unable to 
take action in these areas. The Commission is publishing this proposal 
for comment from interested persons.
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    \1\ ITS is a communications and order-routing network linking 
eight national securities exchanges and the electronic over-the-
counter (``OTC'') market operated by the National Association of 
Securities Dealers, Inc. (``NASD''). ITS was designed to facilitate 
intermarket trading in exchange-listed equity securities based on 
current quotation information emanating from the linked markets. 
Participants to the ITS Plan are the American Stock Exchange, Inc. 
(``Amex''), the Boston Stock Exchange, Inc. (``BSE''), the Chicago 
Board Options Exchange, Inc. (``CBOE''), the Chicago Stock Exchange, 
Inc. (``CHX''), the Cincinnati Stock Exchange, Inc. (``CSE''), the 
NASD, the New York Stock Exchange, Inc. (``NYSE''), the Pacific 
Exchange, Inc. (``PCX''), and the Philadelphia Stock Exchange, Inc. 
(``Phlx'').
    \2\ Rule 11Aa3-2 (17 CFR 240.11Aa3-2) establishes procedures for 
initiating or approving amendments to national market system plans 
such as the ITS Plan. Paragraph (b)(2) of Rule 11Aa3-2 states that 
the Commission may propose amendments to an effective national 
market system plan by publishing the text thereof together with a 
statement of purpose of the amendments. Paragraph (c)(2) requires 
the Commission to publish notice of any amendments initiated by the 
Commission and provide interested parties an opportunity to submit 
written comments. Further, Paragraph (c)(2) of Rule 11Aa3-2 requires 
that promulgation of an amendment to an effective national market 
system plan initiated by the Commission be by rule.
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I. Background

A. ITS/CAES Interface

    Section 11A(a)(2) of the Exchange Act, adopted by the Securities 
Acts Amendments of 1975 (``1975 Amendments''),\3\ directs the 
Commission, having due regard for the public interest, the protection 
of investors and the maintenance of fair and orderly markets, to use 
its authority under the Act to facilitate the establishment of a 
National Market System for securities in accordance with the 
Congressional findings and objectives set forth in Section 11A(a)(1) of 
the Act. Among those findings and objectives is the ``linking of all 
markets for qualified securities through communication and data 
processing facilities.'' \4\
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    \3\ Pub. L. 94-29 (June 4, 1975).
    \4\ Section 11A(a)(1)(D) of the Act, 15 U.S.C. 78k-1(a)(1)(D).
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    On January 26, 1978, the Commission issued a statement on the 
national market system calling for, among other things, the prompt 
development of comprehensive market linkage and order routing systems 
to permit the efficient transmission of orders among the various 
markets for qualified securities, whether on an exchange or over-the-
counter.\5\ In particular, the Commission stated that an intermarket 
order routing system was necessary to ``permit orders for the purchase 
and sale of multiple-traded securities to be sent directly from any 
qualified market to another such market promptly and efficiently.'' \6\ 
The Commission further stated that ``[t]he need to develop and 
implement a new intermarket order routing system to link all qualified 
markets could be obviated if participation in the ITS market linkage 
currently under development were made available on a reasonable basis 
to all qualified markets and if all qualified markets joined that 
linkage.'' \7\
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    \5\ Securities Exchange Act Release No. 14416 (January 26, 1978) 
(``1978 Statement''), at 26, 43 FR 4354, 4358. Previously, on June 
23, 1977, the Commission had indicated that a national market system 
would include those ``regulatory and technological steps [necessary] 
to achieve a nationwide interactive market system.'' See Securities 
Exchange Act Release No. 13662 (June 23, 1977), at 20, 42 FR 33510, 
33512.
    \6\ 1978 Statement, supra note 5, at 4358.
    \7\ In this connection, the Commission specifically indicated 
that ``qualified markets'' would include not only exchanges but OTC 
market makers as well. Id.
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    As requested by the Commission, in March 1978, various exchanges 
\8\ filed jointly with the Commission a ``Plan for the Purpose of 
Creating and Operating an Intermarket Communications Linkage,'' now 
known as the ITS Plan.\9\ On April 14, 1978, the Commission, noting 
that ITS might provide the basis for an appropriate market linkage 
facility in a national market system, issued a provisional order, 
pursuant to Section 11A(a)(3)(B) of the Act,\10\ authorizing the filing 
exchanges (and any other self-regulatory organization (``SRO'') which 
agreed to become a participant in the ITS Plan) to act jointly in 
planning, developing, operating and regulating the ITS in accordance 
with the terms of the ITS Plan for a period of 120 days.\11\
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    \8\ The exchanges involved were Amex, BSE, NYSE, PCX (than 
called the ``PSE''), and Phlx.
    \9\  The ITS Plan is contained in File No. 4-208.
    \10\ 15 U.S.C. 78k-1(a)(3)(B).
    \11\ Securities Exchange Act Release No. 14661 (April 14, 1978), 
43 FR 17419. In authorizing the implementation of ITS, the 
Commission urged those SROs not yet ITS participants to participate 
in ITS. Id. at 7 n. 15, 43 FR 17421. On August 11, 1978, the 
Commission extended ITS authority for an additional period of one 
year. Securities Exchange Act Release No. 15058 (August 11, 1978), 
43 FR 36732. In the interim the ITS Plan had been amended to include 
the Midwest Stock Exchange (``MSE'') as a participant. The MSE is 
now the CHX.
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    In 1979, during the Commission's hearings regarding proposed Rule 
19c-3 under the Act,\12\ the NASD announced plans to enhance its Nasdaq 
System to include, among other things, a computer assisted execution 
system which would enable participating firms to route their orders for 
listed securities through the system to obtain automatic executions 
against quotations of ``third market makers'' participating in the 
enhanced Nasdaq,\13\ later known as the NASD's Computer Assisted 
Execution System (``CAES''). The NASD also contemplated an automated 
interface between the ITS and CAES (``ITS/CAES interface'') to permit 
automated execution of commitments sent from participating exchanges 
and to permit market makers participating in the enhanced Nasdaq to 
route commitments efficiently to exchange markets for execution.\14\
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    \12\ Securities Exchange Act Release No. 15769 (April 26, 1979), 
44 FR 26688. Rule 19c-3 precludes exchange off-board trading 
restrictions from applying to most securities listed after April 26, 
1979.
    \13\ The term ``third market makers'' refers to OTC market 
makers in listed securities.
    \14\ In its discussions with the ITS Participants, the NASD 
indicated that the enhanced Nasdaq would encompass trading of listed 
securities and that it intended to pursue an automated interface. 
See In re Off-Board Trading Restrictions, File No. 4-220, at 9-10, 
23-34.
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    The Commission later extended its authorization for the joint 
operation of the ITS \15\ but indicated several concerns with respect 
to the ITS that would require the attention of the ITS participants 
during the extension period. In particular, the Commission indicated 
that, in order for ITS to serve as a means to achieve price protection 
on an intermarket basis, the ITS Participants should implement ``a 
linkage between the ITS and over-the-counter market makers regulated by 
the NASD. * * * '' \16\ The Commission further indicated its 
expectation that the NASD would become an ITS participant before 
October 1980, and stated that if the contemplated ITS/NASD interface 
was not implemented promptly, the Commission was prepared to review 
whether the temporary approval granted in the order should continue and 
to take appropriate steps to require the inclusion of those market 
centers.\17\
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    \15\ The authorization for the joint operation was extended 
until January 31, 1983. See Securities Exchange Act Release No. 
16214 (September 21, 1979), 44 FR 56069.
    \16\ Id. at 12, 44 FR 56072. The Commission also called for a 
linkage between the ITS and the Cincinnati Stock Exchange's 
(``CSE'') National Securities Trading System (``NSTS'').
    \17\ Id. at 14-15, 44 FR 56072. The Commission substantially 
reiterated these views in a letter to Congress shortly thereafter. 
See letter from Harold M. Williams, Chairman, SEC, to the Honorable 
Bob Eckhardt, Chairman, Subcommittee on Oversight and Investigations 
and the Honorable James Scheuer, Chairman, Subcommittee on Oversight 
and Investigations and the Subcommittee on Consumer Protection and 
Finance, House Committee on Interstate and Foreign Commerce, dated 
November 9, 1979, included in Progress Toward the Development of a 
National Market System, Joint Hearings before the Subcommittee on 
Consumer Protection and Finance of the Committee on Interstate and 
Foreign Commerce, House of Representatives, 90th Cong., 1st Sess., 
Serial 96-89.
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    On June 11, 1980, the Commission adopted Rule 19c-3 under the Act, 
which eliminated off-board trading restrictions with respect to most 
newly-listed securities and thereby permitted member firms of the NYSE 
and Amex to make markets over-the-counter in what was then a small 
number of NYSE and Amex-listed securities.\18\ Although the

[[Page 40750]]

Commission recognized many potential concerns regarding the rule, such 
as internalization,\19\ the Commission determined that they were 
outweighed by the benefits of the rule, including an opportunity for 
competition between the OTC and exchange markets, with concomitant 
benefits to investors. For example, the Commission stated that the 
presence of additional market makers might (1) place competitive 
pressure on primary market specialists, thereby possibly resulting in 
narrower spreads in Rule 19c-3 securities; and (2) create incentives 
for markets to disseminate quotations of greater size and add to the 
depth, liquidity, and continuity of the markets for those 
securities.\20\
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    \18\ Securities Exchange Act Release No. 16888 (June 11, 1980), 
45 FR 41125 (``Rule 19c-3 Adopting Release''). The rule, as adopted, 
precludes exchange off-board trading restrictions from applying to 
securities listed after April 26, 1979 (``Rule 19c-3 securities'').
    \19\ The term ``internalization'' refers to ``the withholding of 
retail orders from other market centers for the purpose of executing 
them ``in-house,'' as principal, without exposing those orders to 
buying and selling interest in those other market centers.'' Id. at 
18 n.31, 45 FR 41128 n.31.
    \20\ The Commission believed that off-board trading restrictions 
had anti-competitive effects because they effectively confined 
trading in listed securities to exchange markets by precluding 
exchange members from trading as principal in the OTC market. 
Adopting Rule 19c-3 limited the expansion of the anti-competitive 
effects. The Commission also announced the development of a 
monitoring program to study the issues raised by commentators, 
determined to publish monitoring reports on a periodic basis and 
committed to a reexamination of those issues as appropriate in light 
of development in the markets. In connection with the adoption of 
Rule 19c-3, the Commission noted the importance of the NASD's 
completion of the Nasdaq enhancements in order to provide ``a more 
efficient mechanism for over-the-counter market making in listed 
securities.'' Id. at 14-15, 45 FR 41127. See Rule 19c-3 Adopting 
Release, supra note 18, at 49-53, 45 FR 41134. The Commission notes 
that it is not, at this time, proposing to amend or expand Rule 19c-
3.
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    The Commission indicated that achieving efficient linkages between 
traditional exchange trading floors and over-the-counter markets was 
essential to obtaining maximum order interaction between the various 
types of markets. The Commission therefore expected the NASD and the 
ITS Participants to establish an automated linkage between the ITS and 
Nasdaq system and to provide the Commission with formal status reports 
on the ITS-Nasdaq linkage.\21\
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    \21\ Id. at 15-16, 45 FR 41127.
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    In September 1980, several Participants submitted identical letters 
which indicated that they were not at that time willing to commit to 
the development of an automated interface.\22\ The MSE, in a separate 
letter, raised various regulatory concerns with respect to the 
automated interface.\23\ In contrast, the NASD responded by reaffirming 
its commitment to the automated interface \24\ and provided the 
Commission and the ITS participants with a functional description of 
the automated interface.\25\ On January 7, 1981, the NYSE Board of 
Directors approved participation in a two-step ``test'' linkage between 
ITS and the enhanced Nasdaq system.\26\ The Commission determined that 
ITS, because of its ability to permit market participants to send 
orders from one market to another, was consistent with national market 
system goals and, if efficiently linked with all markets, could become 
a permanent feature of a national market system. Nonetheless, the 
Commission continued to believe that the absence of any established 
linkage between the exchanges and OTC market makers preserved an 
environment in which there were reduced opportunities to ameliorate 
market fragmentation,\27\ to eliminate pricing inefficiencies, to 
obtain best execution and to promote the type of competitive market 
structure which a national market system was designed to achieve.\28\
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    \22\ These Participants were the Amex, BSE, NYSE, Phlx and PCX. 
See e.g, letter from John J. Phelan, Jr., President and Chief 
Operating Officer, NYSE, to George A. Fitzsimmons, Secretary, SEC, 
dated September 16, 1980. In addition, the Amex submitted a separate 
letter in which it expressed its opposition to efforts to link 
upstairs markets to exchange markets in the context of its 
continuing opposition to Rule 19c-3. See letter from Robert J. 
Birnbaum, President, Amex, to George A. Fitzsimmons, Secretary, SEC, 
dated September 22, 1980, contained in File No. 4-208. See also 
letter from Robert J. Birnbaum, President, Amex, to George A. 
Fitzsimmons, Secretary, SEC, dated December 12, 1980, contained in 
File No. 4-208.
    \23\ See letter from John G. Weithers, President, MSE, to George 
A. Fitzsimmons, Secretary, SEC, dated September 15, 1980 
(``September MSE Letter''), contained in File No. 4-208. See also 
letter from John G. Weithers, President, MSE, to John J. Phelan, 
Jr., President, NYSE, dated July 31, 1980 (``July MSE Letter''), 
contained in File No. 4-208.
    \24\ See letter from Gordon S. Macklin, President, NASD, to 
George A. Fitzsimmons, Secretary, SEC, dated September 12, 1980 
(``NASD Letter''), contained in File No. 4-208. The NASD indicated 
that there were no significant technical concerns in connection with 
building the automated interface and estimated that the automated 
interface could be implemented within six months of an agreement 
among the parties to proceed.
    \25\ See Description of NASD Market Services, Inc., Computer 
Assisted Execution System, contained in File No. 4-208. In its 
functional description, the NASD also committed to developing a 
capability to provide the ITS participants with the best bid and 
offer among all market makers participating in the enhanced Nasdaq.
    \26\ With respect to the actual operation of the automated 
interface, the NYSE plan contemplated an initial ``pilot'' phase in 
which trading through the automated interface would be limited to 
the 30 most active Rule 19c-3 securities. The other ITS participants 
were in general agreement with the NYSE's position with respect to 
the automated interface. During the pilot phase, the NYSE 
anticipated that the ITS participants and the Commission would 
evaluate trading under the Preliminary Rule and other policy 
concerns which may have been raised by trading Rule 19c-3 securities 
through the automated interface. The NYSE plan further anticipated 
that in the subsequent phase the automated interface would be 
expanded to include the trading of all Rule 19c-3 securities, but 
only after the completion of the pilot phase evaluation and 
agreement among the ITS participants and the NASD on any additional 
measures to address policy concerns identified by that evaluation.
    \27\ Fragmentation occurs when investor order flow is directed 
to several markets that are not connected. Among other things, 
fragmentation reduces the probability of matching customer buy and 
sell orders because of the smaller number of orders in each market.
    \28\ Indeed, in mandating that the Commission facilitate the 
establishment of a national market system, the Congress found that 
the linking of all markets for qualified securities through 
communication and data processing facilities would foster 
efficiency, enhance competition, increase the information available 
to brokers, dealers, and investors, facilitate the offsetting of 
investors' orders and contribute to best execution of such orders. 
Section 11A (A)(1)(D) of the Act, 15 U.S.C. 78k-1(a)(1)(D).
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    Therefore, on April 28, 1981, the Commission issued an order \29\ 
requiring the ITS Participants to implement an automated interface 
between CAES and ITS by March 1, 1982, limited to Rule 19c-3 
securities, and to submit proposed amendments to the ITS Plan 
reflecting the inclusion of the NASD as an ITS Participant. On March 
11, 1982 the Commission delayed the implementation date of the 
interface until May 1, 1982 and published its own proposed amendments 
to the ITS Plan.\30\ Consequently, due to the failure of the ITS 
Participants to submit an amendment on May 12, 1982, the Commission 
adopted its own amendments to the ITS Plan.\31\ The

[[Page 40751]]

Commission order applied to Rule 19c-3 securities initially because the 
Commission believed that OTC trading would be more active in these 
securities. The Commission fully intended the ITS/CAES linkage to 
subsequently expand to all listed securities.\32\
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    \29\ Securities Exchange Act Release No. 17744 (April 21, 1981), 
46 FR 23856 (April 28, 1981).
    \30\ Securities Exchange Act Release No. 18536 (March 11, 1982), 
47 FR 10658. The Commission deferred the implementation date in part 
because the Participants had failed to submit amendments to the 
Plan.
    \31\ A majority of the amendments were non-controversial and had 
been agreed upon by the parties or reflected the parties' decision 
to defer resolution of certain issues until after the pilot phase of 
the interface. The areas where the parties could not reach agreement 
were resolved by the Commission. See Securities Exchange Act Release 
No. 18713 (May 12, 1982), 47 FR 20413. The amendments included 
language requiring the NASD to apply trade-through safeguards to 
provide for a sufficient assurance of consistency with the 
exchanges' trade-through rules. A ``trade-through'' occurs when a 
transaction is effected at a price below the best bid, or above the 
best prevailing offer. The NASD submitted a proposed trade-through 
rule on May 4, 1982, which the Commission approved on an accelerated 
basis for six months. The Commission believed that the NASD rule was 
adequate even through it was not identical to the exchangers' trade-
through rules. See Securities Exchange Act Release No. 18714 (May 6, 
1982), 47 FR 20429 (May 12, 1982). The Commission had approved the 
exchanges' trade-through rules on April 9, 1981. See Securities 
Exchange Act Release No. 17704 (April 9, 1981), 46 FR 22520.
    On January 27, 1983, the Commission granted permanent approval 
to the ITS Plan. See Securities Exchange Act Release No. 19456 
(January 27, 1983), 48 FR 4938 (February 3, 1983) (``Final Approval 
Order''). On September 15, 1983 the pilot phase ended and all Rule 
19c-3 securities became eligible for trading through the ITS/CAES 
interface. See Securities Exchange Act Release Nos. 19825 (May 31, 
1983), 48 FR 25043 (June 3, 1983); and 19970 (July 20, 1983), 48 FR 
33103.
    \32\ See Final Approval Order, supra note 31, at 4940 (``The 
Commission also notes that in order to achieve fully the 
Congressional goal that all markets for qualified securities be 
linked (Section 11A(a)(1)(D) of the Act), it will be necessary in 
the future for the ITS/CAES interface to be expanded to include all 
stocks traded in the third market.'').
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    On November 12, 1991, the NASD submitted an application to the 
Commission, pursuant to Rule 11Aa3-2(e), to review the ITS Operating 
Committee's failure to approve two NASD recommendations that would have 
amended the ITS Plan to expand the ITS/CAES linkage to include non-Rule 
19c-3 securities.\33\ Since that submission, the Division of Market 
Regulation (``Division'') issued its Market 2000 Study,\34\ which 
included the Division's findings that it was necessary to expand the 
ITS/CAES linkage,\35\ as well as identifying several regulatory issues 
that the Commission believed the NASD and Nasdaq needed to address 
prior to any expansion of the ITS/CAES linkage.\36\
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    \33\ In a July 8, 1997 letter, commenting on four issues 
relating to ITS that the Commission preliminarily viewed as 
``unreasonably impeding competition among the various markets,'' the 
NASD reaffirmed its position originally made in its 1991 
application. See letter from Robert E. Aber, Vice President and 
General Counsel, Nasdaq, to Jonathan G. Katz, Secretary, Commission 
(``NASD 1997 Letter''). However, the NASD has since withdrawn its 
application submitted to the Commission pursuant to Exchange Act 
Rule 11Aa3-2(e). See letter from Robert E. Aber, Senior Vice 
President and General Counsel, Nasdaq, to Jonathan G. Katz, 
Secretary, Commission, dated July 23, 1998.
    \34\ Division Market Regulation, Market 2000: An Examination of 
Current Equity Market Developments (January 1994) (``Market 2000 
Study'').
    \35\ Specifically, the Market 2000 Study noted that the 
possibility of execution in the OTC market of a significant 
percentage of the total volume in multiply traded securities 
increased the need to enhance interaction of orders in all market 
centers to eliminate trade throughs and to provide market makers in 
those securities the ability to compete for order flow through their 
displayed quotations. Id.
    \36\ In February 1995, the NASD submitted a rule filing 
addressing those recommendations but subsequently withdrew that 
filing in light of the Commission's publication of its Order 
Handling Rules (Securities Exchange Act Release No. 37619A 
(September 6, 1996), 61 FR 48290 (September 12, 1996) (``Order 
Execution Rules'' or ``Order Handling Rules'')), which addressed 
many of the topics covered by the NASD's proposed rules. The NASD 
has stated that it is prepared to submit remaining aspects of this 
1995 filing, when appropriate, that the Commission believes are 
necessary to achieve expansion of the ITS/CAES linkage. The NASD 
also states it is prepared to present any other rule changes to its 
Board that the Commission believes are necessary to achieve this 
expansion. See NASD 1997 Letter, supra note 33. On June 22, 1998, 
the NASD submitted a Petition for Rulemaking (``NASD Petition'') to 
adopt rules necessary to remove the limitation on access to ITS with 
respect to non-Rule 19c-3 securities. The NASD Petition adopts by 
reference the substance of the NASD's 1991 appeal mentioned above.
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    More recently, the Commission solicited comment on whether the ITS/
CAES linkage should be expanded to cover non-Rule 19c-3 securities in 
the proposing release for the Order Execution Rules.\37\ In the 
adopting release for those rules, the Commission deferred action on the 
expansion of the ITS/CAES linkage, and instead encouraged the ITS 
Participants to work jointly to expand the linkage.\38\
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    \37\ See Securities Exchange Act Release No. 36310 (September 
29, 1995), 60 FR 52792 (October 10, 1995).
    \38\ See Order Execution Rules, supra note 36.
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B. Unanimous Vote Requirement

    A unanimous vote of all the Participants is required for any 
amendment to the ITS Plan. Section 4(c) of the ITS Plan states that any 
proposed change in, addition to, or deletion from the ITS Plan may be 
effected only by means of a written amendment to the Plan which is 
executed on behalf of each Participant. In addition, Section 3(c), 
regarding New Participants, states that any national securities 
exchange or national securities association may subscribe to the ITS 
Plan and become a participant by agreeing, in an amendment to the Plan 
adopted in accordance with its provisions, to comply and enforce 
compliance with the provisions of the Plan (as provided in Section 
3(b)). This in effect requires a unanimous vote before a new 
participant can be admitted to the Plan.

II. Discussion

    In 1997, the Commission initiated a review concerning certain anti-
competitive aspects of ITS. The review was prompted by the significant 
changes in the equity markets since the inception of ITS and the 
slowness or inability of ITS to accommodate these changes. The 
Commission believed that certain structural aspects of ITS impeded 
innovation and competition in the national market system. Accordingly, 
the Commission sent a letter to the ITS Participants on May 27, 1997 
outlining four anti-competitive aspects of the ITS Plan and requesting 
that they develop reasonable recommendations to the Commission in the 
form of proposed ITS Plan amendments and proposed SRO rule changes.\39\ 
The Division followed up this letter with another letter to the 
Participants on September 25, 1997, in which the Division reinforced 
the Commission's concerns and provided specific examples of the anti-
competitive nature of the unanimous vote requirement.\40\ The responses 
that the Commission received in reply to both of these letters 
indicated that a number of the Participants will not agree to expand 
the ITS/CAES interface or to eliminate the unanimous vote requirement. 
Because of the unanimous vote requirement, these changes therefore 
cannot be approved by the Participants. Accordingly, the Commission is 
proposing rules to address the anti-competitive operation of these ITS 
provisions.\41\
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    \39\ Preliminarily, the Commission found four elements of the 
current operation of ITS and the ITS Plan to be unreasonably 
impeding competition among the various markets: (1) Minimum 
increments for ITS commitments; (2) the lack of access to ITS for 
OTC market makers; (3) the unanimous vote requirement for ITS Plan 
amendments; and (4) the ITS Participants' special right of review 
for CSE proposed rule changes. See letter from Jonathan G. Katz, 
Secretary, Commission, to ITS Participants, dated May 27, 1997 
(``May 27 Letter''). The Participants have voted to eliminate the 
limitation on access to increments through ITS, and the review of 
CSE rule changes.
    \40\ See letter from Richard R. Lindsey, Director, Market 
Regulation, Commission, to Allan A. Bretzer, Committee Chairman, ITS 
Operating Committee (``ITSOC''), dated September 25, 1997 
(``September 25 Letter'').
    \41\ Section 11A(a)(3)(B) of the Act authorizes the Commission, 
in furtherance of its statutory directive to facilitate the 
development of a national market system, by rule or order, to 
authorize or require self-regulatory organizations to act jointly 
with respect to matters as to which they share authority under the 
Act in planning, developing, operating or regulating a national 
market system (or a subsystem thereof) or one or more facilities 
thereof. 15 U.S.C. 78k-1(a)(3)(B). The language of Section 
11A(a)(3)(B) states explicitly that the Commission not only may 
approve national market system facilities in response to an 
application by SROs, but also may require SROs to implement such 
facilities on their own initiative. Moreover, the possible need for 
Commission regulatory compulsion in connection with the development 
of a national market system where necessary to supplement 
competitive forces was specifically recognized by the Congress in 
enacting the 1975 Amendments. For example, the Committee of 
Conference of both Houses of Congress, in discussing the 
implemention of a national market system stated: It is the intent of 
the conferees that the national market system evolve through the 
interplay of competitive forces as unnecessary regulatory 
restrictions are removed. The conferees expect, however, in those 
situations where competition may not be sufficient, such as the 
creation of a composite quotation system or a consolidated 
transaction reporting system, the Commission will use the power 
granted to it in [1975 Amendments] to act promptly and efficiently 
to ensure that the essential mechanisms of an integrated secondary 
trading system are put into place as rapidly as possible.
    Committee of Conference, Report To Accompany S 249, H.R. Rep. 
No. 94-249, 94th Cong., 1st Sess., at 92, reprinted in [1975] U.S. 
Code Cong. & Ad. News 321, 323. See also Securities Exchange Act 
Release No. 16410 (December 7, 1979), at 13-14, 44 FR 72607, 72608-
09.

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[[Page 40752]]

A. Need for Expanded ITS/CAES Interface

    In its permanent approval order for ITS, the Commission stated that 
``in order to achieve fully the Congressional goal that all markets for 
qualified securities be linked (Section 11A(a)(1)(D) of the Act), it 
will be necessary in the future for the ITS/CAES interface to be 
expanded to include all stocks traded in the third market.'' \42\ The 
Commission continues to believe that it is necessary to expand the ITS/
CAES linkage to all listed securities in order to fully implement the 
1975 Congressional mandate to create a national market system to link 
the exchanges and the OTC market. Originally, the Commission realized 
the need for an efficient lingage between ITS and the OTC market, 
especially in light of the adoption of Rule 19c-3, but limited the ITS/
CAES linkage to Rule 19c-3 securities as an interim measure because it 
could not predict how the linkage would work in practice.\43\ However, 
the Commission explicitly stated that it intended this limitation to be 
temporary and wanted it removed eventually through joint action by ITS 
Participants.
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    \42\ See Securities Exchange Act Release No. 19456 (January 27, 
1983), 48 FR 4938 (February 3, 1983).
    \43\ More recently, in its Market 2000 Study, the Division 
stressed that ``the Commission limited its mandated link (in 1981) 
to Rule 19c-3 securities because it concluded that the adoption of 
Rule 19c-3 heightened the need for an efficient linkage between the 
exchanges and the OTC market.'' See Market 2000 Study, supra note 
34, at AII-12. Furthermore, the Commission already has encouraged 
the ITS Participants to solve this issue, but with no results. See 
Order Execution Rules, supra, note 36.
---------------------------------------------------------------------------

    The Commission now believes that the significant changes to the 
third market that have occurred since 1982, when the Commission first 
approved the ITS/CAES linkage for Rule 19c-3 securities, support the 
expansion of the linkage. Any NASD member that acts in the capacity of 
an OTC market maker must provide continuous two-sided quotations for 
any exchange-listed security in which that member, during the most 
recent calendar quarter, comprised more than 1% of the aggregate 
trading volume for such security as reported in the consolidated system 
(``1% Rule'').\44\ The NASD now requires all third market makers 
registered as CQS market makers to register and participate in ITS/
CAES.\45\ Moreover, all specialists and OTC market makers must now 
display the price and size of all customer limited orders that improve 
their quote (``Limit Order Display Rule'').\46\ Thus, the significant 
limitations in transparency that previously distinguished the OTC 
market from the exchange market have been reduced.
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    \44\ The 1% Rule applied only to Rule 19c-3 securities prior to 
being expanded in the Order Execution Rules. See Securities Exchange 
Act Release No. 39367 (November 26, 1997), 62 FR 64242 (December 4, 
1997) (``Autoquote Order'').
    \45\See Securities Exchange Act Release No. 34280 (June 29, 
1994), 59 FR 34880 (July 7, 1994).
    \46\ See Order Execution Rules, supra, note 36. In addition, if 
a specialist or market maker enters an order into an electronic 
communications network (``ECN'') that improves its quote, it has to 
either (1) reflect that limit order in its quote, or (2) use an ECN 
that is linked to the National Market System, displaying its 
specialist and market maker top of book, and that top of book quote 
must be accessible.
---------------------------------------------------------------------------

    The increase in transparency has been accompanied by a growth in 
trading in the third market. In 1996, third market trading of NYSE 
listed stocks accounted for 8.14% of the volume and 10.74% of the 
trades reported to the consolidated tape. In 1981, however, 98.5% of 
the consolidate tape volume in exchange-listed securities occurred on 
exchange floors.\47\ The growth of third market activity makes it even 
more important to expand the ITS/CAES linkage to all listed securities 
in order to ensure that customers receive the best price regardless of 
the market of execution. In addition, the Commission does not believe 
there have been any substantial adverse effects of the ITS/CAES linkage 
to date. There is no evidence that the linkage has led to poorer 
executions in Rule 19c-3 stocks versus other listed stocks. On the 
contrary, the linkage enables third market makers to make more 
competitive markets and allows orders routed to exchanges to obtain 
those prices. The lack of any adverse effects makes the ITS distinction 
between Rule 19c-3 securities and non-Rule 19c-3 securities a 
historical anachronism. Indeed, this distinction seems to create and 
inappropriate barrier to trading. The Commission preliminarily cannot 
identify convincing justification for maintaining an arbitrary barrier 
which prevents the expansion of the ITS/CAES linkage to non-Rule 19c-3 
securities. Moreover, the absence of an ITS/CAES linkage, in light of 
growing trading in the third market and the presence at times of 
superior quotes in that market, raises questions about whether best 
execution can be obtained by default routing of customer orders to any 
exchange or NASD market maker,\48\ rather than order-by-order routing 
to exchange and market makers, based on the best available quotation.
---------------------------------------------------------------------------

    \47\ See NYSE 1996 Fact Book at 26 and 14.
    \48\ The Commission has previously stated its belief that 
broker-dealers automatically routing order flow to a particular 
market center must regularly and rigorously examine execution 
quality likely to be obtained from the different markets or market 
makers trading a security, carefully examine the extent to which 
directed order flow would be afforded better terms if executed in a 
market or with a market maker offering price improvement 
opportunities, and in the event that material differences exist 
between the price improvement opportunities offered by markets or 
market makers, the broker-dealer must take such differences into 
account. See, e.g., Order Handling Rules, supra note 36.
---------------------------------------------------------------------------

    Consequently, the Commission believes that expansion of the ITS/
CAES linkage to all listed stocks is warranted. Such an expansion will 
increase a broker-dealer's ability to obtain best execution for the 
customer and promote competition in listed securities. It also will 
help ensure more equivalent access to the markets, reduce market 
fragmentation, and provide for additional liquidity and more efficient 
executions. The Commission continues to believe that it is desirable 
for the industry to take a lead in the development, implementation and 
enhancement of national market system facilities and in the formulation 
of solutions to national market system issues. Affected industry 
participants should have every reasonable opportunity to advance 
national market system goals without direct Commission intervention. In 
this instance, however, the Commission believes that change will not 
occur without Commission intervention.
    In the Commission's view, the failure to achieve a linkage between 
exchange and OTC markets in all listed securities inhibits a broker's 
ability to ensure best execution of its customer orders.\49\ With 
regard to non-Rule 19c-3 securities, orders routed to exchange floors 
cannot be easily redirected to the OTC market in situations where more 
favorable prices are offered by OTC market makers. Conversely, OTC 
market makers are precluded from using an efficient means of achieving 
rapid delivery of their orders to exchange floors when the exchange has 
a more favorable price.\50\ Currently, an OTC market maker may be 
trading a security at a better price than an exchange specialist (or 
vice versa) and the exchange specialist (or OTC market maker) is not 
able to access

[[Page 40753]]

directly the better quote for non-Rule 19c-3 securities. Expanding the 
ITS/CAES linkage to non-Rule 19c-3 securities will enable the OTC 
market maker and the exchange specialist to directly access those 
superior priced quotes through ITS, rather than potentially executing 
an order at an inferior price.
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    \49\ The Commission indicated in the Rule 19c-3 Adopting Release 
that intermarket exposure of orders in a national market system 
should maximize competition between and among markets and market 
participants, and further the efficiency and fairness of the 
securities markets. See Rule 19c-3 Adopting Release, supra note 18, 
at 10, 45 FR at 41126.
    \50\ Non-exchange member OTC market makers presently are able to 
access exchange floors only through correspondent relationships with 
member firms.
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    The Commission also believes that the failure to expand the ITS/
CAES linkage impedes ``fair competition among brokers and dealers * * * 
and between exchange markets and markets other than exchange markets,'' 
\51\ and that competitive OTC markets cannot develop fully in the 
absence of a linkage for all listed securities. Without an expanded 
ITS/CAES linkage, OTC market makers in non-Rule 19c-3 securities have 
little ability to interact with the vast majority of retail orders, 
which presently are routed to the primary exchange markets, or to 
attract additional order flow through their displayed quotations. The 
expansion of the ITS/CAES linkage should promote competition in non-
Rule 19c-3 securities by encouraging market makers or specialists to 
improve their quotes to match or better the bid or offer in another ITS 
market, in order to attract order flow from those other markets. The 
Commission also believes the expansion should help equalize access to 
all the markets because OTC market makers and exchange specialists will 
have an ability to access directly each other's markets for non-Rule 
19c-3 securities.
---------------------------------------------------------------------------

    \51\ See Section 11A(a)(1)(C)(ii) of the Act, 15 U.S.C. 78k-
1(a)(1)(C)(ii).
---------------------------------------------------------------------------

    The expansion of the ITS/CAES linkage should also decrease market 
fragmentation because all exchanges and the OTC market would be linked 
directly through ITS for all listed securities. The failure to extend 
the linkage between the OTC market and exchange markets to all listed 
securities obviates trade-through protection for third market trades 
and quotes, and inhibits efforts to achieve comprehensive nation-wide 
price protection. Expanding the ITS/CAES linkage should make ITS a more 
efficient and useful linkage by expanding the applicability of the ITS 
trade-through rule because all market maker trades and quotes in listed 
securities would be subject to the rule.\52\
---------------------------------------------------------------------------

    \52\ Currently, third market makers can trade non-Rule 19c-3 
listed securities without complying with the ITS trade-through rule. 
The NASD, however, has indicated its willingness to amend its rules 
to conform with trade-through protection if the ITS/CAES link is 
expanded. See NASD 1997 Letter, supra, note 33.
---------------------------------------------------------------------------

    Although an expansion of the ITS/CAES linkage should produce 
significant benefits to the national market system, the Commission and 
market participants have suggested in the past that certain 
improvements to third market trading rules and NASD procedures should 
be implemented before the expansion. As discussed below, the Commission 
believes that most of these improvements have been implemented, and 
that the rest could be completed during the pendency of this 
rulemaking.
    The Division, in its Market 2000 Study, identified several areas 
where the NASD should amend its rules prior to an expansion of the ITS/
CAES linkage. Specifically, the Division recommended that the NASD 
amend its rules to provide for: the display of customer limit orders 
that improve the existing ITS best bid or offer (``BBO''); customer 
limit order protection; fixed standards for queuing and executing 
customer orders; crossing of customers' orders, if possible, without 
dealer intervention; and compliance with ITS trade-through and block 
trade policies. The Division also stated that the NASD should develop a 
program specifically designed to enhance oversight examination of the 
third market.\53\
---------------------------------------------------------------------------

    \53\ See Market 2000 Study, supra, note 34.
---------------------------------------------------------------------------

    In addition, in response to a Commission letter,\54\ the ITS 
Participants recently submitted their views in writing to the Division 
on the expansion of the ITS/CAES interface.\55\ Eight of the nine 
Participants supported eliminating the ITS/CAES linkage restriction as 
long as certain significant changes are made to the NASD's rules prior 
to the expansion. Several Participants express concern about the 
accessibility of all third market quotes in listed securities and the 
application of the ITS Plan, including the trade-through rule, if the 
linkage were expanded. One Participant believes that the NASD must 
implement a trade-through rule that would apply to all third market 
makers, even non-ITS/CAES market makers, who trade listed stocks.\56\ 
Several Participants believe the NASD should require all third market 
makers and ``unregulated exchanges'' to participate in ITS,\57\ and 
another believes all NASD members, both market makers and brokers, who 
trade listed securities should be accessible through ITS and willing to 
comply with the Order Handling Rules and all ITS rules, including the 
trade-through rules.\58\ Another commenter suggested that all block 
positioners and non-market makers (that trade listed stocks) linked 
with the National Market System should also be required to comply with 
the ITS trade-through rule. The Commission is soliciting comment on 
whether this is necessary or appropriate, and how it could be 
achieved.\59\
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    \54\ See May 27 Letter, supra, note 39. In that letter, the 
Commission commented on four aspects of the ITS Plan that it 
believes are anti-competitive; the ITS/CAES limitation to Rule 19c-3 
securities was one of those provisions.
    \55\ See letter from Thomas F. Ryan, Jr., President and Chief 
Operative Officer, Amex, to Jonathan B. Katz, Secretary, Commission, 
dated June 26, 1997 (``Amex Letter''); letter from Charles J. Henry, 
President and Chief Operating Officer, CBOE, to Jonathan G. Katz, 
Secretary, Commission, dated June 26, 1997; letter from Robert H. 
Forney, President and Chief Executive Officer, CHX, to Jonathan G. 
Katz, Secretary, Commission, dated November 3, 1997 (``CHX 
Letter''), letter from David Colker, Executive Vice President and 
Chief Operating Officer, CSE, to Jonathan G. Katz, Secretary, 
Commission, dated July 3, 1997 (``CSE Letter''); NASD 1997 letter, 
supra, note 33; letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Jonathan G. Katz, Secretary, Commission, dated 
June 25, 1997 (``NYSE Letter''); and letter from William G. Morton, 
BSE, Robert H. Forney, CHX, Robert M. Greber, PCX, and Nicholas 
Giordano, Phlx, to Jonathan G. Katz, Secretary, Commission, dated 
June 23, 1997 (``Joint Letter'').
    \56\See NYSE Letter, supra note 55.
    \57\See Joint Letter, supra note 55.
    \58\See CSE Letter, supra note 55.
    \59\See Amex Letter, supra note 55.
---------------------------------------------------------------------------

    The Participants also expressed concerns regarding adequate trade-
reporting and surveillance of the third market. The Participants 
believe additional oversight of the third market and third market 
makers is necessary prior to any expansion of the ITS/CAES linkage. One 
Participant believes that the third market must implement timely and 
accurate trade reporting because the operation of ITS, especially the 
operation of the trade-through and block trade policies, depends upon 
timely trade reporting at the actual price of the transaction.\60\ The 
Participant argues that currently, third market transactions can be 
reported that at a price ``reasonably related to the prevailing 
market,'' taking into consideration all relevant circumstances, 
including the costs of executing transactions, market conditions, and 
the number of shares involved.\61\ The Participants also states

[[Page 40754]]

that the Commission has cited its confirmation rule \62\ as resolving 
the trade reporting issue, but the Participant does not think that this 
addresses the issue because that rule merely requires the NASD member 
to report the same price to the customer as they do to the tape.\63\
---------------------------------------------------------------------------

    \60\ See NYSE Letter, supra note 55. If the transaction is not 
reported accurately, there is no way of ascertaining if that 
transaction would have traded-through a superior priced quotation in 
another ITS market. See id. The Commission notes that the ITS block 
trade policy requires anyone handling a block transaction to satisfy 
all superior ITS quotes at the block price.
    \61\ Prior to 1980, third market principal transactions were 
reported to the consolidated system at a ``net'' price which 
included the mark-up or mark-down charged to the customer on the 
transaction. In 1980 the Commission approved an NASD proposed rule 
change requiring third market reporting at a ``gross'' price, 
excluding the mark-up or mark-down charged a customer. The rule 
requires that the price reported to the consolidated system shall be 
reasonably related to the prevailing market, taking into 
consideration all relevant circumstances, including, but not limited 
to, market conditions with respect to the security, the number of 
shares involved in the transaction, the published bids and offers 
with size at the time of execution (including the reporting firm's 
own quotation), accessibility to market centers publishing bids and 
offers with size, the cost of the execution, and the expenses 
involved in clearing the transaction. See Securities Exchange Act 
Release No. 18536 (March 11, 1982), 47 FR 10658, 10662 n.21 and NASD 
Rule 6420(d)(3)(A). NASD Rule 5230 states that transactions in ITS 
securities executed in CAES by ITS/CAES market makers or receive 
through the ITS system and executed by an ITS/CAES market maker are 
reported to the Consolidated Tape by the CAES system at the price 
specified in the ITS commitment or, if executed at a better price, 
the execution price.
    \62\ See Rule 10b-10 under the Exchange Act, 17 CFR 240.10b-10. 
This rule requires that when a NASD member is acting as an agent for 
a customer, the member must confirm to the customer the gross trade 
price, which is the price that was reported to the Consolidated 
Tape, and the commission equivalent as well as the net price to the 
customer. When an NASD member is acting as principal for its own 
account, the member must include in the confirmation the price 
reported to the Consolidated Tape, the net price to the customer, 
and the difference.
    \63\ In the original order adopting amendments to the ITS Plan 
in 1982, the Commission discussed the trade-reporting issue. See 
Final Approval Order, supra note 31. The ITS Participants had stated 
that they believed it was necessary for the NASD to agree to require 
market makers to report trades to the consolidated tape at the same 
price they confirm transactions to their customers, believing that 
such a requirement would impose, through customer monitoring of 
trade confirmations, a discipline on market makers to ensure that 
they reported trades as the true wholesale price. The Commission 
responded that it believed that concerns about accurate trade 
reporting could be effectively resolved through surveillance. The 
Commission believes that its confirmation rule amendments help 
enforce the trade reporting obligations by requiring disclosure of 
the mark-up resulting from the actual reported price. See Securities 
Exchange Act Release No. 18713 (May 6, 1982), 47 FR 20413, 20415 
n.13 (May 12, 1982). The Commission notes that the NASD, in its 
petition for rulemaking to expand the ITS/CAES linkage to non-Rule 
19c-3 securities, has indicated that it intends to modify its last 
trade reporting rules for exchange-listed securities in order to 
address concerns relating to the ITS/CAES linkage expansion. See 
NASD Petition, supra note 36.
---------------------------------------------------------------------------

    The Commission believes that most of these issues have already been 
addressed and that the NASD could address the others prior to the 
implementation of the expansion of the ITS/CAES linkage. The 
Commission's adoption of the Limit Order Display Rule eliminates the 
need for the NASD to implement a rule to require the display of 
customer limit orders that improve the existing ITS/BBO, as recommended 
in the Market 2000 Study.\64\ In addition, the Limit Order Display Rule 
provides enhanced opportunity for public orders to interact with other 
pubic orders without the intermediation of a specialist or market maker 
by requiring certain customer limit orders to be displayed in the 
quote.\65\ The Commission also notes that there is an NASD rule that 
prohibits third market makers from trading ahead of their customer 
limit orders.\66\
---------------------------------------------------------------------------

    \64\ The Limit Order Display Rule requires all specialist and 
market makers to display customer limit orders that improve their 
quotes. See Order Execution Rules, supra note 36.
    \65\ Id.
    \66\ The Commission notes that NASD's Rule 6440(f)(1)(2), which 
applies to listed securities, states that no member shall buy (or 
sell) (or initiate the purchase or sale of) any security at or above 
(or below) the price at which it personally holds or has knowledge 
that any person associated with it holds an unexpected limited price 
order to buy (or sell) such security in the unit of trading for a 
customer.
---------------------------------------------------------------------------

    In addition, the Commission believes that, for the most part, the 
issue of timely and accurate trade reporting has already been 
adequately addressed. The Commission notes that third market 
transactions during regular market hours must be reported to the 
consolidated tape within 90 seconds of execution; this is the same as 
the reporting of transactions on all the exchanges. Moreover, the 
Commission has enacted a rule requiring the third market to report 
transactions to the consolidated tape at the same price as they report 
the transactions to the customer.\67\ Although the Commission believes 
that the rule relating to third market trade reporting could be 
clarified, they are the same for Rule 19c-3 and non-Rule 19c-3 
securities, and thus provide no basis for not extending the ITS/CAES 
linkage to all securities. Nonetheless, the Commission believes that 
the NASD must continue to ensure that it is actively and adequately 
surveilling trade reporting in the third market.\68\
---------------------------------------------------------------------------

    \67\ See supra notes 61-62 and accompanying text.
    \68\ In its Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1935 Regarding the NASD and the Nasdaq Market, the 
Commission noted that the NASD failed to monitor and enforce 
rigorously trade reporting compliance by NASD members trading 
exchange-listed securities in the OTC market, and that they were 
many transactions that constituted trade-through. See U.S. 
Securities and Exchange Commission, Report Pursuant to Section 21(a) 
of the Securities Exchange Act of 1935 Regarding the NASD and the 
Nasdaq Market (August 8, 1996) (``Section 21(a) Report'') at A-44. 
Since that time, the NASD has taken various measures designed to 
comply with the undertakings contained in its settlement of an 
enforcement proceeding with the Commission. One of the undertakings 
required the NASD to improve substantially the reliability of trade 
reporting.
---------------------------------------------------------------------------

    The Commission also believes that the NASD should provide for 
trade-through and block trade policy rules that will apply to all third 
market makers who trade in listed securities, prior to an expansion of 
the ITS/CAES linkage. In addition, the NASD should consider developing 
standards for queuing and executing customer orders. The Commission 
invites the NASD to submit proposed rule changes to address these 
concerns. However, while these standards are needed to better protect 
OTC customers, they are not relevant to orders received via the 
linkage, and so are not fundamentally the concern of other markets.
    Finally, the Commission also wishes to emphasize that all ITS 
Participants need to enforce strictly Rule 11Ac1-1 under the Exchange 
Act (the ``Firm Quote Rule'') to ensure that investors receive best 
execution and that the market receives reliable quotation information. 
The Firm Quote Rule requires that every exchange specialist or OTC 
market maker execute any order to buy or sell a security it receives at 
a price at least at favorable as its published bid or offer in any 
amount up to its published size, subject to two exceptions. The 
Commission emphasizes that the Firm Quote Rule applies to ITS 
commitments; where a specialist or market makers fails to honor its 
quote by refusing to execute an ITS commitment received at its 
published bid or offer, and neither of the exceptions contained in the 
Firm Quote Rule apply, the specialist or market maker is in violation 
of the Firm Quote Rule. A market maker or specialist who fails to meet 
his or her quote obligations is said to have ``backed away.'' \69\
---------------------------------------------------------------------------

    \69\ The Firm Quote Rule by its terms applies to ITS 
commitments.
---------------------------------------------------------------------------

    There are only two exceptions to the Firm Quote Rule. The first 
exception occurs when, prior to the receipt of the order, the market 
maker or specialist has communicated to its association of exchange a 
revised quotation size or revised bid or offer. The second exception 
applies when, prior to the receipt of an order, the market maker or 
specialist is in the process of effecting a transaction in a security 
when an order in the same security is presented, and immediately after 
the completion of such transaction, the market maker or specialist 
communicates to its association or exchange a revised quotation size or 
revised bid or offer (the ``trade ahead'' exception). In its Section 
21(a) Report, the Commission specifically stated that the fact that 
SelectNet orders may have scrolled off a market maker's Nasdaq 
workstation terminal screen did not excuse traders from complying with 
the Firm Quote

[[Page 40755]]

Rule for those orders.\70\ Similarly, the Commission stresses that a 
market maker or specialist cannot claim as a valid excuse for not 
executing an ITS commitment that he did not see the commitment before 
it expired (``timing out''). The Commission wishes to reiterate that 
order expiration is not an exception to the Firm Quote Rule.\71\
---------------------------------------------------------------------------

    \70\ See Section 21(a) Report at note 134 and accompanying text.
    \71\ See Exchange Act Rule 11Ac1-1.
---------------------------------------------------------------------------

B. Unanimous Vote Requirement

    The Commission preliminarily believes that the unanimous voting 
requirement for amendments to the ITS Plan, including the admission of 
new participants, is anti-competitive and impedes the ability of ITS to 
adapt to market changes. As the Commission stated in a May 27, 1997 
letter \72\ to the ITS Participants, the unanimous vote requirement 
allows any single Participant to veto changes to the Plan that could 
increase competition faced by that Participant, such as the entry of 
another market into ITS or expansion of business by a particular ITS 
Participant. It also allows any Participant to block modifications to 
ITS designed to adapt to changed circumstances. As a result, ITS has 
not been able to evolve significantly as the markets changed over the 
past two decades.
---------------------------------------------------------------------------

    \72\ See May 27 Letter, supra note 39.
---------------------------------------------------------------------------

    There are several recent instances that demonstrate the anti-
competitive impact of the unanimous vote requirement.\73\ The first 
instance involved the issue of trading derivative-type securities, such 
as Standard & Poor's Depository Receipts (``SPDRs''), through ITS.\74\ 
Initially, there was disagreement among the Participants over amending 
the ITS Plan to allow eligible securities to trade in increments 
smaller than \1/8\th of a dollar. this modification was necessary 
before a derivative-type product such as SPDRs, which trades in 
increments of \1/64\th of a dollar, could begin trading over ITS. The 
Participants originally disagreed on whether to amend the Plan to 
accommodate trading in smaller increments, and what, if any, the 
smaller increment should be. Eventually, after much debate, the 
Participants agreed to amend the Plan in two stages, to first allow 
trading in smaller increments, and eventually in decimals. 
Nevertheless, due to opposition by a single Participant, resolution of 
this issue was delayed for several months. As a consequence, competing 
markets could not trade SPDRs for an extended period of time.
---------------------------------------------------------------------------

    \73\ See Minutes from the ITS Users' Committee and ITSOC 
meetings held on September 18 and 19, 1997, respectively.
    \74\ CHX, CSE and PCX have received Commission approval to trade 
SPDRs and MidCap SPDRs, both Amex products.
---------------------------------------------------------------------------

    Further, as noted in the May 27, 1997 letter, the Commission 
believes that the ITS provision which provides ITS Participants a 
special right of review for proposed rule changes involving the 
operation of the CSE's NSTS is anti-competitive because it permits 
other Participants to prevent the CSE from improving its market without 
prior notice to and comment from its market competitors. At the recent 
ITS meeting, a single Participant was able to block action on 
elimination of this provision by voting against a motion to amend the 
Plan. All the other Participants voted in favor of the motion.\75\
---------------------------------------------------------------------------

    \75\ The single Participant subsequently changed its position to 
support the Plan amendment.
---------------------------------------------------------------------------

    Another recent example of the significance of the unanimous vote 
requirement relates to OptiMark, a Commission-approved facility of PCX. 
The Commission notes that PCX and other ITS Participants have not been 
able yet to unanimously agree on whether the Participants need to amend 
the ITS Plan prior to the time OptiMark begins to operate, much less on 
the substance of a plan amendment, despite continuous discussion of the 
issue.\76\ The OptiMark experience illustrates that a unanimous vote 
requirement has the potential to block changes in ITS to accommodate 
innovation on the part of Participants. It also suggests the obstacles 
that a new market could face in becoming a new Participant in ITS.
---------------------------------------------------------------------------

    \76\ Two Participants, the NYSE and Amex, refused to participate 
in a vote in December 1997, on whether an amendment to the Plan is 
necessary, while the other seven Participants voted that an 
amendment is not needed prior to the operation of OptiMark. 
Nevertheless, on June 3, 1998, the PCX proposed to the ITSOC two 
Plan amendments to link the PCX Application of the OptiMark System 
to ITS. The amendments were not approved by a vote of 5-4. Although 
a super-majority voting provision would not have made a difference 
in the June 3 vote, the June 3 vote would never have been necessary 
had a super-majority voting provision been in place for the December 
vote. The Commission notes that it issued a companion release to 
amend the ITS Plan to link the PCX Application of the OptiMark 
System to ITS. See Securities Exchange Act Release No. 40204 (July 
15, 1998).
---------------------------------------------------------------------------

    The above instances underscore the limiting effect of the unanimous 
vote requirement. They may represent only a small portion of potential 
changes to ITS hindered by the unanimous vote requirement. Most 
proposals may not even get proffered by ITS Participants because of the 
difficulty of overcoming the unanimous vote requirement. The potential 
veto by a single Participant can slow or prevent ideas for modifying 
ITS to accommodate developments in the markets from even reaching the 
proposal stage, let along being adopted.
    In response to the Commission May 27, 1997 letter, several of the 
Participants argue that the unanimous vote requirement fosters 
competition and the development of the national market system because 
ITS, in conjunction with the Consolidated Quotation System, encourages 
a Participant market to compete for order flow with the knowledge that 
its superior-priced quotations must be honored.\77\ These Participants 
further assert that ``[o]ther than providing [a] limited form of 
access, the Plan has no other effect on market competition'', and that 
``[t]here are no Plan provisions that allow one or more Participant 
markets to veto a competitive initiative of another Participant 
market.'' \78\ However, the Commission strongly believes that ITS can 
affect a market's ability to compete because the unanimous vote 
requirement could effectively prevent a competing market implementing 
structural or operational changes from becoming an ITS Participant, 
which in turn could affect that market's ability to compete for order 
flow and to reach quotations in the competing ITS Participant markets.
---------------------------------------------------------------------------

    \77\ See Joint Letter, supra note 55.
    \78\ See id.
---------------------------------------------------------------------------

    Several of the Participants also believe that the unanimous vote 
requirement, ``rather than being anti-competitive, * * * [constitutes 
a] prudent safeguard[s] to ensure that all Participants are able to 
protect the integrity of their markets and their membership status.'' 
\79\ In other words, a market can exercise its veto to prevent the 
other ITS Participants from imposing restrictive conditions through ITS 
rules, or from eroding its membership value by creating unlimited ITS 
access to its market. Although the Commission recognizes these 
concerns, the Commission believes that there are other means to protect 
a market's interests that are less restrictive and anti-competitive. 
Specifically, the Commission preliminarily believes that a two-thirds 
supermajority voting requirement, with a right to appeal to the 
Commission, could foster a regulatory system that will promote 
innovation and competition while still permitting the Participants to 
preserve the integrity of their markets and membership status.\80\
---------------------------------------------------------------------------

    \79\ See id.
    \80\ See May 27 Letter, supra note 39. Several commenters 
support, to varying degrees, this approach. See letter from Leopold 
Korins, Chairman and Chief Executive Officer, Phlx, to Jonathan G. 
Katz, Secretary, SEC, dated November 12,1997 (``Phlx letter'') 
(supporting a supermajority for most issues, including Plan 
amendments, and a simple majority for resolution of certain 
ministerial issues); letter from David Colker, Executive Vice 
President and Chief Operating Officer, CSE, to Jonathan G. Katz, 
Secretary, SEC, dated January 19, 1998 (``CSE Unanimous Vote 
Letter'') (supporting a supermajority vote for all ITS Plan 
amendments except admission of new participants under the existing 
regulatory structure, for which it supports a simple majority vote); 
letter from Gary K. Staggs, Vice President, Equity Floor Operations, 
PCX, to Jonathan G. Katz, Secretary, Commission (``PCX Letter'') 
(supporting a majority or supermajority vote for general Plan 
amendments); and CHX letter, supra note 55 (supporting a 
supermajority vote requirement of two-thirds of the Participants for 
Plan amendments, including the admission of new Participants).

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[[Page 40756]]

    Several of the Participants argue that the right to appeal to the 
Commission, in the event that a Participant objects to a certain 
amendment approved by a two-thirds majority, does not provide adequate 
protection of their interests.\81\ The Commission believes that the 
appeal right to the Commission in the Plan Rule, and the review it 
undertakes in approving a Plan amendment, provides additional 
protection to all Participants, in part because such review is done in 
accordance with and in furtherance of the purposes of the Exchange 
Act.\82\
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    \81\ See id.
    \82\ Paragraph (c)(2) of Rule 11Aa3-2 (the ``Plan Rule'') 
provides that the Commission will approve a filing only if it finds 
that a plan or amendment ``is necessary or appropriate in the public 
interest, for the protection of investors and the maintenance of 
fair and orderly markets, to remove impediments to, and perfect the 
mechanisms of, a national market system, or otherwise in furtherance 
of the purposes of the [Exchange] Act.''
---------------------------------------------------------------------------

    The Commission has recommended that the ITS Participants eliminate 
the unanimous vote requirement but no consensus has been reached.\83\ 
Consequently, the Commission is proposing an amendment to eliminate the 
unanimous vote requirement contained in Section 4(c) of the ITS Plan 
and replace it with a supermajority/two-thirds vote requirement for 
Plan amendments.\84\
---------------------------------------------------------------------------

    \83\See Phlx letter, supra note 80 (supporting a supermajority 
for most issues, including Plan amendments, and a simple majority 
for resolution of certain ministerial issues); CSE Unanimous Vote 
Letter, supra note 80 (supporting a supermajority vote for all ITS 
Plan amendments except admission of new participants under the 
existing regulatory structure, for which its supports a simple 
majority vote); PCX Letter, supra  note 80 (supporting a majority or 
supemajority vote for general Plan amendments); CHX Letter, supra 
note 55 (supporting a supermajority vote requirement of two-thirds 
of the Participants for Plan amendments, including the admission of 
new participants). But see Joint Letter, supra note 55 (stating that 
the unanimous vote requirement in particular is appropriate because 
it fosters competition and the development of the National Market 
System).
    \84\ Those opposing the amendment would have the right to appeal 
to the Commission.
---------------------------------------------------------------------------

III. Request for Comment

    The Commission solicits comment on the substance of the proposed 
amendment to the ITS Plan to expand the ITS/CAES linkage as discussed 
above, and also requests comment on specific questions relating to this 
proposed expansion.
    With regard to the substance of the trade-through rule the NASD 
must implement prior to expansion of the ITS/CAES linkage, the 
Commission requests comment on whether such rule should apply to all 
NASD members who trade listed securities, or only those market makers 
who trade listed securities. The Commission also requests comment on 
the specifics of a trade-through rule and whether a trade-through rule 
for the third market should be identical to the exchange trade-through 
rules, or whether such rule should be similar to the trade-through rule 
that already applies to ITS/CAES market makers,\85\ but expanded in 
scope and application. Finally, the Commission requests comment on 
what, if any, other amendments to NASD rules are necessary prior to 
expanding the ITS/CAES linkage.\86\
---------------------------------------------------------------------------

    \85\See NASD Rule 5262.
    \86\ The Commission notes that the NASD's autoquote rule would 
have to be revised if the ITS/CAES linkage is expanded, as the rule 
is currently inconsistent with the ITS Plan.
---------------------------------------------------------------------------

    The Commission notes that under current NASD rules, participation 
in CAES and the ITS/CAES linkage is limited to registered CQS market 
makers. As a result, if ITS/CAES linkage were expanded to include non-
Rule 19c-3 securities, ECNs must be CQS market makers to have the 
ability to access the listed markets through ITS, or else exchange 
specialists will be unable to make full use of the ECN Alternative 
under the Order Handling Rules. The Commission requests comment on 
whether the NASD's rules need to be amended to allow ECN participation 
in CAES and the ITS/CAES linkage. The Commission is interested in 
commenters' views on what rule changes would be necessary to 
accommodate ECN participation in CAES and ITS/CAES linkage.
    The Commission is soliciting comment on whether the unanimous vote 
requirement should be eliminated, and what impact such a change would 
have on the operation of ITS and the respective Participant markets, if 
any. The Commission also is soliciting comment on what alternative 
voting scheme should be required for Plan amendments if the unanimous 
vote requirement is eliminated, such as a simple majority vote or a 
two-thirds vote. Should the alternative voting scheme chosen by the 
Commission more directly take into account the actual number of its 
participants? For example, should the Commission adopt a simple 
majority or two-thirds voting scheme if the number of participants is--
as it is now--nine, but allow for automatic modification of that scheme 
by the Commission if the number of participants is 7, 8, 10, or 11? In 
addition, the Commission is soliciting comment on whether all 
amendments to the ITS Plan should be treated equally, or whether 
amendments to admit new participants (currently Section 3(c)) should be 
treated differently from all other ITS Plan amendments, and, if so, why 
the disparate treatment is necessary.
    Some ITS Participants have expressed concerns that non-unanimous 
voting threatens their sovereignty as independent markets. At the same 
time, the existing ITS Plan constrains the market structure of 
Participants, which limits innovation, in order to prevent unbridled 
order routing to other markets through ITS. To address these concerns, 
the Commission requests comment on whether other market linkages should 
be developed to replace ITS. All of the Participants now operate 
automated order routing systems that provide access to their markets. 
As an alternative to ITS, these systems could be opened to other 
markets for use on an order-by-order basis. Alternatively, ITS 
Participants could provide access to other markets directly or through 
one of many private vendors providing order routing services. The 
Commission is requesting comment on two possible alternatives to the 
existing ITS System: (1) Eliminating ITS and requiring each national 
securities exchange and national securities association to provide 
access to other markets through one or more private vendors for the 
purpose of allowing access to better-priced quotations in their 
markets; or (2) eliminating ITS and requiring each participant national 
securities exchange and national securities association to provide 
other markets access to its order routing systems.
    Finally, the Commission requests comment on whether the changes it 
has proposed to the ITS Plan should be supplemented, or wholly 
replaced, by other revisions to the ITS Plan. The current provisions 
can produce a restraint on competition, impediments to ITS' ability to 
adapt to market changes, barriers to new Participants joining the Plan, 
the encumbrances on innovation by the current Participants. The 
Commission recognizes the possibility that eliminating the

[[Page 40757]]

unanimous vote requirement may not be sufficient to address the 
restrictive nature of the current ITS Plan, including the difficulty 
involved in the Plan, before change can occur to remove the provisions 
that control the internal operation of Participant markets. 
Commentators should address whether it would be productive to revise 
the ITS Plan to remove or modify other provisions that unnecessarily 
limit the internal operation of Participants, such as the descriptions 
of specific ITS interfaces and the requirement of two-sided quotations. 
Instead, the Plan could express standards or principles governing use 
by Participants, such as the existing prohibition contained in Plan 
Rule 8(a)(v),\87\ dealing with routing a substantial portion of order 
flow to other markets through ITS. Regardless of whether commentators 
believe that the current changes proposed by the Commission provide for 
an adequate solution to the problems mentioned above, the Commission 
requests additional comment on whether further action, including, but 
not limited to, a revision of the entire ITS Plan by the Commission, is 
warranted.
---------------------------------------------------------------------------

    \87\ Section 8(a)(v) of the ITS Plan provides that ITS is not 
permitted to be used as an automated order delivery system whereby 
all or a substantial portion of orders are routinely rerouted from 
the market where they are received to another market for execution. 
This provision further requires that each Participant take 
reasonable efforts to probe its market to achieve a satisfactory 
execution there before reformatting the order as an ITS commitment 
to trade and rerouting it to another market.
---------------------------------------------------------------------------

IV. Costs and Benefits of the Proposed Amendments and Their Effects 
on Competition, Efficiency and Capital Formation

    Section 23(a)(2) of the Exchange Act requires that the Commission, 
when promulgating rules under the Exchange Act, to consider the 
competitive effects of such rules and to not adopt any rule that would 
impose a burden on competition that is not necessary or appropriate in 
furthering the purpose of the Act.\88\ The Commission preliminarily has 
considered the proposed amendments to the ITS Plan in light of the 
standards cited in Section 23(a)(2) of the Act and believes that they 
would not likely impose any significant burden on competition not 
necessary or appropriate in furtherance of the Exchange Act. Indeed, 
the Commission believes that the proposed amendment to expand the ITS/
CAES linkage should promote competition in non-Rule 19c-3 securities 
because OTC market makers will now be able to attract orders initially 
routed to exchange specialists, by disseminating a superior quote, in 
all listed securities, not just Rule 19c-3 securities. Additionally, 
the expansion of the ITS/CAES linkage will allow exchange specialists 
to attract orders held by OTC market makers in non-Rule 19c-3 
securities. The Commission also believes that eliminating the unanimous 
vote requirements should promote competition by restricting the ability 
of one or more Participants to block an ITS Plan amendment that would 
promote competition between the markets or within one market.
---------------------------------------------------------------------------

    \88\ See 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    Commentators should consider the proposed amendment's effect on 
competition, efficiency and capital formation.
    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, the Commission is also requesting information regarding 
the potential impact of the proposed amendment on the economy on an 
annual basis. If possible, commentators should provide empirical data 
to support their views.
    To assist the Commission in its evaluation of the costs and 
benefits that may result from the proposed amendments, commenters are 
requested to provide analysis and data relating to costs and benefits 
associated with the proposal herein. The Commission preliminarily 
believes that the amendment to the ITS Plan proposed herein to expand 
the ITS/CAES linkage to all listed securities will increase efficiency 
because investors will be able to access directly the exchange and OTC 
markets for all listed stocks. The Commission also notes the impact of 
the proposed ITS Plan amendments on the NYSE in the proposal would 
allow all ITS Participants to access the NYSE for non-Rule 19c-3 
securities, and for the NYSE to access other Participant markets for 
those securities. In addition, the Commission preliminarily believes 
that the proposed amendments would benefit ECNs by allowing them to 
fully integrate into the NMS in all listed securities, which in turn 
would allow for more efficient use of the ECN Alternative mentioned in 
the Order Execution Rules. The Commission also preliminarily believes 
that the proposal would enhance competition between market in non-Rule 
19c-3 securities and improve execution quality for non-Rule 19c-3 
securities. Finally, the Commission notes that there would be 
implementation costs and costs of expanding the linkage to include all 
non-Rule 19c-3 securities.
    In addition, the proposed amendment to eliminate the unanimous vote 
requirement for ITS Plan amendments would remove a significant barrier 
to imposing new and innovative modifications to ITS by preventing a 
small minority of ITS Participants from thwarting innovation that could 
improve market efficiency. The Commission is requesting comment on the 
costs and benefits of the proposed amendments and any possible anti-
competitive impact of the proposed amendments. Specifically, the 
Commission requests comments to address whether the proposed amendment 
would generate the anticipated benefits or impose any costs on U.S. 
investors or others.
    Comments should be submitted by August 31, 1998.

V. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with Section 3 of the Regulatory Flexibility Act 
(``RFA'').\89\ It relates to proposed amendments to the ITS Plan to 
expand the linkage between ITS and the NASD/CAES to all listed 
securities and would eliminate the unanimous vote requirement for 
amendments to the ITS Plan.
---------------------------------------------------------------------------

    \89\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Proposal

    Although the ITS participants have addressed two of the four anti-
competitive aspects of the ITS Plan identified by the Commission, they 
have been unable to take action regarding the expanded linkage and the 
unanimous vote requirement. The Commission thus is proposing to amend 
the ITS Plan on its own initiative.
    The objective of the expanded linkage is to achieve the statutory 
goals of efficient execution of securities transactions and 
opportunities for best execution of customer orders for all listed 
securities. The elimination of the unanimous vote requirement is 
intended to improve the governance of the ITS Plan--the unanimous vote 
requirement in the past has been used by the ITS participants to veto 
changes to the ITS Plan that could increase intermarket competition.

B. Legal Basis

    Section 11A(a)(3)(B) of the Exchange Act authorizes the Commission, 
by rule or order, to authorize or require SROs to act jointly with 
respect to matters as to which they share authority under the Exchange 
Act in planning, developing, operating or regulating a national market 
system (or a subsystem thereof) or one or more facilities thereof. It 
states explicitly that the Commission not only may approve national 
market system facilities in response to an application

[[Page 40758]]

by SROs, but also may require SROs to implement such facilities on 
their own initiative. Rule 11Aa3-2,\90\ adopted by the Commission under 
Section 11A, establishes procedures for proposing amendments to 
national market system plans such as the ITS Plan. Paragraph (b)(2) 
states that the Commission may propose amendments to an effective 
national market system plan by publishing the text of the amendment 
together with a statement of purpose of the amendments.
---------------------------------------------------------------------------

    \90\ 17 CFR 240.11Aa3-2.
---------------------------------------------------------------------------

C. Small Entities Affected by the Proposed Amendments

    The proposal would directly affect the nine ITS Participants, none 
of which are small entities. However, specialists on the exchange 
floors who trade ITS securities, broker-dealers that have access to ITS 
through terminals located on exchange floors, and registered ITS/CAES 
market makers who trade in ITS securities in the third market could be 
indirectly affected. There would be no impact on these broker-dealers 
by the proposed change in the vote requirement as it relates only to 
the governance of the ITS Plan.
    Paragraph (c)(1) of Rule 0-10 \91\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that: (1) Had total capital (net worth 
plus subordinated liabilities) of less than $500,000 in its prior 
fiscal year audited financial statements or, if not required to file 
such statements, on the last business day of the preceding fiscal year; 
and (2) is not affiliated with any person (other than a natural person) 
that is not a small business or small organization. The Commission 
currently does not have any data on the number of small entities that 
could be affected.\92\
---------------------------------------------------------------------------

    \91\ 17 CFR 240.0-10(c)(1).
    \92\ The Commission recently adopted revised definitions of 
``small entity.'' See Definitions of ``Small Business'' or ``Small 
Organization'' Under the Investment Company Act of 1940, the 
Investment Advisers Act of 1940, the Securities Exchange Act of 
1934, and the Securities Act of 1933, Exchange Act Release No. 40122 
(June 24, 1998). The revision, among other things, expanded the 
affiliation standard applicable to broker-dealers, to exclude from 
the definition of a small entity many introducing broker-dealers, to 
exclude from the definition of a small entity many introducing 
broker-dealers that clear customer transactions through large firms. 
Currently, approximately 1,079 of all registered broker-dealers will 
be characterized as ``small.'' See revised Rule 0-10(i). [The 
Commission estimates there are 8,300 registered brokers-dealers.]
---------------------------------------------------------------------------

    To the extent, however, that a specialist or market maker does fall 
under the definition of ``small entity,'' the effect is likely to be 
indirect and positive. Under the current system, an OTC market maker 
may be trading a security at a better price than an exchange specialist 
(or vice versa) and the exchange specialist (or OTC market maker) is 
not able to access directly the better quote for non-Rule 19c-3 
securities. Expanding the ITS/CAES linkage to non-Rule 19c-3 securities 
would enable the OTC market maker and the exchange specialist to access 
directly those superior priced quotes through ITS, rather than 
potentially executing an order at an inferior price. Finally, the 
expansion of the ITS/CAES linkage to non-Rule 19c-3 securities also 
would have an indirect, beneficial effect upon the ability of a broker 
with ITS access on an exchange floor to achieve best execution of 
customer orders.

D. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposals would not impose any new reporting, recordkeeping, or 
other compliance requirements.

E. Duplicative, Overlapping or Conflicting Federal Rules

    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the proposed amendments.

F. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives 
that would accomplish the stated objectives, while minimizing any 
significant economic impact on small entities. In connection with the 
proposal, the Commission considered the following alternatives: (1) The 
establishment of differing compliance or reporting requirements or 
timetables that take into account the resources available to small 
entities; (2) the clarification, consolidation, or simplification of 
compliance and reporting requirements under the Rule for small 
entities; (3) the use of performance rather than design standards; and 
(4) an exemption from coverage of the Rule, of any part thereof, for 
small entities.
    The Commission believes that none of the above alternatives is 
applicable. The ITS Participants are the only parties that are subject 
to the requirements of the ITS Plan. The ITS Participants are all 
national SROs and, as such, are not ``small entities.'' The Commission 
believes that any effect that could possibly be experienced by a 
``small entity'' would be indirect and beneficial. Therefore, having 
considered the foregoing alternatives in the context of the proposed 
amendments, the Commission does not believe they would accomplish the 
stated objectives of the proposal.

G. Solicitation of Comments

    The Commission encourages the submission of comments with respect 
to any aspect of this IRFA. The Commission requests comment as well as 
empirical data on the impact the proposal will have on small broker-
dealers, specialists or market makers that utilize ITS. Comment is 
specifically requested on whether broker-dealers that access ITS meet 
the revised definition of ``small business'' and on the number of small 
entities that would be affected by the proposed rules. Also, the 
Commission is seeking comment on the perceived nature of the impact of 
the proposed amendments on these entities. Such comments will be 
considered in the preparation of the Final Regulatory Flexibility 
Analysis, if the proposed rules are adopted, and will be placed in the 
same public file as comments on the proposed rules themselves. Comments 
should be submitted in triplicate to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Comments also may be submitted electronically at the 
following E-mail address: [email protected]. All comment letters 
should refer to File No. 4-208; this file number should be included on 
the subject line if E-mail is used. Comment letters will be available 
for public inspection and copying in the Commission's Public Reference 
Room, 450 Fifth Street, N.W., Washington, D.C. 20549. Electronically 
submitted comment letters also will be posted on the Commission's 
Internet web site (http://www.sec.gov).

VI. Paperwork Reduction Act

    The Paperwork Reduction Act does not apply because the proposed 
amendments do not impose recordkeeping or information collection 
requirements, or other collections of information which require 
approval of the Office of Management and Budget under 44 U.S.C. 3501, 
et seq.

VII. Description of Proposed Amendments to the ITS Plan

    The Commission hereby proposes to amend the ITS Plan to provide for 
the expansion of the ITS/CAES interface to non-Rule 19c-3 securities, 
as well as for the elimination of the unanimous vote requirement for 
amendments to the ITS Plan, pursuant to Rule 11Aa3-2(b)(2) and (c)(1) 
and the Commission's authority under Section 11A(a)(3)(B) of the 
Act.\93\ Below is the text of the

[[Page 40759]]

amended ITS Plan.\94\ Deleted text is [bracketed] and new language is 
italicized.
---------------------------------------------------------------------------

    \93\ 5 U.S.C. 78k-1(a)(3)(B). Section 11A(a)(3)(B) authorizes 
the Commission, in furtherance of its statutory directive to 
facilitate the development of a national market system, by rule or 
order, to authorize or require self-regulatory organizations to act 
jointly with respect to matters as to which they share authority 
under the Act in planning, developing, operating, or regulating a 
national market system (or subsystem thereof) or one or more of the 
facilities thereof.
    \94\ The text reflects the latest unofficial compilation of the 
ITS Plan supplied by the ITSOC, including all previously 
incorporated amendments up to May 30, 1997.
---------------------------------------------------------------------------

* * * * *
    Section 1. Definitions.
    (1)-(16) No Change.
    (17) ``ITS/CAES Security (stock)'' means a security (stock) (a) 
that is a System security[, (b) that is a 19c-3 security and (c)] and 
(b) as to which one or more ITS/CAES Market Makers are registered as 
such with the NASD for the purposes of Applications. When used with 
reference to a particular ITS/CAES Market Maker, ``ITS/CAES security'' 
means any such security (stock) as to which the particular ITS/CAES 
Market Maker is so registered.
    (18)-(25) No Change.
    [(26) ``19c-3'' security'' means an Eligible Security that is not a 
``covered security'' as that term is defined in SEC Rule 19c-3 as in 
effect on May 1, 1982.]

[(27)](26)
[(27A)](26A)
[(27B)](26B)
[(27C)](26C)
[(27D)](26D)
[(27E)](26E)
[(28)](27)
[(29)](28)
[(30)](29)
[(31)](30)
[(32)](31)
[(33)](32)
[(34)](33)
[(34A)](33A)
[(34B)](33B)
[(35)](34)
[(36)](35)
[(37)](36)
    Section 2. No Change.
    Section 3. No Change.
    Section 4. Administration of ITS Plan.
    (a)-(b) No Change.
    (c) Amendments to the ITS Plan. Any proposed change in, addition 
to, or deletion from the ITS Plan may be effected only by a means of a 
written amendment to the ITS Plan which sets forth the change, addition 
or deletion, is executed on behalf of [each Participant]two-thirds of 
the Participants, and is approved by the SEC or otherwise becomes 
effective pursuant to section 11A of the Act and Rule 11Aa3-2.
    (d)-(f) No Change.
    Section 5. The System.
    (a) No Change.
    (b) General Operation.
    (i) No Change.
    (ii) Selection of System Securities. The System is designed to 
accommodate trading in any Eligible Security in the case of any ITS/
CAES Market Maker, trading in one or more ITS/CAES securities in which 
he is registered as such with the NASD for the purposes of the 
Applications. The particular securities that may be traded through the 
System at any time (``System securities'') shall be selected by the 
Operating Committee. The Operating Committee may add or delete System 
securities as it deems appropriate and may delay the commencement of 
trading in any Eligible Security if capacity or other operational 
considerations shall require such delay. [ITS/CAES securities may be 
traded by Exchange Participants and ITS/CAES Market Makers as provided 
in the ITS Plan and other System securities may be traded by Exchange 
Participants as provided in the ITS Plan.]
    (c)-(d) No Change.
    Section 6. No Change.
    Section 7. No Change.
    Section 8. No Change.
    Section 9. No Change.
    Section 10. No Change.
    Section 11. No Change.
* * * * *
    The proposed amendments do not address the manner which the costs 
of implementing these changes would be apportioned because the 
Commission believes the ITS Participants should decide this issue among 
themselves.

    Dated: July 24, 1998.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-20313 Filed 7-29-98; 8:45 am]
BILLING CODE 8010-01-M
```