[Federal Register Volume 61, Number 111 (Friday, June 7, 1996)]
[Notices]
[Pages 29145-29148]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-14399]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-37272; File No. 10-100]


Exempted Exchanges; AZX, Inc.; Order Amending Exemption Order and 
Granting Amendment to Application for Exemption From Registration as an 
Exchange Under Section 5 of the Securities Exchange Act of 1934; Final 
Order

June 3, 1996.

I. Summary

    AZX, Inc., formerly known as Wunsch Auction Systems; Inc., has 
requested that the Commission amend the exemption order pursuant to 
which AZX, Inc. operates the Arizona Stock Exchange (``AZX'') without 
registration as a national securities exchange.\1\ The proposal was 
published for comment and two comment letters were received.\2\ After 
evaluating the proposal and the comment letters, the Commission 
concludes that AZX will continue to meet the statutory standard 
governing the granting of an exemption from registration as a national 
securities exchange under the Securities Exchange Act of 1934 
(``Act''). Accordingly, the Commission hereby amends AZX's Exemption 
Order to: (1) grant AZX Inc.'s amended application for exemption from 
registration as a national securities exchange, to permit AZX to 
operate a single auction during regular trading hours; and (2) make 
technical corrections to the Exemption Order to conform to changes in 
the operation of the system since the Exemption Order was issued, and 
to clarify reporting requirements applicable to AZX under the Exemption 
Order.
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    \1\ Securities Exchange Act Release No. 28899 (February 20, 
1991), 56 FR 8377 (``Exemption Order''). AZX also operates pursuant 
to a no-action letter regarding non-registration as a broker-dealer, 
clearing agency, transfer agent, and securities information 
processor. Letter regarding Wunsch Auction Systems, Inc. (February 
28, 1991) (``No-action Letter'').
    \2\ Securities Exchange Release No. 35922 (June 30, 1995), 60 FR 
35445 (July 7, 1995), soliciting comment on Amendment to Application 
for Exemption from Registration as a National Securities Exchange. 
File No. 10-100 (May 31, 1995).
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II. Description of AZX

    AZX is a single-price auction system that facilitates secondary 
market trading of registered equity securities by permitting 
institutional and broker-dealer participants to enter buy and sell 
orders for those securities and have those orders executed at an 
``equilibrium'' price determined by the interaction of the orders.\3\ 
Bid orders entered at prices equal to or above the equilibrium price, 
and offer orders entered at prices equal to or below the equilibrium 
price, are eligible for execution for the equilibrium price. After the 
equilibrium price is determined, Investment Technology Group, Inc. 
(``ITG''), the crossing broker for AZX, executes eligible orders on the 
basis of time priority.\4\
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    \3\ AZX is more fully described in the Exemption Order and in 
the No-action Letter.
    \4\ Where there is not sufficient eligible interest on one side 
of a transaction to satisfy all eligible interest on the other side 
of the transaction, eligible orders entered earlier in time will be 
filled first under AZX's time priority rules.
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    AZX's single-price auctions are currently conducted outside the 
regular trading hours of the New York Stock Exchange (``NYSE'') and the 
Nasdaq system, at 5:00 p.m. and 5:30 p.m. (ET) each trading day. During 
the period immediately proceding an auction, AZX participants may enter 
orders into the system by specifying the name of the security and the 
price and size of their order. Orders may be entered into any of four 
separate AZX ``books'': the Open Book, Reserve Book, Balanced Book, and 
Match Book.
    The Open Book contains orders eligible for the auction and displays 
those orders on an anonymous basis to all AZX participants. The Reserve 
Book conceals orders from other participants until a contra side order 
is entered into either the Open Book or the Reserve Book. If such a 
contra side order is entered, the order placed in the Reserve Book will 
move into the Open Book, where it will become eligible for the auction. 
The Balanced Book conceals orders from other AZX participants until 
immediately prior to the auction, at which time any orders that match 
each other, and still meet parameters set by the participants regarding 
net dollars bought or sold,\5\ are matched in the Open Book. The Match 
Book accommodates orders that are not eligible for the auction 
(because, for

[[Page 29146]]

example, the participant requires the order to be matched at the 
closing price for the security on the NYSE and not at any other price, 
such as the price discovered in the AZX auction). The Match Book 
permits such orders to be prematched prior to the auction and routed 
for execution to ITG.\6\
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    \5\ For example, a participant may specify that it is willing to 
purchase ABC stock, and sell PQR stock, but only if the proceeds 
received from the sale of PQR exceed by a specified amount the money 
spent on purchasing ABC.
    \6\ The Match Book feature operates subject to AZX's: (1) 
Aggregating Match Book volume with AZX auction volume in its monthly 
reports pursuant to the Exemption Order, for purposes of the limited 
volume exemption; (2) separately reporting Match Book volume in its 
monthly reports; (3) limiting Match Book trading to securities 
registered pursuant to Sections 12(b) and 12(g) of the Act; and (4) 
limiting the service to transactions in which both sides of the 
trade are entered by the same participant.
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    AZX participants may gain access to the system by establishing a 
communications connection between their computer terminals and the 
central host computer, through direct line, public data network, or 
dial-in via modem.\7\ Alternatively, AZX participants who are customers 
of ITG may request that unfilled orders for AZX-eligible securities be 
routed by the QuantEX system to other trading environments or the next 
AZX auction.\8\
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    \7\ Information regarding the prices and volumes of orders in 
the Open Book and the equilibrium prices and volumes of completed 
transactions in AZX auctions are available through Bridge 
Information Systems (``Bridge'') and through AZX's ``home page'' on 
the World Wide Web. Orders cannot be entered into AZX through these 
two media.
    \8\ QuantEX, which is owned and operated by ITG, allows ITG 
customers to transmit orders to: The NYSE and American Stock 
Exchange, an automated trading system operated by ITG called the 
Portfolio System for Institutional Trading (``POSIT''), the regional 
stock exchanges, over-the-counter market makers, selected broker-
dealers, the ITG trading desk, and AZX.
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III. The Proposed Morning Auction

    In its amendment to its application for exempting from exchange 
registration, AZX Inc. proposes to operate AZX during regular trading 
hours.\9\ Under the proposal, AZX would conduct a daily auction, at a 
fixed time between 9:45 and 10 a.m. (ET), in addition to its current 
operation outside of regular trading hours.\10\ Trading in the proposed 
morning auction would be limited to Nasdaq National Market (``NNM'') 
securities.\11\ AZX initially plans to trade only 15 of the 
approximately 4,023 Nasdaq National Market securities, but will expand 
as demand warrants.\12\
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    \9\ ``Regular trading hours'' refers to the time period in which 
the NYSE and the Nasdaq system permit trading, i.e., 9:30 a.m. to 4 
p.m. (ET) each trading day.
    \10\ AZX will notify the Commission of the exact time of the 
morning auction prior to commencing operation.
    \11\ NNM securities are the top tier of securities quoted on the 
Nasdaq system. They are subject to a transaction reporting plan 
approved by the Commission and to last sale reporting requirements.
    \12\ AZX is not required to seek separate Commission approval in 
order to add additional NNM securities to the list of securities 
eligible for regular-hours trading.
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    AZX's proposed morning auction is identical to AZX's current 
evening auctions in terms of its: Participation criteria; means of 
access to the system; algorithm for discovering the ``equilibrium'' 
price; confirmation, clearance and settlement of matched transactions; 
and commission structure.
    The proposed morning auction will differ from AZX's current evening 
sessions in terms of:

    <bullet> Eligible securities. Securities eligible to be traded 
in the morning auction will be limited to NNM securities. Both 
Nasdaq and exchange-listed securities are eligible for trading in 
the evening auctions.
    <bullet> Time period for order entry. The time period during 
which a participant may enter a limit order for auction trading will 
be limited to the period from 9:00 a.m. to ``auction end'' time--a 
minimum of 45 minutes and a maximum of one hour. Participants in the 
evening auctions may enter orders within a two-hour period (from 
3:00 p.m. to 5:00 p.m.) prior to the 5:00 p.m. auction, and a one-
half hour period prior to the 5:30 p.m.
    <bullet> Price increments for entered orders. Orders must be 
entered in \1/8\ point price increments, and are limited to ``odd'' 
sixteenths (i.e., \1/16\, \3/16\, \5/16\, etc.). By contrast, 
participants in the evening auctions enter orders in increments of 
\1/16\ point.\13\
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    \13\ The purpose of the minimum \1/8\ increment is to encourage 
early entry of Open Book orders, by protecting those orders from 
being out-bid or out-offered by small amounts, such as sixteenths, 
at the end of the auction. The purpose of requiring the minimum 
increments to fall on odd sixteenths is to allow a participant to 
enter an order that may potentially trade at a price that is within 
that spread in the Nasdaq market.
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    <bullet> Absemce of Match Book Service. The Match Book, which is 
available for the evening sessions, is not available for the morning 
auction.
    <bullet> Same-day transaction reporting. ITG, the clearing and 
crossing broker for AZX, will have same-day reporting obligations 
with respect to securities traded during the morning auction.\14\
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    \14\ See Section 11A of the Act, 15 U.S.C. Sec. 78K-1; and 
Schedule D to the NASD's By-Laws, NASD Manual (CCH) Sec. 1867, at 
1637-1643.
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IV. Comment Letters

    The Commission received two comments on the AZX proposal, from the 
Pacific Stock Exchange (''PSE'') and the National Association of 
Securities Dealers, Inc. (``NASD'').\15\ In their comment letters, the 
NASD and PSE stated that they did not oppose AZX's operation during 
regular trading hours. Both commenters, however, expressed concern that 
the new morning auction would likely cause AZX's volume to increase so 
as to invalidate the limited volume exemption. Furthermore, they stated 
that the operation of the morning auction should subject AZX to all the 
rules and regulations to which registered national securities exchanges 
are subject. In particular, they argued that AZX should be treated 
similarly to the Chicago Match System operated by the Chicago Stock 
Exchange (``CHX'') and be regulated as a national securities 
exchange.\16\ Finally, they raised issues dealing with AZX's compliance 
with the Act and the NASD's rules.
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    \15\ Letters from: Richard G. Ketchum, Executive Vice President, 
NASD, dated August 11, 1995 (``NASD Letter'') and David P. Semak, 
Vice President, PSE, dated September 1, 1995 (``PSE Letter''), 
included in File No. 10-100.
    \16\ In particular, the NASD notes that AZX should not be able 
to trade more NNM securities than other exchanges do through 
unlisted trading privileges, i.e. 500 maximum.
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V. Discussion

A. Consistency of Morning Operation With Exemption Order and No-action 
Letter
    The current Exemption Order and NO-action Letter are premised on 
AZX's conducting auctions at discrete, relatively infrequent points of 
time, the absence of broker-dealer participants who have market-maker 
type obligations, and after-hours operation as elements that justify an 
expectation that AZX will have only limited volume as required for an 
exemption under Section 5 of the Act.\17\ The Commission reserved the 
right to apply further conditions or rescind the exemption if 
circumstances changed or AZX did not operate as originally 
represented.\18\ The Commission did not preclude AZX from conducting a 
morning trading session during regular trading hours. Rather, the 
Commission envisioned that AZX would have to file such a proposed 
change as an amendment to its original application for exemption 
pursuant to Rule 6a-1 under the Act,\19\ and that the Commission would 
evaluate the proposal to determine whether AZX would continue to 
warrant an exemption from exchange registration.
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    \17\ Exemption Order, 56 FR at 8380.
    \18\ Exemption Order, 56 FR at 8383.
    \19\ 17 CFR 240.6a-1.
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    The Commission believes that the mere existence of an early morning 
trading session should not change AZX's status as an exempted exchange. 
As previously, AZX will continue to conduct a very limited number of 
auctions at discrete, relatively infrequent points of time and will not 
have broker-dealer participants who owe market-maker type obligations 
to AZX. The limited volume exemption

[[Page 29147]]

continues to be premised on AZX's average daily volume (including both 
day and after-hours auctions) remaining below the average daily volume 
of the lowest volume national securities exchange.\20\ The average 
daily volume currently experienced by AZX is well below that of the 
lowest volume national securities exchange.\21\ Moreover, given the 
wide range of alternative trading environments for registered equity 
securities available to investors during regular trading hours, the 
mere operation of a single AZX morning session does not seem likely to 
cause AZX's volume to exceed the volume of any national securities 
exchange. Should AZX's volume to exceed the volume of any national 
securities exchange. Should AZX's volume exceed the limited volume 
threshold, however, the Commission may rescind the exemption and 
require AZX to register as a national securities exchange under Section 
6 of the Act.\22\
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    \20\ The Exemption Order states that the ``volume levels of 
fully regulated national securities exchanges provide a useful 
benchmark,'' and the Commission would be concerned if the volume of 
an exempted exchange ``exceeded that of any of the fully regulated 
national securities exchanges.'' Exemption Order, 56 FR at 8380.
    \21\ The Philadelphia Stock Exchange (``Phlx'') is currently the 
lowest volume national securities exchange. For calendar year 1995, 
the average daily volume of the Phlx was approximately 5,965,346 
shares. In its comment letter the NASD argues that, in determining 
whether AZX is no longer eligible for the limited volume exemption, 
the Commission is required to apply, as its benchmark for limited 
volume, the average daily volume reported by the Cincinnati Stock 
Exchange (``CSD'') as of the date of the Exemption Order.
    Contrary to the NAS's argument, nothing in the Exemption Order 
limits the Commission's review to the volume level of the CSE at the 
time of the Exemption Order. Rather, the Commission's statement that 
it would be concerned over the competitive implications of AZX 
volume exceeding ``any of the fully regulated national securities 
exchanges'' focuses on current volume reported by the national 
securities exchanges. Accordingly, at the present time, a comparison 
of AZX's volume levels to the reported volume of the Phlx is an 
appropriate benchmark.
    \22\ The Exemption Order states that ``[s]hould the Commission 
learn that any of the conditions set forth in this Order or 
otherwise imposed upon the granting of this exemption have been 
breached * * * the Commission will commence a review to determine 
whether to rescind the exemption.'' Exemption Order, 56 FR 8383.
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B. Equal Regulation in the Securities Markets
    Both the NASD and PSE expressed a concern that regulatory fairness 
was jeopardized by allowing AZX to operate without being bound by the 
rules applicable to other exchanges. As an example, they cited the 
operation of the Chicago Match System which was regulated according to 
the rules and regulations governing national securities exchanges.\23\
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    \23\ The Chicago Match System recently ceased operations.
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    The Chicago Match System was a facility of the Chicago Stock 
Exchange (``CHX''), a national securities exchange; as such, it was 
regulated as part of the CHX. By comparison, the Commission determined 
not to regulate AZX as a national securities exchange due to low 
volume. Consequently, the AZX auction is not a facility of any national 
securities exchange. Accordingly, the requirements that apply to the 
facilities of national securities exchanges do not necessarily apply to 
AZX.
C. Surveillance
    As a condition of the Exemption Order, AZX undertook to conduct 
surveillance with respect to after-hours trading to detect, among other 
things, potential insider trading and manipulative abuses. In their 
comment letters, the NASD and PSE expressed concern regarding whether 
those surveillance procedures remain adequate with respect to the 
regular-hours auction, because the regular-hours auction will take 
place while other markets for AZX-eligible securities are 
operating.\24\ In response to these concerns, AZX has agreed to 
implement a number of additional surveillance procedures to detect 
possible market manipulation and insider trading. The new surveillance 
procedures, among other things, require AZX to compare auction prices 
and bids and offers entered into AZX with activity in the primary 
trading market for the security, and to monitor the effects of an order 
cancellation or order revision on the primary market.
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    \24\ In view of the potential impact that daylight trading could 
have on trading in other markets, the NASD suggested that AZX 
specify the exact time of the daylight auction. AZX states in its 
amendment to its exemptive application that it will establish a set 
time for the auction, to be announced prior to conducting the 
initial auction.
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D. Limitations on Unlisted Trading Privileges
    The NASD argued that AZX should be subject to the restrictions on 
unlisted trading privileges (``UTP'') to which national securities 
exchanges are subject under Temporary Commission Approval of the Joint 
Industry Plan for Exchange Trading of Nasdaq National Market Securities 
(``Temporary Approval''), i.e., no participant national securities 
exchange may trade more than 500 NNM securities on an unlisted 
basis.\25\ AZX proposes to trade only 15 NNM securities at the outset, 
although this number may increase. By virtue of its limited volume 
exemption, AZX is not subject to rules and regulations governing 
national securities exchanges, and thus would not be subject to the 
limits in place under the Temporary Approval. Moreover, premising AZX's 
operation on limited volume places a restraint on AZX volume to which 
national securities exchanges trading NNM securities based on UTP are 
not subject. It would be needless at this time to further restrain AZX 
volume by limiting the number of NNM securities it may trade. However, 
the Commission reserves the right to revisit this issued should the 
number of NNM securities traded in the morning auction approach 500.
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    \25\ Until last year, participant national securities exchanges 
were limited to 100 NNM securities. In August 1995, however, the 
Commission expanded the number or NNM securities that a participant 
national securities exchange could trade to 500 securities. See 
Securities Exchange Act Release No. 36102 (August 14, 1995), 60 FR 
43626.
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E. Compliance with NASD Rules
    1. Limit Order Protection. The NASD expressed concern regarding 
whether AZX's procedures adequately facilitate surveillance of possible 
violations of the NASD's Limit order Protection Interpretation 
(``Interpretation'') by AZX participants who are NASD members.\26\ The 
Interpretation generally prohibits a member firm that accepts and holds 
an unexecuted customer limit order from its own customer or the 
customer of another member from ``trading ahead'' of the customer limit 
order at a price that would satisfy the customer limit order, unless it 
also executes the limit order.
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    \26\ NASD Manual (CCH), Rules of Fair Practice, Art. III, 
Section 1, Sec. 2151.07.
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    Under its surveillance procedures, AZX will maintain records of 
every order entered into the system and will provide the NASD, on 
request, with access to the identities of participants who have entered 
specific orders. In addition, pursuant to the enhanced surveillance 
procedures it has adopted, AZX also will monitor instances in which an 
order is entered at a price that is outside the Nasdaq best bid and 
offer for a particular security. These procedures will facilitate 
detection of possible instances of violation of the NASD's 
Interpretation.
    2. Proposed NAqcess Rules. The NASD also raised an issue regarding 
the applicability of the proposed NAqcess rules to AZX participants who 
are NASD members. NAqcess is a proposed Nasdaq system intended to 
provide small customer orders with limit order

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protection and price improvement.\27\ In general, the NAqcess rules as 
proposed would apply to AZX participants who are NASD members.
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    \27\ See Securities Exchange Act Release No. 36548 (December 1, 
1995), 60 FR 63092.
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    The enhanced surveillance procedures adopted by AZX appear to be 
consistent with the proposed NAqcess rules. Because the NAqcess rules 
are currently in the proposing stage, however, it is premature to 
consider the need for possible changes to AZX's surveillance 
procedures. The Commission will address this issue prior to the 
approval of any NAqcess rules.
    3. Short Sale Rule. The NASD notes that its short sale rule would 
apply to AZX participants who are NASD members.\28\ AZX has taken 
measures to promote compliance with the NASD short sale rule by its 
members. Specifically, orders that are entered into AZX and that 
constitute short sales are put in the Balanced Book and not the Open 
Book. At the time of the auction, if it appears that certain of these 
orders, if executed, would breach the short sale restriction, then they 
will not be allowed to participate in the auction.
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    \28\ Art. III, Section 48 of the Rules of Fair Practice, NASD 
Manual (CCH) Sec. 2200H, at 2216.
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F. Terms and Conditions of the Exemption
    All of the original terms and conditions of the Exemption Order 
remain in effect. The Amended Order notes, in this connection, that the 
following reporting requirements of the Order may be satisfied by 
compliance with the recordkeeping and reporting requirements contained 
in Rule 17a-23 under the Act: \29\
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    \29\ Rule 17a-23 requires registered broker-dealer sponsors of 
certain automated trading systems (``broker-dealer trading 
systems'') to make and keep current certain records, and file 
reports with the Commission (and in certain circumstances, with the 
appropriate self-regulatory organization) regarding the operation of 
the system. ITG, the crossing broker for AZX, is subject to Rule 
17a-23 with respect to the operation of AZX.

    <bullet> The number and identity of system participants;
    <bullet> The volume of business (expressed in dollars, 
transactions, and shares) transacted through the system;
    <bullet> Instances when system participants failed to deliver 
securities or make payment (expressed in transactions, shares and 
dollars); and
    <bullet> A list of securities trading on the system.
    The following information also must continue to be reported 
pursuant to the Exemption Order:
    <bullet> The identity of applicants denied participation and 
reasons for the denial;
    <bullet> The number of auctions conducted; and
    <bullet> The prices at which particular blocks of securities 
were sold during the auctions.

VI. Conclusion

    The Commission has reviewed AZX's amendment to its application for 
exemption from registration as a national securities exchange and has 
determined that AZX continues to qualify for the limited volume 
exemption under the Act. As it found in the Exemption Order, the 
Commission finds that, by reason of the limited volume of transactions 
effected on AZX, it is not practicable and not necessary or appropriate 
in the public interest or for the protection of investors to require 
AZX's registration as a national securities exchange, subject to the 
conditions described herein.
    It is therefore ordered that AZX's Exemption Order be amended to: 
(1) Grant AZX Inc.'s amended application for exemption from 
registration as a national securities exchange; and (2) reflect changes 
to the operation of the system as set forth herein.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 96-14399 Filed 6-6-96; 8:45 am]
BILLING CODE 8010-01-M