National securities exchanges and registered securities associations, along with registered clearing agencies and the Municipal Securities Rulemaking Board, are collectively termed self-regulatory organizations (SROs) under Section 3(a)(26) of the Securities Exchange Act of 1934 (Exchange Act). NASD is the SRO of the securities industry responsible for regulating the over-the-counter (OTC) securities market and the products traded in it. NASD’s responsibilities are contained in Section 15A of the Exchange Act, and it operates subject to SEC oversight. NASD has responsibility for ensuring that its members comply with federal securities laws and NASD rules. It is the largest SRO in the United States, with a membership that includes virtually every broker/dealer in the nation that does a securities business with the public. Through its subsidiaries, NASD Regulation, Inc. (NASDR) and the Nasdaq Stock Market, Inc. (Nasdaq), NASD develops rules and regulations, conducts regulatory reviews of members’ business activities, and designs and operates marketplace services and facilities. NASD helps to establish and coordinate the policy agendas of its two subsidiaries and oversees their effectiveness. It has delegated to Nasdaq the obligation to develop, operate, and maintain systems, services, and products for the securities markets that NASD operates. It has also delegated to Nasdaq responsibility for formulating regulatory policies and listing criteria applicable to the markets it operates. The Nasdaq Stock Market began operation in 1971 as the first electronic, screen-based stock market for nonexchange listed securities. Nasdaq enables securities firms to execute transactions for investors and for themselves in an environment of real-time trade reporting and automated market surveillance. As of December 1997, more than 6,200 securities were traded on Nasdaq, representing approximately 5,500 companies. In addition to its screen-based operations, Nasdaq is distinguished from stock exchanges by its use of multiple market makers—independent dealers who openly compete with one another for investors’ orders in each Nasdaq security. Nasdaq has two tiers: the Nasdaq National Market, where approximately 4,200 of Nasdaq’s larger companies are listed and traded; and the Nasdaq SmallCap Market, where approximately 1,300 smaller, emerging growth companies are traded. Before a company’s stock can be traded on the Nasdaq Stock Market, the company must be admitted to Nasdaq. Upon request, the company receives written notice of the applicable Nasdaq qualifications requirements. The company must then submit a listing application (together with supporting financial statements) in which it states that it (1) will abide by all applicable marketplace rules, (2) currently meets the applicable requirements for inclusion of its stock in Nasdaq, (3) will file with NASD copies of all reports or other information filed with SEC or other regulatory authorities, and (4) will pay the fees associated with inclusion in Nasdaq. As part of the new listing requirements, all companies listing on the Nasdaq Stock Market are required to sign and complete a listing agreement in addition to the listing application. Nasdaq has authority over the initial and continued inclusion of securities in its markets in order to maintain the quality of and public confidence in its markets. Nasdaq may deny initial inclusion or delist securities even though the securities meet all criteria for initial or continued inclusion. “. . . the NASD’s role in Nasdaq is the same as that of the organized exchanges with respect to the lists of securities traded on them. . . . primary emphasis must be placed on the interests of prospective future investors. The latter group is entitled to assume that the securities in the system meet the system’s standards. Hence, the presence in Nasdaq of non-complying securities could have a serious deceptive effect.” SEC’s statutory oversight responsibilities regarding Nasdaq’s listing requirements include its authority to (1) review and approve or deny SRO-proposed rule changes, (2) inspect SROs, and (3) review listing decisions either on appeal or by its own initiative. SRO rules and proposed rule changes may cover such activities as organization and administration, financial products traded, business conduct, and discipline. SRO rules also include listing requirements for traded companies. Nasdaq’s listing requirements are embodied in its marketplace rules. SEC reviews SRO-proposed rules to ensure that they are consistent with the requirements of the Exchange Act and subsequent regulations. If SEC cannot make such a finding, it must disapprove the proposed rule change. On February 28, 1997, NASD filed a proposed rule change with SEC to make listing requirements for issuers listed on Nasdaq more stringent. SEC approved the rule change on August 22, 1997. In addition to its authority to approve SRO-proposed rules, the Exchange Act authorizes the Commission to conduct “reasonable periodic, special, or other examinations” of “ll records” maintained by SROs. These examinations, or inspections, may be conducted “at any time, or from time to time,” as the Commission “deems necessary and appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of this title.” The SEC office responsible for conducting these inspections is the Office of Compliance Inspections and Examinations (OCIE). The Commission created OCIE in 1995 to streamline and improve the inspection process. Previously, the responsibility for inspections was divided between the Divisions of Market Regulation and Investment Management. OCIE’s stated mission is to protect investors, foster compliance with the securities laws, and deter violative conduct through effective inspections of regulated entities. Among the types of inspections OCIE conducts are routine oversight inspections of programs administered by securities industry SROs to monitor the effectiveness with which these organizations fulfill their statutory responsibilities under the federal securities laws. These inspections test SROs’ compliance with their regulatory and other duties, and they are to be routinely conducted on a cyclical basis. OCIE does not inspect an entire SRO, focusing instead on particular program areas. OCIE has inspected several programs in each SRO annually. Its inspection goals are based on such criteria as an established inspection cycle, length of time since last visit, known problems, or recent program developments.Inspection reports are to be reviewed internally by senior management within OCIE as well as by the Commissioners, where appropriate. This review focuses on Nasdaq’s Listing Department and SEC’s Office of Compliance Inspections and Examinations, the office responsible for oversight of SROs. To determine how SEC met its oversight responsibilities regarding SRO listing programs, we reviewed SEC inspection reports, inspection workpapers, annual reports, and other SEC internal documents. We also interviewed SEC officials. To determine whether Nasdaq followed its listing and maintenance requirements with regard to Comparator, we reviewed NASD and Nasdaq manuals; Nasdaq, NASDR, and SEC documents and court papers; and SEC filings. We also interviewed Nasdaq and SEC officials. To identify the actions Nasdaq has taken since May 1996, we reviewed Nasdaq documents and SEC filings. To determine how Nasdaq monitors exceptions to its listing and maintenance requirements, we interviewed Nasdaq officials and reviewed NASD and Nasdaq manuals. We obtained written comments on a draft of this report from SEC (see app. I) and Nasdaq (see app. II), and their comments are discussed at the end of this letter. We did our work in Washington, D.C., between February and September 1997 in accordance with generally accepted government auditing standards. SEC oversight actions related to Nasdaq’s Listing Department included approving two rule changes NASD proposed to make its Smallcap listing requirements more restrictive. In 1997, SEC also inspected Nasdaq’s Listing Department for the first time since 1986. In 1991, and again in 1997, NASD proposed, and SEC approved, rule changes that made listing and maintenance requirements more restrictive for the SmallCap Market. For example, the 1991 change doubled from $2 million to $4 million the assets NASD required of companies applying for listing. The 1997 change tightened this asset requirement from total assets of $4 million to net tangible assets of $4 million. Net tangible assets are total assets minus total liabilities and goodwill. The 1997 rule change retained the $1 minimum bid price for common and preferred stock for continued listing. However, the 1997 rule change removes an alternative available under the 1991 rule allowing a company to maintain its listing when its bid price falls below $1, as long as its capital and surplus exceed $2 million and the market value of its public float exceeds $1 million. NASD’s rationale for this requirement was that it provided a safeguard against certain market activity associated with low-priced securities. Nasdaq officials said the new quantitative listing and maintenance requirements would further protect investors and enhance the quality and credibility of the Nasdaq Smallcap Market. In addition to the quantitative requirements, NASD’s 1997 rule change also included a peer review requirement for independent auditors of Nasdaq SmallCap listed companies. To meet this requirement, these companies must be audited by an independent auditor that has received or is enrolled in a peer review program that meets acceptable guidelines and is subject to oversight by an independent body. To qualify, such a peer review program must provide that an accounting firm’s quality control system is to be externally peer reviewed every 3 years. Nasdaq officials believe that this requirement will improve the quality and stability of Nasdaq companies. When the 1997 rule change was adopted, Nasdaq officials estimated that about 30 percent of companies listed on the SmallCap Market would no longer be eligible for continued listing. Companies currently listed have 6 months to meet the new maintenance requirements (until February 22, 1998).