Opinion ID: 476815
Heading Depth: 2
Heading Rank: 1

Heading: The Integrated Nature of the NASDAQ System

Text: 28 NASD's first basic argument is that the SEC improperly disregarded the integrated design and operation of the NASDAQ system in ordering NASD to exclude Level 2/3 query function costs from the NQDS subscriber fee. This argument appears in NASD's brief in a variety of forms, but the underlying theme is the same. 29 Seizing on the Commission's statement that NASD, in effect, should recover only those costs it would incur if it operated a pure 'pass-through' system, April order, 49 Fed.Reg. at 17,649, NASD asserts that the Commission erroneously based its orders on the theoretical costs of a theoretical 'pass-through' system rather than the real costs of an actual system used to provide the securities information. NASD Br. at 27 (emphasis in the original). In a related argument, it claims that the Commission's reliance on a hypothetical nonexistent system supplying no information contravenes the provisions of section 11A(c)(1)(C), (D) of the Act, 15 U.S.C. Sec. 78k-1(c)(1)(C), (D) (1982), which authorize the Commission to ensure public access to such information as is collected or distributed by exclusive securities information processors like NASD. NASD Br. at 46. NASD also argues that the Commission could not properly exclude query function costs in view of a consultant's finding that the NASDAQ system architecture is monolithic, integrated with respect to functionality, and not susceptible to component analysis of that functionality in a practical sense. Id. at 35. 30 Thus, the essence of NASD's argument is that it cannot be required to separate out query function costs from other NASDAQ system costs because the highly integrated design of the system does not lend itself to such a cost allocation. We must reject this argument, for it is inconsistent with one of the fundamental premises of rate regulation. The problem of allocating costs of common or integrated facilities among different groups of customers is hardly unique to the NASDAQ system; it is presented to some degree in virtually every ratemaking case. That it may be difficult to allocate costs does not provide an excuse for refusing to do so. As one economist has observed: 31 The fact that most services are typically provided in combinations, using the same facilities, does not mean that definable shares of the common costs can not in principle be causally attributed to each.... The cost allocation formulae actually employed may achieve only a rough, rule-of-thumb approximation to the actual costs for which each product or service is responsible, but those costs have objective reality. 32 1 A. Kahn, The Economics of Regulation: Principles and Institutions 78 (1970) (footnote omitted). 33 The Supreme Court has recognized that in allocating costs [p]recision and exactitude in the mathematical sense are not possible. Baltimore & Ohio Railroad v. Aberdeen & Rockfish Railroad, 393 U.S. 87, 92, 89 S.Ct. 280, 283, 21 L.Ed.2d 219 (1968). Even in cases involving highly integrated facilities, cost allocations required by an agency will be upheld if they are not arbitrary and are supported by a reasoned analysis. MCI Telecommunications Corp. v. FCC, 675 F.2d at 413. Avoidance of cross-subsidization of services is a legitimate, non-arbitrary reason for requiring difficult cost allocations. See id. at 410. 34 In the instant case, the SEC articulated persuasive reasons for excluding the cost of the Level 2/3 query function from the NQDS subscriber fee. Most importantly, the Commission wished to prevent Instinet's subscribers from being forced to subsidize NASDAQ Level 2 service. If permitted such a subsidy, NASD would have been given an unfair competitive edge over Instinet in a market in which NASD already had the advantage of its former monopoly position. We find these reasons sufficient to support the Commission's decision to require NASD to make an admittedly difficult and imprecise cost allocation with respect to the Level 2/3 query function. 35 When the Commission's orders are viewed in this context, it is clear that they are not based on any sort of theoretical model of the NASDAQ system. Nor do they require NASD to distribute anything other than such information as is collected by the NASDAQ system. They simply require NASD to allocate the costs of services already provided by the current system. NASD can hardly complain that it is being treated unfairly; similar cost allocations are required in virtually all other regulated industries. 36 NASD protests that the Commission's exclusion of costs related to the query function will prevent it from recovering the full cost of validating new quotations entered into the NASDAQ system by market makers--a cost that the Commission concedes is integral to NQDS data collection and therefore properly recoverable from NQDS subscribers. NASD seems to believe that because certain NASDAQ computer capabilities--principally computer storage capabilities--support both the validation and query functions, it is prohibited by the SEC's orders from recovering any portion of the cost of these capabilities. 37 NASD's fears are not well founded. Any blanket exclusion of the cost of shared computer capabilities would violate the principle of functional cost allocation espoused in the April order. That no such blanket exclusion was intended is apparent from the language of the order, which states: 38 The Commission believes that validation of the quotation information within specified pre-existing parameters and in the correct format is a proper function of a marketplace, and thus may be considered part of the quotation collection system.... Even if validation is accomplished through comparison with inside quotations, the full storage capacity of all quotations is not necessary to validate quotations. Therefore, the Commission would expect that only a fraction of storage costs would be properly allocated to NQDS verification. 39 April order, 49 Fed.Reg. at 17,649-50 n. 92 (emphasis added). Thus, the Commission clearly intended to permit NASD to recover costs allocable to verification, irrespective of whether the computer capabilities involved also support the Level 2/3 query function. Similar logic would apply to all other capabilities that support both update and query functions: costs properly allocable to the updating of quotations may be recovered. Accordingly, NASD is free to substantiate such costs in any future rate proceeding.