June 4, 2002
Edward S. Knight
Re: Request for Interpretive Guidance and Exemptions from Rule 11Ac1-5 for SelectNet and SuperMontage Transactions
Dear Mr. Knight:
In your letter dated June 4, 2002 ("Letter"), The Nasdaq Stock Market, Inc. ("Nasdaq") requested that the Securities and Exchange Commission ("Commission") temporarily exempt orders received through Nasdaq's SelectNet system from the reporting requirements of Rule 11Ac1-5 ("Rule") under the Securities Exchange Act of 1934 ("Exchange Act").1 Nasdaq also requested the Commission to exempt the initial display of orders in Nasdaq's Order Display Facility of the SuperMontage system from the reporting requirements of the Rule. In addition, Nasdaq requested interpretive guidance from the Commission's Division of Market Regulation ("Division") with respect to the reporting requirements of the Rule for the types of orders that will be received in the directed order and non-directed order processes of SuperMontage. This letter responds to Nasdaq's request.
Adopted in November 2000,2 the Rule generally requires a "market center" (as defined in the Rule) that trades national market system securities to make available to the public monthly electronic reports that include uniform statistical measures of execution quality. The Rule has been in effect for all national market system securities since October 1, 2001.
The Rule requires every market center to make available for each calendar month a report on the covered orders in national market system securities that it received for execution from any person.3 Under the Rule, the term "market center" is defined to mean "any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association."4 In addition, the Rule defines the term "covered order" to mean "any market order or any limit order (including immediate or cancel orders) received by a market center during regular trading hours at a time when a consolidated best bid and offer is being disseminated, and, if executed, is executed during regular trading hours." However, the Rule excludes from that definition orders for which the customer requests "special handling for execution," including, among other things, "orders to be executed at their full size."
On June 22, 2001, the Division issued interpretive guidance regarding the application of the Rule to certain SelectNet orders.5 Among other things, the Division took the position that all-or-none ("AON") orders and minimum acceptable quantity ("MAQ") orders routed through SelectNet to SuperSoes Participants (i.e., those market participants that agree to accept automatic executions through Nasdaq's SuperSoes system) for amounts at least 100 shares greater than the firm's displayed quote would not be "covered orders," as defined in paragraph (a)(8) of the Rule. At the same time, orders that SuperSoes Participants receive through SelectNet from exchanges that trade Nasdaq securities pursuant to unlisted trading privileges were exempted from the Rule.
The Letter states that two events have occurred since the June 22, 2001 letter that bring a number of transactions not currently covered by the June 22, 2001 letter within the scope of the Rule's reporting requirements for SuperSoes Participants. First, after the commencement of SuperSoes in July 2001, Nasdaq implemented a change to SelectNet that permits SuperSoes Participants to receive non-liability orders entered at a price that is inferior to the displayed quote of the participant to which the order is directed.6 In the absence of an exemption, Nasdaq believes that SuperSoes Participants that receive those orders would be required to report them under the Rule.
Second, on November 19, 2001, the Commission approved Amendment No. 12 to the Nasdaq/UTP Plan ("Plan"). Amendment No. 12 included a provision that makes Nasdaq SmallCap securities eligible to be traded under the Plan,7 which brings SmallCap securities within the scope of the Rule.8 The order type restrictions in SelectNet that apply to national market system securities (i.e., AON and MAQ orders) do not apply to transactions in SmallCap securities.9 Accordingly, Nasdaq believes that in the absence of another exemption, SuperSoes Participants are required under the Rule to report orders in SmallCap securities that they receive through SelectNet. As discussed below, SuperMontage will replace SelectNet and SuperSoes. As a result, Nasdaq has requested that the Commission temporarily exempt all SuperSoes participants from the reporting requirements of the Rule for orders they receive through SelectNet while SuperMontage is being implemented.
On January 19, 2001, the Commission approved Nasdaq's proposal to establish SuperMontage, which is scheduled to be implemented in the third quarter of 2002.10 Among other things, SuperMontage will allow users to view and access aggregated pools of liquidity. In addition, SuperMontage will allow market centers to enter into and maintain in the system multiple quotes and orders at the same or different price levels that are either attributed to the market center (i.e., displayed under the market center's identifier) or that are not attributed to a particular market center (i.e., displayed under the "SIZE" identifier).
Once it is fully implemented, SuperMontage will be the primary means for accessing liquidity in Nasdaq. As such, it will replace SelectNet and SuperSoes. SuperMontage will permit orders to be entered under one of two processes: the directed order process and the non-directed order process. With respect to Rule 11Ac1-5 reporting requirements, Nasdaq believes that SuperMontage is not directly analogous to any current Nasdaq system. Accordingly, the Letter seeks exemptive relief and interpretive guidance in connection with Nasdaq's reporting obligations under the Rule with respect to SuperMontage.
Nasdaq believes that SuperMontage, which is a facility of Nasdaq, will meet the definition of a market center and as such will have a reporting obligation provided that it received covered orders for execution from any person. The Letter states that, in Nasdaq's view, there are two distinct order events that must be analyzed in determining what reporting obligations Nasdaq will have with respect to SuperMontage: (1) the initial display of orders or quotes in the Order Display Facility and (2) the execution of orders or quotes received for display or for execution.
1. Display of Orders and Quotes in SuperMontage
SuperMontage will permit, but not require, market makers, alternative trading systems (including electronic communications networks ("ECNs")), and exchanges that trade Nasdaq securities pursuant to a grant of unlisted trading privileges ("UTP Exchanges") to enter multiple quotes or orders at the same price or at different prices. In Nasdaq's view, an order or quote displayed in the Order Display Facility of SuperMontage that is the proprietary interest of the market participant displaying the order or quote would not meet the definition of a covered order and therefore would not impose a reporting obligation on Nasdaq under the Rule for receiving the order or quote. Nasdaq believes, for example, that if a Nasdaq market maker displayed a proprietary quote in SuperMontage that did not consist of a customer order then neither the market maker that generated the quote nor Nasdaq would be required under the Rule to report it.
However, the Letter also takes the position that if a market center receives an order from another person and chooses to post that order in SuperMontage, then both the receiving market center and Nasdaq would have a reporting obligation under the Rule with respect to the order. Nasdaq believes that it would be duplicative for both Nasdaq and the other market center to report on such orders because the market center that initially receives the order is required to report on that order from the time it is received until it is executed or canceled, which would include the period that it is displayed in SuperMontage.
Nasdaq has requested the Division to confirm that proprietary quotes posted in SuperMontage are not covered orders under the Rule. In addition, Nasdaq has requested an exemption from reporting on all orders that another market center displays in SuperMontage because the other market center is already required under the Rule to publish a report of those orders.
2. Execution of Orders and Quotes through SuperMontage
In addition to providing a facility for the display of orders and quotes, SuperMontage will replace Nasdaq's current SOES and SelectNet systems for accessing those quotes and orders with two new processes: a directed order process and a non-directed order process.11 Market participants that wish to use either of these processes to interact with the quotes or orders of other market participants (or with their own) may do so by entering orders into SuperMontage.
a. Directed Orders
The Letter states that the directed order process will be functionally similar to the current SelectNet service in that it will allow a user to direct an order to a particular market center and that it will not provide automatic execution capability to those entering orders. As in SelectNet, a directed order can match a posted quote or order of the recipient (a liability order) or not match any quote or order of the recipient (a non-liability order). To avoid creating a risk of double liability, no receiving market center is required to receive directed liability orders through SuperMontage, but may elect to do so.
Unless the market center to which a directed order is being sent has agreed to accept directed liability orders, a directed order must be a non-liability order and must be designated as: (1) all-or-none ("AON") with a size at least one unit of trading greater than the size of the attributable quote or order of the market participant to which the order is directed; or (2) a minimum acceptable quantity order ("MAQ") with a MAQ value of at least one unit of trading greater than the size of the attributable quote or order of the participant to which the order is directed. Nasdaq believes that AON and MAQ orders are excluded from the Rule 11Ac1-5 definition of covered order because they contain special handling instructions. Therefore, Nasdaq believes that no market center, including Nasdaq, should be required to report on directed orders that are non-liability orders. In addition, Nasdaq believes that the role it plays in the directed order process is that of an order routing system like SelectNet, as opposed to an order execution system, and Nasdaq therefore is of the view that it should not be required to report on any directed orders that SuperMontage receives.
b. Non-Directed Orders
The non-directed order process will be the default execution process for marketable orders entered into SuperMontage. A marketable order entered into the non-directed order process will be matched with the highest ranked quotes or orders on the opposite side of the market and either will be executed automatically or delivered on a liability basis, depending upon how the particular market center participates in the non-directed order process (i.e., market makers will be required to receive automatic executions, ECNs and UTP Exchanges that choose to take automatic executions will receive executions, and other market participants will receive liability orders).
SuperMontage will offer three order execution algorithms in the non-directed order process. The market participant entering a non-directed order may select the algorithm used for executing its order, but the system will default to price/time priority if none is selected. Within each algorithm, a non-directed order entered by a quoting market participant will be matched first against its own quote or order on the other side of the market, if it is at the SuperMontage best bid or offer (BBO). In addition, a market participant entering a non-directed order will be permitted to "preference" the order to a particular market participant, if that participant's quote or order is at the BBO. Nasdaq is of the view that it should be obligated to report under Rule 11Ac1-5 on all orders that it receives through the non-directed order process.
A. Exemption from the Rule for SelectNet Orders
On the basis of your representations and the facts presented, the Commission, by the Division pursuant to delegated authority,12 is using its authority under paragraph (c) of the Rule to exempt temporarily all SuperSoes Participants (i.e., market participants that have agreed to accept automatic executions in SuperSoes) from the reporting requirement of paragraph (b)(1) of the Rule for all orders received through SelectNet, until the earlier of (1) December 31, 2002; or (2) the date on which SuperMontage is implemented with respect to all securities that are subject to Rule 11Ac1-5 reporting obligations. Nasdaq has represented that, when SuperMontage is fully implemented, it will be the primary means for accessing liquidity in Nasdaq and it will replace SelectNet and SuperSoes. Nasdaq has indicated the manner in which it will comply with the Rule's reporting requirements with respect to SuperMontage. In addition, as noted above, the Commission already has exempted from the Rule certain orders that SuperSoes Participants receive through SelectNet. In light of Nasdaq's representation that SelectNet will be replaced by SuperMontage, the Commission finds that exempting the SelectNet orders not exempted by the June 22, 2001 Letter is necessary or appropriate in the public interest, and is consistent with the protection of investors.
B. Exemption from the Rule for Orders Displayed in SuperMontage
The Commission, by the Division pursuant to delegated authority, is also exempting from the reporting requirement of Rule 11Ac1-5 all orders that SuperMontage initially receives for display or maintenance within the system. The Commission does not agree that all proprietary trading interests displayed would not meet the definition of a covered order under the rule. However, the Commission does agree that covered orders displayed in SuperMontage already should be subject to reporting under the Rule by the market center displaying the order. Accordingly, the Commission believes that it would be duplicative for both Nasdaq and the market centers to prepare reports under the Rule for those orders. The Commission therefore finds that the exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. However, the Commission emphasizes that this exemption will terminate if and when SuperMontage accepts orders in the display that are not controlled by or represented by market centers that have a reporting obligation under the Rule for such orders.
C. Interpretive Positions with respect to SuperMontage
The Division agrees with Nasdaq's position that AON and MAQ orders are excluded from the Rule's definition of covered order and therefore are not subject to the Rule's reporting requirements. As noted above, the Rule's definition of a covered order specifically excludes orders that may only be executed at their full size. By their terms, AON and MAQ may only be executed at their full size. In addition, Nasdaq has represented that a directed order that is a non-liability order must be designated as AON or MAQ. Based on that representation, the Division believes that the reporting requirements of the Rule do not apply to non-liability orders effected through the directed order process of SuperMontage.
The Division further agrees that Nasdaq is not obligated to report on any orders that SuperMontage receives through the directed order process (i.e., both liability orders and non-liability orders) because such orders are routed to another market center for execution and are not executed in SuperMontage. In particular, the Division agrees that in the directed order process SuperMontage performs an order routing function similar to that of SelectNet, which the Division has previously stated is not a market center.13 However, this position is based on the assumption that orders in the directed order process of SuperMontage are directed to market centers with a reporting obligation under the Rule.
Finally, the Division agrees with Nasdaq's position that it is obligated to report under the Rule on all orders that SuperMontage receives through the non-directed order process. SuperMontage will manage the execution of all orders received through the non-directed order process, either by carrying out the execution directly or delivering it as a liability order requiring execution under Nasdaq's rules (with limited exceptions).
The interpretive views expressed in this letter are those of the Division only. The Commission is not bound by these views and may interpret the Rule as it deems necessary or appropriate in the public interest or for the protection of investors. Because this position is based on the representations made to the Division, any different facts or conditions might require different conclusions. Further, the exemptions granted in this letter are subject to modification or revocation at any time if the Commission determines that such action is necessary or appropriate in the public interest or otherwise in furtherance of the purposes of the Exchange Act.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority.
Robert L.D. Colby
1 17 CFR 240.11Ac1-5.
2 Securities Exchange Act Release No. 43590 (November 17, 2000), 65 FR 75414 ("Adopting Release").
3 Exchange Act Rule 11Ac1-5(b)(1), 17 CFR 240.11Ac1-5(b)(1).
4 Exchange Act Rule 11Ac1-5(a)(14), 17 CFR 240.11Ac1-5(a)(14).
5 Letter from Annette L. Nazareth, Director, Division, to Richard G. Ketchum, President, The Nasdaq Stock Market, Inc. dated June 22, 2001 ("June 22, 2001 Letter").
6 NASD Rule 4720(c)(iii); see Securities Exchange Act Release No. 44506 (July 3, 2001), 66 FR 36020.
7 Securities Exchange Act Release No. 45081 (November 19, 2001), 66 FR 59273.
8 See Exchange Act Rule 11Ac1-5(b)(1), 17 CFR 240.11Ac1-5(b)(1) (providing that the reporting requirement applies to covered orders in national market system securities); Exchange Act Rule 11Aa2-1, 17 CFR 11Aa2-1 (providing that a "national market system security" is any reported security as defined in Exchange Act Rule 11Aa3-1); Exchange Act Rule 11Aa3-1(a)(4), 17 CFR 240.11Aa3-1(a)(4) (providing that a "reported security" is any security for which transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan).
9 See Securities Exchange Act Release No. 42344 (January 14, 2000), 65 FR 3987 (order approving SuperSoes rules).
10 See Securities Exchange Act Release No. 43863 (January 19, 2001), 66 FR 8020.
11 The Letter states that Nasdaq participants are not required to use either the directed or non-directed order process to execute their orders but instead may choose, systematically or on an order-by-order basis, to continue to use other methods such as telephone access or direct connections to market makers, ECNs, and UTP Exchanges. In addition, the Letter states that any Nasdaq member is free to offer a competing execution service, and may even use the Nasdaq service as one of its options.
12 17 CFR 200.30-3(a)(69).
13 Division of Market Regulation: Staff Legal Bulletin Number 12, Response to Question 10 (June 22, 2001).