==========================================START OF PAGE 1====== TABLE OF CONTENTS Page I. PROBLEMS OF THE NASDAQ STOCK MARKET . . . . . . . . . . 2 A. Quotes, Trades, and Trade Reporting . . . . . . . . 2 1. The Pricing Convention and Related Practices . . . . . . . . . . . . . . 2 a. The Pricing Convention . . . . . . . . . 2 b. Disincentive to Breaking the Spread . . . 14 c. Size Convention . . . . . . . . . . . . . 16 d. Pressure and Harassment . . . . . . . . . 18 e. Bear Stearns Meeting and Subsequent Narrowings . . . . . . . . . . 18 2. The NASD's Failure to Address Adequately the Pricing Convention and Related Practices . . . . . . . . . . . . . . 27 3. Coordinated Activity Among Market Makers . . . 37 a. Coordinated Quote Movements and Transactions . . . . . . . . . . . . 37 b. Agreements to Delay Trade Reports . . . . 40 c. Information Sharing . . . . . . . . . . . 41 B. Late Trade Reporting . . . . . . . . . . . . . . . 46 1. Late and Inaccurate Trade Reports . . . . . . 46 2. The NASD's Enforcement of Trade Reporting Rules Was Inadequte . . . . . . . . . . . . . 51 C. The Firm Quote Rule . . . . . . . . . . . . . . . . 55 1. The Importance of Firm Quotes . . . . . . . . 55 2. Failure to Honor Quotes . . . . . . . . . . . 57 3. Selective Refusal to Trade . . . . . . . . . . 58 ==========================================START OF PAGE ii====== 4. The NASD's Enforcement of the Firm Quote Rule Was Inadequate . . . . . . . . . . . . . 60 II. THE NASD'S REGULATORY DEFICIENCIES . . . . . . . . . . . 68 A. The SOES Controversy . . . . . . . . . . . . . . . 68 1. Origin of the SOES Controversy . . . . . . . . 68 2. SOES Rulemaking in Response to Market Maker Complaints . . . . . . . . . . . 70 a. Limiting Access to SOES . . . . . . . . . 70 b. Commission Action on SOES Rules Amendments . . . . . . . . . . 78 c. Effect of SOES Rules Amendments . . . . . 80 3. The NASD's Focus on the Examination and Disciplining of SOES Firms . . . . . . . . . . 81 4. Application of Standards and Criteria for Admission to Membership . . . . . . . . . . . 86 B. The NASD's Laxity in Rule Enforcement . . . . . . . 91 1. The NASD's Failure to Enforce Excused Withdrawal Rules . . . . . . . . . . . . . . . 91 2. The NASD's Inadequate Enforcement of MSRB Rule G-37 . . . . . . . . . . . . . . . . 95 C. Other Areas of Regulatory Concern . . . . . . . . . 97 1. Authority of District Business Conduct Committees . . . . . . . . . . . . . . 97 2. The Excess Spread Rule . . . . . . . . . . . . 98 3. The Contested Election Process . . . . . . . . 99 4. Audit Trail . . . . . . . . . . . . . . . . . 100 ==========================================START OF PAGE 1====== APPENDIX TO REPORT PURSUANT TO SECTION 21(a) OF THE SECURITIES EXCHANGE ACT OF 1934 REGARDING THE NASD AND THE NASDAQ MARKET This Appendix provides additional information and elaborates on certain of the issues identified in the Commission's Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market ("NASD Report").-[1]- As described in Part IV. of the NASD Report, the Commission staff's investigation of the NASD and the Nasdaq market occurred over a period in excess of eighteen months and included the review of thousands of hours of taped conversations, hundreds of thousands of pages of documents, and the testimony of dozens of market participants and NASD officials, employees, and committee members. Part I. of the Appendix describes certain conduct of Nasdaq market makers and the resulting problems with the operation and functioning of the Nasdaq market. Part I.A. describes the coordination by numerous market makers of quotes, trades, and trade reporting, including the pricing convention and the NASD's failure adequately to investigate and prosecute potential violations of its rules and the federal securities laws.-[2]- Part I.B. focuses on the problem of late trade reporting and the NASD's failure to enforce adequately the late trade reporting rules. Part I.C. describes the failure of numerous market makers to honor their quotes and the NASD's failure to enforce adequately the firm quote rules. Part II. of the Appendix describes other deficiencies in the NASD's performance of its statutory obligations as an SRO, as well as a number of other areas of general regulatory concern. ---------FOOTNOTES---------- -[1]- As is the case with the Report, the findings made herein are solely for the purpose of the Report and this Appendix and are not binding on any other person or entity named as a respondent or defendant in any other proceeding. It should be noted that the issuance of the Report and this Appendix, and the concurrent enforcement action against the NASD, do not preclude further enforcement actions against other persons or entities arising from activities uncovered in the investigation. -[2]- The record varies as to the degree of participation of particular market makers in the specific activities described in this Report. ==========================================START OF PAGE 2====== Part II.A. focuses on the issues surrounding the NASD's small order execution system ("SOES"), including the SOES rules, examination and discipline of SOES firms, and impediments to membership. Part II.B. discusses the NASD's laxity in enforcing its excused withdrawal rules and MSRB Rule G-37. Part II.C. discusses other issues identified in the investigation as areas of regulatory concern: (i) the excessive authority of District Business Conduct Committees; (ii) the excess spread rule; (iii) participation in contested elections; and (iv) the need for improvements to the audit trail. I. PROBLEMS OF THE NASDAQ STOCK MARKET A. Quotes, Trades, and Trade Reporting 1. The Pricing Convention and Related Practices The evidence gathered in this investigation revealed that Nasdaq market makers widely followed an anticompetitive pricing convention concerning the increments they used to adjust their displayed quotes, which resulted in many Nasdaq stocks being quoted only in even-eighths.-[3]- Various market makers also discouraged one another from narrowing the inside spread. Adherence to the pricing convention and this tendency to avoid narrowing spreads have often had the effect of increasing the transaction costs paid by many investors. Market makers who either entered quotes inconsistent with the pricing convention or narrowed spreads were sometimes subjected to harassment by other market makers. The NASD was aware of, at least as early as the summer of 1990, facts and circumstances evidencing both the pricing convention and allegations of intimidation and pressure directed against market makers that narrowed spreads. It did not, however, take appropriate action to address the issues raised by this information. a. The Pricing Convention Prior to late May 1994, the pricing convention was widely followed by Nasdaq market makers. According to testimony from Nasdaq traders, the convention was based on tradition and represented the "professional" way to trade in the Nasdaq market. Market makers expected other market makers to follow the convention. Several traders testified that senior traders at their respective firms trained them to follow the pricing convention. Still other traders admitted to following a practice of setting quote increments based on the size of the dealer ---------FOOTNOTES---------- -[3]- An even-eighth is 2/8, 4/8, 6/8, or 8/8. An odd- eighth is 1/8, 3/8, 5/8, or 7/8. The Nasdaq pricing convention is further discussed herein at I.A.1.a. ==========================================START OF PAGE 3====== spread, but stopped short of characterizing the practice as a "convention."-[4]- Under the pricing convention, stocks with a dealer spread of $3/4 or more were to be quoted in even-eighths ("even-eighth stocks"). Stocks for which the dealer spread was less than $3/4 could be quoted in both odd and even-eighths.-[5]- The existence of this convention is confirmed by the testimony of traders who make markets on Nasdaq, documentary evidence, taped conversations, and through analysis of the price and quote data in the Nasdaq market.-[6]- Prior to May 1994, more than 80% of all domestic Nasdaq National Market stocks,-[7]- of which there were more than 3,200, followed the pricing convention.-[8]- Of the more than 1,900 domestic National Market stocks priced greater than $10 per share, more than 90% followed the pricing convention and approximately 78% were even- eighth stocks.-[9]- ---------FOOTNOTES---------- -[4]- Traders have also described the practice as an "ethic," a "custom," or a "tradition." -[5]- Nasdaq accepts market maker quote increments of 1/8 or greater for stocks bid ten dollars and over. Stocks bid less than $10 per share can be quoted in smaller increments. -[6]- For this analysis, the Commission used Nasdaq Market Maker Price Movement data from December 1993 through May 23, 1994 which identifies, for every market maker, the time, price, and size (i.e., amount) of each quote update (i.e., a change in the market maker's quotes). -[7]- Nasdaq National Market stocks (also referred to herein as "NMS stocks") are the top tier of Nasdaq stocks in terms of capitalization, number of shareholders, and activity. These companies comprise over 95% of the capitalization of all Nasdaq companies. -[8]- The Commission's analysis of the data confirms widespread adherence to the pricing convention, including, substantial, albeit lesser adherence in stocks priced less than $10, which under Nasdaq rules may be quoted in increments of $1/16 or finer. -[9]- For the analysis in Figures 1 to 4 and the accompanying text, stocks were classified using a percentage test. A stock was initially classified (continued...) ==========================================START OF PAGE 4====== Often the effect of this convention was to limit how small the inside spread of even-eighth stocks could be. When stocks are quoted only in even-eighths, the minimum inside spread will be $1/4. Stocks that are quoted in both even and odd-eighths can have an inside spread of $1/8. Figure 1 below shows that market makers, consistent with the pricing convention they described in their testimony, quoted stocks with dealer spreads less than $3/4 ---------FOOTNOTES---------- -[9]-(...continued) as one with a dealer spread of $3/4 or greater if on a particular day more than 90% of quote updates in that stock on that day resulted in a dealer spread at or above $3/4 (Group A). Likewise, a stock was initially classified as one with a dealer spread below $3/4 if more than 90% of quote updates in that stock on that day resulted in a dealer spread below $3/4 (Group B). All stocks were then classified on a monthly basis. If a stock belonged to Group A every day of the month, the stock was classified as one with a predominant dealer spread at or above $3/4. Similarly, if a stock belonged to Group B every day of the month, the stock was classified as one with a predominant dealer spread below $3/4. Stocks belonging to Group A were classified as following the convention during the month if odd-eighth quotes comprised less than 10% of all odd and even-eighth quotes. Stocks belonging to Group B were classified as following the convention during the month if both odd and even-eighths were used; thus, a stock with a dealer spread of $1/2 in which less than 10% of all quote updates were in odd-eighths would not be classified as following the convention. Therefore, all stocks were classified into one of three groups: (1) following the pricing convention with a predominant dealer spread of $3/4 or greater; (2) following the pricing convention with a predominant dealer spread of less than $3/4; and (3) not following the convention. ==========================================START OF PAGE 5====== in odd-eighth quotes approximately as often as in even-eighth quotes. This stands in stark contrast to the way market makers quoted stocks with dealer spreads greater than or equal to $3/4. Figure 2 below shows that market makers, consistent with the pricing convention they described in their testimony, quoted these stocks in odd-eighths less than 5% of the time and in even- eighths the rest of the time. ==========================================START OF PAGE 6====== The dealer spread was understood by market makers as indicating which of the two quotation increments applied to a particular security. Although under the excess spread rule-[10]- it is possible for market makers to quote dealer spreads of $5/8 when other dealers have spreads of $3/4, adherence to the pricing convention precluded the use of such quote combinations since it would be unclear whether the stock should be an even-eighth or odd-eighth stock.-[11]- The data show that a sharp line was maintained between the two groups of stocks. For domestic Nasdaq NMS stocks, the combination of dealer quotes of $5/8 and $3/4 in a particular stock occurred less than 0.8% of the time.-[12]- Thus, the Commission's analysis of more than 18 million quote updates supports the testimony of the market makers as to the functioning of the pricing convention and underscores the extent to which the convention was followed in the market. Market makers' adherence to this pricing convention often increased the transaction costs paid by customers trading Nasdaq securities.-[13]- Most customer orders, particularly those to purchase or sell smaller amounts of stock, are executed by ---------FOOTNOTES---------- -[10]- The Nasdaq excess spread rule requires that a market maker's spread not exceed 125% of the average of the three lowest dealer spreads in a stock. Hence, the range of allowable market maker spreads for a stock is limited to groups such as {$1/2 and $5/8}, {$5/8 and $3/4}, {$3/4, $7/8, and $1}, and {$1, $1+1/8, and $1+1/4}. -[11]- Similarly, dealer quote combinations such as {$3/4 and $7/8}, {$7/8 and $1} and {$1 and $1 1/8}, all of which are permissible under the excess spread rule, were, in the pre-May 24, 1994 Nasdaq market, rarely or never used by market makers. Natural economic forces do not explain the absence of such quote combinations, but such an absence would be expected under the pricing convention. -[12]- In circumstances where market makers acted to narrow their dealer spreads in stocks routinely quoted with dealer spreads of $3/4 or better, they typically narrowed from $3/4 directly to $1/2, skipping $5/8. -[13]- The spread between the inside bid and ask prices is a cost that investors bear in buying and selling stocks at those prices. ==========================================START OF PAGE 7====== market makers at the inside bid or offer.-[14]- Because market makers generally moved their quotations in even-eighth increments for the majority of Nasdaq NMS stocks, the inside best bid and offer for these stocks almost always moved in $1/4 increments. As a result, the inside spread for even-eighth stocks almost never narrowed to $1/8. Investors purchasing and selling even-eighth stocks at the inside spread thus rarely traded at odd-eighth prices. This often resulted in wider inside spreads and caused trades to be executed at prices that were less favorable for investors than if there had been no pricing convention. Similarly, the quotations can affect the ability of institutional investors to obtain favorable prices. The quotations may be part of the mix of information that factors into the efforts of institutional investors to negotiate the best prices possible and may serve as benchmarks for such negotiations. Quotations which are kept wide by the pricing convention may place institutional investors at a disadvantage in such negotiations and create a distorted picture of the market. Although adherence to the pricing convention acted to prevent market makers from displaying odd-eighth quotes for even- eighth stocks on Nasdaq, it did not constrain them from entering ---------FOOTNOTES---------- -[14]- An analysis of over 10 million Nasdaq NMS trades from February 1994 through May 1994 compared trade prices to the inside quotes which existed at the time of execution, or the reported time if the execution time was not available. Over 60% of all trades were executed at the inside quotes. Smaller trades were executed at the inside quotes more often than larger trades. For example, in May 1994, over 90% of customer trades less than 1,000 shares were executed at the inside quotes, compared to approximately 75% of 1,000-5,000 share customer trades. Nevertheless, almost 60% of 5,000 share or greater customer trades were executed at the inside quote. Many small orders (1,000 shares or less) are executed automatically through SOES or market makers' internal small order execution systems at the inside spread (market maker internal systems sometimes automatically execute orders up to 2,000 or 3,000 shares at the inside quotes). Institutional customers, who typically trade in larger size than retail customers, and who have access to other means of price discovery, may have a degree of economic leverage to bargain for better prices. Nonetheless, the inside quotes may serve as a benchmark from which the negotiations proceed. ==========================================START OF PAGE 8====== odd-eighth bids and offers for those same stocks on Instinet-[15]- and SelectNet.-[16]- Market makers regularly placed orders to buy or sell even-eighth stocks at odd- eighth prices on these systems, while quoting the same stocks almost exclusively in even-eighth increments on Nasdaq.-[17]- Figure 3 below shows how market makers entered quotes in Nasdaq for odd and even-eighth stocks. As discussed above, for stocks with a dealer spread of $3/4 or greater, odd-eighth ---------FOOTNOTES---------- -[15]- Instinet is a proprietary screen-based automated trading system consisting of a network of computer terminals that permits broker-dealers and institutions to enter anonymously orders to buy and sell and execute against those orders through a computerized system. Instinet does not accept retail customers. Nothing in this Report or Appendix is intended to suggest improper or illegal activity by Instinet. -[16]- SelectNet is an electronic trading system owned and operated by the Nasdaq Stock Market, Inc. and is available as a trading vehicle only to NASD member firms. -[17]- A tape obtained in the investigation contains a conversation by a market maker who refuses to put an odd-eighth quote on Nasdaq when requested to do so by a retail broker, but indicates he will put an order on Instinet containing the odd-eighth quote. He explains to the broker that displaying an odd-eighth quote in the stock on Nasdaq would make a "Chinese market," which is considered unprofessional and which other market makers do not like. He stated: "I really can't do that 'cause it creates what they call a Chinese market, stock trades in 1/4 point. I'm on Instinet. If somebody wants to whack me at 7/8ths, that's where they're going to whack me." The Commission recognizes the potentially pejorative connotation of the term "Chinese market," and by repeating it herein does not condone its use by any Nasdaq market makers. ==========================================START OF PAGE 9====== quotations are rarely used in the Nasdaq market. This can be contrasted with the way market makers place quotes (in the form of limit orders) in Instinet.-[18]- As shown in Figure 4 below, even and odd-eighths are as frequently ---------FOOTNOTES---------- -[18]- Because Instinet orders express market makers' willingness to deal at stated prices, such orders may be regarded as the functional equivalent of market maker quotes, and are referred to as quotes for the purposes of this Report. ==========================================START OF PAGE 10====== used for odd and even-eighth stocks.-[19]- The routine use of odd-eighths by market makers in Instinet for stocks quoted in even-eighths in the Nasdaq market lends additional support to market maker testimony, documentary evidence, and taped conversations regarding the pricing convention and clearly indicates that adherence to the pricing convention, as detailed in this Report, was not the result of natural market forces. Moreover, the size of trades in Instinet and Nasdaq were essentially the same. During April through June 1994, the average trade size for NMS stocks on Instinet was approximately 1,600 shares, smaller than the Nasdaq average of approximately 1,900 shares for all NMS trades. The median trade size was 1,000 shares for both Instinet and Nasdaq.-[20]- Access to the quote information and trade opportunities displayed on Instinet and SelectNet, however, was limited only to certain brokers, market makers, and institutional investors. Individual investors and other market participants did not have direct access to the information or trading opportunities that ---------FOOTNOTES---------- -[19]- In addition to the Market Maker Price Movement data obtained from Nasdaq, the Commission obtained from Instinet the Instinet Activity Report, which includes times, prices, sizes, and identities for orders placed and executed in Instinet for the months of April, May, and June 1994. -[20]- These trade sizes for Instinet and Nasdaq are roughly the same for all months in the sample. ==========================================START OF PAGE 11====== were offered on these systems.-[21]- Thus while Instinet and SelectNet provided avenues for market makers to quote and trade at odd-eighth prices with a limited subset of market traders, many investors, particularly retail customers, could only observe and trade at the Nasdaq quotes, where odd-eighth prices often were not available because of market makers' widespread adherence to the pricing convention.-[22]- ---------FOOTNOTES---------- -[21]- In the following conversation, two traders comment upon a suggestion made by another trader (Trader 3) at a meeting that retail customers should be given access to Instinet: Trader 1: What did he [Trader 3] have to say? Trader 2: `I come from [firm], and we do a lot of retail, and I think there ought to be a way that our customers have access to Instinet.' I'm like, Trader 1: What? Trader 2: What? Trader 1: Well, then you wouldn't do the retail, you moron. Trader 2: Like [name of Trader 3], then there'd be no need for you, you jarhead. -[22]- Some traders recognized that by trading through Instinet, they could trade inside the Nasdaq spread. This contributed to wide spreads on Nasdaq. The following conversation between two traders reflects that understanding: Trader 1: The thing I think should be done is allow the public to participate. For example, the market is 9 to 1/2. Years ago that stock would be 9 to a 1/4. And if it was trading 9 to an 1/8, the only way you would compete or get in the flow, was offer at an 1/8 and bid 9. Trader 2: Yep. Trader 1: Today, you don't have to do that. Trader 2: Because you could just use the stupid toy [Instinet]. Trader 1: Exactly. Trader 2: Bid an 1/8 on [Instinet]. Trader 1: Right. You don't have to put it in. I think there's got to be something done. For example, yesterday 9 to a 1/2. I bid an 1/8 and I buy for 4,000 from a guy. I know there are sellers out there. He should be required, after he makes a sale at an 1/8 and (continued...) ==========================================START OF PAGE 12====== Instinet and, to a lesser extent, SelectNet, have emerged as primary arenas for market makers to attract, negotiate, and execute trades within the inside spread.-[23]- In these trading systems, market makers can enter quotes and trade at prices better than the inside spread without creating a new inside market at which all market makers regard themselves as being obligated to trade with their customers.-[24]- ---------FOOTNOTES---------- -[22]-(...continued) has more to do, to offer at an 1/8 in [Nasdaq]. Trader 2: Yeah. Trader 1: OK. Trader 2: Yeah, how can you--how can you, how can you enforce that, though? Trader 1: Well, let's put it this way. We don't want them to enforce it. But if we make a suggestion that maybe that's something that could be done, it would do two things. It would cut the spread down from 9 to 1/2 to 9 to an 1/8. Trader 2: It would also keep them off our back for a while. -[23]- Instinet is larger than any of the organized U.S. stock markets other than the New York Stock Exchange or Nasdaq, even though it excludes retail order flow. For example, in 1994, trading volume on Instinet was approximately 10.8 billion shares with an approximate dollar volume of $282 billion. By comparison, Nasdaq had 74 billion shares traded with an approximate dollar volume of $1,449 billion (including the volume on Instinet). In 1994, the New York Stock Exchange had trading volume of approximately 76 billion shares with an approximate dollar volume of $2,841 billion. Market makers and other broker-dealers are responsible for most of the trading volume in Instinet. Institutional investors account for the remaining volume. Instinet trading constitutes a significant share of total Nasdaq trading. An analysis of market data for the month of May 1994 shows that Instinet trades represented over seventeen percent of all NMS trades and approximately fifteen percent of NMS trading volume during the period. -[24]- Some traders believe that Instinet has emerged as a preferable "market" to Nasdaq. In a conversation between two traders discussing the (continued...) ==========================================START OF PAGE 13====== Analysis of data for May 1994 shows that approximately 85% of bids and offers displayed by market makers on Instinet and 90% of bids and offers displayed on SelectNet were at better prices than those posted on Nasdaq. In addition, approximately 77% of trades executed on Instinet and 60% of trades executed on SelectNet were at prices superior to the Nasdaq inside spread.-[25]- The market participants who most often traded at the superior prices available on Instinet were market makers. Analysis of data for May 1994 shows that approximately 90% of all trades executed on Instinet had a market maker on at least one side of the trade, while institutional investors were direct parties to less than 20% of Instinet trades. All trades on SelectNet involve NASD member firms; institutional and retail investors cannot trade on this system. The trading activity on Instinet and SelectNet indicates that these systems have been used by market makers to facilitate adherence to the pricing convention. Notwithstanding the benefits of the pricing convention to market makers, at times ---------FOOTNOTES---------- -[24]-(...continued) narrowing of the spreads of certain stocks in the spring of 1994 (see Part I.A.1.e.), the traders discussed Instinet: Trader 1: It would be interesting to see if this does anything to, to Instinet. It's really not right to give two different quotes. Trader 2: I agree. Trader 1: You know, if people start looking in Nasdaq first and Instinet second, that's what you got to get doing. But you go and see these accounts, and stop up at their offices, they all have Instinet. That's the first place they look. Trader 2: Instinet's the market. You're right, that's it. Trader 1: If something's offered and they're in the middle and they have it to buy, they take it. Trader 2: Yeah, yeah. Trader 1: They don't even look at the ******* box. They don't care what it looks like. -[25]- These numbers are representative of the trading activity during all months of the sample described supra note 14. The quality of trade executions on Instinet and SelectNet may be compared with the quality of trade executions in Nasdaq as described supra note 14, where most trades are executed at the displayed inside quotations. ==========================================START OF PAGE 14====== they wanted to trade at prices that would be inconsistent with the convention. The availability of private systems allowed market makers to trade at prices better than the Nasdaq inside quotes without violating the pricing convention and without affecting the prices at which other market makers trade with the public.-[26]- The availability of these systems, particularly Instinet, reduced the necessity to narrow the Nasdaq spreads, thereby facilitating adherence to the pricing convention and reducing competition in the Nasdaq market.-[27]- The trading activities of market makers on Instinet and SelectNet, together with the activities meant to enforce the pricing convention, demonstrate that adherence to the convention, as detailed in this Report, was not the result of "natural" market forces or a custom that evolved for ease of administration.-[28]- The limitation of quote updates to ---------FOOTNOTES---------- -[26]- The advantages to market makers of such limited access systems have fostered the development of a two-tiered market -- the public Nasdaq market for retail investors and some institutional investors, and the private, limited access systems where broker-dealers and certain large institutional investors can observe and trade at better prices, yet in similarly sized trades, as in Nasdaq. -[27]- One trader's testimony illustrates this point: Back in the eighties you really did not have Instinet as it was [sic] today and so sometimes you would move your market up, you would close your spread to try to signal to another market maker hey, in this case, say going up in the bid I am a buyer and you might go twenty-nine and an eighth bid and stay there for a while and then go down to let people know you are a twenty-nine and an eighth buyer. You have tried institutional and you cannot find. Instinet was not what it was [sic] today, they did not do that kind of volume, so the only way to really let the world know you are a buying [sic] rather than just take them the twenty-nine and a quarter stock is to close your spread or do what you call the odd[-]eighth. -[28]- Pertinent to this point is the partial breakdown of the pricing convention after the May 24, 1994 Bear Stearns meeting (discussed in Section I.A.1.e.), at which the NASD urged market makers (continued...) ==========================================START OF PAGE 15====== even-eighth increments allowed market makers to maintain artificially wide spreads. This increased their profits, but often had a negative impact on the prices paid by investors. b. Disincentive to Breaking the Spread Market makers usually set their dealer spreads at levels no narrower than the spreads displayed by other dealers in that particular stock. As a result, until May of 1994,-[29]- even when market makers could have narrowed their spreads consistent with the pricing convention, dealer spreads nevertheless were rarely narrowed, even if the pricing convention was followed. The evidence obtained in the investigation indicated that a number of market makers discouraged their peers from entering dealer spreads narrower than the dealer spreads entered by other market makers in any particular security, even if such a narrowing conformed with the pricing convention.-[30]- If market makers in a particular ---------FOOTNOTES---------- -[28]-(...continued) to narrow spreads, and the subsequent publicity over the Christie-Schultz study's conclusion of tacit collusion. The number of stocks following the pricing convention dropped from over 80% before October 1994 to approximately 68% by July 1995, as shown in Figure 5 in the text infra Part I.A.1.e. These changes in dealer quotation activity further indicate that the adherence to the pricing convention, as detailed in this Report, was not a natural pattern of conduct. -[29]- Spreads in a number of high volume stocks began to narrow beginning in late May 1994 and thereafter following the Bear Stearns meeting on May 24, 1994, publicity concerning the Christie-Schultz study, which suggested possible implicit collusion among Nasdaq market makers, and the filing of class action litigation against a number of market makers alleging price fixing in the spreads of Nasdaq stocks. -[30]- For example, on September 20, 1994, the initial public offer of the common stock of Comcast U.K. (CMCAF) was made. In the minutes preceding the opening of trading, various market makers displayed a $3/4 dealer spread in their quotes, but one market maker (MM 1) displayed a $1/2 dealer spread in its quotes. MM 1 was called by the lead underwriter for CMCAF (MM 2), who informed MM 1 that MM 2 had displayed a $3/4 (continued...) ==========================================START OF PAGE 16====== security were quoting dealer spreads of $3/4 and $1, other market ---------FOOTNOTES---------- -[30]-(...continued) dealer spread and that a $3/4 dealer spread was the right thing to do. MM 1 then changed its quotes to a $3/4 dealer spread. This point is also exemplified by the market for McCaw Cellular stock (MCAWA) on April 8, 1994. On this day, all market makers were displaying $3/4 dealer spreads or wider, except one who displayed a $1/2 dealer spread. Another market maker then changed its quotes to reflect a $1/4 dealer spread. Due to the excess spread rule, all other market makers were then required to display quotes having a dealer spread of $5/8 or less. A number of dealers displayed quotes having a $1/2 dealer spread. Shortly thereafter, three market makers made an effort to widen the dealer spread out to $3/4 again by displaying $5/8 dealer spreads in the apparent hope of inducing other market makers to follow them. If all or almost all the market makers had followed them to $5/8, they could have then widened to a $3/4 dealer spread without violating the excess spread rule. Two of them engaged in the following dialogue: MM 1: Hey, alright, uh, we're still goofing around with this MCAWA. I just went down an eighth on the bid. MM 2: Okay. MM 1: And that let me do that. So I told [MM 3] to go down an eighth. . . . . MM 2: If that's what you guys want me to do, I'll do it. MM 1: Try it and then I'm going to try and go down another eighth, you know what I mean, and get it, get it back to $3/4 spread. This attempt to widen the dealer spread to $3/4 failed because too many market makers continued to display $1/2 dealer spreads. However, the willingness of three market makers to act collectively in an effort to widen the spread almost immediately after it narrowed is indicative of the disincentive against narrowing the spread even in compliance with the pricing convention. In addition, the negative reactions of some market makers to narrowings of the spreads in certain heavily traded Nasdaq stocks in late May 1994 further demonstrates this disincentive. See infra discussion notes 47-51 and accompanying text. ==========================================START OF PAGE 17====== makers understood that they were not supposed to "break the spread" by quoting a dealer spread narrower than $3/4. A reduction in the dealer spread to less than $3/4 by one dealer could, if joined by other dealers, result in quotation increments being reduced to $1/8 increments pursuant to the pricing convention and the inside spread being reduced to $1/8. Like the pricing convention, the disincentive against "breaking the spread" contributed to the artificially wide inside spreads on Nasdaq. This general disincentive against narrowing the spread is a further anticompetitive influence in the Nasdaq market. A number of market makers discouraged their peers from price cutting, even within the pricing convention. This practice artificially interfered with the free flow of competition. c. Size Convention Traders testified to the existence of another market maker practice that discouraged a narrowing of the inside spread in certain circumstances. This practice provided that a market maker that moves a quote to create a new inside bid or offer must be willing to trade at that new price level for a quantity of shares significantly greater than the minimum required by NASD rule (which requires 1,000 shares for the more heavily traded stocks).-[31]- Traders have testified that a market maker who creates a new inside bid or offer should be willing to trade in the range of 2,000 shares to 5,000 shares (and sometimes more) at that new price level. If a trader is only willing to trade 1,000 shares at a new inside bid or offer, the accepted practice is that the market maker refrain from moving the quote to that price level.-[32]- This practice discouraged traders from ---------FOOTNOTES---------- -[31]- NASD Manual, Schedule D to the By-Laws, Part V,  2, (CCH) 1819 (1995) (prescribing minimum sizes of quotations). -[32]- Some traders have testified that if the market maker at the inside does not have substantial size to trade, that market maker is "distorting" the market, that his quote is not "real," and that his quote is making negotiations with other market makers' customers more difficult. In these circumstances, some market makers ask the market maker quoting the inside bid or ask to move its quote. The notion that an inside quote for the minimum required number of shares is not "real" is fallacious, because a market maker is only required to be willing to trade the legal minimum. Some traders have testified that the inside quote (continued...) ==========================================START OF PAGE 18====== entering quotes that would improve the inside bid or offer when they were seeking to trade only the legal minimum quantity of stock.-[33]- Certain market makers testified that, in connection with the size convention, they were not concerned with the narrowing of spreads but rather with the improved price they would have to give to customers. They testified that their concern was that the creation of a new inside bid raised the price they would have to pay for customer sales and the creation of a new inside ask lowered the price they would have to accept for customer purchases. This, however, only points to the significance of narrower spreads. When market makers, through the size convention, discouraged new inside quotations that improved the price given to investors, the flexibility and fairness of prices were artificially impaired. Thus, the size convention inhibited price transparency by limiting quote changes to those circumstances where a market maker was willing to trade substantially greater volume than its NASD required minimum quotation size. This impaired price competition in the Nasdaq market, because quotations meeting only ---------FOOTNOTES---------- -[32]-(...continued) in some circumstances is the starting point for negotiations with institutional customers, and another market maker's quote can affect such negotiations. This dynamic, however, does not justify interference with the other market makers' pricing decisions. -[33]- One market maker testified that the size convention (which he characterized as a "practice") does not apply when the price of the stock is rising or falling generally, but rather when the market maker disseminating the new quotation is "sticking out." In one instance in 1994, this market maker and a second market maker harassed one of their peers for narrowing the inside spread by putting an odd-eighth quote for Intel, a stock then normally quoted in even- eighths. The harassers claimed that they were upset not by the use of odd-eighths but by the fact that the firm narrowing the spread would only trade the legal minimum of 1,000 shares with them, rather than 2,500 or more shares. Even if one gives credence to this testimony, the harassment in this instance impedes the free flow of competition by burdening price changes with a much greater volume requirement than the minimum prescribed by NASD rule. ==========================================START OF PAGE 19====== the NASD minimum quotation sizes were deterred. Spreads were wider because the size convention artificially restrained aggressive pricing. The size convention operated independently of the pricing convention, in that it applied to the creation of new inside prices both in conformity with and in violation of the pricing convention. Thus, its effect was cumulative to the anticompetitive effects of the pricing convention. d. Pressure and Harassment Various Nasdaq market makers have exerted pressure on market makers who acted inconsistently with the above-described trading conventions, narrowing the inside spread, and consequently reducing the profits of all other market makers in the stock. The investigation has developed evidence of instances where market makers entered quotes that narrowed the inside spread in contravention of established trading and pricing practices and then were the subject of harassing telephone calls. These calls involved other market makers questioning or complaining about the narrower spread, requesting or demanding that the market maker widen the spread back out, asserting that the market maker was ruining the market or was unprofessional, unethical, or embarrassing, or accusing the market maker of "making a Chinese market."-[34]- Some market makers have also complained about other market makers narrowing the spread by disseminating messages over the SelectNet system.-[35]- In addition, ---------FOOTNOTES---------- -[34]- The term "Chinese market" is used by Nasdaq traders to describe a market that is quoted in a manner that is inconsistent with the usual quoting pattern for the stock. For example, if the market makers in a stock are quoting dealer spreads of 3/4 of a point, and one market maker publishes a dealer spread of 3/4 of a point at odd-eighth intervals, e.g., 20 1/8 bid to 20 7/8 offer, that market maker would be considered to be making a Chinese market. At times, a degree of imagination was applied to the harassing telephone calls. When one market maker narrowed the spread on certain occasions from 1/4 to 1/8, it received anonymous telephone calls in which the caller, in a phony Chinese accent, ordered chop suey, moo goo gai pan or other Chinese food, in an apparent allusion to the understanding among market makers not to make "Chinese markets." -[35]- In addition to delivering orders, SelectNet can be used to transmit short text messages. Examples of messages complaining about spread narrowings are set forth in infra note 48. ==========================================START OF PAGE 20====== market makers who violated the conventions occasionally encountered refusals by other market makers to trade with them. e. Bear Stearns Meeting and Subsequent Narrowings In the spring of 1994, market makers began to narrow spreads in a number of high profile stocks. Several events appear to have precipitated this development. On May 24, 1994, the Security Traders Association (the "STA")-[36]- sponsored a meeting to discuss the width of spreads at the Manhattan offices of Bear Stearns (the "Bear Stearns Meeting"). The meeting was attended by approximately one hundred traders from many of the major Nasdaq market making firms, as well as senior officers of the STA and the NASD. The President of the STA began the meeting by urging traders to narrow spreads voluntarily or face regulations forcing a tightening of spreads.-[37]- NASD senior officers then made a presentation showing that the spreads of top Nasdaq securities had widened and that in many stocks, the displayed spread was substantially wider than the spread at which the stock actually could be traded.-[38]- The NASD officers suggested that because of such spreads, there existed a substantial risk that some significant Nasdaq companies would leave Nasdaq to list on the New York Stock Exchange, thereby reducing the trading revenues of Nasdaq market makers. The NASD officers urged traders to examine the stocks that they traded, ---------FOOTNOTES---------- -[36]- The STA is a trade association composed of individuals in the securities industry which largely represents the interests of market makers. -[37]- In his prepared remarks the STA President stated: [L]et me suggest that if we do not voluntary (sic) close . . . quotes, it will be done by regulation by the NASD, the SEC or Congress and in the meantime we will lose many companies to the exchange and receive much bad and distressing publicity. He also quoted from the Christie-Schultz study and a letter from an issuer complaining about its spread. -[38]- The presentation included slides showing a list of the top 25 Nasdaq stocks by market value and their inside spreads, a list of six large Nasdaq stocks with substantial spreads, and charts tracking average spreads on Nasdaq, the growth of Nasdaq market value and capitalization, and related increases in market maker trading revenue. ==========================================START OF PAGE 21====== particularly the high profile Nasdaq stocks, to see whether or not they could reduce their displayed dealer spreads. NASD officers also pointed out in response to a comment in the audience that intimidation against market makers that narrowed spreads was a violation of NASD rules. One NASD officer pointed out that spreads had not narrowed since certain SOES rules changes, which had reduced market maker exposure on SOES,-[39]- had taken effect in January 1994. He pointed out that for a long time many market makers had stated that SOES activity was the cause of widening spreads.-[40]- ---------FOOTNOTES---------- -[39]- These rule changes, known as the interim SOES rules, included a reduction of the maximum SOES order size from 1,000 shares to 500 shares, a reduction in the number of times that a market maker would be exposed to SOES executions from five to two (thereby effectively reducing the market maker's exposure from 5,000 shares to 1,000 shares), the authorization for the Nasdaq Stock Market, Inc. to offer an automated quote update feature that moved a market maker's quote away from the inside quote after receipt of a SOES execution, and a prohibition on short sales in SOES. See NASD Special Notice to Members 94-1, Jan. 5, 1994. The NASD proposed these changes on the basis that they would narrow spreads. Exchange Act Release No. 32143 (Apr. 21, 1993) 58 Fed. Reg. 21484 (Apr. 24, 1993). -[40]- Market makers generally have attempted to blame active SOES trading for the width of the Nasdaq market spreads. Some market makers anticipated that the changes brought by the SOES interim rules would put pressure on market makers to narrow spreads because they could no longer blame wide spreads on SOES abuse. A January 7, 1994 memo to the STA Board of Governors from the STA Trading Issues Committee states: [Spreads w]ill probably become THE hot issue for 1994 in the minds of the issuers and, therefore, the NASD. With the interim SOES rules removing SOES abuse as a (legitimate) excuse, pressure on spreads will become intense. Look for questions about market- maker quotations at one price, and bids/offers in SelectNet/Instinet/private systems at a different price. (continued...) ==========================================START OF PAGE 22====== This individual indicated that the interim rules, by reducing SOES tier sizes from 1,000 to 500 shares, had reduced the pressure on market makers to maintain wide spreads, but that following that reduction the spreads had not narrowed. He argued that market makers should therefore focus on reducing spreads in light of their reduced SOES exposure. On May 26, 1994, several major newspapers reported that the Christie-Schultz study had concluded that market makers may tacitly collude to maintain wide spreads.-[41]- The publicized allegations of collusion, the perceived threat of regulatory action, and the possibility of Nasdaq issuers moving to the exchanges led to heightened concerns over spreads.-[42]- These concerns appear to have prompted certain market makers to reduce the spreads of several high profile Nasdaq stocks beginning on May 26 and 27, 1994.-[43]- One market maker narrowed its spread in the ---------FOOTNOTES---------- -[40]-(...continued) The absence of an overall narrowing of spreads after the adoption of the interim SOES rules is inconsistent with the argument that SOES trading is responsible for wide spreads. -[41]- The NASD had received a draft of the Christie- Schultz study in late 1993, and was concerned about its conclusions. Some market makers became aware of the study in early 1994 before the study was widely publicized. -[42]- On May 27, 1994, several class action lawsuits were filed against certain market makers alleging violations of federal and state antitrust and securities statutes. Additional class actions were filed in the summer of 1994. In the fall of 1994, more than two dozen class action complaints were consolidated into one action in the United States District Court for the Southern District of New York alleging an unlawful conspiracy among leading Nasdaq market makers to eliminate odd- eighth quotations in order to increase spreads in violation of the Sherman Act (earlier allegations of violations of the securities laws were dropped). -[43]- In several taped telephone conversations, traders attributed the narrowing of the dealer spreads in late May to the Bear Stearns meeting and the reports of the Christie-Schultz study conclusions. The head trader at the market maker who first (continued...) ==========================================START OF PAGE 23====== common stock of Microsoft Corporation after the market closed on May 26, 1994. On May 27, 1994, other market makers-[44]- tightened their dealer spreads in Microsoft, Amgen Inc., Apple Computer Inc., Cisco Systems, Inc., and Wellfleet Communications, Inc. These stocks and their respective spreads had been displayed on the slides presented by the NASD staff at the Bear Stearns meeting.-[45]- In the days following the meeting, certain market makers narrowed their dealer spreads in these stocks from $3/4 to $1/2 and began to move their quotes in $1/8 ---------FOOTNOTES---------- -[43]-(...continued) narrowed the dealer spread in the common stock of Apple Computer Inc. testified that he narrowed because of the issues raised at the Bear Stearns meeting. He also testified that he called the market maker that was the first to narrow the dealer spread in the common stock of Microsoft Corporation and told the trader that if his firm could set an example in Microsoft, then he could set an example in Apple. Traders at the firm that first narrowed the spread in Microsoft after the market closed on May 26, 1994 testified that they narrowed their dealer spread because of a stock split one week before and not because of any issues raised at the Bear Stearns meeting. -[44]- Some of the market making firms that took the lead on narrowing several of the high profile Nasdaq stocks were represented on the Trading Committee of the NASD. The Trading Committee had been involved in analyzing the issue of wide spreads and the competitive threat posed by the New York Stock Exchange as early as 1990. At least some members of the Committee were also aware of the issues of market maker intimidation and the operation of the pricing convention. -[45]- Three of these stocks, Amgen, Wellfleet, and Apple, were listed on a slide entitled "LARGE NASDAQ STOCKS WITH SUBSTANTIAL SPREADS." [emphasis in original] The slide showed a substantial difference between the displayed spread and the spread at which market makers actually traded the stocks. Microsoft, Apple, Amgen, and Wellfleet were listed on the slide displaying the inside spreads of the Nasdaq top 25 stocks by market value. The slide showed the inside spreads of these four stocks as being $1/4, while other stocks on the list had inside spreads of $1/8. ==========================================START OF PAGE 24====== increments, instead of $1/4 increments.-[46]- This movement toward narrowing spreads on certain stocks generated resistance. Market makers recognized that the spread reduction in these few stocks could lead to tightening of spreads in other Nasdaq stocks.-[47]- Some traders called the market makers who narrowed their spreads to raise questions or complain. Other market makers broadcast messages over the SelectNet system that criticized the change in the dealer spreads.-[48]- Certain market makers then narrowed their dealer spreads in one stock even further to $1/4, apparently as an expression of their frustration.-[49]- Because of the ---------FOOTNOTES---------- -[46]- In Microsoft, Amgen, and Cisco, at least three market makers moved to cut the dealer spreads to $1/2. Because the excess spread rule requires that no market maker can enter a spread more than 125% of the three narrowest dealer spreads, the narrowings forced all of the market makers in these stocks to enter dealer spreads no greater than $5/8. -[47]- The head trader of a firm discussed the implications of the narrowings in a taped telephone call: You can still make markets, stocks will still move around, but certainly the margins are going the wrong way, and it's going to be a hell of a lot more difficult. I don't see how any trading desk can keep their profitability up if the trend continues, and they start breaking down these other stocks. The next day, he told another trader: I'm not going to initiate it [a narrower spread]. Why should I do that? You know? We might as well milk it for as long as we can, and you know, it's going to be a different business. Hopefully, we'll all figure a way to make money in it. -[48]- The messages included "Rediculous [sic]," "Great Market," "Stpkidding," "Howbout 64s," and "NotFunny." -[49]- In Microsoft, three market makers had narrowed their spreads to $1/2 by the time the market opened for trading on May 27, 1994. Within 25 (continued...) ==========================================START OF PAGE 25====== operation of the excess spread rule, the additional spread tightening to $1/4 forced market makers to quote these stocks with even tighter spreads, making it difficult to trade.-[50]- One market maker, who was angry that another market maker had narrowed the dealer spread of Microsoft, began to use odd-eighths in quoting the common stock of Cisco. This trader intimated to another trader that he cut the spread in Cisco to retaliate against the market maker who had narrowed the spread in Microsoft, whom he knew to be one of the largest volume traders of Cisco.-[51]- ---------FOOTNOTES---------- -[49]-(...continued) minutes, three other market makers narrowed their spreads to $1/4. One of the traders who narrowed to a $1/4 dealer spread testified that he narrowed to express his frustration to the market maker that narrowed its dealer spread to $1/2 and that he felt Microsoft was too volatile a stock to trade at a $1/2 dealer spread. On a tape, a trader at another firm that narrowed to $1/4 spread explained that the head of the Nasdaq trading desk "did it [permitted Microsoft to be quoted with a 1/4 point spread] just to **** everybody up." -[50]- Several traders testified that there was no economic reason to narrow the dealer spread to $1/4 in these stocks. At these levels, the market maker would always be quoting either the inside bid or offer, and would therefore always be exposed to SOES and other orders, requiring intensive monitoring of quotes and executions. -[51]- In the taped telephone conversation, the trader who narrowed Cisco (Trader 2) speaks of a third firm which had narrowed the spread in Microsoft: Trader 1: Hi. Trader 2: Hi. What's up? Trader 1: Oh, tell me. Trader 2: What, you mean with these spreads? Trader 1: Yeah. Trader 2: Well, [name of third firm] started it with Microsoft, so . . . Trader 1: Oh, that what happened? Trader 2: Yeah. You know, did you see the Journal today? And all that **** that's going on. Trader 1: What, no. I'm sorry. It was all, it was kinda, it had to be done? Trader 2: It doesn't have to be done. It's the end of (continued...) ==========================================START OF PAGE 26====== Over the summer of 1994, the spreads in other Nasdaq stocks were narrowed by market makers. The trend appears to have been reinforced following additional negative publicity in October of 1994. On October 19, 1994, reports of a Justice Department investigation of allegations of price-fixing by Nasdaq dealers were published. The following day, the Los Angeles Times began a six-part series highly critical of the Nasdaq market.-[52]- ---------FOOTNOTES---------- -[51]-(...continued) the business. It's the end of your profits. If you make 600 a month, you gonna make 400 a month. Trader 1: . . . I'm ******* sitting here with a knot in my stomach you can't imagine. Trader 2: Yeah. Trader 1: It *****. Oh, so [third firm] cut the Microsoft? Oh, okay. What was in, what's in the Journal? Trader 2: It's a whole study about how spreads are too big. Trader 1: Oh. If that's what's going to happen, that's what's got to be, right? Trader 2: Yup. Trader 1: Yeah. Trader 2: Alright. Trader 1: I know you didn't want to . . . I know, I knew it wasn't your style, you know . . . . Trader 2: No. But I did it [narrowed the spread in Cisco]* to get him [third firm]* back. I knew he was involved in Cisco. * Trader 2 testified that this sentence had the meaning indicated in the brackets. Within three minutes after Trader 2 used the odd-eighth quote in Cisco, three other market makers narrowed their dealer spreads to one-half and began moving their quotes in eighth point increments. -[52]- Scot Paltrow, "Inside Nasdaq, Questions About America's Busiest Stock Market," The Los Angeles Times, Oct. 20, 1994, at 1. See infra note 69 and accompanying text. The first article identified a trader at one market making firm ("Firm A") that reportedly called the market maker that cut the spread of Intel Corporation, an even-eighth stock, to $1/8 and "complain[ed] 'You guys break the spread for 1,000 shares?'" The next day, Firm A began to move its quotes for Intel in $1/8 increments, although it temporarily continued to (continued...) ==========================================START OF PAGE 27====== Thereafter, market makers began to narrow the spreads of other stocks. Market makers narrowed spreads both by following the pricing convention and narrowing their dealer spreads to less than $3/4, and by using odd-eighth quotations with $3/4 dealer spreads. Figure 5 shows the changes in market maker quotation behavior from December of 1993 to July of 1995. Starting in the summer of 1994, there was a shift of stocks to the less than $3/4 dealer spread category along with what appears to be the beginning of a more general breakdown of the pricing convention.-[53]- The potential liabilities associated with the allegations of collusion, government investigations, and the private lawsuits more than likely played a significant role in discouraging adherence to the pricing convention and may have reduced the use and effectiveness of peer ---------FOOTNOTES---------- -[52]-(...continued) quote a $3/4 dealer spread. On October 24, Firm A was the second market maker to cut its dealer spread to $1/2. -[53]- Some traders have testified that the pricing convention is no longer followed consistently. ==========================================START OF PAGE 28====== pressure to discourage those market makers that narrowed the spread. In sum, the pricing convention, the size convention, the disincentive against narrowing the spread, their attendant enforcement mechanisms, and the availability of nonpublic trading systems for market makers resulted in a fragmented market for Nasdaq stocks where investors, institutional and retail, transacted at a considerable disadvantage to market makers. Investors were often confronted by artificially wide, inflexible spreads, and frequently could not transact in the markets at the best prices. Attempts by dissident market makers to compete on the basis of price were in a number of instances met with hostility and harassment. 2. The NASD's Failure to Address Adequately the Pricing Convention and Related Practices The investigation inquired into how the NASD addressed the issues raised by the anticompetitive activities described above. The issue of the width of spreads for Nasdaq securities has been raised frequently by market participants and other observers over a number of years. The registered stock exchanges, which compete with Nasdaq for listings, have focused on the issue of spreads in marketing materials designed to encourage issuers to list on the exchanges. Various issuers have raised concerns about what they have perceived to be wide spreads in their stocks, and investors have complained about the issue. Economists have studied spreads as a measure of transaction costs paid by investors, and articles and academic studies have appeared identifying the issue as a problem on Nasdaq. In the course of reacting to the issue of the size of spreads on Nasdaq, the NASD became aware of both a pricing convention operating in the Nasdaq market and the allegations that certain market makers harassed and intimidated those who narrowed spreads. At a June 27, 1990 meeting of the Trading Committee of the NASD, the issue of spreads was raised in a discussion about a New York Stock Exchange letter to a Nasdaq issuer questioning the width of spreads on Nasdaq. During the meeting, committee members and senior NASD staff-[54]- discussed facts evidencing the pricing convention, its enforcement, and the rigidity of Nasdaq spreads. The pricing convention was described ---------FOOTNOTES---------- -[54]- Seven of the nine committee members present were representatives of Nasdaq market making firms (and one of these seven members was also a member of the NASD Board of Governors at the time). The NASD staff present included members of the Office of General Counsel, Division of Market Surveillance, and Division of Market Operations. ==========================================START OF PAGE 29====== by one committee member as an "ethic" in the Nasdaq market, part of which was not to close spreads or make "Chinese markets." Two other committee members stated that if a market maker attempts to break a spread, it gets calls from large firms questioning the reason for the narrower spread. The committee concluded that it was inadvisable to legislate spreads and that the Security Traders Association of New York, an industry trade association, should address the issue of the "ethic" because it was an "internal" matter.-[55]- Despite the presence at this meeting of senior NASD staff, the NASD did not take any action following this meeting to investigate the existence, impact, or legality of an "ethic" that market makers should not break spreads or make "Chinese markets," or the practice of market makers discouraging one another from narrowing spreads. In 1992, a senior NASD executive undertook an evaluation and analysis of the issue of widening spreads as part of an effort to achieve a 1992 NASD corporate goal to reduce spreads.-[56]- In connection with this effort, the staff member discussed the issue of widening spreads with members of the Quality of Markets ---------FOOTNOTES---------- -[55]- The official minutes of the meeting state: "The Committee also discussed the inadvisability of trying to legislate spreads; that whatever movement necessary to narrow spreads must come from within the market itself, and through industry groups such as the Securities [sic] Traders Association." Beginning in 1990, certain Nasdaq traders serving as governors of STA encouraged market makers to narrow voluntarily their dealer spreads. These efforts were not successful, as spreads did not begin to narrow generally until mid-1994. Some market makers indicated to one STA governor that they were not willing to narrow their dealer spreads because they were concerned about receiving phone calls from other market makers pressuring them not to narrow. -[56]- Although some NASD witnesses testified that the primary reason for the initiative was to reduce the transaction costs paid by investors trading at the inside spreads, the weight of the evidence indicates that concerns about losing issuer listings to the exchanges was the primary motivation for the NASD's efforts to reduce spreads. ==========================================START OF PAGE 30====== Subcommittee of the Trading Committee.-[57]- The subjects of "Chinese markets," the quoting patterns dictated by the pricing convention, and the intimidation of market makers were discussed during at least one meeting of the Quality of Markets Subcommittee, held on March 24, 1992, at which NASD staff members were present. The senior officer wrote a memorandum dated June 30, 1992 summarizing his thoughts and proposing a number of initiatives to address the issue of widening spreads (the "June 1992 Memo"). The June 1992 Memo was distributed to most of the senior officers of the NASD. The June 1992 Memo identified an absolute increase in inside spreads from the first quarter of 1989 through May 1992 from $0.226 to $0.369, an increase of 63%. It then set forth the author's opinions as to the reasons for the widening spreads. The June 1992 Memo described order flow arrangements, the increased use of SelectNet and Instinet, and market maker exposure to SOES trades as contributing factors. It also identified the stigma associated with making a "Chinese market" and the observance of uniform quote increments as contributing to widening spreads, stating: Unlike auction markets, dealers do not change prices one side at a time and there is a stigmatism [sic] associated with making so called "Chinese" markets. Tangential to this, is statistical evidence that shows, stocks that move (i.e. the next quote change) in 1/8 point increments have narrower spreads than 1/4 pt., 1/4 pt. narrower than 1/2 pt. etc. No one attempts to do just a "little" better with their published quote change (e.g. 1/16) where as in negotiation of the trade itself that smaller price improvement is accomplished. As a result stocks that get stuck in a particular quote increment mode never seem to change e.g. Apple always moves in 1/4 pt. increments. MCI happens to enjoy a 1/8 point increment. What's the difference? The June 1992 Memo then discussed the subject of peer pressure associated with the narrowing of spreads: Dealer spreads are arbitrarily established at the time of an IPO [initial public offerings] and after initially set, there is no incentive to reduce them. I understand that when attempts are made by individual dealers to do so, peer pressure is brought to bear to ---------FOOTNOTES---------- -[57]- The Quality of Markets Subcommittee was formed in early 1991 to address two issues: the development of the short sale rule and the issue of spreads. The Subcommittee was composed only of representatives of market making firms. ==========================================START OF PAGE 31====== reverse any narrowing of spreads. I have no hard evidence of this and the information is only anecdotal and this was not described as happening in every case. However, enough people have said it for me to believe it to be true. The memo then outlined proposed solutions to the problem of wide spreads. These proposals included modifying SOES tier limits and SOES exposure, converting SOES from an order execution system to an order delivery system, modifying the limit order file, and redefining the excess spread parameters. The memo also addressed the issue of peer pressure: We need to support those market makers who attempt to compete through the price improvement process and also make it clear that tampering or using coercion in influencing other's [sic] pricing decision[s] is a violation of fair trade practices. The issues set forth in the June 1992 Memo were discussed at a meeting of NASD senior management in July of 1992. At the meeting, the author repeated the observations set forth in the memo. Members of NASD senior management inquired about specific instances of intimidation or harassment, but received no specific examples. The NASD did not take appropriate steps to investigate the issue of dealer intimidation or uniform quoting practices described in the June 1992 Memo. No attempts were made to assess more comprehensively the impact of these market maker practices on spreads or trade executions. NASD management did not undertake a study of the competitive issues confronting the market nor did it utilize the NASD's enforcement resources to inquire into the conduct of market makers to assess compliance with the NASD's rules.-[58]- Beginning in 1992, the NASD considered regulatory and structural measures which it described as being designed to narrow the spreads on Nasdaq in a manner that would be acceptable to the market making community. These measures focused on modifying the SOES system to convert it from an automatic order ---------FOOTNOTES---------- -[58]- NASD witnesses testified that they did not pursue these matters because they did not have any specific information as to instances of intimidation or harassment. The absence of specific information about incidents of intimidation or harassment did not excuse the NASD from proactively ascertaining whether or not its rules had been violated or whether the integrity of the Nasdaq market was in jeopardy. ==========================================START OF PAGE 32====== execution system to an order delivery system, thereby allowing market makers to reject orders delivered through SOES. This approach was intended, in part, to respond to the demands of market makers advocating the elimination of trading sponsored by SOES firms.-[59]- The NASD staff also considered proposing changes to the SOES limit order file that would allow market orders to interact with limit orders between the inside spread, thereby increasing the number of trades executed inside the spread.-[60]- The NASD staff anticipated that although ---------FOOTNOTES---------- -[59]- Many market makers believed that active SOES trading resulted in substantial losses to market makers. Consequently, they exerted significant pressure on the NASD to eliminate active trading on SOES. Market makers publicly blamed wide spreads on active SOES trading. They claimed that because of the automatic execution feature of SOES, SOES traders had an unfair trading advantage in periods of volatility, when they could execute trades in SOES before the market makers had an opportunity to adjust their quotes in response to the changing market. Market makers also claimed that the trading risks created by SOES traders forced them to widen their spreads to reduce their market exposure, and many took the position that they would not narrow their spreads until the alleged "SOES abuse" was curbed. The NASD publicly accepted the view that SOES trading was a primary cause of wide spreads, submitting several studies to the Commission allegedly demonstrating this to be true, and pursued a solution to the issue of wide spreads that first and foremost addressed the concerns of the market making community. See infra part II. for a discussion of the market makers' influence on the NASD. As discussed in note 40 supra, the fact that market makers did not narrow their spreads on an overall basis after receiving regulatory relief through the interim SOES rules is inconsistent with the argument that SOES trading was responsible for wide spreads. -[60]- Additionally, the NASD implemented changes to the excess spread rule that were intended to create downward pressure on spreads. The rule, however, inadvertently created incentives for dealers to discourage one another from narrowing spreads. See infra part II.C.2. NASD senior staff members were aware of this possible consequence of the rule. The 1993/1994 Business Plan of the Market (continued...) ==========================================START OF PAGE 33====== many market makers would oppose this change in the limit order file, they would accept the changes, if proposed in conjunction with the changes in SOES strongly advocated by market makers.-[61]- Conversely, the NASD staff apparently believed that the SEC would not accept the SOES changes without a proposal to reform the limit order file.-[62]- Thus, the NASD staff made a "tactical" decision to link SOES reform to changes in the limit order file in order to gain acceptance of the package by both the SEC and the market makers. The NASD staff proposals to reform SOES did not address the other issues that were identified in the June 1992 Memo as contributing to excessively wide spreads. The NASD did, however, ---------FOOTNOTES---------- -[60]-(...continued) Surveillance Department states in a section headed "External Environment" that "[n]ew excess spread policy may lead to collusion amongst firms to widen spreads." -[61]- In a July 31, 1992 memo to members of NASD senior management, the author of the June 1992 Memo stated: There are a number of solutions which I originally suggested in my June 30th memorandum. . . . For pure [sic] tactical reasons, I recommend we narrow the solution, at this time, to only one. Specifically, link the change of SOES to a [sic] order routing system with the interaction of that order with the limit order file (emphasis in original). -[62]- A November 16, 1992 memo from a NASD Senior Vice President to members of the Quality of Markets Subcommittee states: Attached is a proposal for changing the SOES execution system to an order delivery system. Because this will be viewed as a diminution of the public's access to the market, this proposal also contemplates a change to the Limit Order File. The body of the circulated proposal states in part: [T]here is no possibility that the SEC will approve modifications to SOES that disadvantage some market orders without some form of quid prop [sic] quo. ==========================================START OF PAGE 34====== target the SOES execution system for elimination, thereby satisfying a priority of the Nasdaq market makers, the NASD's most powerful constituency. The NASD continued to receive indications of a lack of vigorous price competition in the Nasdaq market. An article appeared on August 16, 1993 in Forbes magazine entitled "Fun and Games on Nasdaq," describing market maker practices, including the harassment of traders that narrow spreads. A December 8, 1992 comment letter submitted to the SEC by the American Stock Exchange contained allegations that Nasdaq quoted spreads almost never vary, and that dealers do not narrow spreads because of concern that other market makers will then not "play ball" with them and help them lay off position risk.-[63]- While the NASD failed to address adequately these indications of potentially improper market maker practices, it ---------FOOTNOTES---------- -[63]- Questions about the integrity of Nasdaq market makers were raised in other areas. In late 1993, the NASD undertook a survey of institutional investors concerning their perceptions of the Nasdaq stock market. The findings of the survey were presented to the senior management group of the NASD and Nasdaq, and to the Trading Committee and Institutional Investors Committee of the NASD using a series of overhead slides. These slides included direct quotations from particular institutional investors interviewed and included the following quotes: "There is a sense that dealers collude and share information that we don't see." [emphasis in original] "Market makers are self-serving. They take care of their own accounts first, then their `broker buddies.' We're the last ones they care about." [emphasis in original] "There's no accountability on the part of market makers. They make excuses about SOES bandits prohibiting them from executing a trade. These excuses insult our intelligence. We'd rather go out of our way to alternative trading systems to sidestep market makers and the games they play." [emphasis in original] The NASD did not take any action to address the issues raised by the survey results. ==========================================START OF PAGE 35====== was aggressively promoting the Nasdaq market.-[64]- As part of these efforts, the NASD pursued economic research projects to portray the Nasdaq market favorably and counter negative publicity.-[65]- In one instance, the NASD explicitly retained the right to prevent publication of the results of economic research it commissioned because of concerns that the results could be negative for the Nasdaq market.-[66]- Beginning in the spring of 1994, the Christie-Schultz study generated substantial negative publicity about the Nasdaq market. In addition, class action lawsuits were filed against market makers, and, in the fall of 1994, the media published reports of government investigations of the Nasdaq market. The NASD developed a public relations campaign designed to counter the conclusions of the study and to promote Nasdaq as a competitive market without collusion.-[67]- NASD senior officials ---------FOOTNOTES---------- -[64]- From 1992 to 1994, the annual marketing expenditures of the NASD and Nasdaq combined rose from $23,971,000 to $42,986,000. Even though this was a period of increasing revenues and expenditures for the NASD and Nasdaq, marketing expenses rose from 10.7% to 12.9% of the combined expenditures of the NASD and Nasdaq. In the same period, regulatory staff dropped from 37.7% to 35.7% of total staff at the NASD and Nasdaq. -[65]- To ensure that research would generate results favorable to Nasdaq, staff of the NASD's Economic Research Department from time to time conducted preliminary research of an area being considered for an NASD commissioned study before hiring an outside economist to perform the research. -[66]- An agreement between the NASD and an economist retained as a consultant to study the issue of individual versus institutional transaction costs provided that the NASD could prevent the consultant from publishing the results of his study by paying him an additional $1,000. An internal NASD memorandum stated that the provision was created "[b]ecause of the negative publicity that may be generated by poor results. . . ." -[67]- This broad public relations campaign resulted in the development and implementation of numerous projects targeting various NASD constituencies, the press, and the academic community. The NASD's determination to defend the status quo rather than (continued...) ==========================================START OF PAGE 36====== publicly criticized the Christie-Schultz study, and senior NASD officers disclaimed the existence of anticompetitive problems on Nasdaq.-[68]- NASD economists prepared a rebuttal to the Christie-Schultz study. The NASD also commissioned outside economic studies to challenge the notion that there was collusion among Nasdaq market makers to keep spreads wide. While pursuing this effort, the NASD took few significant steps to address the underlying issues or to investigate the indications of the problem described herein. In October 1994, the Los Angeles Times series critical of the Nasdaq market described instances of harassment of a market maker, Domestic Securities Inc. ("Domestic"), that narrowed spreads in particular securities.-[69]- The NASD decided to investigate these incidents. Domestic had previously complained to the NASD's Market Surveillance Department about at least one of these incidents. Domestic sent a letter to the Market Surveillance Department on June 6, 1994 describing the episode and attaching a printout of a harassing SelectNet message. According to Domestic's letter, a market maker sent the message "Pathetic" to Domestic immediately after Domestic had narrowed the inside spread in Intel from 1/4 to 1/8.-[70]- The Market Surveillance Department sent a form letter to the market maker in question on June 6, 1994, ---------FOOTNOTES---------- -[67]-(...continued) objectively examine its market was exemplified in an internal memorandum dated April 5, 1995, which praised outside economists hired by the NASD for attacking the Christie-Schultz study and described the economists hired by the NASD as "[o]ur surrogates." -[68]- In a memorandum to Nasdaq market makers discussing press reports of the Justice Department inquiry into trading practices on Nasdaq, a senior NASD officer, who had reviewed the June Memo, stated "As you well know, The Nasdaq Stock Market is stringently overseen by both the SEC and the NASD and neither we nor the SEC have ever found anti- competitive practices to exist in our market." -[69]- The first installment discussed the width of spreads on Nasdaq and the harassment of renegade dealers who tried to narrow spreads. The article described several incidents of such harassment when Domestic narrowed the inside spreads in three Nasdaq securities in June and July 1994. -[70]- NASD records confirm this sequence of events. ==========================================START OF PAGE 37====== asking for its explanation for sending the "Pathetic" message. The market maker responded by letter on June 20, 1994, asserting that when its trader observed Domestic's tightening of the spread, he tried to trade with Domestic. The letter stated that when Domestic refused to enter into a trade, the trader transmitted the "Pathetic" message to Domestic. A review of the NASD's own equity audit trail, however, would have revealed that Domestic, in fact, purchased 1,000 shares of Intel from the market maker. The NASD closed the matter without further investigation. It was only after the Los Angeles Times article was published that the NASD revived the investigation.-[71]- In November 1994, the staff of the Market Surveillance Department spoke to the three market makers involved in the incidents noted in the articles. All three market makers denied that any statements they made to Domestic were in retaliation for its breaking the spread. Instead, the traders attributed any disparaging remarks to Domestic's refusal to trade for more than 1,000 shares.-[72]- The NASD did not attempt to expand the inquiry beyond the discrete events noted in the Los Angeles Times article. A report summarizing the findings of the NASD's investigation was given to the Compliance Subcommittee of the Market Surveillance Committee in January 1995. The members of the Compliance Subcommittee were reluctant to impose sanctions on any of the three market makers because they believed that comments concerning the depth of the market were common between traders. The NASD staff stated that the Subcommittee should consider the matter seriously and carefully, given the existing environment of class-action lawsuits, government investigations by the Department of Justice and the SEC, and a spate of negative ---------FOOTNOTES---------- -[71]- According to the Los Angeles Times article of October 20, 1994, market makers made the following comments to Domestic: "You guys break the spread for 1,000 shares?," "You're embarrassing and pathetic. . . . You're breaking spreads for everybody," and "This is ********. I have institutional customers who come to me and I have to match your price. It's ********, you guys going down an eighth for a thousand shares." -[72]- As noted in part I.A.1.c., supra, there is a widely observed industry custom of not initiating a new inside bid or offer unless the market maker is willing to trade in large (at least 2,000 to 5,000 shares) size, even though the NASD firm quote rule only calls for market makers to be willing to trade 1,000 shares, at the most. ==========================================START OF PAGE 38====== press articles. In the end, the Compliance Subcommittee recommended that a Letter of Warning, which is the lightest sanction available to the NASD, be sent to one market maker.-[73]- After similar discussion at the Market Surveillance Committee the next day, the Letter of Warning was issued and the other matters dismissed. 3. Coordinated Activity Among Market Makers The evidence indicates that instead of dealing as competitors at arms length, certain Nasdaq market makers have coordinated particular trade and quote activities with one another, furthering their proprietary interests at the expense of investors and other market participants. This coordinated conduct has included: (a) arrangements under which these market makers agree to move their published quotes at the request of other market makers, or assist one another in executing trades; (b) agreements to delay reporting specific trades likely to have a negative impact on the value of the requesting market maker's trading position or to obscure the true sequence of trades from customers or other market participants; and (c) the routine sharing of information by these market makers concerning customer orders, securities positions, trading strategies, and intended quote movements. Although many market makers attempt to coordinate their activities on a widespread basis, such coordination is particularly pronounced among market makers that have regular and close contact in the course of trading the same securities. Some traders in testimony have referred to these cooperative traders as "friendly competitors." In addition to impeding competition with respect to specific transactions, the existence of groups of cooperating "friendly competitors," and the demonstrated unwillingness of some market makers to trade with firms they dislike, poses a significant obstacle for new entrants to market making. The obstacle of obtaining membership in one or more groups of cooperating market makers is in addition to a number of other start-up requirements confronting new entrants in the market, including requirements imposed by regulators. For example, significant business and regulatory requirements would include: (a) the need for personnel with substantial knowledge and experience in the securities industry who are duly licensed by the NASD and have a thorough knowledge of the markets and the rules that govern them; ---------FOOTNOTES---------- -[73]- The Subcommittee distinguished between the fact that the "Pathetic" message was sent on SelectNet, while the other two comments were made over the telephone. The staff indicated that this fact was not a meaningful basis for distinction, but failed to convince the Subcommittee to change its recommendation. ==========================================START OF PAGE 39====== (b) substantial capital in order to obtain the necessary facilities and equipment and meet regulatory capital requirements; and (c) admission to NASD membership (which, as is discussed further in the text, may be a difficult process for certain applicants). In addition, attracting order flow can be a significant obstacle for new entrants. As described herein, attempts to obtain order flow competitively by narrowing the spread may well result in harassment and refusals to trade. a. Coordinated Quote Movements and Transactions Certain Nasdaq market makers have engaged in a practice of discussing among themselves their prospective quote movements and transactions in specific securities, and coordinating the sequence, timing, and size of particular quote changes and transactions. Taped telephone conversations have revealed numerous instances of market makers asking other market makers to make specific quote movements,-[74]- sometimes requesting the market maker who is quoting the best bid or offer to move that quote away from the inside quote or in a manner that creates a new inside market.-[75]- In other instances, market makers ask other market makers to join an existing inside bid or ask quote, to create the impression of increased buying or selling interest that may facilitate a transaction by the ---------FOOTNOTES---------- -[74]- In some circumstances, market makers have moved their quotes only after obtaining approval from other market makers. -[75]- Because market makers view the prices quoted at the inside spread as benchmarks for the prices given to customers, effecting changes in the inside quotes can allow market makers to trade with their customers at more profitable prices. For example, in one taped conversation, a trader asked another trader to move his quote down before the market opened: Trader 1: Hi [name of Trader 2], it's [name of Trader 1], can I help for [name of another trader]? Trader 2: Yeah, if he's not involved in Lotus, can he slide down. I got 'em for sale this morning. Trader 2 testified that he had accounts that wanted to sell Lotus to him. He believed that the reason he wanted the other firm to move its quotes down was because he did not want to get caught holding the Lotus stock at a price at which there were no buyers. Data shows that Trader 1's firm was at the inside bid when the conversation occurred and that subsequently it moved its bid down. ==========================================START OF PAGE 40====== requesting market maker. Some traders have testified that they accede to these requests out of "courtesy," and in some instances, because of an expectation that the requesting market maker will reciprocate in the future. By working together to coordinate quote movements or transactions, these market makers can sometimes move the quoted price of a stock up or down, thereby facilitating trades at prices that are more favorable for the market makers, often at the expense of their customers.-[76]- Some market makers refer to these practices as "holding hands."-[77]- In ---------FOOTNOTES---------- -[76]- An example of market makers coordinating quotations in an apparent effort to create the appearance that the market for a stock is moving up, or that buying interest is emerging, is set forth in the following taped telephone conversation. One trader, holding a long position in the stock Parametric Technology Corp. (PMTC), asked another to move his bid up: Trader 1: Are you doing anything in Parametrics [sic]? Trader 2: Ah, running for the hills, bro. Trader 1: Okay, can you. . . Trader 2: What can I do for you? Trader 1: Can you go 1/4 bid for me? Trader 2: Yeah, sure. Trader 1: If you want, I'll sell you two at 1/4, just go up there. I'm long them and I want it going. Trader 2: Yeah. Trader 1: Okay, I sold you. . . Trader 2: Two. That would be great. Trader 1: I sold you two at 1/4. Just go up there, okay? Trader 2: I'm goosing it, cuz. Trader 1: Thank you. The requesting trader (Trader 1) was engaged in selling substantial quantities of Parametric stock. A third market maker had just minutes earlier raised its bid price (and the inside bid) to $26 1/4, and in complying with Trader 1's request, Trader 2 became the second market maker to move its bid up to $26 1/4. -[77]- One trader described "holding hands" as follows: It is, like, two market makers would be kind of in cahoots, one guy would know what the other guy is doing. It would (continued...) ==========================================START OF PAGE 41====== certain circumstances, such undisclosed collaboration can be injurious to the interests of investors.-[78]- For example, a market maker helping another market maker dispose of an unwanted long position in a security will find itself in conflict with the firm's obligation to obtain the best price for those of its customers to whom it sells those securities. This cooperation can improperly influence prices, create an inaccurate picture of the market, and in some cases may evidence market manipulation, in violation of the antifraud provisions of the securities laws.-[79]- b. Agreements to Delay Trade Reports The investigation has uncovered instances in which some market makers entered into explicit agreements to delay reporting trades. These arrangements have occurred in situations where a ---------FOOTNOTES---------- -[77]-(...continued) be, like, two guys would talk on the stock, instead of the one guy going down to the offer, then he would let somebody else go to the offer for him or go to the bid for him. For instance, if [a large market maker] was on the bid, nobody would hit him -- because everybody thinks he is the real buyer, he wouldn't go to the real bid. Everybody runs away from [the large market maker], because they think they are always big. . . . He might send a little, small guy up there instead to buy stock. -[78]- The Commission is not suggesting that for market makers to use multiple agents to obtain executions of customer orders is per se improper. -[79]- The term "antifraud provisions" as used herein refers to Section 17(a) of the Securities Act of 1933, 15 U.S.C.  77q(a) (1994), and Sections 10(b) and 15(c)(1)(A) of the Exchange Act, 15 U.S.C.  78j(b) and 78o(c)(1)(A) (1994), and Rules 10b-5 and 15c1-2 promulgated thereunder, 17 C.F.R.  240.10b-5 and 240.15c1-2 (1995). In addition, there is evidence that market makers from time to time have entered into agreements to widen their dealer spreads in particular stocks. Such conduct has serious anticompetitive implications and may also constitute market manipulation in violation of the antifraud provisions. ==========================================START OF PAGE 42====== timely report of a significant trade could have resulted in a market price movement unfavorable to the market maker's position in such security. The delay of a trade report under such circumstances creates a window of opportunity for the market maker to trade at prices not affected by knowledge of the trade. This practice could allow the market maker to take unfair advantage of other market participants, thereby obtaining an undeserved economic benefit. Certain market makers have also entered into agreements to delay trade reports in order to prevent customers with whom they were trading from seeing the prices of other contemporaneous trades.-[80]- In both situations, the true appearance of the market is deliberately obscured, and the ability of investors to make accurate price discovery is hampered. In addition, depending upon the circumstances, an intentional delay of a trade report may violate NASD rules and the antifraud provisions of the federal securities laws. ---------FOOTNOTES---------- -[80]- The following conversation is an example of market makers agreeing to delay a print to hide it from a customer. Trader 1: I just sold 25 at 1/4, 1/8 for any part of whatever you want. Trader 2: Oh, that's ******* beautiful, buddy. Trader 1: . . . . Trader 2: Why don't I sell you - This sounds so horrible - I'm gonna sell you, is 10 G's okay? . . . Trader 1: . . . . Trader 2: . . . I'd love to sell you 10, I owe you one. Trader 1: I bought 10 at 1/8, and don't print it for, for a few minutes, 'cause I told the guy I'm just making a sale out of the blue. Alright? Trader 2: I'll, I'll print after the bell. Trader 1: Thanks, bud. The conversation took place at approximately 3:54 p.m. The trade was reported late after the close of the market at 4:01:40 p.m. Trader 1 testified that he had told the salesperson at his firm that he was selling "out of the blue," which meant that he was selling out of inventory rather than crossing the trade. He explained that certain customers, such as large mutual funds, do not like to see multiple trade reports, which reflect the customer buying from the market maker who is buying from another market maker who is buying from another customer, often with mark-ups at each trade. Trader 1 testified that he therefore wanted the trade prints to be separate from one another. ==========================================START OF PAGE 43====== c. Information Sharing The investigation has further identified a number of practices, which are loosely characterized as "professional" or "ethical" obligations by Nasdaq traders that generally govern market maker trading activities. Certain market makers share information with other market makers concerning the size of their customers' orders, and in some instances, the identity of their customers. They also disclose to each other their own market making positions and their intended trading strategies and quote movements. Market makers may also discuss non-public news releases, and research reports and recommendations concerning particular stocks.-[81]- In accordance with these so- ---------FOOTNOTES---------- -[81]- Market makers often warn their regular market maker contacts about anticipated market price movements and suggest that they move their quotes or establish positions to avoid trading losses. For example, in the following conversation, Trader 1 warned Trader 2 before the opening of the market that the stock Applied Bio-Sciences [APBI] had been taken off of Trader 1's firm's "focus list" of recommended stocks, and that Trader 1 was about to sell stock for his customers by hitting the bids in the market: Trader 1: Applied Bio, go down, I took it off my focus list, I'm gonna rip it [sell stock by hitting the bids]. Trader 2: Oh. Update down a quarter. Trader 1: I just didn't want you to be up there while [inaudible]. Trader 2: I appreciate it, my friend. As a result of the call, Trader 2 moved his bid quote down from 5 3/4 to 5 1/2, off the inside bid. Trader 1 had similar conversations with other market makers of APBI, who also moved their quotes down prior to the market opening. The warnings created downward pressure on the market price for the stock. At the time of the calls, Trader 1 had retail customer orders to sell 15,000 shares. Trader 1 sold 11,000 shares at an average price of 5 5/8 during the first five minutes following the opening. Approximately five minutes following the last of these sales, after the inside bid had dropped to 5 3/8, Trader 1 bought 11,200 shares of APBI from his customers at prices between 5 3/8 and 5 5/8. Trader 1, by disclosing his intent to hit the bids and warning market makers to move off of the inside bid, helped move the market price down, against his customers' interest. ==========================================START OF PAGE 44====== called "professional" practices, it is understood that market makers who receive this information will not use it to trade against the disclosing market maker's interest.-[82]- Nor is such information expected to be disclosed to other market participants. The evidence shows that market makers who engage in this behavior typically disclose the full extent of their customers' orders when negotiating a trade with another market maker.-[83]- If additional orders are received from the customer, the market maker with the order may also consider itself under a "professional" obligation to seek to trade first with the market maker with whom he last traded. It is also generally understood that a market maker that hits another market maker's bid or lifts its offer will not thereafter move its quotes without first consulting the market maker with whom it just traded. Market makers who fail to observe these practices are considered "unprofessional," at times receive complaints and harassing phone calls from other market makers, and risk losing access to information and trading opportunities provided by others.-[84]- Market makers rely on each other to provide ---------FOOTNOTES---------- -[82]- For example, it is understood among market makers that if a market maker tells another market maker that he is selling a substantial block of stock, the market maker to whom that information is disclosed is under an "ethical" obligation not to attempt to sell stock ahead of the market maker that is selling the substantial block. A market maker may disclose this type of information to another market maker (a) in connection with a request that the other market maker help work the order or move his quotes in a manner that facilitates trading, (b) to warn the other market maker that the market will be moving in a particular direction as a result of the trading activity, or (c) to find trading interest. -[83]- Some traders have testified that they do not disclose this information to all market makers with whom they trade, but only to those market makers they trust. -[84]- For example, in one taped conversation, a trader complains to another trader who did not fully disclose his customer's order when they first traded: Trader 1: . . . if you had more you should just show me your picture. I try and make good prints for (continued...) ==========================================START OF PAGE 45====== order flow, information, and cooperation to help them trade positions profitably.-[85]- Traders do not want other ---------FOOTNOTES---------- -[84]-(...continued) you. But-- Trader 2: . . . I'm dealing with a very difficult customer. I ask him, "How much have you got to sell?" . . . They don't even--they say, "**** you. I ain't telling what's for sale. This is what I've got. Work it." Trader 1: Ok. Trader 2: That's how it's done--I mean, I'm not playing games. Believe me. I'm the last person in the street to play those things. Trader 1: Ok, I was, it's just that, I mean I got long the stock trying to move it with my retail when you offer it down. And I don't have any room to pay out the credit to my broker. Then I get stuck, stuck long 10. You offer it down. Then I end up having to go out and hit the stock. And I mean it's not doing anybody any good. . . . Trader 2: Alright . . . I hear you. Trader 1: Just . . . I understand with these guys you can't communicate with them. But if in the future, if you'd like to try, think it would make us both a lot more money. Trader 1 later complains to a trader at another firm about Trader 2: "You know, we try to do the right thing. We keep an orderly market. And this guy just ****** all over us." In this situation, Trader 1's desire to keep the quotes from dropping while making retail sales is inconsistent with the interests of the customers to whom his firm is selling stock. -[85]- In one taped conversation, two traders discuss the benefits of sharing information and cooperating: Trader 1: . . . you've bailed me out a couple of times too. That's the game. Trader 2: Yep. Trader 1: You know? And, uh-- Trader 2: And by you helping me out in some of these other ones. I mean, I'll always make you money in the Vicor [VICR] that, you know, anytime you get a position and stuff like that. That's, you know, that's nice that (continued...) ==========================================START OF PAGE 46====== market makers to perceive them as being "uncooperative," "unethical," or "unprofessional" because that perception may result in their losing access to their trader networks. Market makers may refrain from sharing information with or offering trading opportunities to market makers who fail to comply with the "professional" trading practices discussed herein. Exclusion of market makers who do not follow these practices serves to deter competition in the Nasdaq market. Disclosure by market makers of their inventory positions, trading strategies, and future quote movements to other market makers would normally be risky for the disclosing market maker, because the receiving market makers could use such information to their advantage. The existence of an expectation that the receiving market makers will not use the information against the disclosing market maker is a further indication of the degree of collaboration in the Nasdaq market. These information sharing courtesies can affect customers of the market makers. The information shared pursuant to these "professional" or "ethical" courtesies (the size of customer orders, inventory positions, intended trading strategies, future quote movements, and the identity of the customer) would normally be viewed as proprietary. A primary purpose of the sharing by market makers appears to be protecting each other from inventory risks that might arise otherwise. These information sharing "courtesies" were usually not extended to customers, and could conflict with duties owed by broker-dealers to customers. Investors may be deprived of benefits that would otherwise be available in a competitive market. For customers trading in large size, a market maker who reveals the size of a market order from the customer may impair the ability of the customer to obtain the best execution. Market makers learning of the order could adjust the price and size of their quotations in ways disadvantageous to the customer. In situations where market makers share the customer's identity, the customer's ability to seek competitive quotations from market makers is significantly ---------FOOTNOTES---------- -[85]-(...continued) way. You know-- Trader 1: Help each other. I'm more than, even if I have to lose a lot of jake [money]. I don't care. Trader 2: Yeah. Trader 1: Because, bottom line is everything comes out. Trader 2: Well, it makes my life a ****-of-a lot easier knowing that you can tell me what's going on when I got some things going, you know--Like the other times I got something going on in something so I can just tell you. And just tell you to get the **** out of the way-- ==========================================START OF PAGE 47====== hampered.-[86]- B. Late Trade Reporting 1. Late and Inaccurate Trade Reports Market participants rely on trade reports for trading Nasdaq securities and are thus affected by the quality of trade reporting. Numerous broker-dealers on Nasdaq repeatedly failed to report transactions on an accurate and timely basis in accordance with NASD rules.-[87]- Late and inaccurate ---------FOOTNOTES---------- -[86]- One reason advanced by some market makers for disclosing the identity of a customer is the suspicion that the customer is doing business with more than one market maker. Traders testified that they will share the identity of a customer when they believe the customer is trading with both market makers at the same time, in order to better evaluate the risks of trading with that customer. This testimony indicates that because the dealers trade with customers as principal, they may at times be tempted to overlook their obligation to deal fairly with their customers. A customer may properly deal simultaneously with more than one market maker in order to secure the best execution of its orders. This is one way in which the customer obtains the benefit of a dealer market. However, for a market maker to collaborate with other market participants against the interests of its customer is inconsistent with the fair dealing obligations of market makers in a free and open market. -[87]- Pursuant to Rules 11Aa3-1 and 11Aa3-2 under the Exchange Act, the NASD adopted a transaction reporting plan for National Market System securities in 1982. Exchange Act Release No. 18590 (Mar. 24, 1982), 47 Fed. Reg. 13617 (Mar. 31, 1982). As part of this plan, transactions in designated Nasdaq securities must be reported by the broker-dealer with reporting responsibility within 90 seconds after execution. A pattern or practice of late reporting without exceptional circumstances may be considered conduct inconsistent with high standards of commercial honor and just and equitable principles of trade, in violation of Article III, Section 1 of the Rules of Fair Practice. NASD Manual, Schedule D to the By-Laws, Part X,  2(a) (CCH) 1867 (1995). ==========================================START OF PAGE 48====== trade reporting occurred frequently in this market and undermined the accuracy of the last sale transaction report information that was disseminated by the NASD. The NASD accorded a low regulatory priority to trade reporting issues and failed to enforce adequately its trade reporting rules. Analysis of late trade reporting on Nasdaq begins with trades which are reported as late trades. NASD rules require that a trade report which is late be designated as such so that market participants will recognize it as an out of sequence report.-[88]- The scope of such late trade reporting is set forth in Table 1 below. Table 1 Time Period: Percent of Trades Percent of Volume Marked Late Marked Late 2/94 to 12/94 3.6 4.5 1/95 to 7/95 1.9 2.9 Underlying the figures in Table 1 are, for the period February through December 1994, approximately 1.12 million Nasdaq NMS trades that were reported as late trades.-[89]- These late trade reports embodied a trading volume of over 2.6 billion ---------FOOTNOTES---------- -[88]- The party obligated to report the trade is required to designate as late all trades reported more than 90 seconds after execution by appending to the trade report a modifying code, ".SLD." See NASD Manual, Schedule D to the By-Laws, Part X,  2(a)(8) (CCH) 1867 (1995). The reporting responsibility in a transaction between two market makers or between two non-market makers is on the broker-dealer representing the sell side. In transactions between one market maker and one non- market maker, only the market maker is required to report. In addition, all transactions between a broker-dealer and customer are reported by the broker-dealer. NASD Manual, Schedule D to the By- Laws, Part X,  2(b), (CCH) 1867 (1995). -[89]- These figures are based on all trades reported on Nasdaq and include trades reported through systems such as SOES, SelectNet, and ACES. ==========================================START OF PAGE 49====== shares.-[90]- During the same period, late trades accounted for only .09% of reported trades and .49% of reported volume on the New York Stock Exchange.-[91]- While the figures for the period January 1995 to July 1995 show a reduction in the degree of late trade reporting, the extent of the problem remains significant. In addition to reported trades marked late, analysis of audit trail data revealed that a significant percentage of trades between broker-dealers were reported late but were not properly designated late by the reporting broker-dealer. The Commission staff reviewed data for a sample of trades between broker-dealers that were not designated as late reports, and found that from February to December, 1994, 6.7% of trades and 8.7% of volume in transactions between broker-dealers were reported as regular trades when they were in fact late and should have been identified as such by the broker-dealers having the reporting responsibility.-[92]- These transaction reports violated ---------FOOTNOTES---------- -[90]- Excluding trades executed through automated systems such as SOES, SelectNet, and ACES, which automatically report trades and generally eliminate the possibility of late trade reports, late trades in 1994 accounted for approximately 4.5% of all reported trades and 4.9% of all reported volume. Approximately 20% of Nasdaq NMS trades and 8% of volume are reported through ACES, SelectNet, and SOES. -[91]- From January through July 1995, following the initiation of the Commission's investigation and increased scrutiny by the NASD of late trade reporting problem