Section of Business Law

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October 1, 1997

Securities and Exchange Commission

450 Fifth Street, N.W.

Mail Stop 6-9

Washington, DC 20549

Attention: Mr. Jonathan G. Katz, Secretary

Re: File No. S7-16-97

Ladies and Gentlemen:

The Committee on Federal Regulation of Securities (the "Committee"), Section of Business Law, of the American Bar Association welcomes this opportunity to comment on the Concept Release issued by the Securities and Exchange Commission (the "Commission") concerning the regulation of exchanges and other markets under the Securities Exchange Act of 1934 (the "Exchange Act"), which was announced in SEC Release No. 34-38672 (May 23, 1997) (the "Release").

A draft of this letter was circulated for comment among members of the Subcommittee on Market Regulation and the Chairs and Vice-Chairs of the other subcommittees and task forces of the Committee, the Advisory Committee of the Committee, the officers of the Committee, and the officers of the Section. A substantial majority of those who responded have indicated their general agreement with the views expressed. This letter, however, does not represent the official position of the American Bar Association, the Section or the Committee, nor does it necessarily reflect the views of all those who have reviewed it.

General approach. The Release presents a thoughtful and interesting analysis of the Commission's statutory authority and exposes for public comment a broad range of alternatives for the regulation of domestic and

foreign markets, including domestic exchanges, alternative trading systems ("ATSs") and cross-border trading. The Release presents a detailed analysis of the basic premises that go into the regulation of markets. It undoubtedly will be a resource for the Commission and the bar for years to come. In raising for public analysis and discussion the assumptions that underlie the Commission's regulation of the markets, it makes a real contribution to the public debate on these important issues. 1

The Release does not identify in any specific detail, however, any actual current regulatory problems that are in need of the dramatic and far-reaching resolutions suggested. The Commission has not yet shown that there is a legally sufficient regulatory predicate for expanding the Commission's regulatory grasp to the degree the Release appears to envision. The Committee has found it difficult, as a result, to assess whether the Commission's proposed regulatory approaches are a reasonable response to abuses or problems in the public securities markets since the concrete objectives of these regulatory approaches are not specified.

The Commission has broad powers under the Exchange Act. Even before the National Securities Markets Improvement Act of 1996 ("NSMIA"), it had the power to classify persons and entities in its rulemaking. The Commission's new exemptive power carries with it the lesser included power to exempt in part but not in whole. Together with the Commission's other powers in the Exchange Act, that power gives the Commission great flexibility in devising solutions to regulatory problems. But NSMIA does not increase the Commission's regulatory authority to classify persons and entities. 2

The absence of an articulated factual basis for making any of the regulatory choices suggested in the Release makes even more difficult the task of commenting on so formidable a catalogue of regulatory alternatives. In making legally supportable use of its authority, the Commission must have a valid regulatory predicate, a more than fanciful or theoretical problem that needs solving. 3 The Release does indicate that the Commission's goal is to develop "a forward-looking and enduring approach that will permit diverse markets to evolve and compete, while preserving market-wide transparency, fairness, and integrity," 4 but it does not identify in concrete terms the factual circumstances that make the current regulatory pattern obsolete or inappropriate. In proposing rules in this area, the Commission should articulate what it believes the ultimate goals would be in changing the current regulatory regime, beyond general expressions of concern about increasing regulatory control over denials of access, the need to increase surveillance possibilities, prevent manipulation, ensure adequate systems capacity, and other laudable but non-specific objectives.

The Commission has traditionally relied to a considerable degree on market forces to determine the structure of the securities markets. In the absence of fraud or demonstrated abuse, the Commission has generally refrained from dictating the shape of things to come or imposing its own will on the forces of competition. Indeed, the Commission's reliance on market forces has strong congressional support in the legislative history of the Exchange Act. In framing the Securities Acts Amendments of 1975, for example, the Congress instructed the Commission that in the development of a national market system, "in economic areas affecting the securities industry, competition, rather than regulation, should be the guiding force." 5 The Commission has previously acknowledged its instructions from the Congress to "facilitate, but not design, the national market system." 6

The Release, however, seems to herald a departure from that history of restraint and to suggest that the Commission is gearing up to increase greatly its regulation of the trading markets and trading systems, at least in the case of the most commercially successful ATSs. Even while the Commission states that it hopes to promote the development of competition and diversity, the regulatory approaches it contemplates seem to reflect suspicion on the Commission's part about the continued wisdom of relying on competition, technology and market forces to keep the markets and market participants on track. That presents both policy issues and, in some cases, issues of legal authority.

Definition of "exchange". As the Commission acknowledged in the Release, 7 it announced a test for what it would consider an exchange in the Delta litigation in the early 1990s. 8 Since then, ATSs have increased their share volume and market share but, the Committee understands, have not changed their mode of operation. In at least some aspects of their operation, ATSs are more like electronic broker-dealer trading desks that assemble institutional trades than they are like the traditional model of an exchange. The Release suggests that the Commission is prepared to expand its view of what constitutes an exchange, but it does not discuss the factors that might impel the Commission to reverse course and overrule its prior views, as articulated in Delta. Have there, for example, been denials of access, market manipulations or capacity failures in the last several years that justify new governmental regulation? Also, what are the real concerns about regulatory transparency? It is commonly understood that the largest ATSs have electronic audit trails that are at least as good and more precise than exist on the major exchanges. Have there been investigations into ATS trading that have been frustrated by the absence of data or recordkeeping? If manipulative schemes are affecting the operation of ATSs, are they not susceptible to enforcement action today under existing rules?

Legislative intent and purposes. As a technical matter, the Commission could determine to classify as exchanges, rather than as broker-dealers, ATSs that meet certain characteristics (e.g., interaction of system participants with each other without direct participation by the sponsor on other than an agency cross or riskless principal basis, as opposed to the spokes-around-the-hub approach where each sponsor trades independently on a risk basis with each of its participant/customers). 9 Indeed, the Commission could use its exemptive power to get to exactly where it is today with broker-dealer regulation of these entities, or virtually all the way to full exchange regulation, or somewhere in-between. The Commission should consider, however, whether the exemptive adjustments that would be needed for ATS exchanges would have to be so extensive as to suggest that a more sensible policy choice might be to tailor broker-dealer regulation to fit ATSs more precisely instead of trying to force ATSs into the regulatory mold designed for exchanges.

Simply reading the words of the Exchange Act, moreover, to see whether the Commission can revise its treatment of ATSs and then use its exemptive authority to cure resulting problems does not answer the basic question whether such an exercise would in fact be consistent with the Commission's congressional mandate. The exemptive power granted to the Commission under NSMIA was intended to promote deregulation, not to provide an opportunity for the Commission to increase its regulation. In the words of Representative Jack Fields, the sponsor of the legislation, it was designed to empower the Commission to "eliminate rules and regulations that no longer serve a legitimate purpose." 10

The Congress was not thereby authorizing the Commission to use the exemptive authority as a predicate for expanding its jurisdiction through a reinterpretation of the reach of the basic definition of the entities that would have to register as exchanges. The Committee would recommend, therefore, that the Commission evaluate whether its proposed new approach, to overrule Delta and to expand the definition of the term exchange, and then grant extensive exemptions to mitigate the impacts of its action, would indeed be consistent with the congressional intent behind NSMIA.

If the Commission were to adopt such a change in approach, moreover, it would do so a relatively short time after its Delta decision. The Delta case followed a detailed and considered evaluation by the Commission of the application of the definition of the exchange registration requirement to electronic trading systems. The Commission has not pointed to any substantial, unforeseen change from the factual setting at the time Delta was decided that would make it necessary to overrule that decision. That naturally may provoke concern as to why the Commission, in the wake of substantially deregulatory legislation, is taking such a course.

Currently, the Commission has the Order Execution Rules (rules 11Ac1-1 and 11Ac1-4 under the Exchange Act) to regulate ECNs through the power to grant or deny to ATSs the coveted status as "compliant ECNs." 11 While this subject is not discussed in the Release, the Commission apparently has used the threat of withdrawing the existing no-action letters granted to Instinet Corp. ("Instinet") as a means of pressing that ATS to develop more systemic capacity. 12 The Commission might wish to consider whether its continued use of the no-action process in that way, during the period of time the Commission is sorting out the regulatory categories, is appropriate as a matter of administrative due process.

Competition and regulation. The Commission speaks in the Release of wishing not to stifle innovation and market forces, but several of the regulatory approaches it suggests in the Release seem inconsistent with that objective. For example, it might be wondered whether market forces would not by themselves be sufficient to induce ATSs to develop and maintain adequate capacity to meet the needs and expectations of their customers. The Commission does not dictate to other broker-dealers how many traders to hire or how much back office capacity the burgeoning clearance and settlement networks operated by the major clearing brokers should have. What makes an ATS any different from the point of view of needed governmental prodding?

It would appear that the Commission's real problem involves its relations with the existing self-regulatory organizations ("SROs"). Technology and competition have affected the environment in which the Commission regulates the exchanges and Nasdaq and have challenged some of the regulatory assumptions that underlie the Commission's regulatory program with respect to the exchanges and Nasdaq. For example, over the years, the Commission has taken advantage of the leverage afforded by the virtual monopoly the major exchanges and Nasdaq enjoy over their markets to engraft onto their operations various collateral programs and objectives, such as the Small Order Execution System ("SOES"), that were developed by the Commission rather than by the securities industry and that have not in some cases accorded well with the competitive, economically driven demands of the markets.

The Commission's continued ability to impose such burdens on the existing SROs is directly threatened by the ability of private businesses, like the most successful ATSs, to compete with the exchanges and Nasdaq without having to put up with similar regulatory burdens. That suggests that the Commission will either have to increase the burden on ATSs or decrease it on the exchanges. Unless there are real problems that require governmental intervention, it often is the case that deregulation and competition are a better policy choice than increased regulation.

A broad policy question the Commission should address in using its powers under the Exchange Act in some of the ways suggested in the Release is the extent to which it is appropriate to use them to achieve economic ends and, if so, what ends should be sought. Should the Commission, for example, rebalance the economics of the market, or grant a special regulatory preference or subsidy to the investor who invests directly rather than indirectly in the market? Efforts to mandate "fair" access to ATSs, or to limit the ability of institutional investors to trade among themselves without giving the retail investor a chance to interact with their order flow, seem designed to rewrite the rules of the marketplace. Is that the Commission's mandate?

Today, many investors, including state employees, union workers and others whose economic stake is very small indeed, invest only through institutional investment vehicles. Is an individual investor who can afford to invest directly in the market more deserving of a regulatory preference or governmental subsidy than one whose retirement or other moneys are invested for him or her by a public or private pension fund or a mutual fund? While the Commission has fostered the development of a two-tiered market in foreign securities through rule 144A under the Securities Act of 1933 (the "Securities Act") and rule 15a-6 under the Exchange Act, which limits the ability of foreign broker-dealers to solicit investors other than large institutions, its proposed approach under the market-oriented portions of the Exchange Act heads in just the other direction. The resulting inconsistencies seem worthy of further thought.

Regulatory approaches. As a legal matter, construing and applying the legal definition of the term "exchange" in section 3(a)(1) of the Exchange Act necessarily involves consideration of more than just that section alone. The term "exchange", if not limited by a real-world perspective, could in theory apply to any number of entities, such as a telephone company whose lines and other facilities bring together purchasers and sellers of securities. Fortunately, the Congress provided some additional content to the concept through the provisions in sections 6 and 19, which embody (among other things) the concept of a membership organization with fair representation of members, a rulemaking entity that regulates conduct on the exchange floor or other trading facilities, and a disciplinary and enforcement body. Those provisions lend credence to the notion that the Congress did not intend to require that other entities, not having similar functions or structures, be registered or regulated as exchanges.

Ultimately, as a practical matter, if the Commission does indeed make liberal use of either its exemptive power or its rulemaking power, it might not matter in which definitional and regulatory box the Commission places ATSs, exchanges or broker-dealers. Despite the misgivings that might be voiced about whether the Commission's response to NSMIA is consistent with the congressional intendment, the Exchange Act is sufficiently flexible to admit of a variety of possible regulatory structures. 13 As the Commission suggests in the Release, the alternatives include increasing the regulation of ATSs as broker-dealers, an effort it once before tried with its formerly proposed rule 15c2-10 under the Exchange Act, or using the Securities Information Processor ("SIP") approach suggested in the Release, or using a stripped-down version of exchange registration and regulation. The key question, whichever route the Commission chooses, is what will be the intended purpose and result of such regulation?

It is not clear whether continued reliance on the broker-dealer rubric for regulating ATSs would be sufficient or insufficient. For example, the Commission could achieve many of its stated objectives by simply adopting rules having particular application to ATSs. Whether it is problematic for ATSs to be subject to scrutiny by a competitor such as Nasdaq has much to do with the Commission's own ability to supervise the National Association of Securities Dealers, Inc. ("NASD") to ensure that the separation between NASD Regulation, Inc. ("NASD-R") and Nasdaq is appropriately maintained. While the recent enforcement action against the NASD may reflect on the past inadequacy of that separation, that episode does not preclude the conclusion that, in the future, enhanced Commission oversight of the resulting Nasdaq/NASD-R separation would not suffice to address the competitive issue. Also, it would appear that the objective of treating the ATSs as full members of the Intermarket Trading System group for purposes of equal access to order-routing mechanisms does not require that ATSs be exchanges instead of broker-dealers. If the Commission thinks it untoward to increase the regulation of ATSs under the aegis of the NASD's regulatory function, it could relieve the NASD of supervision by adopting rules under section 19(g)(2) of the Exchange Act and imposing its own, more impartial regulation. 14

The suggested move from broker-dealer status to that of a registered, but partially exempt, exchange would involve several issues that the Commission should evaluate before taking such a step, including the following:

1. Institutional membership. If ATSs are registered as exchanges, section 6(c) of the Exchange Act might appear to require that institutional investor participants register as broker-dealers themselves, or else participate through an affiliate or other entity registered as a broker-dealer (except, of course, for the one particular entity that was the only exchange member exempted from such registration by virtue of section 31(a) of the Securities Acts Amendments of 1975). 15 Section 11(a) of the Exchange Act basically requires, except to the extent the Commission has modified the result through rulemaking, that institutional investors hire a broker if they join exchanges and trade for their own accounts or accounts they manage. Additional rulemaking under section 11(a) would be required. 16

2. Fair representation of members. Section 6(b)(3) of the Exchange Act requires that registered exchanges provide for fair representation of members. This requirement, if applied to ATSs that are for-profit corporations, would dramatically change their governance.

3. Enforcement and discipline. It is difficult to envision requiring a for-profit business enterprise to conduct inspectorial, enforcement and disciplinary powers over what are, in essence, its customers. It would also raise nice questions of delegation of quasi-governmental powers to an entity ill-suited to exercise them and could raise constitutional questions. 17 Exemption could solve this problem, but it would be necessary to require either that the NASD or another SRO, or perhaps the Commission itself, take over these responsibilities. That might necessitate requiring that participants in an ATS also belong to one or more "real" exchanges or to the NASD, which would raise the question whether treating the ATS as an exchange in the first place was a sensible policy choice. 18

Timing. The Commission has pressed for two very substantial changes in market regulation in the last year. First, the Order Execution Rules prevent market makers from quoting one set of prices privately in an ATS and another, inferior, set of prices in Nasdaq. That addressed a problem demonstrated to have occurred with Nasdaq and promoted greater market transparency, much in the same way as did the elimination years ago of the "representative bid and asked" quotations that used to be the only publicly displayed quotations while the real "inside market" remained secret. 19 It has been widely reported that increased transparency has led to much narrowed spreads, but it also is beginning to appear that there have been liquidity costs. 20 Second, it is reported that the movement of the minimum pricing increment to the sixteenth has narrowed spreads, and it may be that the planned movement to decimalization (whether a five-cent or one-cent minimum increment) will narrow spreads further.

The Commission should take the opportunity, before beginning new regulatory initiatives, to assess the effects of these regulatory developments. It may be, for example, that the Commission can now allow market forces to work toward greater innovation and market efficiency without a re-calibration of the regulations that apply to ATSs. The reasons for the success of such ATSs as Instinet, The Island System and Bloomberg Tradebook, as well as the experiences of the Cincinnati Stock Exchange, should be analyzed. Whether and to what extent ATSs can survive and thrive in a market now subject to the Order Execution Rules, narrowed spreads and the Commission's enhanced best execution principles (set forth in the release announcing adoption of the Order Execution Rules) remain to be seen. Why they survive and why they thrive, if they do, will be worth examining before the Commission decides what is best for them as a regulatory matter. 21

The Commission does not evaluate in the Release whether it would be useful to encourage a proliferation of SROs. It may be, for example, that to take ATSs out from under the aegis of the NASD and the NYSE would solve one problem, the possibility of competitive interference by the SROs with their regulatees' trading systems. At the same time, such an approach could well create another problem, by diluting the self-regulatory apparatus to the point where the "lower end" of the securities industry would be encouraged to become participants in ATSs of their own devising to avoid having to be subject to effective self-regulation by the NASD or the New York Stock Exchange, Inc. (the "NYSE"). That would complicate the Commission's own task in regulating the markets and market professionals. Securities markets participants can organize new SROs, of course, but there has been little impetus for doing so, and it is fair to question whether the Commission should encourage such a development.

Deregulatory alternatives. An alternative the Commission put forward, possibly only very tentatively, is deregulating the exchanges and Nasdaq. Particularly in light of NSMIA, the Commission should consider whether it would be appropriate to focus more attention on deregulating the markets before adopting more extensive regulation. A principal problem the Commission has faced in the past is the conflict between its desire to allow the markets to grow and innovate on their own and the Commission's inclination to take a more assertive role. The SRO rule-review process, like the no-action process, suffers from chronic and severe regulatory delay, in no way contemplated by the Exchange Act. The Commission has the SROs under powerful regulatory constraints. As a result, instituting new systems, improving old ones and keeping up with competitive developments from the unregulated markets has been a real burden for the NYSE and Nasdaq.

One approach to that problem might be to allow certain rule changes involving the introduction of new products or systems to go into effect upon filing with the Commission if the SRO consented to allowing the Commission to revoke or amend the rules if bad results occurred or anti-competitive effects were perceived. While the history of SRO rulemaking is replete with examples of rules that had anti-competitive effects or would have had such effects if the Commission had not intervened, 22 one solution might have been to let such SROs take their chances with the U.S. Department of Justice without the shield of the antitrust immunity given by Commission approval of SRO rule changes. 23

Foreign securities and markets. The Commission suggests two ways in the Release in which it may curtail the ability of investors to purchase foreign securities. First, by subjecting ATSs to exchange regulation, the Commission could prevent them from trading in any securities the Commission did not specifically approve, which would permit it to impose section 12 registration on foreign issuers and keep out issuers whose financial statements were not prepared in conformity with US GAAP, and therefore could not meet the standards of a section 12 registration. Second, the Commission has raised questions about the circumstances in which a foreign securities exchange should be permitted to seek U.S. investors to engage in "electronic cross-border trading", such as through a computer link provided by a broker-dealer or electronic communications network.

To some extent today, the U.S. federal securities laws allow foreign companies to sell securities into the United States without full reconciliation to U.S. GAAP. Private placements pursuant to section 4(2) of the Securities Act or Regulation D (to "accredited investors"), offerings to qualified institutional buyers ("QIBs") pursuant to rule 144A under the Securities Act and secondary market transactions pursuant to section 4(1) are permitted, subject to the antifraud provisions, without meeting any affirmative disclosure requirements, such as conformity of financial statements to U.S. GAAP. In addition, an individual U.S. investor who chooses to do so may purchase a foreign security abroad, either through a U.S. broker-dealer or otherwise.

A basic question for the Commission to address is whether, and under what circumstances, it should permit U.S. exchanges, Nasdaq, unregistered foreign exchanges (directly or through U.S. broker-dealers) and U.S. broker-dealers themselves to offer and sell foreign securities into the U.S. markets without insisting that the issuers of the foreign securities conform to U.S. disclosure standards, including U.S. GAAP. One possible resolution, and certainly one that is consistent with the way in which rule 144A operates, would be to allow closed circuit systems to operate and to trade foreign securities, and to afford direct access to foreign exchanges, where there is some control on the participants in the closed circuit, such as a requirement that they be QIBs, or other categories of accredited investors. The question to be addressed is whether disclosure of the non-compliance with U.S. disclosure standards should suffice in such a case. If it works for a private placement, or a rule 144A transaction, why not for a secondary market trade or trading market?

The Commission may have a problem of public perception and SRO objection in allowing Instinet and others to trade in such a fashion while not allowing, e.g., Nasdaq and the NYSE to have an off-line market in non-conforming securities. Apparently, one reason the PORTAL system has never been broadly supported by the SROs is that the Commission has refused to allow them to publicize its existence and publish its quotations. If the Commission finds itself unable, given the First Amendment, to enjoin distribution in the United States of securities pricing via the Financial Times and other news media, or to use the federal securities laws to prevent non-U.S. users of the Internet from communicating with U.S. persons, 24 it must be wondered why it would be inappropriate to allow the NYSE and other markets to trade foreign securities under circumstances where the affected investors, particularly institutional investors, were fully aware of the non-conformity to U.S. disclosure standards, given the ready availability in an increasingly information-driven age of alternatives to the NYSE to trade in such instruments.

The NYSE itself is not open to direct access by the general public, but is itself a membership organization limited to registered broker-dealers. That would make it difficult, on at least one level, to distinguish between the NYSE and the closed-circuit network constructed by a broker-dealer to permit its institutional customers to trade non-conforming foreign securities. The answer to that may be one of labeling, however, as well as relying more heavily on the suitability doctrine. The Commission might also permit the NYSE and other SROs to trade such securities if the investors were sophisticated and were specifically told that the securities were non-conforming. Alternatively, the Commission might treat as solely a matter of suitability whether investors might, with adequate notice, be sold non-conforming foreign securities. 25

Responses to Specific Questions.

Questions 1 and 2: As stated above, the Committee believes that the general concerns expressed by the Commission in the Release do not by themselves provide a legally sufficient factual predicate for re-regulating ATSs at this time if the re-regulation involves more than a change in form and in fact increases to any considerable degree the burdens placed on ATSs. Market access and fairness and market transparency and coordination are concerns raised by institutional domination of the secondary markets and the disintermediation caused by institutional trading. ATSs could be regulated as SIPs as the Release, somewhat inconsistently, proposes for foreign exchange systems. The real issues, not fully vetted in the Commission's lengthy Release, are whether institutions should continue to be forced (by section 11(a) or otherwise) to trade through broker-dealer intermediaries and whether retail customers should have equal access with institutions to secondary securities trading mechanisms. The re-regulation of ATSs, along the lines suggested in the Release, will not resolve these questions.

Question 3: The Commission should rely more heavily on competition, technology and market forces and less heavily on government regulation. Instead of focusing on the success of ATSs and on engaging in their greater regulation, the Commission should consider how deregulation of exchanges and Nasdaq might promote competition and innovation.

Question 4: Congressional goals in the Exchange Act with regard to market regulation are somewhat contradictory because there are conflicting policy objectives. The Commission's goals with regard to ATSs should be to foster fair and efficient pricing mechanisms. Market stability and the elimination of systemic risks should be encouraged but cannot be ensured. Competitive trading systems, however, are of assistance and not inimical to these goals. The decoupling of market surveillance and regulation of market participants from trading markets, as now accomplished by the NASD, should be considered. This could be accomplished through an SRO for ATSs, or by supervision by NASD–R with active, vigilant Commission oversight.

Question 5: The regulatory categories of the Exchange Act are flexible but do not specifically contemplate ATSs. The Commission probably could establish, however, a separate ATS registration by rule as a subcategory of broker-dealers or some other designation.

Questions 6 and 7: Once the general approach is decided upon, the promulgation of general standards is a better approach than micro-management through no-action letters. In either event, the Commission should place greater reliance on competition as an alternative to governmental regulation and enforcement.

Question 8: In other areas of securities regulation, the Commission relies heavily on disclosure and the antifraud provisions. In the market regulation area, the Commission similarly could rely more heavily on transparency and best execution.

Question 9: The current regulatory structure is capable of addressing the Commission's concerns regarding the growth of ATSs. For example, the Commission could:

• Use its exemptive authority to release ATS operators from inapplicable regulatory requirements;

• Rely on the forces of competition to ensure ATSs maintain sufficient systems capacity, integrity and security; and

• Enhance broker-dealer regulation to address identified problems.

Question 10: In general, ATSs meet the statutory definition of a "broker"; they are principally engaged in the business of effecting securities transactions for the account of others. As such, regulating ATSs as broker-dealers is appropriate. The Commission could also regulate ATSs in the same manner as it does SIPs. As the Commission knows, however, ATSs, as broker-dealers, are provisionally excluded from the definition of a SIP in section 3(a)(22)(A) of the Exchange Act.

Question 11: The question whether ATSs should be required to submit all customer orders to the public quotation systems has many different competing policy and legal implications. There is no clear congressional mandate, and perhaps no authority, for the Commission to require so fundamental a change in market structure. Unlike market makers and exchange specialists, which have a duty to the market-at-large to display their best bid and asked prices, institutions and non-market-making broker-dealers currently have no regulatory obligation to display their proprietary trading interest to the entire marketplace except to the extent that their fiduciary duty to use reasonable efforts to obtain best execution of transactions may require. To impose such a per se obligation on non-market makers merely by virtue of their usage of an ATS would be a further step towards a "black box" centralization of order flow; the Commission should evaluate whether such a development would discourage use of ATSs and drive order flow underground. Incomplete, but possibly adequate, market transparency already is ensured by requiring that the principal intermediaries in a given market display their best bid and ask prices, and that broker-dealers display their best customer limit-order prices. As stated above, the Commission should study the effects of the new Order Handling Rules before determining that the current degree of transparency is inadequate. A different question, however, might be whether ATSs should be required to offer to their institutional participants the choice as to whether to have the ATS display their orders in the public market. Also, the Commission might wish to evaluate whether the disparate treatment under the Order Execution Rules of institutional orders given to ATSs through market makers, on the one hand, and those given to ATSs directly by institutional investors, on the other, is appropriate. 26

Question 12: The Commission could relieve ATS subscriber broker-dealers of their reporting obligations with respect to these orders.

Question 13: The Commission should consider carefully the likely impact of its regulation on "buy side" trading behavior. Currently, any ATS customer wishing to have an order displayed in the public quotation system may do so by routing the order to an appropriate market maker or exchange specialist (assuming the order is for a security subject to the Limit Order Display Rule), or by routing an order to an ATS that permits non-market maker order display. To require display of non-market-maker ATS orders could well propel institutions that value anonymity to seek non-ATS mechanisms to effect securities transactions, ultimately leading to a decrease in order transparency.

Question 14: Transparency of orders of non-market-maker ATS customers potentially disadvantages the ATS customer, who has no duty to expose its trading interest to the general public. Institutions and non-market-making broker-dealers use ATSs because the combination of limited transparency, liquidity and anonymity ensures that trades will be executed at the most favorable prices possible. Even if trader identity remains anonymous, disclosure of trading strategy in the public quotation system might well increase the market impact of institutional trading interest, which could adversely affect volatility and result in the trader's receiving a worse trade execution.

Question 15: The Commission may wish to consider whether present "SelectNet" linkage to ECN prices provide an adequate model on which to base any future non-subscriber access to ATS orders.

Question 16: The Commission may wish to consider whether the fees that ATSs assess their own subscribers should be the benchmark against which to measure the reasonableness of non-participant fees. As for-profit organizations, ATSs probably should be allowed to set non-participant fees equivalent to subscriber charges so as to discourage free riders, as long as such fees do not violate the antitrust laws. The history of rate regulation by the Commission has not been a happy one and the Commission should avoid rate regulation in any segment of the securities industry that enjoys competition.

Question 17: The Commission should resist the temptation to impose economic regulation over a private business in the absence of demonstrated regulatory need. That one or more ATSs are commercially successful is not, by itself, a legally sufficient reason either to socialize their order flow, or require that they accept orders from all broker-dealers regardless of considerations of credit worthiness. Where broker-dealers use an ATS to circumvent public reporting of their quotations, as the Commission found in its rulemaking proceeding preceding adoption of the Order Execution rules, that provides a regulatory predicate to stamp out the practice. There has not, however, been any comparable demonstration of a public need to require disclosure of institutional investor trading interest, or to regulate the commercial terms on which ATSs provide access to market participants.

Question 18: The SRO should be able to learn the identity of the counterparty (assuming that this is done by a reliably impartial inspection team and is not communicated to the marketing arm of the SRO). The SRO should have sufficient access to ensure that its surveillance system has necessary information on a timely basis.

Question 19: The Commission could mandate the required parameters for audit trails to be maintained by ATSs and require certain data to be electronically fed to the appropriate SRO surveillance group.

Question 20: The Committee believes this is a business and not a legal question.

Question 21: The Commission may have the legal authority to get into this area, but what is the factual basis for doing so? What rules currently regulate systemic capacity of the SROs? The Commission does not have explicit statutory authority to mandate expenditures by SROs. Unfunded mandates by the Federal Government raise complex constitutional and other questions. The Commission's use of informal leverage, for example, to compel the NYSE to increase capacity may be justified because of the NYSE's statutory obligations, which ATSs currently do not have.

Questions 22 and 23: The Committee believes these are business and not legal questions.

Questions 24-31: At present, it is generally possible for every investor (directly or indirectly) to have "access" to all markets and all trading systems. The problem is one of expense and efficiency. Thus the question the Commission should ask is what type of access, for whom and at what price. As a general proposition, bids and offers that are displayed in Nasdaq or on another exclusive SIP should be readily accessible to all registered broker-dealers at reasonable cost. What priced ATS orders must be displayed is another question. Requiring reasonable access to displayed ATS orders is not the same thing however, as requiring that broker-dealers have access to all ATSs. Also, the question of whether institutional investors' orders should be treated the same as market makers' orders involves complex legal and policy issues beyond a general quest for greater market transparency.

Question 25: This question begs the question of whether ATSs should be subject to a fair-access requirement imposed by the Commission. Such systems generally have an economic incentive to admit as many appropriate participants as possible, not to exclude participants. This dynamic is one of the ways in which ATSs differ from exchanges. Exchanges are controlled by their members and therefore may have a built in incentive to deny access to competitors of the existing members. 27 That is why traditional exchanges became subject to fair access requirements and Commission review." 28 In the absence of demonstrated abuse, it is unclear why governmental regulation of access to ATSs is needed or useful.

Question 26: The Commission has not identified any such unfair denials. SelectNet now provides an alternative trading venue through the Order Execution Rules.

Question 27: No, but more could be done to assure the separation of the market and regulatory functions of the NASD and other SROs. For example, it might be appropriate to require a demonstration of an effective Chinese Wall between NASD–R’s regulation of ATSs and Nasdaq’s operation of its stock market. If there are complaints about SRO regulation of ATSs, the Commission could use its authority under section 19(g)(2) of the Exchange Act to relieve the NASD and other SROs from the obligation to regulate these entities and then it could directly regulate these entities as it did when it operated the SECO program. 29

Questions 28-29: Although it may be feasible to establish a new SRO, the Commission should focus on the policy implications of such a development. Does the industry need yet another SRO? The establishment of a new SRO may raise questions concerning, among other things, the integration of such an SRO into the existing marketplace, the operational capacities of such an SRO, the adequacy of its surveillance. Can the Commission not assure that the NASD’s regulation of ATSs is even-handed and appropriate? Of course, if the ATSs wish to establish such a new SRO at their own expense, they are free to do so, but the dangers of promoting a race to the bottom in regulatory oversight would need to be addressed.

Question 30: The Commission has not identified instances of serious anti-competitive practices by the ATSs and the Committee is not aware of any. The Commission has many tools for addressing serious anti-competitive practices if they should occur, including the adoption of rules under section 15 of the Exchange Act. In that regard, the Committee refers the Commission to formerly proposed rule 15c2-10. As mentioned above, the incentives of the ATSs are very different from those of traditional exchanges.

Question 31: The legal and policy benefits of preserving the broker-dealer approach are three: first, it builds on an existing regulatory structure in an evolutionary way instead of possibly disrupting existing market arrangements; second, if not dramatically changed, it preserves and encourages the existing proprietary character and incentives of ATSs, thereby protecting their unique innovative capacities; and third, it avoids confusing market operations with self-regulatory responsibilities. The drawbacks of such an approach are the applicability of inappropriate broker-dealer requirements to these ATSs, i.e., those requirements identified by the Commission in section II.B.1 of the Release. The Commission can address these problems through its plenary exemptive power to exempt particular broker-dealers from inappropriate regulatory requirements.

Question 32: The Commission's proposed definition is too broad. The Committee believes that the definition of an "exchange" in section 3(a)(1) of the Exchange Act, in referring to "functions commonly performed by a stock exchange as that term is commonly understood," means that the presumptions of what an exchange is in sections 6 and 19 must be read in conjunction with section 3(a)(1). Traditionally, and as the Commission has previously determined, 30 an exchange centralizes orders transmitted by intermediaries, executes those orders according to a price priority system and provides two-sided quotations on a regular or continuous basis so that buyers and sellers have an expectation of liquidity. Importantly, exchanges have been non-profit membership organizations. The type of regulation of exchanges long in effect may be appropriate only in markets where one person represents the orders of another and therefore enforcement of fiduciary responsibilities is legally necessary.

Question 33: No. As stated above, the Commission has not presented evidence of regulatory abuse. The Commission would not be justified in overhauling the current regulatory scheme without compelling evidence of abuse or necessity. More targeted initiatives may be more appropriate. Second, broadening a regulatory scheme and then exempting from it does not seem the best way to regulate and, as noted above, is a legally questionable use of the Commission's new powers granted to it in NSMIA. Finally, exempting "exchanges" with low volume or that otherwise have an insignificant impact on secondary markets is questionable policy because it penalizes efficiency and success and does not focus on the purposes of exchange regulation.

Questions 34-36: As between an exemption based on volume and one based on the limited function of price discovery performed, the latter may make more sense. It would be better, however, for the Commission to focus on whether the exchange is a place for orders to interact with others on an equal basis. If the Commission nevertheless adopts this approach, it may be important to have certainty and to measure volume over a relatively long period of time.

Questions 37-39: The answer to these questions turns on the purpose of exchange regulation. Current regulation, with incremental adaptations, probably is sufficient.

Question 40: Many of those requirements seem unnecessary or duplicative of current requirements and are unlikely to survive a realistic cost-benefit analysis. The only meaningful requirement suggested is trade reporting.

Question 41: As stated above, the Commission has not put forward a sufficient justification for the exempted exchanges proposal. If the Commission should nevertheless follow such a route, it should develop and adduce persuasive, factually grounded reasons for the regulation suggested.

Question 42: The answer to this question depends on what the goal of the regulation is. If it is fraud prevention, there is no reason to vary requirements. If the goal is to force trade reporting, it may make sense to vary requirements.

Question 43: We think not. Why should the requirements of section 12(g) of the Exchange Act be trumped in this fashion? Would issuers then be required to pay listing fees to ATSs? Would new corporate governance standards be imposed upon them? Why should the decision by an ATS to trade a security suddenly subject the issuer to new regulatory requirements? Unless a retail investor is induced to trade these securities, full section 12 disclosure and related protections do not seem justified.

Question 44-49: Although the Exchange Act does not flatly outlaw exchange institutional membership by an institution willing to register as a broker-dealer or form a subsidiary that will so register, the Exchange Act does not contemplate it and, in section 11(a), affirmatively discourages it. The idea in the Release of narrowing the definition of an exchange "member" to natural persons flatly contradicts the statute. Permitting institutional membership on existing exchanges would work a radical restructuring of the securities industry. Prohibiting institutional membership on ATSs would limit their economic justification in a way that bears no obvious, or demonstrated, regulatory justification or public benefit.

Questions 50-52: A major problem with the Commission's proposal to regulate ATSs as exchanges is that ATSs are for-profit, non-membership organizations and exchanges are not-for-profit, membership organizations. The idea of an ATS disciplining or regulating an institutional member such as a bank, an insurance company or investment adviser, subject to Commission oversight, is unwise and unprecedented. It ignores not only the structure of the Exchange Act but the legal and historical divisions between Commission and other financial regulators, including divided responsibility for regulation of the financial services industry at the federal and state levels.

Question 53: The Committee believes the revised interpretation of the term "exchange" proposed in the Release is dubious as a legal matter when considered in the context of the Exchange Act as a whole. It also is highly ambiguous and open-ended and could cover a wide variety of participants in the securities industry, including many broker-dealers in addition to ATSs.

Question 54: A customer order and a market maker quotation are legally distinct.

Question 55: Material conditions for trading on an exchange are conditions that set trading priorities or compel the execution of trades.

Questions 56-59: As the Release recognizes, distinguishing between block trading or internalization of customer order flow by broker-dealers and exchange trading is primarily a matter of tradition; the definition of an "exchange" in the Exchange Act recognizes this history. In general, broker-dealers owe duties to their customers and not the markets, whereas exchanges owe duties to the public as well as to their members. If the Commission believes ATSs should owe certain duties to the public, it should focus on why, what these duties should be, and whether the Commission has the legal authority to create such new duties.

Question 60: If Nasdaq will not be regulated as an exchange under the Commission's new definition, it seems somewhat inconsistent to capture other similar organizations of dealers under a new definition. That may suggest the appropriateness of requiring Nasdaq to be treated in the same way as ATSs, or even seeking legislation to combine sections 6 and 15 of the Exchange Act insofar as the regulation of markets operated by SROs is concerned.

Questions 61: The Commission's proposed new definition of an exchange would appear to exclude passive bulletin boards, but could capture them when they become more active. The Commission should identify problems with each type of ATS before it steps up regulation, and then tailor regulation to address those problems.

Question 62: The Commission's implicit suggestion that inter-dealer brokers that trade only in exempted securities should be exempted from regulation as exchanges may suggest that expanding the scope of exchange registration is not the best way to deal with whatever problems are presented for non-equity securities markets.

Question 63: Inter-dealer brokers could be regulated simply as brokers; ATSs can be distinguished in that, typically, they involve order interaction between and among participants, on an anonymous basis, with only a passive intermediation by an entity that completes the trades on a dual agency basis.

Questions 64-68: These questions show well the problem of imposing a detailed exchange regulatory scheme on trading systems not at all like those that the Congress and the Commission had in mind in establishing and administering that scheme. The very existence of questions like these indicates that the Commission should be wary of extending the exchange regulatory scheme to other markets, especially in the absence of carefully considered evidence that any Commission action, let alone such an extension, is necessary. There likely will be numerous side effects from such a change, some such as those discussed in the Release and some not imagined by the Commission or anyone else.

Question 69: This question reveals the competitive concerns that underlie most of the issues identified in the Release and touches on fundamental business, rather than legal, issues.

Questions 70-80 are technical or business questions outside of the Subcommittee's province.

Question 81: Unless exemptions were granted, section 6 of the Exchange Act would require the institutions to participate in the trading systems through broker-dealer affiliates. Section 11(a) of the Exchange Act would severely restrict their trading unless further exemptions were granted. The publication of their trading interest, which the Commission has not previously required of institutional investors, would likely have substantial impacts on their trading behavior, but this is not a legal issue.

Question 82: One of the few instances of an abuse cited by the Commission as a justification for regulating ATSs as exchange is anti-competitive activity by the NASD, an organization created at the behest of the Commission and regulated by the Commission since its inception as a national securities association under section 15A of the Exchange Act. Forcing institutions to become exchange members would raise questions under section 11(a)(1) and change political compromises made in 1975 and embedded in amendments then made to the Exchange Act. The Commission should have clear and convincing policy reasons for overturning current arrangements.

Questions 83-86: The idea of exchanges surveilling mutual funds, insurance companies, banks and other institutions with respect to any matters other than market manipulation, insider trading or the honoring of contractual obligations is troubling. Further, although the Commission has the power and responsibility for regulating mutual funds, it would offend the teaching of the United States Court of Appeals for the District of Columbia Circuit in American Bankers Association v. Securities and Exchange Commission, supra, note 2, for the Commission to require SROs under its oversight to regulate and surveil banks, insurance companies or pension funds.

Questions 87-88: Business entities should not be subject to dual regulation as broker-dealers and exchanges. Broker-dealers generally are not required to register in additional capacities because the Commission has more than adequate authority to regulate their relationship with their customers and one another. The example of specialists given in the Release does not contribute meaningfully to the analysis of the problems raised. Specialists are registered with the Commission as broker-dealers only.

Question 89: For the reasons given above, the Committee does not recommend that the Commission pursue, on the basis of the factual record developed to date, the concept of regulating ATSs as exchanges. It would appear that the principal benefits of this approach would be to give the Commission greater power to command and control the business of an ATS. Regulation of ATSs exchanges need not be a predicate for sharing with them inter-market order-routing facilities and revenues from trade reporting and other sources. The Commission needs a more convincing factual predicate for such a dramatic increase in regulation, particularly if an ATS prefers to remain registered as a broker-dealer and to remain regulated by NASD–R. It would be desirable, however, to ensure that the surveillance of the ATS markets remains strong and the Commission may need to work with NASD–R to increase the quantity and quality of inspections and other surveillance techniques. The fact, for example, that Instinet now accounts for 20% of the market in Nasdaq securities and 4% of the market in NYSE-listed securities demands vigilance on the Commission's part; it does not necessarily demand that the regulatory structures applicable to Instinet and other ATSs be overhauled unless there would otherwise be demonstrable problems that threaten the markets.

Questions 90: This question goes beyond the Committee's expertise to the extent it relates to business questions such as market impact. Nevertheless, it would appear that rule changes that have the effect of instituting new technology could be the subject of immediate effectiveness. It may be, however, that it would be easier to forestall possible problems if a rule change did not require the elaborate procedures of a proceeding under section 19(c) of the Exchange Act to undo it if problems arose. One solution would be to provide simply that a rule change could become effective immediately if the filing SRO provided in the rule that it had a sunset provision (say, three years after effectiveness, with a provision for truncation of the period if the Commission made certain findings) that would trigger refiling and Commission review but would not cause the rule to terminate automatically (unless the Commission so provided at the time of initiating the review). Following such a review, the rule change could terminate at a future date to be determined by the Commission if it concluded that the rule did not meet the Exchange Act standards. That would give the SRO some comfort, which could be important where substantial implementation costs are involved, but would give the Commission greater control than it would have if it had to initiate a section 19(c) proceeding to undo the rule. 31

Question 91: The Commission could rely on the SROs to act in good faith unless the contrary were demonstrated, in which case, the Commission could provide for limitation or termination of the offending SRO's privilege to file for automatic effectiveness.

Question 92: This is an operational question that goes beyond the Committee's expertise.

Question 93: This is a factual question that goes beyond the Committee's expertise. Logically, however, it would appear that a system having "locked-in" trades and automated, timed audit trails should be more susceptible to Commission surveillance than systems depending on human interaction on an exchange floor where there is only an imprecise record of what went on.

Question 94: This is largely a factual question that goes beyond legal issues, but it would appear that areas in which the Commission should evaluate deregulatory possibilities would include rule filings, as suggested above, and the development of new products. In the Committee's view, the Commission should not at this time reduce oversight over sales and trading practices themselves, over SRO fulfillment of inspection duties with respect to their members, over disciplinary procedures, or over the imposition of trading rules and other rules that may have anti-competitive consequences.

Question 95: If the Commission requires private, for-profit entities to register as exchanges, it should exempt them entirely from enforcement and disciplinary powers and responsibilities. If so exempted, it may well be that the entity's corporate governance need not be a matter of federal concern.

Question 96: In the case of ATSs, see the answer to question 95. In the case of traditional exchanges, we doubt as a policy and legal matter that the Commission should allow such delegation except as currently allowed in the establishment of designated examining authorities.

Question 97: We would expect that regulation of ATSs as broker-dealers imposes no additional costs on ATS customers as compared with market participants that trade through more traditional broker-dealers. In a competitive marketplace, the costs associated with a refusal to deal by an ATS should be minimal, but the Commission and the securities industry ought to be better able to assess this question after further experience with the obligation of certain ATSs to submit trade information to SelectNet.

Question 98: This is not a legal question.

Question 99: It would appear that the costs associated with initial compliance with section 6 of the Exchange Act (developing rules, procedures, etc.) can not be shared and are likely to be a significant portion of overall regulatory costs. In future, while SROs can share some regulatory responsibilities over members that use the facilities of multiple exchanges, procedural, disciplinary and surveillance costs are still borne by each exchange individually. In any event, as stated above, we do not believe it is within the framework of the securities laws for ATSs or exchanges to exercise oversight over institutions that are not broker-dealers.

Question 100: This is a technical question beyond our province, but the answer would appear to be no.

Question 101: Technology as a means for increasing efficiency is a principal means for reducing regulatory costs. The Commission should refrain from imposing new regulation on market mechanisms simply by virtue of their use of such technology.

Question 102: This is a question which SROs should answer.

Question 103: Current regulatory requirements targeting technologically-advanced market participants (e.g., rule 17a-23 under the Exchange Act) are generally not significant enough to produce a decrease in innovation as a form of regulatory avoidance. The alternatives suggested in the Release may very well change this, leading both brokerage providers and customers to "low tech" solutions in view of the regulatory implications of automation.

Question 104: The Commission's position that dealer activity should be excused from the exchange definition because such activities "do not involve systematic interaction of customer orders where the customers themselves are informed and have an opportunity to agree to the terms of a trade" (Release in text following n. 135) probably is correct, but the converse, that trades involving order interaction necessitate exchange regulation, is not entirely correct.

Question 105: The Commission's concerns (e.g., disclosure, surveillance) are not particularly exacerbated by automation, except to the extent that technology broadens access. Requiring U.S. registered brokers to disclose the characteristics of foreign markets before allowing their retail customers to trade in them, regardless of the means used to access such a market, is a possible alternative. The Commission already has in place rule 15a-6 under the Exchange Act requiring a foreign broker-dealer that solicits customers in the United States to register with the Commission as a broker-dealer. Active solicitation of U.S. customers should be the jurisdictional basis for the application of the U.S. securities laws to foreign broker-dealers or exchanges, although cases involving the Internet may limit even this approach. 32

Question 106: Apart from prosecuting brokers that mislead investors as to the characteristics of foreign markets and/or sell unsuitable foreign securities, the Commission should assume that investors who take the initiative and trade on foreign markets are aware of their characteristics.

Questions 107-108: The Commission should avoid attempts to directly regulate foreign exchanges. An access-provider approach is workable only to the extent such a provider is a securities market participant (i.e., a broker) that can be required to make requisite disclosures and suitability determinations. The Commission's Internet example exposes how analogous regulation of technology providers is not feasible. This may not be problematic, however, so long as such providers do not allow direct retail access to trading on foreign exchanges.

Question 109: Regulation of the U.S. members remotely accessing foreign markets, rather than the markets themselves, would adequately address Commission concerns without an extraterritorial application of the Exchange Act. Any U.S. member of a foreign market effecting or otherwise facilitating transactions for the account of non-members on a foreign market would likely satisfy the Exchange Act definition of a "broker", and as such could be subjected to disclosure requirements so that customers would be aware of potential risk and regulatory disparities associated with investments in foreign markets.

Question 110: Requiring SIP registration of foreign-market access providers is problematic. Mandating SIP registration of foreign markets that themselves provide direct remote access to U.S. members would create a schismatic standard whereby U.S. exchanges would receive one regulatory classification and foreign exchanges another, and may also lead to regulatory retribution that inhibits U.S. securities activities abroad. SIP registration is unnecessary, moreover; access providers typically are regulated entities, or service providers for regulated entities. Commission regulation at the broker-dealer level, accordingly, is more appropriate.

Question 111: Foreign-market order-routing preferences will likely arise from the characteristics of the relevant foreign market and competitive forces, which the Commission should allow to develop free from any regulatory disincentives.

Question 112: A foreign market, at least to the extent that it trades only in non-U.S. securities, need not be required to register as a national securities exchange if it provides direct remote access exclusively to U.S. entities that are either members of an exchange, or Commission-regulated entities. If it trades U.S. securities, it might be competitively unfair not to require it to assume the regulatory burdens imposed on U.S. exchanges.

Question 113: Where an access provider merely develops and/or provides a mechanism to access the facilities of an exchange, and does not otherwise accept or execute customers orders, handle customer funds, or promote foreign markets or their subject securities, the access provider and the relevant foreign market should not be subjected to any additional Commission regulation.

Question 114: This description would not likely encompass much current activity, as the large majority of U.S. investors trade on foreign markets with some intermediation by a U.S. broker-dealer. Such a description would not cover ATSs that, while allowing investors to directly access and place orders in a limit order book for foreign securities, do not constitute a "foreign market".

Question 115: It is unclear why the Commission should distinguish between U.S. investors that trade on foreign markets through "traditional" intermediation by a broker, versus investors that are granted more direct electronic access by their broker. Concerns regarding the sufficiency of investor protection and issuer disclosure regulation in foreign markets are not affected by the means of U.S. investor access to those markets.

Question 116: Foreign broker-dealers that provide automated access to foreign markets presumably solicit customer business and handle customer funds and securities. Accordingly, absent use of an exemptive provision such as rule 15a-6, these entities should have to register as broker-dealers.

Question 117: Disclosure requirements that inform U.S. investors of the potential regulatory disparities associated with trading on foreign markets should be the sole condition imposed on access providers.

Questions 118-120: A bona fide foreign market should be one in which a majority of members are foreign. The Committee refers the Commission to the definition of the term "foreign person controlled by a United States person" in Regulation X under the Exchange Act for guidance as to how to define a foreign member. Whether a foreign exchange has entered the United States for jurisdictional purposes should turn on the concept of solicitation as set forth in rule 15a-6 under the Exchange Act. This concept also is important in Regulation S under the Securities Act. Although the surrounding facts and circumstances would have to be analyzed, if a foreign exchange places its terminals in the United States, it would appear to be soliciting business within the United States Nevertheless, the availability of the Internet, and the developing case law concerning it, may undermine even this geographically based approach. 33

Question 121: If the Commission changes its definition of an exchange, this changed definition would on its face cover a foreign exchange doing business in the United States as well as a U.S. exchange. This is one reason the Committee believes it would at least appear, on the surface, to be arbitrary and inconsistent to define U.S. ATSs as "exchanges" and foreign ATSs as "SIPs".

Questions 122-123: The Commission should recognize that it has limited jurisdiction to regulate foreign exchanges unless a foreign exchange enters the United States Further, the Commission cannot, as a practical matter, and should not, as a policy matter, prevent U.S. investors from seeking out opportunities to execute transactions on foreign exchanges. This has been properly recognized in Regulation S under the Securities Act. If a foreign exchange or foreign ATS wishes to solicit or do business in the United States, the Commission properly can condition such business on the existence of information-sharing agreements.

Questions 124-128: The Committee is concerned about the issue of reciprocity. If foreign regulators use the Commission's concept as a model, the result could be a major increase in foreign regulation of the existing business of U.S. broker-dealers (as well as duplicative and possibly inconsistent U.S. and foreign regulation of cross-border transactions). A better result would be the Commission's alternative of relying primarily on home-country regulation. For the most part, home-country regulation is the approach the European Union is taking to cross-border trading issues within the union. The Commission can and should continue to prosecute international frauds (such as insider trading), and the Commission should regulate improper sales practices occurring in this country (for example, cold-calling U.S. residents to convince them to trade in foreign markets). On regulatory issues, however, it is entirely appropriate for the Commission to exercise more limited jurisdiction over international transactions.

Indeed, there are serious questions about whether the Commission has jurisdiction to issue the kind of cross-border regulatory initiative it is considering: the relevant court cases support U.S. jurisdiction over fraud but are much more limited on regulatory and filing requirements. The Release does not discuss at any length how the Commission would investigate, serve process on, or enforce judgments against foreign exchanges or access providers that do not register as foreign market SIPs.

The Commission seems to believe that U.S. investors who desire to trade abroad do not understand the rules of foreign markets or their risks. But it does not provide any substantiation for this assertion, which seems a doubtful one, particularly since many investors, including retail investors, buy registered foreign country funds that describe in detail the characteristics and risks of foreign markets. Indeed, the disclosures that typically appear in country fund prospectuses concerning the risks of investing in non-U.S. markets might form the basis of a disclosure document for U.S. investors considering investment in such markets, analogous to the section 9(b) disclosure document given to investors in standardized options. 34

In any event, if lack of information is the problem, then a disclosure-based solution (as suggested above) should satisfy the Commission's goals. With adequate disclosure, it should not be necessary to limit cross-border trading to sophisticated investors. The Commission's objective should be to facilitate access for all U.S. investors who are adequately informed and are willing to take the risks. Limiting electronic access to U.S.-registered foreign securities, as the Release proposes, would completely defeat the purpose of cross-border linkages: securities that are already registered in the United States are almost always traded in U.S. markets, so U.S. investors do not need access to foreign markets for these securities. Finally, the Commission's release suggests that electronic links particularly require new regulation, even though for decades U.S. investors have been able to place telephone orders with U.S. brokers for foreign securities. This approach discourages innovation without advancing investor protection.

Questions 129-131: For the Commission to require foreign exchanges or ATSs to make and keep records of any kind would be an unprecedented extraterritorial application of the securities laws of doubtful validity. Further, it would risk retaliation against U.S. exchanges and broker-dealers by foreign regulators. Whether this type of regulation would violate any trade agreements between the United States and others is a question beyond this Committee's direct expertise, but it seems an ill-advised concept at a time when other parts of the Federal Government are trying to liberalize trade in services.

Questions 132-134: The only really relevant disclosure is that other countries and their securities industry participants do not comply with the U.S. securities laws.

Questions 135-141: U.S. investors can go abroad today and purchase foreign securities, directly through foreign broker-dealers or through U.S. broker-dealers. By itself, technology does not and should not change existing legal analyses. Further, it is unfair, discriminatory and ultimately not feasible for the Commission to attempt to prevent individual investors from purchasing foreign securities on foreign markets.

Question 142: If more U.S. investors own foreign securities of foreign issuers that do not comply with Commission financial disclosure requirements, there may well be implications for U.S. companies, but these problems should be handled through the development of international accounting standards which the Commission has committed to fostering.

Question 143: For the reasons stated above, it is the Committee's view that the approaches to foreign market activities in the United States described in the Release do not take sufficient account of the need to promote global economic and technological developments.

* * *

If members of the Committee may be of further service to the Commission or its staff in their evaluation of these matters, please let us know.

Respectfully submitted,

/s/ John M. Liftin


John M. Liftin

Chair, Committee on Federal

Regulation of Securities

/s/ Roger D. Blanc


Roger D. Blanc

Chair, Subcommittee on Market


cc: The Hon. Arthur Levitt, Chairman

The Hon. Norman S. Johnson, Commissioner

The Hon. Isaac C. Hunt, Jr., Commissioner

Richard H. Walker, Esq., General Counsel

Dr. Richard R. Lindsey, Director,

Division of Market Regulation

Robert L. D. Colby, Esq., Deputy Director,

Division of Market Regulation

Howard Kramer, Esq., Associate Director,

Division of Market Regulation

Brian J. Lane, Director,

Division of Corporation Finance

Meredith B. Cross, Esq., Deputy Director,

Division of Corporation Finance

Paul M. Dudek, Esq., Chief,

Office of International Corporate Finance,

Division of Corporation Finance

Drafting Committee:

Professor Roberta S. Karmel, Chair

Marcy Engel, Esq.

Lloyd H. Feller, Esq.

Alton B. Harris, Esq.

Sam Scott Miller, Esq.

Professor Steven Thel



-[1]- Many of the questions on which the Commission specifically requested public comment appear to raise competitive and technological issues that the Committee does not have the special expertise to address. Accordingly, while the Committee will attempt to address the wide range of issues and questions posed in the Release, it will not respond to each of the 143 questions asked.

-[2]- As a result, for example, the Commission could not now regulate a bank as a broker-dealer by reintroducing rule 3b-9 under the Exchange Act and then exempting most banks from registration. See American Bankers Ass'n v. Securities & Exch. Comm'n , 804 F.2d. 739 (D.C. Cir. 1986).

-[3]- On more than one occasion in the past, in comment letters by the Committee and others, the Commission has been reminded of an observation in City of Chicago v. Fed'l Power Comm'n , 458 F.2d 731 (D.C. Cir. 1971): "A regulation perfectly reasonable in the face of a given problem may be highly capricious if that problem does not exist."

-[4]- Release in section I.A.

-[5]- HOUSE REPORT ON S. 249, Securities Acts Amendments of 1975, H.R. REP. No. 94-123, 94th Cong. 1st Sess., at 47 (April 1975), citing Securities Industry Study, Report of the Subcommittee on Commerce and Finance of the Committee on Interstate and Foreign Commerce. H.R. REP. NO. 92-1519, 92d Cong. 2d Sess. (1972).

-[6]- Testimony of Brandon Becker, Director, Division of Market Regulation, Securities and Exchange Commission, Before the Subcommittee on Telecommunications and Finance, U.S. House of Representatives, 1994 WL 275297 (F.D.C.H.) (June 22, 1994). See section 11A(a)(2) of the Exchange Act: "The Commission is directed, therefore, . . . to use its authority under this title to facilitate the establishment of a national market system . . . ."

-[7]- Release in text at nn.122-24

-[8]- See Board of Trade of the City of Chicago v. Securities & Exch. Comm'n , 923 F.2d 1270 (7th Cir. 1991).

-[9]- An additional issue the Commission should consider is whether it is appropriate to attempt to distinguish between continuous-auction systems such as Instinet and the others identified in the Release, and periodic call or matching systems such as the Arizona Stock Exchange and the OptiMark System operated by the Pacific Stock Exchange, as described in, e.g., Securities Exchange Act Release No. 39086 (September 17, 1997), 1997 SEC LEXIS 1950. If the Commission draws such a distinction, the question arises whether it thereby would induce system operators to elect an interval between scheduled matches that would be just beyond the regulatory boundary (such as, say, one or a few minutes) and even whether the establishment of such an arbitrary boundary would be appropriate or legally permissible as a matter of statutory construction and administration. Both before and after the Exchange Act was enacted, national securities exchanges have operated call auctions (which would appear to be economically similar in many respects to electronic matching systems that provide for periodic matches) as well as continuous auctions, and it may appear that either would properly be viewed as "a stock exchange as that term is generally understood" within the meaning of section 3(a)(1) of the Exchange Act. See , e.g., Securities & Exch. Comm'n, special study of securities markets, pt. 2 at 8, 912-915 (1963).

-[10]- 142 Cong. Rec. H6446 (daily ed. June 18, 1996).

-[11]- Under the Order Execution Rules, market makers can avoid having to adjust their own quotations, or to reflect certain customer limit orders in their quotations, only if they place the orders into an electronic communications network that publishes them, in accordance with the Commission's standards, in the public market. The Commission's public declaration, by no-action letters that currently have short-term expiration dates, that an ECN is indeed complying with the Commission's standards, is essential as a practical matter to its continued ability to attract that order flow.

-[12]- See Instinet Real-Time Trading System, SEC No-Action Letter (June 27, 1997), 1997 SEC No-Act. LEXIS 717; see also "SEC Warns Reuters' Instinet About Trading Capacity Limitation," July 8, 1997, THE BLOOMBERG (available under NI SEC ).

-[13]- It is not clear, however, how the creation of a new type of registration category under the Exchange Act for ATSs in the United States would fit into the regulatory scheme of the state securities laws ("Blue Sky Laws"). Pursuant to their Blue Sky Laws, the states register or otherwise qualify persons involved in the financial services business, including broker-dealers and investment advisers. The state regulators often follow the federal securities law analysis in determining whether a particular entity is a broker or dealer. The definition of that term is not uniform, however, especially in interpretations of the status of a new category of Commission registrant. Currently, it is not the practice of the state securities regulators to require registration of stock exchanges. A number of ATSs, however, are currently registered as broker-dealers with the states. The Uniform Securities Act, which is adopted in a large number of the states, provides that the term "broker-dealer" means any person engaged in the business of effecting transactions in securities for the account of others, which tracks the Exchange Act definition in section 3(a)(4), or for his own account, which does not. If ATSs are relegated to a new registration category under the Exchange Act, therefore, they still may be required to register as brokers or dealers with the various states unless exemptions are granted. This may be problematical in that the registration requirements for an ATS under the new category proposed by the Commission may not include requirements of the state regulations and statutes. In addition, should the ATSs no longer be considered brokers or dealers under the Exchange Act, the federal preemption provided by NSMIA of certain state-specific requirements enjoyed by ATSs now because of their registration with the Commission would not be available.

-[14]- The Commission previously has used its power under section 19(g)(2) to relieve concerns about the anti-competitive aspects of SRO authority. The Commission adopted rule 19g2-1 under the Exchange Act to address, among other things, the risk that use of the regulatory inspection powers of SROs might otherwise discourage membership by foreign-based financial entities. See NYSE rule 304.12; see also Securities Exchange Act Release Nos. 12737 (August 25, 1976), 1976 SEC LEXIS 984, and 17473 (January 19, 1981), 1981 SEC LEXIS 2237.

-[15]- See also , section 15(e) of the Exchange Act, which authorized the Commission to impose similar regulation on that entity. That section also might facilitate the filling of regulatory gaps if exemptions from broker-dealer registration were granted to permit institutional investors to become members of exchanges. If the Commission caused institutional investor participants in ATSs to become "exchange members" for purposes of the Exchange Act, it should evaluate whether the inclusion of "exchange member" in the several uses of the phase "broker, dealer or exchange member", which was designed in 1975 to include the one exchange member that would not have to register as a broker, would apply appropriately to institutional investors.

-[16]- The fact that the Exchange Act requires exchange members to be broker-dealers, and encompasses section 11(a) as a means of discouraging institutional membership, has anti-competitive consequences, if not purposes. It may suggest, among other things, that classifying the ATSs as exchanges would necessitate serious thought as to the competitive consequences.

-[17]- See, e.g., A.L.A. Schechter Poultry Corp. v. United States , 295 U.S. 495, 538-41 (1935) (National Industrial Recovery Act involved unconstitutional delegation of governmental powers to private body).

-[18]- Under any new definition of an exchange, consideration might be given to whether Nasdaq's status should be changed to that of an exchange.

-[19]- See , e.g., Securities Exchange Act Release No. 16590 (February 19, 1980), 1980 SEC LEXIS 2240.

-[20]- See , e.g., "Merrill To Stop Making Markets in 350 Nasdaq Stocks," Securities Week (September 8, 1997) (Merrill Lynch, Pierce, Fenner & Smith Incorporated reported to reduce the number of stocks it trades on the Nasdaq Stock Market to 500 from 850 in order to concentrate on the 500 stocks that account for 85% of the firm's current trading volume).

-[21]- Allowing the ATSs to participate directly in the ITS system and other inter-market systems that shunt order-flow to the best market, and allowing them to share revenues from trade-reporting mechanisms, could well be beneficial as a legal and policy matter, but do they have to occur only as a result of subjecting the ATSs to regulation as exchanges or exempted exchanges?

-[22]- See , e.g., the Ętna proceeding, Securities Exchange Act Release No. 9632 (June 7, 1972) (Commission partially abrogated, as in excess of NASD authority and anti-competitive, part of former Art. III, Sec. 25 of NASD Rules of Fair Practice (now NASD Conduct Rule 2420)); Plaza Securities Corporation , Securities Exchange Act Release No. 10643 (February 14, 1974) (NASD disciplinary order under former section 25 set aside); Securities & Exch. Comm'n, Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, 1996 SEC LEXIS 2123 (August 8, 1996); the "Multiple Trading Case", Matter of The Rules of the New York Stock Exch. , 10 SEC 270 (October 4, 1941) (NYSE rule prohibiting dealings on other markets declared to be against public interest and illegal); Securities Exchange Act Release No. 12737 (August 25, 1976), 1976 SEC LEXIS 984 (order disapproving proposed NYSE rules 309 and 310); Securities Exchange Act Release No. 12249 (SR-NYSE-76-5) (March 23, 1976), 1976 SEC LEXIS 2116 (entry of order to disapprove NYSE Public Limit Order Protection Rule); and Matter of Applications of William J. Higgins and Michael D. Robbins , Securities Exchange Act Release No. 24429 (May 6, 1987), 1987 SEC LEXIS 1879 (NYSE action denying access on basis of policy not reasonably and fairly implied by existing rule set aside). See also Securities Exchange Act Release No. 12994 (November 18, 1976) in text accompanying nn. 14-23, and authorities cited therein. Cf. Silver v. New York Stock Exch., Inc. , 373 U.S. 341 (1963).

-[23]- See , e.g., Gordon v. New York Stock Exch., Inc. , 422 U.S. 659 (1975); U.S. v. Nat'l Ass'n of Securities Dealers, Inc. , 422 U.S. 694 (1975).

-[24]- The Internet poses difficult problems for enforcement of the registration provisions of the Securities Act given the fact that information entered at one location is available from any other location within and without the United States. The courts are beginning to disallow efforts by governments other than the government of the place in which the Internet entrant resides to assert in personam jurisdiction over the entrant. See Bensusan Restaurant Corp. v. Richard B. King , 1997 U.S. App. LEXIS 23742 (2d Cir. September 10, 1997) (New York State cannot assert in personam tort jurisdiction over person entering information into the Internet from another state). If application of the federal securities laws were to be similarly limited in connection with Internet users located outside the United States, the impact on the Commission's regulatory programs likely would be profound.

-[25]- Under the Blue Sky Laws, the states also retain authority to regulate secondary trading in securities of issuers that are not reporting companies under the Exchange Act. These applications of the Blue Sky Laws were not preempted by NSMIA.

-[26]- As the Commission knows, pursuant to rule 11A1-4 under the Exchange Act, market makers generally can elect not to display in the public market orders of block size, and if so directed by the customer orders of less than block size, except that they lose that ability if they display the order in an electronic communications network; in such a case, either the broker-dealer or the electronic communications network must display the order in the public market. See Securities Exchange Act Release No. 37619A (August 29, 1996) at n.247, (1996-97 Dec.) Fed. Sec. L Rep. (CCH) ¶ 85,837. Institutional investors, however, can elect (if the ATS so permits) whether to have the ATS display publicly the orders they enter directly into the ATS.

-[27]- See, e.g., Securities Exchange Act Release No. 12737, supr a, note 14.

-[28]- This issue, moreover, surfaced as a legal problem in the context of fixed commission rates. See Silver v. New York Stock Exch. , 373 U.S. 341 (1963); Gordon v. New York Stock Exch. , supra , 23). The problem has arisen again, at least on a theoretical level, at a time when the incremental trading differential is being reduced. As stated above, the Commission should give the industry time to adjust to this change and then inquire whether there is any issue of "fair access".

-[29]- The SECO program was abolished in 1983. See Securities Exchange Act Release No. 20409 (November 22, 1983).

-[30]- See Release in text at nn. 120-33.

-[31]- There are precedents in the federal securities laws for exemptive applications that become effective on filing in good faith unless the Commission objects and requires a more elaborate procedure. See, e.g., section 2(a)(7) of the Public Utility Holding Company Act of 1935: "The filing of an application hereunder in good faith by a company other than a registered holding company shall exempt the applicant from any obligation, duty, or liability imposed in this title upon the applicant as a holding company, until the Commission has acted upon such application."

-[32]- See note 24, supra .

-[33]- Id .

-[34]- Committee members can provide further information on this subject if the Commission or the staff believe it would be helpful.