SECURITIES AND EXCHANGE COMMISSION
Securities Exchange Act of 1934
Release No. 51163 / February 9, 2005
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 (“Exchange Act”) Regarding The Nasdaq Stock Market, Inc. (“Nasdaq”), as Overseen By Its Parent, The National Association of Securities Dealers, Inc. (“NASD”)
The Commission is issuing this Report of Investigation, pursuant to Section 21(a) of the Exchange Act,1 in order to emphasize the regulatory responsibilities of (1) a self-regulatory organization (“SRO”) that delegates its statutory SRO responsibilities to or among separate entities, and (2) the entities that have been delegated SRO responsibilities. The investigation at issue involved: (1) a large number of wash trades and matched orders in March 2002 by MarketXT, an Electronic Communications Network (“ECN”), NASD member, and registered broker-dealer, which were reported through Nasdaq, and (2) MarketXT’s failure to maintain adequate net capital, and its inability to meet its financial obligations to Nasdaq. These circumstances, which indicated violations by MarketXT of the anti-fraud and net-capital provisions of the securities laws, were not adequately addressed by Nasdaq, as overseen by its parent, NASD.
As a primary matter, the NASD, an SRO, retains overall responsibility for enforcing the federal securities laws and its own rules. Pursuant to an NASD proposed and SEC approved delegation plan, NASD has delegated certain regulatory responsibilities to its two operating subsidiaries, Nasdaq and NASD Regulation, Inc. (“NASDR”). Here, Nasdaq failed to communicate the observations of Nasdaq staff members relating to the trading described above to NASDR, which is the primary regulator of Nasdaq’s market center, and NASDR’s automated surveillance programs did not independently detect the suspicious conduct. In addition, Nasdaq did not inform NASDR that MarketXT was delinquent to Nasdaq in the payment of trading fees, a fact that likely would have resulted in a targeted examination of MarketXT’s net capital compliance, and NASDR did not resolve MarketXT’s net capital deficiencies.
The facts learned in this investigation point to the need for reiteration of a fundamental premise of self-regulation: an SRO must vigorously enforce its regulatory responsibilities, and must take particular care when market and regulatory functions are delegated to separate entities. Furthermore, an entity that conducts market activities retains the SRO functions delegated to it, even when another entity has been entrusted with primary regulatory responsibility for that entity’s market activities.
This Report of Investigation provides a suitable vehicle to communicate the risks and challenges in the allocation or delegation of self-regulatory responsibilities among distinct entities that retain regulatory responsibilities. In response to the Commission’s investigation (and the inspection from which it sprung) and its own findings from a self-study, the NASD and Nasdaq have implemented a number of remedial steps, all designed to strengthen the self-regulatory oversight of their market.
II. DELEGATION OF REGULATORY RESPONSIBILITIES BY NASD TO NASDAQ AND NASDR
The NASD is a “national securities association” registered with the SEC pursuant to Section 15A of the Exchange Act. Nasdaq is a subsidiary and “facility” of the NASD, pursuant to Section 3(a)(2) of the Exchange Act. As a registered association, the NASD has the statutory obligation to comply with the Exchange Act, and to enforce compliance by its members with the Exchange Act and its own rules. 15 U.S.C. § 78o-3. As a “facility” of a registered association, and by virtue of a 1996 Delegation Plan, the NASD delegated certain of its regulatory and market responsibilities to Nasdaq.2 The Delegation Plan reserves ultimate regulatory responsibility to the NASD itself, and acknowledges that “the staff, books, records, and premises of the Subsidiaries [NASDR and Nasdaq] are the staff, books, records and premises of the NASD ….”3 Therefore, while the NASD and Nasdaq are separate corporate entities, Nasdaq is a part of the NASD SRO.
The Delegation Plan further provides that in operating the NASD’s market, Nasdaq shares responsibility for carrying out the NASD’s duties as an SRO, as the Commission has previously made clear: “Nasdaq, a facility of the NASD, a self-regulatory organization, cannot operate in all respects like a private enterprise. Both the NASD and Nasdaq must be governed and operated in accordance with the obligations of an SRO as set forth in the Exchange Act and the NASD’s rules.”4
Specifically, the Delegation Plan assigns a range of regulatory responsibilities to Nasdaq. On the one hand, Nasdaq is responsible for providing information to NASDR for operation of the surveillance audit trail and operating Stockwatch in conjunction with NASDR. On the other hand, Nasdaq assumes the general responsibility to “develop and adopt rules, interpretations, policies and procedures . . . to maintain and enhance the integrity, fairness, efficiency and competitiveness of . . . markets operated by The Nasdaq Stock Market.”5 The market professionals who are employed by Nasdaq play a meaningful role in effective regulation of the Nasdaq market center.6
Under the Delegation Plan, NASDR is the primary regulator of Nasdaq’s market center, and pursuant to the Delegation Plan, NASDR has express responsibility for monitoring unlawful trading in listed securities reported to the “third market,” or the “InterMarket.” See Delegation Plan II(A)(1)(d). 7
III. OPERATION OF NASDAQ’S INTERMARKET AS A COMMERCIAL BUSINESS
One source of revenue for Nasdaq derives from Nasdaq’s participation in the CTA Plan, which administers the Consolidated Tape. Like other exchange participants in the CTA plan, Nasdaq receives revenues for trades it reports to the Consolidated Tape in stocks listed on the New York Stock Exchange (“NYSE”) and American Stock Exchange (“Amex”). In an effort to compete with other market centers for market-data fees, Nasdaq publicized the advantages of trading in listed stocks on Nasdaq, known at Nasdaq as the “InterMarket,” to NASD members. During the relevant period, Nasdaq, like other market centers, rebated a portion of the consolidated tape revenue it received to qualifying NASD members, based on the number of transactions the firm executed on Nasdaq.8 Marketing materials distributed by Nasdaq’s InterMarket division described a “negative cost environment,” i.e., the rebate from each trade in Amex-listed securities could exceed the transaction-based fees owed to Nasdaq. Nasdaq paid qualifying firms without deducting any fees those firms may have owed to Nasdaq. Nasdaq’s InterMarket personnel solicited participation in the InterMarket, providing information and technical support to firms, with the goal of increasing Nasdaq’s market share, which was threatened by the departure of Archipelago from Nasdaq, and possible departure of Island (which later materialized). In January 2003, the head of Nasdaq’s InterMarket division was paid a bonus of about $15,000, based in part on his having significantly exceeded the strategic goal for market share of Tape B in the fourth quarter of 2002.
IV. WASH TRADES AND MATCHED ORDERS BY MARKETXT
An NASD member firm, MarketXT, developed an automated program to take advantage of the market-data rebates available from Nasdaq. The program executed rapid-fire wash trades in three exchange-traded funds (“ETFs”), the QQQs, (the Nasdaq-100 Index Tracking Stock), SPYs (SPDR Trust Series 1), and DIAs (the DIAMONDS, Trust Series 1). These ETFs, as well as other Amex-listed stocks, appeared on “Tape B” of the Consolidated Tape and yield far higher rebates than trade reports, “Tape A ” (NYSE-listed-stocks) or Nasdaq-listed stocks. The wash trades and matched orders were offsetting purchase and sale transactions which, in this case, were designed to generate trading activity for the sole purpose of obtaining rebates.
An individual associated with MarketXT executed the program in two accounts at a broker-dealer affiliated with MarketXT, Momentum Securities. The individual communicated with Nasdaq InterMarket personnel about qualifying for market-data rebates, as he sought to report an average of 500 qualifying trades per day for the quarter. For example, on Friday, March 22, 2002, he emailed to a Nasdaq employee: “So can you tell me how many more trades are needed to qualify for Tape A and B? Is it about 18,000 trades needed?” Nasdaq’s response to MarketXT was: “right—18,000 trades gets you qualified for Tape B . . . .”
On the following three business days, March 25, 26 and 27, MarketXT reported a sufficient number of trades to meet the threshold needed to qualify for Tape B rebates for the first quarter of 2002, with a dramatic increase in trading activity on March 27, reflected below:
On March 27 (before trade data from the 27th was available for Nasdaq to review), an analyst in Nasdaq’s InterMarket was analyzing trades reported by MarketXT to Nasdaq on March 26 in order to assess whether an unrelated trade reporting error had been corrected. He noted a pattern of matching buys and sells with a single broker-dealer on both sides of the market. A Nasdaq supervisor expressed concern to Nasdaq’s InterMarket personnel that the same party appeared to be on both sides of the trades and told Nasdaq InterMarket personnel to ask MarketXT for an explanation. MarketXT personnel reportedly responded that the trade reports reflected unrelated day traders accessing quotes through MarketXT. The Nasdaq supervisor regarded the explanation as implausible, and suspected that market data revenue offered an incentive for such trading behavior. It appears from an e-mail that the InterMarket head planned to discuss with a senior Nasdaq official whether the circumstances constituted a “regulatory matter,” but no Nasdaq supervisor took any steps to ensure that the suspicious trading pattern was referred to NASDR, and, in fact, no referral was made. Moreover, NASDR’s automated surveillance programs did not independently detect the suspicious conduct.
There are several possible explanations for why Nasdaq did not refer this information to market surveillance officials at NASDR.9 InterMarket personnel had no formal training in their regulatory responsibilities and did not appreciate the significance of their observations regarding MarketXT’s trade reports. In addition, Nasdaq Transaction Services (of which the InterMarket was a part) had no mechanism in place for making sure referrals to NASDR were properly handled and tracked. Nasdaq officials also may have erroneously believed that, because of a prior referral, NASDR was already investigating wash trades by MarketXT. It is also possible that the business interests of the Nasdaq InterMarket, which had the goal of increasing its market share of Tape B trades, may have contributed to a failure by InterMarket personnel to appreciate the implications of the trading pattern they observed.
That said, other Nasdaq employees did understand their obligation to refer potential regulatory matters to NASDR. In 2002, Nasdaq referred to NASDR three problems involving MarketXT. In January 2002, analysts in Economic Research identified a trade-reporting problem involving double-reporting by MarketXT. The trading irregularity was referred to NASDR and the trade-reporting problem was subsequently corrected. In March 2002, a managing director in Nasdaq Transaction Services received allegations concerning wash sales in a Nasdaq stock involving MarketXT, and communicated those concerns to NASDR. In April 2002, Nasdaq TradeWatch referred transactions by MarketXT to NASDR for investigation of possible market manipulation, which were under review by NASDR when MarketXT ceased its securities business in July 2002.
Although the omission in this instance was limited, Nasdaq failed to refer the observations concerning MarketXT’s trade reports on March 26 to NASDR, and NASD failed to assure the obligations delegated to Nasdaq were effectively fulfilled.
V. MARKETXT’S NET CAPITAL DEFICIENCY
In the competitive environment facing Nasdaq in early 2002, Nasdaq officials hoped that MarketXT, the first ECN participating in Nasdaq’s SuperSOES, would attract liquidity to Nasdaq. MarketXT was, however, having serious financial difficulties and became significantly in arrears in paying fees to Nasdaq.10 In fact, at the time, MarketXT was operating without adequate net capital, and only appeared to be in compliance with net capital requirements because it was impermissibly shifting its liabilities, including Nasdaq payables, to an unregistered parent company.
While Nasdaq officials were promoting MarketXT, they were aware that MarketXT and its affiliates were severely delinquent in paying their bills for Nasdaq’s services. As of the first quarter of 2002, MarketXT had not paid Nasdaq since October, when MarketXT already owed Nasdaq over $300,000. In January 2002, Nasdaq wrote MarketXT and threatened to deny it access to Nasdaq services for failing to make payments. At the high point, MarketXT and its affiliates owed Nasdaq over $2 million, related to services provided as early as September 2001. However, internal memoranda and emails reveal that a senior Nasdaq official intervened with Nasdaq’s finance department to continue service to MarketXT while the firm paid down its arrearage under a payment plan, due to the official’s desire to delay termination of service to MarketXT.11
Nasdaq officials did not appropriately consider the regulatory implications of MarketXT’s failure to meet its financial obligations to Nasdaq in a timely manner and took steps to continue service to the ECN. The information about MarketXT’s arrearages, which suggested the possibility of a net capital problem, was not conveyed to NASDR’s Member Regulation Department, which oversees members’ compliance with the net capital requirements. Indeed, there was no protocol for referring information about failing firms from Nasdaq’s financial unit to NASDR. Moreover, while a surveillance break properly alerted the NASDR staff to a potential net capital violation, the follow-up review of MarketXT did not resolve MarketXT’s net capital deficiencies. Specifically, NASD’s financial surveillance system produced an alert regarding MarketXT’s September 2001 FOCUS report. Member Regulation specifically instructed its staff responsible for MarketXT to conduct a review by requesting from the firm documentation relevant to the alert. While the staff obtained the information, it did not follow standard protocols for completing its inquiry into MarketXT’s financial condition.12
VI. REMEDIAL STEPS TAKEN BY NASDAQ
Nasdaq has undertaken the following remedial steps in response to this investigation:
A. Creation of Nasdaq Regulation Group: Nasdaq reorganized certain functions to create Nasdaq Regulation Group, which encompasses those operational areas that have, as a principal part of their responsibilities, the interpretation of regulatory issues and the communication of information to NASD. This reorganization was designed to functionally separate those regulatory functions from Nasdaq’s business lines.
B. Referral Tracking and Review: Nasdaq Office of General Counsel and Nasdaq Regulation Group formalized a procedure for responding to information that suggests a possible rule violation or that simply appears suspicious.
C. Employee Education: Nasdaq instituted a mandatory, company-wide employee education program to ensure that employees have been trained in their regulatory responsibilities.
D. Protocol for Sharing Financial Information: Nasdaq implemented an information-sharing protocol with the NASD to ensure that information concerning a member’s failure to pay Nasdaq’s bills is transmitted on a monthly basis to the NASD.
E. Credit and Service Termination Policy: Nasdaq has adopted a uniform credit and service termination policy, announced in NASD Notice to Members 2003-80.
F. Code of Conduct Amendments: Nasdaq amended its Code of Conduct to require explicitly that employees refer potential regulatory violations to the Office of General Counsel or other appropriate Nasdaq departments, which in turn are responsible for ensuring all referrals reach NASDR.
G. Rebate Processing: NASD members receiving rebates are now paid in the form of a reduction of outstanding liabilities, rather than by wire transfer.
H. Rebate Refund: Nasdaq will refund to the CTA Plan the gross market data fees it received associated with MarketXT's trading of DIAs, SPYs and QQQs during the period from March 25 through 28, 2002.
VII. REMEDIAL STEPS UNDERTAKEN BY THE NASD
The NASD has taken a number of steps over the past two years to strengthen its oversight of Nasdaq’s regulatory operations.
A. A Committee of the NASD board that was created to review a number of governance issues studied the standards for NASD review of Nasdaq board items.
B. In the fall of 2003, NASD retained a law firm to review the interactions between NASD and Nasdaq in the regulatory area. This study led to the retention of an outside consultant to do a detailed analysis of all of the areas where Nasdaq engages in regulatory activities that are not outsourced to NASD (e.g., listings, real time surveillance).
C. The NASD board appointed a special committee with the charge of reviewing the relationship between NASD and Nasdaq, and NASD’s oversight of that relationship. That committee has recommended and the board at its November 2004 meeting approved a number of changes to the relationship that are currently in the process of implementation. These include ensuring that a Nasdaq board committee is specifically charged with responsibility for Nasdaq’s regulatory functions, direct input for NASD into the Nasdaq board nominating committee process and the establishment of an NASD, staff level, risk oversight committee that will work with Nasdaq staff on an ongoing basis to ensure a proper flow of information to the NASD board on matters relating to regulatory risks.
A critical line of defense for investors is the self-regulatory organization. In carrying out their regulatory responsibilities, SROs must ensure that they effectively manage the inherent conflicts between their role as a market and their role as a regulator. If they fail in these responsibilities, the damage done far exceeds the harm to one SRO. Rather, it directly affects the integrity of U.S. markets.
Investors are entitled to expect that SROs will take all steps necessary to ensure the integrity of their markets. Specifically, where regulatory responsibilities are delegated to multiple business entities, the SRO must ensure that those responsible for regulation have sufficient understanding of the markets and unimpeded access to information about the functioning of the markets. Just as important, those running the markets must have an understanding of their regulatory obligations, which includes understanding the regulatory consequences of market activities. It is imperative that the SRO oversees the structure to ensure that the markets act responsibly and in compliance with their regulatory obligations.
By the Commission
1 Section 21(a) of the Exchange Act authorizes the Commission to investigate violations of the federal securities laws and, in its discretion, to “publish information concerning any such violations.” The NASD and Nasdaq have consented to the issuance of this Report without admitting or denying any of the statements or conclusions herein. This Report does not constitute an adjudication of any fact or issue addressed herein. In addition, the statements and conclusions in this Report do not represent determinations by the Commission with respect to any persons or entities other than the NASD and Nasdaq.
2 The Delegation Plan created two new operating subsidiaries of the NASD: NASDR and the Nasdaq. Securities Exchange Act Release No. 37107 (April 11, 1996), 61 FR 16948 (Self-Regulatory Organizations Notice of Filing and Order Granting Temporary Accelerated Approval).
3 Delegation Plan I(F). See also NASD Rule 0130.
4 Report Pursuant to Section 21(a) Regarding the NASD and the Nasdaq Market (“1996 21(a) Report”) at 49.
5 Delegation Plan, III (A)(1)(e).
6 See e.g., The NASD Select Comm. On Structure and Governance, Hon. Warren Rudman, chair, at R-4 (1995): “Given the complexities of the Nasdaq market, effective regulation requires intimate knowledge of how the market works. This cannot effectively be acquired or maintained in isolation.”
7 Under the Delegation Plan, Nasdaq pays NASDR for its regulatory services, as disclosed in Nasdaq’s Report on Form 10-K for its year ended December 31, 2003. (Payments by Nasdaq to NASDR for regulatory services totaled $61.8 million in 2003 and $76.7 million in 2002.)
8 See NASD Rule 7010(c)(2). Other exchanges offered similar rebates. See, e.g., National Stock Exchange Rule 11.10(A)(k).
9 NASDR might well have further investigated the suspicious trading pattern. At the time, NASDR was investigating MarketXT for other trading patterns that appeared designed solely to capture tape revenues. Further, on June 27, 2002, the NASD brought a disciplinary proceeding against NASD member, Swift Trade Securities USA, Inc. (“Swift Trade”), which was using an automated program to route simultaneous, or nearly simultaneous, offsetting limit orders for QQQs to Island ECN. NASD found that: “[O]rders were executed at the same price and quantity on both sides of the market for the customer’s proprietary account and did not result in any change of beneficial ownership of QQQ shares. SWFT. . . executed these ‘wash’ transactions through ISLD to profit from the market data revenue sharing provided by ISLD to its subscribers, while not subjecting [an affiliated broker-dealer] to the risk of profit or loss from the underlying trading.” The NASD’s complaint alleged that Swift Trade violated Section 10(b) of the Exchange Act and Exchange Act and Rule 10b-5, as well as various NASD Conduct Rules.
10 Indeed, in August 2002, the Commission’s Division of Market Regulation withdrew the no-action letter confirming that MarketXT could operate as an ECN.
11 For example, an email dated June 19, 2002, states:
I asked Collections to give Market XT another 10 days to pay the $2.5mm that became delinquent on June 17 and June 19, despite Collections recommendation against giving MarketXT more time. Standard Nasdaq Collections procedure would have been to terminate MarketXT services COB today, June 19. MarketXT is an important customer because they are the largest liquidity provider on SuperSoes.
12 The Commission also notes that in response to concerns raised by its staff about liability-shifting, the NASD undertook an expansive survey and analysis of approximately 800 NASD members reporting zero liabilities, with the goal of assessing the extent of the practice. Using, in part, the results of this initiative, in October 2003, the SEC approved the issuance of guidance to NASD member firms, including new record-keeping requirements concerning the application of the financial responsibility rules when a third party agrees to assume responsibility for payment of a broker-dealer's expense. “Expense-Sharing Agreements,” Notice to Members, 03-63, available on the NASD’s website.