Appendix
July 6, 2023
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TABLE OF CONTENTS
Page
I. PROBLEMS OF THE NASDAQ STOCK MARKET . . . . . . . . . . 2
A. Quotes, Trades, and Trade Reporting . . . . . . . . 2
1. The Pricing Convention and
Related Practices . . . . . . . . . . . . . . 2
a. The Pricing Convention . . . . . . . . . 2
b. Disincentive to Breaking the Spread . . . 14
c. Size Convention . . . . . . . . . . . . . 16
d. Pressure and Harassment . . . . . . . . . 18
e. Bear Stearns Meeting and
Subsequent Narrowings . . . . . . . . . . 18
2. The NASD's Failure to Address
Adequately the Pricing Convention and
Related Practices . . . . . . . . . . . . . . 27
3. Coordinated Activity Among Market Makers . . . 37
a. Coordinated Quote Movements
and Transactions . . . . . . . . . . . . 37
b. Agreements to Delay Trade Reports . . . . 40
c. Information Sharing . . . . . . . . . . . 41
B. Late Trade Reporting . . . . . . . . . . . . . . . 46
1. Late and Inaccurate Trade Reports . . . . . . 46
2. The NASD's Enforcement of Trade Reporting
Rules Was Inadequte . . . . . . . . . . . . . 51
C. The Firm Quote Rule . . . . . . . . . . . . . . . . 55
1. The Importance of Firm Quotes . . . . . . . . 55
2. Failure to Honor Quotes . . . . . . . . . . . 57
3. Selective Refusal to Trade . . . . . . . . . . 58
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4. The NASD's Enforcement of the Firm Quote
Rule Was Inadequate . . . . . . . . . . . . . 60
II. THE NASD'S REGULATORY DEFICIENCIES . . . . . . . . . . . 68
A. The SOES Controversy . . . . . . . . . . . . . . . 68
1. Origin of the SOES Controversy . . . . . . . . 68
2. SOES Rulemaking in Response to
Market Maker Complaints . . . . . . . . . . . 70
a. Limiting Access to SOES . . . . . . . . . 70
b. Commission Action on
SOES Rules Amendments . . . . . . . . . . 78
c. Effect of SOES Rules Amendments . . . . . 80
3. The NASD's Focus on the Examination and
Disciplining of SOES Firms . . . . . . . . . . 81
4. Application of Standards and Criteria for
Admission to Membership . . . . . . . . . . . 86
B. The NASD's Laxity in Rule Enforcement . . . . . . . 91
1. The NASD's Failure to Enforce Excused
Withdrawal Rules . . . . . . . . . . . . . . . 91
2. The NASD's Inadequate Enforcement of
MSRB Rule G-37 . . . . . . . . . . . . . . . . 95
C. Other Areas of Regulatory Concern . . . . . . . . . 97
1. Authority of District Business
Conduct Committees . . . . . . . . . . . . . . 97
2. The Excess Spread Rule . . . . . . . . . . . . 98
3. The Contested Election Process . . . . . . . . 99
4. Audit Trail . . . . . . . . . . . . . . . . . 100
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APPENDIX TO
REPORT PURSUANT TO SECTION 21(a) OF THE
SECURITIES EXCHANGE ACT OF 1934
REGARDING THE NASD AND THE NASDAQ MARKET
This Appendix provides additional information and elaborates
on certain of the issues identified in the Commission's Report
Pursuant to Section 21(a) of the Securities Exchange Act of 1934
Regarding the NASD and the Nasdaq Market ("NASD
Report").-[1]- As described in Part IV. of the NASD Report,
the Commission staff's investigation of the NASD and the Nasdaq
market occurred over a period in excess of eighteen months and
included the review of thousands of hours of taped conversations,
hundreds of thousands of pages of documents, and the testimony of
dozens of market participants and NASD officials, employees, and
committee members.
Part I. of the Appendix describes certain conduct of Nasdaq
market makers and the resulting problems with the operation and
functioning of the Nasdaq market. Part I.A. describes the
coordination by numerous market makers of quotes, trades, and
trade reporting, including the pricing convention and the NASD's
failure adequately to investigate and prosecute potential
violations of its rules and the federal securities
laws.-[2]- Part I.B. focuses on the problem of late trade
reporting and the NASD's failure to enforce adequately the late
trade reporting rules. Part I.C. describes the failure of
numerous market makers to honor their quotes and the NASD's
failure to enforce adequately the firm quote rules.
Part II. of the Appendix describes other deficiencies in the
NASD's performance of its statutory obligations as an SRO, as
well as a number of other areas of general regulatory concern.
---------FOOTNOTES----------
-[1]- As is the case with the Report, the findings made
herein are solely for the purpose of the Report
and this Appendix and are not binding on any other
person or entity named as a respondent or
defendant in any other proceeding. It should be
noted that the issuance of the Report and this
Appendix, and the concurrent enforcement action
against the NASD, do not preclude further
enforcement actions against other persons or
entities arising from activities uncovered in the
investigation.
-[2]- The record varies as to the degree of
participation of particular market makers in the
specific activities described in this Report.
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Part II.A. focuses on the issues surrounding the NASD's small
order execution system ("SOES"), including the SOES rules,
examination and discipline of SOES firms, and impediments to
membership. Part II.B. discusses the NASD's laxity in enforcing
its excused withdrawal rules and MSRB Rule G-37. Part II.C.
discusses other issues identified in the investigation as areas
of regulatory concern: (i) the excessive authority of District
Business Conduct Committees; (ii) the excess spread rule; (iii)
participation in contested elections; and (iv) the need for
improvements to the audit trail.
I. PROBLEMS OF THE NASDAQ STOCK MARKET
A. Quotes, Trades, and Trade Reporting
1. The Pricing Convention and Related Practices
The evidence gathered in this investigation revealed that
Nasdaq market makers widely followed an anticompetitive pricing
convention concerning the increments they used to adjust their
displayed quotes, which resulted in many Nasdaq stocks being
quoted only in even-eighths.-[3]- Various market makers
also discouraged one another from narrowing the inside spread.
Adherence to the pricing convention and this tendency to avoid
narrowing spreads have often had the effect of increasing the
transaction costs paid by many investors. Market makers who
either entered quotes inconsistent with the pricing convention or
narrowed spreads were sometimes subjected to harassment by other
market makers. The NASD was aware of, at least as early as the
summer of 1990, facts and circumstances evidencing both the
pricing convention and allegations of intimidation and pressure
directed against market makers that narrowed spreads. It did
not, however, take appropriate action to address the issues
raised by this information.
a. The Pricing Convention
Prior to late May 1994, the pricing convention was widely
followed by Nasdaq market makers. According to testimony from
Nasdaq traders, the convention was based on tradition and
represented the "professional" way to trade in the Nasdaq market.
Market makers expected other market makers to follow the
convention. Several traders testified that senior traders at
their respective firms trained them to follow the pricing
convention. Still other traders admitted to following a practice
of setting quote increments based on the size of the dealer
---------FOOTNOTES----------
-[3]- An even-eighth is 2/8, 4/8, 6/8, or 8/8. An odd-
eighth is 1/8, 3/8, 5/8, or 7/8. The Nasdaq
pricing convention is further discussed herein at
I.A.1.a.
==========================================START OF PAGE 3======
spread, but stopped short of characterizing the practice as a
"convention."-[4]-
Under the pricing convention, stocks with a dealer spread of
$3/4 or more were to be quoted in even-eighths ("even-eighth
stocks"). Stocks for which the dealer spread was less than $3/4
could be quoted in both odd and even-eighths.-[5]- The
existence of this convention is confirmed by the testimony of
traders who make markets on Nasdaq, documentary evidence, taped
conversations, and through analysis of the price and quote data
in the Nasdaq market.-[6]- Prior to May 1994, more than 80%
of all domestic Nasdaq National Market stocks,-[7]- of which
there were more than 3,200, followed the pricing
convention.-[8]- Of the more than 1,900 domestic National
Market stocks priced greater than $10 per share, more than 90%
followed the pricing convention and approximately 78% were even-
eighth stocks.-[9]-
---------FOOTNOTES----------
-[4]- Traders have also described the practice as an
"ethic," a "custom," or a "tradition."
-[5]- Nasdaq accepts market maker quote increments of
1/8 or greater for stocks bid ten dollars and
over. Stocks bid less than $10 per share can be
quoted in smaller increments.
-[6]- For this analysis, the Commission used Nasdaq
Market Maker Price Movement data from December
1993 through May 23, 1994 which identifies, for
every market maker, the time, price, and size
(i.e., amount) of each quote update (i.e., a
change in the market maker's quotes).
-[7]- Nasdaq National Market stocks (also referred to
herein as "NMS stocks") are the top tier of Nasdaq
stocks in terms of capitalization, number of
shareholders, and activity. These companies
comprise over 95% of the capitalization of all
Nasdaq companies.
-[8]- The Commission's analysis of the data confirms
widespread adherence to the pricing convention,
including, substantial, albeit lesser adherence in
stocks priced less than $10, which under Nasdaq
rules may be quoted in increments of $1/16 or
finer.
-[9]- For the analysis in Figures 1 to 4 and the
accompanying text, stocks were classified using a
percentage test. A stock was initially classified
(continued...)
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Often the effect of this convention was to limit how small
the inside spread of even-eighth stocks could be. When stocks
are quoted only in even-eighths, the minimum inside spread will
be $1/4. Stocks that are quoted in both even and odd-eighths can
have an inside spread of $1/8. Figure 1 below shows that market
makers, consistent with the pricing convention they described in
their testimony, quoted stocks with dealer spreads less than $3/4
---------FOOTNOTES----------
-[9]-(...continued)
as one with a dealer spread of $3/4 or greater if
on a particular day more than 90% of quote updates
in that stock on that day resulted in a dealer
spread at or above $3/4 (Group A). Likewise, a
stock was initially classified as one with a
dealer spread below $3/4 if more than 90% of quote
updates in that stock on that day resulted in a
dealer spread below $3/4 (Group B). All stocks
were then classified on a monthly basis. If a
stock belonged to Group A every day of the month,
the stock was classified as one with a predominant
dealer spread at or above $3/4. Similarly, if a
stock belonged to Group B every day of the month,
the stock was classified as one with a predominant
dealer spread below $3/4. Stocks belonging to
Group A were classified as following the
convention during the month if odd-eighth quotes
comprised less than 10% of all odd and even-eighth
quotes. Stocks belonging to Group B were
classified as following the convention during the
month if both odd and even-eighths were used;
thus, a stock with a dealer spread of $1/2 in
which less than 10% of all quote updates were in
odd-eighths would not be classified as following
the convention. Therefore, all stocks were
classified into one of three groups: (1) following
the pricing convention with a predominant dealer
spread of $3/4 or greater; (2) following the
pricing convention with a predominant dealer
spread of less than $3/4; and (3) not following
the convention.
==========================================START OF PAGE 5======
in odd-eighth quotes approximately as often as in even-eighth
quotes.
This stands in stark contrast to the way market makers
quoted stocks with dealer spreads greater than or equal to $3/4.
Figure 2 below shows that market makers, consistent with the
pricing convention they described in their testimony, quoted
these stocks in odd-eighths less than 5% of the time and in even-
eighths the rest of the time.
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The dealer spread was understood by market makers as
indicating which of the two quotation increments applied to a
particular security. Although under the excess spread
rule-[10]- it is possible for market makers to quote dealer
spreads of $5/8 when other dealers have spreads of $3/4,
adherence to the pricing convention precluded the use of such
quote combinations since it would be unclear whether the stock
should be an even-eighth or odd-eighth stock.-[11]- The
data show that a sharp line was maintained between the two groups
of stocks. For domestic Nasdaq NMS stocks, the combination of
dealer quotes of $5/8 and $3/4 in a particular stock occurred
less than 0.8% of the time.-[12]- Thus, the Commission's
analysis of more than 18 million quote updates supports the
testimony of the market makers as to the functioning of the
pricing convention and underscores the extent to which the
convention was followed in the market.
Market makers' adherence to this pricing convention often
increased the transaction costs paid by customers trading Nasdaq
securities.-[13]- Most customer orders, particularly those
to purchase or sell smaller amounts of stock, are executed by
---------FOOTNOTES----------
-[10]- The Nasdaq excess spread rule requires that a
market maker's spread not exceed 125% of the
average of the three lowest dealer spreads in a
stock. Hence, the range of allowable market maker
spreads for a stock is limited to groups such as
{$1/2 and $5/8}, {$5/8 and $3/4}, {$3/4, $7/8, and
$1}, and {$1, $1+1/8, and $1+1/4}.
-[11]- Similarly, dealer quote combinations such as {$3/4
and $7/8}, {$7/8 and $1} and {$1 and $1 1/8}, all
of which are permissible under the excess spread
rule, were, in the pre-May 24, 1994 Nasdaq market,
rarely or never used by market makers. Natural
economic forces do not explain the absence of such
quote combinations, but such an absence would be
expected under the pricing convention.
-[12]- In circumstances where market makers acted to
narrow their dealer spreads in stocks routinely
quoted with dealer spreads of $3/4 or better, they
typically narrowed from $3/4 directly to $1/2,
skipping $5/8.
-[13]- The spread between the inside bid and ask prices
is a cost that investors bear in buying and
selling stocks at those prices.
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market makers at the inside bid or offer.-[14]- Because
market makers generally moved their quotations in even-eighth
increments for the majority of Nasdaq NMS stocks, the inside best
bid and offer for these stocks almost always moved in $1/4
increments. As a result, the inside spread for even-eighth
stocks almost never narrowed to $1/8. Investors purchasing and
selling even-eighth stocks at the inside spread thus rarely
traded at odd-eighth prices. This often resulted in wider inside
spreads and caused trades to be executed at prices that were less
favorable for investors than if there had been no pricing
convention.
Similarly, the quotations can affect the ability of
institutional investors to obtain favorable prices. The
quotations may be part of the mix of information that factors
into the efforts of institutional investors to negotiate the best
prices possible and may serve as benchmarks for such
negotiations. Quotations which are kept wide by the pricing
convention may place institutional investors at a disadvantage in
such negotiations and create a distorted picture of the market.
Although adherence to the pricing convention acted to
prevent market makers from displaying odd-eighth quotes for even-
eighth stocks on Nasdaq, it did not constrain them from entering
---------FOOTNOTES----------
-[14]- An analysis of over 10 million Nasdaq NMS trades
from February 1994 through May 1994 compared trade
prices to the inside quotes which existed at the
time of execution, or the reported time if the
execution time was not available. Over 60% of all
trades were executed at the inside quotes.
Smaller trades were executed at the inside quotes
more often than larger trades. For example, in
May 1994, over 90% of customer trades less than
1,000 shares were executed at the inside quotes,
compared to approximately 75% of 1,000-5,000 share
customer trades. Nevertheless, almost 60% of
5,000 share or greater customer trades were
executed at the inside quote. Many small orders
(1,000 shares or less) are executed automatically
through SOES or market makers' internal small
order execution systems at the inside spread
(market maker internal systems sometimes
automatically execute orders up to 2,000 or 3,000
shares at the inside quotes). Institutional
customers, who typically trade in larger size than
retail customers, and who have access to other
means of price discovery, may have a degree of
economic leverage to bargain for better prices.
Nonetheless, the inside quotes may serve as a
benchmark from which the negotiations proceed.
==========================================START OF PAGE 8======
odd-eighth bids and offers for those same stocks on
Instinet-[15]- and SelectNet.-[16]- Market makers
regularly placed orders to buy or sell even-eighth stocks at odd-
eighth prices on these systems, while quoting the same stocks
almost exclusively in even-eighth increments on
Nasdaq.-[17]-
Figure 3 below shows how market makers entered quotes in
Nasdaq for odd and even-eighth stocks. As discussed above, for
stocks with a dealer spread of $3/4 or greater, odd-eighth
---------FOOTNOTES----------
-[15]- Instinet is a proprietary screen-based automated
trading system consisting of a network of computer
terminals that permits broker-dealers and
institutions to enter anonymously orders to buy
and sell and execute against those orders through
a computerized system. Instinet does not accept
retail customers. Nothing in this Report or
Appendix is intended to suggest improper or
illegal activity by Instinet.
-[16]- SelectNet is an electronic trading system owned
and operated by the Nasdaq Stock Market, Inc. and
is available as a trading vehicle only to NASD
member firms.
-[17]- A tape obtained in the investigation contains a
conversation by a market maker who refuses to put
an odd-eighth quote on Nasdaq when requested to do
so by a retail broker, but indicates he will put
an order on Instinet containing the odd-eighth
quote. He explains to the broker that displaying
an odd-eighth quote in the stock on Nasdaq would
make a "Chinese market," which is considered
unprofessional and which other market makers do
not like. He stated: "I really can't do that
'cause it creates what they call a Chinese market,
stock trades in 1/4 point. I'm on Instinet. If
somebody wants to whack me at 7/8ths, that's where
they're going to whack me."
The Commission recognizes the potentially pejorative
connotation of the term "Chinese market," and by
repeating it herein does not condone its use by any
Nasdaq market makers.
==========================================START OF PAGE 9======
quotations are rarely used in the Nasdaq market.
This can be contrasted with the way market makers place
quotes (in the form of limit orders) in Instinet.-[18]- As
shown in Figure 4 below, even and odd-eighths are as frequently
---------FOOTNOTES----------
-[18]- Because Instinet orders express market makers'
willingness to deal at stated prices, such orders
may be regarded as the functional equivalent of
market maker quotes, and are referred to as quotes
for the purposes of this Report.
==========================================START OF PAGE 10======
used for odd and even-eighth stocks.-[19]-
The routine use of odd-eighths by market makers in Instinet
for stocks quoted in even-eighths in the Nasdaq market lends
additional support to market maker testimony, documentary
evidence, and taped conversations regarding the pricing
convention and clearly indicates that adherence to the pricing
convention, as detailed in this Report, was not the result of
natural market forces. Moreover, the size of trades in Instinet
and Nasdaq were essentially the same. During April through June
1994, the average trade size for NMS stocks on Instinet was
approximately 1,600 shares, smaller than the Nasdaq average of
approximately 1,900 shares for all NMS trades. The median trade
size was 1,000 shares for both Instinet and Nasdaq.-[20]-
Access to the quote information and trade opportunities
displayed on Instinet and SelectNet, however, was limited only to
certain brokers, market makers, and institutional investors.
Individual investors and other market participants did not have
direct access to the information or trading opportunities that
---------FOOTNOTES----------
-[19]- In addition to the Market Maker Price Movement
data obtained from Nasdaq, the Commission obtained
from Instinet the Instinet Activity Report, which
includes times, prices, sizes, and identities for
orders placed and executed in Instinet for the
months of April, May, and June 1994.
-[20]- These trade sizes for Instinet and Nasdaq are
roughly the same for all months in the sample.
==========================================START OF PAGE 11======
were offered on these systems.-[21]- Thus while Instinet
and SelectNet provided avenues for market makers to quote and
trade at odd-eighth prices with a limited subset of market
traders, many investors, particularly retail customers, could
only observe and trade at the Nasdaq quotes, where odd-eighth
prices often were not available because of market makers'
widespread adherence to the pricing convention.-[22]-
---------FOOTNOTES----------
-[21]- In the following conversation, two traders comment
upon a suggestion made by another trader
(Trader 3) at a meeting that retail customers
should be given access to Instinet:
Trader 1: What did he [Trader 3] have to say?
Trader 2: `I come from [firm], and we do a lot of
retail, and I think there ought to be a way
that our customers have access to Instinet.'
I'm like,
Trader 1: What?
Trader 2: What?
Trader 1: Well, then you wouldn't do the retail, you
moron.
Trader 2: Like [name of Trader 3], then there'd be no
need for you, you jarhead.
-[22]- Some traders recognized that by trading through
Instinet, they could trade inside the Nasdaq
spread. This contributed to wide spreads on
Nasdaq. The following conversation between two
traders reflects that understanding:
Trader 1: The thing I think should be done is allow the
public to participate. For example, the
market is 9 to 1/2. Years ago that stock
would be 9 to a 1/4. And if it was trading 9
to an 1/8, the only way you would compete or
get in the flow, was offer at an 1/8 and bid
9.
Trader 2: Yep.
Trader 1: Today, you don't have to do that.
Trader 2: Because you could just use the stupid toy
[Instinet].
Trader 1: Exactly.
Trader 2: Bid an 1/8 on [Instinet].
Trader 1: Right. You don't have to put it in. I think
there's got to be something done. For
example, yesterday 9 to a 1/2. I bid an 1/8
and I buy for 4,000 from a guy. I know there
are sellers out there. He should be
required, after he makes a sale at an 1/8 and
(continued...)
==========================================START OF PAGE 12======
Instinet and, to a lesser extent, SelectNet, have emerged as
primary arenas for market makers to attract, negotiate, and
execute trades within the inside spread.-[23]- In these
trading systems, market makers can enter quotes and trade at
prices better than the inside spread without creating a new
inside market at which all market makers regard themselves as
being obligated to trade with their customers.-[24]-
---------FOOTNOTES----------
-[22]-(...continued)
has more to do, to offer at an 1/8 in
[Nasdaq].
Trader 2: Yeah.
Trader 1: OK.
Trader 2: Yeah, how can you--how can you, how can you
enforce that, though?
Trader 1: Well, let's put it this way. We don't want
them to enforce it. But if we make a
suggestion that maybe that's something that
could be done, it would do two things. It
would cut the spread down from 9 to 1/2 to 9
to an 1/8.
Trader 2: It would also keep them off our back for a
while.
-[23]- Instinet is larger than any of the organized U.S.
stock markets other than the New York Stock
Exchange or Nasdaq, even though it excludes retail
order flow. For example, in 1994, trading volume
on Instinet was approximately 10.8 billion shares
with an approximate dollar volume of $282 billion.
By comparison, Nasdaq had 74 billion shares traded
with an approximate dollar volume of $1,449
billion (including the volume on Instinet). In
1994, the New York Stock Exchange had trading
volume of approximately 76 billion shares with an
approximate dollar volume of $2,841 billion.
Market makers and other broker-dealers are
responsible for most of the trading volume in
Instinet. Institutional investors account for the
remaining volume. Instinet trading constitutes a
significant share of total Nasdaq trading. An
analysis of market data for the month of May 1994
shows that Instinet trades represented over
seventeen percent of all NMS trades and
approximately fifteen percent of NMS trading
volume during the period.
-[24]- Some traders believe that Instinet has emerged as
a preferable "market" to Nasdaq. In a
conversation between two traders discussing the
(continued...)
==========================================START OF PAGE 13======
Analysis of data for May 1994 shows that approximately 85% of
bids and offers displayed by market makers on Instinet and 90% of
bids and offers displayed on SelectNet were at better prices than
those posted on Nasdaq. In addition, approximately 77% of trades
executed on Instinet and 60% of trades executed on SelectNet were
at prices superior to the Nasdaq inside spread.-[25]-
The market participants who most often traded at the
superior prices available on Instinet were market makers.
Analysis of data for May 1994 shows that approximately 90% of all
trades executed on Instinet had a market maker on at least one
side of the trade, while institutional investors were direct
parties to less than 20% of Instinet trades. All trades on
SelectNet involve NASD member firms; institutional and retail
investors cannot trade on this system.
The trading activity on Instinet and SelectNet indicates
that these systems have been used by market makers to facilitate
adherence to the pricing convention. Notwithstanding the
benefits of the pricing convention to market makers, at times
---------FOOTNOTES----------
-[24]-(...continued)
narrowing of the spreads of certain stocks in the
spring of 1994 (see Part I.A.1.e.), the traders
discussed Instinet:
Trader 1: It would be interesting to see if this does
anything to, to Instinet. It's really not
right to give two different quotes.
Trader 2: I agree.
Trader 1: You know, if people start looking in Nasdaq
first and Instinet second, that's what you
got to get doing. But you go and see these
accounts, and stop up at their offices, they
all have Instinet. That's the first place
they look.
Trader 2: Instinet's the market. You're right, that's
it.
Trader 1: If something's offered and they're in the
middle and they have it to buy, they take it.
Trader 2: Yeah, yeah.
Trader 1: They don't even look at the ******* box. They
don't care what it looks like.
-[25]- These numbers are representative of the trading
activity during all months of the sample described
supra note 14. The quality of trade executions on
Instinet and SelectNet may be compared with the
quality of trade executions in Nasdaq as described
supra note 14, where most trades are executed at
the displayed inside quotations.
==========================================START OF PAGE 14======
they wanted to trade at prices that would be inconsistent with
the convention. The availability of private systems allowed
market makers to trade at prices better than the Nasdaq inside
quotes without violating the pricing convention and without
affecting the prices at which other market makers trade with the
public.-[26]- The availability of these systems,
particularly Instinet, reduced the necessity to narrow the Nasdaq
spreads, thereby facilitating adherence to the pricing convention
and reducing competition in the Nasdaq market.-[27]-
The trading activities of market makers on Instinet and
SelectNet, together with the activities meant to enforce the
pricing convention, demonstrate that adherence to the convention,
as detailed in this Report, was not the result of "natural"
market forces or a custom that evolved for ease of
administration.-[28]- The limitation of quote updates to
---------FOOTNOTES----------
-[26]- The advantages to market makers of such limited
access systems have fostered the development of a
two-tiered market -- the public Nasdaq market for
retail investors and some institutional investors,
and the private, limited access systems where
broker-dealers and certain large institutional
investors can observe and trade at better prices,
yet in similarly sized trades, as in Nasdaq.
-[27]- One trader's testimony illustrates this point:
Back in the eighties you really did not have
Instinet as it was [sic] today and so
sometimes you would move your market up, you
would close your spread to try to signal to
another market maker hey, in this case, say
going up in the bid I am a buyer and you
might go twenty-nine and an eighth bid and
stay there for a while and then go down to
let people know you are a twenty-nine and an
eighth buyer. You have tried institutional
and you cannot find. Instinet was not what
it was [sic] today, they did not do that kind
of volume, so the only way to really let the
world know you are a buying [sic] rather than
just take them the twenty-nine and a quarter
stock is to close your spread or do what you
call the odd[-]eighth.
-[28]- Pertinent to this point is the partial breakdown
of the pricing convention after the May 24, 1994
Bear Stearns meeting (discussed in Section
I.A.1.e.), at which the NASD urged market makers
(continued...)
==========================================START OF PAGE 15======
even-eighth increments allowed market makers to maintain
artificially wide spreads. This increased their profits, but
often had a negative impact on the prices paid by investors.
b. Disincentive to Breaking the Spread
Market makers usually set their dealer spreads at levels no
narrower than the spreads displayed by other dealers in that
particular stock. As a result, until May of 1994,-[29]-
even when market makers could have narrowed their spreads
consistent with the pricing convention, dealer spreads
nevertheless were rarely narrowed, even if the pricing convention
was followed. The evidence obtained in the investigation
indicated that a number of market makers discouraged their peers
from entering dealer spreads narrower than the dealer spreads
entered by other market makers in any particular security, even
if such a narrowing conformed with the pricing
convention.-[30]- If market makers in a particular
---------FOOTNOTES----------
-[28]-(...continued)
to narrow spreads, and the subsequent publicity
over the Christie-Schultz study's conclusion of
tacit collusion. The number of stocks following
the pricing convention dropped from over 80%
before October 1994 to approximately 68% by July
1995, as shown in Figure 5 in the text infra Part
I.A.1.e. These changes in dealer quotation
activity further indicate that the adherence to
the pricing convention, as detailed in this
Report, was not a natural pattern of conduct.
-[29]- Spreads in a number of high volume stocks began to
narrow beginning in late May 1994 and thereafter
following the Bear Stearns meeting on May 24,
1994, publicity concerning the Christie-Schultz
study, which suggested possible implicit collusion
among Nasdaq market makers, and the filing of
class action litigation against a number of market
makers alleging price fixing in the spreads of
Nasdaq stocks.
-[30]- For example, on September 20, 1994, the initial
public offer of the common stock of Comcast U.K.
(CMCAF) was made. In the minutes preceding the
opening of trading, various market makers
displayed a $3/4 dealer spread in their quotes,
but one market maker (MM 1) displayed a $1/2
dealer spread in its quotes. MM 1 was called by
the lead underwriter for CMCAF (MM 2), who
informed MM 1 that MM 2 had displayed a $3/4
(continued...)
==========================================START OF PAGE 16======
security were quoting dealer spreads of $3/4 and $1, other market
---------FOOTNOTES----------
-[30]-(...continued)
dealer spread and that a $3/4 dealer spread was
the right thing to do. MM 1 then changed its
quotes to a $3/4 dealer spread.
This point is also exemplified by the market for McCaw
Cellular stock (MCAWA) on April 8, 1994. On this day,
all market makers were displaying $3/4 dealer spreads
or wider, except one who displayed a $1/2 dealer
spread. Another market maker then changed its quotes
to reflect a $1/4 dealer spread. Due to the excess
spread rule, all other market makers were then required
to display quotes having a dealer spread of $5/8 or
less. A number of dealers displayed quotes having a
$1/2 dealer spread. Shortly thereafter, three market
makers made an effort to widen the dealer spread out to
$3/4 again by displaying $5/8 dealer spreads in the
apparent hope of inducing other market makers to follow
them. If all or almost all the market makers had
followed them to $5/8, they could have then widened to
a $3/4 dealer spread without violating the excess
spread rule. Two of them engaged in the following
dialogue:
MM 1: Hey, alright, uh, we're still goofing around
with this MCAWA. I just went down an eighth on the bid.
MM 2: Okay.
MM 1: And that let me do that. So I told [MM 3] to go
down an eighth.
. . . .
MM 2: If that's what you guys want me to do, I'll do
it.
MM 1: Try it and then I'm going to try and go down
another eighth, you know what I mean, and get it, get
it back to $3/4 spread.
This attempt to widen the dealer spread to $3/4 failed
because too many market makers continued to display
$1/2 dealer spreads. However, the willingness of three
market makers to act collectively in an effort to widen
the spread almost immediately after it narrowed is
indicative of the disincentive against narrowing the
spread even in compliance with the pricing convention.
In addition, the negative reactions of some market
makers to narrowings of the spreads in certain heavily
traded Nasdaq stocks in late May 1994 further
demonstrates this disincentive. See infra discussion
notes 47-51 and accompanying text.
==========================================START OF PAGE 17======
makers understood that they were not supposed to "break the
spread" by quoting a dealer spread narrower than $3/4. A
reduction in the dealer spread to less than $3/4 by one dealer
could, if joined by other dealers, result in quotation increments
being reduced to $1/8 increments pursuant to the pricing
convention and the inside spread being reduced to $1/8. Like the
pricing convention, the disincentive against "breaking the
spread" contributed to the artificially wide inside spreads on
Nasdaq.
This general disincentive against narrowing the spread is a
further anticompetitive influence in the Nasdaq market. A number
of market makers discouraged their peers from price cutting, even
within the pricing convention. This practice artificially
interfered with the free flow of competition.
c. Size Convention
Traders testified to the existence of another market
maker practice that discouraged a narrowing of the inside spread
in certain circumstances. This practice provided that a market
maker that moves a quote to create a new inside bid or offer must
be willing to trade at that new price level for a quantity of
shares significantly greater than the minimum required by NASD
rule (which requires 1,000 shares for the more heavily traded
stocks).-[31]- Traders have testified that a market maker
who creates a new inside bid or offer should be willing to trade
in the range of 2,000 shares to 5,000 shares (and sometimes more)
at that new price level. If a trader is only willing to trade
1,000 shares at a new inside bid or offer, the accepted practice
is that the market maker refrain from moving the quote to that
price level.-[32]- This practice discouraged traders from
---------FOOTNOTES----------
-[31]- NASD Manual, Schedule D to the By-Laws, Part V,
2, (CCH) 1819 (1995) (prescribing minimum sizes
of quotations).
-[32]- Some traders have testified that if the market
maker at the inside does not have substantial size
to trade, that market maker is "distorting" the
market, that his quote is not "real," and that his
quote is making negotiations with other market
makers' customers more difficult. In these
circumstances, some market makers ask the market
maker quoting the inside bid or ask to move its
quote. The notion that an inside quote for the
minimum required number of shares is not "real" is
fallacious, because a market maker is only
required to be willing to trade the legal minimum.
Some traders have testified that the inside quote
(continued...)
==========================================START OF PAGE 18======
entering quotes that would improve the inside bid or offer when
they were seeking to trade only the legal minimum quantity of
stock.-[33]-
Certain market makers testified that, in connection with the
size convention, they were not concerned with the narrowing of
spreads but rather with the improved price they would have to
give to customers. They testified that their concern was that
the creation of a new inside bid raised the price they would have
to pay for customer sales and the creation of a new inside ask
lowered the price they would have to accept for customer
purchases. This, however, only points to the significance of
narrower spreads. When market makers, through the size
convention, discouraged new inside quotations that improved the
price given to investors, the flexibility and fairness of prices
were artificially impaired.
Thus, the size convention inhibited price transparency by
limiting quote changes to those circumstances where a market
maker was willing to trade substantially greater volume than its
NASD required minimum quotation size. This impaired price
competition in the Nasdaq market, because quotations meeting only
---------FOOTNOTES----------
-[32]-(...continued)
in some circumstances is the starting point for
negotiations with institutional customers, and
another market maker's quote can affect such
negotiations. This dynamic, however, does not
justify interference with the other market makers'
pricing decisions.
-[33]- One market maker testified that the size
convention (which he characterized as a
"practice") does not apply when the price of the
stock is rising or falling generally, but rather
when the market maker disseminating the new
quotation is "sticking out." In one instance in
1994, this market maker and a second market maker
harassed one of their peers for narrowing the
inside spread by putting an odd-eighth quote for
Intel, a stock then normally quoted in even-
eighths. The harassers claimed that they were
upset not by the use of odd-eighths but by the
fact that the firm narrowing the spread would only
trade the legal minimum of 1,000 shares with them,
rather than 2,500 or more shares. Even if one
gives credence to this testimony, the harassment
in this instance impedes the free flow of
competition by burdening price changes with a much
greater volume requirement than the minimum
prescribed by NASD rule.
==========================================START OF PAGE 19======
the NASD minimum quotation sizes were deterred. Spreads were
wider because the size convention artificially restrained
aggressive pricing. The size convention operated independently
of the pricing convention, in that it applied to the creation of
new inside prices both in conformity with and in violation of the
pricing convention. Thus, its effect was cumulative to the
anticompetitive effects of the pricing convention.
d. Pressure and Harassment
Various Nasdaq market makers have exerted pressure on market
makers who acted inconsistently with the above-described trading
conventions, narrowing the inside spread, and consequently
reducing the profits of all other market makers in the stock.
The investigation has developed evidence of instances where
market makers entered quotes that narrowed the inside spread in
contravention of established trading and pricing practices and
then were the subject of harassing telephone calls. These calls
involved other market makers questioning or complaining about the
narrower spread, requesting or demanding that the market maker
widen the spread back out, asserting that the market maker was
ruining the market or was unprofessional, unethical, or
embarrassing, or accusing the market maker of "making a Chinese
market."-[34]- Some market makers have also complained
about other market makers narrowing the spread by disseminating
messages over the SelectNet system.-[35]- In addition,
---------FOOTNOTES----------
-[34]- The term "Chinese market" is used by Nasdaq
traders to describe a market that is quoted in a
manner that is inconsistent with the usual quoting
pattern for the stock. For example, if the market
makers in a stock are quoting dealer spreads of
3/4 of a point, and one market maker publishes a
dealer spread of 3/4 of a point at odd-eighth
intervals, e.g., 20 1/8 bid to 20 7/8 offer, that
market maker would be considered to be making a
Chinese market.
At times, a degree of imagination was applied to the
harassing telephone calls. When one market maker
narrowed the spread on certain occasions from 1/4 to
1/8, it received anonymous telephone calls in which the
caller, in a phony Chinese accent, ordered chop suey,
moo goo gai pan or other Chinese food, in an apparent
allusion to the understanding among market makers not
to make "Chinese markets."
-[35]- In addition to delivering orders, SelectNet can be
used to transmit short text messages. Examples of
messages complaining about spread narrowings are
set forth in infra note 48.
==========================================START OF PAGE 20======
market makers who violated the conventions occasionally
encountered refusals by other market makers to trade with them.
e. Bear Stearns Meeting and Subsequent Narrowings
In the spring of 1994, market makers began to narrow spreads
in a number of high profile stocks. Several events appear to
have precipitated this development.
On May 24, 1994, the Security Traders Association (the
"STA")-[36]- sponsored a meeting to discuss the width of
spreads at the Manhattan offices of Bear Stearns (the "Bear
Stearns Meeting"). The meeting was attended by approximately one
hundred traders from many of the major Nasdaq market making
firms, as well as senior officers of the STA and the NASD. The
President of the STA began the meeting by urging traders to
narrow spreads voluntarily or face regulations forcing a
tightening of spreads.-[37]- NASD senior officers then
made a presentation showing that the spreads of top Nasdaq
securities had widened and that in many stocks, the displayed
spread was substantially wider than the spread at which the stock
actually could be traded.-[38]- The NASD officers
suggested that because of such spreads, there existed a
substantial risk that some significant Nasdaq companies would
leave Nasdaq to list on the New York Stock Exchange, thereby
reducing the trading revenues of Nasdaq market makers. The NASD
officers urged traders to examine the stocks that they traded,
---------FOOTNOTES----------
-[36]- The STA is a trade association composed of
individuals in the securities industry which
largely represents the interests of market makers.
-[37]- In his prepared remarks the STA President stated:
[L]et me suggest that if we do not voluntary
(sic) close . . . quotes, it will be done by
regulation by the NASD, the SEC or Congress
and in the meantime we will lose many
companies to the exchange and receive much
bad and distressing publicity.
He also quoted from the Christie-Schultz study and a
letter from an issuer complaining about its spread.
-[38]- The presentation included slides showing a list of
the top 25 Nasdaq stocks by market value and their
inside spreads, a list of six large Nasdaq stocks
with substantial spreads, and charts tracking
average spreads on Nasdaq, the growth of Nasdaq
market value and capitalization, and related
increases in market maker trading revenue.
==========================================START OF PAGE 21======
particularly the high profile Nasdaq stocks, to see whether or
not they could reduce their displayed dealer spreads. NASD
officers also pointed out in response to a comment in the
audience that intimidation against market makers that narrowed
spreads was a violation of NASD rules.
One NASD officer pointed out that spreads had not narrowed
since certain SOES rules changes, which had reduced market maker
exposure on SOES,-[39]- had taken effect in January 1994.
He pointed out that for a long time many market makers had stated
that SOES activity was the cause of widening spreads.-[40]-
---------FOOTNOTES----------
-[39]- These rule changes, known as the interim SOES
rules, included a reduction of the maximum SOES
order size from 1,000 shares to 500 shares, a
reduction in the number of times that a market
maker would be exposed to SOES executions from
five to two (thereby effectively reducing the
market maker's exposure from 5,000 shares to 1,000
shares), the authorization for the Nasdaq Stock
Market, Inc. to offer an automated quote update
feature that moved a market maker's quote away
from the inside quote after receipt of a SOES
execution, and a prohibition on short sales in
SOES. See NASD Special Notice to Members 94-1,
Jan. 5, 1994. The NASD proposed these changes on
the basis that they would narrow spreads.
Exchange Act Release No. 32143 (Apr. 21, 1993) 58
Fed. Reg. 21484 (Apr. 24, 1993).
-[40]- Market makers generally have attempted to blame
active SOES trading for the width of the Nasdaq
market spreads. Some market makers anticipated
that the changes brought by the SOES interim rules
would put pressure on market makers to narrow
spreads because they could no longer blame wide
spreads on SOES abuse. A January 7, 1994 memo to
the STA Board of Governors from the STA Trading
Issues Committee states:
[Spreads w]ill probably become THE hot issue
for 1994 in the minds of the issuers and,
therefore, the NASD. With the interim SOES
rules removing SOES abuse as a (legitimate)
excuse, pressure on spreads will become
intense. Look for questions about market-
maker quotations at one price, and
bids/offers in SelectNet/Instinet/private
systems at a different price.
(continued...)
==========================================START OF PAGE 22======
This individual indicated that the interim rules, by reducing
SOES tier sizes from 1,000 to 500 shares, had reduced the
pressure on market makers to maintain wide spreads, but that
following that reduction the spreads had not narrowed. He argued
that market makers should therefore focus on reducing spreads in
light of their reduced SOES exposure.
On May 26, 1994, several major newspapers reported that the
Christie-Schultz study had concluded that market makers may
tacitly collude to maintain wide spreads.-[41]- The
publicized allegations of collusion, the perceived threat of
regulatory action, and the possibility of Nasdaq issuers moving
to the exchanges led to heightened concerns over
spreads.-[42]- These concerns appear to have prompted
certain market makers to reduce the spreads of several high
profile Nasdaq stocks beginning on May 26 and 27,
1994.-[43]- One market maker narrowed its spread in the
---------FOOTNOTES----------
-[40]-(...continued)
The absence of an overall narrowing of spreads after
the adoption of the interim SOES rules is inconsistent
with the argument that SOES trading is responsible for
wide spreads.
-[41]- The NASD had received a draft of the Christie-
Schultz study in late 1993, and was concerned
about its conclusions. Some market makers became
aware of the study in early 1994 before the study
was widely publicized.
-[42]- On May 27, 1994, several class action lawsuits
were filed against certain market makers alleging
violations of federal and state antitrust and
securities statutes. Additional class actions
were filed in the summer of 1994. In the fall of
1994, more than two dozen class action complaints
were consolidated into one action in the United
States District Court for the Southern District of
New York alleging an unlawful conspiracy among
leading Nasdaq market makers to eliminate odd-
eighth quotations in order to increase spreads in
violation of the Sherman Act (earlier allegations
of violations of the securities laws were
dropped).
-[43]- In several taped telephone conversations, traders
attributed the narrowing of the dealer spreads in
late May to the Bear Stearns meeting and the
reports of the Christie-Schultz study conclusions.
The head trader at the market maker who first
(continued...)
==========================================START OF PAGE 23======
common stock of Microsoft Corporation after the market closed on
May 26, 1994. On May 27, 1994, other market makers-[44]-
tightened their dealer spreads in Microsoft, Amgen Inc., Apple
Computer Inc., Cisco Systems, Inc., and Wellfleet Communications,
Inc. These stocks and their respective spreads had been
displayed on the slides presented by the NASD staff at the Bear
Stearns meeting.-[45]- In the days following the meeting,
certain market makers narrowed their dealer spreads in these
stocks from $3/4 to $1/2 and began to move their quotes in $1/8
---------FOOTNOTES----------
-[43]-(...continued)
narrowed the dealer spread in the common stock of
Apple Computer Inc. testified that he narrowed
because of the issues raised at the Bear Stearns
meeting. He also testified that he called the
market maker that was the first to narrow the
dealer spread in the common stock of Microsoft
Corporation and told the trader that if his firm
could set an example in Microsoft, then he could
set an example in Apple. Traders at the firm that
first narrowed the spread in Microsoft after the
market closed on May 26, 1994 testified that they
narrowed their dealer spread because of a stock
split one week before and not because of any
issues raised at the Bear Stearns meeting.
-[44]- Some of the market making firms that took the lead
on narrowing several of the high profile Nasdaq
stocks were represented on the Trading Committee
of the NASD. The Trading Committee had been
involved in analyzing the issue of wide spreads
and the competitive threat posed by the New York
Stock Exchange as early as 1990. At least some
members of the Committee were also aware of the
issues of market maker intimidation and the
operation of the pricing convention.
-[45]- Three of these stocks, Amgen, Wellfleet, and
Apple, were listed on a slide entitled "LARGE
NASDAQ STOCKS WITH SUBSTANTIAL SPREADS." [emphasis
in original] The slide showed a substantial
difference between the displayed spread and the
spread at which market makers actually traded the
stocks. Microsoft, Apple, Amgen, and Wellfleet
were listed on the slide displaying the inside
spreads of the Nasdaq top 25 stocks by market
value. The slide showed the inside spreads of
these four stocks as being $1/4, while other
stocks on the list had inside spreads of $1/8.
==========================================START OF PAGE 24======
increments, instead of $1/4 increments.-[46]-
This movement toward narrowing spreads on certain stocks
generated resistance. Market makers recognized that the spread
reduction in these few stocks could lead to tightening of spreads
in other Nasdaq stocks.-[47]- Some traders called the
market makers who narrowed their spreads to raise questions or
complain. Other market makers broadcast messages over the
SelectNet system that criticized the change in the dealer
spreads.-[48]- Certain market makers then narrowed their
dealer spreads in one stock even further to $1/4, apparently as
an expression of their frustration.-[49]- Because of the
---------FOOTNOTES----------
-[46]- In Microsoft, Amgen, and Cisco, at least three
market makers moved to cut the dealer spreads to
$1/2. Because the excess spread rule requires
that no market maker can enter a spread more than
125% of the three narrowest dealer spreads, the
narrowings forced all of the market makers in
these stocks to enter dealer spreads no greater
than $5/8.
-[47]- The head trader of a firm discussed the
implications of the narrowings in a taped
telephone call:
You can still make markets, stocks will still
move around, but certainly the margins are
going the wrong way, and it's going to be a
hell of a lot more difficult. I don't see
how any trading desk can keep their
profitability up if the trend continues, and
they start breaking down these other stocks.
The next day, he told another trader:
I'm not going to initiate it [a narrower
spread]. Why should I do that? You know?
We might as well milk it for as long as we
can, and you know, it's going to be a
different business. Hopefully, we'll all
figure a way to make money in it.
-[48]- The messages included "Rediculous [sic]," "Great
Market," "Stpkidding," "Howbout 64s," and
"NotFunny."
-[49]- In Microsoft, three market makers had narrowed
their spreads to $1/2 by the time the market
opened for trading on May 27, 1994. Within 25
(continued...)
==========================================START OF PAGE 25======
operation of the excess spread rule, the additional spread
tightening to $1/4 forced market makers to quote these stocks
with even tighter spreads, making it difficult to
trade.-[50]- One market maker, who was angry that another
market maker had narrowed the dealer spread of Microsoft, began
to use odd-eighths in quoting the common stock of Cisco. This
trader intimated to another trader that he cut the spread in
Cisco to retaliate against the market maker who had narrowed the
spread in Microsoft, whom he knew to be one of the largest volume
traders of Cisco.-[51]-
---------FOOTNOTES----------
-[49]-(...continued)
minutes, three other market makers narrowed their
spreads to $1/4. One of the traders who narrowed
to a $1/4 dealer spread testified that he narrowed
to express his frustration to the market maker
that narrowed its dealer spread to $1/2 and that
he felt Microsoft was too volatile a stock to
trade at a $1/2 dealer spread. On a tape, a
trader at another firm that narrowed to $1/4
spread explained that the head of the Nasdaq
trading desk "did it [permitted Microsoft to be
quoted with a 1/4 point spread] just to ****
everybody up."
-[50]- Several traders testified that there was no
economic reason to narrow the dealer spread to
$1/4 in these stocks. At these levels, the market
maker would always be quoting either the inside
bid or offer, and would therefore always be
exposed to SOES and other orders, requiring
intensive monitoring of quotes and executions.
-[51]- In the taped telephone conversation, the trader
who narrowed Cisco (Trader 2) speaks of a third
firm which had narrowed the spread in Microsoft:
Trader 1: Hi.
Trader 2: Hi. What's up?
Trader 1: Oh, tell me.
Trader 2: What, you mean with these spreads?
Trader 1: Yeah.
Trader 2: Well, [name of third firm] started it with
Microsoft, so . . .
Trader 1: Oh, that what happened?
Trader 2: Yeah. You know, did you see the Journal
today? And all that **** that's going on.
Trader 1: What, no. I'm sorry. It was all, it was
kinda, it had to be done?
Trader 2: It doesn't have to be done. It's the end of
(continued...)
==========================================START OF PAGE 26======
Over the summer of 1994, the spreads in other Nasdaq stocks
were narrowed by market makers. The trend appears to have been
reinforced following additional negative publicity in October of
1994. On October 19, 1994, reports of a Justice Department
investigation of allegations of price-fixing by Nasdaq dealers
were published. The following day, the Los Angeles Times began a
six-part series highly critical of the Nasdaq market.-[52]-
---------FOOTNOTES----------
-[51]-(...continued)
the business. It's the end of your profits.
If you make 600 a month, you gonna make 400 a
month.
Trader 1: . . . I'm ******* sitting here with a knot in
my stomach you can't imagine.
Trader 2: Yeah.
Trader 1: It *****. Oh, so [third firm] cut the
Microsoft? Oh, okay. What was in, what's in
the Journal?
Trader 2: It's a whole study about how spreads are too
big.
Trader 1: Oh. If that's what's going to happen, that's
what's got to be, right?
Trader 2: Yup.
Trader 1: Yeah.
Trader 2: Alright.
Trader 1: I know you didn't want to . . . I know, I
knew it wasn't your style, you know . . . .
Trader 2: No. But I did it [narrowed the spread in
Cisco]* to get him [third firm]* back. I
knew he was involved in Cisco.
* Trader 2 testified that this sentence had the
meaning indicated in the brackets.
Within three minutes after Trader 2 used the odd-eighth
quote in Cisco, three other market makers narrowed
their dealer spreads to one-half and began moving their
quotes in eighth point increments.
-[52]- Scot Paltrow, "Inside Nasdaq, Questions About
America's Busiest Stock Market," The Los Angeles
Times, Oct. 20, 1994, at 1. See infra note 69 and
accompanying text. The first article identified a
trader at one market making firm ("Firm A") that
reportedly called the market maker that cut the
spread of Intel Corporation, an even-eighth stock,
to $1/8 and "complain[ed] 'You guys break the
spread for 1,000 shares?'" The next day, Firm A
began to move its quotes for Intel in $1/8
increments, although it temporarily continued to
(continued...)
==========================================START OF PAGE 27======
Thereafter, market makers began to narrow the spreads of
other stocks. Market makers narrowed spreads both by following
the pricing convention and narrowing their dealer spreads to less
than $3/4, and by using odd-eighth quotations with $3/4 dealer
spreads. Figure 5 shows the changes in market maker quotation
behavior from December of 1993 to July of 1995.
Starting in the summer of 1994, there was a shift of stocks
to the less than $3/4 dealer spread category along with what
appears to be the beginning of a more general breakdown of the
pricing convention.-[53]- The potential liabilities
associated with the allegations of collusion, government
investigations, and the private lawsuits more than likely played
a significant role in discouraging adherence to the pricing
convention and may have reduced the use and effectiveness of peer
---------FOOTNOTES----------
-[52]-(...continued)
quote a $3/4 dealer spread. On October 24, Firm A
was the second market maker to cut its dealer
spread to $1/2.
-[53]- Some traders have testified that the pricing
convention is no longer followed consistently.
==========================================START OF PAGE 28======
pressure to discourage those market makers that narrowed the
spread.
In sum, the pricing convention, the size convention, the
disincentive against narrowing the spread, their attendant
enforcement mechanisms, and the availability of nonpublic trading
systems for market makers resulted in a fragmented market for
Nasdaq stocks where investors, institutional and retail,
transacted at a considerable disadvantage to market makers.
Investors were often confronted by artificially wide, inflexible
spreads, and frequently could not transact in the markets at the
best prices. Attempts by dissident market makers to compete on
the basis of price were in a number of instances met with
hostility and harassment.
2. The NASD's Failure to Address Adequately the
Pricing Convention and Related Practices
The investigation inquired into how the NASD addressed the
issues raised by the anticompetitive activities described above.
The issue of the width of spreads for Nasdaq securities has been
raised frequently by market participants and other observers over
a number of years. The registered stock exchanges, which compete
with Nasdaq for listings, have focused on the issue of spreads in
marketing materials designed to encourage issuers to list on the
exchanges. Various issuers have raised concerns about what they
have perceived to be wide spreads in their stocks, and investors
have complained about the issue. Economists have studied spreads
as a measure of transaction costs paid by investors, and articles
and academic studies have appeared identifying the issue as a
problem on Nasdaq. In the course of reacting to the issue of the
size of spreads on Nasdaq, the NASD became aware of both a
pricing convention operating in the Nasdaq market and the
allegations that certain market makers harassed and intimidated
those who narrowed spreads.
At a June 27, 1990 meeting of the Trading Committee of the
NASD, the issue of spreads was raised in a discussion about a New
York Stock Exchange letter to a Nasdaq issuer questioning the
width of spreads on Nasdaq. During the meeting, committee
members and senior NASD staff-[54]- discussed facts
evidencing the pricing convention, its enforcement, and the
rigidity of Nasdaq spreads. The pricing convention was described
---------FOOTNOTES----------
-[54]- Seven of the nine committee members present were
representatives of Nasdaq market making firms (and
one of these seven members was also a member of
the NASD Board of Governors at the time). The
NASD staff present included members of the Office
of General Counsel, Division of Market
Surveillance, and Division of Market Operations.
==========================================START OF PAGE 29======
by one committee member as an "ethic" in the Nasdaq market, part
of which was not to close spreads or make "Chinese markets." Two
other committee members stated that if a market maker attempts to
break a spread, it gets calls from large firms questioning the
reason for the narrower spread. The committee concluded that it
was inadvisable to legislate spreads and that the Security
Traders Association of New York, an industry trade association,
should address the issue of the "ethic" because it was an
"internal" matter.-[55]-
Despite the presence at this meeting of senior NASD staff,
the NASD did not take any action following this meeting to
investigate the existence, impact, or legality of an "ethic" that
market makers should not break spreads or make "Chinese markets,"
or the practice of market makers discouraging one another from
narrowing spreads.
In 1992, a senior NASD executive undertook an evaluation and
analysis of the issue of widening spreads as part of an effort to
achieve a 1992 NASD corporate goal to reduce spreads.-[56]-
In connection with this effort, the staff member discussed the
issue of widening spreads with members of the Quality of Markets
---------FOOTNOTES----------
-[55]- The official minutes of the meeting state: "The
Committee also discussed the inadvisability of
trying to legislate spreads; that whatever
movement necessary to narrow spreads must come
from within the market itself, and through
industry groups such as the Securities [sic]
Traders Association."
Beginning in 1990, certain Nasdaq traders serving as
governors of STA encouraged market makers to narrow
voluntarily their dealer spreads. These efforts were
not successful, as spreads did not begin to narrow
generally until mid-1994. Some market makers indicated
to one STA governor that they were not willing to
narrow their dealer spreads because they were concerned
about receiving phone calls from other market makers
pressuring them not to narrow.
-[56]- Although some NASD witnesses testified that the
primary reason for the initiative was to reduce
the transaction costs paid by investors trading at
the inside spreads, the weight of the evidence
indicates that concerns about losing issuer
listings to the exchanges was the primary
motivation for the NASD's efforts to reduce
spreads.
==========================================START OF PAGE 30======
Subcommittee of the Trading Committee.-[57]- The subjects
of "Chinese markets," the quoting patterns dictated by the
pricing convention, and the intimidation of market makers were
discussed during at least one meeting of the Quality of Markets
Subcommittee, held on March 24, 1992, at which NASD staff members
were present. The senior officer wrote a memorandum dated June
30, 1992 summarizing his thoughts and proposing a number of
initiatives to address the issue of widening spreads (the "June
1992 Memo"). The June 1992 Memo was distributed to most of the
senior officers of the NASD.
The June 1992 Memo identified an absolute increase in inside
spreads from the first quarter of 1989 through May 1992 from
$0.226 to $0.369, an increase of 63%. It then set forth the
author's opinions as to the reasons for the widening spreads.
The June 1992 Memo described order flow arrangements, the
increased use of SelectNet and Instinet, and market maker
exposure to SOES trades as contributing factors. It also
identified the stigma associated with making a "Chinese market"
and the observance of uniform quote increments as contributing to
widening spreads, stating:
Unlike auction markets, dealers do not change prices
one side at a time and there is a stigmatism [sic]
associated with making so called "Chinese" markets.
Tangential to this, is statistical evidence that shows,
stocks that move (i.e. the next quote change) in 1/8
point increments have narrower spreads than 1/4 pt.,
1/4 pt. narrower than 1/2 pt. etc. No one attempts to
do just a "little" better with their published quote
change (e.g. 1/16) where as in negotiation of the trade
itself that smaller price improvement is accomplished.
As a result stocks that get stuck in a particular quote
increment mode never seem to change e.g. Apple always
moves in 1/4 pt. increments. MCI happens to enjoy a
1/8 point increment. What's the difference?
The June 1992 Memo then discussed the subject of peer
pressure associated with the narrowing of spreads:
Dealer spreads are arbitrarily established at the time
of an IPO [initial public offerings] and after
initially set, there is no incentive to reduce them. I
understand that when attempts are made by individual
dealers to do so, peer pressure is brought to bear to
---------FOOTNOTES----------
-[57]- The Quality of Markets Subcommittee was formed in
early 1991 to address two issues: the development
of the short sale rule and the issue of spreads.
The Subcommittee was composed only of
representatives of market making firms.
==========================================START OF PAGE 31======
reverse any narrowing of spreads. I have no hard
evidence of this and the information is only anecdotal
and this was not described as happening in every case.
However, enough people have said it for me to believe
it to be true.
The memo then outlined proposed solutions to the problem of
wide spreads. These proposals included modifying SOES tier
limits and SOES exposure, converting SOES from an order execution
system to an order delivery system, modifying the limit order
file, and redefining the excess spread parameters. The memo also
addressed the issue of peer pressure:
We need to support those market makers who attempt to
compete through the price improvement process and also
make it clear that tampering or using coercion in
influencing other's [sic] pricing decision[s] is a
violation of fair trade practices.
The issues set forth in the June 1992 Memo were discussed at
a meeting of NASD senior management in July of 1992. At the
meeting, the author repeated the observations set forth in the
memo. Members of NASD senior management inquired about specific
instances of intimidation or harassment, but received no specific
examples.
The NASD did not take appropriate steps to investigate the
issue of dealer intimidation or uniform quoting practices
described in the June 1992 Memo. No attempts were made to assess
more comprehensively the impact of these market maker practices
on spreads or trade executions. NASD management did not
undertake a study of the competitive issues confronting the
market nor did it utilize the NASD's enforcement resources to
inquire into the conduct of market makers to assess compliance
with the NASD's rules.-[58]-
Beginning in 1992, the NASD considered regulatory and
structural measures which it described as being designed to
narrow the spreads on Nasdaq in a manner that would be acceptable
to the market making community. These measures focused on
modifying the SOES system to convert it from an automatic order
---------FOOTNOTES----------
-[58]- NASD witnesses testified that they did not pursue
these matters because they did not have any
specific information as to instances of
intimidation or harassment. The absence of
specific information about incidents of
intimidation or harassment did not excuse the NASD
from proactively ascertaining whether or not its
rules had been violated or whether the integrity
of the Nasdaq market was in jeopardy.
==========================================START OF PAGE 32======
execution system to an order delivery system, thereby allowing
market makers to reject orders delivered through SOES. This
approach was intended, in part, to respond to the demands of
market makers advocating the elimination of trading sponsored by
SOES firms.-[59]- The NASD staff also considered proposing
changes to the SOES limit order file that would allow market
orders to interact with limit orders between the inside spread,
thereby increasing the number of trades executed inside the
spread.-[60]- The NASD staff anticipated that although
---------FOOTNOTES----------
-[59]- Many market makers believed that active SOES
trading resulted in substantial losses to market
makers. Consequently, they exerted significant
pressure on the NASD to eliminate active trading
on SOES. Market makers publicly blamed wide
spreads on active SOES trading. They claimed that
because of the automatic execution feature of
SOES, SOES traders had an unfair trading advantage
in periods of volatility, when they could execute
trades in SOES before the market makers had an
opportunity to adjust their quotes in response to
the changing market. Market makers also claimed
that the trading risks created by SOES traders
forced them to widen their spreads to reduce their
market exposure, and many took the position that
they would not narrow their spreads until the
alleged "SOES abuse" was curbed. The NASD
publicly accepted the view that SOES trading was a
primary cause of wide spreads, submitting several
studies to the Commission allegedly demonstrating
this to be true, and pursued a solution to the
issue of wide spreads that first and foremost
addressed the concerns of the market making
community. See infra part II. for a discussion of
the market makers' influence on the NASD. As
discussed in note 40 supra, the fact that market
makers did not narrow their spreads on an overall
basis after receiving regulatory relief through
the interim SOES rules is inconsistent with the
argument that SOES trading was responsible for
wide spreads.
-[60]- Additionally, the NASD implemented changes to the
excess spread rule that were intended to create
downward pressure on spreads. The rule, however,
inadvertently created incentives for dealers to
discourage one another from narrowing spreads.
See infra part II.C.2. NASD senior staff members
were aware of this possible consequence of the
rule. The 1993/1994 Business Plan of the Market
(continued...)
==========================================START OF PAGE 33======
many market makers would oppose this change in the limit order
file, they would accept the changes, if proposed in conjunction
with the changes in SOES strongly advocated by market
makers.-[61]- Conversely, the NASD staff apparently
believed that the SEC would not accept the SOES changes without a
proposal to reform the limit order file.-[62]- Thus, the
NASD staff made a "tactical" decision to link SOES reform to
changes in the limit order file in order to gain acceptance of
the package by both the SEC and the market makers.
The NASD staff proposals to reform SOES did not address the
other issues that were identified in the June 1992 Memo as
contributing to excessively wide spreads. The NASD did, however,
---------FOOTNOTES----------
-[60]-(...continued)
Surveillance Department states in a section headed
"External Environment" that "[n]ew excess spread
policy may lead to collusion amongst firms to
widen spreads."
-[61]- In a July 31, 1992 memo to members of NASD senior
management, the author of the June 1992 Memo
stated:
There are a number of solutions which I
originally suggested in my June 30th
memorandum. . . . For pure [sic] tactical
reasons, I recommend we narrow the solution,
at this time, to only one. Specifically,
link the change of SOES to a [sic] order
routing system with the interaction of that
order with the limit order file (emphasis in
original).
-[62]- A November 16, 1992 memo from a NASD Senior Vice
President to members of the Quality of Markets
Subcommittee states:
Attached is a proposal for changing the SOES
execution system to an order delivery system.
Because this will be viewed as a diminution
of the public's access to the market, this
proposal also contemplates a change to the
Limit Order File.
The body of the circulated proposal states in part:
[T]here is no possibility that the SEC will
approve modifications to SOES that
disadvantage some market orders without some
form of quid prop [sic] quo.
==========================================START OF PAGE 34======
target the SOES execution system for elimination, thereby
satisfying a priority of the Nasdaq market makers, the NASD's
most powerful constituency.
The NASD continued to receive indications of a lack of
vigorous price competition in the Nasdaq market. An article
appeared on August 16, 1993 in Forbes magazine entitled "Fun and
Games on Nasdaq," describing market maker practices, including
the harassment of traders that narrow spreads. A December 8,
1992 comment letter submitted to the SEC by the American Stock
Exchange contained allegations that Nasdaq quoted spreads almost
never vary, and that dealers do not narrow spreads because of
concern that other market makers will then not "play ball" with
them and help them lay off position risk.-[63]-
While the NASD failed to address adequately these
indications of potentially improper market maker practices, it
---------FOOTNOTES----------
-[63]- Questions about the integrity of Nasdaq market
makers were raised in other areas. In late 1993,
the NASD undertook a survey of institutional
investors concerning their perceptions of the
Nasdaq stock market. The findings of the survey
were presented to the senior management group of
the NASD and Nasdaq, and to the Trading Committee
and Institutional Investors Committee of the NASD
using a series of overhead slides. These slides
included direct quotations from particular
institutional investors interviewed and included
the following quotes:
"There is a sense that dealers collude and share
information that we don't see." [emphasis in
original]
"Market makers are self-serving. They take care
of their own accounts first, then their `broker
buddies.' We're the last ones they care about."
[emphasis in original]
"There's no accountability on the part of market
makers. They make excuses about SOES bandits
prohibiting them from executing a trade. These
excuses insult our intelligence. We'd rather go
out of our way to alternative trading systems to
sidestep market makers and the games they play."
[emphasis in original]
The NASD did not take any action to address the issues
raised by the survey results.
==========================================START OF PAGE 35======
was aggressively promoting the Nasdaq market.-[64]- As
part of these efforts, the NASD pursued economic research
projects to portray the Nasdaq market favorably and counter
negative publicity.-[65]- In one instance, the NASD
explicitly retained the right to prevent publication of the
results of economic research it commissioned because of concerns
that the results could be negative for the Nasdaq
market.-[66]-
Beginning in the spring of 1994, the Christie-Schultz study
generated substantial negative publicity about the Nasdaq market.
In addition, class action lawsuits were filed against market
makers, and, in the fall of 1994, the media published reports of
government investigations of the Nasdaq market. The NASD
developed a public relations campaign designed to counter the
conclusions of the study and to promote Nasdaq as a competitive
market without collusion.-[67]- NASD senior officials
---------FOOTNOTES----------
-[64]- From 1992 to 1994, the annual marketing
expenditures of the NASD and Nasdaq combined rose
from $23,971,000 to $42,986,000. Even though this
was a period of increasing revenues and
expenditures for the NASD and Nasdaq, marketing
expenses rose from 10.7% to 12.9% of the combined
expenditures of the NASD and Nasdaq. In the same
period, regulatory staff dropped from 37.7% to
35.7% of total staff at the NASD and Nasdaq.
-[65]- To ensure that research would generate results
favorable to Nasdaq, staff of the NASD's Economic
Research Department from time to time conducted
preliminary research of an area being considered
for an NASD commissioned study before hiring an
outside economist to perform the research.
-[66]- An agreement between the NASD and an economist
retained as a consultant to study the issue of
individual versus institutional transaction costs
provided that the NASD could prevent the
consultant from publishing the results of his
study by paying him an additional $1,000. An
internal NASD memorandum stated that the provision
was created "[b]ecause of the negative publicity
that may be generated by poor results. . . ."
-[67]- This broad public relations campaign resulted in
the development and implementation of numerous
projects targeting various NASD constituencies,
the press, and the academic community. The NASD's
determination to defend the status quo rather than
(continued...)
==========================================START OF PAGE 36======
publicly criticized the Christie-Schultz study, and senior NASD
officers disclaimed the existence of anticompetitive problems on
Nasdaq.-[68]- NASD economists prepared a rebuttal to the
Christie-Schultz study. The NASD also commissioned outside
economic studies to challenge the notion that there was collusion
among Nasdaq market makers to keep spreads wide. While pursuing
this effort, the NASD took few significant steps to address the
underlying issues or to investigate the indications of the
problem described herein.
In October 1994, the Los Angeles Times series critical of
the Nasdaq market described instances of harassment of a market
maker, Domestic Securities Inc. ("Domestic"), that narrowed
spreads in particular securities.-[69]- The NASD decided
to investigate these incidents.
Domestic had previously complained to the NASD's Market
Surveillance Department about at least one of these incidents.
Domestic sent a letter to the Market Surveillance Department on
June 6, 1994 describing the episode and attaching a printout of a
harassing SelectNet message. According to Domestic's letter, a
market maker sent the message "Pathetic" to Domestic immediately
after Domestic had narrowed the inside spread in Intel from 1/4
to 1/8.-[70]- The Market Surveillance Department sent a
form letter to the market maker in question on June 6, 1994,
---------FOOTNOTES----------
-[67]-(...continued)
objectively examine its market was exemplified in
an internal memorandum dated April 5, 1995, which
praised outside economists hired by the NASD for
attacking the Christie-Schultz study and described
the economists hired by the NASD as "[o]ur
surrogates."
-[68]- In a memorandum to Nasdaq market makers discussing
press reports of the Justice Department inquiry
into trading practices on Nasdaq, a senior NASD
officer, who had reviewed the June Memo, stated
"As you well know, The Nasdaq Stock Market is
stringently overseen by both the SEC and the NASD
and neither we nor the SEC have ever found anti-
competitive practices to exist in our market."
-[69]- The first installment discussed the width of
spreads on Nasdaq and the harassment of renegade
dealers who tried to narrow spreads. The article
described several incidents of such harassment
when Domestic narrowed the inside spreads in three
Nasdaq securities in June and July 1994.
-[70]- NASD records confirm this sequence of events.
==========================================START OF PAGE 37======
asking for its explanation for sending the "Pathetic" message.
The market maker responded by letter on June 20, 1994, asserting
that when its trader observed Domestic's tightening of the
spread, he tried to trade with Domestic. The letter stated that
when Domestic refused to enter into a trade, the trader
transmitted the "Pathetic" message to Domestic. A review of the
NASD's own equity audit trail, however, would have revealed that
Domestic, in fact, purchased 1,000 shares of Intel from the
market maker. The NASD closed the matter without further
investigation.
It was only after the Los Angeles Times article was
published that the NASD revived the investigation.-[71]-
In November 1994, the staff of the Market Surveillance Department
spoke to the three market makers involved in the incidents noted
in the articles. All three market makers denied that any
statements they made to Domestic were in retaliation for its
breaking the spread. Instead, the traders attributed any
disparaging remarks to Domestic's refusal to trade for more than
1,000 shares.-[72]- The NASD did not attempt to expand the
inquiry beyond the discrete events noted in the Los Angeles Times
article.
A report summarizing the findings of the NASD's
investigation was given to the Compliance Subcommittee of the
Market Surveillance Committee in January 1995. The members of
the Compliance Subcommittee were reluctant to impose sanctions on
any of the three market makers because they believed that
comments concerning the depth of the market were common between
traders. The NASD staff stated that the Subcommittee should
consider the matter seriously and carefully, given the existing
environment of class-action lawsuits, government investigations
by the Department of Justice and the SEC, and a spate of negative
---------FOOTNOTES----------
-[71]- According to the Los Angeles Times article of
October 20, 1994, market makers made the following
comments to Domestic: "You guys break the spread
for 1,000 shares?," "You're embarrassing and
pathetic. . . . You're breaking spreads for everybody,"
and "This is ********. I have institutional customers
who come to me and I have to match your price. It's
********, you guys going down an eighth for a thousand
shares."
-[72]- As noted in part I.A.1.c., supra, there is a
widely observed industry custom of not initiating
a new inside bid or offer unless the market maker
is willing to trade in large (at least 2,000 to
5,000 shares) size, even though the NASD firm
quote rule only calls for market makers to be
willing to trade 1,000 shares, at the most.
==========================================START OF PAGE 38======
press articles. In the end, the Compliance Subcommittee
recommended that a Letter of Warning, which is the lightest
sanction available to the NASD, be sent to one market
maker.-[73]- After similar discussion at the Market
Surveillance Committee the next day, the Letter of Warning was
issued and the other matters dismissed.
3. Coordinated Activity Among Market Makers
The evidence indicates that instead of dealing as
competitors at arms length, certain Nasdaq market makers have
coordinated particular trade and quote activities with one
another, furthering their proprietary interests at the expense of
investors and other market participants. This coordinated
conduct has included: (a) arrangements under which these market
makers agree to move their published quotes at the request of
other market makers, or assist one another in executing trades;
(b) agreements to delay reporting specific trades likely to have
a negative impact on the value of the requesting market maker's
trading position or to obscure the true sequence of trades from
customers or other market participants; and (c) the routine
sharing of information by these market makers concerning customer
orders, securities positions, trading strategies, and intended
quote movements. Although many market makers attempt to
coordinate their activities on a widespread basis, such
coordination is particularly pronounced among market makers that
have regular and close contact in the course of trading the same
securities. Some traders in testimony have referred to these
cooperative traders as "friendly competitors."
In addition to impeding competition with respect to specific
transactions, the existence of groups of cooperating "friendly
competitors," and the demonstrated unwillingness of some market
makers to trade with firms they dislike, poses a significant
obstacle for new entrants to market making. The obstacle of
obtaining membership in one or more groups of cooperating market
makers is in addition to a number of other start-up requirements
confronting new entrants in the market, including requirements
imposed by regulators. For example, significant business and
regulatory requirements would include: (a) the need for
personnel with substantial knowledge and experience in the
securities industry who are duly licensed by the NASD and have a
thorough knowledge of the markets and the rules that govern them;
---------FOOTNOTES----------
-[73]- The Subcommittee distinguished between the fact
that the "Pathetic" message was sent on SelectNet,
while the other two comments were made over the
telephone. The staff indicated that this fact was
not a meaningful basis for distinction, but failed
to convince the Subcommittee to change its
recommendation.
==========================================START OF PAGE 39======
(b) substantial capital in order to obtain the necessary
facilities and equipment and meet regulatory capital
requirements; and (c) admission to NASD membership (which, as is
discussed further in the text, may be a difficult process for
certain applicants). In addition, attracting order flow can be a
significant obstacle for new entrants. As described herein,
attempts to obtain order flow competitively by narrowing the
spread may well result in harassment and refusals to trade.
a. Coordinated Quote Movements and Transactions
Certain Nasdaq market makers have engaged in a practice of
discussing among themselves their prospective quote movements and
transactions in specific securities, and coordinating the
sequence, timing, and size of particular quote changes and
transactions. Taped telephone conversations have revealed
numerous instances of market makers asking other market makers to
make specific quote movements,-[74]- sometimes requesting
the market maker who is quoting the best bid or offer to move
that quote away from the inside quote or in a manner that creates
a new inside market.-[75]- In other instances, market
makers ask other market makers to join an existing inside bid or
ask quote, to create the impression of increased buying or
selling interest that may facilitate a transaction by the
---------FOOTNOTES----------
-[74]- In some circumstances, market makers have moved
their quotes only after obtaining approval from
other market makers.
-[75]- Because market makers view the prices quoted at
the inside spread as benchmarks for the prices
given to customers, effecting changes in the
inside quotes can allow market makers to trade
with their customers at more profitable prices.
For example, in one taped conversation, a trader
asked another trader to move his quote down before
the market opened:
Trader 1: Hi [name of Trader 2], it's [name of Trader
1], can I help for [name of another trader]?
Trader 2: Yeah, if he's not involved in Lotus, can he
slide down. I got 'em for sale this morning.
Trader 2 testified that he had accounts that wanted to
sell Lotus to him. He believed that the reason he
wanted the other firm to move its quotes down was
because he did not want to get caught holding the Lotus
stock at a price at which there were no buyers. Data
shows that Trader 1's firm was at the inside bid when
the conversation occurred and that subsequently it
moved its bid down.
==========================================START OF PAGE 40======
requesting market maker. Some traders have testified that they
accede to these requests out of "courtesy," and in some
instances, because of an expectation that the requesting market
maker will reciprocate in the future.
By working together to coordinate quote movements or
transactions, these market makers can sometimes move the quoted
price of a stock up or down, thereby facilitating trades at
prices that are more favorable for the market makers, often at
the expense of their customers.-[76]- Some market makers
refer to these practices as "holding hands."-[77]- In
---------FOOTNOTES----------
-[76]- An example of market makers coordinating
quotations in an apparent effort to create the
appearance that the market for a stock is moving
up, or that buying interest is emerging, is set
forth in the following taped telephone
conversation. One trader, holding a long position
in the stock Parametric Technology Corp. (PMTC),
asked another to move his bid up:
Trader 1: Are you doing anything in Parametrics [sic]?
Trader 2: Ah, running for the hills, bro.
Trader 1: Okay, can you. . .
Trader 2: What can I do for you?
Trader 1: Can you go 1/4 bid for me?
Trader 2: Yeah, sure.
Trader 1: If you want, I'll sell you two at 1/4, just
go up there. I'm long them and I want it
going.
Trader 2: Yeah.
Trader 1: Okay, I sold you. . .
Trader 2: Two. That would be great.
Trader 1: I sold you two at 1/4. Just go up there,
okay?
Trader 2: I'm goosing it, cuz.
Trader 1: Thank you.
The requesting trader (Trader 1) was engaged in selling
substantial quantities of Parametric stock. A third
market maker had just minutes earlier raised its bid
price (and the inside bid) to $26 1/4, and in complying
with Trader 1's request, Trader 2 became the second
market maker to move its bid up to $26 1/4.
-[77]- One trader described "holding hands" as follows:
It is, like, two market makers would be
kind of in cahoots, one guy would know
what the other guy is doing. It would
(continued...)
==========================================START OF PAGE 41======
certain circumstances, such undisclosed collaboration can be
injurious to the interests of investors.-[78]- For
example, a market maker helping another market maker dispose of
an unwanted long position in a security will find itself in
conflict with the firm's obligation to obtain the best price for
those of its customers to whom it sells those securities. This
cooperation can improperly influence prices, create an inaccurate
picture of the market, and in some cases may evidence market
manipulation, in violation of the antifraud provisions of the
securities laws.-[79]-
b. Agreements to Delay Trade Reports
The investigation has uncovered instances in which some
market makers entered into explicit agreements to delay reporting
trades. These arrangements have occurred in situations where a
---------FOOTNOTES----------
-[77]-(...continued)
be, like, two guys would talk on the
stock, instead of the one guy going down
to the offer, then he would let somebody
else go to the offer for him or go to
the bid for him. For instance, if [a
large market maker] was on the bid,
nobody would hit him -- because
everybody thinks he is the real buyer,
he wouldn't go to the real bid.
Everybody runs away from [the large
market maker], because they think they
are always big. . . . He might send a
little, small guy up there instead to
buy stock.
-[78]- The Commission is not suggesting that for market
makers to use multiple agents to obtain executions
of customer orders is per se improper.
-[79]- The term "antifraud provisions" as used herein
refers to Section 17(a) of the Securities Act of
1933, 15 U.S.C. 77q(a) (1994), and Sections
10(b) and 15(c)(1)(A) of the Exchange Act, 15
U.S.C. 78j(b) and 78o(c)(1)(A) (1994), and
Rules 10b-5 and 15c1-2 promulgated thereunder, 17
C.F.R. 240.10b-5 and 240.15c1-2 (1995). In
addition, there is evidence that market makers
from time to time have entered into agreements to
widen their dealer spreads in particular stocks.
Such conduct has serious anticompetitive
implications and may also constitute market
manipulation in violation of the antifraud
provisions.
==========================================START OF PAGE 42======
timely report of a significant trade could have resulted in a
market price movement unfavorable to the market maker's position
in such security. The delay of a trade report under such
circumstances creates a window of opportunity for the market
maker to trade at prices not affected by knowledge of the trade.
This practice could allow the market maker to take unfair
advantage of other market participants, thereby obtaining an
undeserved economic benefit. Certain market makers have also
entered into agreements to delay trade reports in order to
prevent customers with whom they were trading from seeing the
prices of other contemporaneous trades.-[80]- In both
situations, the true appearance of the market is deliberately
obscured, and the ability of investors to make accurate price
discovery is hampered. In addition, depending upon the
circumstances, an intentional delay of a trade report may violate
NASD rules and the antifraud provisions of the federal securities
laws.
---------FOOTNOTES----------
-[80]- The following conversation is an example of market
makers agreeing to delay a print to hide it from a
customer.
Trader 1: I just sold 25 at 1/4, 1/8 for any part of
whatever you want.
Trader 2: Oh, that's ******* beautiful, buddy.
Trader 1: . . . .
Trader 2: Why don't I sell you - This sounds so
horrible - I'm gonna sell you, is 10 G's
okay? . . .
Trader 1: . . . .
Trader 2: . . . I'd love to sell you 10, I owe you one.
Trader 1: I bought 10 at 1/8, and don't print it for,
for a few minutes, 'cause I told the guy I'm
just making a sale out of the blue. Alright?
Trader 2: I'll, I'll print after the bell.
Trader 1: Thanks, bud.
The conversation took place at approximately 3:54 p.m.
The trade was reported late after the close of the
market at 4:01:40 p.m. Trader 1 testified that he had
told the salesperson at his firm that he was selling
"out of the blue," which meant that he was selling out
of inventory rather than crossing the trade. He
explained that certain customers, such as large mutual
funds, do not like to see multiple trade reports, which
reflect the customer buying from the market maker who
is buying from another market maker who is buying from
another customer, often with mark-ups at each trade.
Trader 1 testified that he therefore wanted the trade
prints to be separate from one another.
==========================================START OF PAGE 43======
c. Information Sharing
The investigation has further identified a number of
practices, which are loosely characterized as "professional" or
"ethical" obligations by Nasdaq traders that generally govern
market maker trading activities. Certain market makers share
information with other market makers concerning the size of their
customers' orders, and in some instances, the identity of their
customers. They also disclose to each other their own market
making positions and their intended trading strategies and quote
movements. Market makers may also discuss non-public news
releases, and research reports and recommendations concerning
particular stocks.-[81]- In accordance with these so-
---------FOOTNOTES----------
-[81]- Market makers often warn their regular market
maker contacts about anticipated market price
movements and suggest that they move their quotes
or establish positions to avoid trading losses.
For example, in the following conversation, Trader
1 warned Trader 2 before the opening of the market
that the stock Applied Bio-Sciences [APBI] had
been taken off of Trader 1's firm's "focus list"
of recommended stocks, and that Trader 1 was about
to sell stock for his customers by hitting the
bids in the market:
Trader 1: Applied Bio, go down, I took it off my focus
list, I'm gonna rip it [sell stock by hitting
the bids].
Trader 2: Oh. Update down a quarter.
Trader 1: I just didn't want you to be up there while
[inaudible].
Trader 2: I appreciate it, my friend.
As a result of the call, Trader 2 moved his bid quote
down from 5 3/4 to 5 1/2, off the inside bid. Trader 1
had similar conversations with other market makers of
APBI, who also moved their quotes down prior to the
market opening. The warnings created downward pressure
on the market price for the stock. At the time of the
calls, Trader 1 had retail customer orders to sell
15,000 shares. Trader 1 sold 11,000 shares at an
average price of 5 5/8 during the first five minutes
following the opening. Approximately five minutes
following the last of these sales, after the inside bid
had dropped to 5 3/8, Trader 1 bought 11,200 shares of
APBI from his customers at prices between 5 3/8 and 5
5/8. Trader 1, by disclosing his intent to hit the
bids and warning market makers to move off of the
inside bid, helped move the market price down, against
his customers' interest.
==========================================START OF PAGE 44======
called "professional" practices, it is understood that market
makers who receive this information will not use it to trade
against the disclosing market maker's interest.-[82]- Nor
is such information expected to be disclosed to other market
participants. The evidence shows that market makers who engage
in this behavior typically disclose the full extent of their
customers' orders when negotiating a trade with another market
maker.-[83]- If additional orders are received from the
customer, the market maker with the order may also consider
itself under a "professional" obligation to seek to trade first
with the market maker with whom he last traded. It is also
generally understood that a market maker that hits another market
maker's bid or lifts its offer will not thereafter move its
quotes without first consulting the market maker with whom it
just traded.
Market makers who fail to observe these practices are
considered "unprofessional," at times receive complaints and
harassing phone calls from other market makers, and risk losing
access to information and trading opportunities provided by
others.-[84]- Market makers rely on each other to provide
---------FOOTNOTES----------
-[82]- For example, it is understood among market makers
that if a market maker tells another market maker
that he is selling a substantial block of stock,
the market maker to whom that information is
disclosed is under an "ethical" obligation not to
attempt to sell stock ahead of the market maker
that is selling the substantial block. A market
maker may disclose this type of information to
another market maker (a) in connection with a
request that the other market maker help work the
order or move his quotes in a manner that
facilitates trading, (b) to warn the other market
maker that the market will be moving in a
particular direction as a result of the trading
activity, or (c) to find trading interest.
-[83]- Some traders have testified that they do not
disclose this information to all market makers
with whom they trade, but only to those market
makers they trust.
-[84]- For example, in one taped conversation, a trader
complains to another trader who did not fully
disclose his customer's order when they first
traded:
Trader 1: . . . if you had more you should just show me
your picture. I try and make good prints for
(continued...)
==========================================START OF PAGE 45======
order flow, information, and cooperation to help them trade
positions profitably.-[85]- Traders do not want other
---------FOOTNOTES----------
-[84]-(...continued)
you. But--
Trader 2: . . . I'm dealing with a very difficult
customer. I ask him, "How much have you got
to sell?" . . . They don't even--they say,
"**** you. I ain't telling what's for sale.
This is what I've got. Work it."
Trader 1: Ok.
Trader 2: That's how it's done--I mean, I'm not playing
games. Believe me. I'm the last person in
the street to play those things.
Trader 1: Ok, I was, it's just that, I mean I got long
the stock trying to move it with my retail
when you offer it down. And I don't have any
room to pay out the credit to my broker.
Then I get stuck, stuck long 10. You offer
it down. Then I end up having to go out and
hit the stock. And I mean it's not doing
anybody any good. . . .
Trader 2: Alright . . . I hear you.
Trader 1: Just . . . I understand with these guys you
can't communicate with them. But if in the
future, if you'd like to try, think it would
make us both a lot more money.
Trader 1 later complains to a trader at another firm
about Trader 2: "You know, we try to do the right
thing. We keep an orderly market. And this guy just
****** all over us."
In this situation, Trader 1's desire to keep the quotes from
dropping while making retail sales is inconsistent with the
interests of the customers to whom his firm is selling
stock.
-[85]- In one taped conversation, two traders discuss the
benefits of sharing information and cooperating:
Trader 1: . . . you've bailed me out a couple of times
too. That's the game.
Trader 2: Yep.
Trader 1: You know? And, uh--
Trader 2: And by you helping me out in some of these
other ones. I mean, I'll always make you
money in the Vicor [VICR] that, you know,
anytime you get a position and stuff like
that. That's, you know, that's nice that
(continued...)
==========================================START OF PAGE 46======
market makers to perceive them as being "uncooperative,"
"unethical," or "unprofessional" because that perception may
result in their losing access to their trader networks. Market
makers may refrain from sharing information with or offering
trading opportunities to market makers who fail to comply with
the "professional" trading practices discussed herein. Exclusion
of market makers who do not follow these practices serves to
deter competition in the Nasdaq market.
Disclosure by market makers of their inventory positions,
trading strategies, and future quote movements to other market
makers would normally be risky for the disclosing market maker,
because the receiving market makers could use such information to
their advantage. The existence of an expectation that the
receiving market makers will not use the information against the
disclosing market maker is a further indication of the degree of
collaboration in the Nasdaq market.
These information sharing courtesies can affect customers of
the market makers. The information shared pursuant to these
"professional" or "ethical" courtesies (the size of customer
orders, inventory positions, intended trading strategies, future
quote movements, and the identity of the customer) would normally
be viewed as proprietary. A primary purpose of the sharing by
market makers appears to be protecting each other from inventory
risks that might arise otherwise. These information sharing
"courtesies" were usually not extended to customers, and could
conflict with duties owed by broker-dealers to customers.
Investors may be deprived of benefits that would otherwise be
available in a competitive market. For customers trading in
large size, a market maker who reveals the size of a market order
from the customer may impair the ability of the customer to
obtain the best execution. Market makers learning of the order
could adjust the price and size of their quotations in ways
disadvantageous to the customer. In situations where market
makers share the customer's identity, the customer's ability to
seek competitive quotations from market makers is significantly
---------FOOTNOTES----------
-[85]-(...continued)
way. You know--
Trader 1: Help each other. I'm more than, even if I
have to lose a lot of jake [money]. I don't
care.
Trader 2: Yeah.
Trader 1: Because, bottom line is everything comes out.
Trader 2: Well, it makes my life a ****-of-a lot easier
knowing that you can tell me what's going on
when I got some things going, you know--Like
the other times I got something going on in
something so I can just tell you. And just
tell you to get the **** out of the way--
==========================================START OF PAGE 47======
hampered.-[86]-
B. Late Trade Reporting
1. Late and Inaccurate Trade Reports
Market participants rely on trade reports for trading
Nasdaq securities and are thus affected by the quality of trade
reporting. Numerous broker-dealers on Nasdaq repeatedly failed
to report transactions on an accurate and timely basis in
accordance with NASD rules.-[87]- Late and inaccurate
---------FOOTNOTES----------
-[86]- One reason advanced by some market makers for
disclosing the identity of a customer is the
suspicion that the customer is doing business with
more than one market maker. Traders testified
that they will share the identity of a customer
when they believe the customer is trading with
both market makers at the same time, in order to
better evaluate the risks of trading with that
customer. This testimony indicates that because
the dealers trade with customers as principal,
they may at times be tempted to overlook their
obligation to deal fairly with their customers. A
customer may properly deal simultaneously with
more than one market maker in order to secure the
best execution of its orders. This is one way in
which the customer obtains the benefit of a dealer
market. However, for a market maker to
collaborate with other market participants against
the interests of its customer is inconsistent with
the fair dealing obligations of market makers in a
free and open market.
-[87]- Pursuant to Rules 11Aa3-1 and 11Aa3-2 under the
Exchange Act, the NASD adopted a transaction
reporting plan for National Market System
securities in 1982. Exchange Act Release No.
18590 (Mar. 24, 1982), 47 Fed. Reg. 13617 (Mar.
31, 1982). As part of this plan, transactions in
designated Nasdaq securities must be reported by
the broker-dealer with reporting responsibility
within 90 seconds after execution. A pattern or
practice of late reporting without exceptional
circumstances may be considered conduct
inconsistent with high standards of commercial
honor and just and equitable principles of trade,
in violation of Article III, Section 1 of the
Rules of Fair Practice. NASD Manual, Schedule D
to the By-Laws, Part X, 2(a) (CCH) 1867
(1995).
==========================================START OF PAGE 48======
trade reporting occurred frequently in this market and undermined
the accuracy of the last sale transaction report information that
was disseminated by the NASD. The NASD accorded a low regulatory
priority to trade reporting issues and failed to enforce
adequately its trade reporting rules.
Analysis of late trade reporting on Nasdaq begins with
trades which are reported as late trades. NASD rules require
that a trade report which is late be designated as such so that
market participants will recognize it as an out of sequence
report.-[88]- The scope of such late trade reporting is
set forth in Table 1 below.
Table 1
Time Period: Percent of Trades Percent of Volume
Marked Late Marked Late
2/94 to 12/94 3.6 4.5
1/95 to 7/95 1.9 2.9
Underlying the figures in Table 1 are, for the period
February through December 1994, approximately 1.12 million Nasdaq
NMS trades that were reported as late trades.-[89]- These
late trade reports embodied a trading volume of over 2.6 billion
---------FOOTNOTES----------
-[88]- The party obligated to report the trade is
required to designate as late all trades reported
more than 90 seconds after execution by appending
to the trade report a modifying code, ".SLD." See
NASD Manual, Schedule D to the By-Laws, Part X,
2(a)(8) (CCH) 1867 (1995). The reporting
responsibility in a transaction between two market
makers or between two non-market makers is on the
broker-dealer representing the sell side. In
transactions between one market maker and one non-
market maker, only the market maker is required to
report. In addition, all transactions between a
broker-dealer and customer are reported by the
broker-dealer. NASD Manual, Schedule D to the By-
Laws, Part X, 2(b), (CCH) 1867 (1995).
-[89]- These figures are based on all trades reported on
Nasdaq and include trades reported through systems
such as SOES, SelectNet, and ACES.
==========================================START OF PAGE 49======
shares.-[90]- During the same period, late trades
accounted for only .09% of reported trades and .49% of reported
volume on the New York Stock Exchange.-[91]- While the
figures for the period January 1995 to July 1995 show a reduction
in the degree of late trade reporting, the extent of the problem
remains significant.
In addition to reported trades marked late, analysis of
audit trail data revealed that a significant percentage of trades
between broker-dealers were reported late but were not properly
designated late by the reporting broker-dealer. The Commission
staff reviewed data for a sample of trades between broker-dealers
that were not designated as late reports, and found that from
February to December, 1994, 6.7% of trades and 8.7% of volume in
transactions between broker-dealers were reported as regular
trades when they were in fact late and should have been
identified as such by the broker-dealers having the reporting
responsibility.-[92]- These transaction reports violated
---------FOOTNOTES----------
-[90]- Excluding trades executed through automated
systems such as SOES, SelectNet, and ACES, which
automatically report trades and generally
eliminate the possibility of late trade reports,
late trades in 1994 accounted for approximately
4.5% of all reported trades and 4.9% of all
reported volume. Approximately 20% of Nasdaq NMS
trades and 8% of volume are reported through ACES,
SelectNet, and SOES.
-[91]- From January through July 1995, following the
initiation of the Commission's investigation and
increased scrutiny by the NASD of late trade
reporting problems, late trade reports declined to
1.9% of trades and 2.9% of volume.
-[92]- The analysis was based on a sample that
represented approximately 20% of all NMS trades,
and included all trades between broker-dealers
containing both a trade report time and a
counterparty report time. The sample does not
include trades executed through SOES, SelectNet,
or ACES (which have automated trade reporting),
nor does it include broker-dealer trades with
customers. The trades in the sample were
identified by comparing the time that the
counterparty to the trade (the party without the
trade reporting obligation) confirmed the trade
with the time of the report from the dealer with
the reporting obligation. Because the
counterparty cannot confirm a trade before the
(continued...)
==========================================START OF PAGE 50======
the NASD trade reporting rules set forth in Schedule D of the
NASD By- Laws.-[93]- While the sample consists only of
broker-dealer to broker-dealer trades for which both parties
submitted trade reports, these transactions, constituting
approximately 20% of total Nasdaq volume, are an important
segment of the market. Such a degree of undesignated late trade
reporting in this segment alone warrants serious concern.
Because reports of larger trades are more likely to affect
prices and liquidity than smaller trades, market makers seeking
to fill an order or cover a position may have a greater incentive
to delay intentionally large trade reports than they do small
trade reports. Analysis of the data shows that the proportion of
designated and undesignated late trades is significantly higher
for larger trades than for smaller trades. In 1994, 2.2% of
trades in Nasdaq NMS stocks between 501 and 1,000 shares were
reported as late trades. This rate increased to 4.5% for trades
between 5,000 and 9,999 shares, and to 5.2% for trades for 10,000
shares or more.-[94]-
A similar pattern was found in broker-dealer to broker-
dealer trades reported late without being designated late. In
1994, 4.6% of the sample of broker-dealer to broker-dealer trades
between 501 and 1,000 shares were undesignated late trade
---------FOOTNOTES----------
-[92]-(...continued)
trade has been executed, trades confirmed by the
counterparty more than 90 seconds before the trade
report were necessarily reported late by the
broker-dealer with reporting responsibility. Even
when a three-minute delay was used as a benchmark
of lateness (rather than the legally required 90
seconds), 3.1% of broker-dealer to broker-dealer
trades accounting for 4.3% of volume in the sample
were reported as regular trades when they were
late and should have been identified accordingly.
-[93]- The percentages of unreported late trades in the
sample of broker-dealer to broker-dealer trades
declined in 1995, falling to 5.4% of trades and 7%
of volume.
-[94]- The late trade rate for trades of 500 shares and
less is also high at 4.2%. This is attributable
to operational problems experienced by several
broker-dealers, including dealers that handle a
large number of retail orders. In fact, a review
of monthly data by trade size shows that the late
trade rate for this group of trades fell by half
in February 1995 when the operational problems
were corrected.
==========================================START OF PAGE 51======
reports. The rate of undesignated broker-dealer to broker-dealer
late trade reports increased to 8.6% for trades between 5,000 and
9,999 shares and to 11.7% for trades of 10,000 shares or more.
Percentages for this sample were similarly disproportionate for
1995, with 3.8% of trades between 501 and 999 shares, 6.9% of
trades between 5,000 and 9,999 shares, and 9.6% of trades of
10,000 shares or more being reported late without being
designated as such.
Because of the greater incentive to report large trades
late, these higher percentages for large trade reports raise a
concern that such late trade reports may have been the result of
intentional reporting delays rather than negligence or computer
errors. Testimony from traders and tapes obtained during the
investigation indicate that some trades were intentionally
reported late. A trade report, particularly the report of a
large trade, may result in the market price of a stock moving in
a manner detrimental to the reporting market maker's inventory
position.-[95]- Some traders therefore deliberately
delayed reporting trades to allow themselves time to cover their
positions in a market in which prices and liquidity are
unaffected by a timely trade report. In such situations, the
trader covering his position is trading at a significant
informational advantage to his counterparty.-[96]- The
intentional delay of a trade report in such circumstances could
be construed as an attempt unlawfully to manipulate the market.
Examinations of broker-dealers conducted in connection with
this investigation confirmed the frequency of late trade
reporting. The examinations uncovered hundreds of trades that
were reported late but were not designated as late, in accordance
---------FOOTNOTES----------
-[95]- For example, if a market maker sells short a
substantial block of stock to a customer, and
reports the trade before the market maker covers
its short position, other market participants,
based upon the reported information, may perceive
that the market maker has a substantial short
position that it needs to cover and will demand a
premium price for the stock.
-[96]- As noted supra in part I.A.3.b., there is also
evidence that certain market makers delayed trade
reports in circumstances where they were buying or
selling stock from a customer and
contemporaneously covering their positions in the
market, because they did not want their customer
to see the prices obtained by the market maker or
other parties in substantially contemporaneous
trades.
==========================================START OF PAGE 52======
with Schedule D of the NASD By-Laws.-[97]- The
examinations also revealed numerous other inaccurate trade
reports including (i) trades executed after the market closed and
not identified accordingly; (ii) trades identified as late that
were not submitted late; (iii) trades reported incorrectly as
executed after the market closed; (iv) trades not reported; and
(v) inaccurate execution times submitted in trade reports.
The examinations also found that many of the order tickets
created by the broker-dealers examined were inaccurate or
otherwise deficient. Numerous order tickets contained the wrong
execution time of the trade.-[98]- Other order tickets
examined did not reflect any execution time for the trade. For a
number of trades examined, the broker-dealers were unable to
produce any order tickets at all, in violation of Rule 17a-4 of
the Exchange Act.-[99]-
In sum, the scope of the trade reporting problem created
significant difficulties for investors. This late trade
reporting distorted the appearance of the market, misleading
those who rely on the tape to make trading decisions and monitor
the cost and quality of trade executions. Trade reporting
problems also hamper the ability of investors, firms, and
regulators to monitor broker-dealer compliance with a variety of
investor protection rules, including limit order protection and
markups. Intentional late trade reporting raises serious
concerns about possible manipulative activity in the market.
Thus, late and inaccurate trade reporting undermines the
integrity of the Nasdaq market.-[100]-
---------FOOTNOTES----------
-[97]- The staff conducted examinations of sixteen Nasdaq
market makers, representing a sample of large New
York based dealers, regional and mid-sized
dealers, and wholesalers. In addition,
examinations were conducted of certain market
makers that, from a review of Nasdaq audit trail
data, appeared to have reported numerous late
trades without designating the reports as late.
-[98]- The execution times shown on many of the order
tickets examined contradicted information shown on
other records of the firm or on the audit trail.
Posting incorrect trade execution times on order
tickets violates Rule 17a-3 promulgated under the
Exchange Act, 17 C.F.R. 240.17a-3 (1995).
-[99]- 17 C.F.R. 240.17a-4 (1995).
-[100]- The structure of the Nasdaq market contributes to
trade reporting problems. In a dealer market,
(continued...)
==========================================START OF PAGE 53======
2. The NASD's Enforcement of Trade Reporting Rules
was Inadequate
The investigative record indicates that the NASD's
enforcement of the trade reporting rules was inadequate. Until
this investigation began, the NASD's surveillance program to
detect trade reporting violations was accorded low priority and
was ineffective.-[101]- The NASD lacked sufficient
procedures to identify and follow-up on patterns of trade
reporting errors by particular firms.-[102]- Automated
reviews designed to identify trades that may have been reported
late were deficient, erroneously eliminating or ignoring
potential late trades. This failure occurred despite the fact
that the NASD identified the "lack of adequate exception reports"
for late trade reports as an internal weakness in the 1992/1993
---------FOOTNOTES----------
-[100]-(...continued)
each market maker must install and maintain a
trade reporting capability on its premises. By
comparison, on an exchange, the trade reporting
process is installed and maintained by the
exchange, and the physical presence of key market
participants on the exchange floor makes the trade
reporting system easier to administer. The
dispersion of vital parts of the trade reporting
system in the Nasdaq market places added
responsibility on market makers for monitoring
their trade reporting systems. Particular
attention must be paid to the personnel at trading
desks, who are the human element in trade
reporting, and cause delays in the submission of
trade reports. Market makers must commit the
resources necessary to ensure the soundness of
their trade reporting systems to overcome the
complications posed by the dispersed structure of
the Nasdaq market.
-[101]- A trade report task force had been formed in 1993
to review member firm compliance with trade
reporting rules, but the project was not given
high priority, and its implementation was delayed,
because a sharp increase in backing away
complaints diverted Market Surveillance resources
and the NASD did not provide additional resources.
-[102]- In addition, the NASD did not generate automated
surveillance reports designed to identify trades
that are reported late but not marked ".SLD" in
accordance with Schedule D of the By-Laws. NASD
Manual, Schedule D to the By-Laws, Part X, 2
(CCH) 1867 (1995).
==========================================START OF PAGE 54======
Market Surveillance Business Plan.
Although the NASD periodically generated a report of all
trades designated as late, it did not review these reports on a
regular basis, despite the large percentage of late trades
reported. NASD examination programs for trade reporting were too
limited in scope to detect adequately non-compliance with trade
reporting requirements.-[103]- As a result of these
deficiencies in the surveillance and examination programs,
various trade reporting problems went undetected.-[104]-
The NASD's investigations of trade reporting violations have
also proven inadequate. There have been delays in both
conducting reviews and issuing sanctions, which were often
insufficient and inconsistent with the NASD's penalty
guidelines.-[105]- Prior to October 1994, the NASD had
not sanctioned any member firms for a pattern of excessive late
---------FOOTNOTES----------
-[103]- For example, the NASD exam modules were designed
to identify only trades more than two minutes
late, even though the NASD By-Laws define a late
trade as one occurring more than ninety seconds
after the trade is executed. In addition,
examiners selected sample sizes too small to
detect patterns of trade reporting problems at
individual firms.
-[104]- For example, the NASD failed to notice that
certain high volume market making firms never
properly reported after hours trades as occurring
outside normal market hours as required by the
NASD By-Laws.
-[105]- The NASD's published Sanction Guidelines state
that for Trade Reporting violations monetary fines
ranging from $1,000 to $100,000 may be imposed.
In the period July 1990 through June 1994, of the
367 trade reporting cases that resulted in
sanctions, only 34, or less than ten percent,
resulted in any fine being imposed, and 20 of
these resulted in fines of $500 or less,
notwithstanding the minimum $1,000 fine set forth
in the NASD Sanction Guidelines. None of the
cases resulted in fines in excess of those
described in the NASD Sanction Guidelines. The
balance of the cases resulted in warning letters
or letters of caution.
==========================================START OF PAGE 55======
trade reports.-[106]- When the NASD detected trade
reporting violations, it had insufficient procedures to ensure
that the deficiencies were corrected.
Examinations by Commission staff revealed that the NASD also
failed to monitor and enforce rigorously trade reporting
compliance by NASD members trading exchange-listed securities in
the OTC market. Certain exchange-listed securities are traded by
NASD members in the OTC market, much the same way that they trade
Nasdaq stocks: prices are quoted on Nasdaq workstations, and
trades are executed over the telephone, SelectNet, or Instinet
and reported through the NASD's ACT system. The NASD has rules
requiring prompt and accurate trade reporting by market makers in
exchange-listed securities comparable to those for market makers
in Nasdaq securities, and the NASD is responsible for
surveillance and enforcement of these rules.-[107]-
The Commission's examinations reviewed 329 complaints
received by the NASD between January 1994 and June 1995 from
exchanges that had detected trades reported by NASD members at
prices outside the best bid or offer displayed in the market
("trade-throughs"). In many cases, the apparent trade-throughs
were attributable to trade reporting errors by the NASD member,
including late trade reports not marked late, and trades reported
with incorrect prices. The NASD staff typically resolved such
complaints by correcting the trade reports. However, the
Commission's examinations found that the NASD staff did not refer
any of these complaints for further investigation, including
situations where best execution concerns were raised.
Furthermore, the NASD had no formal procedures for identifying
and referring trade reporting errors for further review. As a
result, none of these complaints were analyzed for patterns
indicating abuse, and no disciplinary actions were taken for
repeated violations.
The deficiencies in the NASD's program for monitoring trade
reporting compliance were highlighted in a subsequent cause
examination by Commission staff of a firm that had been
identified as responsible for a disproportionate number of
---------FOOTNOTES----------
-[106]- Since October 1994, the NASD has taken action to
improve its program to detect, investigate, and
discipline member firms for trade reporting
violations. The Department of Market Surveillance
of the NASD implemented procedures to identify
firms with excessive late trade reports and
initiated actions that resulted in fines and a
reduction in the percentage of late trade reports.
-[107]- NASD Manual, Schedule G to the By-Laws (CCH)
1917-22 (1995).
==========================================START OF PAGE 56======
violations during the examination period. The Commission's
examination found extensive trade reporting violations in
exchange-listed securities traded OTC, including late trades that
were not marked late, trade reports marked late that were not
late, and trades erroneously reported twice. The Commission's
examination also revealed that for a number of exchange-listed
securities traded OTC, the firm failed to report trades
representing significant percentages of total market volume for
those securities. For example, in one security, over a period of
three days, the firm failed to report trades representing 11% of
total market volume in the security. On another day, the firm
failed to report trades representing 12.9% of the total market
volume in the security.
In some instances, when incorrect trade reports were brought
to the attention of the NASD staff, their response was to correct
the trade report or ask the firm making the report to submit a
corrected report. The NASD did not take disciplinary action
against the violators in these cases. A tape obtained during the
investigation reflects one instance in which an NASD Market
Surveillance supervisor inappropriately instructed a trader to
submit an inaccurate trade report. The trader, who disclosed to
the supervisor that a trade had occurred during a trading halt,
was advised that it could be remedied by changing the reported
time of the trade to make it appear to have been done prior to
the trading halt. The same supervisor explained to another
trader that the NASD efforts to make "corrections" to trade
reports showing execution times during trading halts arose out of
criticism of the NASD in the press.-[108]-
In sum, the NASD has failed to enforce adequately its trade
reporting rules. It did not fully appreciate the significance of
late trade reporting attributable to systems problems until after
the Commission's investigation began, even though late trade
reporting due to systems problems can significantly distort the
appearance of the market. By bringing few disciplinary actions
for late or inaccurate trade reporting, and imposing unduly light
---------FOOTNOTES----------
-[108]- In advising the trader to modify a report of a
trade reflected as occurring during a trading
halt, the supervisor stated:
The only reason we are going to such great
lengths is all the ripping that we've taken
from the press. And frankly we've had a
phone call from Dow Jones, from the Wall
Street Journal, and they are doing a story on
it, and that is one of the things they are
asking about - - all these trades that are
going through after the halt. They all look
like they are being executed during the halt.
==========================================START OF PAGE 57======
sanctions, the NASD put too little regulatory pressure on market
makers to ensure timely reporting of trades, and thus did not
serve the investors' interest in a full and accurate picture of
transactions in the market.-[109]-
C. The Firm Quote Rule
1. The Importance of Firm Quotes
Under the Commission's "firm quote" rule,-[110]- a
market maker is required to execute any order presented to it to
buy or sell a security at a price at least as favorable to the
buyer or seller as the market maker's published bid or offer and
up to its published quotation size.-[111]- NASD rules
also require that market makers honor their
quotations.-[112]- The Commission has emphasized that
SROs need to enforce strict compliance with the firm quote rule
to ensure that investors receive best execution and that the
---------FOOTNOTES----------
-[109]- One reason advanced by the NASD for its
inattentiveness to enforcement of trade reporting
requirements was that staff members were diverted
by the filing of numerous backing away complaints
by SOES activist firms in 1994. This does not
explain the lack of enforcement of trade reporting
in prior time periods, nor does it address
inadequacies in the examination process. This
contention may, however, point to inadequacies in
the resources committed by the NASD to the
enforcement process. The Rudman Committee report
recommended increasing the resources devoted to
enforcement. The findings of this investigation
provide further support for that recommendation.
However many resources are applied to the problem,
the NASD must conduct a thorough evaluation of
personnel and training to assure the NASD's strict
adherence to its obligations as an SRO.
-[110]- Exchange Act Rule 11Ac1-1, 17 C.F.R. 240.11Ac1-1
(1995).
-[111]- A market maker who fails to meet his firm quote
rule obligations is said to have "backed away"
from its quote.
-[112]- NASD Manual, Schedule D to the By-laws, Part V,
2(b) (CCH) 1819 (1995).
==========================================START OF PAGE 58======
market receives reliable quotation information.-[113]- As
stated in the 1963 Special Study of the Securities Markets:
By quoting ostensibly firm markets over the telephone
or wire dealers represent that a unit of trading can
actually be bought or sold at the prices quoted. Upon
the basis of these quotations, professionals check
competing markets and prices and make their trading
decisions. Broker-dealers also obtain these quotations
in connection with their retail activities, so that
investment decisions of customers and the quality of
executions for customers may depend on them. In these
and other respects, backing away from quotations
impairs a basic mechanism on which orderly operation of
over-the-counter markets depends.-[114]-
There are two exceptions to the firm quote rule under which
market makers can reject orders. The first exception occurs
when, prior to the receipt of the order, the market maker has
communicated to its exchange or association a revised quotation
size or revised bid or offer. The second exemption applies when,
prior to the receipt of the order, the market maker is in the
process of effecting a transaction in a security when an order in
the same security is presented, and immediately after the
completion of such transaction, the market maker communicates to
its exchange or association a revised quotation size or revised
bid or offer (hereinafter referred to as the "trade-ahead"
exception).
Market makers have a fundamental obligation to honor their
quotations. Market maker quotations are one of the foundations
of the Nasdaq market and the national market system. The
reliability of quotations is essential to investor confidence and
to an efficient process of price discovery. Failure to honor
quotations deprives investors of the liquidity market makers
advertise they will provide, and diminishes the credibility of
the market. When quotations are not firm, investors seek other
---------FOOTNOTES----------
-[113]- See In re: Philadelphia Stock Exch., Inc., Admin.
Proc. File No. 3-5890, 1980 SEC LEXIS 1891
(Philadelphia Stock Exchange censured for failure
to enforce firm quote rule).
-[114]- Staff of Special Study of the Securities Markets,
88th Cong., 1st Sess., Report of the Special Study
of Securities Markets, pt. 2 at 573 (Comm. Print
1963).
==========================================START OF PAGE 59======
means for order execution, which results in market
fragmentation.-[115]-
2. Failure to Honor Quotes
A significant number of market makers have failed to comply
consistently with their firm quote obligations. Tapes of
traders' telephone lines reviewed during the investigation
include numerous conversations of market makers declining to
transact at their quotes for seemingly spurious reasons. In
addition, the tapes of market maker telephone calls and market
maker testimony disclose that they often instructed other market
makers to "give me ahead," i.e., use the name of the first market
maker to claim a trade-ahead exception if a third market maker
asks the second to complete a trade. The latter tactic may be
utilized in reprisal for a perceived incident of backing away by
the third market maker at some earlier point in time. Such a
request may also be made if the market makers are competing for
the same order flow-[116]- or if a market maker moves its
---------FOOTNOTES----------
-[115]- For example, one options market maker informed the
staff that over the years he has directed
approximately 95% of his trading in Nasdaq stocks
to Instinet and stated that most traders use
Instinet because they believe it has better prices
and firm quotes. This options market maker stated
that Nasdaq quotes are rarely firm and Nasdaq
market makers would not display his bids between
the inside spread.
-[116]- The following audio taped telephone conversation
is between two Nasdaq traders at different firms.
Trader 1: I saw [stock] get a little weaker. I went
out and hit [firm 3], and he told me [firm 4]
ahead.
Trader 2: Oh really?
Trader 1: If [firm 4] comes in to you, give me ahead.
Trader 2: OK.
Trader 1: I just don't like the way . . . I don't like
the stock. I got a feeling that my seller is
going to come back and sell more.
Trader 2: I got you.
Trader 1: But I don't want to get you in trouble in the
thing, either.
Trader 2: Oh, it doesn't matter. I made some sales
yesterday. I'm long 8 now.
Trader 1: Yeah. It's that I don't want to see you get
hurt, so.
Trader 2: Look.
(continued...)
==========================================START OF PAGE 60======
quotes in a manner that harms the requesting market maker.
3. Selective Refusal to Trade
Certain market makers have backed away from orders presented
to them by firms that the market makers "dislike" or perceive to
be overly competitive. Some market makers preferred not to trade
with firms that they considered to be "professional traders,"
such as options market makers,-[117]- firms that act as
block positioners,-[118]- exchange members with unlisted
---------FOOTNOTES----------
-[116]-(...continued)
Trader 1: Stay put if you'd like, if you want. And,
you know, then give me ahead or tell them
you've got me tied up. Why don't we do that?
Maybe we'll be able to make some more sales.
I'm long about 5.
Trader 2: OK.
-[117]- In the following audio taped telephone
conversation, a market maker calls another market
maker to inquire about consummating a trade in
order to avoid trading with an options market
maker.
Trader 1: [T]he option guys are trying to ******* whack
me [hit his bid].
Trader 2: Oh.
Trader 1: So I was like, ****, you know, I'd rather buy
your. . . . If you don't want to sell your
stock, that's fine.
Trader 2: No, I already sold them. I sold them on
Instinet at 1/4.
Trader 1: Oh, you did?
Trader 2: Yeah, I'm all right.
Trader 1: All right, so there's a 1/4 print on the
machine. That's all I care. . . .
-[118]- An audio taped telephone conversation discloses
that, after being told by his trading assistant
that his firm had sold stock to a block
positioning firm, a trader made the following
comments to the trading assistant.
Trader: I do not like [block positioner]. I do not
want to trade with him, period. I know he's
a non-market maker. He's brokering.
Aide: OK.
* * * *
Trader: I am not interested in being short. . . .
(continued...)
==========================================START OF PAGE 61======
trading privileges for Nasdaq stocks,-[119]- and SOES
firms. The evidence indicates that some market makers wanted to
avoid trading with such firms because the trading "styles" of
such firms may leave market makers at a
disadvantage.-[120]- For instance, some market makers
---------FOOTNOTES----------
-[118]-(...continued)
It's very important for me to make money this
month. . . . I don't need this ****. It's
very simple, no prints to anybody.
* * * *
Trader: I told you very specifically I did not want
to be short the stock. I do not trade with
[block positioner]. He is a scumbag in the
stock. . . . I am not here to accommodate
him, that's it, end of discussion.
-[119]- An exchange member may trade a security with
unlisted trading privileges as if it were listed
on the exchange. See Exchange Act 12(f), 15
U.S.C. 78l (1994).
-[120]- In the following audio taped telephone
conversation, two traders at the same firm are
discussing an order from an exchange member that
makes a market in Nasdaq securities that traded on
an exchange pursuant to Unlisted Trading
Privileges.
Trader 1: Listen to me [name of Trader 2]. Listen to
me. I took around four calls in here already
that came in looking for that because they
were paying for size looking for fast money.
All these guys want to do the same thing.
OK, now [name of UTP trading firm] is on the
options floor. He watches Instinet. He sees
what's going on. He is not a legitimate
customer per se.
Trader 2: There are two out there. There are two [name
of UTP trading firm]s. I've been telling you
this once before. One is on the options
floor. The other one is a retail call.
They're upstairs at one of the buildings.
They are not on the floor and that's where
that order came from. . . . It's legitimate
[name of UTP trading firm]. If it comes from
the other call, I'd say no. But that one --
I have two keys at [name of UTP trading
firm]. I have a legitimate key and a
******** key.
==========================================START OF PAGE 62======
have testified that they believe that these firms will "front
run" market makers orders-[121]- or "pick off" market
makers who are slow to update their quotes following news
announcements. Such practices are considered "unprofessional" or
"unethical" as between market makers and are discouraged within
the market maker community.
The selective refusal of certain market makers to trade with
these firms further erodes the underpinnings of the firm quote
rule, and is unfair and inconsistent with the concept of a free
and open market. It also hinders the development of the national
market system. The options markets cannot operate efficiently if
options market makers' trading in the underlying stock is
hampered. The competitive benefits of permitting trading through
Unlisted Trading Privileges are diminished if market makers can
avoid trading with exchange specialists. The firm quote rule is
vitiated if market makers can pick and choose the parties with
whom they will trade. Refusals to trade contribute to market
fragmentation, and thereby impair pricing efficiency and fairness
to investors.
4. The NASD's Enforcement of the Firm Quote Rule was
Inadequate
The NASD is responsible for ensuring that market makers
comply with the firm quote rule. The policies and practices of
the NASD were insufficient to detect and deter backing away by
market makers. The NASD did not generate automated surveillance
reports designed to identify potential instances of backing away.
NASD examination modules did not address potential non-compliance
with the firm quote rule by market makers. The NASD's oversight
of compliance with the firm quote rule was limited to responding
to complaints against market makers. However, there has been
limited incentive to filing backing away complaints because a
successful complainant was not awarded a trade execution. The
only sanctions imposed by the NASD were fines against offending
firms. This practice differs from many of the exchanges, where a
floor official will instruct a specialist who improperly backed
---------FOOTNOTES----------
-[121]- In this context, the term "front running" is used
to describe a practice of entering orders
immediately after learning information that could
affect the market for a given security. For
example, a market maker might enter a 20,000 share
order to sell in Instinet or SelectNet. Another
firm may see this large order and try to sell
short immediately and cover at a lower price after
the larger order is executed.
==========================================START OF PAGE 63======
away to fill the order.-[122]- The lack of an adequate
remedy acted as a disincentive to the filing of backing away
complaints by aggrieved parties.
Even if a firm did file a backing away complaint, the NASD's
procedures for processing complaints were deficient. Prior to
1994, the NASD required firms to submit written backing away
complaints. The accused market maker would be given a copy of
the complaint and told to respond within five days. Analysts in
the Market Surveillance Department would review records and
contact the traders involved. If the Market Surveillance staff
felt that further action was warranted, the matter would be
referred to the Market Surveillance Committee. The entire
process could take months to complete.
Beginning in late January 1994 and just after the NASD
limited access to SOES through the interim SOES rules, SOES firms
began using SelectNet for much of their trading. Unlike SOES,
which provided for automatic execution, SelectNet is an order
delivery system that allows market makers to accept or reject
orders. Immediately after the interim SOES rules went into
effect, the NASD began receiving large numbers of backing away
complaints from SOES firms.-[123]- The orders involved in
these backing away complaints were mostly directed SelectNet
orders.-[124]- The submission of large numbers of backing
---------FOOTNOTES----------
-[122]- See NYSE Guide, Rules of Board-Dealings &
Settlements, Rule 75 (CCH) 2075 (1996); Amex
Guide, General & Floor Rules, Rule 126(h) (CCH)
9276.02 (1996). The NASD's sanction practices are
also in contrast to the handling of trade-through
complaints in the Intermarket Trading System
("ITS"). A prevailing ITS trade-through
complainant is awarded a prompt fill at the
quotation traded through.
-[123]- Over 4,700 backing away complaints were filed in
1994. In comparison, the NASD received 41 backing
away complaints in 1993. The NASD had learned no
later than 1991, however, that SOES firms had
difficulty in executing phone orders through
market makers. See infra note 188, and
accompanying text.
-[124]- A firm entering a SelectNet order to buy or sell a
Nasdaq security can direct its order to a single
market maker (referred to as a "directed" or
"preferenced" order). Directed SelectNet orders
trigger the market maker's obligation to honor its
quotes, assuming the order is priced at the market
(continued...)
==========================================START OF PAGE 64======
away complaints led the NASD to modify its existing procedures to
facilitate a more expeditious review. The NASD's new procedures
for processing and evaluating backing away complaints had the
effect of favoring the market makers accused of backing away by
eliminating complaints for reasons not set forth in, and
inconsistent with, the Commission's and the NASD's firm quote
rules. In connection with the investigation, the Commission
staff reviewed a large number of backing away complaints filed
with the NASD in 1994.-[125]- Although the NASD took no
enforcement action in most of these cases, the Commission staff's
review found that a significant number of these complaints were
eliminated from consideration for disciplinary action even though
they may well have violated the firm quote rule.
On March 10, 1994, the NASD issued a notice to its members
that cited the increase in the volume of SelectNet backing away
complaints and reiterated the obligation that market makers honor
their quotes.-[126]- The March 10th Alert also set forth
the procedures to file and respond to a backing away complaint.
The complaining firm was instructed to contact the market maker
within five minutes of the incident. If the complaint was still
unresolved after such contact, the complaining firm had to
contact the NASD's Market Surveillance Department within 15
minutes after the alleged backing away. An "official" backing
away complaint form had to be filed in writing within 24 hours.
The Compliance Subcommittee of the NASD Market Surveillance
Committee was responsible for ruling on the validity of backing
away complaints and determining the appropriate sanctions for
violations of the rule. In early 1994, the Compliance
Subcommittee became concerned about its ability to process the
increased number of backing away complaints and directed the
Market Surveillance Department staff to develop guidelines for
processing complaints. After reviewing and commenting upon the
staff-generated criteria, the Compliance Subcommittee authorized
on March 10, 1994 the use of new SelectNet backing away
---------FOOTNOTES----------
-[124]-(...continued)
maker's quotes. SelectNet orders can also be
broadcast to all market makers. SelectNet orders
remain on the Nasdaq workstation for three minutes
(unless the order entry firm specifies a longer
time period), after which time the order
automatically expires.
-[125]- The SEC staff reviewed a sample consisting of
1,616 complaints filed against 16 market makers.
-[126]- NASD Special Regulatory Alert, "NASD Reiterates
Members' Firm Quote Obligations" (Mar. 10, 1994)
[hereinafter "Alert"].
==========================================START OF PAGE 65======
procedures to review complaints, even though certain of these
criteria were not consistent with the Commission's and the NASD's
rules regarding firm quotations.-[127]- Under these
procedures, a market maker was entitled to the trade-ahead
exception to the firm quote rule if (1) a trade was reported
through the Automated Confirmation Transaction Service system
("ACT")-[128]- and the market maker's quotations were
revised by the firm within two minutes of the SelectNet order;
(2) a trade was reported within one minute prior to a SelectNet
order and quotations were revised within ten seconds after the
order; (3) a trade was executed through SOES within thirty
seconds before an order and quotations were revised within ten
seconds of the SelectNet order or within thirty seconds after the
SOES execution; or (4) a trade was executed through SOES within
thirty seconds after an order and quotations were revised within
thirty seconds after the SOES execution. Additionally, the
backing away procedures dictated that a complaint would be
dismissed if the SelectNet order was cancelled before three
minutes (when orders are automatically cancelled by the SelectNet
system) by the complaining firm or if the complaint itself was
deficient (e.g., filed late or lacked sufficient
detail).-[129]- Any complaints that were not resolved by
---------FOOTNOTES----------
-[127]- The criteria adopted by the Compliance
Subcommittee went beyond the scope of the relevant
factors outlined in the Alert. Although staff of
the Commission's Division of Market Regulation had
reviewed drafts of the Alert prior to its
issuance, the staff was not apprised of all of the
criteria adopted by the NASD for processing
backing away complaints until it began an
inspection of the NASD in July of 1994. The staff
of the Division of Market Regulation did not
approve the specific criteria adopted by the NASD
for reviewing backing away complaints.
-[128]- The ACT system is an automated system for trade
reporting and clearing owned and operated by NASD
Market Services Inc.
-[129]- The Alert advised members that their "cancellation
of preferenced SelectNet orders before a market
maker has declined the order or before the order
'times out' will generally be deemed conduct
evidencing a lack of an intent to trade, thus
precluding the member from raising a valid backing
away complaint." [Emphasis added.] The procedures
adopted by the Compliance Subcommittee went beyond
the guideline expressed in the Alert, making a
cancellation prior to the expiration of three
(continued...)
==========================================START OF PAGE 66======
application of the procedures were to be presented to the
Compliance Subcommittee for further review.-[130]-
The backing away procedures nullified many valid complaints
for reasons not permitted by the firm quote rule. All complaints
involving orders that were cancelled by the order entry firm
before they automatically expired after three minutes should not
have been rejected.-[131]- Some of these cancellations
were entered after the market maker moved its quotation without
responding to the SelectNet order. Other orders were cancelled
after the order entry firm completed the transaction through some
other means. An order entry firm should not be required to bear
the risk of continuing to expose its order to pursue a backing
away complaint. A market maker's obligation to fill an order
begins when the order is presented, and not upon the expiration
of the three minute time period.
The NASD's backing away procedures also gave a market maker
a trade-ahead exemption if it reported a trade and changed its
quote within two minutes. The apparent logic behind the two
minute time period was that a market maker was required to report
a trade in ninety seconds and the extra thirty seconds
represented an additional "cushion." Working backwards in time,
a market maker was presumed to have been in the process of
effecting that transaction when the directed SelectNet order was
presented.-[132]- The many automated trading systems now
---------FOOTNOTES----------
-[129]-(...continued)
minutes an absolute bar to the filing of a backing
away complaint.
-[130]- The SelectNet backing away parameters and
procedures were not published or generally
disclosed to the NASD's members.
-[131]- The requirement imposed by the NASD that the
SelectNet order had to be outstanding for a full
three minutes for a backing away complaint to be
valid effectively created a third exception to the
firm quote rule, permitting market makers in these
circumstances to avoid honoring their quotes where
an order was validly presented to them.
-[132]- In using the time the other trade was reported
(rather than the time of entry or execution), the
NASD recognized the inadequacy of member firms'
records for use in reconstructing trades. For
telephone trades, most firms did not create
records that evidenced the time that telephone
orders were presented or executed. The lack of
(continued...)
==========================================START OF PAGE 67======
in use, however, would have allowed the NASD, in evaluating
backing away complaints, to determine whether such orders in fact
preceded a directed SelectNet order. Instead, the NASD adopted
an approach that had the effect of favoring the market makers by
allowing any order within two minutes to qualify as a trade-ahead
exception.
The backing away procedures also permitted a trade-ahead
exemption for any SOES executions received within thirty seconds
after the directed SelectNet order. Because SOES executions are
automatic and instantaneous, a market maker could not have been
in the process of executing a SOES order that was received after
a SelectNet order. Such transactions clearly should not have
qualified as trade-ahead exceptions.
In handling these complaints, the NASD staff applied the
criteria of the protocol unevenly. The complaining firms were
held to the letter of each requirement, while market makers were
at times given the benefit of the doubt. For example, a
complaint based on a SelectNet order which was displayed for a
period of almost but not quite three minutes would be eliminated.
However, a market maker who reported a trade and updated its
quotations two minutes and a few seconds after the complainant's
order was placed would sometimes be excused from having to
execute that order.
Even where a market maker violated the terms of the
protocol, often the NASD staff and Market Surveillance Committee
failed to impose sanctions. In some instances, the staff of the
Market Surveillance Department did not refer backing away
complaints to the Compliance Subcommittee even though the
complaints met the criteria of the backing away procedures.
Valid complaints were also not forwarded due to the use by the
Market Surveillance Department of the wrong trading data in
evaluating the complaints and the expansion of the time periods
for the trade-ahead exception. Examinations by the SEC staff
indicated that at least an additional 76 complaints in the SEC
sample should have been sent to the Compliance Subcommittee for
review.
The Compliance Subcommittee also screened out certain
complaints that satisfied the backing away parameters and had
been forwarded by the Market Surveillance Department. Although
the rationale of most of the Compliance Subcommittee's decisions
was not memorialized in writing, it appears that these rulings
were based on expanded time periods for a trade-ahead exception,
or by a market maker's assertion that it was not aware of the
---------FOOTNOTES----------
-[132]-(...continued)
such records made it more difficult to analyze
backing away complaints properly.
==========================================START OF PAGE 68======
directed SelectNet order, that its subsequent offer to execute a
trade was refused, or that the order entry firm did not contact
it about the incident. At least 29 complaints in the SEC sample
that appeared valid under the terms of the procedures were
dismissed without sanctions by the Compliance
Subcommittee.-[133]-
The firm quote rule is triggered when an order is
"presented" to the market maker. Because all directed SelectNet
orders are delivered electronically to a particular market maker,
the presentment of an order is readily ascertainable. In
responding to backing away complaints, some market makers argued
that if a directed SelectNet order to them scrolled off the
SelectNet order screen and they did not observe it, then their
inattentiveness relieved them of their firm quote obligations.
In some cases, the Compliance Subcommittee of the Market
Surveillance Committee used the same logic to dismiss backing
away complaints. The fact that SelectNet orders may have
scrolled off the most frequently used screen on the Nasdaq
workstation terminal does not excuse traders from complying with
the firm quote rule.-[134]- It does illustrate, however,
a defect in the NASD's trading systems that fostered non-
---------FOOTNOTES----------
-[133]- The 76 complaints that should have been sent to
the Compliance Subcommittee for review and the 29
complaints that should have been treated as valid
by the Compliance Subcommittee (which total 105
complaints) are likely to understate the number of
backing away complaints that were improperly
tabled in the NASD's review process. These 105
complaints were instances in which the NASD staff
or the Compliance Subcommittee did not follow the
NASD's protocol, which was unduly lenient. Had
more reasonable criteria been used to identify
meritorious backing away complaints, the number of
valid complaints would have been higher.
-[134]- Market makers claim that directed SelectNet orders
often scrolled off their trading screens in a
brief time span, especially in periods of high
market volatility. SelectNet orders appear on the
screen of the Nasdaq workstation terminal and a
trader can adjust the number of SelectNet orders
that would appear on the first page of the Nasdaq
display. SelectNet orders that scrolled off the
first page could be accessed on another page of
the Nasdaq display, but traders rarely checked
this page for active SelectNet orders. Instead,
traders usually relied on phone calls from the
order entry firm to alert them to these orders.
==========================================START OF PAGE 69======
compliance. After market makers raised the issue of orders
scrolling off the trading screen, the NASD should have addressed,
among other things, this design flaw in the Nasdaq workstation.
Even if a backing away complaint was found to be
meritorious, the NASD did not always follow its own guidelines in
imposing sanctions. The NASD's sanction guidelines set forth
certain minimum penalties based on the number of violations
committed within a twelve month period.-[135]- The NASD
combined separate incidents of backing away by a market maker and
counted them as one violation. The fines imposed on the market
makers were thus often smaller than those set forth in the
guidelines because of the consolidation of violations. The
NASD's policies and practices with respect to backing away
complaints consistently favored the market makers and did not act
as a sufficient deterrent to market makers' non-compliance with
the firm quote rule.
In sum, the NASD's lack of commitment to enforcing the firm
quote rule was evident in its handling of the 1994 backing away
complaints. Thus, it failed to secure for investors the
liquidity that firm quotations provide and failed to dispel the
false appearance of the market that illusory quotations
project.-[136]-
---------FOOTNOTES----------
-[135]- The sanction guidelines set forth the following
sanctions:
First violation -- Letter of Warning
Second violation -- Letter of Caution
Third violation -- Acceptance, Waiver and Consent
proceeding ("AWC") and $1,000 fine
Fourth violation -- AWC and $2,500 fine
Fifth violation -- AWC and $5,000 fine
Sixth violation -- AWC or Formal Complaint
-[136]- It should be noted that the deliberations of the
Market Surveillance Committee and the reasons for
its decisions on whether or not to authorize
charges were poorly documented. The committee's
records are generally unclear regarding what
discussion the committee engaged in and what basis
the committee had for its decisions. Of
particular concern are the cases which satisfied
the parameters used by the NASD staff for a valid
backing away complaint, but which the committee
did not authorize for action. While the
Commission's settlement with the NASD requires,
among other things, that the Market Surveillance
Committee shall no longer have a grand jury
(continued...)
==========================================START OF PAGE 70======
II. THE NASD'S REGULATORY DEFICIENCIES
A. The SOES Controversy
1. Origin of the SOES Controversy-[137]-
SOES was established by Nasdaq in 1984 to permit small
orders in Nasdaq stocks to be automatically executed at the
inside quotes.-[138]- Since 1988, significant controversy
has revolved around the SOES system and its use. There are two
types of participants in SOES: SOES market makers and SOES order
entry firms. A SOES participant must belong to the NASD and be
registered as either a SOES market maker or SOES order entry firm
in a particular stock. A dealer cannot be both a SOES market
maker and a SOES order entry firm in the same security.
SOES was intended to achieve the timely and efficient
processing of small trades, by providing automatic execution of a
market order at the inside quotes for a required minimum size,
---------FOOTNOTES----------
-[136]-(...continued)
function, the activities of NASD disciplinary
bodies should be thoroughly documented at all
stages, in order to ensure compliance with the
NASD's obligation to maintain a fair procedure for
the disciplining of members and persons associated
with members, as required by Section 15A(b)(8) of
the Exchange Act.
-[137]- The NASD has a statutory obligation to oversee the
Nasdaq market and to enforce its rules and
regulations as to all member firms in an
evenhanded and impartial manner. The record in
the investigation suggests the undue influence of
market makers and a lack of vigor and balance in
the NASD's enforcement activities with respect to
such firms that is inconsistent with its
obligations. Section 19(g)(1)(B) of the Exchange
Act, 15 U.S.C. 78(t)(1)(B). The Report and
Appendix should not be read to suggest any
conclusion by the Commission on the merits of any
specific enforcement action or inspection by the
NASD of any SOES firm.
-[138]- NASD Notice to Members 88-43, June 22, 1988
(adopting amendments to the Rules of Practice and
Procedures for the NASD Small Order Execution
System).
==========================================START OF PAGE 71======
even during periods of heavy volume.-[139]- During the
market break of October 1987, however, many SOES market makers
withdrew from the SOES system, which forced SOES-eligible
customers to attempt to obtain execution of their orders by
telephone.-[140]- As a result of the October 1987 market
break, the NASD took steps to ensure that investors would have
access to the SOES system even in periods of high volume. On
June 30, 1988, SOES was changed to require all Nasdaq market
makers to participate in SOES and the penalty to market makers
for unexcused withdrawals of quotations from the Nasdaq system
was increased.-[141]-
After SOES became mandatory for all Nasdaq market makers in
NMS securities, there was an increase in trading by customer
accounts at SOES order entry firms whose primary, if not
exclusive, business line was promoting SOES trading ("SOES
firms"). These firms, sometimes referred to as "SOES bandits,"
"SOES activists," "day traders," or "SOES abusers," developed
trading strategies based on the automatic execution capabilities
and firm quotes available in the system, which involved entering
orders for customer accounts in response to changes in market
conditions or promptly after the announcement of news or other
relevant market information, but before a market maker updated
---------FOOTNOTES----------
-[139]- Because SOES reports trade data automatically, a
trader would not have to spend time processing
trade related paperwork. Additionally, SOES
trades can be completed without having to make a
telephone call to another market maker. SEC
Division of Market Regulation, The October 1987
Market Break, Feb. 1988, p. 9-13 [hereinafter
referred to as "The October 1987 Market Break
Report"].
-[140]- The October 1987 Market Break Report, pp. 9-14 and
9-15. Telephonic access to dealers was already
difficult during the market break, due to the high
volume of orders.
-[141]- After the rule changes, a market maker was subject
to a twenty business day suspension for unexcused
withdrawal from the Nasdaq system. NASD Notice to
Members No. 88-43, June 22, 1988. Previously, the
penalty for an unexcused withdrawal was a two-day
prohibition. The October 1987 Market Break
Report, p. 9-13, n.47. But see, infra part
II.B.1., for discussion of NASD's failure to
adequately discipline members for unexcused
withdrawals.
==========================================START OF PAGE 72======
its quote.-[142]- The position established in the
customer accounts would be closed out after market makers had
updated their quotations. This style of trading was commonly
referred to as "picking off" a market maker.
Considerable acrimony developed between the market makers
and the SOES firms.-[143]- Market makers viewed SOES
firms as market professionals who were profiting from rapid fire
trading on a system not designed for such activity. Market
makers asserted that this activity resulted in their
institutional customers receiving inferior prices. For their
part, the SOES firms asserted that automatic execution was the
best way to complete a trade, because market makers often "backed
away" from any telephone orders placed by SOES firms.
Because SOES executions do not require the specific
agreement of the market maker to the order, the market makers
could not preclude the trading activities of the SOES firms
without withdrawing from the market. Market makers turned to the
NASD to urge that it limit the impact of SOES.
The market makers sought to deal with the competitive
problems posed by SOES by enlisting the support of the NASD in
three areas: (1) rulemaking and interpretation; (2) the
aggressive investigation of SOES firms and enforcement of the
SOES rules; and (3) the restriction of admissions and an increase
in conditions to NASD membership. In each of these areas, the
NASD took steps to constrain the activities of SOES firms.
2. SOES Rulemaking in Response to Market Maker
Complaints
a. Limiting Access to SOES
Four significant modifications have been made to the SOES
rules since the system became mandatory in 1988. Each of these
modifications limited the access to the SOES system of SOES firms
---------FOOTNOTES----------
-[142]- See NASD Notice to Members No. 91-67, Oct. 16,
1991.
-[143]- For example, interviews with persons at SOES firms
disclose that certain market makers frequently
made obscene remarks to such persons during
telephone calls. Review of SelectNet text
messages uncovered other harassing messages
directed by market makers at SOES firms, although
the use of obscenities on SelectNet is prohibited
by the NASD. At the 1991 annual meeting of the
Security Traders Association, "SOES Sucks" buttons
were distributed to general acclaim.
==========================================START OF PAGE 73======
and their customers, or decreased the obligation of market makers
to execute SOES orders.-[144]- The market makers pressed
these changes to the SOES rules through lobbying efforts,
majority participation in NASD committees, and, in certain
instances, influence with the NASD staff.
Amendments to the SOES rules typically originated with
either the NASD's Trading Committee or the Market Surveillance
Committee. The rules proposed by the committees were approved by
the NASD Board of Governors-[145]- and ultimately by the
Commission. During the relevant time period, a significant
majority of Trading and Market Surveillance Committee members
were associated with firms that made markets.-[146]-
---------FOOTNOTES----------
-[144]- For example, the volume which market makers were
obligated to trade on SOES has ranged from a high
of 5,000 shares in 1988 to a low of 500 shares in
1993. In 1995, notwithstanding the NASD's efforts
to hold market makers' size obligation on SOES to
500 shares, the Commission restored a minimum of
1,000 shares. Exchange Act Release No. 35535
(Mar. 27, 1995), 60 Fed. Reg. 16690 (Mar. 31,
1995).
-[145]- The Board did not modify or reject any of the
proposed amendments. The conduct of the Board in
this regard is consistent with the Rudman Report's
finding that the Board acted "primarily as a
`referee' in the rulemaking process," Rudman
Report at IV-3, and that "the Trading Committee
wields significant power in the NASD's regulation
of the Nasdaq market." Rudman Report at IV-6.
-[146]- From 1987 to 1994, 39 out of 49 members of the
Trading Committee came from firms that made
markets. During the same time period, 36 of 39
members of the Market Surveillance Committee also
worked for firms engaged in market making. Not
one was affiliated with a firm generally
considered to be a SOES firm.
Appointments to the Trading Committee and Market
Surveillance Committee have been controlled by senior
NASD officials. Members of the Trading Committee were
selected by a three-person panel consisting of the NASD
President, the outgoing Chairman of the NASD Board of
Governors, and the incoming Chairman of the NASD Board
of Governors. Members of the Market Surveillance
Committee were selected by a nominating committee
consisting of the two past chairs of the Market
(continued...)
==========================================START OF PAGE 74======
Additionally, a significant number of NASD committee members also
were officers of market maker trade associations. Some were from
STA, while others were from a regional affiliate of STA, the
Security Traders Association of New York, Inc.
("STANY").-[147]- Of 61 individuals who have served as
officers, directors, or governors of the STA or STANY between
1988 and 1994, about half (29) have also served on significant
NASD boards, committees, or subcommittees,-[148]- in most
cases (24) simultaneously with their service at STA or
STANY.-[149]-
The first significant modification to SOES occurred in
August 1988, when the NASD issued a rule interpretation relating
to the maximum order size in SOES.-[150]- The rule
interpretation concerned the "order splitting" provision of the
---------FOOTNOTES----------
-[146]-(...continued)
Surveillance Committee and three members of the Board
of Governors.
-[147]- See, e.g., Letter from STANY to Jonathan Katz,
Secretary of the Commission, dated May 28, 1991
("STANY represents more than 1200 individuals in
the greater New York metropolitan area, the
majority of whom are NASDAQ market makers.").
-[148]- These boards, committees, and subcommittees
include the NASD Board of Governors, the NASD
Executive Committee, the NASD National Nominating
Committee, the National Business Conduct
Committee, the Market Operations Review Committee,
the Market Surveillance Committee (including its
Compliance and Investigations Subcommittees), the
SOES Users Committee, the Trading Committee
(including its Quality of Markets, SelectNet/SOES,
and SOES Tier Size Review Subcommittees), and the
various District Committees of the NASD.
-[149]- This is not to suggest that market makers may not,
directly or through their trade associations,
lobby their regulators or participate in the
governance structure of the NASD. However, the
undue influence of market makers diminished the
objectivity and effectiveness of the NASD. This
contributed to the failure of the NASD to enforce
its rules evenhandedly.
-[150]- NASD Notice to Members 88-61, Aug. 25, 1988.
==========================================START OF PAGE 75======
SOES rules.-[151]- This provision set a maximum size for
SOES orders-[152]- and prohibited the division of larger
orders into smaller parts to avoid the size limitations. The
August 1988 rule interpretation provided that in certain
circumstances trades of different customers should be aggregated
in determining non-compliance with the order splitting rule. The
NASD redefined "split orders" to include trades done on a
discretionary basis by a single trader.-[153]-
The August 1988 rule interpretation resulted from concerns
expressed by the SOES Users Committee, an NASD committee
consisting largely of market makers, and recommendations made by
the market makers through the STA and its regional
affiliates.-[154]- The STA stated in a July 27, 1988
letter to the President of the NASD, that its members were
"extremely concerned" about rapid-fire SOES executions. The STA
suggested, among other things, that orders in discretionary
accounts be combined for purposes of the order splitting rule.
The NASD's rule interpretation, issued less than one month later,
---------FOOTNOTES----------
-[151]- NASD Manual, SOES Rule c(3)(C) (CCH) 2460
(1995).
-[152]- There are three tiers (1,000, 500, or 200 shares)
depending on the trading characteristics of the
security involved.
-[153]- According to the rule interpretation, if two or
more trades flowed from a "single investment
decision," then those trades were aggregated. A
single investment decision was presumed if the
trades occurred within a five minute period in
accounts controlled by either a customer or a
person associated with the SOES firm. Control
would be inferred if the customer or associated
person exercised discretion over the account, was
granted a power of attorney, or if the account was
the personal account of the customer or associated
person (including the immediate family of the
associated person). NASD Notice to Members 88-61,
Aug. 25, 1988.
-[154]- NASD employees and committee members drafted the
actual text of this and other amendments to the
SOES rules. The NASD staff was prompted by the
SOES Users Committee in June 1988 to examine the
use of SOES by persons associated with member
firms who had discretionary authority over
customer accounts. In general, the NASD
committees worked with the NASD staff to develop
ideas to alter the existing regulatory framework.
==========================================START OF PAGE 76======
incorporated the STA's recommendation.
In crafting the rule interpretation to include trades where
there was a common associated person, such as a trader or broker,
and not just a common customer, the NASD was able to classify a
large part of the business of SOES firms as split orders. At the
time of the rule interpretation, the NASD believed that many SOES
trades were made on a discretionary basis. The effect of the
rule interpretation was to reduce the volume of trading by SOES
firms. The interpretation of "order splitting" served as the
basis for a number of NASD disciplinary actions, including cases
against SOES firms.
The NASD further amended the SOES rules in December 1988 by
adopting the professional trading account ("PTA") rule. This
rule permitted the NASD to designate a customer's account as a
PTA if certain criteria were met.-[155]- Once the account
was classified as a PTA, no SOES trades could be executed for
that account, which in effect disqualified the account from
access to the SOES system. Market makers initiated the rule
change. An August 8, 1988 memo from NASD staff members to the
SOES Users Committee-[156]- listed proposed restrictions
to access on SOES and stated "[t]he above proposals were
suggested by members who have complained about the abuse of SOES
by certain order entry firms." STANY supported further denial of
access to "day traders," and the NASD advanced the proposal.
The third major group of modifications of the SOES rules
occurred in October 1991. These modifications followed from the
complaints of member firms to the NASD staff about the activities
of SOES firms in the spring of 1990. The Trading Committee and
---------FOOTNOTES----------
-[155]- Using a two-prong test, the NASD defined a
professional trading account as an account in
which (1) five or more day trades (buy and sell in
same security on same day) via SOES were made; or
(2) there was a professional trading pattern as
evidenced by a pattern of day trades, a high
volume of day trades as compared to longer term
transactions, or a high volume of day trades in
relation to amount and value of securities in the
account. NASD Notice to Members 88-103, Dec. 19,
1988.
-[156]- Like the Trading Committee and the Market
Surveillance Committee, the SOES Users Committee
(which was eliminated in 1990) consisted largely
of representatives of firms that made markets.
See Report of the NASD Select Committee on
Structure and Governance to the NASD Board of
Governors, p. IV-25, n.56 (Sept. 15, 1995).
==========================================START OF PAGE 77======
Market Surveillance Committee, both of which consisted largely of
representatives of firms that made markets, considered possible
rule changes proposed by the NASD to broaden the definition of a
PTA at meetings in June and July 1990, respectively. A letter
dated October 31, 1990 from STANY to the Chairman of the NASD's
Trading Committee advocated changes to the SOES rules and
recommended three solutions to the problem of SOES abuse,
including expanding the definition of a PTA. These recommended
solutions also included the use of a time delay between SOES
executions by a market maker.-[157]- Testimony confirms
that the suggestion for a time delay came directly from the
market makers.
The change in the definition of a PTA expanded the types of
activity that could be used to classify an account as a
PTA.-[158]- The amendments to the PTA definition were
challenged as overly burdensome and vague, and this rule was
ultimately repealed after being criticized by the U.S. Court of
Appeals for the D.C. Circuit in Timpinaro v. SEC.-[159]-
---------FOOTNOTES----------
-[157]- The third proposal suggested in the October 31,
1990 letter was to ban all short selling on SOES.
This suggestion was later adopted in the so-called
interim SOES rules, which became effective on a
pilot basis in January 1994. See NASD Special
Notice to Members 94-1, Jan. 5, 1994.
-[158]- Day trading was redefined to include using SOES on
only one side of a buy and sell transaction.
Under the 1988 version of the PTA rules, day
trading required the use of SOES on both sides of
the transaction. Under the second prong of the
test, the 1991 amendments permitted the use of
additional factors in considering whether an
account was a PTA. These criteria included:
(1) excessive frequency of short-term trading;
(2) excessive frequency of short-sale
transactions; (3) trading of discretionary
accounts; and (4) direct or physical access to
Nasdaq quotation screens or SOES terminals. NASD
Notice to Members 91-67, Oct. 16, 1991.
-[159]- 2 F.3d 453 (D.C. Cir. 1993). The NASD did not
publish any guidelines as to what frequency of
short term trades or short sale trades was
"excessive." Thus, even the NASD analysts and
supervisors responsible for selecting accounts for
possible PTA designation did not have objective
criteria for distinguishing between excessive and
acceptable trading. Contemporaneous notes and
testimony concerning a June 27, 1990 meeting of
(continued...)
==========================================START OF PAGE 78======
The October 1991 SOES rule amendments as filed with the
Commission also allowed for the modification of the SOES
operating software to provide for a fifteen-second delay between
executions by a particular market maker. The purpose of this
delay was to give the SOES market maker an opportunity to update
its quotations after receiving a report of a trade executed
through SOES. In fact, the NASD implemented an effective delay
of twenty seconds, which reduced the ability of SOES users to
obtain executions.-[160]- The purported rationale for the
additional five-second delay was to allow for the time taken for
the electronic transmission of execution reports and quote
updates. According to internal NASD studies, however, any delays
in transmission occurred only at the opening of busy trading days
and the vast majority of any such delays were no more than two to
three seconds in length. The NASD should have set forth in its
filings with the Commission seeking approval for the delay that
the time between executions had been set at twenty seconds, but
did not do so. The existence of the additional five second delay
was discovered by the Commission staff during the investigation.
The final change to the SOES system involved the interim
SOES rules and the proposed N*PROVE system, both of which were
part of a single initiative to reform SOES. The stated purpose
of N*PROVE was to replace SOES's immediate automatic execution
with an order delivery system. The proposed N*PROVE system
allowed a market maker fifteen seconds to accept or decline an
incoming order, before the order was executed by the
system.-[161]- The N*PROVE system was proposed by the
NASD as a replacement for SOES, but was ultimately withdrawn by
the NASD without any formal action by the Commission.
---------FOOTNOTES----------
-[159]-(...continued)
the Trading Committee indicate that the Committee
believed that excessive trading should not be
defined quantitatively and a "[y]ou know it when
you see it" standard should be used.
-[160]- The Release by the Commission approving the
proposed rule changes explicitly noted that the
delay function was set at fifteen seconds and
stated that "[a]ny change in the time period must
be submitted to the Commission for review pursuant
to Section 19(b) of the [Exchange] Act." Exchange
Act Release No. 29810 (Oct. 10, 1991), 56 Fed.
Reg. 52098 (Oct. 17, 1991), n.10. The NASD has
never made any such submission.
-[161]- A market maker could refuse a N*PROVE order only
if a valid exception to the firm quote rule, 17
C.F.R. 240.11Ac1-1(c) (1995), was available.
==========================================START OF PAGE 79======
The interim SOES rules were a series of modifications
designed to alleviate market maker concerns about SOES "abuse"
until N*PROVE became operational. The interim SOES rules
included provisions for the reduction of the maximum SOES order
size from 1,000 shares to 500 shares,-[162]- a reduction
in the number of times that a market maker would be exposed to
SOES executions from five to two with a fifteen-second interval
between the two executions,-[163]- the authorization for
Nasdaq to offer an automated quote update feature that would move
a market maker's quote away from the inside quote after a SOES
execution of an order in the maximum SOES order
size,-[164]- and a prohibition on short sales in SOES.
As before, market makers (both on and off the NASD's Trading
Committee) initiated these further restrictions on SOES trading.
A market maker who was an STA officer (as well as a NASD
committee member) testified that he conceived of the reduction in
the maximum SOES order size to 500 shares. The STA was also a
source for the proposal to reduce the number of times a market
maker was exposed to SOES executions. As noted above, STANY had
previously suggested a ban on SOES short selling. The market
makers also supported the conversion of SOES into an order
delivery system, because this gave them a measure of control over
whether or not to enter into a given transaction.
The Commission approved the interim rules in December 1993,
but limited the rules to a one-year pilot program to provide an
---------FOOTNOTES----------
-[162]- This reduction was made even though market maker
quotes in many Nasdaq NMS stocks must be valid for
at least 1,000 shares under the firm quote rule.
-[163]- The reduction in maximum order size and the
reduction in number of executions effectively
reduced a market maker's exposure on SOES from
5,000 to 1,000 shares, after which the market
maker had five minutes in which to refresh its
quotations.
-[164]- Some individual broker-dealers already had auto-
quote update systems in place, which they had
designed themselves. These programs, sometimes
referred to as "bandit systems," updated a
quotation upon receipt of a SOES execution, but
only if specified SOES order entry firms were
involved. Generally, the firms identified by such
systems were ones believed to be sponsoring active
SOES trading. The Nasdaq Stock Market's auto-
quote update system did not permit the market
maker selectively to update quotes based on the
identity of the order entry firm.
==========================================START OF PAGE 80======
opportunity to test the claims that active trading on SOES
impaired market quality.-[165]- One year later, the NASD
sought to extend the interim rules, arguing that the rules indeed
had resulted in decreased spreads and volatility in Nasdaq. For
example, in filings with the Commission, the NASD asserted that
"the interim SOES rules have been associated with positive market
developments in terms of lower spreads on Nasdaq"-[166]-
and that "spreads in Nasdaq securities experienced a decline in
the immediate period following implementation" of the interim
rules.-[167]- These positions were inconsistent with
statements and data presented by the NASD at the Bear Stearns
Meeting on May 24, 1994 that spreads had not narrowed following
adoption of the interim rules.-[168]-
---------FOOTNOTES----------
-[165]- Exchange Act Release No. 33377, (Dec. 23, 1993),
58 Fed. Reg. 69419, 69424 and 69429 (Dec. 30,
1993).
-[166]- Exchange Act Release No. 35077 (Dec. 9, 1994), 59
Fed. Reg. 65105, 65107 (Dec. 16, 1994).
-[167]- Exchange Act Release No. 35080 (Dec. 9, 1994), 59
Fed. Reg. 65109, 65110 (Dec. 16, 1994). In
support of its proposal to extend the interim
rules, the NASD submitted an econometric study
purporting to show a decrease in spreads as a
result of the interim rules. The NASD also
submitted an economic study by an outside
consulting firm that purported to show "a
statistically significant improvement in effective
spreads for the top 100 Nasdaq stocks (based on
dollar volume) during the three month period
following implementation of the rules." Letter
from NASD to Securities and Exchange Commission,
at 15 (Jan. 12, 1995).
-[168]- See supra notes 39-40 and accompanying text. The
NASD has continued to argue in its Commission
filings that active trading on SOES was
responsible for wide spreads. See, e.g., letter
from NASD to Securities and Exchange Commission,
at 2-3, 8-9 (Mar. 22, 1995) (SOES rules "have been
associated with narrower spreads"); Exchange Act
Release No. 36154 (Aug. 31, 1995), 60 Fed. Reg.
45502 (Aug. 31, 1995) ("the NASD continues to
believe that concentrated bursts of SOES activity
by active order-entry firms contribute to
increased short-term volatility, wider spreads,
and less market liquidity on Nasdaq").
==========================================START OF PAGE 81======
b. Commission Action on SOES Rules Amendments
The Commission's approval of the various modifications to
SOES was based on its assessment of the apparent costs and
benefits of the amendments. From the outset, the NASD, the STA,
and individual market makers raised serious concerns that the
manner in which SOES orders were entered by certain firms could
"impose substantial additional costs and risks on SOES market
makers" that "could cause market makers to reduce substantially
the number of securities for which they make a
market."-[169]- Opponents of the NASD's modifications to
SOES challenged the theory that SOES orders produced the harms
alleged and argued that the changes were discriminatory and
anticompetitive.
The Commission's role in approving the NASD's rule changes
was first, to evaluate whether certain types of SOES use that
were claimed to be abusive did indeed threaten the efficient
functioning of the NASDAQ market, and second, whether the
response to that threat was rational and measured.-[170]-
While the underlying rationale of the system of self-regulation
requires the Commission to accord deference to the expertise and
knowledge of the self-regulatory organizations for the markets it
regulates, the Commission must carefully consider all comments
received, and independently evaluate the facts. Each time the
Commission engaged in this weighing process from 1988 to 1993, it
determined that the balance of expected harm outweighed the
restrictive effects on order entry firms. In approving the rule
changes, the Commission balanced its predictive judgment against
"the relative difficulty of generating any meaningful empirical
studies on the effects of professional trading."-[171]-
The Commission first undertook to consider empirical
evidence in evaluating the effects of SOES on market quality when
the PTA rules were remanded to the Commission by the U.S. Court
of Appeals for the D.C. Circuit in 1993.-[172]- The court
noted that while the Commission's approval of the rules was based
on a "sound theory of market behavior," the Commission should
have explored whether it was possible to determine these issues
---------FOOTNOTES----------
-[169]- Exchange Act Release No. 26361 (Dec. 15, 1988), 53
Fed. Reg. 51605, 51605 (Dec. 22, 1988).
-[170]- Exchange Act Release No. 33377, (Dec. 23, 1993),
58 Fed. Reg. 69419, 69420 (Dec. 30, 1993).
-[171]- Exchange Act Release No. 32092, (Apr. 1, 1993), 58
Fed. Reg. 18279, 18281 (Apr. 8, 1993).
-[172]- Timpinaro v. SEC, 2 F.3d 453 (D.C. Cir. 1993).
==========================================START OF PAGE 82======
through empirical analysis of trading data.-[173]-
Accordingly, in evaluating subsequent NASD proposals to modify
SOES, the Commission focused on whether active SOES trading
produced a quantifiable impact on market quality that would
justify restricting access to the system.
In this regard, the Commission examined the validity of
arguments about the effects of active SOES trading when it
considered the NASD's interim rules proposal. In particular, the
Commission reviewed a study submitted by the NASD attributing
wide spreads and increased volatility to SOES trading. Based on
its own analysis as well as comments received, the Commission
found that the study was inconclusive and did not establish the
purported result.-[174]- In the absence of any conclusive
empirical analysis, the Commission limited approval of the rule
changes to a one-year pilot program to provide an opportunity for
the Commission and the NASD to assess the impact of the rules on
spreads and volatility.-[175]- Although the Commission
noted its concern over the lack of reliable statistical analysis,
it approved the rules, among other reasons, because of the
limitation on their duration and the commitment to monitor the
rules' effect.-[176]-
One year later, the NASD sought to extend the interim rules,
arguing that the rules had limited the effects of active SOES
trading in Nasdaq, resulting in decreased spreads and volatility.
However, based on its review of the NASD's arguments and
analyses, the Commission determined that the NASD had not made
the requisite showing that the interim rules resulted in
decreased spreads and volatility.-[177]- Accordingly, the
Commission indicated that an extension of the interim rules
beyond a 60-day phase-out period could not be justified under the
---------FOOTNOTES----------
-[173]- Id. at 458-60. After the Timpinaro case, the NASD
chose to withdraw the PTA rules, in part because
they had not been particularly successful in
limiting the use of SOES, and submitted new rules
(the interim rules are discussed supra notes 162-
168 and accompanying text).
-[174]- Exchange Act Release No. 33377, (Dec. 23, 1993),
58 Fed. Reg. 69419, 69424 (Dec. 30, 1993).
-[175]- Id. at 69424 and 69429.
-[176]- Exchange Act Release No. 35275 (Jan. 25, 1995), 60
Fed. Reg. 6327, 6327-28 (Feb. 1, 1995).
-[177]- Id. at 6328-29.
==========================================START OF PAGE 83======
applicable statutory standard.-[178]-
Although the NASD learned over time that factors other than
SOES likely contributed to the width of spreads on Nasdaq, such
information was not adequately made known to the Commission as
the NASD sought further amendments to the SOES
rules.-[179]- The process by which the NASD proposed and
implemented the SOES rules illustrates the extent to which the
NASD allowed itself to advocate the interests of market makers.
c. Effect of SOES Rules Amendments
The changes to the SOES rules from 1988 through 1994
consistently favored the interests of the market makers over
those of the SOES firms. These rule changes largely evolved from
concepts developed by market makers, who proposed them to the
NASD staff. The resulting rule changes were approved through the
NASD's rule making process, which was unduly influenced by firms
that made markets. The NASD should have ensured that other
interested member firms, investors, and issuers received adequate
consideration in the rule making process. The NASD staff was
institutionally constrained from advocating in a balanced way the
interests of all its constituencies.
---------FOOTNOTES----------
-[178]- Id. Accordingly, the prohibition on short selling
through SOES was allowed to expire on January 25,
1995, Exchange Act Release No. 35077 (Dec. 9,
1994), 59 Fed. Reg. 65105 (Dec. 16, 1994), and the
reduction in the SOES maximum order size to 500
shares was allowed to expire on March 28, 1995.
Exchange Act Release No. 35535 (Mar. 27, 1995), 60
Fed. Reg. 16690 (Mar. 31, 1995). The Commission
has extended the remaining two components of the
interim SOES rules.
-[179]- See supra notes 39-40 and accompanying text and
Part I.A.2.
==========================================START OF PAGE 84======
3. The NASD's Focus on the Examination and
Disciplining of SOES Firms
The NASD made enforcement of the SOES rules a
priority.-[180]- Planning documents of the District
offices expressly identified as a goal the "aggressive
enforcement of SOES rules," and various Market Surveillance
Department staff members devoted substantial time and effort to
enforcement of the SOES rules.-[181]- The Market
Surveillance Department established a dedicated telephone line
listed in the NASD Manual through which market makers and others
could register complaints about specific SOES
transactions.-[182]- Logs maintained by the NASD reflect
that market makers lodged hundreds of complaints regarding
alleged violations of the SOES rules. Many of these complaints
related specifically to trading by SOES firms and some were
---------FOOTNOTES----------
-[180]- The institution of a NASD disciplinary action
typically followed from an investigation by the
NASD's staff. If a matter appeared to warrant
formal disciplinary action, the staff brought it
before a NASD committee for review. District
office inquiries were reviewed by the District
Business Conduct Committee ("DBCC") and
investigations by the Market Surveillance
Department were reviewed by the Market
Surveillance Committee. If the respective
Committee decided to bring a formal disciplinary
action, a hearing was held in accordance with the
NASD's Code of Procedure. A decision adverse to
the respondent could be appealed to the National
Business Conduct Committee ("NBCC"), then to the
NASD Board of Governors and ultimately to the
Commission. A decision adverse to the staff could
not be appealed.
-[181]- The enforcement of the SOES rules was largely,
though not exclusively, within the domain of the
Market Surveillance Department and the Market
Surveillance Committee. The District offices
could investigate and prosecute violations of the
SOES rules, and they also provided assistance to
any inquiries being conducted by Market
Surveillance. Such assistance usually took the
form of conducting examinations of member firms,
accumulating and analyzing documents, and
testifying at subsequent disciplinary hearings.
-[182]- In contrast, no such effort was taken specifically
for complaints about late trade reporting or
market makers not honoring their quotations.
==========================================START OF PAGE 85======
relied upon as the basis for instituting investigations by the
NASD staff.-[183]- Complaints made by market makers to
other individuals at the NASD were also passed on to Market
Surveillance for possible review.-[184]- Senior Nasdaq
officers ensured that Market Surveillance followed up on the
complaints of market makers.
In a 1992 memorandum, a senior NASD executive wrote that the
market makers are "extremely frustrated and angry. Unless they
---------FOOTNOTES----------
-[183]- Two examples illustrate the NASD's responsiveness
to market maker complaints about SOES. In June
1994, a market maker complained to senior officers
of the Nasdaq market that a large number of SOES
trades in a single stock had been executed against
it by a particular SOES firm. NASD officials in
Washington, D.C. directed examiners at District 10
to conduct a highly unusual same day examination.
Moreover, all of the trades were cancelled by the
NASD as "clearly erroneous," pursuant to NASD
Uniform Practice Code 70. NASD Manual, Uniform
Practice Code, 70 (CCH) 3570 (1995).
A January 1991 report of the examination of another
SOES firm noted that "[t]he staff has continuously
received complaints from member firms that [name of
SOES firm] is abusing the Small Order Execution System
(SOES). Many of the firms allege that they had
received SOES orders from [name of SOES firm] in fast
moving markets and were disadvantaged by these orders."
An examination of the SOES firm was conducted even
though the complaints did not necessarily indicate
illegal activity. No evidence of wrongdoing was
uncovered and the matter was filed without action.
-[184]- Market makers lobbied the NASD to take
disciplinary action against SOES activists. An
April 1995 memo from the NASD Liaison Committee of
the STA reads:
There is considerable consternation in the
Street over what is perceived as the NASD's
inability to discipline "SOES firms" for
obvious violations of the Short Sale Rule.
The senior staff of Market Surveillance, the
Chairman of the Market Surveillance Committee
and the NASD President have been informed of
this growing resentment. Look for the NASD
to take some severe action in the near future
or else face a difficult situation with its market
makers.
==========================================START OF PAGE 86======
get some immediate relief the subject of SOES abuse is going to
come back to haunt us." One "possible measure" identified in the
memorandum is "immediate prosecution of SOES violations with
simultaneous suspension from SOES. I can't emphasize how
important this is. Even if we bring a precise, abbreviated
complaint that can get immediate relief, following up with a full
investigation with all i's dotted and t's crossed." This
memorandum was distributed to, among others, the two top NASD
executives with responsibility for the disciplinary process.
The NASD made substantial efforts to identify the SOES firms
and closely monitor their trading activity. SOES firms were
generally subjected to routine examination every
year.-[185]- At least one market maker provided an NASD
officer with a list of "SOES bandits" and this officer forwarded
the list to the Market Surveillance Department. A senior Market
Surveillance officer wrote the market maker to thank him for the
list and assured him that the NASD was familiar with the names on
the list. The letter encouraged the market maker to support the
1991 proposed rule amendments designed to limit SOES
"abuse."-[186]-
---------FOOTNOTES----------
-[185]- Routine examinations were conducted on one (Level
1), two (Level 2) or three or more (Level 3) year
cycles. Firms were classified as Level 1, 2, or 3
depending on various characteristics of the firm
and its business. SOES firms, along with other
types of firms, were considered Level 1 firms.
-[186]- The Market Surveillance Department began compiling
its own list of SOES firms in 1993. Firms were
placed on the list if computer generated reports
reflected that they frequently placed multiple
SOES orders in the same security within a short
time frame and that such orders were at or near
the maximum SOES tier size. These lists were
generated roughly every quarter during 1994. The
SOES firm lists were distributed to the
supervisors within the Market Surveillance
Department who were responsible for the
enforcement of the SOES rules, as well as to all
supervisors in the District Offices. The NASD
staff used the lists to identify firms for which
special SOES "sweep" exams were conducted. NASD
examiners would also examine firms for compliance
with the SOES rules during other special or
routine examinations if the firm's name appeared
on a SOES firm list. The Market Surveillance
Department did not utilize its data bases or
computerized surveillance capabilities to create
(continued...)
==========================================START OF PAGE 87======
At various times, the NASD conducted a coordinated series of
exams at SOES firms to look for potential SOES rule violations.
Such "SOES sweep exams" were often, but not exclusively, made
soon after amendments to the SOES rules. Thus, comprehensive
SOES sweep exams were conducted in January 1991, December 1991,
August 1992, and February 1994.-[187]- In addition, other
special SOES exams were conducted from time to time at individual
firms suspected of SOES rule violations.
The SOES sweep examinations in January 1991 were scheduled
to coincide with the beginning of the Persian Gulf war because
the NASD staff believed that the commencement of hostilities
might result in a severe market downturn. Examiners from
District 10 in New York City were dispatched to five SOES
firms-[188]- to look for improper short sale violations.
Although the examinations did not uncover any breach of the SOES
rules, the exam report discussed the trading habits of SOES
firms. The report noted that:
One common scenario is to sell short through SOES and
cover through SELECTNET. The SELECTNET leg is
advantageous to the firm because when an initial bid or
offer is placed into the system, the identity of the
firm is not disclosed until the trade is consummated.
Since some of these firms [the SOES firms] have created
"enemies" on the street, they might otherwise have
difficulty executing transactions with the same market
makers they may have previously "picked off" through
SOES.
The report reflects that it was distributed to senior supervisors
---------FOOTNOTES----------
-[186]-(...continued)
lists of market makers that were frequently late
in reporting trades or had possibly failed to
honor their quotations with respect to preferenced
SelectNet orders. Market Operations personnel did
not maintain records sufficient to allow the
creation of lists of market makers that frequently
requested excused withdrawals. Moreover, during
the relevant period the NASD did not conduct sweep
examinations of market makers with respect to
compliance with the trade reporting, firm quote,
or excused withdrawal rules.
-[187]- Sweep exams are an effective tool to ensure rule
compliance and the Commission has effectively used
such exams in the past.
-[188]- These firms were described in a NASD memorandum as
"potential SOES rules violators."
==========================================START OF PAGE 88======
in District 10 and the Market Surveillance Department. While the
exam report indicated that some market makers were apparently
backing away from their quotes, no follow-up investigation of
such backing away was ever instituted.
A second SOES sweep examination was conducted in December
1991 to detect violations of the recent amendments to the SOES
rules which broadened the definition of a professional trading
account. District 10 examined nine SOES firms selected by the
Market Surveillance Department. The comprehensive examination
and subsequent analysis of documents consumed a great deal of
District 10's examination resources during the relevant time
period. These examinations ultimately led to the designation of
PTAs at three SOES firms.-[189]-
In one instance, the NASD instituted an accelerated
enforcement proceeding against a SOES firm. A senior NASD
enforcement officer sent a congratulatory letter to the Market
Surveillance Department staff members who worked on this
proceeding which stated that "there is no better service quality
we could have provided to our market maker customers and the
individual investor." (Emphasis added.)-[190]-
The NASD conducted another SOES sweep examination in
February 1994, concentrating on compliance with the recently
enacted interim SOES rules. A list of SOES firms created by the
Market Surveillance Department, distributed to prepare for a
January 1994 planning meeting at the NASD's District 10 offices,
was used to select the six firms examined by NASD staff.
Disciplinary actions for violations of the short sale
prohibitions of the SOES rules were brought against four of these
firms.
In addition, the NASD designated a number of PTAs arising
out of special examinations of individual firms. In all such
cases, the accounts designated were maintained at SOES firms.
The NASD did not conduct special examinations of any non-SOES
firms for possible PTA designation.
The Market Surveillance Department did not have objectively
defined benchmarks or guidelines with which to determine if an
---------FOOTNOTES----------
-[189]- One of the accounts designated as a PTA was that
of Geraldine and William Timpinaro. It was this
designation which led to the litigation
challenging the validity of the PTA rules and
their subsequent repeal.
-[190]- This emergency remedial proceeding was only one of
two such proceedings ever brought by the NASD.
==========================================START OF PAGE 89======
account was a PTA.-[191]- In addition, the Chairman of
the Market Surveillance Committee (a trader who made markets on
Nasdaq) was responsible for approving all proposed PTA
designations. The identity of the firm where the accounts in
question were maintained was disclosed in every case to the
Chairman during his deliberations.-[192]- A procedure of
this type creates the potential for disparate treatment.
In sum, the NASD placed substantial emphasis on enforcement
of the SOES rules. At the same time, rules applicable to market
makers were enforced with considerably less vigor and scrutiny.
The NASD should have ensured a better balance in its enforcement
activities and maintained evenhandedness consistent with its
obligation to employ a fair procedure for disciplining its
members.
4. Application of Standards and Criteria for
Admission to Membership
The NASD, particularly District 10 in New York, used the
admissions process to limit the admission and activities of
potential SOES firms.-[193]-
---------FOOTNOTES----------
-[191]- In its release approving the amendment of the PTA
rule, the Commission addressed the issue of the
generality of the rule by stating that "[w]hile
the NASD will have discretion to determine exactly
what is `excessive' and to determine based upon
these factors which accounts are professional
trading accounts, the NASD is required to act
fairly and reasonably." Exchange Act Release No.
29,809 (Oct. 10, 1991). The facts uncovered in
the Commission's investigation indicate that this
discretion appears not to have been properly
exercised.
-[192]- The deficiencies in these procedures were
compounded by participation in the process of a
market maker with an economic interest in the
outcome. In another matter, the Commission
reversed an NASD disciplinary proceeding because
the presiding panel included individuals whose
employer firms were involved in certain of the
transactions at issue in the proceeding. In the
Matter of Datek Securities Corp. and Sheldon
Maschler, Exchange Act Release No. 32,560 (June
30, 1993).
-[193]- This District Committee consisted largely of
representatives of firms that made markets.
==========================================START OF PAGE 90======
Applications for membership by new SOES firms did not become
a major concern of the NASD until 1993. Before 1993, admissions
to membership were handled by the various District Committees,
with the assistance of the District staff. For example, in
District 10, there was a staff pre-membership section composed of
several examiners and a staff supervisor devoted to processing
applications for membership.-[194]- The prospective
member was required to submit financial and other information to
the pre-membership section and a pre-membership interview ("PMI")
was held.-[195]- After the PMI, the application and the
staff's recommendation were submitted to the full District
Committee for final approval.-[196]-
In May 1993, District 10 created an ad hoc PMI Subcommittee
and delegated to it full authority from the District Committee to
make the final determination on membership
applications.-[197]- The minutes of the May 19, 1993
District Committee meeting note that one of the principal reasons
for the creation of the new PMI Subcommittee was to provide for
---------FOOTNOTES----------
-[194]- Between 1993 and 1995, approximately three-
quarters of all SOES firms were situated in
District 10, according to NASD lists of SOES
firms.
-[195]- See NASD Manual Section C to the By-Laws, Part I,
(1), (CCH) 1783 (1995).
-[196]- Before 1994, there was a conflict between Article
III of the NASD's By-Laws and Schedule C to the
By-Laws as to whether the District Committee or
the NASD staff made the initial determination to
admit or deny membership. Article III of the By-
Laws invested such authority in the District
Committee, while Schedule C implied that the staff
made the initial decision. The common practice of
the NASD before 1993 was for the District
Committee to make the ruling. The conflict was
resolved by amendments to the By-Laws and Schedule
C effective July 20, 1994, that gave such power to
the District Committee or to a pre-membership
subcommittee, if the District Committee designated
such a subcommittee. NASD Notice to Members 94-
22, Apr. 1994.
-[197]- The denial of membership can be appealed to the
District Committee, the NBCC, the NASD Board of
Governors, and then to the Commission. NASD
Manual, Schedule C to the By-Laws, Part I, (2)
(CCH) 1783 (1995) and Exchange Act, 19(d)(2),
15 U.S.C. 78s(d)(2) (1994).
==========================================START OF PAGE 91======
"enhanced review" of new applications. In a September 29, 1993
meeting of the District Committee, several members of the
Committee expressed an interest in finding out under what
circumstances an application could be rejected. The NASD staff
was asked to prepare a set of guidelines for the denial of
membership in the association and a District 10 supervisor
developed a one page set of guidelines.
The guidelines were distributed and discussed at the
November 17, 1993 meeting of the District Committee. At the
meeting, the staff member who drafted the guidelines stated that
he was trying to capture the concerns previously expressed by the
Committee. One of the proposed guidelines would have denied
membership to:
Owners, control persons or principal officers who have
been recently employed by a known SOES activist and who
have indicated an interest in being a SOES activist
themselves. This interest would be evidenced by
conducting business predominately on a retail agency
basis and the request to have pieces of equipment with
SOES capabilities that is close in number to RR's
[registered representatives] that the firm intends to
employ.
While there was a general consensus at the meeting that this and
other guidelines were a good idea, and should be used by the PMI
Subcommittee, an NASD lawyer opined that this guideline went
beyond the provisions noted in Schedule C to the By-Laws
regarding the denial of membership.-[198]- The director
of District 10 did not authorize the use of this guideline, based
on the attorney's advice. Even though not adopted as official
policy, a copy of the guidelines was provided to the supervisor
of the PMI section of District 10 without an explanation of the
attorney's advice, and the supervisor applied this particular
SOES-related guideline to new applicants along with the other
guidelines in identifying issues for the PMI Subcommittee to
consider.-[199]-
---------FOOTNOTES----------
-[198]- The other guidelines were unrelated to SOES.
-[199]- Less than one month after the November 17, 1993
District Committee meeting, the one page set of
guidelines was faxed to a meeting of the NASD's
Advisory Council (which consists of members of all
the District Committees and provides general
recommendations to the Board of Governors on
various issues) at the request of a District 10
Committee member attending the Advisory Council
meeting. Among other issues, the Advisory Council
(continued...)
==========================================START OF PAGE 92======
The minutes of the September 29, 1993 District Committee
meeting note that the director of District 10 suggested that the
PMI Subcommittee take "an aggressive posture" with respect to
membership applications. This "aggressive posture" manifested
itself, in part, in the identification of applicants who were
perceived as potential new SOES firms, the undue delay of some of
these membership applications, and the imposition of a variety of
restrictions on their SOES trading.
A number of perceived likely SOES firms were effectively
hindered or delayed in their efforts to seek NASD membership. At
the direction of the PMI Subcommittee, the District 10 staff
created a list of applicants that were of "regulatory concern."
The PMI Subcommittee's belief that the applicant intended to be a
SOES firm was a reason for including the firm on the "regulatory
concern" list.-[200]- Some applicants perceived as likely
SOES firms who were placed on the list experienced lengthy delays
in the processing of their membership applications,-[201]-
and at least one applicant abandoned the process due to a lengthy
delay. Other applicants perceived as likely SOES firms included
in the "regulatory concern" list were often required to accede to
various limitations on their SOES trading activities.
---------FOOTNOTES----------
-[199]-(...continued)
discussed Schedule C to the By-Laws and the need
for uniform criteria for NASD membership. The
guidelines distributed to the Advisory Council
meeting still included SOES activism as grounds
for denial of membership, and there was no
indication that an NASD attorney had advised
against the use of this criterion. The Advisory
Council made no recommendation that this guideline
be adopted as official policy.
-[200]- Likely SOES usage was generally not the only
reason for placing a particular applicant on the
regulatory concern list and many applicants were
placed on the list for reasons other than likely
SOES usage. Even though the Regulatory Concern
List did not include only potential SOES firms,
the identification of likely SOES usage in the
application process and the inclusion of SOES-
related restrictions in the restriction agreements
of certain applicants was inappropriate, as is
discussed further in the text.
-[201]- Lengthy delays are contrary to the provisions of
Schedule C, Part I 1(b) of the By-Laws, which
requires a reasonable review period. NASD Manual,
Schedule C to the By-Laws, Part I, 1(b) (CCH)
1783 (1995).
==========================================START OF PAGE 93======
The PMI Subcommittee curtailed the ability of certain firms
to use the SOES system. The NASD expressly conditioned
membership on certain firms' acceptance of substantial
limitations on its SOES trading activity. These restrictions
included, in certain circumstances, outright prohibitions on the
use of SOES, limitations on the number of SOES terminals
available to the firm, and restatement in the membership
agreement of the order splitting-[202]- and professional
trading account rules.-[203]-
Established SOES firms which sought modification of existing
restriction agreements also faced obstacles. The NASD applied an
informal policy to prevent firms from seeking modifications of
any restrictions by conditioning membership on the requirement
that the firm forbear from seeking modifications for six months
to one year, despite NASD rules permitting a firm to seek a
modification at any time.-[204]- NASD documents indicate
that all SOES-related restrictions had to be approved by a
District 10 subcommittee (unlike other restrictions) and that no
changes in SOES related restriction agreements were granted in
late 1993.
The restrictions discussed above were inconsistent with the
NASD's rules concerning the membership application
---------FOOTNOTES----------
-[202]- For some firms, the time period in which orders
would be aggregated was expanded beyond five
minutes provided by NASD rule to, for example,
seven minutes.
-[203]- The inclusion of the PTA rules in members'
restriction agreements had the effect of
increasing the sanctions that could be imposed for
violations of the rules. Violations of the PTA
rules now subjected the firms to potential loss of
their NASD membership, a greater sanction than any
set forth in the NASD Sanction Guidelines.
Without such provisions in the restriction
agreements, violations of the PTA rules would only
prevent the customer account involved from further
SOES trading. Particularly troubling is the fact
that PTA restrictions were retained in restriction
agreements as much as eighteen months after the
PTA rules were repealed.
-[204]- NASD Manual, Schedule C to the By-Laws, Part I,
3, (CCH) 1783 (1995).
==========================================START OF PAGE 94======
process.-[205]- Furthermore, Sections 15A(b)(3) and
15A(g) of the Exchange Act-[206]- together prescribe the
bases on which membership or access to services may be denied by
the NASD, and require that certain standards for denial, such as
those applied to potential SOES firms, be defined in the rules of
the NASD. Some of the criteria applied to potential SOES firms
were not defined in the NASD's rules, nor were they set forth in
any filing with the Commission for notice and comment pursuant to
Section 19(b)(2) of the Exchange Act,-[207]- as would be
required for the adoption of a rule.
Although the NASD may have had concerns over potential rule
compliance or disciplinary history issues with respect to certain
applicants, the use of the SOES system, by itself, was legally
permissible and could not serve as the basis for heightened
regulatory scrutiny. Restriction agreements cannot be used to
subject member firms to potential loss of their membership for
violations of the Professional Trading Account or other rules
simply because these firms are believed to be likely to sponsor
use of the SOES system. Applicants are permitted to seek to
modify or remove restrictions upon written application under
Schedule C of the NASD By-laws, and cannot be denied that
opportunity as a condition to NASD membership. The imposition of
the restrictions described herein and the ad hoc manner in which
they were applied was an inappropriate exercise of regulatory
discretion by the NASD, and underscores the need for structural
change of the membership application process.
The NASD's staff should have the sole authority to handle
approval of membership applications and the conditions and
limitations that can be placed thereon. Written standards for
denial or limitation of membership applications should be
promulgated and filed with the Commission pursuant to Section
19(b) of the Exchange Act. The PMI Subcommittee, and its parent,
the District Committee, should no longer have any involvement in
individual membership applications, as prevailing practices have
too readily allowed for the interjection of improper criteria
into the membership application process.
---------FOOTNOTES----------
-[205]- 15 U.S.C. 78s(g) (1994). The NASD rules
governing membership applications are set forth in
the NASD By-Laws. NASD Manual, Schedule C to the
By-Laws, Part I (CCH) 1783 (1995).
-[206]- 15 U.S.C. 78o-3(b)(3) and 78o-3(g) (1994).
-[207]- 15 U.S.C. 78s(b)(2) (1994).
==========================================START OF PAGE 95======
B. The NASD's Laxity in Rule Enforcement
The NASD has been lax in enforcing rules applicable to
market makers and other significant constituents. This is
illustrated by its inadequate enforcement of the firm quote rule
and the trade reporting rules discussed earlier, and is further
exemplified by the following.
1. The NASD's Failure to Enforce the Excused
Withdrawal Rules
NASD rules require each member firm to enter and maintain
two-sided quotations on a continuous basis for every Nasdaq
security in which the member firm is registered as a market
maker.-[208]- The NASD has failed to enforce adequately
the mandatory suspension penalties applicable to Nasdaq market
makers that do not maintain continuous quotations in accordance
with these rules.
Under the rules, a member firm that withdraws its quotations
in a particular security must also withdraw as a market maker in
that security for a twenty-day period. An exception may be
granted if the market maker obtains excused withdrawal status
from the NASD prior to withdrawing its quote.-[209]-
Excused withdrawals may be granted only for the specific reasons
enumerated in the rule.-[210]- In addition, a market
maker that does not "refresh" its quote in a security within a
five-minute period after its SOES exposure limit has been
exhausted will be deemed to have withdrawn as a market maker in
that security for twenty- business days (a "SOES
withdrawal").-[211]- The SOES rules provide that a market
---------FOOTNOTES----------
-[208]- See NASD Manual, Schedule D to the By-Laws, Part
V, 2(a) (CCH) 1819 (1995).
-[209]- See NASD Manual, Schedule D to the By-Laws, Part
V, 8 (CCH) 1824 (1995).
-[210]- The reasons include (1) physical circumstances
beyond the market maker's control, such as
computer problems, bomb threats, or fires; (2)
demonstrated legal or regulatory requirements,
such as trading restrictions pursuant to Rule 10b-
6 of the Exchange Act or in cases in which the
market maker is in possession of material
nonpublic information; (3) religious holidays; or
(4) vacation.
-[211]- See NASD Manual, Rules of Practice and Procedure
for the Small Order Execution System, Rule c(2)(G)
(continued...)
==========================================START OF PAGE 96======
maker that obtains excused withdrawal status from the NASD, prior
to withdrawing from SOES, is not subjected to the twenty-day SOES
suspension.-[212]-
The NASD began routinely to grant waivers for SOES
withdrawals for reasons outside the scope of the rules. This
practice has allowed market makers that failed to refresh their
quotes after their SOES exposure was exhausted to avoid the
requisite twenty-day suspension. Until 1995, the practice of
Nasdaq Market Operations-[213]- was to grant SOES
withdrawal waivers as a matter of course without inquiring into
the reasons for the withdrawals.-[214]- A market maker
---------FOOTNOTES----------
-[211]-(...continued)
(CCH) 2460 (1995). See also Exchange Act
Release No. 25791 (June 9, 1988), 53 Fed. Reg.
22594 (June 16, 1988) n.9.
-[212]- See NASD Manual, Rules of Practice and Procedure
for the Small Order Execution System, Rule c(2)(H)
(CCH) 2460 (1995).
-[213]- Nasdaq Market Operations is responsible for
processing excused withdrawals and waivers.
-[214]- A taped conversation between an operations clerk
in Nasdaq Market Operations and a trader
exemplifies this practice:
Trader: Hey it's [trader's name] from [firm]. How
you doing?
Clerk: Alright. Yourself?
Trader: Good and not so good. I got suspended in
Apple. The trader's assistant's out and
we're a little short on the desk, I'm
calling from [firm name].
Clerk: [firm symbol]?
Trader: Yeah.
Clerk: Okay, I'll put you back in.
Trader: And I'm, I'm going to update it so it's, so
it's a greater amount.
Clerk: [unclear] See, the thing is not what you're
doing as far as upping. The thing is,
(continued...)
==========================================START OF PAGE 97======
merely had to request the waiver and Nasdaq Market Operations
granted it. Beginning in 1995, Nasdaq Market Operations started
to make some inquiry into the reasons for the SOES withdrawals,
granting waivers based upon an examination of four
factors.-[215]- These factors, however, are not generally
relevant to the acceptable reasons, as articulated in the rules,
for granting excused withdrawal status.-[216]- Nor were
these factors included in any filing made by the NASD with the
Commission pursuant to Section 19(b) of the Exchange Act, as
amendments or interpretations of its rules. The NASD has
continued to grant waivers for reasons other than those listed in
the applicable rules,-[217]- allowing market makers to
avoid suspension penalties.
There are other significant problems with the NASD's excused
withdrawal program. The NASD has not maintained appropriate
databases to record waivers and excused withdrawals, compromising
its ability to identify market makers that make excessive
requests or to supervise its own staff to determine if they are
properly granting excused withdrawals. It did not consistently
---------FOOTNOTES----------
-[214]-(...continued)
somebody's got to watch out, because . . .
the thing is, we're not supposed to be doing
this.
Trader: Right, Right.
-[215]- The factors are (1) the timeliness of the market
maker's call to Market Operations; (2) the
volatility of the stock; (3) the liquidity of the
market and the number of market makers in the
stock; and (4) the number of Nasdaq terminals at
the market maker to which the orders could be
routed (which was relevant in cases where the
market maker requested an excused withdrawal due
to mechanical or electronic failure of a Nasdaq
terminal).
-[216]- See NASD Manual, Schedule D to the NASD By-Laws,
Part V, 8(b) (CCH) 1824 (1995), which states
in part: "[t]he withdrawal of quotations because
of pending news, a sudden influx of orders or
price changes, or to effect transactions with
competitors shall not constitute acceptable
reasons for granting excused withdrawal status."
-[217]- For example, market makers were granted waivers
after their SOES exposure was exhausted because
they were away from their desk, working another
order, or covering another trader's stocks.
==========================================START OF PAGE 98======
verify the validity of the excuses offered by market makers
requesting the excused withdrawal or waiver, and lacked any
mechanism to track market makers who frequently made such
requests. In numerous instances, market makers requested and
were granted such withdrawals without providing the notice to the
NASD required by the rules.-[218]-
The NASD's failure to enforce its excused withdrawal rules
has fostered an environment that allowed market makers to avoid
their responsibilities to maintain continuous quotes in the
securities in which they made markets. Market makers were able
to withdraw voluntarily from SOES beyond the permitted five-
minute window, or otherwise withdraw from the market during
periods of volatility without substantial risk that the NASD will
enforce a twenty-day suspension.-[219]- This undermines a
fundamental premise of the dealer market: that market makers
stand willing to buy and sell securities at all times. Allowing
market makers to evade this responsibility reduces liquidity in
the market and threatens the ability of investors to execute
trades.
The NASD did not place administration of the excused
withdrawal rule in its enforcement or regulatory staff, but
rather in its Market and Trading Services staff. That laxity in
the application of market making rules occurred in an area other
than the NASD's enforcement or regulatory staff is indicative
that the NASD's ongoing efforts to reform should extend to all
employees who may affect the self-regulatory
process.-[220]-
---------FOOTNOTES----------
-[218]- The rules require five days advance notice to the
NASD for excused withdrawal requests for religious
holidays and twenty days advance notice for
excused withdrawal requests for vacation.
-[219]- The suspension was increased from two to twenty
days in the aftermath of the 1987 market break
because of findings by the Brady Commission, the
SEC, and the NASD that market makers simply
withdrew from the market. See supra note 141.
-[220]- Relegating the administration of the excused
withdrawal rule to the NASD's Operations staff in
its Trumbull, Connecticut facility raises certain
issues. Although the excused withdrawal rule
relates to the operation of the market, it is
nevertheless a rule and should be administered
from a regulatory standpoint. All rules, whether
categorized as disciplinary or operational, must
be administered objectively and impartially. The
(continued...)
==========================================START OF PAGE 99======
The failure of the NASD to enforce the letter and spirit of
the excused withdrawal rules made it possible for market makers
routinely to avoid their responsibilities to make markets and
provide liquidity, without being penalized. This approach to
enforcement of the excused withdrawal rules was inappropriate in
light of the NASD's responsibilities to maintain the integrity of
the Nasdaq market.
2. The NASD's Inadequate Enforcement of MSRB Rule
G-37
The results of an inspection by the Commission staff of the
NASD's enforcement of Municipal Securities Rulemaking Board Rule
G-37 ("Rule G-37") further highlight the lack of balance in the
NASD's self-regulatory activities. Rule G-37 was adopted in
April 1994, and prohibits any broker, dealer, or municipal
securities dealer from engaging in municipal securities business
with a municipal securities issuer if it or certain persons
associated with or controlled by it contributes more than $250 (a
"relevant contribution") to any person who can influence the
award of municipal securities business with that
issuer.-[221]- The NASD is responsible for overseeing
compliance with Rule G-37 by its members.-[222]- An SEC
inspection of the NASD's program to oversee compliance with Rule
G-37 identified several deficiencies in the program.
The MSRB's rule changes were controversial and highly
publicized, and results of the inspection indicated that the NASD
did not implement in a timely and effective manner Rule G-37
---------FOOTNOTES----------
-[220]-(...continued)
persons administering the operational rules must
be especially mindful of the need to be evenhanded
and dispassionate, since these rules are
administered with fewer procedural safeguards than
the disciplinary rules (e.g., investors injured by
a reduction in liquidity due to non-enforcement of
the excused withdrawal rule have no means of
learning of violations or seeking relief). As is
the case with the regulatory staff, the persons
administering operational rules must have
regulatory training and must follow regulatory
procedures.
-[221]- The prohibition lasts for two years after the
relevant contribution. See Exchange Act Release
No. 33868 (Apr. 7, 1994), 59 Fed. Reg. 17621 (Apr.
13, 1994).
-[222]- Section 15B(c)(7) of the Exchange Act. 15 U.S.C.
78o-4(c)(7) (1994).
==========================================START OF PAGE 100======
examination modules, procedures, and sanction guidelines.
Examination modules and procedures were distributed to the
District Offices charged with conducting examinations up to ten
months after Rule G-37 went into effect. Specific sanction
guidelines were given to District Offices approximately 17 months
after the Rule's effective date. The examination modules for
Rule G-37 reviews were inadequate.-[223]- For example,
the modules were confined to a review of the examined firm's
books and records. Individual contributions by associated
persons of a firm may not be revealed by such a limited
exam.-[224]-
The NASD's surveillance program to detect non-compliance
with Rule G-37 also was deficient. It did not include any
effective mechanisms to identify firms that failed to file
requisite forms,-[225]- firms that engaged in municipal
securities underwriting business within two years of a relevant
contribution, or municipal finance professionals that made
political contributions. In addition, the NASD's computerized
complaint system did not classify complaints related to the Rule,
making it difficult to track and investigate such complaints.
When violations of the Rule were presented to the NASD, it
failed to take sufficiently strong action against members who
violated Rule G-37. The NASD allowed a grace period for firms to
comply with the Rule, and permitted firms to file late Form G-37
filings and revise inadequate written supervisory procedures
prior to the close of examinations, thereby avoiding even
informal sanctions. In addition, the NASD construed the
exemptive relief provisions of the Rule too broadly and granted
---------FOOTNOTES----------
-[223]- The modules cover recordkeeping and filing
requirements related to the Rule, written
supervisory procedures, procedures for the use of
consultants, and bans on municipal activity or
exemptions from the Rule.
-[224]- Outside sources of information would include
lobbying registration reports filed with state
authorities, PAC filings, minutes of meetings held
by issuers of municipal bonds underwritten by the
firm, and campaign and election records.
-[225]- Rule G-37(e)(i) requires all brokers, dealers, or
municipal securities dealers to file with the
Municipal Securities Rulemaking Board quarterly
reports of political contributions on Form G-37.
==========================================START OF PAGE 101======
such relief inappropriately.-[226]- No minutes were
prepared for the meetings of the Executive Committee of the NASD
Board at which exemptions were granted. Thus, the bases for such
exemptions were inadequately documented.
Rule G-37 was adopted over the objections of numerous
municipal securities underwriters. The NASD, whose members
include the nation's leading municipal securities underwriters,
failed to implement its enforcement of the Rule adequately. This
failure reinforces concerns that the NASD is reluctant to enforce
rules against the major constituencies of its membership.
C. Other Areas of Regulatory Concern
1. Authority of District Business Conduct Committees
Much of the ability of market makers to influence
disciplinary actions was attributable to their participation in
the District Business Conduct Committees ("DBCC's"). The DBCC's
have a dual role in the disciplinary process. First, they have a
"grand jury" function, in which the NASD staff must seek their
authorization before it can proceed with an enforcement action.
Secondly, they serve as an adjudicatory body, deciding the
outcome of litigated enforcement actions and approving
settlements. The grand jury function is of particular concern,
because it provides firms that make markets with a preliminary
opportunity to influence the process. As described above, such
firms have inappropriately used their influence on the NASD's
committee structure to advance their interests. Meaningful self-
regulation does not require that industry representatives have a
grand jury function. The adjudicatory role of the DBCC provides
them with a powerful and central role in the operation of the
NASD. In order to promote the objectivity and impartiality of
the disciplinary process, the DBCC's should no longer have a
grand jury function. Similarly, the Market Surveillance
Committee, which has had a similar grand jury function with
respect to actions proposed by the staff of the NASD's Market
Surveillance Department, should no longer retain that function.
2. The Excess Spread Rule
As discussed above, one initiative undertaken by the NASD to
address the issue of wide spreads on Nasdaq was to implement a
rule against excessive market maker spreads. This measure,
however, has had certain undesirable effects. The "excess
---------FOOTNOTES----------
-[226]- On June 3, 1994, Rule G-37 was amended to provide
procedures for dealers to seek exemptive relief
from the Rule. Exchange Act Release No. 34160
(June 3, 1994), 59 Fed. Reg. 30376 (June 13,
1994).
==========================================START OF PAGE 102======
spread" rule requires that market makers input quotes with dealer
spreads no greater than 125% of the average dealer spread of the
three market makers having the narrowest dealer spreads in each
security listed in Nasdaq.-[227]- The maximum width of a
market maker's spread in a particular security is thus dependent
upon the spreads quoted by other market makers in the stock. The
interdependence of quotes mandated by the rule may deter market
makers from narrowing their dealer spreads, because, once the
spread is tightened, the rule in some instances precludes a
market maker from widening the spread to earlier levels.
For example, if a stock is uniformly quoted with 3/4 of a
point dealer spreads, and a market maker narrows its dealer
spread from 3/4 of a point to 1/2 of a point, and two other
dealers match the 1/2 of a point dealer spread, no market maker
in the stock can enter a dealer spread greater than 5/8 of a
point. Thus, the market maker that initiated the narrower spread
cannot return to quoting the stock with a 3/4 of a point dealer
spread.-[228]- In these circumstances, a market maker may
refrain from initiating a narrower dealer spread in order to
avoid being locked in at a 1/2 of a point dealer spread.
In addition, the interdependence of dealer spreads created
by the excess spread rule establishes an economic incentive for
market makers to discourage one another from narrowing their
dealer spreads.-[229]- Market makers may be required to
narrow their dealer spreads, not because they believe it to be
economically appropriate, but because the excess spread rule
---------FOOTNOTES----------
-[227]- A market maker is not required to quote less than
a $1/4 spread in any security. NASD Manual,
Schedule D to the By-Laws, Part V, 2(c) (CCH)
1818 (1995).
-[228]- In a taped conversation between two Nasdaq
traders, one trader discussed the narrowing of
spreads following the Bear Stearns meeting and the
problems created by the excess spread rule:
Nightmare, you know. The one thing, too is
that if people close them up and now with
these new . . . excessive spread things and
there's there is no way to open them back up
again. . . . So now you've closed them up and
we can't, and there's no way to open them up
again. So everyone's ******.
-[229]- The NASD recognized the possibility that the rule
could encourage collusion among market makers.
See note 60 and accompanying text.
==========================================START OF PAGE 103======
forces them to follow the lead of other market
makers.-[230]- Rather than follow the lead of a market
maker that narrows its spread, market makers may attempt to
convince that market maker to widen its spread back out.
The stated purpose of the rule was to prevent market makers
from disseminating quotations that were always outside the inside
spread and receiving a certain amount of order flow at little
risk to themselves. However, it has had undesirable effects,
creating incentives for market makers to avoid narrowing the
quotes and to urge other market makers to avoid narrowing the
quotes. Thus, the excess spread rule may interfere with the free
flow of prices in the market and impede attempts by the market to
reach the optimal competitive spread. It may also create
incentives for market makers to collaborate, which is
particularly undesirable in light of the evidence of
inappropriate collaboration described herein. Hence, the
Commission has sought and obtained the NASD's commitment in the
settlement of the enforcement action brought concurrently with
the issuance of the Report, to modify the rule to eliminate its
undesirable effects, or to repeal it.
3. The Contested Election Process
In the Report issued by the Rudman Committee in its review
of the NASD's operations, the Committee discussed the NASD's
District Nominating Committee and made particular reference to a
contested election in 1994 in District 10.
The Rudman Committee stated:
[The NASD] addressed issues that arose on an ad hoc
basis, and generally handled the election
inappropriately -- particularly insofar as NASD staff
appeared to take sides in the matter. NASD officials
have acknowledged that the election was
mishandled.-[231]-
The gist of the Rudman Committee's concerns arose out of two
letters sent by the District 10 Nominating Committee, the first
---------FOOTNOTES----------
-[230]- In one conversation, one trader tells another
trader:
Two years ago [before the excess spread rule
was changed], 3 guys did it [broke the
spread], it didn't matter, 'cause we'd all
stay at 3/4. Now, we have no choice, we have
to follow them.
-[231]- Rudman Report at III-16.
==========================================START OF PAGE 104======
of which was on NASD letterhead, endorsing the candidacy of one
person over the challenger. In addition, volunteers recruited by
the NASD's District Nominating Committee actively campaigned in
support of the successful candidate.
The NASD's By-Laws only specifically authorize the
Nominating Committee to select the regular candidate. The NASD,
its committees and its staff should not in any way exhibit
favoritism or partiality in such elections.
4. The Audit Trail
In the course of the investigation, the Commission staff
encountered significant difficulties reconstructing activity in
the Nasdaq market. Broker-dealer order tickets, among the most
fundamental of records, were too often unavailable or
inconvenient to retrieve. Timestamping was often unreliable for
the purposes of determining compliance with applicable rules,
such as the firm quote rule and limit order protection
rules.-[232]-
A further difficulty was the inadequate documentation of
telephone orders received at OTC trading desks. As noted above,
order tickets, if they were available at all, were not always
reliably timestamped. Having reliable and accurate records of
telephone orders is crucial to evaluating a market maker's
compliance with the firm quote rule and trade reporting rule.
Because telephone orders and transactions are a significant part
of the activity in the Nasdaq market, the documentation of these
orders and transactions is essential to adequate surveillance and
compliance in the market.
The NASD has automated surveillance capabilities with
respect to its current audit trail, although it has not
consistently maintained adequate routine automated surveillance
capabilities over the audit trail. Its surveillance and
enforcement responsibilities with respect to market conduct have
increased substantially in recent years. The adoption of limit
order protection rules in 1994 and 1995, and the frequency of
backing away from quotations and late trade reporting revealed by
this investigation, all indicate the need for an improved
surveillance capability. In light of the high volume of trading
on today's Nasdaq market and the dispersed nature of that market,
these rules cannot be efficiently enforced through current NASD
examination techniques, such as time consuming on-site
inspections and analysis of hard copies of order tickets and
other records. Automated surveillance is essential if these
---------FOOTNOTES----------
-[232]- At one firm, the timestamping did not include
seconds, which particularly frustrated the
Commission's ability to reconstruct the market.
==========================================START OF PAGE 105======
rules are to be effectively enforced. This surveillance
capability can only be implemented with an improved audit trail.
Hundreds of millions of shares trade every day on Nasdaq,
and effective regulation of this market requires a comprehensive
centralized and computerized recordkeeping system. Surveillance
methods employed in this market must keep pace with the rapidity
of trading done with computer technology. A comprehensive audit
trail, beginning with the time an order is placed and continuing
to record the life of the order through the process of execution,
is essential to maintaining the integrity of the Nasdaq market.
Such an audit trail would feature the computerized recordation of
the time and terms of an order, and of the sequence of steps
taken to execute the order. By providing these details, the
enhanced audit trail would allow for prompt surveillance on a
scale that cannot be attained with traditional methods of
examination. It would greatly facilitate the ability of the NASD
and the Commission to protect the interests of investors and
promote the best execution of their orders. In view of the
deficiencies in the Nasdaq market uncovered in this
investigation, substantial improvement to the audit trail is
crucial to market reform. As set forth in the NASD's
undertakings in the concurrent administrative proceeding, and as
discussed in the Report, the NASD has undertaken to design and
implement an audit trail sufficient to reconstruct markets
promptly, surveil them effectively and enforce its rules.
* * * * *
Last Reviewed or Updated: Aug. 31, 2023