Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the NASDAQ Market
July 6, 2023
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Report Pursuant to Section 21(a)
of the Securities Exchange Act of 1934
Regarding the NASD and the NASDAQ Market
TABLE OF CONTENTS
Page
I. INTRODUCTION AND SUMMARY . . . . . . . . . . . . . . . . 1
II. CONCURRENT COMMISSION ENFORCEMENT ACTION . . . . . . . . 5
III. REMEDIAL MEASURES IMPLEMENTED BY THE NASD . . . . . . . 5
IV. SELF-REGULATION IN THE OTC MARKET . . . . . . . . . . . 6
A. The NASD and the OTC Market . . . . . . . . . . . . 6
B. The Nasdaq Stock Market . . . . . . . . . . . . . . 9
C. Commission Oversight of the NASD . . . . . . . . . 9
D. Governance of the NASD . . . . . . . . . . . . . . 9
1. The Pre-Investigation Structure
of the NASD . . . . . . . . . . . . . . . . . 9
2. The Rudman Committee's Review . . . . . . . . 11
V. THE COMMISSION'S INVESTIGATION . . . . . . . . . . . . . 12
VI. PROBLEMS OF THE NASDAQ STOCK MARKET . . . . . . . . . . 14
A. Impediments to Price Competition . . . . . . . . . 14
1. Importance of Competition . . . . . . . . . . 14
2. Price Quotations in Nasdaq . . . . . . . . . . 14
3. The Nasdaq Pricing Convention . . . . . . . . 17
4. The Nasdaq Size Convention . . . . . . . . . . 24
5. Effect of the Pricing and Size Conventions . . 25
B. Coordination of Quotations, Trades, and
Trade Reports . . . . . . . . . . . . . . . . . . . 26
C. The Exchange of Proprietary Information . . . . . . 30
D. Collaboration in the Nasdaq Market . . . . . . . . 32
E. Failure to Honor Quotations . . . . . . . . . . . . 32
F. Late Trade Reporting . . . . . . . . . . . . . . . 33
VII. THE NASD'S PERFORMANCE AS AN SRO . . . . . . . . . . . . 35
A. The NASD's Awareness of the Nasdaq
Pricing Convention . . . . . . . . . . . . . . . . 35
1. Events in 1990 . . . . . . . . . . . . . . . . 35
2. Events in 1992 . . . . . . . . . . . . . . . . 36
3. Post-1992 Developments . . . . . . . . . . . . 37
B. The NASD's Regulatory Deficiencies . . . . . . . . 40
1. Market Maker Influence . . . . . . . . . . . . 40
2. The Undue Influence of Market Makers
in the Disciplinary Process . . . . . . . . . 42
a. Enforcement Emphasis on SOES Activity . . 42
b. The NASD's Laxity in Enforcing the
Firm Quote Rule . . . . . . . . . . . . . 42
c. The NASD's Laxity in Enforcing Trade
Reporting Rules . . . . . . . . . . . . . 44
d. Failure to Enforce the Excused
Withdrawal Rules . . . . . . . . . . . . 45
e. The NASD's Imbalance in Enforcement
of Its Rules . . . . . . . . . . . . . . 46
3. The Undue Influence of Market Makers in
the Regulatory Process . . . . . . . . . . . . 46
a. Market Maker Influence . . . . . . . . . 46
b. Application of Standards and
Criteria for Membership . . . . . . . . . 48
4. The NASD's Corporate Goals . . . . . . . . . . 49
VIII. CONCLUSION . . . . . . . . . . . . . . . . . . . . 50
A. Settlement with the NASD . . . . . . . . . . . . . 50
B. Commission Rule Proposals . . . . . . . . . . . . . 54
C. Summation . . . . . . . . . . . . . . . . . . . . . 56
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REPORT PURSUANT TO SECTION 21(a) OF THE
SECURITIES EXCHANGE ACT OF 1934
REGARDING THE NASD AND THE NASDAQ MARKET
I. INTRODUCTION AND SUMMARY
The Commission staff has conducted an investigation of the
operations and activities of the National Association of
Securities Dealers, Inc. ("NASD") and of market making activities
in the Nasdaq Stock Market ("Nasdaq market"). The investigation
uncovered a number of matters of fundamental concern about the
operations and structure of the NASD and the Nasdaq market, as
set forth herein. The Commission believes that significant
changes to the NASD and the Nasdaq market are warranted. The
Commission has deemed it appropriate to issue this Report of
Investigation ("Report") pursuant to Section 21(a) of the
Securities Exchange Act of 1934 ("Exchange Act") in order to
discuss the matters uncovered in the investigation and, in
particular, deficiencies in the NASD's oversight of the Nasdaq
market and its failure to enforce compliance with the NASD's
rules and the requirements of the federal securities
laws.-[1]-
Based on the results of the investigation, the Commission
finds that the NASD violated Section 19(g) of the Exchange Act by
failing adequately to comply with certain NASD rules and, without
reasonable justification or excuse, to enforce compliance with
the Exchange Act and the rules and regulations thereunder,
including Sections 10(b), 11A, and 15(c) and Rules 10b-5, 11Aa3-
1(c), 11Ac1-1(c), and 15c1-2, and its own rules, including
Article III, Section 1 of the NASD's Rules of Fair Practice and
Schedule C of the NASD's By-Laws. The NASD has consented to the
issuance of this Report without admitting or denying any of the
findings set forth herein.
---------FOOTNOTES----------
-[1]- The findings made in the Commission's Report are
solely for the purpose of the Report and are not
binding on any other person or entity named as a
respondent or defendant in any other proceeding.
In addition to describing conduct directly
evidencing the NASD's violation of Section 19(g)
of the Exchange Act, the Report describes conduct
of the NASD and its members that has problematic
implications for the Nasdaq market and the manner
in which the NASD carries out its self-regulatory
functions. The issuance of this Report 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.
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A primary focus of the investigation was whether the NASD
had adequately carried out its obligation under the Exchange Act
to oversee the Nasdaq market and the conduct of its members. The
investigation identified a number of serious deficiencies in the
NASD's performance of its duties as a self-regulatory
organization ("SRO"), especially as they relate to oversight of
the Nasdaq market. The NASD failed over a period of time to
conduct an appropriate inquiry into an anticompetitive pricing
convention among Nasdaq market makers, even though the NASD knew
of facts and circumstances evidencing such matters by 1990. In
addition, the NASD failed to enforce vigorously significant rules
applicable to its market maker members. These rules included the
firm quote rule-[2]- and the trade reporting rule,-[3]-
both of which are crucial to the fair operation of the Nasdaq
market.
The investigation revealed that the Nasdaq market has not
always operated in an open and freely competitive manner. Nasdaq
market makers have engaged in a variety of abusive practices to
suppress competition and mislead customers.-[4]- The
investigation found the following abusive practices:
ù Nasdaq market makers widely followed a pricing
convention pursuant to which many securities were
quoted only in even-eighth prices.-[5]- Adherence
to this practice, as detailed in this Report, was not
the result of natural economic forces and often
increased the transaction costs paid by
investors.-[6]- Certain market makers also
---------FOOTNOTES----------
-[2]- See infra note 68.
-[3]- See infra note 73.
-[4]- The record varies as to the degree of
participation of particular market makers in the
specific activities described in this Report.
-[5]- For example, prices will be quoted in intervals
such as $20 1/4, $20 1/2, $20 3/4, or $21, but not
$20 1/8, $20 3/8, $20 5/8, or $20 7/8. The
pricing convention is described herein at VI.A.3.
-[6]- The Commission is not suggesting that parallel
pricing behavior, standing alone, is necessarily a
violation of the securities laws. However, such
conduct may well raise serious questions that
regulators should investigate and evaluate. When
a pricing convention results from a reciprocal
understanding among market makers, is maintained
(continued...)
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discouraged other market makers from narrowing the
displayed quotes for smaller orders. Market makers
that failed to follow these conventions were sometimes
subjected to harassment and an unwillingness to trade
by other market makers who were attempting to enforce
compliance with the conventions.
ù Numerous market makers collaborated without disclosure
to their customers in ways that misled and
disadvantaged their customers and other market
participants. These market makers coordinated their
price quotations, their transactions in securities, and
their trade reports. For example, the investigation
found that some market makers have displayed quotations
at prices at which they did not intend to trade in
order to help another market maker trade, have
orchestrated artificial increases or decreases in
prices of trades, and have improperly delayed the
reporting of trades to the Nasdaq market for their
benefit or that of another market maker.
ù Some market makers, without disclosure to their
customers, shared information with each other about
their customers' orders, including the size of the
order and, on occasion, the identity of the customer.
They also shared information about their inventory
positions, trading strategies, and the prices they
planned to quote.
ù Numerous market makers frequently have failed to honor
their price quotations in violation of Commission and
NASD rules requiring firm quotations and prohibiting
misleading or fictitious quotations. Certain market
makers have also refused to honor their firm quote
obligations in a selective and discriminatory fashion
as a means of punishing certain market participants.
This conduct was anticompetitive, inconsistent with the
operation of a free and open market, and resulted in
unfair discrimination between and among market
participants.
ù Many market makers have not consistently reported their
trades to the Nasdaq market on time or appropriately
designated as required by NASD rules. As a result, the
sequence of trades publicly reported by Nasdaq has been
inaccurate.
---------FOOTNOTES----------
-[6]-(...continued)
by a reciprocal understanding, or is enforced
through harassment or other means, it raises
serious anticompetitive concerns.
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These practices by market makers directly harmed the Nasdaq
market, other market participants, and large and small
investors.-[7]- Adherence to the pricing convention often
affected the prices reflected in the Nasdaq quotes, thereby
impacting the fairness and accuracy of quotation information
disseminated in the market and interfering with the economically
efficient execution of transactions. The convention also
impaired the ability of investors to ascertain the best market
for their trades, increased the costs of transactions, and
resulted in unfair discrimination among classes of market
participants. The undisclosed activities of market makers that
coordinated price quotations, transactions in securities, and the
timeliness and sequence in which they reported trades, misled
market participants and customers, impaired disclosure of the
quotations and prices at which dealers were actually willing to
buy and sell, and lessened the ability of investors and other
market participants to obtain competitive prices. The interests
of market participants in accurate, fair, and reliable pricing
were not served. Moreover, the duties that those market makers
owed to their customers were compromised by undisclosed sharing
of customer information and the repeated failure to honor quotes
or report trades promptly or with appropriate designations.
The NASD's failure to investigate and pursue aggressively
clear indications of possible violations seriously undermined its
ability to ensure compliance with the NASD's own rules as well as
the requirements of the federal securities laws. As discussed
below, the consequences for the Nasdaq market of this failure
were exacerbated by the undue influence exercised by Nasdaq
---------FOOTNOTES----------
-[7]- While the Commission is describing the behavior of
market makers in the Nasdaq market in discussing
the conduct of the NASD, the Commission is not
making specific findings in this Report with
regard to the conduct of any individual market
making firm. The investigation of trading in the
Nasdaq market recently conducted by the Department
of Justice's Antitrust Division found no evidence
that the pricing convention described herein
resulted from "an express agreement reached among
all of the market makers in a smoke-filled room."
Competitive Impact Statement of the U.S.
Department of Justice Antitrust Division at 15,
United States v. Alex. Brown & Sons., et al.,
(S.D.N.Y. Jul. 17, 1996). Although the findings
of the Commission's investigation are consistent
with that conclusion, one need not determine that
the pricing convention arose out of explicit
"collusion" to find that the convention had
anticompetitive consequences and was harmful to
the interests of investors.
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market makers over various aspects of the NASD's operations and
regulatory affairs. This influence made vigorous enforcement by
the NASD even more essential to the fair operation of the Nasdaq
market.
II. CONCURRENT COMMISSION ENFORCEMENT ACTION
Along with the issuance of this Report, the Commission has
today instituted proceedings against the NASD pursuant to Section
19(h) of the Exchange Act.-[8]- The Order Instituting
Proceedings in that action alleges that the NASD failed to comply
with certain NASD rules and, without reasonable justification or
excuse, failed to enforce compliance with the Exchange Act, the
rules and regulations promulgated thereunder, and its own rules,
in violation of Section 19(g) of the Exchange Act. The Order
finds, among other things, that the NASD failed to take
appropriate action to investigate effectively and to address
adequately violations and potential violations of the federal
securities laws and the NASD's rules. Without admitting or
denying the allegations of the Order, the NASD consented to the
entry of the Order, which censured the NASD and ordered it to
comply with certain undertakings designed to address the problems
alleged in the Order.-[9]-
III. REMEDIAL MEASURES IMPLEMENTED BY THE NASD
The Commission notes that the NASD has taken and will take
significant remedial steps relating to its governance and
regulatory structure. Combined with the undertakings which the
NASD has agreed to as part of the resolution of the concurrent
administrative proceeding instituted by the Commission, these
measures are intended to address many of the issues and concerns
discussed in this Report.
The NASD reorganized to provide for a Board of Governors
which includes a majority of non-industry members. The NASD also
created two new subsidiaries: (a) NASD Regulation, Inc.
("NASDR"), which has primary responsibility for regulatory
matters, and (b) The Nasdaq Stock Market, Inc., which has primary
responsibility for operating The Nasdaq Stock Market. Both of
these subsidiaries have Boards of Directors consisting of equal
numbers of industry and non-industry members. Members of all
---------FOOTNOTES----------
-[8]- On September 29, 1995, the Commission also
proposed new rules and rule amendments intended to
improve order handling and transparency in both
exchange and dealer markets ("Order Handling
Rules"). See discussion infra part VIII.B.
-[9]- A description of the undertakings appears infra
part VIII.A.
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three of these Boards were carefully selected to represent a wide
range of the NASD's constituencies. Importantly, the concept of
balance, of industry and non-industry, or, in some cases,
majority non-industry members, has been extended to certain
important committees of the NASD or its subsidiaries. These
include the NASD Audit Committee, the NASDR Executive Committee,
the NASDR National Business Conduct Committee, the NASDR National
Arbitration and Mediation Committee, the Nasdaq Executive
Committee, and the Nasdaq Quality of Markets Committee. These
steps represent significant changes in the NASD's self-regulatory
process.
The NASD has also commenced affirmative steps to address the
regulatory issues discussed in this Report. The NASDR Board of
Directors has authorized a 7% increase in NASDR staff for
positions principally in the Enforcement, Examination, and Market
Regulation programs. The NASD has instituted measures to enhance
the enforcement of the trade reporting, firm quote, customer
limit order handling, and other market making rules, and has
begun the development of an enhanced audit trail. The NASD is in
the process of taking additional remedial measures to ensure the
fair review and disposition of applications for membership and to
change its disciplinary processes to include hearing officers and
add procedures aimed at achieving greater efficiency and
fairness. The NASD is also enhancing its systems for trading and
market surveillance, including compliance with late trade
reporting and various other NASD trading rules. The NASD has
created two new offices, the Office of Individual Investor
Services and the Office of the Ombudsman, to more fully serve the
interests of investors and other NASD constituents.
The NASD has represented that in conjunction with the
undertakings set forth in the Order Instituting Proceedings and
other remedial measures it has taken and will take, the Board of
Governors of the NASD and the Board of Directors of NASDR have
authorized $25 million and have committed to expend an additional
$75 million over the next five years, to enhance its systems for
market surveillance, including the development and implementation
of an enhanced audit trail, and to increase its staffing in the
areas of examination, surveillance, enforcement, and internal
audit.-[10]-
---------FOOTNOTES----------
-[10]- These funds are in addition to 1995 funding levels
for these activities. If, over the course of this
time period, the Board of Governors of the NASD
and the Board of Directors of NASDR believe that
the $100 million expenditure is not achievable or
feasible, the NASD may, by application to the
Commission, seek modification of this commitment.
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IV. SELF-REGULATION IN THE OTC MARKET
A. The NASD and the OTC Market
When the Maloney Act was adopted in 1938, its principal
purpose was to provide for a means of regulating the over-the-
counter ("OTC") market. To that end, the NASD was organized in
1939, incorporating the concept of industry self-regulation which
had received federal recognition in the Exchange Act. Under the
Exchange Act, the NASD, as an SRO, must be organized and have the
capacity to comply with and enforce compliance with the Exchange
Act and rules thereunder. The NASD's rules must be designed to
prevent fraud and manipulation, to promote just and equitable
principles of trade, and to protect investors and the public
interest. Its rules may not unfairly discriminate among
customers, brokers, dealers, or issuers, fix minimum profits, or
regulate matters not related to the purposes of the Exchange Act.
The rules are required to provide fair procedures both for
disciplining members and for denying access to services. Because
of the vital public interest in the fairness and integrity of
quotations, the NASD is specifically required by the Exchange Act
to have rules designed to ensure that quotes are fair and
informative and to prevent fictitious or misleading quotations.
The Exchange Act mandates that the NASD vigilantly safeguard the
integrity of its market by striving to meet these goals.
Historically, Nasdaq market makers have not been subjected
to the restrictions on trading activity that were imposed on
exchange specialists by Section 11(b) of the Exchange Act and
Exchange Rules. Because the OTC market was structured to provide
for multiple competing dealers, Congress and the Commission saw
less need to limit proprietary trading or to otherwise address
the conflicts that arise from the combined role of broker and
dealer. Vigorous inter-dealer competition was seen as assuring
efficient price discovery, narrow spreads, absence of collusive
opportunity, and the self-enforcing effects for which self-
regulation strives.
The 1963 Special Study of the Securities Markets ("Special
Study") reiterated that "[t]he ultimate safeguard for the
integrity of interdealer markets is often said to be the factor
of competition among dealers."-[11]- The Special Study
identified a number of anticompetitive and manipulative practices
in the OTC markets of the day: failure to honor quotations,
trading ahead of customers, "hand holding" (friendliness among
traders ranging from sharing customer trade information to
---------FOOTNOTES----------
-[11]- Staff of Special Study of the Securities Markets,
88th Cong., 1st Sess., Report of Special Study of
the Securities Markets, pt. 2, 661 (Comm. Print
1963).
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secretly investing in joint accounts), blackballing,
nontransparent pricing, and wide spreads set by committees of
members, among others. The Special Study concluded that
"competition in these markets may at times be impaired, resulting
in an appearance of competition that may not always accord with
reality."-[12]- Moreover, the Special Study found that:
the appearance of several dealers' active interest in a
security may not be a reliable indication of a
competitive market, either because most of them are in
fact appearing for one and thus making a single market
or because "holding hands" or similar practices may
restrain actual competition. Regulatory measures
appropriate for genuinely competitive markets may thus
be quite inappropriate or inadequate for those where
competition is lacking, whether this fact is readily
apparent or is disguised under an appearance of
competition.-[13]-
To address these issues and in the wake of Congress's 1975
mandate for a national market system, the Commission pursued
various initiatives toward the creation of greater transparency
and reliability for OTC quotations: consolidation and public
dissemination of the market-wide best bid and offer, firm quote
obligations, and designated market maker status. Timely last
sale reporting and surveillance capabilities sufficient to police
compliance with trade reporting rules were other initiatives
designed to provide a greater level of disclosure of market
information, which in turn was seen as a means to enhance the
level of competition in the OTC markets. Each of these changes
has given the Nasdaq market greater visibility and enhanced
investor confidence in its essential fairness.
Notwithstanding the inherent potential for self-regulation
to favor the interests of the securities industry over those of
the investing public, self-regulation has been viewed as having
certain advantages over direct governmental regulation. Industry
participants bring to bear expertise and intimate knowledge of
the complexities of the securities industry and thereby should be
able to respond quickly to regulatory problems. Self-regulation
supplements the resources of the government and reduces the need
for large government bureaucracies. In addition, SROs can adopt
and enforce compliance with ethical standards beyond those
required by law.
The benefits of self-regulation, however, can be realized
only if, among other things, the SRO fully informs itself of the
---------FOOTNOTES----------
-[12]- Id. at pt. 2, 577.
-[13]- Id. at pt. 2, 661-62.
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nature and purposes of the full range of activities occurring in
the market. The SRO must vigilantly surveil and investigate the
activities of market participants and take appropriate action as
warranted under the facts and as required by law.
B. The Nasdaq Stock Market
Nasdaq is the second largest stock market in the United
States. Founded in 1971, the Nasdaq market has experienced
remarkable growth in the twenty-five years of its existence.
Today nearly 6,000 issues trade on Nasdaq and total
capitalization exceeds $1 trillion. Daily trading volume of 400
million shares is commonplace and, in recent months, has exceeded
600 million shares at times. The Nasdaq composite index has
risen from 100 in 1971 to over 1,000 today.
The NASD owns and operates Nasdaq and also serves as the
Nasdaq market's primary regulator. This dual role requires the
NASD to subordinate its commercial interests as the owner of the
market to its public interest mandate as an SRO to protect
investors. The Securities Act of 1933 ("Securities Act") and the
Exchange Act were both adopted, in part, based on the recognition
that the securities markets are imbued with the public interest.
Nasdaq, as a facility of the NASD, a self-regulatory
organization, cannot operate in all respects like a private
enterprise. Both the NASD and Nasdaq must be governed and
operated in accordance with the obligations of an SRO as set
forth in the Exchange Act and the NASD's rules.
C. Commission Oversight of the NASD
The Commission recognizes its responsibility to oversee the
NASD and, ultimately, to ensure compliance with the federal
securities laws. The Commission's investigation of this matter
has been lengthy and thorough and it believes that the resulting
undertakings of the NASD will facilitate a more open and
competitive over-the-counter market. Notwithstanding this, and
the obligation of the NASD as an SRO to enforce compliance with
its rules as well as the rules and regulations of the Exchange
Act, the concept of self-regulation is, of course, a partnership
between industry and government. Therefore, the Commission
acknowledges that it too has responsibility for overseeing the
market with a view to preventing the conduct described in this
Report. In this regard, both the NASD and the Commission will
have to commit greater and ongoing vigilance in oversight if
self-regulation is to be effective.
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D. Governance of the NASD
1. The Pre-Investigation Structure of the NASD
The NASD is governed by a structure of national and regional
bodies. The NASD Board of Governors ("the Board") is the
ultimate governing body, but significant day-to-day authority has
been vested in committees composed primarily of NASD members and
NASD governors, who are generally representatives of NASD member
firms. The committees have conducted virtually all of the
disciplinary proceedings, with the Board having an appellate
role. The committees also have regulatory functions, such as the
admission or rejection of applicants to the NASD and the
formulation of policy and rule proposals.
Prior to April 1996, the Board consisted of governors from
each NASD regional district, a number of governors at large, and
the NASD president. The Board had a certain degree of latitude
to determine the composition and number of Board governors.
However, the number of district governors always exceeded the
number of governors not elected by the districts (i.e.,
Governors-At-Large and the President).-[14]- The NASD's
By-Laws required that various constituencies, such as issuers,
investors, investment company underwriters, and insurance
companies, have representatives on the Board.-[15]-
However, the By-Laws ensured that NASD member firms would always
have a majority vote on the Board.
The Board worked directly with various corporate committees,
advisory boards, and standing committees that advised the Board
on specific areas of NASD activity. The national committees were
appointed by the Board as it deemed necessary and one or more
governors could sit on such committees.-[16]- Any
committee or subcommittee that consisted of one or more Governors
could exercise all the powers and authority of the Board in the
management of the business and affairs of the NASD as permitted
by the By-Laws or by resolution of the Board.
The NASD's district structure distinguishes the NASD from
other SROs in the securities industry. To provide for local
---------FOOTNOTES----------
-[14]- See NASD Manual, By-Laws, Art. VII, 4(a) (CCH)
1183 (1995).
-[15]- NASD Manual, By-Laws, Art. VII, 4(c) (CCH)
1183 (1995); cf. 15 U.S.C. 78o-3(b)(4)
(requiring that at least one director be a
representative of issuers and investors).
-[16]- See NASD Manual, By-Laws, Art. XI, 1 (CCH) 1241
(1995).
=========================================START OF PAGE 10======
administration of the affairs of the NASD, each district elects a
governing body called the District Committee. The District
Committees are responsible for the local administration of the
association's affairs and for providing representatives of the
district to the Board of Governors. While the Board of Governors
is responsible for overall management, the structure of the NASD
is centralized and grants the districts broad discretionary
authority. In particular, the District Committees act as the
functional equivalent of a grand jury with respect to proposed
disciplinary actions, conduct disciplinary proceedings, and
approve or disapprove applications for membership. Thus, members
sitting on the District Committees have the simultaneous
responsibility to determine enforcement policy, sit in judgment
of other industry members, and decide who will be admitted to the
NASD as a member.
2. The Rudman Committee's Review
The NASD's system of governance has recently been the
subject of analysis by the NASD Select Committee on Structure and
Governance, chaired by former United States Senator Warren Rudman
(the "Rudman Committee"). This committee was appointed in
November 1994 by the NASD's Board of Governors with the mandate
to review the NASD's governance structures and the NASD's
oversight of the Nasdaq market.-[17]- The Rudman Committee
inquired into the appropriateness of the NASD's structures for
governance and for oversight and operation of the Nasdaq market,
the NASD's regulatory and disciplinary processes, the extent to
which the NASD provided for appropriate representation of its
constituencies, and its policy and rulemaking processes. The
Rudman Committee submitted its report to the NASD on
September 15, 1995.-[18]-
The Rudman Committee's report addressed a wide range of
issues and recommended changes to the NASD in a number of
respects. Particularly pertinent here is the Rudman Committee's
conclusion that the NASD's governance structure had "blur[red]
the distinction between regulating the broker-dealer profession
and overseeing the Nasdaq stock market."-[19]- The Rudman
Committee also found that the NASD would benefit from greater
---------FOOTNOTES----------
-[17]- The Rudman Committee's mandate expressly excluded
reviewing the matters that were the subjects of
the Commission's investigation.
-[18]- Report of the NASD Select Committee on Structure
and Governance (Sept. 15, 1995) ("Rudman Report").
-[19]- Executive Summary of Report of the NASD Select
Committee on Structure and Governance 21 (Sept.
15, 1995).
=========================================START OF PAGE 11======
public representation in its governing bodies. The Rudman
Committee recommended that the NASD reorganize its corporate
structure such that the Nasdaq market and the NASD's regulatory
functions would be in separate subsidiaries of the NASD, and that
the NASD and these two subsidiaries have 50% or greater public
representation on their boards of governors or directors,
respectively. The NASD is now implementing, in large part, these
recommendations of the Rudman Committee.
The report of the Rudman Committee noted that "[t]he NASD is
still governed largely by a host of committees, each with a
measure of authority to assert its own interests and one (the
Trading Committee) with significant influence over the Nasdaq
market and trading systems."-[20]- The Rudman Committee
found that "the NASD Board [was] not well-suited to take a firm
hand in regulating the Nasdaq market and its trading
systems."-[21]- Moreover, the Rudman Committee observed
that the void created by the inability of the NASD Board to
oversee the Nasdaq market was filled by the Trading Committee,
"which primarily represents the interests of Nasdaq market
makers."-[22]-
The Trading Committee considered issues relating to market
making and trading in the Nasdaq market. The Trading Committee
also developed and recommended new NASD rules and amendments to
existing rules that related to trading and market making.
Membership on the Trading Committee has not consisted of a cross-
section of NASD members.-[23]- As noted in the Rudman
Committee report:
The Trading Committee has significant influence in
matters affecting the Nasdaq market. At the same time,
however, its membership does not reflect the diverse
constituencies interested in Nasdaq. It is, quite
literally, a traders' committee, and more importantly,
a dealers' committee.-[24]-
Other Standing Committees that influenced rulemaking efforts,
such as the Market Surveillance Committee and the SOES Users
Committee, were also composed primarily of market makers. The
Rudman Committee concluded that "[t]he inescapable fact is that
---------FOOTNOTES----------
-[20]- Rudman Report at IV-6.
-[21]- Id. at IV-6.
-[22]- Id. at IV-5.
-[23]- See Appendix part II.A.2.
-[24]- Rudman Report at III-25. [emphasis in original]
=========================================START OF PAGE 12======
the NASD's structure was tailored to the relatively insignificant
OTC markets of an earlier era, not the second largest securities
market in the United States."-[25]-
V. THE COMMISSION'S INVESTIGATION
The Commission's investigation followed allegations that
raised serious questions about the integrity of both the Nasdaq
market and the NASD's oversight of that market. Throughout 1993,
the NASD's attempts to restrict use of its SOES system generated
criticism that market makers were using the NASD's regulatory
process to hamper legitimate competition. In the spring of 1994,
a widely publicized economic study suggested that market makers
implicitly colluded to maintain artificially wide inside spreads
on Nasdaq by avoiding odd-eighth quotations in many
stocks.-[26]- Thereafter, several class action lawsuits
alleging collusion were filed against Nasdaq market makers in the
summer of 1994. In addition, media accounts reported widespread
allegations that market makers routinely refused to trade at
their published quotes, intentionally reported transactions late
in order to hide trades from other market participants, and
engaged in other market practices detrimental to individual
investors.-[27]- Certain NASD member firms also alleged
that the NASD had targeted them for regulatory and disciplinary
action because these firms engaged in trading practices that were
disliked by the market makers which dominated and controlled the
NASD. The Commission opened a formal inquiry in the fall of 1994
to investigate the functioning of the Nasdaq market and to
determine whether the NASD was complying fully with its
obligations as an SRO.
During the investigation, the Commission staff requested and
obtained documentary evidence from the NASD, Nasdaq market
makers, and other market participants. The staff reviewed
thousands of hours of audio tapes of traders' telephone lines,
which were produced pursuant to subpoenas issued to Nasdaq
dealers. The staff took the testimony of numerous witnesses,
including traders from many Nasdaq market making firms and many
of the NASD's officers, employees, and committee members. The
staff conducted examinations of more than twenty Nasdaq market
maker firms for compliance with certain NASD and Commission rules
---------FOOTNOTES----------
-[25]- Id. at IV-6.
-[26]- William G. Christie & Paul H. Schultz, Why Do
NASDAQ Market Makers Avoid Odd-Eighth Quotes?, 49
J. Fin. 1813-40 (1994)("Christie-Schultz Study").
-[27]- See, e.g., Scot Paltrow, "Inside Nasdaq: Questions
about America's Busiest Stock Market," L.A. Times,
Oct. 20-25, 1994.
=========================================START OF PAGE 13======
and inspections were performed of various aspects of the NASD's
regulatory, surveillance, and enforcement programs. At the
Commission staff's request, the NASD produced computer data that
embodied audit trail and market maker quote reports for the
entire Nasdaq market for a period of more than one year. This
and other data were used in analyzing trading and pricing
patterns and practices in the Nasdaq market.
VI. PROBLEMS OF THE NASDAQ STOCK MARKET
A. Impediments to Price Competition
1. Importance of Competition
The Exchange Act contemplates that the U.S. securities
markets shall be "free and open"-[28]- with safeguards "to
protect investors and the public interest."-[29]- Vigorous
price competition is a hallmark of a free and open market and is
critically important to the efficient functioning and regulation
of a dispersed dealer market. Because Nasdaq market makers trade
securities which are otherwise fungible, price should be a
principal means of competition in the Nasdaq market. Any
significant hindrance to price competition impedes the free and
open market prescribed by the Exchange Act. The investigation
found that certain activities of Nasdaq market makers have both
directly and indirectly impeded price competition in the Nasdaq
market.
2. Price Quotations in Nasdaq
The Nasdaq market is a dealer market, in which a number of
broker-dealers make markets in the same security. Making a
market consists of standing ready to buy and sell a security at
displayed prices. The market makers in Nasdaq quote two prices:
a "bid" price, at which they are willing to buy the security, and
an "ask" price, at which they are willing to sell the security.
In so doing, they seek to profit by buying at lower prices and
selling at higher prices. A market maker's bid price will always
be lower than its ask price, and the difference between the two
prices is called the "dealer spread."
Market makers play an important role in financial markets.
Demand for market making services generally arises because buyers
and sellers of securities do not arrive at the market at the same
time or with the same quantities to trade. The market maker
---------FOOTNOTES----------
-[28]- Exchange Act, 6(b)(5), 15 U.S.C. 78f(b)(5)
(1994).
-[29]- Exchange Act, 15A(b)(6), 15 U.S.C. 78o-3(b)(6)
(1994).
=========================================START OF PAGE 14======
helps provide a solution to the uneven flow of supply and demand
by standing ready to buy and sell. The market maker is thus said
to provide immediacy to the market. In general, market makers
seek to sell to buyers at prices higher than the prices at which
they buy from sellers. The spread represents part of the market
maker's potential compensation.
Market makers are on one or both sides of almost all trades
on Nasdaq. Each issuer must have at least two market makers for
its stock, but the average stock has eleven market makers. Some
of the more actively traded stocks have fifty or more. As of the
end of 1995, there were 512 firms registered to make markets in
Nasdaq securities and 60,950 market making positions in those
securities. Often these market makers display different bid and
ask prices. Their quotes are displayed on the Nasdaq market's
electronic quotation system. The highest bid and the lowest ask
prices are also separately displayed together, as the "inside
quotes," and the difference between the two is called the "inside
spread." Display of the inside quotes allows a viewer to observe
immediately the best prices quoted on the Nasdaq market for both
buying and selling a given security.
In general, different market makers will be quoting the
inside bid and the inside ask prices. This is because, at any
given point in time, some market makers will want to display an
interest in buying a given security and will therefore quote high
bid prices, while other market makers will want to display an
interest in selling the security and will therefore quote lower
ask prices.-[30]-
Most Nasdaq market making firms not only trade as principals
with other broker-dealers in their market making activities, but
also accept customer orders for Nasdaq securities. When
executing a customer order, market makers are required to seek
the most favorable terms for the customer under the
circumstances. Historically it was generally accepted among
market makers that this obligation was satisfied for a customer
---------FOOTNOTES----------
-[30]- For example, assume there are three market makers
in a stock. Market maker A quotes $20 bid and $20
3/4 ask. Market maker B quotes $20 1/4 bid and
$21 ask. Market maker C quotes $20 1/2 bid and
$21 1/4 ask. Each market maker has a $3/4 dealer
spread, but at different prices. The inside
spread is only $1/4 wide, consisting of $20 1/2
bid (by market maker C) and $20 3/4 ask (by market
maker A).
=========================================START OF PAGE 15======
market order-[31]- when it was executed at the appropriate
inside quote (i.e., customer orders to buy would be executed at
the inside ask price, and customer orders to sell would be
executed at the inside bid price).-[32]- The size of the
inside spread therefore usually has direct cost implications for
investors in the market.-[33]- A customer who buys at the
ask price would experience a loss equivalent to the inside spread
if he or she were to liquidate the position immediately at the
bid price. Over the life of the investment, the spread between
the ask and the bid represents a transaction cost for the
investor, in addition to any other fees (such as commissions or
mark-ups) that may be incurred: the wider the inside spread, the
higher the transaction cost.
It is also a general practice for a Nasdaq market maker
receiving a retail customer order to execute the order itself
rather than to send it to another market maker, even if that
other market maker is quoting the best price (i.e., the best
inside bid or offer) and the executing market maker is not. The
executing market maker will provide the customer with the price
displayed in the inside quotes, whether or not it is quoting
---------FOOTNOTES----------
-[31]- A market order is an order in which the customer
does not specify any particular price, but where
the broker-dealer is to execute the order at the
best price available under the circumstances.
-[32]- The Commission's proposing release for the Order
Handling Rules notes that broker-dealers must
consider the opportunities for price improvement
beyond the inside quote when fulfilling their
obligation to obtain best execution for customer
market orders in Nasdaq securities. Exchange Act
Release No. 36310 (Sept. 27, 1995), 60 Fed. Reg.
52792, 52794 (Oct. 10, 1995).
-[33]- Large institutional customers and sophisticated
individual customers often attempt to negotiate
for prices better than the inside quotes. The
inside quotes are often important to these
negotiations, however, because they may serve as a
benchmark from which the negotiations proceed.
Many institutional customers have access to other
avenues of price discovery, including proprietary
trading systems and direct telephone contact with
market makers. Customers with less market power
(e.g., trades of 1,000 shares or less) do not have
access to such systems, generally cannot
negotiate, and usually must accept the prices
displayed at the inside quotes.
=========================================START OF PAGE 16======
those prices itself.-[34]- By executing customer orders
in-house, market makers attempt to capture the inside spread,
rather than allowing another market maker to benefit from the
spread.-[35]- Thus, market makers have a significant
interest in each other's quotes because those quotes directly
affect their actual trading prices. This interdependency of
prices strongly affects the conduct of market makers and provides
a significant economic incentive for establishing and enforcing
the pricing convention described below.
3. The Nasdaq Pricing Convention
The evidence gathered in the investigation indicates that
Nasdaq market makers followed and in some cases overtly enforced
a pricing convention that was used to determine the increments in
which they would adjust their displayed quotes.-[36]- This
practice resulted in most stocks being quoted only in increments
of $1/4. Market makers testified that under the convention,
stocks in which dealers were quoting spreads of $3/4 or more were
to be quoted in even-eighths (i.e., $1/4, $1/2, $3/4), thereby
giving rise to a minimum inside spread of $1/4 ("even-eighth
stocks"). Stocks with dealer spreads less than $3/4 could be
quoted in both even and odd-eighths, thereby allowing a minimum
inside spread of $1/8. The dealer spread was understood by
market makers as indicating which of the two quotation increments
applied to a particular security.-[37]- The Nasdaq pricing
---------FOOTNOTES----------
-[34]- This may reduce the incentive of market makers to
try to attract order flow on the basis of
incremental improvements in quotes.
-[35]- Many market makers pay non-market making brokerage
firms to send customer orders to them for
execution, a practice known as "payment for order
flow." This purchased order flow is also executed
at the inside quotes. For example, market maker,
Firm A, may pay a non-market maker brokerage firm,
Firm B, two cents per share for orders, with the
understanding that Firm A will execute those
orders at prices at least as good as the inside
quotes regardless of whether Firm A is quoting at
the inside. Firm A's profits for purchased orders
will be the inside spread, less the two cents per
share it pays Firm B for the orders.
-[36]- See Appendix part I.A.1.
-[37]- Although Christie and Schultz (see supra note 26)
observed the paucity of odd-eighth quotes in the
Nasdaq market, they did not have the data that
reflected the dealers' individual spreads.
=========================================START OF PAGE 17======
convention was generally treated by market makers as a pricing
"ethic," "tradition," or "professional norm" that other market
makers were expected to follow, and was sometimes enforced
through harassment, or threatened or actual refusals to deal.
This pricing convention both directly and indirectly restricted
the independent pricing decisions of individual market makers,
and thereby negatively impacted price competition. Pricing and
quoting decisions independently arrived at by individual market
participants do not, in and of themselves, raise the same
anticompetitive concerns.
The existence of this pricing convention is confirmed
through analysis of the price and quote data in the Nasdaq
market. Prior to May 1994, more than 80% of all domestic Nasdaq
NMS stocks (more than 3,200 stocks) followed the pricing
convention.-[38]- Of the more than 1,900 domestic NMS
stocks greater than $10, more than 90% followed the pricing
convention and approximately 78% were even-eighth
stocks.-[39]- Among the 100 most actively traded domestic
Nasdaq stocks, at least 96% of them followed the convention and
66% of them had dealer spreads of $3/4 or greater.-[40]-
---------FOOTNOTES----------
-[38]- The Commission's data confirms widespread
adherence to the convention, including
substantial, albeit lesser, adherence among stocks
priced under $10, which under Nasdaq rules may be
quoted in increments of $1/16 or finer. The fact
that approximately 20% of stocks were classified
as not following the pricing convention is to a
large degree attributable to two factors. First,
the Commission applied conservative classification
parameters (described in note 9 of the Appendix).
Second, two-thirds of the stocks not classified as
adhering to the convention had prices below $10
per share, which show lower levels of adherence to
the pricing convention. In order to avoid a
statistical bias, the Commission included all
domestic stocks in its sample.
-[39]- After May 1994, following negative publicity about
the Nasdaq market and the actions undertaken as a
result of the "Bear Stearns meeting," market
makers began to change their behavior. See infra
note 56, and accompanying text.
-[40]- The top 100 domestic stocks constituted 57% of
total NMS dollar volume and 35.4% of total NMS
share volume traded on Nasdaq in the period
February 1994 through May 1994.
=========================================START OF PAGE 18======
This pricing convention-[41]- was well understood and
widely observed by traders throughout the Nasdaq
market.-[42]- According to some market makers, the pricing
convention was based on tradition and represented the
"professional" way to quote in the Nasdaq market. Indeed, a
number of traders testified that senior traders at their
respective firms trained them to follow the pricing convention.
Other traders have described the practice as an "ethic," a
"custom," or a "tradition."
Market makers who enforced adherence to the convention did
so in a number of ways. When certain market makers attempted to
violate the convention by quoting in smaller increments (such as
$1/8 when the majority of dealers were quoting with dealer
spreads of greater than or equal to $3/4), they were subjected to
harassing telephone calls. One trader explained that the reason
he called another market maker who was quoting in a manner that
violated the pricing convention was "[t]o get him to get his
increments and his spreads to conform to what I thought was the
right thing to do."-[43]- There was widespread awareness
among market makers of the harassing telephone calls. Traders
from numerous market making firms, including traders who served
on various NASD committees, testified to having received or made
telephone calls complaining about or questioning quotations that
violated the pricing convention. Traders testified that the
---------FOOTNOTES----------
-[41]- As discussed further in the text, adherence to the
convention often adversely affects both the prices
at which orders are executed and the starting
prices from which customers negotiate with the
market makers. Thus, although the convention is
described in terms of quotations, it is
appropriately referred to as a "pricing
convention."
-[42]- Quoting in violation of the pricing convention was
pejoratively described by traders as making a
"Chinese market." Industry-wide recognition of
the pricing convention is reflected in the third
quarter 1989 newsletter of a securities industry
trade association, Securities Traders Association
of New York, which stated that "it is clearly
UNETHICAL to make a Chinese Market or to run ahead
of an order." (Emphasis and capitalization in
original.) Facts and circumstances evidencing the
existence of the pricing convention and its
enforcement also were known to the NASD by 1990.
(see infra part VII.A.1.).
-[43]- This trader also testified that he was trained to
make such calls.
=========================================START OF PAGE 19======
telephone calls were effective in deterring market makers from
entering quotes that were inconsistent with the pricing
convention and narrowed spreads.-[44]- In general, the
mere threat of such harassment was sufficient to discourage
market makers from violating the convention. In addition, market
makers who broke the convention and reduced the spreads were at
times subjected to refusals by other market makers to trade with
them. Such conduct lends strong support to the conclusion that
the pricing convention, as detailed in this Report, was not the
result of natural, competitive economic forces or structural
aspects of the Nasdaq market.-[45]-
The pricing convention limited the flexibility and
competitiveness of price quotations in the Nasdaq market. For
stocks in which dealers were quoting spreads equal to or greater
than $3/4, the avoidance of odd-eighth quote increments meant
that the inside spread could not be narrowed to $1/8, since the
---------FOOTNOTES----------
-[44]- One trader explained why, when he was a junior
trader, these telephone calls dissuaded him from
narrowing spreads, stating "[b]ecause, many years
ago, as a junior trader, I wanted to be accepted."
Another trader who admitted that he had made calls
questioning other market makers' "unprofessional
quotations" explained that the calls imposed "peer
pressure" on traders who violated the convention.
He testified:
no man or woman who is a trader wants to have
people think you are a fool, at least not
when you are working for a reputable firm,
you have institutional clients out there. You
don't want a reputation for leaving off such
questions as legality and ethics. That's a
given. Obviously, you don't want that. But
you also don't want people to think you're an
idiot. And that's the kind of pressure I'm
talking about.
-[45]- When market participants enforce the avoidance of
odd-eighth quote increments, the "price
clustering" that results (i.e., the tendency of
prices to fall on certain increments) cannot be
regarded as the result of natural economic forces.
Regardless of the size of the inside spread or the
dealer spread, one would expect quote updates to
use all possible eighth increments. Moreover, the
almost total avoidance of odd-eighths in a large
percentage of Nasdaq stocks is inconsistent with
the degree of price clustering that occurs in
other financial markets.
=========================================START OF PAGE 20======
use of odd-eighth quotations violated the convention.-[46]-
Thus, the pricing convention discouraged price competition among
Nasdaq market makers.
Market makers' adherence to the pricing convention often
increased the transaction costs paid by customers trading Nasdaq
securities. Most customer orders, particularly smaller orders,
are executed by market makers at the inside spread. Because
market makers primarily moved their quotations in even-eighth
increments for most domestic Nasdaq NMS stocks, the inside best
bid and offer for these stocks almost always moved in even-eighth
increments. This often resulted in wider inside spreads, which
caused trades to be executed at prices that were less favorable
for investors than if there had been no pricing
convention.-[47]- The practice also had an impact on the
ability of some institutional investors to obtain favorable
prices and may have placed them at a disadvantage in price
---------FOOTNOTES----------
-[46]- For the 100 most active domestic stocks during the
period December 1993 through May 1994,
approximately two-thirds were quoted with dealer
spreads of $3/4 or greater, with odd-eighth quotes
being used less than 1.6% of the time in those
stocks. If the sample were extended to all
domestic Nasdaq NMS stocks over $10, during the
same period, approximately 84% were quoted with
dealer spreads of $3/4 or greater, with odd-eighth
quotes being used less than 2.5% of the time in
those stocks. See Appendix part I.A.1. for a
discussion of the data and methodology used.
-[47]- This is reflected in the testimony of a trader
with 35 years experience, including service on the
NASD Trading Committee, concerning the pricing
convention and its enforcement:
There is no ethical issue whatsoever. It was
just the way the marketplace--I'm not sure
but I can tell you, you know, having been in
the business for 35 years, it existed prior
to that and economically, there was no
earthly good reason. I will just add but I
shouldn't say that. When you start trading,
if you bid a 3/4 point spread and you started
trading an 1/8 point increments, the
economics of the business were such that from
a profit standpoint `you were cutting off
your nose to spite your face' because there
was a chance when --of making 1/4 point on a
trade at times which allowed you to make up
for a multitude of sins. . . .
=========================================START OF PAGE 21======
negotiations.
The Commission does not mean to suggest that a $1/4 or
greater inside spread could not be appropriate in a particular
security, assuming that such a spread is independently determined
based on the free interplay of competitive economic forces.
Similarly, there may be occasions when a market maker acting
independently might reasonably choose to update quotes in
increments other than $1/8. There is, however, no valid economic
justification for the widespread avoidance of odd-eighth
quotations which resulted from adherence to the pricing
convention.
Further evidence that the pricing convention was an
artificial constraint on the Nasdaq market was found in the
trading activity of market makers in Instinet. Instinet is a
proprietary system in which Nasdaq stocks, among others, are
traded.-[48]- Instinet is accessible only to broker-
dealers and institutional investors who become
participants.-[49]- A key feature of Instinet is that its
quotes are not displayed on Nasdaq or otherwise broadcast to the
general public. Thus, the prices displayed on Instinet did not
modify the inside quotes on Nasdaq, and broker-dealers did not
regard prices displayed on Instinet as changing the prices at
which they were obligated to execute customer orders.
Trading volume on Instinet has reached sizable proportions.
More trading occurs on Instinet than on any of the organized
United States stock markets other than the New York Stock
---------FOOTNOTES----------
-[48]- Instinet currently operates as a registered
broker-dealer and is an NASD member. Nothing in
this Report is intended to suggest improper or
illegal activity by Instinet.
-[49]- A large number of broker-dealers have access to
Instinet, although Instinet does not allow all
broker-dealers to trade on its system. Many
institutional investors also have access to
Instinet, although, as described in the text, they
account for a relatively small part of the direct
trading activity on Instinet. The "quotes" on
Instinet consist of limit orders placed by persons
having trading privileges on Instinet and are
completely anonymous. 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 the
analysis in this Report.
=========================================START OF PAGE 22======
Exchange and Nasdaq.-[50]- Market makers use Instinet
extensively: for the period April through June, 1994,
approximately 90% of all trading activity on Instinet involved a
market maker. Approximately 85% of the quotes that market makers
placed on Instinet were better than the inside quote in the
Nasdaq market. Analysis of Instinet trading activity showed that
market makers regularly quoted odd-eighth prices in Instinet for
stocks that were quoted only in even-eighths in Nasdaq. That
market maker quotations on Instinet involved the regular use of
odd-eighths for stocks quoted only in even-eighths in Nasdaq
supports the conclusion that natural economic forces were not
freely operating in Nasdaq.-[51]- The clustering of quote
increments in the Nasdaq market should be contrasted with the
absence of clustering for exactly the same stocks by the same
market makers in the quotes they place in Instinet, where even
and odd-eighths are used almost equally. The disparity in market
maker quoting in Nasdaq and Instinet, as well as the market maker
conduct described throughout this Report, undermine price
clustering as an explanation for the pricing convention.
Market makers did not follow the pricing convention when
trading in Instinet, in part, because Instinet is an anonymous
system. More important, however, is the fact that quoting
between the spread on Instinet does not affect the inside spread
on Nasdaq and therefore does not affect the prices at which
market makers trade with the public. Thus, market makers did not
have the same economic incentive to prevent one another from
using odd-eighth quotes on Instinet. Ultimately, the ability of
market makers to attract trading interest through Instinet
allowed them to trade without using odd-eighth quotes and
---------FOOTNOTES----------
-[50]- 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 approximately 74 billion
shares traded, for an approximate dollar volume of
$1,449 billion. (It should be noted that Instinet
trade and dollar volume is included in the Nasdaq
numbers.) The New York Stock Exchange volume for
1994 was approximately 76 billion shares with an
approximate dollar volume of $2,841 billion.
-[51]- For the period April through June, 1994, the
average trade size in Instinet was approximately
1,600 shares, compared to approximately 1,900
shares in Nasdaq. Thus it does not appear that
the use of different quotations in Instinet can be
explained by differences in order sizes.
=========================================START OF PAGE 23======
narrowing the Nasdaq spread.-[52]-
The artificial nature of the Nasdaq pricing convention was
further evidenced by the behavior of market makers after May
1994. Beginning in late May 1994, the Nasdaq market received
considerable adverse publicity stemming from the Christie-Schultz
study suggesting implicit collusion among Nasdaq market
makers,-[53]- the filing of class action litigation against
a number of market makers, and news reports in late 1994 of
government investigations into the activities of market makers.
Before May 1994, approximately 12% of the Nasdaq NMS stocks
priced over $10 had dealer spreads less than $3/4 and were
therefore routinely quoted in both even and odd-eighths. After a
meeting of NASD officials and market makers at Bear Stearns in
late May 1994,-[54]- efforts were made by some market
makers to narrow the spreads of certain high profile stocks that
had previously been quoted only in even-eighths. What is
noteworthy is that although these market makers started quoting
in odd-eighths, they generally did so by following the pricing
convention, narrowing their dealer spreads from $3/4 and above to
less than $3/4.-[55]- Throughout the remainder of 1994 and
into 1995, market makers increasingly moved to quoting odd-
eighths both by following the convention and narrowing their
dealer spreads to less than $3/4,-[56]- and by quoting odd-
eighths with dealer spreads of $3/4 or more. These recent
changes provide additional support for the conclusion that the
pricing convention was not an inherent or essential feature of
pricing in the Nasdaq market.
The increased use of odd-eighths in certain stocks after the
---------FOOTNOTES----------
-[52]- The Commission's analysis showed similar use of
the NASD's SelectNet system, a screen based order
communication and negotiation system that is part
of Nasdaq and is available only to NASD members.
The data showed that most of the prices market
makers placed in SelectNet improved the inside
spread, and market makers regularly used odd-
eighths in SelectNet for stocks that were quoted
in even-eighths on Nasdaq.
-[53]- See supra note 26.
-[54]- See Appendix part I.A.1.e.
-[55]- This was not particularly well received by other
market makers. See Appendix part I.A.1.e.
-[56]- By July 1995, approximately 22% of domestic Nasdaq
NMS stocks over $10 were being quoted with dealer
spreads less than $3/4.
=========================================START OF PAGE 24======
May 24, 1994 Bear Stearns meeting generally resulted in narrower
spreads in those stocks. The Commission's concerns in this
Report are not directed at spreads per se, but at the
inflexibility in pricing that results from adherence to the
pricing convention. The avoidance of odd-eighths in market maker
quotations pursuant to the pricing convention inhibits price
competition, while an increased usage of odd-eighths enhances
price competition. Thus, the greater use of odd-eighths in
market maker quotations after May 24, 1994 would be expected to
result in narrower spreads. While volatility, liquidity, and the
price of the security are likely to affect spreads, they do not
explain the adherence to the pricing convention, nor do they
explain the significant changes in quotation behavior and
narrowing of spreads in various stocks following the Bear Stearns
meeting and the commencement of investigations by the Department
of Justice and the Commission.
4. The Nasdaq Size Convention
The investigation has also determined that many Nasdaq
market makers have adhered to a convention under which they would
not display a new inside quote unless they were willing to trade
in an amount substantially greater than the minimum volume
required by NASD rules (the "size convention").-[57]- The
size convention required the market maker to be willing to trade
in the range of two to five times the minimum NASD volume
requirement when creating a new inside quote. The effect of this
convention was that market makers would narrow the inside spread
on Nasdaq only if they were willing to trade at the substantially
larger volume required by the convention. Thus, a market maker
in a stock where the minimum NASD quotation amount is 1,000
shares who narrowed the spread from $1/2 to $1/4, or from $1/4 to
$1/8, was expected to trade between 2,000 and 5,000 shares. Like
---------FOOTNOTES----------
-[57]- See Appendix part I.A.1.c. NASD rules require
market makers to be willing to trade at least
1,000 shares at their quoted prices for the more
actively traded stocks and lesser amounts for
other Nasdaq stocks. See NASD Manual, Schedule D
to the By-Laws, Part V, 2 (CCH) 1819
(1995)(prescribing minimum sizes of quotations).
The Commission recognizes that an independent
decision to trade in greater size than the
published quote is a service that a market maker
may extend to its customers. However, to the
extent that the size convention became the
"professional norm" that all other market makers
were expected to follow or was enforced as
described above, this convention was
anticompetitive and resulted in artificially wide
spreads.
=========================================START OF PAGE 25======
the pricing convention, the size convention was in some instances
overtly enforced by Nasdaq market makers through intimidation,
harassment or other improper conduct.
The size convention had an anticompetitive effect. It
inhibited price transparency by limiting quote changes to those
circumstances where a Nasdaq market maker was willing to trade in
substantially greater volume than the NASD prescribed minimum.
This impaired price competition in the Nasdaq market, because
improved quotations to reflect orders smaller than those required
by the convention were deterred. Spreads were necessarily wider
because the size convention discouraged aggressive pricing. The
fact that the size convention was enforced by some market makers
through harassment and other similar conduct supports the
conclusion that it was artificially imposed in the Nasdaq market.
5. Effect of the Pricing and Size Conventions
In sum, the pricing convention, the size convention, and the
availability to market makers of alternative trading systems
resulted in a fragmented market for Nasdaq stocks. Customers
were often confronted by artificially wide, inflexible spreads,
and lacked access to the markets with the best prices. Attempts
by certain market makers to compete on the basis of price were
discouraged through harassment and the potential loss of trading
opportunities. These practices cannot be reconciled with the
"free and open" market contemplated by the Exchange Act and
evidence significant underlying problems in the Nasdaq market.
B. Coordination of Quotations, Trades, and Trade Reports
The investigation has determined that a number of Nasdaq
market makers have coordinated quotations, trades, and trade
reports with other Nasdaq market makers for the purpose of
advancing or protecting the market makers' proprietary trading
interests.-[58]- By engaging in such conduct, these market
makers may have acted contrary to the best interests of their
customers and created a false or misleading appearance of trading
activity in the Nasdaq market.
For example, the tapes reflect numerous occasions in which
market makers have asked other market makers to move their
displayed quotations in a particular direction to help the
requesting market maker trade (often with customers) at prices
more favorable to the requesting market maker. The requesting
market maker generally disclosed his or her intentions for future
price movements and transactions to the cooperating market
makers. Cooperating market makers acceded to these requests
because of an expectation that the requesting market maker would
---------FOOTNOTES----------
-[58]- See Appendix part I.A.3.
=========================================START OF PAGE 26======
reciprocate in the future. Such cooperative activity improperly
influenced prices, often at the expense of investors, while
creating an inaccurate picture of market conditions. The market
makers involved in such conduct may, depending upon the facts and
circumstances of each particular situation, be deemed to have
engaged in unlawful manipulation of the market or otherwise
violated applicable antifraud provisions of the federal
securities laws or NASD rules.-[59]-
Some Nasdaq market makers have also worked improperly
together in this way to fill customer orders or to reduce
inventory exposure.-[60]- In such cases, a market maker
having a sizeable customer order or an inventory imbalance called
upon other market makers to coordinate their quotations and
transactions with the requesting market maker.-[61]- The
---------FOOTNOTES----------
-[59]- The applicable antifraud provisions could include
Section 17(a) of the Securities Act, 15 U.S.C.
77q(a) (1994), and Sections 10(b) and 15(c)
of the Exchange Act, 15 U.S.C. 78j(b) and
78o(c) (1994), and Rules 10b-5 and 15c1-2
promulgated thereunder, 17 C.F.R. 240.10b-5 and
240.15c1-2 (1996), and Article III, Section 1 of
the NASD Rules of Fair Practice, NASD Manual,
(CCH) 2151 (1995). This Report does not purport
to address the potential liability of any person
or entity under other federal or state laws.
-[60]- Inventory exposure arises from either holding a
large long position or a large short position in a
given security for any significant length of time.
For example, a market maker holding a long
position of 50,000 shares of a security
experiences a paper loss of $50,000 if the market
price drops $1. In general, market makers prefer
to minimize their inventory positions for this
reason.
-[61]- The following taped conversation illustrates this
type of coordination. On June 17, 1994, a market
maker (Market Maker 1) in the common stock of AES
Corp. (AESC) had an order to buy a quantity of
AESC stock. Market Maker 1 entered a bid of $18
1/4, a quarter point above the other bids in the
market, to attract sellers. Another market maker
(Market Maker 2) had an order to sell AESC stock.
Market Maker 2 called and asked Market Maker 1 to
lower its bid because Market Maker 2 wanted to pay
less for the stock it was buying (as the
counterparty to the order to sell that it had
(continued...)
=========================================START OF PAGE 27======
fact that a market maker used these arrangements when engaged in
buying or selling securities for a customer was typically not
disclosed and may have violated the duties owed by the market
maker to its customer.
Such undisclosed collaboration can injure the interests of
both retail and institutional investors. A market maker
representing a customer order is required to obtain the most
favorable terms for its customer that are available under the
circumstances. See, e.g., Opper v. Hancock Securities
---------FOOTNOTES----------
-[61]-(...continued)
received):
MM 2: I just seen [sic] you go 1/4 bid. Without like
going through a whole bunch of, you know, **** **** I
know I got a bunch of these for sale at the opening. I
would rather buy them at 18, if you know what I'm
saying. If there's a ticket to write, I will write it
with you [meaning I will sell some AESC stock to you if
you are looking to buy some].
MM 1: There absolutely is a ticket to write.
MM 2: OK.
MM 1: I can make a sale at the opening myself.
MM 2: You can?
MM 1: Yes.
MM 2: OK, so.
MM 1: As long as it's -- I can go down . . . .
Trading records indicate that Market Maker 1 dropped
its bid price to $18. Market Maker 2 proceeded to
purchase 8,000 shares of AESC stock at $18. In the
meantime, Market Maker 1 sold 16,700 shares at $18 1/2
to its customer, of which 7,500 shares were sold short.
Market Maker 2 subsequently sold 6,500 shares to Market
Maker 1 at $18 1/4. Market Maker 2 injured the
interests of the seller by asking Market Maker 1 to
lower its bid price so that Market Maker 2 could pay
$18 per share, rather than $18 1/4 (a difference of
$2,000 for the entire trade). Market Maker 1 was also
a participant, since it changed its bid at Market Maker
2's request, to create a deceptive appearance to the
market, and made it harder for the seller to observe
the true level of buying interest.
=========================================START OF PAGE 28======
Corporation, 250 F. Supp. 668 (S.D.N.Y.), aff'd per curiam, 367
F.2d 157 (2d Cir. 1966) (broker-dealer liable for trading ahead
of customer's order on an undisclosed basis). When a market
maker with a customer order is helping another market maker
dispose of a quantity of a security, it may not bargain hard with
the other market maker in order to get the best price for its
customer because it is accommodating the interests of the other
market maker.-[62]- In these instances, the market maker's
interest in helping a fellow market maker conflicts with the
firm's obligation to obtain the best available terms for its
customer.-[63]- An undisclosed arrangement between or
among market makers that results in a broker-dealer acting
contrary to the interests of its customer is incompatible with
the firm's agency duties to its customers.-[64]-
The investigation also revealed instances in which some
Nasdaq market makers agreed to delay reporting trades they had
done with each other. The report of a trade, particularly a
large trade, can affect market price. Thus, the delay of a trade
report can provide an information advantage to a market maker.
The investigation found that cooperating market makers have
agreed to withhold a trade report until one of them could
inappropriately trade for the firm's own account in a market
unaware of the unreported transaction. Certain Nasdaq market
makers also asked other market makers to delay trade reports in
order to prevent a customer from judging the quality of an order
execution against substantially contemporaneous dealer-to-dealer
transactions. If the dealer-to-dealer trades were reported on
time, the customer might have been able to tell if its price was
worse than other contemporaneous trades and then question whether
---------FOOTNOTES----------
-[62]- Such cooperative trading is evidenced by tape
recordings obtained in the investigation, which
showed that market makers frequently did not
bargain with each other for the best prices for
their customers.
-[63]- The Commission is not suggesting that the usage of
multiple brokers to obtain executions of orders is
by itself improper. The discussion in this Report
is directed to the activities of market makers on
the Nasdaq market who engaged in these practices
to the detriment of their customers.
-[64]- Even in situations in which market makers trade
with customers as principals, they nevertheless
have duties to deal fairly with their customers.
See, e.g., Charles Hughes & Co. v. SEC, 139 F.2d
434 (2d Cir. 1943)(broker-dealer liable for
undisclosed mark-ups to customers).
=========================================START OF PAGE 29======
it had received the best price available under the
circumstances.-[65]- Agreeing to withhold trade reports
---------FOOTNOTES----------
-[65]- An example of such delayed trade reporting
occurred on June 22, 1994. Three market makers
arranged for a sequence of four trades in the
common stock of PXRE Corp., in which shares sold
by Market Maker 1's customer would ultimately be
bought by Market Maker 3's customer. Market Maker
3 did not want its customer to see the true
sequence of trades and obtained Market Maker 2's
promise to hold its trade report and asked Market
Maker 2 to secure Market Maker 1's agreement to
hold its trade reports. Market Maker 1 agreed to
hold its trade reports for ten minutes. Market
Maker 2 told Market Maker 3 that Market Maker 1
would hold his trade reports but omitted to say
for ten minutes only. The trades occurred as
follows:
1. MM1 bought 20,000 shares at $24 1/2 from its
customer at approximately 12:15 p.m. (Trade A).
2. MM1 sold 20,000 shares at $24 9/16 to MM2 at
approximately 12:18 p.m. (Trade B).
3. MM2 sold 20,000 shares at $24 19/32 to MM3 at
approximately 12:23 p.m. (Trade C).
4. MM3 sold 20,000 shares at $24 11/16 to its
customer at approximately 12:24 p.m. (Trade D).
These trades were reported, however, in the following
sequence:
1. MM3 reported its sale of 20,000 shares at $24
11/16 to its customer at 12:24:51 p.m. (Trade D).
2. MM1 reported its purchase of 20,000 shares at $24
1/2 from its customer at 12:25:01 p.m. (Trade A).
3. MM1 reported its sale of 20,000 shares at $24 9/16
to MM2 at 12:28:00 p.m. (Trade B).
4. MM2 reported its sale of 20,000 shares at $24
19/32 to MM3 1:26:12 p.m. (Trade C).
None of the last three trades was reported with an
".SLD" modifier, which would have identified it as a
late trade report. Because Market Maker 1 reported its
(continued...)
=========================================START OF PAGE 30======
under the foregoing circumstances, to create a false appearance
of activity in the market and possibly to deceive investors, may
have violated the antifraud provisions of the federal securities
laws as well as the NASD's rules requiring timely reporting of
trades.
C. The Exchange of Proprietary Information
As part of coordinating their activities, various Nasdaq
market makers often shared with each other customer information
and other information that would normally be viewed as
proprietary.-[66]- For example, the evidence demonstrates
that these market makers regularly shared information concerning
the size of customer orders and sometimes the identity of the
customer. A market maker was typically expected to reveal the
full extent of its customer's order when negotiating a trade with
another market maker. Market makers also shared information
concerning their own inventory positions, their intended trading
strategies, and future quote movements. Market makers testified
that this was often done with the understanding that other market
makers with whom such information was shared would not use it
against the disclosing market maker's interests.
Market makers involved in such information sharing have
indicated that they regarded it as "professional," "ethical," or
a courtesy. Frequently, market makers shared information to
protect each other from price movements in the market price of a
particular security. Those market makers who were unwilling to
observe these practices had less access to information and
trading opportunities from other market makers.
These information sharing "courtesies" were typically not
extended to customers and could conflict with the basic
---------FOOTNOTES----------
-[65]-(...continued)
lower priced trades immediately after Market Maker 3
reported its trade with its customer, Market Maker 3,
in an angry frame of mind, spoke to Market Maker 2:
MM3: So now I got ******, okay. . . . I hope I don't
have to cancel the trade, but I might have to
because as soon as the ******* guy [MM3's
customer] sees it, you know, the ******* guy is
going to start jumping up and down, okay.
MM2: Were you able to sell it? . . . .
MM3: I sold 'em. I mean the guy didn't get the *******
report yet, you know what I mean.
-[66]- See Appendix part I.A.3.
=========================================START OF PAGE 31======
obligations owed by a broker-dealer to its customers. Investors
may be deprived of benefits that would otherwise be available in
a competitive market. Revealing the size of a customer order may
be detrimental to the ability of the customer to obtain the best
execution. The customer's interests often are best served by
concealing the scope of its trading interest, especially if the
customer is trading in large quantities. Market makers learning
of the order could adjust the price and size of their quotations
to force the customer to pay more or sell for less than would
have been the case if the customer's confidentiality had been
protected by its executing market maker.
In the situations where market makers share the customer's
identity, the customer's ability to seek competitive quotations
from market makers is significantly hampered. A reason that has
been given by some market makers for disclosing the identity of a
customer is the suspicion that the customer was doing business
with more than one market maker. Traders testified that they
sometimes would share the identity of a customer when they
believed the customer was 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 market makers 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 a primary 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.
D. Collaboration in the Nasdaq Market
The pricing convention, the size convention, the
coordination of quotations, trades and trade reports, and the
sharing of proprietary and customer information, by themselves,
raise significant concerns. Taken together, these practices
point to a broader problem: that Nasdaq market makers have had a
tendency to improperly collaborate and coordinate their
activities. In such an environment, the forces of competition
were impeded. It is of overriding regulatory importance that
Nasdaq market making not be permitted to evolve into a culture of
non-competition. This inclination to collaborate has broad
implications for the functioning of the Nasdaq market. In a
dealer market, it is important that dealers compete aggressively
with each other and that the benefits of that competition are
passed on to investors. If dealers do not vigorously compete,
the value to investors and the public of a dealer market is
diminished. The above-described tendency of some Nasdaq market
makers to protect each other without regard to the interests of
their customers and other market participants underscores the
=========================================START OF PAGE 32======
need for significant market reform.-[67]-
E. Failure to Honor Quotations
Market makers have a fundamental obligation to honor their
quotations.-[68]- Prompt, accurate, reliable, and fair
information with respect to quotations is a cornerstone of the
national market.-[69]- The reliability of quotations is
essential to investor confidence and to the efficient operation
of the market. Investors have difficulty obtaining reliable
price information or order executions in the absence of firm
quotations. Failure to honor quotations deprives investors of
the liquidity that market makers advertise they will provide and
injures the credibility of the market as a whole.
The investigation revealed numerous violations of the firm
quote rule by Nasdaq market makers.-[70]- Certain market
makers at times did not honor their quotations for those with
whom they preferred not to trade and "backed away" from their
quotes as reprisal for, among other reasons, perceived prior
backing away by other market makers. Certain market makers have
also variously refused to trade with order entry
firms,-[71]- certain other market makers, and market
---------FOOTNOTES----------
-[67]- This is not meant to suggest that a dealer market
is undesirable. The Commission continues to view
dealer markets as an appropriate market structure,
provided they are competitive, free, and open as
required by the Exchange Act.
-[68]- The firm quote rule is set forth in Exchange Act
Rule 11Ac1-1, 17 C.F.R. 240.11Ac1-1 (1996). See
also NASD Manual, Schedule D to the By-Laws,
Article V, 2(b) (CCH) 1819 (1995).
-[69]- Exchange Act Release No. 14416 (Jan. 26, 1978),
43 Fed. Reg. 4354 (Feb. 1, 1978).
-[70]- See Appendix part I.C.
-[71]- Order entry firms are broker-dealers that route
customer orders to market makers for execution.
Some order entry firms execute small customer
orders through the SOES system, which provides
automated execution of small orders. Certain
order entry firms that are active users of SOES
are disliked by market makers.
=========================================START OF PAGE 33======
participants they "dislike," such as options market
makers.-[72]- Market makers at times backed away from
their trading obligations to avoid unwanted orders placed when
they coordinated their quotations with other market makers. The
incidence of backing away in the marketplace has contributed to
market fragmentation and has weakened the pricing mechanism in
Nasdaq. Nasdaq market makers must consistently honor their
quotes to safeguard the integrity of Nasdaq as a viable dealer
market.
F. Late Trade Reporting
Market makers and certain other broker-dealers are required
to report trades in Nasdaq stocks within 90 seconds of the
transaction.-[73]- Trades that are reported late are
required to be specifically identified with the designation "SLD"
so that market participants will know that these reports are
being reported more than 90 seconds after the execution. Timely
trade reporting and the accurate designation of late trade
reports with the "SLD" designation are essential to providing
investors and other market participants with an accurate picture
of Nasdaq market activity.
Numerous market makers repeatedly failed to report Nasdaq
transactions on an accurate and timely basis.-[74]-
Calculations by the Commission staff indicate that at least 3.6%
of all Nasdaq trades in the period February through December 1994
---------FOOTNOTES----------
-[72]- Options market makers on the various options
exchanges make markets in standardized common
stock options on Nasdaq and exchange-listed
stocks. An options market maker needs to be able
to execute trades in the security underlying the
option in order to hedge the option's risk.
-[73]- Pursuant to Exchange Act Rules 11Aa3-1 and
11Aa3-2, 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). 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 NASD Rules of Fair Practice. NASD Manual,
Schedule D to the By-Laws, Part X, 2(a)(8) (CCH)
1867 (1995).
-[74]- See Appendix part I.B.1.
=========================================START OF PAGE 34======
were reported late.-[75]- During the same time period,
late trades accounted for only .09% of reported trades on the New
York Stock Exchange. In addition to trades reported more than 90
seconds late and marked "SLD," approximately 6.7% of trades
between broker-dealers in a sample of 1994 transactions examined
by the staff were reported late, but were not marked late by the
reporting market maker as required by NASD rules.-[76]-
The staff's analysis revealed that for both marked and unmarked
late trades, the percentage of larger trades reported late was
significantly higher than for smaller trades. Because reports of
larger trades are more likely to be market sensitive, market
makers seeking to fill an order or cover a position may have a
greater incentive to report large trades late. The higher
percentage of large trades reported late raises a concern that a
portion of these late reports may be the result of intentional
reporting delays rather than negligence or computer errors. In
testimony, traders have admitted that they sometimes deliberately
delayed reporting trades, and examinations of a cross-section of
Nasdaq market makers by the staff confirmed an unacceptable
frequency of late trade reporting. The examinations revealed
numerous other inaccurate trade reports including trades executed
after the market closed and not identified accordingly; trades
identified as late that were not submitted late; trades reported
incorrectly as executed after the market closed; trades not
reported; and inaccurate execution times submitted in trade
reports.
Many Nasdaq market makers did not treat trade reporting as a
priority and in some cases used inadequate trade reporting
systems. Late and inaccurate trade reporting by Nasdaq
---------FOOTNOTES----------
-[75]- This figure includes trades reported through
systems such as SOES, SelectNet, and ACES, which
automatically report trades and generally
eliminate the possibility of late trade reports.
When trades on these systems are excluded, late
trades account for approximately 4.5% of all
reported trades for the period. As discussed in
the Appendix, the NASD began to take action to
improve its program for enforcing trade reporting
rules in late 1994. The percentage of trades
reported late on Nasdaq fell in 1995. See
Appendix part I.B.1 and note 101.
-[76]- This analysis was based on a sample that
represented approximately 20% of all NMS trades
from February through December 1994 and included
all trades between broker-dealers containing both
a trade report time and a counterparty time and
that were not executed through SOES, SelectNet, or
ACES.
=========================================START OF PAGE 35======
broker-dealers undermines the integrity of the Nasdaq market.
Accurate and timely transaction reports provide critical
information to investors, issuers, and brokers and dealers
trading Nasdaq securities, as well as options and other
derivative products. 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 rules prohibiting
excessive markups. The scope of the trade reporting problem
shown to exist on Nasdaq compels the conclusion that corrective
action was warranted.
VII. THE NASD'S PERFORMANCE AS AN SRO
The Exchange Act requires the NASD to enforce its rules and
the federal securities laws vigorously and in an evenhanded and
impartial manner. Moreover, the NASD has an affirmative
obligation to be vigilant in surveilling, evaluating, and
effectively addressing potential violations of the federal
securities laws and its rules, as well as conduct that could
adversely affect the competitiveness or integrity of the Nasdaq
market.
A. The NASD's Awareness of the Nasdaq Pricing Convention
1. Events in 1990
By 1990, the NASD was aware of facts and circumstances
evidencing the pricing convention, actions undertaken by market
makers to enforce it, and the rigidity of Nasdaq
spreads.-[77]- In August 1989, the New York Stock Exchange
("NYSE") sent a letter to a Nasdaq listed company which contended
that Nasdaq spreads were wider than NYSE spreads for comparable
securities and urged the company to transfer its listing to the
NYSE. This letter, together with facts evidencing the pricing
convention, its enforcement, and the rigidity of Nasdaq spreads,
were the topics of discussion at a June 27, 1990 meeting of the
NASD's Trading Committee.-[78]- At this meeting, a
committee member urged that the NYSE letter reflected competitive
pressure and that Nasdaq market makers should narrow their
spreads or face the loss of "clients" and "product." The pricing
convention was described by one committee member as an "ethic" in
the Nasdaq market, part of which was not to close the spreads or
make "Chinese markets." Two other committee members stated that
---------FOOTNOTES----------
-[77]- See Appendix part I.A.2.
-[78]- The NASD staff attending this meeting included
representatives of the Office of General Counsel,
the Market Surveillance Department, and the Market
Operations Department.
=========================================START OF PAGE 36======
attempts to break the spreads would prompt telephone calls asking
about the reason for the narrowed spreads. The committee
concluded that it was inadvisable to legislate spreads and that
the "ethic" was an "internal" matter which the Security Traders
Association of New York, an industry trade association, should
address. The NASD took no action following this meeting to
investigate the existence of the pricing convention or address
the detrimental effects it could have on competition and the
interests of investors.
The NASD, by its inaction in 1990, failed to satisfy its
responsibilities as an SRO. The NASD viewed the pricing
convention and, to a great extent, spreads, as commercial issues
pertaining to its competitive standing with the New York Stock
Exchange, instead of significant regulatory problems. Because of
the effect of the pricing convention on the competitiveness and
fairness of the Nasdaq market, the NASD should have acted
promptly and vigorously to investigate indications that its
market maker members were potentially violating the Exchange Act
or the NASD's rules. The use of substantial enforcement and
other resources to investigate these issues would have been fully
warranted. The NASD's regulatory policies failed to address
these concerns. In particular, by not reacting to the issues
raised at this committee meeting, the NASD was effectively
deferring to the securities industry and its trade organizations
in responding to these allegations of potentially illegal
practices. This placed responsibility for the problem in the
hands of the persons with the least incentive to address the
issues effectively and change the status quo. There was little
likelihood that the securities industry and its trade
associations would voluntarily take sufficient corrective
measures to deal with the problems, particularly when any
corrective action was likely to directly affect the proprietary
interests of the NASD's market maker members.
2. Events in 1992
In 1992, the fundamental elements of the pricing convention
were brought to the attention of the NASD's executive
management.-[79]- In early 1992, a senior NASD executive
was assigned the task of obtaining a better understanding of
spreads on Nasdaq and identifying possible means of reducing
spreads. He undertook an evaluation and analysis and consulted
with the NASD Quality of Markets Subcommittee of the Trading
Committee.-[80]- At a March 24, 1992 meeting of the
---------FOOTNOTES----------
-[79]- See Appendix part I.A.2.
-[80]- The Quality of Markets Subcommittee was formed in
early 1991 to address two issues: the development
(continued...)
=========================================START OF PAGE 37======
Quality of Markets Subcommittee, this senior executive and
committee members discussed the issue of widening spreads,
"Chinese markets," the quoting patterns dictated by the pricing
convention, and the intimidation of market makers. The senior
executive prepared a memorandum dated June 30, 1992 (the "June
1992 Memo") which reported on the analysis he had conducted of
widening spreads in the Nasdaq market. The June 1992 Memo
identified the stigma associated with making "Chinese markets,"
and noted the absence of odd-eighth quotations in stocks that
typically moved in even-eighth quotes.-[81]- The June 1992
Memo also noted that peer pressure was applied to dealers that
narrowed the spreads. The June 1992 Memo recommended that the
NASD should support market makers that competed through price
improvement and should protect them from harassment by other
market makers. The June 1992 Memo was distributed to the NASD's
executive management.
The NASD failed to take appropriate action at the time of
the June 1992 Memo to address the issues raised by the pricing
convention and its enforcement through market maker harassment.
The NASD made no attempt to assess the impact of these market
maker practices on spreads or trade executions. Despite the
gravity of the behavior and the potential injury to investors,
the NASD failed to investigate possible violations of law or the
NASD's rules. The NASD's inaction failed to satisfy its
statutory responsibilities as an SRO under the Exchange Act.
3. Post-1992 Developments
After June 1992, the NASD continued to receive information
regarding the pricing convention and its
implications.-[82]- While the NASD was concerned over the
relatively wide spreads on Nasdaq, it pursued limited regulatory
and structural measures such as the excess spread
---------FOOTNOTES----------
-[80]-(...continued)
of the short sale rule and the issue of spreads.
The Subcommittee was composed only of
representatives of market making firms.
-[81]- The June 1992 Memo included a substantial
discussion of certain concepts for regulatory or
structural change of the market as means of
addressing the widening of spreads. See Appendix
at p. 30.
-[82]- Id.
=========================================START OF PAGE 38======
rule-[83]- and a trading system called N*PROVE, which were
designed, in part, to narrow displayed spreads. The N*PROVE
proposal was submitted to the Commission as a replacement for the
SOES system and its immediate automatic execution feature which
was widely disliked by market makers.-[84]- These limited
initiatives were not an adequate substitute for the NASD's duty
to investigate the conduct of its market maker members or to
enforce compliance with the NASD's rules and the federal
securities laws.-[85]-
---------FOOTNOTES----------
-[83]- The excess spread rule in substance provides that
all dealer spreads for a stock must be within 125%
of the average of the three narrowest dealer
spreads in that stock. NASD Manual, Schedule D to
the By-Laws, Part V, 2(d) (CCH) 1819 (1995).
While this rule limits the width of dealer
spreads, it does not address the problem of
inflexibility of pricing and the impact of such
inflexibility on even the narrowest of dealer
spreads.
-[84]- N*PROVE was filed with the Commission on March 28,
1994. Exchange Act Release No. 34145 (June 1,
1994), 59 Fed. Reg. 29649 (June 8, 1994). N*PROVE
was designed to replace SOES's immediate automatic
execution system with an order delivery system
that would have given Nasdaq market makers 15
seconds to decline incoming small orders rather
than having the orders automatically executed
against them. The N*PROVE proposal also included
a limit order file which would have provided some
opportunity for customer orders to interact with
each other. Because the Commission had continuing
concerns that N*PROVE would not provide sufficient
opportunities for customer interaction without the
intervention of a market maker, as well as
concerns about enforcement of the firm quote rule,
the N*PROVE proposal was ultimately withdrawn by
the NASD without formal action by the Commission.
See Exchange Act Release No. 35275 (Jan. 25,
1995), 60 Fed. Reg. 6327, 6329 (Feb. 1, 1995).
-[85]- The NASD and Nasdaq market makers have generally
tried to blame SOES traders for the width of the
spreads in the Nasdaq market. As evidence of the
pricing convention and the other anticompetitive
practices described herein demonstrates, there is
ample reason to doubt this contention. In
addition, the fact that a reduction of the market
makers' exposure to SOES trading in 1994 resulted
(continued...)
=========================================START OF PAGE 39======
The NASD continued to receive indications of a lack of
vigorous price competition in the Nasdaq market. For example, an
article in the August 16, 1993 edition of Forbes reported that
Nasdaq market makers were reluctant to narrow the spreads and
made complaining telephone calls to market makers who did narrow
the spreads.-[86]- Although NASD management was critical
of the Forbes article because of certain perceived inaccuracies,
the senior NASD executive who authored the June 1992 memo
concerning spreads circulated comments regarding the article to
members of the NASD's executive management stating, with respect
to the complaining telephone calls, "I believe this to be true."
In late 1993, the NASD conducted a survey of institutional
investors, which disclosed, among other things, that certain
investors were concerned about possible collusion and self-
dealing by Nasdaq market makers.-[87]- Institutional
investors cited such concerns as a reason for using trading
systems other than Nasdaq-operated systems. The NASD took no
action to investigate or address these concerns.
In May 1994, the media reported on the Christie-Schultz
study which suggested the possibility of tacit collusion among
Nasdaq market makers.-[88]- The Christie-Schultz study
---------FOOTNOTES----------
-[85]-(...continued)
in no perceptible narrowing of spreads further
undercuts such a claim. Specifically, at a May
24, 1994 meeting of market makers and
representatives of the NASD at Bear Stearns & Co.,
an NASD senior executive pointed out that spreads
had not narrowed after the SOES rules changed in
January 1994 to reduce the amount of volume market
makers were obligated to trade on SOES. He urged
market makers to narrow their spreads in light of
their reduced SOES exposure. The absence of an
overall narrowing of spreads after these changes
in the SOES rules is inconsistent with the
argument that SOES trading was responsible for
wide spreads.
-[86]- Gretchen Morgenson, "Fun and Games on Nasdaq,"
Forbes, Aug. 16, 1993, at 75-76.
-[87]- One institutional investor noted his concern that
"dealers collude and share information that we
don't see," while another stated the belief that
"[m]arket 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]
-[88]- See supra note 26 and, accompanying text.
=========================================START OF PAGE 40======
independently raised similar concerns about price rigidity as
discussed in the June 1990 Trading Committee meeting and the June
1992 Memo and should have prompted the NASD to investigate
objectively the issues being raised. The NASD's response,
however, was to engage in public denials, to solicit support from
issuers and market makers, and to undertake economic
research-[89]- to discredit what, by June 1994, it should
have recognized to be well founded.
The NASD failed to meet its statutory obligations as a
result of its failure to investigate meaningfully the pricing
convention and related issues. The NASD's response to these
issues demonstrates a lack of the objective, proactive approach
to addressing potential violations of its rules and federal law
that the Exchange Act requires. Repeatedly faced with serious
allegations concerning widespread, potentially illegal conduct by
market makers, the NASD simply failed to confront the problem.
As an SRO, the NASD is obligated by statute to monitor the Nasdaq
market closely and maintain its integrity. The NASD has a
statutory duty to surveil and enforce vigorously its rules and
the federal securities laws against its members whenever such
members act contrary to the interests of investors and the
public.
B. The NASD's Regulatory Deficiencies
1. Market Maker Influence
The NASD, like any regulator, must be cognizant of the
natural tendency of a regulated industry to influence its
regulator to protect the industry's proprietary interests. As an
SRO, the NASD must guard against the efforts of any one segment
of its membership, such as its market maker members, to assert
undue influence over its regulatory functions and processes.
While the NASD's market maker members have a significant and
appropriate role to play in the self-regulatory process governing
the Nasdaq market, the public interest must be the predominant
---------FOOTNOTES----------
-[89]- The NASD sometimes followed a result oriented
approach to economic research it sponsored. For
example, the NASD would from time to time conduct
preliminary research in an area to ascertain
likely results before commissioning an outside
economist to conduct the research. In one
instance, an agreement with an outside economist
provided that the NASD retained the right to
prevent publication of the research for a $1,000
payment. An internal NASD memorandum explained
that this provision was included in the agreement
"[b]ecause of the negative publicity that may be
generated by poor results. . . ."
=========================================START OF PAGE 41======
concern.
Market makers have exerted substantial influence over the
affairs of the NASD through their traditional active role in its
governance.-[90]- Representatives of firms that make
markets have constituted a majority of the Nasdaq market's Board
of Directors, as well as the committees and subcommittees central
to the governance of the NASD, the administration of its
disciplinary process and the operation of the Nasdaq
market.-[91]- Other less organized constituencies, such as
retail and institutional investors and other broker-dealers, did
---------FOOTNOTES----------
-[90]- See supra note 20, and accompanying text.
-[91]- Changes effected in early 1996 provide for the
composition of the NASD's Board of Governors to be
a majority of non-industry members. Prior to this
time, representatives of firms that make markets
have comprised a majority or a substantial portion
of the NASD's Board of Governors. Much of the
market makers' influence over the disciplinary
process came from their participation in the
District Business Conduct Committees ("DBCCs").
The DBCCs have had a "grand jury" function, in
which the NASD staff must seek DBCC authorization
to initiate a disciplinary action. The DBCCs also
serve as adjudicative bodies, which decide the
outcome of litigated enforcement proceedings and
approve settlements. The grand jury function
provides the NASD's industry members with the
ability to veto NASD staff enforcement
recommendations and allows them to prosecute those
cases they, sitting as members of the DBCC, deem
appropriate. The adjudicatory role of the DBCC
provides NASD members with a powerful and central
role in the self-regulatory process. Meaningful
self-regulation does not require that industry
representatives also perform a grand jury function
in the disciplinary process. The objectivity and
impartiality of the disciplinary process will be
advanced by removing the DBCCs from the grand jury
function and the potential for abuse that such a
role entails. Similarly, the Market Surveillance
Committee, which has a grand jury function with
respect to disciplinary actions proposed by the
NASD's Market Surveillance Department, should no
longer retain that function. The NASD has agreed
to make these changes as part of its undertakings
in the settlement of the administrative proceeding
brought by the Commission concurrently with the
issuance of this Report.
=========================================START OF PAGE 42======
not have comparable representation on those boards and
committees.
2. The Undue Influence of Market Makers in the
Disciplinary Process
The following discussion concerns the NASD's enforcement
process. Nothing herein should be interpreted to mean that the
NASD should not have an active and aggressive enforcement program
with respect to all member firms, including member firms that
traded actively on behalf of customers on SOES ("SOES firms"), to
enforce all rules and regulations of the NASD. This Report
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 SOES firms.
a. Enforcement Emphasis on SOES Activity
The repeated complaints of market makers, coupled with what
the NASD has represented was its belief that the SOES firms were
a source of serious problems in the Nasdaq market, precipitated a
concerted effort by the NASD staff to bring disciplinary actions
against SOES firms.-[92]- A telephone number was listed in
the NASD directory specifically for "Small Order Execution System
(SOES)--Rule Violations/Inquiries." Perceived violations of the
SOES rules became an enforcement priority for the NASD staff.
Firms were identified as potential violators with information
provided by market makers or developed through monitoring SOES
activity by the NASD's Market Surveillance Department. Certain
firms were subjected to special SOES "sweep" examinations, which
in some cases resulted in disciplinary actions. Substantial
resources at the NASD's District 10 Office in New York City and
in its Market Surveillance Department were devoted to monitoring,
examining, and bringing disciplinary actions for potential
violations of the SOES rules.-[93]-
b. The NASD's Laxity in Enforcing the Firm Quote Rule
In contrast to its aggressive enforcement of the SOES rules,
the NASD was far less attentive to possible rule violations by
---------FOOTNOTES----------
-[92]- See Appendix part II.A.3.
-[93]- This is not to suggest that these firms may not
have engaged in conduct that may be violative of
the NASD's rules. Even though the NASD may have
believed that substantial resources were needed
for SOES enforcement, it remained obligated to
ensure balance in both its enforcement process and
allocation of enforcement resources.
=========================================START OF PAGE 43======
market makers.-[94]- For example, the firm quote rule was
enforced only if an aggrieved party filed a written complaint
with the Market Surveillance Department, which initiated a
disciplinary process that could take months to resolve. If a
violation was found, the remedy was only to impose letters of
caution or a relatively small financial penalty against the
offending market maker. Even if the complainant proved its case,
it could not be rewarded with an executed trade. Thus, backing
away complaints were effectively discouraged both by an
ineffective procedure for enforcing the rule and by the absence
of adequate sanctions for demonstrated misconduct.-[95]-
---------FOOTNOTES----------
-[94]- See Appendix parts I.B.2., I.C.4., II.A.3., and
II.B.
-[95]- The small number of NASD formal disciplinary
actions for market related rule violations brought
against joint NYSE/NASD member firms, which would
encompass the larger firms in the securities
industry, illustrates the Commission's concern
over the NASD's enforcement priorities:
Nasdaq
Backing Excess NMS Trade
Year Away Spread Reporting
1991 2 4 9
1992 2 17 6
1993 0 19 4
1994 2 65 3
1995 13 44 16
This record of enforcement activity indicates that
backing away complaints and trade reporting became
enforcement priorities for the NASD after it learned
that the Commission had significant concerns about the
firmness of quotations and the accuracy of trade
reporting. Similarly, enforcement of the excess spread
rule escalated sharply as the width of Nasdaq spreads
became the subject of increasing public controversy.
As discussed further in the text, the excess spread
rule has certain undesirable consequences, and the NASD
is obligated under its settlement with the Commission
to repeal that rule or eliminate its undesirable
consequences.
=========================================START OF PAGE 44======
In 1994, after temporary approval by the Commission of NASD
rule changes limiting access to SOES, SOES firms increased their
use of SelectNet to execute orders. During this period, the SOES
firms filed several thousand complaints alleging that market
makers failed to honor their quotes.-[96]- The NASD
committee that reviewed the complaints excluded the large
majority of these claims from consideration for possible
disciplinary action on the basis of criteria that were
inconsistent with the Commission's firm quote rule and the NASD's
own rule requiring market makers to honor their quotes.
Additionally, in certain of the cases where violations were
found, the NASD committee aggregated the violations and as a
result imposed sanctions less than those recommended by the
NASD's Sanction Guidelines. The result was that the firm quote
rule was not enforced as vigorously as it should have been, and
violations were not adequately deterred. The fact that the
complaining parties were widely disliked by market makers
contributed to the appearance of an imbalance in the NASD's
disciplinary process. The NASD's failure to enforce adequately
the firm quote rule relieved market makers of their obligation to
provide investors with a continuous market as required by the
rules of the Commission and the NASD and created an inaccurate
picture of the market.
c. The NASD's Laxity in Enforcing the Trade Reporting
Rules
The NASD's enforcement of the trade reporting rules was also
inadequate.-[97]- The NASD's trade reporting surveillance
procedures were deficient and were hampered by insufficient
automated surveillance reports. The NASD's examination programs
relied on antiquated methodologies, such as comparing small
samples of manually timestamped order tickets to the times of
trade reports. In fact, an analysis by the Commission's staff of
data readily available to the NASD revealed numerous violations
of trade reporting rules, particularly with respect to larger
orders. Some of the late trade reporting was attributable to
problems with NASD members' internal systems. However, the NASD
did not recognize the extent and 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.
Despite the high rates of late trade reporting identified by
the Commission staff from NASD market data, the NASD historically
---------FOOTNOTES----------
-[96]- Three SOES firms filed the large majority of these
complaints.
-[97]- See Appendix part I.B.2.
=========================================START OF PAGE 45======
has brought very few cases for late trade reporting. When it did
bring cases, the NASD often imposed sanctions inconsistent with
and lighter than those recommended in its Sanctions Guidelines.
Additionally, it had no procedures to follow up and ensure that
deficient firms undertook appropriate corrective action. Thus,
the NASD put little regulatory pressure on market makers to
ensure timely reporting of trades and thereby neglected the
interest of investors and other market participants in having a
full and accurate picture of transactions in the Nasdaq
market.-[98]- In any market, this toleration of late trade
reporting would have created conditions conducive to fraudulent
trading activities such as front running and manipulation.
d. Failure to Enforce the Excused Withdrawal Rules
The excused withdrawal rules apply to the obligations of
market makers to maintain two-sided quotations on a continuous
basis.-[99]- Market makers who have transacted the minimum
volume required by the SOES system have their quotes temporarily
removed from Nasdaq and are given five minutes to revise and
reinstate their quotations.-[100]- Failure to revise and
reinstate their quotes results in suspension of market maker
status in the affected security for twenty days. An exception to
the twenty day suspension may be granted if the market maker
obtains an excused withdrawal from the NASD prior to withdrawing
its quotes.-[101]- The NASD's rules provide that excused
withdrawals may be granted only for certain specific reasons.
The NASD was lax in holding market makers to their quotation
obligations.-[102]- It routinely granted waivers for SOES
withdrawals for reasons not permitted by the rules and failed to
keep adequate records of excused withdrawals granted (which would
have enabled it to detect excessive requests by particular market
---------FOOTNOTES----------
-[98]- Examinations by the Commission's staff also found
that the NASD failed to monitor and enforce
rigorously trade reporting compliance by NASD
members trading exchange listed securities in the
OTC market.
-[99]- See NASD Manual, Schedule D to the By-Laws, Part
V, 2(a) (CCH) 1819 (1995).
-[100]- See NASD Manual, Rules of Practice and Procedure
for the Small Order Execution System, Rule c(2)(G)
(CCH) 2460 (1995).
-[101]- See NASD Manual, Schedule D to the By-Laws, Part
V, 8 (CCH) 1824 (1995).
-[102]- See Appendix part II.B.1.
=========================================START OF PAGE 46======
makers). Until 1995, the NASD regularly granted SOES suspension
waivers as a matter of course without inquiring into the reasons
for the withdrawals. Beginning in 1995, the NASD started to make
some inquiry into the reasons for the SOES withdrawals, although
it continued to grant excused withdrawals for reasons not
permitted by the rules. The NASD's failure to enforce the
excused withdrawal rule undermined the requirement that market
makers provide investors with a continuous market as required by
the NASD's rules.
e. The NASD's Imbalance in Enforcement of Its Rules
The NASD has a statutory obligation to oversee the Nasdaq
market and to enforce its rules and regulations fairly as to all
member firms. The record in the investigation suggests undue
influence of market makers and a lack of vigor and balance in the
NASD's enforcement activities with respect to market maker firms
that is inconsistent with this obligation. See Section
19(g)(1)(B) of the Exchange Act, 15 U.S.C.
78t(1)(B).-[103]- Moreover, the NASD's failure diligently
to enforce its trading rules against its market maker members as
described herein was detrimental to the interests of investors
and the public.
3. The Undue Influence of Market Makers in
the Regulatory Process
a. Market Maker Influence
During the period covered by this investigation, Nasdaq
market makers in certain instances unduly influenced the NASD's
regulatory process in their favor.-[104]- They initiated
or advocated changes in the SOES rules which limited the ability
to trade through SOES. The ideas for these changes often
emanated from trade associations controlled by market makers,
which worked closely with the NASD staff to formulate ideas for
regulatory policy.-[105]- In other instances, the changes
---------FOOTNOTES----------
-[103]- The NASD's failure to effectively enforce Rule G-
37 of the Municipal Securities Rulemaking Board,
which regulates political contributions by
underwriters of municipal securities, provides
another example. See Appendix part II.B.2.
-[104]- See Appendix part II.A.
-[105]- On a number of occasions, associated persons at
NASD member firms have served simultaneously on a
committee or board of a trade association and on
an NASD committee. Although self-regulation
(continued...)
=========================================START OF PAGE 47======
originated from individuals serving on the NASD's Trading
Committee, which consisted largely of market
makers.-[106]- The interests of other NASD constituencies
---------FOOTNOTES----------
-[105]-(...continued)
presupposes that members of industry will
participate in the regulatory activities of their
SROs, such simultaneous service gives rise to
potential conflicts of interest. An obvious
example would be a trader's advocacy for the
proprietary interests of market makers on the one
hand, and his or her undertaking on behalf of the
SRO to safeguard the interests of investors and
the public. The NASD and its industry members
must be sensitive to such actual and potential
conflicts and strive to maintain the fact and
appearance of fairness and objectivity at all
times. Any uncertainty must, of course, be
resolved in favor of steadfast adherence by the
NASD to its obligations to the public and to
investors.
-[106]- The NASD adopted the concept of "customer service"
throughout its organization, including in its
regulatory and disciplinary activities. For
example, NASD managers asked member firms to
evaluate the performance of specific NASD
examiners. There is also evidence that the
concept was applied to enforcement. Thus, when a
disciplinary action was brought against a firm in
1992, a senior NASD executive issued a
congratulatory memorandum to the staff assigned to
the case, which stated "there is no better service
quality we could have provided to our market maker
customers and the individual investor."
Although any regulator may benefit from the regulated
industry's input regarding such things as the
competence or professionalism of the regulator's staff,
the NASD's application of this approach to its
regulatory and disciplinary process raises questions
about the appropriate balance an SRO should strike
between serving the public interest, as an aggressive
regulator, and ensuring that its member "customers" are
satisfied with the "services" they receive in the
course of being regulated. Simply put, excessive
concern about a member's dissatisfaction with
regulation could undermine investor protection.
Similarly, treating a disciplinary action against a
firm as a service to market maker "customers" overlooks
(continued...)
=========================================START OF PAGE 48======
received inadequate consideration in the formulation of these
rule changes. The NASD staff was institutionally constrained
from vigorously advocating those interests by the undue influence
of market makers in the NASD's regulatory process.
b. Application of Standards and Criteria for
Membership
The extent of market maker influence in the NASD's
regulatory process was also reflected in the procedures for
reviewing membership applications.-[107]- At the New York
City District 10 office of the NASD, the District Committee, or a
subcommittee it created called the PMI Subcommittee, played
central roles in reviewing applications for NASD membership.
Both committees consisted largely of individuals associated with
market maker firms. Beginning in 1993, the District 10 Committee
encouraged close scrutiny of applicants who appeared likely to
engage in active SOES trading. This scrutiny sometimes delayed
these applications substantially, even though NASD rules provide
for reasonable review periods.-[108]- The PMI
Subcommittee also encouraged the placement of restrictions on
many applicants in order to limit, discourage, or prohibit use of
the SOES system. The NASD also required certain applicants to
satisfy criteria not enumerated in its rules and prevented such
members, once admitted, from seeking modifications to their
restriction agreements for a period of time. These additional
restrictions were not consistent with the NASD's rules relating
---------FOOTNOTES----------
-[106]-(...continued)
the fact that the SRO's disciplinary process is
intended to serve the public interest, and not the
proprietary interests of a powerful segment of the
NASD's membership.
-[107]- This Report does not pass on the merits of the
NASD's processing or final determination with
respect to any specific membership application,
and nothing in the Report should be interpreted to
be a determination on any such matters.
-[108]- Schedule C of the NASD By-Laws requires a
reasonable review period for membership
applications. NASD Manual, Schedule C to the By-
Laws, Part 1, 1(b) (CCH) 1783 (1995). In
addition, Section 15A(b)(8) of the Exchange Act
requires the NASD to provide a fair procedure for
the denial of membership. 15 U.S.C. 78o-3(b)(8)
(1996).
=========================================START OF PAGE 49======
to the applications process.-[109]-
4. The NASD's Corporate Goals
Since its inception in 1971, the Nasdaq market has become
the second largest stock market in the United States. It has
provided listing, growth opportunities, and access to capital to
thousands of publicly held companies, as well as investment
opportunities to millions of investors. While vigorous
competition between the NASD and the exchanges is beneficial to
the overall development of the U.S. securities markets, no market
should allow its competitive zeal to overshadow its statutory
obligations as a self-regulatory organization.
The investigation uncovered evidence suggesting that, at
times, the NASD may have allowed the critical distinctions
between its two functions to blur. For example, at the time the
NASD first focused on the width of spreads in the Nasdaq market,
its primary concern appeared to be that it perceived spreads in
comparable NYSE listed stocks to be generally narrower. The NASD
focused its concern on the fact that the Nasdaq market would lose
listings to the NYSE and attempted to deal with the spreads issue
through measures, such as the excess spread rule, or through
exhortation, such as at the May 1994 Bear Stearns meeting, rather
than by conducting an investigation of potential violations of
the NASD's rules and the federal securities laws.-[110]-
Viewing the issue of spreads primarily through the prism of its
market-to-market competition with the NYSE, rather than as a
threshold investor protection issue, appears to have contributed
to the NASD's failure to respond adequately to mounting evidence
that the width of the spreads could be attributable to
anticompetitive conduct by Nasdaq market makers.
The investigation also disclosed an excessive emphasis on
public image that is difficult to reconcile with the NASD's role
as the SRO of a major capital market. The results of the
Commission's investigation suggest that surveillance and
---------FOOTNOTES----------
-[109]- The rules relating to membership applications are
set forth in the NASD By-Laws. NASD Manual,
Schedule C to the By-Laws, Part I (CCH) 1783
(1995). The NASD has represented that beginning
in 1993, members of its District 10 Committee had
regulatory concerns about applicants likely to
engage in SOES activity. The District 10
Committee and PMI Subcommittee, however, pursued
their mandate improperly by applying criteria and
standards not permitted by the NASD's rules to
such applicants.
-[110]- See Appendix part I.A.1.e.
=========================================START OF PAGE 50======
enforcement and the enhancement of Nasdaq's trading system should
take priority over an excessive concern with public image. This
observation is directly supported by the NASD's response to the
adverse publicity resulting from publication of the Christie-
Schultz Study and the initiation of government investigations.
Such response reflected an inappropriate emphasis on a defense of
the status quo, rather than a thoughtful examination of the
significant issues that had been raised.
VIII. CONCLUSION
A. Settlement with the NASD
Under Section 19(h)(1) of the Exchange Act, the Commission
may impose appropriate sanctions if the Commission finds that an
SRO has failed to comply with or, without reasonable
justification or excuse, to enforce compliance by its members
with the federal securities laws or its own rules. The
Commission has determined that the NASD's conduct described
herein demonstrates a failure to comply with its statutory
obligations.-[111]- The Commission has entered into a
---------FOOTNOTES----------
-[111]- The Commission has exercised its authority to
bring enforcement actions against SROs on four
occasions in recent years: (a) Midwest Clearing
Corporation ("MCC"), Exchange Act Release No.
31416 (Nov. 6, 1992), 57 Fed. Reg. 54435 (Nov. 18,
1992) (MCC and the Midwest Securities Trust
Company violated, among other things, the
antifraud, books and records, rule making,
customer protection, and clearing agency
registration requirements under the Exchange Act;
MCC settled with the Commission and was censured,
required to undertake certain actions generally
designed to improve internal controls, permanently
enjoined from violating the Exchange Act and Rules
promulgated thereunder, and ordered to pay a civil
penalty of $2,000,000); (b) Chicago Board Options
Exchange ("CBOE"), Exchange Act Release No. 26809
(May 11, 1989) (CBOE failed to enforce certain of
its rules in the face of compelling circumstantial
evidence, was without "reasonable justification or
excuse" in violation of the Exchange Act, and was
censured and ordered to strengthen its
surveillance activities and disciplinary process
and address potential conflicts of interest); (c)
Philadelphia Stock Exchange ("Phlx"), Exchange Act
Release No. 16648 (Mar. 13, 1980) (Phlx, without
reasonable justification or excuse, failed to
comply with or enforce compliance by its members
(continued...)
=========================================START OF PAGE 51======
settlement with the NASD of an administrative proceeding
instituted pursuant to Section 19(h) of the Exchange Act, under
which the NASD, which does not admit or deny the allegations of
the Commission, is censured and ordered to comply with certain
undertakings, which are described below.
The NASD's settlement of the Commission's enforcement action
creates a framework for the reformation of the NASD which builds,
in part, on the recommendations of the Rudman Committee. While
self-regulation benefits from the knowledge, insight, and
---------FOOTNOTES----------
-[111]-(...continued)
with the Commission's quotation rule, and was
censured based on Phlx's representation that it
had made and had undertaken to make extensive
organizational revisions designed to strengthen
its market surveillance and enforcement
capabilities); and (d) Boston Stock Exchange
("BSE") and Boston Stock Exchange Clearing
Corporation ("BSE Clearing Corp."), Exchange Act
Release No. 17183 (Oct. 1, 1980) (violations of
applicable margin, net capital, and bookkeeping
requirements on the part of several BSE
specialists and failure of BSE to maintain
adequate surveillance procedures to ensure
compliance, along with failure of BSE Clearing
Corp. to fulfill its responsibility under
Regulation T to monitor compliance with the
applicable margin requirements, and extension by
BSE Clearing Corp. of excessive credit in
violation of Regulation T; resulted in BSE and BSE
Clearing Corp. being censured and BSE being
ordered to undertake, among other things, to
reassess its corporate governance structure and
surveillance procedures).
Prior to the Securities Act Amendments of 1975, the
Commission had a limited arsenal of regulatory options
to address an SRO's breach of its statutory
responsibilities. Generally, the Commission was
limited to terminating an SRO's registration or
exercising its rulemaking authority to address an SRO's
violations. As a result, Commission action against
SROs prior to 1975 were rare. See Exchange Act Release
No. 7870 (Apr. 22, 1966) (Commission proceedings
pursuant to section 19(a)(1) to withdraw San Francisco
Mining Exchange's registration as a national securities
exchange for repeatedly failing to enforce compliance
with the Exchange Act); S.E.C., Staff Rpt. on
Organization, Management, and Reg. of Conduct of
Members of the Am. Stock Exch. (Jan. 3, 1962).
=========================================START OF PAGE 52======
expertise brought by industry participants, it must give primacy
to the fundamental purpose of regulation of the securities
markets: the protection of investors and the public interest.
As part of its settlement with the Commission, the NASD has
agreed to perform various undertakings to address problems
uncovered in the investigation. First, it has undertaken to
reorganize its governance structure to provide for significantly
greater involvement by representatives of the public and NASD
constituencies other than the market makers.-[112]- These
changes are intended to alter the perspectives of the NASD and
infuse it with a greater sense of objectivity and impartiality.
Diversified representation should instill greater awareness of
the need for evenhanded treatment of all regulated persons in
every aspect of the NASD's activities, including rulemaking,
regulation, disciplinary processes, and operations. Increased
public representation is also intended to heighten the NASD's
appreciation for the needs of investors and the public interest
in a free, open, and competitive market.
The NASD has undertaken to institute the participation of
professional hearing officers, with legal training, to preside
over disciplinary proceedings. This measure should enhance the
dispassionate application of the rules and fairness in the
disciplinary process. Since representatives of NASD member firms
will no longer preside over the hearings, any negative
implications of business persons sitting in judgment on their
competitors should be alleviated. Since industry representatives
will continue to constitute a majority of each hearing panel,
they will continue to have a central role in bringing their
market expertise to bear on the disciplinary process.
The NASD has undertaken to provide for the autonomy and
independence of its staff with respect to disciplinary and
regulatory matters where the commercial interests of the NASD's
members, or any particular segment of its members, could be
inappropriately inserted. Staff autonomy and independence are
---------FOOTNOTES----------
-[112]- These changes will build upon structural reforms
recommended by the Rudman Committee. In terms of
structural change, the Rudman Committee generally
called for substantially greater public
participation in the governance of the NASD and a
separation of the NASD's regulatory function and
the Nasdaq market into separate corporate
subsidiaries. The NASD has adopted in large
measure the recommendations of the Rudman
Committee. The Commission is requiring additional
refinements of the NASD's governance structure
because of the nature and scope of the
Commission's findings.
=========================================START OF PAGE 53======
vital to the future effectiveness of the NASD if it is to comply
with its statutory mandate. The NASD staff must have an
environment in which they can bring to bear the objectivity,
professionalism, and concern for investor protection that an SRO
must always display.
The NASD has undertaken to promulgate and consistently apply
uniform guidelines for regulatory and other access issues, such
as membership applications and conditions of
admission.-[113]- The NASD will also institute safeguards
to ensure fair and evenhanded access to all services and
facilities of the NASD. These measures should bring greater
consistency and fairness to the membership application process,
and other regulatory activities, and deter arbitrariness or the
insertion of inappropriate considerations into these processes.
The NASD has undertaken to ensure the existence of a
substantial independent internal audit staff. The Commission's
findings in its investigation demonstrate the need for an
effective internal audit staff with a direct line of reporting to
the NASD's Board of Governors. The internal audit staff should
address complaints received from members and other NASD
constituencies, maintain a program of regular audits of the
NASD's activities, and independently initiate inquiries with
respect to possible anticompetitive practices and violations of
law or the NASD's rules that otherwise come to their attention.
This measure should ensure that the NASD engages in a process of
comprehensive ongoing self-evaluation.
The NASD has undertaken to design and implement an audit
trail sufficient to reconstruct the markets promptly and
effectively surveil them and enforce its rules. The new audit
trail will include, subject to the Commission's approval, among
other things, an accurate time-sequenced record of orders and
transactions, beginning with the receipt of an order and
documenting the life of the order through the process of
execution. Such an audit trail will significantly enhance the
ability of the NASD to surveil the market to enforce investor
protection rules, such as the prohibitions against trading ahead
of limit orders, and other rules such as the firm quote rule and
trade reporting rules. Vigorous enforcement of these rules will
enhance investor confidence. Improved surveillance is essential
to the integrity of the Nasdaq market and the NASD.
The NASD has undertaken to improve substantially the
surveillance and examination of order handling. Improved
---------FOOTNOTES----------
-[113]- Such guidelines, and guidelines for disciplinary
sanctions, should be filed with the Commission
pursuant to Section 19(b) of the Exchange Act. 15
U.S.C. 78s(b) (1994).
=========================================START OF PAGE 54======
regulatory oversight in this area is warranted in light of the
problems uncovered by the Commission's investigation.
The NASD has undertaken to upgrade substantially its
capability to enforce the firm quote rule by (a) implementing a
process for backing away complaints to be addressed as they are
made during the trading day so that valid complaints may be
satisfied with a contemporaneous trade execution and (b) taking
other appropriate actions. The firm quote rule is a primary
means of ensuring that the market makers provide liquidity. The
frequency of backing away uncovered in the investigation requires
prompt and strict enforcement of the firm quote rule.
The NASD has undertaken to propose a rule or rule
interpretation for Commission approval that will make explicit
that coordination by or among market makers of their quotations,
trades and trade reports, and actions taken as retribution or
retaliation for competitive actions of another market maker or
other market participant, are unlawful under the NASD's rules.
The coordinated activities of market makers described herein sap
the competitive vigor of the market. Such a rule or rule
interpretation is necessary to ensure that a culture of
competition exists in the Nasdaq market.
The NASD has undertaken to enforce Article III, Section 1 of
the NASD Rules of Fair Practice, with a view to enhancing market
maker competitiveness by eliminating anticompetitive or
unlawfully enforced or maintained industry pricing conventions,
disciplining market makers who harass other market makers in
retaliation for competitive conduct, eliminating coordination of
quotations, trades, and trade reports, and acting to protect
order entry firms and non-market maker firms from concerted
discrimination and concerted refusals to deal by market makers.
Such conduct is antithetical to the goal of free and open markets
and the NASD must use its enforcement authority to investigate
and sanction members who engage in it.
The NASD has undertaken to improve substantially the
reliability of trade reporting, through, among other things,
enhancement of surveillance, examination, and enforcement.
Reliable trade reporting is one of the foundations of investor
confidence. The NASD has agreed that a substantial increase in
enforcement resources to enforce trade reporting requirements is
warranted to impress upon market makers the importance of making
timely and accurate trade reports.
The NASD has undertaken to redefine the excess spread rule
to eliminate any disincentive to close the spread in market maker
quotations, or to repeal the rule. The Commission is concerned
that the excess spread rule as presently formulated interferes
with the pricing mechanism of the market. It may have also
created disincentives to narrowing dealer spreads and incentives
=========================================START OF PAGE 55======
for market makers to restrain other market makers from narrowing
their dealer spreads. Regulations which are not serving their
intended purpose or are creating undesirable consequences should
be modified or repealed, and the NASD has agreed to address the
problems created by the excess spread rule.
B. Commission Rule Proposals
The evidence gathered during the Commission's investigation
underscores the need to enhance competition among Nasdaq
participants and to heighten the standards for the handling of
customer orders. The Commission believes that the internal
governance and market reforms that the NASD is undertaking,
including its organizational restructuring, represent significant
advances in this regard. Comprehensive and lasting relief,
however, also requires certain reforms to the operation of the
Nasdaq market. Out of concern for certain practices that have
developed in both the OTC and exchange markets, the Commission
recently proposed a series of requirements for specialists and
market makers concerning order handling and execution practices
on exchanges and the OTC markets that may help to inject
competition into the Nasdaq market.-[114]- The proposal
would enhance transparency and diminish fragmentation by
providing for prices that more fully reflect overall supply and
demand in the market and, thereby, increase competition.
The Commission's proposed amendment to the Quote Rule would
require market makers who submit priced orders to certain
electronic communications networks to make those orders publicly
available. As noted earlier in this Report, market makers are
currently able to avoid quoting odd-eighths in Nasdaq because of
the availability of systems such as Instinet and SelectNet, which
allow market makers to attract trading interest at prices inside
the spread without adjusting their Nasdaq quotes. By ensuring
that the public quotes for a security reflect the best prices at
which market makers are willing to trade, the proposed amendment
would limit the ability of market makers to avoid quoting in odd-
eighths on Nasdaq, without limiting the usefulness of these
systems as efficient alternative mechanisms for negotiating
transactions.
In addition, the Commission's proposal would require market
---------FOOTNOTES----------
-[114]- Although the Commission's rule proposal addresses
certain concerns independent of those detailed in
this Report, the proposed rules, by stressing the
importance of transparency and customer order
interaction, are expected to enhance competition
among Nasdaq market participants and provide a
structural response to some of the anticompetitive
behavior discussed in this Report.
=========================================START OF PAGE 56======
makers to display immediately customer limit orders that improve
their quote. This proposal would improve competition among
market participants by providing investors enhanced access to the
market and, consistent with the statutory directive of achieving
a national market system, would provide greater opportunities for
investors' orders to interact with one another. Further,
transparency of customer limit orders would significantly improve
price discovery and significantly undermine the ability of market
makers to coordinate quotations.
Finally, the proposed rules would require specialists and
OTC market makers to provide their customer market orders with an
opportunity for price improvement. Providing customer orders
with an opportunity for price improvement would allow those
orders to compete with market maker quotations and, thus, impose
competitive pressure on market maker quotations.
These rules were published for comment in September 1995 and
Commission staff are currently studying the proposals and
reviewing the approximately 175 comment letters received. The
Commission anticipates receiving a final recommendation from the
staff on the proposed rules in the near future.
C. Summation
The paramount goals for the NASD are to ensure the free flow
of competition to the Nasdaq market and to attain the
impartiality, objectivity, and public-interest orientation
statutorily required of an SRO. The long term interests of the
Nasdaq market are to provide investors with a free and open
market where execution costs are set through dynamic competition.
To move forward as an effective SRO, the NASD must transform its
attitudes and conduct and renew its commitment to the interests
of investors and the public. The confidence of the public and
investors in the Nasdaq market and in the NASD requires nothing
less, and investors and the public deserve nothing less.
* * * * *
Last Reviewed or Updated: Aug. 31, 2023