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93-29 SEC Approves Rule 10b-6 Passive Market Making and Changes to Notification Procedures Under Schedule D of the NASD By-Laws

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Executive Summary

The Securities and Exchange Commission (SEC) has approved an exception to SEC Rule 10b-6 (Rule 10b-6) and a new companion rule, Rule 10b-6A, under the Securities Exchange Act of 1934 to permit "passive market making" in certain distributions of securities traded on the Nasdaq National Market® or The Nasdaq SmallCap MarketSM during the two-business-day "cooling off" period. Currently, Rule 10b-6 generally requires market makers to withdraw from the market during the cooling-off period to prevent artificially conditioning the market to facilitate a distribution. Rule 10b-6A will permit market makers who are prospective underwriters of a distribution to remain in the market during the cooling-off period.

The NASD® considers adoption of passive market making to be a significant enhancement to the quality of Nasdaq® markets that will alleviate the negative impact of Rule 10b-6 on the cost of capital for companies involved in secondary distributions. Further, the depth and liquidity added to the market by passive market making should reduce market volatility during the cooling-off period before a secondary offering begins.

The SEC also approved amendments to Schedule D to the NASD By-Laws that require the managing underwriter of a secondary offering to inform the NASD when market makers intend to engage in passive market making under Rule 10b-6A.

The amendments to Rule 10b-6 and Rule 10b-6A become effective May 17, 1993. The text of the Schedule D amendments as well as a copy of the Federal Register release announcing the Rule 10b-6 changes follows this Notice.

Background

On July 27, 1992, the NASD filed an Amended Petition for Rule Making (Petition) with the SEC requesting changes to SEC Rule 10b-6 under the Securities Exchange Act of 1934 that would permit passive market making. The Petition resulted from the NASD's findings that, when compared with prices and spreads for exchange-traded securities, special liquidity problems exist in the market for Nasdaq securities during the cooling-off period before an offering. The NASD determined that these liquidity concerns arise because Nasdaq market makers must withdraw from the market to comply with Rule 10b-6. That rule prohibits persons participating in a distribution of a security and their affiliated purchasers from bidding for or purchasing, or inducing others to purchase, such security until they have completed their participation in the distribution.

On October 21, 1992, the SEC approved a release soliciting comments on the requested amendments to Rule 10b-6. The 48 comments received generally indicated strong support for the proposal. Issuers and market makers, in particular, believe that the presence of passive market making may produce a more efficient market for an issuer's securities during the cooling-off period.

Currently, an inordinate amount of volatility can occur after market makers withdraw to comply with Rule 10b-6. The NASD believes that permitting certain market makers to continue to maintain passive two-sided markets when Rule 10b6 applies will permit market forces to operate and set the price of the security before the secondary offering without the influence of an artificially illiquid market.

Nine months following effectiveness of passive market making, the NASD will submit a report to the SEC thoroughly analyzing the amendment's operation. The SEC will then issue a release that calls for an evaluation of the effectiveness of the new rule. This release will give the NASD and market participants an opportunity to comment on the operation of passive market making.

Provisions of Passive Market Making

Security and Distribution Qualifications — A company's securities and its prospective underwriters must meet the following requirements to be eligible for passive market making: the security must trade on the Nasdaq National Market or The Nasdaq SmallCap Market; the security must trade at no less than $5 a share and have at least 400,000 shares in public float; and the underwriting must be a "firm commitment," fixed-price offering. Any security meeting these requirements is deemed an "eligible security."

Market makers, including both prospective underwriters and selling group members, registered in the security during the two calendar months immediately prior to the filing of the offering (reference period) are eligible to engage in passive market making. Market makers, invited to join the syndicate, must account for at least 30 percent of the average daily trading volume in the security during the two full consecutive calendar months immediately prior to the filing of the offering (30 percent Syndicate Test). This permits market makers with an extended market presence before the offering to continue providing liquidity to the market for the security. Volume data is based on activity reported on the Nasdaq Monthly Summary of Activity Report, and passive market makers must notify the NASD of their intention to make a passive market before engaging in such activity.

Trading Restrictions Imposed on a Passive Market Maker —

Passive market making is available during the two-business-day cooling-off period currently provided for in Rule 10b-6. A passive market maker's bids and purchases will be restricted based on the bidding activity of market makers registered in the security but not involved in the distribution (independent bids). Generally, for an eligible security, a passive market maker may not enter a bid or effect a purchase at a price that exceeds the highest independent bid displayed on Nasdaq. A passive market maker may engage in purchases and sales, but must close its market for the remainder of the day if its net purchases (the amount of securities purchased less sales executed) exceed 30 percent of its average daily trading volume (30 percent ADTV Limit).

Given these restrictions, a passive market maker may make a market in eligible securities, as follows:

  • Establishing the bid at the open — at commencement of trading a passive market maker's bid cannot exceed the highest independent bid displayed for the security.

  • In a rising market — if the best independent bid rises, a passive market maker has the option to raise its bid to match the new higher independent bid, but does not have to.

  • Restrictions in a declining market — when the last independent bid drops below the current bid of a passive market maker(s), leaving only passive market makers at the best inside bid, the passive market maker may maintain its higher bid until its purchases equal or exceed the "minimum exposure limit" in the Small Order Execution System (SOES)SM rules (i.e., currently 5,000, 2,500, or 1,000 shares) which the SEC defines as the "SOES mandatory exposure limit" for the security.

In its release, the SEC interprets several situations involving passive market making. Where a passive market maker, nearing its daily 30 percent ADTV Limit, has a customer sell order and a customer buy order in its possession, the passive market maker can effect both transactions with its customers contemporaneously. Therefore, though the purchase may precede the sale, the market maker would not equal or exceed its 30 percent ADTV Limit if the sale transaction is effected and reported within 90 seconds of the purchase transaction.

If a passive market maker receives a customer buy or sell order but does not have a matching order(s) to execute contemporaneous offsetting transactions against, the market maker has 15 minutes to locate a party, including another market maker, willing to take the other side of the transaction. After locating the other side of the order, the market maker must effect the first transaction then effect and report the second one within 90 seconds.

The SEC also notes that a passive market maker's ability to interact with other market makers throughout the day. They confirm that a passive market maker may hit another market maker's bid; however, the passive market maker may not take another market maker's offer.

Single-Transaction Provision, Displayed Size, and Disclosure Obligations

A passive market maker can fully execute any single order that results in the 30 percent ADTV Limit being equaled or exceeded. The passive market maker's displayed size for a security in passive market making cannot exceed the lesser of the security's SOES mandatory exposure limit or the market maker's remaining purchasing capacity under its 30 percent ADTV Limit.

The rule requires that passive market maker bids be designated as such on the Nasdaq screen. In addition, the prospectus relating to the offering of an eligible security must disclose that certain underwriters and selling group members may engage in passive market making.

* * * * *

For a complete statement and explanation of all provisions relating to passive market making see the SEC Release that follows this Notice.

Amendments to Schedule D

On April 16, 1993, the SEC also approved amendments to Schedule D that streamline the procedure for notifying the NASD when market makers intend to engage in passive market making under Rule 10b-6.

Under the streamlined procedure, the managing underwriter of the offering must notify Nasdaq Operations of the identity of not only the distribution participants but also the market makers that intend to act as passive market makers no later than 12 noon on the business day before the cooling-off period begins. The manager must advise the market makers that it has provided such advice to Nasdaq Operations and that Nasdaq will designate their quotations as passive. Each market maker may inform Nasdaq Operations separately of its intention to act as a passive market maker or, by 4 p.m. on the business day before the cooling-off period begins, that it has decided, after the notification by the manager, not to have its quotations identified as passive.

As noted in Notice to Members 88-69 (September 1988) the managing underwriter may employ the same streamlined procedure to inform Nasdaq Operations of those active market makers that will require an excused withdrawal when they comply with 10b-6 by ceasing market-making activities.

* * * * *

Questions regarding this Notice may be directed to Charles L. Bennett, Director, or Richard J. Fortwengler, Associate Director, NASD Corporate Financing Department at (202) 728-8258. Specific questions on the identification of market makers as passive market makers and other market-maker procedures may be directed to Nasdaq Operations at (212) 5093618 or (800) 635-6485.

(Note: New language is underlined.)

Schedule D to the NASD By-Laws

Part VI

Requirements Applicable to Nasdaq Market Makers

* * * * *

Sec. 8. Withdrawal of Quotations and Passive Market Making

* * * * *

(d) Passive market maker status may be granted to a market maker that is a distribution participant in order to comply with Rule 10b-6 or Rule 10b-6A adopted under the Securities Exchange Act of 1934, as amended, on the following conditions:
(1) A market maker acting as a manager of a distribution may no later than noon Eastern Time on the business day prior to the beginning of the cooling-off period: (i) provide written notice to Nasdaq Operations of the contemplated date and time of the commencement of the cooling-off period, the identity of the market makers that are distribution participants that intend to act as passive market makers, and the identity of the Nasdaq security or securities subject to Rule 10b-6; and (ii) advise the market makers that they have been identified as passive market makers and that their quotations will be automatically identified as passive market maker quotations upon the request made by the manager unless they submit to Nasdaq Operations the notice specified in paragraph (2), below; provided, however, that a distribution participant shall inform Nasdaq Operations of its intention to act as a passive market maker pursuant to the procedure in subparagraph (i) if the manager does not provide the required notification.
(2) A market maker that has been identified to Nasdaq Operations as a passive market maker shall provide written notice to Nasdaq Operations and the manager of its intention not to participate in the prospective distribution or not to act as a passive market maker no later than 4:00 PM Eastern Time on the business day prior to the beginning of the cooling-off period in order to avoid having its quotations identified as the quotations of a passive market maker.
(3) In the event the manager of a distribution is not a market maker, each market maker that is a distribution participant shall comply with Subsection (d)(1) unless another market maker has assumed responsibility for compliance.

For purposes of this paragraph (d), the term "cooling-off period" refers to the period specified in Rule 10b-6(a)(4)(xi)(A), the terms "distribution" and "distribution participant" refer to these terms as defined in Rule 10b-6(c)(5) and (c)(6), and the term "passive market maker" refers to this term as defined in Rule 10b-6A.

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 228,229, and 240

[Release No. 33-6991, 34-32117; File No. S7-33-92]

RIN 3235-AF52

Passive Market Making

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange Commission is adopting a new exception to Rule 10b-6 and a new companion rule. Rule 10b-6A, under the Securities Exchange Act of 1934, which permit "passive market making" by NASDAQ market makers in connection with certain distributions of NASDAQ-quoted securities during the period when Rule 10b-6 otherwise would prohibit such activity. The new provisions apply to firm commitment distributions of NASDAQ securities that qualify for the two business day "cooling-off period of Rule 10b-6. A passive market maker's bids and purchases are limited by the level of bids of NASDAQ market makers that are not participating in the distribution. Certain technical amendments also are being made to Rules 502 and 508 of Regulation S-B and Rules 502 and 508 of Regulation S-K under the Securities Act of 1933. The Commission will review the operation of the new rule one year following its effectiveness.

EFFECTIVE DATE: May 17, 1993.

FOR FURTHER INFORMATION CONTACT: Nancy J. Sanow, M. Blair Corkran, Elizabeth Pucciarelli Hensley, or Susan H. Schleisner, Office of Trading Practices, Division of Market Regulation, at (202) 272-2848, Securities and Exchange Commission, 450 Fifth Street, NW., Mail Stop 5-1, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

The Securities and Exchange Commission ("Commission") is adopting a new exception to Rule 10b-61 and a companion rule, Rule 10b-6A, under the Securities Exchange Act of 1934 ("Exchange Act"),2 which permit "passive market making" on the National Association of Securities Dealers Inc.'s ("NASD") Automated Quotation system ("NASDAQ") during the period when Rule 10b-6 otherwise would prohibit such activity.

The Commission proposed the passive market making provisions in response to an amended petition for rulemaking filed with the Commission by the NASD in July 1992.3 The passive market making proposal reflected a cooperative effort between the Commission and the NASD to permit a market presence by NASDAQ market makers when they or their "affiliated purchasers"4 are engaged in a distribution for Rule 10b-6 purposes, subject to certain conditions designed to maintain the Rule's anti-manipulation objectives.

Forty-eight comment letters were received in response to the Proposing Release.5 Forty-six commenters supported the passive market making proposal. Generally, these commenters stated that the new rule would enhance market depth and liquidity during the covered period. Twenty-one commenters suggested various modifications to the proposal. While not expressly supporting or opposing the proposal, two commenters, both of which are national securities exchanges, stated that analogous relief from the provisions of Rule 10b-6 for exchange specialists affiliated with distribution participants should be granted.

The Commission has determined to adopt the passive market making proposal with several modifications suggested by commenters. Rule 10b-6A reduces the restrictions on the market activities of broker-dealers participating in certain distributions of NASDAQ securities and thus should facilitate capital formation by NASDAQ issuers. The Commission expects the NASD, at the end of a nine month period following effectiveness of the new rule, to submit a report thoroughly analyzing the operation of Rule 10b-6A and the adequacy of its surveillance procedures governing passive market making activity. Shortly thereafter, the Commission will issue for public comment a report evaluating the effectiveness of the rule. The Commission believes that this time frame will be sufficient for the NASD and the Commission to obtain information on the operation of passive market making and make any changes, if needed, to the rule. Because the rule introduces a new construct to permit distribution participants to continue market making activities during the Rule 10b-6 cooling-off period, it may function in unanticipated ways and require adjustments prior to the end of the review period. In that event, the Commission would consider making appropriate "mid-course" adjustments prior to the expiration of this period.6
II. Background

Rule 10b-6 is an anti-manipulation rule that is intended to prevent participants in a distribution of securities from artificially conditioning the market for the securities in order to facilitate the distribution, and to protect the integrity of the securities trading market as an independent pricing mechanism. Rule 10b-6 applies to securities offerings that present a potential for manipulation, and covers those persons who may have an incentive to manipulate the market during the distribution. Adopted in 1955, Rule 10b-6 codifies "principles which historically have been applied in considering questions relating to manipulative activity and stabilization in connection with a distribution."7 Specifically, Rule 10b-6 prohibits persons8 participating in a distribution 9 of a security and their affiliated purchasers from bidding for or purchasing, or inducing others to purchase, such security or any related security10 until they have completed their participation in the distribution.11

Rule 10b-6 contains several exceptions to its general prohibitions that are intended to permit an orderly distribution of securities or to limit disruptions in the market for the securities being distributed. In particular, paragraph (a)(4)(xi)12 of Rule 10b-6 ("Exception (xi)") allows an underwriter, prospective underwriter, or dealer, or their affiliated purchasers, among other things, to effect solicited principal transactions13 prior to a two or nine business day "cooling-off" period. This exception reflects the desirability of maintaining depth and liquidity in the market for the issuer's securities consistent with the anti-manipulation objectives of the Rule.14 Once the cooling-off period commences, the distribution participant and its affiliated purchasers must suspend solicited principal activities, including market making (unless otherwise excepted by Rule 10b-6), until the termination of the distribution.15

As described more fully in the NASD Petition and the Proposing Release, the NASD believes that special liquidity problems exist in the NASDAQ market during the cooling-off period prior to an offering, relative to prices and spreads for exchange-traded securities. The NASD Petition ascribes these liquidity concerns to the withdrawal from the market of NASDAQ market makers that must comply with the provisions of Rule 10b-6 when they or their affiliated purchasers participate in a distribution. Therefore, the NASD requested that the Commission amend Rule 10b-6 to permit a NASDAQ market maker to engage in passive market making transactions in NASDAQ securities designated as national market system ("NMS") securities and that qualify for the two business day cooling-off period.
III. The New Exception and Rule

New paragraph (a)(4)(xiv) to Rule 10b-6 excepts passive market making transactions effected in compliance with Rule 10b-6A from the general prohibitions of Rule 10b-6.
A. Eligibility Requirements
1. Securities

As proposed, to be eligible for passive market making a security would have had to: (1) Be a NASDAQ/NMS security;16 (2) have a minimum price of five dollars per share and a minimum public float of 400,000 shares, as computed in accordance with Rule 10b-6(c)(7) ("$5/400,000 Share Test");17 and (3) have NASDAQ market makers who are underwriters or prospective underwriters,18 or affiliated purchasers of underwriters or prospective underwriters, that, in the aggregate, account for at least 40 percent of the average daily trading volume ("ADTV")19 in the security ("syndicate ADTV"), during the two full consecutive calendar months immediately preceding the date of filing of the registration statement under the Securities Act pertaining to the eligible security to be distributed ("reference period"). The purpose behind the $5/ 400,000 Share Test and the NASDAQ/ NMS condition was to require that eligible securities have markets of sufficient depth and liquidity and be subject to real-time transaction reporting that would facilitate surveillance to detect manipulative activity.

The Commission received comments on all of the above three eligibility requirements. Several commenters supported eliminating the requirement that eligible securities be designated as NMS securities, on the basis that the $5/ 400,000 Share Test suffices to identify liquid securities, and that NASDAQ Small-Cap securities (i.e., non-NMS NASDAQ securities) also are subject to real-time reporting requirements.20 In response to the comments, the rule, as adopted, allows any NASDAQ security satisfying the $5/400,000 Share Test to be eligible for passive market making.21

The Commission requested that commenters consider whether the 40 percent syndicate criterion was appropriate, or should be raised or lowered, and whether it would affect syndicate formation. One commenter believed that a level higher than 40 percent would be appropriate. Ten commenters, however, indicated that the Commission should delete or reduce the 40 percent syndicate criterion on the basis that a level as high as 40 percent may affect syndicate formation because the managing underwriter may invite market makers into the syndicate solely to reach the 40 percent threshold. One commenter opposing the 40 percent criterion, stated that a market maker accounting for a percentage of ADTV substantially lower than that level still could represent the principal and most important source of liquidity in the market for that security.

In response to commenters, the Commission has determined to modify this provision in the final rule, while retaining its essential function.22 As adopted, NASDAQ market makers who are underwriters or prospective underwriters or affiliated purchasers of underwriters or prospective underwriters must, in the aggregate, account for at least 30 percent of the ADTV in the security during the reference period ("30% Syndicate Test").23 This lower level responds to commenters' suggestions that a reduced level may be more appropriate, because it may help relieve pressure to expand the syndicate to reach the required level.

The Commission believes that the adopted 30% Syndicate Test is consistent with its belief that passive market making be available only in those instances when Rule 10b-6 otherwise would require a withdrawal of substantial market making capacity. This determination also is consistent with the rationale underlying the NASD Petition: passive market making should be allowed where the market for NASDAQ securities is affected adversely when market makers otherwise are required to withdraw their quotations.
2. Distributions

The Commission has adopted the requirement that passive market making be limited to distributions of securities registered pursuant to the Securities Act and underwritten on a firm commitment basis at a fixed price. One commenter urged modifying this condition to accommodate non-registered and at-the-market offerings. Since the application of Rule 10b-6A to non-registered and at-the-market offerings would be complex and the NASD's surveillance plan would not easily accommodate such offerings, this provision is adopted as proposed.
3. Qualifying Period

As adopted, passive market making is permitted from the time an eligible market maker otherwise would be prohibited from effecting transactions in an eligible security under the terms of Rule 10b-6(a)(4)(xi)(A) (the two business day cooling-off period), until the earlier of the time of the commencement of offers or sales in the distribution or the time at which a stabilizing bid in such security is made pursuant to Rule 10b-724 under the Exchange Act ("qualifying period"). Although this period typically will be two business days, it may be longer (for example, if the scheduled effective date of the registration statement is delayed) or shorter (for example, if pre-effective stabilization is undertaken). This provision is adopted as proposed.
4. Market Makers

As proposed, to be eligible to engage in passive market making. Rule 10b-6A required a market maker to be registered on NASDAQ in the securities that are the subject of the distribution: (1) during the reference period;25 and (2) during the qualifying period. Under the proposal, NASDAQ market makers who are distribution participants (including a member of the selling group who is not an underwriter or prospective underwriter) satisfying the above requirements would have been permitted to engage in passive market making.

Several commenters addressed the requirement conditioning eligibility for passive market making on NASDAQ registration in the offered security during the reference period. Some favored a one-month reference period; another commenter favored eliminating the requirement because it appeared to preclude broker-dealers who were not market makers for the entire two-month reference period from engaging in passive market making.

After considering the comments received, the Commission has determined to delete the proposed reference period and qualifying period requirements in paragraph (b)(9) of the proposed rule. Broker-dealers are not precluded from engaging in passive market making because they were not registered as NASDAQ market makers at the beginning of the reference period or were not so registered for the entire period. However, as adopted, Rule 10b- 6A will continue to limit a passive market maker's purchases to 30 percent of its ADTV,26 which will be provided by the NASD on the basis of NASDAQ market making transactions effected during the reference period.27 Accordingly, a broker-dealer that was a NASDAQ market maker for only a portion of the reference period would have a proportionately reduced ADTV because the volume is averaged over the total number of trading days during that two-month period.28 The qualifying period requirement has been deleted as superfluous, because by the rule's definition a broker-dealer must be registered as a NASDAQ market maker in order to engage in passive market making.29
B. Level of Market Maker Bids

As adopted, during the qualifying period, Rule 10b-6A prohibits a passive market maker generally from entering a bid or effecting a purchase in an eligible security at a price that exceeds the highest bid for those securities displayed on NASDAQ by a market maker that is not participating in the distribution and is not an affiliated purchaser 30 of a distribution participant ("independent bid").31 Rule 10b-6A does not require that a passive market maker's bid equal other passive market makers' bids.

If all independent bids for an eligible security are lowered below a passive market maker's bid made in accordance with Rule 10b-6A, a passive market maker may continue to effect purchases at its bid at a price exceeding the then-highest independent bid until the passive market maker's purchases (aggregate, not net) equal or exceed an amount equal to the mandatory exposure limit in the NASD's small order execution system ("SOES") 32 ("SOES mandatory exposure limit") 33 for the security.34 Once the passive market maker has purchased an amount equal to the SOES mandatory exposure limit, the passive market maker must immediately lower its bid to a level not higher than the highest independent bid. In addition, a passive market maker may purchase all of the securities that are part of any single order that, when executed, results in the SOES mandatory exposure limit being equalled or exceeded without having to withdraw its quotations.35 These provisions facilitate the execution of customer orders by allowing the passive market maker to remain in the market, and give passive market makers an opportunity to remain at their bid during a short-term lowering of the bids of independent market makers.

One commenter supported, and two commenters opposed, the general requirement that a passive market maker's bids must follow independent bids. The latter commenters argued that the passive market makers would possess the most knowledge about the issuer and its business and, therefore, should be relied upon to maintain and protect the security's trading market and pricing mechanism. In the Commission's view, the condition governing permissible levels of market maker bids is the very essence of passive market making. It reflects the Commission's effort to reconcile the goal of Rule 10b-6 (i.e., preventing price-influencing activity by distribution participants, who have an incentive to condition the market for securities in distribution) with the desirability of adding liquidity to the NASDAQ market during periods when distribution participants otherwise would be prohibited from making markets.
C. Purchase Limitation

As proposed, on each business day36 of the qualifying period, a passive market maker's net purchases37 in an eligible security could not have exceeded 25 percent of its ADTV in that security during the reference period. Several commenters opposed the proposed 25 percent ADTV level for various reasons, including difficulty of compliance, lack of necessity in light of the independent bid requirement, lack of purchasing limits in the context of passive market making in foreign markets38 and Rule 10b-7 stabilization activities. Others suggested increasing the ADTV limit, with one commenter suggesting 40 percent on the basis that it would achieve a better balance in promoting a two-sided market, and would lend itself to greater uniformity in light of the proposed 40 percent syndicate criterion for market maker eligibility.

The Commission is adopting the provision subjecting each passive market maker to a daily net purchase limitation. The proposed 25 percent ADTV level, however, is being increased to a level of 30 percent ("30% ADTV Limit").39 The Commission believes that the 30 percent level responds to commenters' suggestions that the purchasing volume limitation be raised.

The ADTV will be derived from the NASD Monthly Activity Report, and will be provided by the NASD to market makers. Based on this information, each passive market maker will be required to determine its 30% ADTV Limit. When a passive market maker's net purchases equal or exceed its 30% ADTV Limit at any time during the qualifying period, Rule 10b-6A requires the passive market maker to withdraw its quotations from NASDAQ immediately, and prohibits the passive market maker from effecting any transactions for the remainder of that day unless otherwise permitted by Rule 10b-5.40

The Commission believes that the net purchasing provision reflected in the 30% ADTV Limit appropriately permits passive market makers to contribute significantly to market liquidity, while it limits the potential for price impact through such activities. A price limit alone would not prevent market makers from influencing the security's pries. Even where a market maker's bids and purchases do not lead the market, they can stimulate activity by others at higher levels and can support prices at higher levels.41 The Commission also believes that an average daily trading limit based on net purchases, rather than aggregate purchases, recognizes that the price impact of market maker sales may tend to offset the effects of market maker purchases. It is also important to note that, with a net purchasing provision, passive market makers will be able to continue to provide liquidity throughout the qualifying period where their trading position is relatively "flat," which is typical of normal market making.

With regard to comments concerning the complexity of a net purchase formulation, the Commission believes that NASDAQ market makers tend to monitor closely their trading positions, and particularly will do such monitoring when they are involved in underwritings. Moreover, they have the capability (enhanced by automated systems) to determine if the 30% ADTV Limit has been exceeded. Once NASDAQ market makers become familiar with passive market making, concerns about its complexity should ease.

As proposed, a passive market maker's aggregate purchases during the last full hour of trading on NASDAQ that precedes the pricing of the eligible security to be distributed could not have exceeded an amount equal to the proposed 25 percent ADTV level reduced by the passive market maker's net purchases as of the beginning of that hour ("last-hour provision").

Several commenters opposed the last-hour provision on the grounds that it was unnecessary and too complicated, and also impractical because of the difficulty in determining the exact time of the offering's pricing. The NASD argued that, because the hour prior to pricing is critical to the efficient pricing of the offering, a restriction on a passive market maker's ability to commit capital during this hour would increase the security's volatility.

The Commission has determined not to adopt any special limitation on purchases during the last hour of trading prior to pricing. Accordingly, a passive market maker's purchases during the last hour will be subject to the same 30% ADTV Limit that is applicable during the rest of the day.

The proposed last-hour provision was based upon a concern that passive market makers could effect sales earlier in the day with a view to entering the last hour with the ability to purchase a very large amount of shares that would in effect stabilize the price of the security. It is not clear, however, that such a strategy would be viable, given the likely impact of those sales. Moreover, the Commission agrees with commenters who argued that a special last-hour provision would have added complexity to the rule. The Commission expects, however, that the NASD will monitor passive market making activity during the final trading hour prior to pricing closely, and provide the Commission with data on last hour transactions. The Commission will consider that information in determining whether the rule should be revised to include a special last hour limitation when the rule is reviewed following the monitoring period.

As adopted. Rule 10b-6A permits a passive market maker to complete any single order that, when executed, equals or exceeds its 30% ADTV Limit.42 Immediately after executing the order, the market maker must withdraw its quotations from NASDAQ. Once a passive market maker has withdrawn its bid, it may not enter any bids for, nor effect any purchases of, the eligible security for the remainder of that day irrespective of additional sales, absent the applicability of a separate exception to Rule 10b-6.
D. Passive Market Making Interpretations

The provisions described above are designed to reflect the fundamental premise underlying passive market making: Bidding and purchasing activity is to be passive, i.e., bids limited by the prices of independent market makers, and purchases limited by such prices and effected in response to order flow. This section discusses interpretations that are intended to reflect this premise. These interpretations, which were included in the Proposing Release, have been modified in response to the comments received.
1. Interaction With Other Market Makers The Proposing Release stated that:

[I]f a passive market maker has a net sales position during the day, it may not affirmatively take another market maker's offer to reduce its short position. Conversely, if the passive market maker is in a net purchase position, it may not affirmatively hit another market maker's bid to reduce its long position. The passive market maker may only adjust its quotations within the parameters of [the proposed rule] to solicit transactions on one side of the market or the other.43

This statement was intended as an explication of what "passive" activity encompassed. In fact, since a passive market maker cannot make a bid or purchase above the level of the highest independent bid, and the highest bid will be below the lowest offer (except in unusual circumstances), the statement that a passive market maker could not take another market maker's offer (i.e., make a purchase) did not constitute a limitation not already included in the passive market making concept.

In general, however, neither Rule 10b-6 nor Rule 10b-6A is concerned with sales activity. The Commission agrees, therefore, with commenters who pointed out that it is not necessary to restrict sales even in instances where a passive market maker initiates the transaction with another market maker. For example, a passive market maker may affirmatively hit another market maker's bid to reduce a long position. This has been reflected in Rule 10b-6A(c), which applies passive market making conditions only to "transactions," which is defined in paragraph (b)(15) as "bids or purchases."
2. Contemporaneous Customer Transaction

Where a market maker has in its possession both a customer order to sell and a customer order to purchase an eligible security, the passive market maker may effect the transactions as principal with each customer contemporaneously. In this situation, the sequence in which the transactions are executed would be ignored so long as the second transaction is effected and reported within 90 seconds of the execution of the first transaction,44 and only the net position would be relevant to passive market making activity. For example, if the purchase from one customer (passive market maker purchase) occurs before the sale to the other customer and the sale is effected and reported within 90 seconds of the execution of the first transaction, then the market maker will not be deemed to have equalled or exceeded its 30% ADTV Limit. No comments were received on this interpretation.

3.15 Minute Provision

In the event a market maker receives a customer sell or customer buy order and the market maker does not have in its possession a matching order or orders with which contemporaneous offsetting executions can be effected,45 the market maker is permitted to hold the initial order for a time period not to exceed 15 minutes, in which time the market maker can attempt to locate a party, other than another market maker, willing to take the other side of the transaction. In this limited situation,46 the Commission does not consider the market maker's efforts to locate the matching order47 to be proscribed solicited activity.48 If the market maker locates customer interest for the other side of the order in the appropriate time frame, the market maker must effect the transactions contemporaneously as described in Section III.D.2. above (i.e., the second transaction must be effected and reported within 90 seconds of the execution of the first transaction).

Several commenters opposed the 15 minute provision, while several others suggested modifications. One commenter suggested that the time limit should relate to the security's ADTV, so that market makers would have more time to locate the other side of an order in a security with a lower ADTV and less time in an actively-traded security. Others believed that the passive market maker should be able to match the order with an unsolicited order of another market maker. One commenter stated that, if, at the end of the 15 minute period the order is still unmatched, the market maker should be able to "hit" another market maker's bid.

The Commission believes that the 15 minute provision provides flexibility for passive market makers while at the same time it prevents a passive market maker from improperly withholding a sell order from the market for an extended period or executing a customer purchase order in a manner that would vitiate the efficacy of the passive market making conditions. Consistent with the discussion above of sales activity by passive market makers and the suggestion of a commenter, during the 15 minute period a passive market maker could "hit" other market makers' bids to fill the customer sell order.

Finally, given the limited nature of the activities discussed in these interpretations, the Commission has determined not to include the interpretations in the text of Rule 10b-6A.
E. Limitation on Displayed Size

As adopted, Rule 10b-6A requires that, at a!! times, each passive market maker's displayed size may not exceed the SOES mandatory exposure limit49 for the eligible security, or its remaining purchasing capacity as set forth in Section III.C. above, whichever is smaller. The Commission has determined to adopt this provision as proposed.
F. Disclosure of Passive Market Making

Because passive market making represents a significant change in the level of distribution participant activity in the market, and bears some resemblance to stabilization activity, the Commission believes that disclosure of passive market making is necessary and appropriate to inform the market of its potential impact on the price and volume of eligible securities.
1. Bid Disclosure

Rule 10b-6A, as adopted, requires that the bid displayed by a passive market maker be designated as such.50 This identification will alert investors and other market participants that distribution participants are effecting passive market making transactions, and will facilitate surveillance of their activities. Each passive market maker is responsible for confirming that its passive market making bids are identified properly. One comment supporting this provision was received.
2. Prospectus Disclosure

The Commission has determined to require that the following legend be included on the inside front cover of the prospectus for any offering in which any passive market maker intends to enter bids or effect purchases in any eligible security:

In connection with this offering, certain underwriters [and selling group members] or their affiliates may engage in passive market making transactions in (identify each class of securities in which such transactions may be effected] on NASDAQ in accordance with Rule 10b-6A under the Securities Exchange Act of 1934. See "Plan of Distribution."

The Commission has revised the language to accommodate commenters' concerns that the legend as proposed appeared to require information that would not be known at the time the preliminary prospectus is filed. This legend disclosure requirement is being adopted as an amendment to Rule 502(d)51 of Regulation S-K under the Securities Act rather than as a part of Rule 10b-6A. This should facilitate compliance by preparers of prospectuses. Similarly, the Commission is adopting, as an amendment to Rule 50852 of Regulation S-K under the Securities Act, the requirement that the prospectus contain a brief description of passive market making in the "Plan of Distribution" section. Similar amendments have been made to Rules 502(d)53 and 508 54 of Regulation S-B under the Securities Act.
3. Transaction Disclosure

Paragraph (c)(10) of the proposed rule would have required a passive market maker who sells to, or purchases any eligible security for the account of, any person to give or send to such person, at or before the completion of each transaction, written notice that passive market making transactions may be or have been effected. If, however, at or before the completion of the transaction, the purchaser received a prospectus, confirmation, or other writing containing disclosure similar to that described in Section III.F.2., then no other written notice would have been required to be given to such purchaser.55

Commenters argued that investors would not find transaction notice of passive market making meaningful and that, in light of prospectus disclosure, separate transaction notice would be unnecessary. One commenter pointed out that investors currently do not receive notification when market makers have to withdraw from the market in accordance with the provisions of Rule 10b-6. The Commission has decided not to require transaction disclosure for investors who purchase securities that are the subject of passive market making. When the Commission revisits Rule 10b-6A, it may reconsider whether transaction disclosure should be required.
G. Notice and Reporting to the NASD As adopted, Rule 10b-BA requires a market maker to provide advance written notification to the NASD of its intention to engage in passive market making. The notice must include information demonstrating that the security, distribution, and market maker qualify for passive market making.56 In addition, the new rule requires that a passive market maker submit to the NASD information about passive market making purchases, in such form as the NASD shall prescribe.

Three commenters provided their views on the proposed notice and reporting requirements. One commenter considered the requirements unnecessary; another remarked that while these requirements may be appropriate, there is no mechanism to enforce compliance; and a third stated that the new rule should list the types of information to be submitted to the NASD.

The Commission has determined to adopt the notice and reporting requirements as proposed. The notice will ensure that the NASD's Surveillance Department receives adequate and timely notification of market makers' intentions to engage in passive market making and thus can initiate the appropriate surveillance procedures to monitor the market for the security that is the subject of the distribution. The NASD is in a better position to determine the specific information that will permit it to conduct appropriate surveillance. Also, the information submitted to the NASD will be useful in the preparation of the NASD's findings and analysis of the operation of passive market making.
H. Transactions at Prices Resulting From Unlawful Activity

As adopted, paragraph (d) provides that no bids or purchases of an eligible security may be made at a price that the passive market maker knows or has reason to know is the result of activity that is fraudulent, manipulative, or deceptive under the Exchange Act or any rule or regulation thereunder.57 Furthermore, any transactions by a passive market maker engaged in for the purpose of creating actual, or apparent, active trading in or raising the price of an eligible security will not be within the provisions of exception (a)(4)(xiv), which incorporates Rule 10b-6A.58
I. Surveillance Procedures

The NASD has developed a comprehensive surveillance plan for passive market making that includes online monitoring and a review and analysis of historical quotation and trading information, as well as the use of the NASD's existing automated surveillance reports. The Commission considers the surveillance plan to be a critical element of the passive market making concept, and expects to work with the NASD during the pilot period to refine and monitor the surveillance procedures.
J. Rule Review

The Commission has determined to adopt Rule 10b-6A as a final rule, but views the rule to be operational on a pilot basis. The Commission expects the NASD to monitor carefully all instances of passive market making to determine its impact on the NASDAQ market during the nine month period following the effectiveness of Rule 10b-6A, and shortly thereafter to provide the Commission with a report about the rule's operation during the nine month period. The Commission believes it would be appropriate, after some experience is gained with the operation of the new rule and the NASD has submitted sufficient data, to evaluate its operation. The Commission, therefore, directs the Division of Market Regulation to prepare a report evaluating the effectiveness of the rule. The report will be issued within 90 days after the rule has been fully operative for nine months, and will be issued for public comment. Once interested parties have commented, and the Commission has made its own evaluation, the Commission will decide what, if any, revisions are appropriate.
IV. Final Regulatory Flexibility Analysis

A final regulatory flexibility analysis has been prepared regarding the amendments to Rule 10b-6 and the adoption of Rule 10b-6A in accordance with 5 U.S.C. 604. A copy of the analysis may be obtained by contacting K. Susan Graft on, Division of Market Regulation, 450 Fifth Street, NW., Washington, DC 20549.
V. Effects on Competition

Section 23(a) of the Exchange Act59 requires the Commission, in adopting rules under the Exchange Act, to consider the anti-competitive effects of such rules, if any, and to balance any impact against the regulatory benefits gained in terms of furthering the purposes of the Exchange Act. In the Proposing Release, the Commission solicited commenters' views on whether the proposed rule would result in any anti-competitive impact, particularly as the proposed exception is applicable to a single United States market. Two exchanges submitted comments requesting that the Commission simultaneously promulgate a rule that would permit specialists affiliated with distribution participants to continue to make markets during the cooling-off periods of Rule 10b-6. In particular, the New York Stock Exchange, Inc. ("NYSE"), noting that passive market making does not apply to the NYSE's market structure and its specialist system, proposed that a specialist organization that is an affiliated purchaser of a distribution participant and that has obtained exemptive relief pursuant to NYSE Rule 9860 be entitled to a total exemption from Rule 10b-6 under certain specified conditions. These conditions would be premised on a specialist meeting its market making obligations, the existence of effective transaction monitoring by the specialist, and effective specialist surveillance by the NYSE. In contrast, two commenters stated that it was unnecessary to provide relief to exchange specialists.

The Commission has determined that exception (a)(4)(xiv) of Rule 10b-6 and Rule 10b-6A, as adopted, will not impose any significant burden on competition not necessary or appropriate in furtherance of the Exchange Act. Transactions on an exchange are not affected by the pendency of a distribution in the way that over-the-counter transactions are. The principal market makers in a NASDAQ security often will be chosen by the issuer as underwriters for the distribution. Rule 10b-6 requires such market makers to withdraw from the market at the commencement of the cooling-off period unless an exception is available. Such withdrawal can affect the depth and liquidity for the security, and the 30% Syndicate Test is designed to limit passive market making to those situations where these effects are likely to be significant. In contrast, exchange specialists do not participate in distributions. Rule 10b-6 requires the specialist to suspend its specialist activities, however, when an affiliate is a distribution participant. In such situations, exchange rules provide for a transfer of the specialist "book,"61 and the continuation of specialist functions.

The limitations on market making activity contained in Rule 10b-6A are not compatible with the obligations imposed on specialists to maintain orderly markets,62 and the exchanges have not suggested that passive market making would work in that context. Instead, the exchanges have suggested a different construct for Rule 10b-6 relief for specialists. The Commission recognizes that "passing the book" causes some degree of disruption to specialist activity, and exemptions from Rule 10b-6 have been granted in appropriate circumstances.63 As part of the Commission's ongoing review of Rule 10b-6. its staff is evaluating the appropriateness of broader relief for exchange specialists.
VI. Statutory Basis and Text of Rule Amendments

Rule 10b-6A and the amendments to Rule 10b-6 are adopted under the Exchange Act, 15 U.S.C. 78a et seq., and particularly Sections 2, 3, 9(a)(6], 10(a), 10(b), 15(c)(2), and 23(a) of the Exchange Act, 15 U.S.C. 78b, 78c, 78i(a)(6), 78j(a), 78j(b). 78o(c)(2], and 78w(a). The amendments to Items 502 and 508 of subpart 228.500 and Items 502 and 508 of subpart 229.500 are adopted under the Securities Act, 15 U.S.C. 77 et seq.

List of Subjects in 17 CFR Parts 228, 229, and 240

Broker-dealers, Fraud, Issuers, Reporting and recordkeeping requirements, Securities.

For the reasons set out in the preamble, Title 17, Chapter II of the Code of Federal Regulations is amended as follows:

PART 228-INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS

1. The authority citation for part 228 continues to read as follows:

Authority: 15 U.S.C. 77e, 77f, 77g, 77h. 77j, 77k, 77s, 77aa(25), 77aa(26). 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn, 77sss, 78l, 78m, 78n, 78o, 78w, 78ll, 80a-8, 80a-29, 80a-30, 80a-37, 80b-11, unless otherwise noted.
2. In § 228.502 paragraph (d) is redesignated as follows:

Old paragraph


New paragraph

(d) heading

(d)(1)



(d)(1)

(d)(1)(i)

(d)(2)

(d)(1)(ii)

(d)(3) introductory text.

(d)(1)(iii) introductory text

(d)(3) (i) through (v).

(d)(1)(iii) (A) through (E)

3. Section 228.502 is further amended by adding new paragraph (d)(2) as follows:

§228.502 (Item 502) inside front and outside back cover pages of prospectus.

* * * * *

(d)
(1) Stabilization. * * *
(2) Passive market making. Include the following statement, if true:

IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS [AND SELLING GROUP MEMBERS] MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE [IDENTIFY EACH CLASS OF SECURITIES IN WHICH SUCH TRANSACTIONS MAY BE EFFECTED] ON NASDAQ IN ACCORDANCE WITH RULE 10b-6A UNDER THE SECURITIES EXCHANGE ACT OF 1934. SEE "PLAN OF DISTRIBUTION."

* * * * *

4. Section 228.508 is amended by adding paragraph (i) to read as follows:

§ 228.508 (Item 508) Plan of distribution.

* * * * *

(i) Passive market making. If the underwriters or any selling group members intend to engage in passive market making transactions as permitted by § 240.10b-6A of this chapter, indicate such intention and briefly describe passive market making.

PART 229-STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND CONSERVATION ACT OF 1975- REGULATION S-K

5. The general authority citation for part 229 continues to read in part as follows:

Authority: 15 U.S.C 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn, 77sss, 78c, 78i, 78j, 78i, 78m, 78n, 78o, 78w, 78ll(d), 79e, 79n, 79t, 80a-8, 80a-29, 80a-30, 80a-37, 80b-11, unless otherwise noted.

* * * * *

6. In § 229.502 paragraph (d) is redesignated as follows:

Old paragraph


New paragraph

(d) heading

(d)(1)



(d)(1)

(d)(1)(i)

(d)(2)

(d)(1)(ii)

(d)(3) introductory text.

(d)(1)(iii) introductory text

(d)(3) (i) through (v).

(d)(1)(iii) (A) through (E)

7. Section 229.502 is further amended by adding new paragraph (d)(2) as follows:

§ 229.502 (Item 502) Inside front and outside back cover.

Pages of Prospectus

* * * * *

(d)
(1) Stabilization. * * *
(2) Passive Market Making. If the registrant or any of the underwriters knows or has reason to believe that there is an intention to engage in passive market making transactions in compliance with §240.10b-6A of this chapter, set forth a statement in substantially the following form, subject to appropriate modification where circumstances require. Such statement shall be in capital letters, printed in boldface roman type at least as large as ten-point modern type and at least two points leaded:

IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS [AND SELLING GROUP MEMBERS] MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE [IDENTIFY EACH CLASS OF SECURITIES IN WHICH SUCH TRANSACTIONS MAY BE EFFECTED] ON NASDAQ IN ACCORDANCE WITH RULE 10b-6A UNDER THE SECURITIES EXCHANGE ACT OF 1934. SEE "PLAN OF DISTRIBUTION."

* * * * *

8. Section 229.508 is amended by adding paragraph (k) to read as follows:

§ 229.508 (Item 508) Plan of distribution.

* * * * *

(k) Passive market making. If the underwriters or any selling group members intend to engage in passive market making transactions as permitted by § 240.10b-6A of this chapter, indicate such intention and briefly describe passive market making.

PART 240-GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

9. The authority citation for part 240 continues to read, in part, as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77), 77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78i, 78m, 78n, 78o, 78p, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.

* * * * *

10. Section 240.10b-6 is amended by removing the "." at the end of paragraph (a)(4)(xiii) and replacing it with a "; or" and adding paragraph (a)(4)(xiv) to read as follows:

§ 240.10b-6 Prohibitions against trading by persons interested in a distribution.
(a)* * *
(4) * * *
(xiv) Market making transactions complying with § 240.10b-6A.

* * * * *

11. Section 240.10b-6A is added to read as follows:

§ 240.10b-6A Passive market making.

(a) Scope of section. This section permits broker-dealers to engage in market making transactions in eligible securities without being in violation of the provisions of § 240.10b-6.
(b) Definitions. Unless the context otherwise requires, all terms used in this section shall have the same meaning as in the Act and § 240.10b-6 thereunder. In addition, unless the context otherwise requires, the following definitions shall apply:
(1) The term ADTV means the average daily trading volume in an eligible security during the reference period, as obtained from the NASD. If a passive market maker excludes SOES volume from the calculation of its net purchases as defined in paragraph (b)(8) of this section, then SOES volume also must be excluded in determining the market maker's ADTV.
(2) The term 30% ADTV Limit means 30 percent of the market maker's ADTV.
(3) The term eligible security means a NASDAQ security that:
(i) Is the subject of a firm commitment, fixed price offering registered under the Securities Act of 1933 or is a related security;
(ii) Has a minimum price of five dollars per share and a minimum public float of 400,000 shares, as computed in accordance with § 240.10b-6(c)(7); and
(iii) Has NASDAQ market makers that are underwriters or prospective underwriters, or affiliated purchasers of underwriters or prospective underwriters, that account for at least 30% of the total trading volume in such security, as reported to the NASD for the reference period.
(4) The term independent bid means a bid for a security displayed on NASDAQ by a market maker who is not participating in the distribution of that security or a related security, and is not an affiliated purchaser of such a participating market maker.
(5) The term NASD means the National Association of Securities Dealers, Inc.
(6) The term NASDAQ means the NASDAQ system as defined in §240.11Acl-2(a){3).
(7) The term NASDAQ security means a security that is authorized for quotation on NASDAQ, and such authorization is not suspended, terminated, or prohibited.
(8) The term net purchases means the amount by which a passive market maker's purchases exceed its sales. A passive market maker's SOES purchases and sales may be excluded from the calculation of net purchases if the adjustments to ADTV are made as required by paragraph (b)(i) of this section.
(9) The term passive market maker means a market maker that effects transactions in accordance with the provisions of paragraph (c) of this section.
(10) The term qualifying period means the period from the time that a passive market maker would otherwise be prohibited from effecting transactions in an eligible security under the terms of § 240.10b-6(a)(4)(xi)(A), until the earlier of the time of commencement of offers or sales of the eligible security to be distributed or the time at which a stabilizing bid for such security is made pursuant to § 240.10b-7.
(11) The term reference period means the two full consecutive calendar months immediately preceding the date of filing of the registration statement under the Securities Act of 1933 pertaining to the security to be distributed.
(12) The term related security means:
(i) A security of the same class and series as, or a right to purchase, the security to be distributed or deemed to be in distribution; and
(ii) Any security deemed to be in distribution pursuant to § 240.10b-6(b).
(13) The term SOES means the NASD's Small Order Execution System, as defined in the NASD Rules of Practice and Procedures for the Small Order Execution System.
(14) The term SOES mandatory exposure limit means the aggregate number of shares of the security equal to five times the maximum order size for that security that may be entered into or executed through SOES.
(15) The term transaction means a bid or a purchase.
(c) Conditions to be met.
(1) General limitations. A passive market maker must effect all transactions in the capacity of a registered market maker on NASDAQ. Except as provided below, during the qualifying period, a passive market maker shall not effect a transaction in an eligible security at a price that exceeds the highest independent bid for the eligible security at the time of the transaction.
(2) Level of bid. A passive market maker may display its bid at a price not in excess of the highest independent bid for an eligible security.
(3) Requirements to lower the bid. If all independent bids for an eligible security are lowered below the passive market maker's bid, the passive market maker must lower its bid to a level not higher than the then highest independent bid; Except That:
(i) The passive market maker may continue to effect purchases at its bid at a price exceeding the then highest independent bid until the passive market maker purchases an amount of the eligible security that equals or exceeds the SOES mandatory exposure limit for that security; and
(ii) A passive market maker may purchase all of the securities that are part of a single order that, when executed, results in the SOES mandatory exposure limit being equalled or exceeded.
(4) Purchase limitation. On each day of the qualifying period, a passive market maker's net purchases shall not exceed its 30% ADTV Limit; Except That a passive market maker may purchase all of the securities that are part of a single order that, when executed, results in its 30% ADTV Limit being equalled or exceeded. If a passive market maker's net purchases equal or exceed its 30% ADTV Limit, it shall immediately withdraw its quotations from NASDAQ, and it may not effect any transaction in the eligible security for the remainder of that day, irrespective of any additional sales during that day, unless otherwise permitted by § 240.10b-6.
(5) Limitation on displayed size. At all times, the passive market maker's displayed bid size may not exceed the smaller of the SOES mandatory exposure limit for the eligible security, or the passive market maker's remaining purchasing capacity under paragraph (c)(4) of this section.
(6) Identification of a passive market making bid. The bid displayed by a passive market maker shall be designated as such.
(7) Notification and reporting to the NASD. A passive market maker shall notify the NASD in writing in advance of its intention to engage in passive market making. A passive market maker shall submit to the NASD information regarding passive market making purchases in such form as the NASD shall prescribe.
(8) Prospectus disclosure. The prospectus for any offering in which any passive market maker intends to effect transactions in any eligible security shall contain the information required in §§ 228.502, 228.508, 229.502 and 229.508 of this chapter.
(d) Transactions at prices resulting from unlawful activity. No transaction shall be made at a price which the passive market maker knows or has reason to know is the result of activity which is fraudulent, manipulative, or deceptive under the Act or any rule or regulation thereunder.

Dated: April 8, 1993

By the Commission. Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 93-8710 Filed 4-14-93; 8:45 am]

BILLING CODE 80l0-01-P


1 17 CFR 240.10b-6.

2 15 U.S.C. 78(a) et seq.

3 See Securities Exchange Act Release No. 31347 (October 22.1992), 52 FR 49039 ("Proposing Release").

The NASD filed a petition for rulemaking, and an amendment thereto ("NASD Petition"), with the Commission requesting that it amend Rule 10b-6 to permit "passive market making" during certain distributions. The NASD filed the original petition on June 28, 1991, pursuant to Section 553(e) of the Administrative Procedure Act. 5 U.S.C 553(e), and Rule 4(a) of the Commission's Rules of Practice, 17 CFR 201.4(a). The original submission, supplementary material, and the July 27, 1992 amendment are available in the Commission's Public Reference Section at the address noted above in File No. S7-33-92.

4 "Affiliated purchaser" is defined in 17 CFR 240.10b-6(c)(6).

5 The Commission received letters from 29 NASDAQ issuers, nine broker-dealers, four associations, four self-regulatory organizations, and two law firms. A Summary of Comments has been prepared by the Division of Market Regulation ("Division") and is included in File S7-33-92. The Summary of Comments does not include one comment letter received from a broker-dealer after the Summary was prepared.

6 The Division is conducting a general review of the operation of Rule 10b-6 and related provisions. The results of this review also may affect the Commission's evaluation of passive market making.

7 Securities Exchange Act Release No. 5040 (May 18, 1954), 19 FR at 2966. See also IX L. Loss & J. Seligman. Securities Regulation 4015 (3d ed. 1992).

8 Among others. Rule 10b-6 applies to issuers, underwriters, prospective underwriters, dealers, brokers, and other persons who have agreed to participate or are participating in a distribution. With particular reference to the NASD Petition, the Rule covers market makers when they or their affiliated purchasers are involved in a distribution.

9"Distribution" is defined in 17 CFR 240.10b-6(c)(5) as an offering of securities, whether or not subject to registration under the Securities Act of 1933 ("Securities Act"), 15 U.S.C. 77a et seq., that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.

10 "Related security" refers to: (A) A security of the same class and series or right to purchase the security in distribution; or (B) a security that is deemed to be in distribution because of the operation of Rule 10b-6(b). 17 CFR 240.10b-6(b), which provides that the distribution of a security (1) which is immediately exchangeable for or convertible into another security, or (2) which entitles the holder thereof immediately to acquire another security, shall be deemed to include a distribution of such other security within the meaning of Rule 10b-6. See Rule 10b-6A(b)(12).

11 See Securities Exchange Act Release No. 19565 (March 4. 1983). 48 FR 10628 ("Release 34-19565").

12 17 CFR 240.10b-6(a)(4)(xi).

13 The publication of a market maker's bid quotation involves a solicitation for the security.

14 See Securities Exchange Act Release No. 24003 (January 16, 1987), 52 FR 2994.

15 See 17 CFR 240.10b-6(c)(3). Any transactions effected in accordance with any of the exceptions to Rule 10b-6. including exception (a)(4)(xi), may not be engaged in for the purpose of creating actual, or apparent, active trading in or raising the price of the covered securities. 17 CFR 240.10b-6(a)(4).

16 NASDAQ/NMS securities are securities that are: quoted on NASDAQ; and subject to real-time reporting pursuant to a transaction reporting plan filed by the NASD under Section 11A of the Exchange Act. 15 U.S.C. 78k-l. See also Schedule D of the NASD By-Laws. Part XIII. NASD Manual (CCH) 111867A-1867C.

17 17 CFR 240.10b-6(c)(7). The criteria included those contained in paragraph (a)(4)(xi)(A) of Rule 10b-6, which permit distribution participants to solicit purchases of the securities that are the subject of the distribution, or any related security, until two business days prior to the commencement of offers or sales of the securities to be distributed. 17 CFR 240.10b-6(a)(4)(xi)(A).

In order to be eligible for passive market making, a "related security" as defined in Rule 10b-6A(b)(12) must satisfy the eligibility criteria set forth in this section. See n.10 supra.

18 These terms are defined in 17 CFR 240.10b-6(c) (1) and (2).

19 The ADTV constitutes the daily trading volume in an eligible security as reported to the NASD by the market maker and thereafter reported by the NASD in a monthly report ("NASD Monthly Activity Report").

20 All securities quoted on NASDAQ are now subject to real-time transaction reporting. In 1992, Schedule D to the NASD By-Laws was amended to add requirements for trade reporting for securities quoted on the "NASDAQ Small-Cap Market" that are similar to the trade reporting requirements for NASDAQ/NMS securities. NASDAQ Small-Cap securities are not reported pursuant to Section 11A under the Exchange Act, 15 U.S.C. 78k-l. and are not NMS securities. See Securities Exchange Act Release No. 30569 (April 10.1992). 57 FR 13396.

21 In response to the Commission's request for comment, eight commenters addressed the issue of whether a security eligibility standard based on the dollar value of ADTV is more indicative of market depth and liquidity and should be used in place of the $5/400.000 Share Test Five commenters favored keeping the $5/400,000 Share Test on the basis that it is easy to apply and has worked well in the context of Rule 10b-6. Three commenters, however, urged revisions to this test and suggested alternative standards, such as an ADTV of at least $500,000 for the security; reliance on (actors such as market capitalization, number of institutional holders, dollar value of ADTV, the number of market makers: and dollar value of public float One commenter stated that the $5/400,000 Share Test was inappropriate because of the susceptibility of small companies' stocks to price manipulation, and suggested limiting the availability of the passive market making provisions to issuers with a minimum market capitalization of $200 million. Following a comprehensive review of Rule 10b-6 and related provisions, the Commission may determine to modify Rule 10b-6's currant standard for reliance on the two business day cooling-off period, and thus revise the corresponding criterion for passive market making eligibility.

22 One commenter recommended that a market maker be given flexibility in calculating its own ADTV level, suggesting, for example, a "rolling" 60 day standard. The staff of the Division will consider specific no-action requests from individual firms that wish to calculate their own ADTV over some period other than the two calendar month period provided for in Rule 10D-6A. Such individual requests should be submitted to the Division, along with appropriate information on the basis for the alternative ADTV calculation. The firm concurrently should notify the NASD that it is making such a request

23 The NASD will calculate and provide to the managing underwriter the ADTV levels for prospective market makers for purposes of the 30% Syndicate Test and the net purchase limitation discussed infra in Section III.C.

24 17 CFK 240.10D-7. Rule 10b-7 governs the placing of stabilizing bids or the effecting of stabilizing purchases to facilitate an offering. Stabilization does not encompass transactions that raise the price of the security or create actual, or apparent, active trading greater than that necessary to prevent or retard a decline in the price. The Commission has observed that similarities of purpose and effect exist between stabilization and passive market making. See Release 34-19565.

25 As stated above, the reference period is the two calendar months immediately preceding the filing of the registration statement in connection with the offering. Rule 10b-6A(b)(11).

26 See Section III.C infra.

27 See n.23 supra and accompanying text

28 Trading days in which a market maker does not effect any trades in the eligible security will reflect a trading volume of zero for purposes of calculating the ADTV. In calculating a market maker's ADTV. the NASD will not consider days on which the market maker has obtained an excused withdrawal pursuant to NASD rules. See Section 8 of Schedule D to the NASD By-Laws. NASD Manual (CCH) ¶ 1824.

29 See Rule 10b-6A(c)(l).

30 The term "affiliated purchaser" includes "a person directly or indirectly acting in concert" with a distribution participant in the acquisition or distribution of the distribution security or any related security. 17 CFR 240.10b-6(c)(6)(i)(A). For example, if a distribution participant influenced an ostensibly independent market maker to publish a bid or make purchases at some price or at certain times, the market maker would be an affiliated purchaser, and its bids and purchases could not be used to determine the permissible levels of passive market making activity. In addition, such activity likely would violate Rule 10b-6. See, e.g., SEC v. Scott Taylor & Co., Inc., 183 F. Supp. 904, 908 (S.D.N.Y. 1959).

31 In the event that no independent bid exists in the market (i.e., all market makers in a security are members of the syndicate), then passive market making would not be permitted.

32 SOES was designed to provide the benefits of immediate execution to retail customer orders for securities quoted on NASDAQ by permitting orders to be executed automatically at the best bid or ask price ("inside market"). SOES is restricted to public customer orders of 1,000 or fewer shares in NASDAQ/NMS securities and 500 or fewer shares in NASDAQ non-NMS securities. See Securities Exchange Act Release No. 29809 (October 10, 1991), 56 FR 52092.

33 The SOES mandatory exposure limit is the number of shares of a security that a market maker is required to accept for its account through SOES executions. Specifically, the SOES mandatory exposure limit for a security is the aggregate number of shares of the security equal to five times the maximum order size for that security. The term maximum order size means the maximum size of individual orders for a security that may be entered into or executed through SOES. All NASDAQ/NMS securities are in one of three tiers of maximum order sizes in SOES: 1,000, 500. and 200. See NASD Rules of Practice and Procedures for the Small Order Execution System, Sections a-f. NASD Manual (CCH) 112451-2470.

34 This purchasing provision is not limited to SOES transactions. All passive market making purchases would count against the permitted SOES mandatory exposure limit level. A passive market maker's purchases also are restricted by its net purchase limit

35 A market maker who sought to combine two or more orders to purchase an amount of shares that it would not be able to purchase if the transactions were executed separately would not be within the provisions of Rule 10b-6A. The Commission expects that the NASD will monitor carefully those transactions that take a market maker over the SOES mandatory exposure limit for the security to ensure that orders are not aggregated to take advantage of this provision.

36 Consistent with Rule 10b-6, the staff interprets a business day as a twenty-four hour period determined with reference to the principal market for the security, and that includes a complete trading session for that market (i.e., the same-day opening and closing on NASDAQ). See Letter regarding Rule 10b-6: Interpretation of "Business Day" (July 29, 1991), 11991) Fed. Sec. L. Rep. (CCH) ¶ 79,751.

37 "Net purchases" are defined as the amount by which a passive market maker's purchases exceeds its sales. See Rule 10b-6A(b)(8).

38 See, e.g., Letter regarding the International Stock Exchange of the United Kingdom and the Republic of Ireland Limited (now the London Stock Exchange ("LSE")) (September 29,1987). [1987] Fed. Sec. L. Rep. (CCH) ¶ 78,713, as modified in Letter regarding the International Stock Exchange of the United Kingdom and the Republic of Ireland Limited (October 14.1988) [available on LEXIS], and Letter regarding Distribution of Certain SEAQ Securities (December 1, 1992) (available on LEXIS) (exemptions from Rules 10b-6 and 10b-7 to permit LSE market makers to engage in a form of passive market making transactions on the Stock Exchange Automated Quotations system during the period that the provisions of Rule 10b-6 normally would prohibit such activities).

39 The Commission believes that it is desirable to give passive market makers flexibility regarding the treatment of SOES volume in connection with passive market making activities. Therefore, a passive market maker may opt to exclude SOES volume from its passive market making activities, see supra n.33 and accompanying text in other words, a passive market maker may disregard SOES purchases when calculating its net purchases. If the market maker elects this option, it must disregard SOES sales in determining its purchasing capacity. If a passive market maker excludes SOES volume from its 30% ADTV Limit, then SOES volume also must be excluded in determining the market maker's ADTV during the reference period.

40 A market maker whose net purchases on Day 1 of the qualifying period are less than its 30% ADTV limit cannot carry over the balance to Day 2. A passive market maker that has withdrawn its quotations from the market cannot re-enter passive market making quotations during that day irrespective of other transactions that it may effect pursuant to other Rule 10b-6 exceptions.

41 See, eg., SEC v. Scott Taylor S-Co., Inc., 183 F Supp. 004, 906 (S-D.N.Y. 1959); Haltey, Stuart A Co., Inc., 30 IE.C 106.121 (1949).

42 The NASD has represented that it will monitor carefully those transactions that are permissible but take a market maker over its 30% ADTV Limit to ensure that there is no aggregation of orders to take advantage of this exception or other inappropriate activity.

43 Proposing Release, 52 FR at 49047, n.87. The "contemporaneous customer transaction" and the "15 minute provision" discussed below deal with situations that the Commission believes will occur rarely during the qualifying period, but may provide useful guidance to passive market makers

44 NASDAQ market makers are required to report a transaction within 90 seconds of its execution. Schedule D of the NASD By-laws. Part XII, Section 2. NASD Manual (CCH) 1 1867. Therefore, the execution of the first transaction by the market maker will start the 90 second "clock," and the market maker will be required to report that trade, and execute and report the second trade, within the 90 second period in order for them to be considered contemporaneous.

45 See Section in.D.2.

46 This would be the situation where the passive market maker received a customer order during the qualifying period that exceeded the size of the passive market maker's quotation and that the passive market maker did not wish to execute because it would cause it to exceed its 30% ADTV Limit, although such a transaction is permitted under the rule (see text at n.42 supra).

47 Except as described in Section III.D.1. above, the passive market maker cannot fill the order with other market makers.

48 The market maker's solicitation activities are limited to only those necessary to offset the order

49 As discussed in n.33 supra, the SOES mandatory exposure limit for a security is the aggregate number of shares of the security equal to five times the maximum order size for that security

50 NASDAQ operations will insert a special designation next to the quotations of a passive market maker.

5117CFR229.502(d).

52 17 CFR 229.508.

53 17CFR228.502(d).

54 17 CFR 228.508.

55 This proposed provision was modeled upon the transaction disclosure requirement in connection with stabilization activities. See Proposing Release, 57 FR at 49046.

56 Cf. Schedule D to the NASD By-laws, Part VI, Section 3. NASD Manual (CCH) ¶ 1820 (requiring market makers to provide advance notice to the NASD of their intention to engage in stabilization).

57 Cf. 17 CFR 240.10b-7(i).

58 See Rule 10b-6(a)(4). Moreover, the general antifraud and anti-manipulation provisions of the securities laws continue to apply.

59 15U.S.C. 78w(a)(2).

60 Rule 98. Restrictions on Approved Persons Associated with a Specialist's Member Organization. NYSE Guide (CCH) 12098. Rule 98 provides relief for entities in a control relationship with a specialist organization from other NYSE rule restrictions that otherwise would be applicable to such entities' transactions in securities in which the specialist organization is registered, or to business transactions with the issuers of such securities.

61 See NYSE Rules 104.15.104.17.106A. and 460.20, NYSE Guide (CCH) 112104.15, 2104.17. 2106A, and 2460.20: Amex Rules 172 and 173. Amex Guide (CCH) 119312 and 9313.

62 See NYSE Rule 104. NYSE Guide (CCH) 12104; Amex Rule 170. Amex Guide (CCH) 19310.

63 See. e.g., Letter regarding Application of Rules 10b-6 and 10b-13 to Specialists Affiliated with NYSE Member Firms (September 15, 1992) (1992) Fed. Sec. L. Rep. (CCH) 176.279.


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