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92-8 Proposed Amendment to Rules of Fair Practice, Article III, New Section 46: Short-Sale Rule for Nasdaq/NMS Securities and New Section 47: Primary Nasdaq Market Makers; Last Voting Date: March 13, 1992
The NASD invites members to vote on a new Section 46, Article III of the Rules of Fair Practice regarding adoption of a short-sale rule or "bid test" for Nasdaq National Market System (Nasdaq/NMS) securities. The proposed short-sale rule will prohibit members from effecting short sales at or below the bid for themselves or their customers when the current inside or best bid is below the previous inside bid. The rule will be in effect during normal, domestic market hours (9:30 a.m. to 4 p.m., Eastern Time) and includes an exemption for transactions by qualified Nasdaq market makers. Qualified or "primary" Nasdaq market makers are designated as such if they comply with the criteria set forth in new Section 47. The three primary criteria relate to dealer spread, time at the inside quotation, and quote changes in relation to trades. A supplemental criterion relates to the share of trading volume accounted for by a market maker. The NASD Board of Governors approved adoption of a short-sale rule in November 1991 and approved the primary market-maker qualifications in January 1992 following a year of comment and discussion among members, issuers, and institutional participants in the Nasdaq market.
The text of the proposed rules follow this notice.
In January 1991, the NASD solicited comment from the membership on the concept of a short-sale rule for the Nasdaq market. More than 100 comment letters supporting and opposed to the concept from members and issuers were submitted, along with hundreds of short form responses from issuers in support of the rule. Thereafter, the issue was referred to appropriate committees for consideration. During the past year, the Corporate Advisory Board and the Issuer Affairs, Institutional Investors, Corporate Financing, Marketing, and Trading Committees discussed the pros and cons of adopting a short-sale rule. In addition, joint meetings were held to address concerns of the different constituencies and representatives of the market-making community and of professional short sellers met with Board representatives.
Each committee that reviewed the short-sale issue submitted a positive recommendation for such a rule to the Board of Governors. While the committee votes were not unanimous on the issue, the consensus among committees and overwhelming support from Nasdaq issuers for a short-sale rule persuaded the Board to approve the rule.
The short-sale rule developed for the Nasdaq market is comparable to the short-sale rule for listed stocks in many ways. The SEC short-sale rule, Rule 10a-l, was adopted to prevent speculative selling in exchange-listed securities from accelerating a decline in the price of a security and to prevent a form of manipulation known as "bear raiding" or "piling on." Piling on occurs when short sellers exert pressure on a stock's price, forcing the price to drop precipitously, frequently within a single trading day. The SEC rule applies to exchange-listed securities but does not apply to Nasdaq securities.
Because of differences between exchange and Nasdaq markets, the short-sale rule for the Nasdaq market is based on a "bid test" rather than the exchange "tick test." A "tick" means the last reported sale price on the consolidated tape, and the SEC rule prohibits short sales of exchange-listed securities at prices below the previous reported last sale price (minus tick) or at the last sale price if that price is below the previous different last sale price (zero-minus tick). Since the substantial majority of trade reports in most exchange-listed securities occur on a single exchange floor, generally ensuring sequential trade reporting, the SEC short-sale rule is based on the last sale or tick.
Trade reporting in Nasdaq/NMS securities, on the other hand, may involve as many as 50 different market makers in a given stock, reporting trades from different locations to the NASD via computer interface or through Nasdaq WorkstationSM terminals. Although trades are required to be reported within 90 seconds after execution, they do not necessarily appear on the Nasdaq tape in sequential order. For this reason, the Nasdaq short-sale rule was designed as a bid test.
HOW THE NASD SHORT-SALE RULE WORKS
The NASD short-sale rule will operate to prohibit short sales at or below the bid when the current inside bid for a Nasdaq/NMS security is below the previous inside bid in the security. The Nasdaq system calculates the inside bid as the best bid from all market makers in the security, and the system will be configured to indicate on the screen whether the current bid is an "up bid" or a "down bid" so that members will have that information at their fingertips when effecting short sales. The NASD rule will also include many of the same exceptions contained in the SEC's short-sale rule (discussed below).
A sale is considered "short" if the seller does not own the stock, or if the seller owns the stock but delivers borrowed stock to the buyer at settlement. To determine whether the seller is long or short overall, the seller must net all positions in the security just as is required in short sales for listed securities.
The NASD short-sale rule applicable to Nasdaq/NMS securities will:
The Board of Governors has also authorized, simultaneous with adoption of a rule applicable to NASD members, submission of a petition to the SEC to amend its short-sale rule, Rule 10a-1, to include Nasdaq/NMS securities so that short-sale restrictions will apply to all market participants.
COMPARISON WITH SEC SHORT-SALE RULE
In order to reduce compliance burdens for members, the NASD rule incorporates the exemptions in Rule 10a-1 that are relevant to trading in the Nasdaq market. Specifically, the rule exempts:
Because the definition of short sale fails to take into account all economically equivalent securities in defining a long position, the liquidation of index arbitrage positions was covered by the literal language of Rule 10a-l. To alleviate this problem, in 1986 the SEC took a "no action" position that allows broker/dealers to sell short on a down tick while liquidating index arbitrage positions under certain conditions. The SEC stated that a broker/dealer could effect sales of long positions in stocks that are offset by short positions in stock index futures and/or options in connection with the unwinding of index arbitrage positions without regard to the short-sale rule. The exemption applies when the firm has a net short position in any of those stocks that is attributable to unrelated arbitrage, risk arbitrage, or hedge activities.
In 1990, the SEC clarified the application of the 1986 no-action position. Relief is available only when unwinding index arbitrage positions that were established in compliance with Rule 3b-3 (the SEC rule defining short sales that require netting) and Rule 10a-l, and where action is taken to reverse both sides of the position as nearly simultaneously as practicable. The NASD would recognize this exemption. The proposed rule also contains a provision that would allow the NASD to adopt SEC amendments to Rule 10a-1 that are applicable to the Nasdaq market without recourse to membership vote.
EXEMPTION FOR QUALIFIED NASDAQ MARKET MAKER
Since an exemption from the short-sale rule for bona fide market-making activity is considered fundamental to avoid disrupting traditional dealer activity, defining qualifications for exempt Nasdaq market makers is critical to such a rule. The NASD proposal contains an exemption for qualified market makers so that dealer activities that provide liquidity and continuity to the Nasdaq market will continue uninterrupted.
The Trading Committee and its Quality of Markets Subcommittee developed objective, quantitative criteria that could be applied equitably to all market makers regardless of size and, most importantly, that would be within the market maker's ability and control to satisfy. The primary criteria include amount of time at the inside bid or ask quotation, comparison of an individual market maker's spread to the average dealer spread in each stock, and frequency of dealer quotation updates without a corresponding execution in the security.
Using these components, in order to be considered a primary market maker in the Nasdaq system, market makers must satisfy two out of the three specific threshold standards:
In addition, recognizing that overall volume is also indicative of quality market making, the committees added a supplemental test based on proportionate volume which is met if a market maker accounts for 1½ times its proportionate share of volume in the stock. That is, if there are 10 market makers in a stock, each dealer's proportionate share should be 10 percent; therefore 1½ times proportionate share would mean 15 percent of the overall volume.
Where a market maker meets the proportionate volume test, it may be designated as a primary Nasdaq market maker if it also satisfies one of three criteria set forth above. For example, if a market maker kept its bid or offer at the inside quote at least 35 percent of the time, but maintained a ½ point spread in the stock when the other dealers averaged a ¼ point spread and changed its quote three times on average for every trade, then the market maker would have to meet the proportionate volume test in order to qualify as a primary market maker.
A market maker satisfying these criteria will be designated as a primary market maker in the Nasdaq system, and that "primary" or "P" designation will be displayed on the Nasdaq screen.
The time frame for review of market-maker performance in each criterion under consideration will be a calendar month. Compliance with the criteria will be tracked through the Nasdaq system, which will enable market makers to review their status in each criterion in each stock and will also provide members with notice of their compliance with the standards at set intervals.
The committees also sought to identify situations that warrant special or unique treatment, such as secondary offerings. The NASD believes that the time period after secondary offerings have been announced is so sensitive to short-selling pressure that special time frames and eligibility criteria for primary market makers are warranted. To be a primary market maker in stocks involved in secondary offerings requires registration in the security prior to announcement or filing of the registration statement for the secondary offering, or the market maker must satisfy the criteria for 40 business days prior to becoming a primary market maker.
Additionally, separate criteria have been developed for other registration situations, such as for qualifying when registering in an existing security, in an initial public offering, or in a merger or acquisition situation. These special criteria permit market makers with a proven track record (e.g., they have primary market maker status in 80 percent of the stocks they have registered in for the past year) to be afforded the primary designation upon initiation of quotations. If dealers cannot meet the 80 percent test, then other avenues are set forth in the proposed rule to permit them to qualify.
If a Nasdaq market maker does not satisfy the qualification criteria, then it remains a market maker in the Nasdaq system, but it is not a primary market maker in the stock, and it cannot take advantage of the exemption from the short-sale rule. The NASD will provide a forum for review if market makers wish to request reconsideration of their failure to meet the primary market-maker standards. Because the standards are objective rather than subjective, however, requests for reconsideration will be limited to consideration of system failures, excused withdrawals, or related activity in derivative or convertible securities that may affect a market maker's compliance with the criteria.
To analyze the effect that the proposed criteria and threshold standards would have on Nasdaq market makers, the committees reviewed members' performance on selected days. If members are interested in reviewing statistical data regarding their performance involving the proposed criteria during the review period, please contact Tim McCormick, Corporate Communications, NASD, 1735 K Street, NW, Washington DC 20006-1506, or call him at (202) 728-6910.
Finally, the NASD is sensitive to the fact that there may be unforeseen consequences or unfavorable treatment to a class of members or investors that may necessitate modifications to the proposals. To ensure that the NASD maintains the ability to make adjustments on an expeditious basis, the rule permits the NASD Board to rescind or modify the threshold levels of the criteria if necessary. Similarly, the Board has retained the authority to separately modify the market-maker exemption criteria if necessary to achieve SEC approval of the rule.
The Board believes that short-sale abuse is not merely a perception problem for issuers. A year ago, qualitative market research conducted among issuers and professional investors indicated that the lack of a short-sale rule in the Nasdaq market was a factor among those who expressed negative attitudes toward Nasdaq. While research and studies may show no difference in long-term short-interest positions between exchange-listed or Nasdaq stocks, issuers are concerned that instances of extreme intraday volatility may inhibit existing shareholders' ability to sell their stock if professional short sellers are in the market before them, exacerbating downward pressure on stocks, and reducing liquidity in the marketplace.
Issuers also report that they feel disadvantaged in secondary offerings on Nasdaq because of the increased potential for short selling to adversely affect the price at which the offering is conducted. Accordingly, the Board believes that adoption of the proposed short-sale rule will assure both issuers and investors that they are subject to at least equivalent protection from inappropriate short selling in the Nasdaq market as they are on an exchange.
The Board recognizes that a short-sale rule must be formulated in a manner to preserve market-maker depth and liquidity in Nasdaq/NMS securities. Qualified market makers must have the unfettered ability to effect short sales to balance their positions at any time during the trading day, and therefore the proposed rule has been designed to include an exemption that does not hamper a dealer's ability to buy and sell stock. Additionally, the Board is committed to implementing a short-sale rule that does not adversely affect a market maker's ability to manage risk. Dealers must be permitted the flexibility to sell short when necessary so that they will not be forced to reduce the number of stocks in which they make markets. The market-maker exemption and the criteria for qualification are firmly embedded in the short-sale rule so that the exemption will not be eroded in the future and the rule will not unduly affect the way in which market makers perform their roles.
The Board believes that the new Rules of Fair Practice regarding short sales and primary Nasdaq market makers are necessary and appropriate and recommends that members vote their approval. Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to the Corporation Trust Company. Ballots must be postmarked no later than March 13, 1992. Questions concerning this notice may be directed to Gene L. Finn, Chief Economist, at (202) 728-8243, Glen R. Shipway, Senior Vice President, Market Operations, at (212) 858-4448, or Beth E. Weimer, Associate General Counsel, at (202) 728-6998.
TEXT OF PROPOSED RULES
Rules of Fair Practice
(Note: All language is new.)
Section 46 — Short Sales
Section 47 — Primary Nasdaq Market Maker
1 The threshold standards initially shall be established as:
(a) a market maker must maintain the best bid or best offer as shown in the Nasdaq system no less than 35% of the time;
(b) a market maker must maintain a spread no greater than 102% of the average dealer spread;
(c) no more than 50% of a market maker's quotation up dates may occur without being accompanied by a trade execution of at least one unit of trading.
The NASD Board of Governors reserves the authority to rescind or modify one or more of the threshold standards immediately upon a finding that the standard is operating in a manner that is unfair to a class of investors or members, or that continued imposition of the standard results in a substantial adverse impact on the liquidity or market quality of the Nasdaq market.
2 The threshold proportionate volume standard initially shall require a market maker to account for volume of at least 1 ½ times its proportionate share of overall volume in the stock for the review period.