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88-54 Implementation of Reporting Requirements for Non-NASDAQ OTC Securities; Effective September 1, 1988

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Senior Management
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*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

The Securities and Exchange Commission (SEC) recently approved new Schedule H to the NASD By-Laws that establishes an electronic system of mandatory price and volume reporting for principal transactions in OTC equity securities that are not part of the NASDAQ System. Under new Schedule H, members that are NASDAQ subscribers will be required to use their NASDAQ/ Harris terminals, NASDAQ Workstations, or authorized foreign-terminal emulations to report the price and volume data under the minimum reporting thresholds required by Schedule H.

Those members that use a computer-to-computer interface (CTCI) with NASDAQ, either directly or through service bureaus, will be permitted to use that interface to report price and volume data as required by Schedule H. Those Members that are not NASDAQ subscribers will be required to report through a dial-up electronic reporting system for non-NASDAQ OTC securities developed by the NASD for this purpose.

Implementation of the new reporting requirements will proceed in two phases. During Phase I, which will become effective on September 1, 1988, all members will be required to report price and volume data for all non-NASDAQ OTC equity securities that are cleared through the National Securities Clearing Corporation (NSCC). The second phase, which is anticipated to go into effect at the beginning of 1989, will require price and volume reporting for all non-NASDAQ OTC equity securities whether or not the securities are cleared through NSCC. The text of Schedule H follows this notice.

BACKGROUND

The SEC recently approved new Schedule H to the NASD By-Laws,1 which establishes an electronic system of mandatory price and volume reporting for OTC securities that are not part of the NASDAQ System.

The NASD adopted new Schedule H to enhance its regulatory capabilities to routinely surveil for trading abuses in the non-NASDAQ OTC securities market and in response to directives from the SEC urging the NASD to develop a nationwide automated market surveillance program for non-NASDAQ OTC securities. To address these concerns, the NASD Market Surveillance Committee considered possible approaches to the routine surveillance of this market ("pink-sheet" securities2) and subsequently made a series of recommendations relative to price and volume reporting to the NASD Board of Governors. The Board approved the recommendations of the Market Surveillance Committee at its meeting on September 14, 1987.

Prior to the NASD's initiation of its automated surveillance system of the non-NASDAQ market, no facility existed for gathering, disseminating, and electronically testing market information in non-NASDAQ OTC issues. This lack of readily available and reliable transaction information created a serious impediment to the systemic automated surveillance of the non-NASDAQ OTC market and in general, hampered NASD regulatory efforts in this area. The electronic non-NASDAQ reporting system provides the means for creating a centralized data base of price and transaction information that will be subjected to a computerized market surveillance system to detect the types of violative practices that have been a concern for OTC issues traded outside the NASDAQ System. This automated surveillance system will generate computerized regulatory reports for use in addressing abuses (in "pink sheet" stocks) such as manipulation, fraudulent pricing and markups, and other serious sales/trading practices.

The NASD's enhanced oversight of the non-NASDAQ OTC securities market was fully supported by the NASD's Regulatory Review Task Force (Task Force) in its Final Report. In its discussion of the NASD's efforts to develop the non-NASDAQ reporting system, the Task Force indicated, in pertinent part, that it favored compliance with the mandatory reporting requirements of Schedule H by all firms. The Task Force further stated that "[T]he goal should be the development of surveillance capabilities comparable to those that exist for the NASDAQ market." 3

EXPLANATION OF AMENDMENTS

New Schedule H to the NASD By-Laws defines the terms "non-NASDAQ security" and "non-NASDAQ reporting system" and establishes minimum threshold-reporting requirements for non-NASDAQ OTC equity securities.

Section 1 of Schedule H defines the term "non-NASDAQ reporting system" as any electronic price- and volume-reporting system operated by the NASD for non-NASDAQ securities. The term "non-NASDAQ security" is defined as any equity security that is neither included in the NASDAQ System nor traded on any national securities exchange.

Section 2 of Schedule H requires members executing principal transactions in non-NASDAQ equity securities to provide price and volume data for both purchase and sale transactions if the member's aggregate daily volume of sales or purchases exceeds either a minimum of 50,000 shares or $10,000. In addition, members must report price and volume data for both sides of the market if the aggregate share or dollar volume is reached on either side of the market. For example, if a member executes an aggregate purchase volume in a non-NASDAQ issue of 70,000 shares and has an aggregate sale volume of 20,000 shares, it will be required to report both the purchase and sale sides of the transaction, as well as price data, because the minimum threshold level was reached on the buy side of the market. (Additional examples of the minimum reporting levels accompany the rules as explanatory material.) If they choose to do so, members may report even if the minimum threshold levels established by Schedule H are not reached.

Members meeting the daily minimum reporting levels are also required to report the highest price at which the member sold the non-NASDAQ OTC equity security and the lowest price at which it bought the non-NASDAQ OTC equity security, and indicate whether these trades were executed with a customer or with another broker-dealer. The price to be reported on customer transactions is inclusive of markups or markdowns.

Finally, the new rules also amend the Interpretation of the Board of Governors Execution of Retail Transactions in the Over-the-Counter Market (the "Best Execution Interpretation") by adding a new paragraph (D) that requires members to check a minimum of three dealers (or all dealers in a security if three or less) prior to executing any transaction on behalf of a customer in a non-NASDAQ security.4

IMPLEMENTATION OF SCHEDULE H

The NASD will implement the price and volume reporting requirements of Schedule H in two phases. In Phase I, all NASD members are required to report price and volume data on transactions in non-NASDAQ OTC securities that are cleared through the NSCC and that meet the minimum threshold-reporting requirements of Schedule H.5 Phase II will require price and volume reporting for all non-NASDAQ securities whether or not the securities clear through NSCC. From the beginning of Phase I, the following additional requirements apply:

  • Members have the option to report price and volume data under new Schedule H either between the hours of 4 p.m. and 6:30 p.m. Eastern Time on trade date or between 7:30 a.m. and 9 a.m. on the next business day. Members experiencing technical problems in reporting their trades of non-NASDAQ securities may call (800) 321-NASD for assistance.
  • Members that are NASDAQ subscribers (e.g., Level 2/3 or TARS-only subscribers) will be required to use their NASDAQ/Harris terminals, NASDAQ Workstations, CTCI (direct and through service bureaus), or authorized foreign-terminal emulations to report the price and volume data required by Schedule H.
  • Members that do not subscribe to NASDAQ service will be required to report through a dial-up electronic reporting system for non-NASDAQ securities that is similar in function to the system currently provided to NASDAQ subscribers.

All firms using the dial-up, non-NASDAQ reporting system will be required to subscribe to and pay for the Telenet public network and possess a terminal or PC and a modem. Appropriate hardware specifications and information as to the method of subscribing to the Telenet service will be provided to users of the dial-up, non-NASDAQ reporting system responding to the questionnaire discussed below and attached to this Notice.

  • To comply with the provisions of Schedule H, members must use an electronic reporting system to meet the requirements to report price and volume information on non-NASDAQ OTC securities. There are no provisions for hard-copy reporting; thus failure to report via electronic means will be contrary to the rule.

Non-NASDAQ Subscribers Questionnaire

Members that are not NASDAQ subscribers are required to report principal trades in non-NASDAQ issues pursuant to Schedule H through the NASD's dial-up electronic reporting system. To determine the universe of NASD members that will be required to use this reporting system, the attached brief questionnaire has been developed. All NASD members that do not subscribe to NASDAQ service that transact any business in non-NASDAQ OTC securities must complete and return this questionnaire no later than July 27, 1988, to Elizabeth Wollin, Assistant Director, NASD Automated Reports, 9513 Key West Avenue, Rockville, Maryland 20850.

Questions regarding this notice can be directed to either Elizabeth Wollin, Assistant Director, NASD Automated Reports, at (301) 738-6887, or James M. Cangiano, Director, NASD Market Surveillance, at (202) 728-8186.

* * * * *

NEW SCHEDULE H TO THE NASD BY-LAWS

Section 1—Definitions

For purposes of Schedule H, unless the context requires otherwise:

(a) "Non-NASDAQ security" means any equity security that is neither included in the National Association of Securities Dealers Automated Quotations System nor traded on any national securities exchange.
(b) "Non-NASDAQ Reporting System" means the electronic price and volume reporting system operated by the Association for non-NASDAQ securities.

Section 2—Price and Volume Reporting

(a) On any day that principal transactions in the non-NASDAQ security exceed an aggregate daily volume of sales or purchases of either a minimum of 50,000 shares or a minimum of $10,000, each member shall report through the Non-NASDAQ Reporting System (i) the highest price at which it sold and the lowest price at which it purchased any non-NASDAQ security; (ii) the total volume of purchases and sales executed by it in any non-NASDAQ security; and (iii) whether the trades establishing the highest price at which the member sold and the lowest price at which the member purchased the security represented an execution with a customer or with another broker-dealer. The price to be reported for principal sales and purchases from customers shall be inclusive of markup or markdown.

The following examples illustrate the minimum reporting levels established by paragraph (a) above.

1. Dealer A executes aggregate purchases of 70,000 shares of AAA stock and executes aggregate sales of 20,000 shares of AAA stock. Because the minimum reporting requirement is exceeded by the purchases, Dealer A is required to report aggregate purchases of 70,000 shares, aggregate sales of 20,000 shares of AAA stock, and the highest price at which it sold and lowest price at which it purchased AAA stock, even though the volume of sales did not reach the minimum requirement.
2. Dealer B executes aggregate purchases of 60,000 shares of BBB stock and does not execute any sales of BBB stock. Dealer B is required to report purchases of 60,000 shares, zero volume of sales, and the lowest price at which it purchased BBB stock.
3. Dealer C executes aggregate purchases of 40,000 shares for a total of $8,000 in CCC stock and executes aggregate sales of 49,000 shares for a total of $9,900 in CCC stock. CCC stock is not subject to reporting by Dealer C, as neither the volume nor price of aggregate purchases or sales of CCC stock exceed the minimum requirements for reporting.
4. Dealer D executes aggregate purchases of 45,000 shares in DDD stock for a total of $11,000 and executes aggregate sales of 35,000 shares in DDD stock for a total of $9,000. Dealer D is required to report aggregate purchases of 45,000 shares and sales of 35,000 shares of DDD stock, as well as the highest purchase price and lowest sale price of DDD stock, because the aggregate purchase price exceeds the minimum requirement.
(b) Members shall report the price and volume information required by Section 2(a) above through the Non-NASDAQ Reporting System between the hours of 4 p.m. and 6:30 p.m. Eastern Time on the trade date or between 7:30 a.m. and 9 a.m. Eastern Time on the next business day or, at such other time as determined by the Association.

INTERPRETATION OF THE BOARD OF GOVERNORS—EXECUTION OF RETAIL

TRANSACTIONS IN THE OVER-THE-COUNTER MARKET

Add the following new section:



(D) In any transaction for or with a customer pertaining to the execution of an order in a non-NASDAQ security (as defined in Schedule H to the By-Laws), a member or person associated with a member, shall contact and obtain quotations from three dealers (or all dealers if three or less) to determine the best inter-dealer market for the subject security.

1 File No. SR-NASD-87-55, Securities Exchange Act Release No. 25637 (May 2,1988).

2 Non-NASDAQ OTC securities are commonly referred to as "pink sheet" securities because information on many of the securities is published by the National Quotation Bureau in its Pink Sheets.

3 Final Report of the NASD Regulatory Review Task Force at p. 14.

4 The provisions of Schedule H and its approval by the SEC also were discussed in NASD Notice to Members 88-40 (June 1,1988). That Notice also solicited NASD member vote on a proposed amendment to Article III, Section 21 of the NASD Rules of Fair Practice. The proposed amendment will require the marking of customer order tickets to reflect the dealers contacted by members and the quotations received to determine the best inter-dealer market as required by the new amendment to the NASD's "Best Execution Interpretation," recently approved by the SEC in conjunction with new Schedule H.

5 Prior to implementation of Phase I, the NASD will publish a list that establishes, as of a specific date, all of the securities subject to price and volume reporting under Schedule H during Phase I. The NASD anticipates approximately 7,000 issues will be involved.



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