SEC Division of Trading and Markets no-action letter: NASD, Inc.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON. D.C. 20549
DIVISION OF June 26,2006 MARKET REGULATION
Executive Vice President and General Counsel
NASD, Inc.
1735K Street, NW
Washington, D.C. 20006-1506
Re: Request' for Exemption from Securities Exchange Act Rule 10a-1 File No. TP 06-75 Dear Mr. Menchel:
In your letter dated February 16,2006, as supplemented by telephone conversations with the staff, you request exemptive relief regarding Rule 10a-1 under the Securities Exchange Act of 1934 (Exchange Act) to permit (1) Nasdaq National Market securities traded over-the-counter and reported to a NASD facility to be subject to proposed NASD Rule 5100 rather than Rule 10a-1; and (2) Nasdaq Capital Market securities traded over-the-counter and reported to a NASD facility to not be subject to either Rule 1 0a- 1 or proposed NASD Rule 5 100. This response is attached to the enclosed photocopy of your letter. By doing this, we avoid having to recite or summarize the facts set forth in your letter. Each defined term in this response has the same meaning as defined in your letter, unless otherwise noted. Background:
Rule 10a-1 governs short sales. Paragraph (a) of Rule 10a-1 governs short sales of any security registered on, or admitted to unlisted trading privileges on, a national securities exchange if such transactions are made pursuant to an effective transaction reporting plan as defined in Rule 600 of Regulation NMS. Unless a specific exemption applies, short sales are prohibited at a price that is either (1) below the last reported price of a transaction reported pursuant to an effective transaction reporting plan (a "minus tick"); and (2) at the last reported price if that the price is lower than the last reported different price (a "zero-minus tick"). Absent an exemption, once Nasdaq begins operation as a national securities exchange, Nasdaq National Market securities and Nasdaq Capital Market securities will be exchange-registered securities reported to an effective transaction reporting plan and therefore subject to Rule 10a- 1, wherever they are traded.

.June 26,2006
Because Nasdaq was not an exchange, Rule 10a-1 did not previously apply to Nasdaq

securities. Instead, Nasdaq adopted its own price test rule. Similarly, short sales in Nasdaq

securities effected on any national securities exchange that traded Nasdaq securities on an

unlisted trading privileges basis or in the over-the-counter market were also not subject to Rule

10a-1.

In 1994, the Commission granted temporary approval to the NASD to apply its own short sale rule to Nasdaq National Market securities.' NASD Rule 3350 prohibits short sales in Nasdaq National Market securities at or below the current best (inside) bid when the current best (inside) bid is below the previous best (inside) bid in a security. NASD Rule 3350 is inapplicable to National Capital Market securities. Since that time, the NASD has proposed and the Commission has granted extensions of Rule 3350. Recently, the NASD proposed to renumber current NASD Rule 3350 as NASD Rule 5100.~ In the Commission's order approving the Nasdaq Stock Market LLC's application to become an exchange,3 the Commission granted a temporary exemption fi-om Rule 10a-1 to permit the Nasdaq Exchange to apply a bid test4 to short sales in Nasdaq National Market securities occurring on the Nasdaq Exchange and to allow Nasdaq Capital Market securities5 to be exempt fiom the application of the tick test.6 By doing so, the Commission maintained the status quo for Nasdaq National Market securities trading on Nasdaq. In granting the exemption, the Commission noted that it believed that it is important to maintain the status quo of short sale regulation during the Regulation SHO Pilot Program ("Pilot Program") in order to avoid unnecessarily burdening the market^.^ Under the Pilot Program, the 1 Securities Exchange Act Release No. 34277 (June 29,1994), 59 FR 34885 (July 7,1994). Securities Exchange Act Release No. 52049 (July 15,2005). The Commission approved the Nasdaq's Exchange registration as a national securities exchange on January 13,
2006. Securities Exchange Act Release No. 53128 (January 13,2006), 71 FR 3350 (January 23,2006)
("Nasdaq Exchange Order"). In the Nasdaq Exchange Order, the Commission conditioned the Nasdaq Exchange's operation as a national exchange on the satisfaction of certain enumerated requirements. Nasdaq Exchange Rule 3350, which is based on the current bid test of NASD Rule 3350. 5 These were formerly known as Nasdaq SmallCap securities. 6 The exemptions from Rule 10a-1 expire upon termination of the Pilot Program or at such other time if the Commission determines that such exemptions are no longer necessary or appropriate in the public interest or consistent with the protection of investors. ' The Pilot Program was created pursuant to Rule 202T of Regulation SHO, which established procedures to allow the Commission to temporarily suspend short sale price tests so that the Commission could study the effectiveness of short sale price tests. Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (August 6, 2004). In addition, pursuant to the terms of Regulation SHO, the Commission approved an order establishing a one-

June 26,2006
Commission by order temporarily suspended short sale price tests in a group of securities to evaluate the overall effectiveness and necessity of such restrictions. We expect that the Commission will consider any further action on the adoption of a price test after the completion of the Pilot Program. In order to promote efficient regulation and to avoid unnecessarily burdening markets with the imposition of costs associated with implementing a price test that may be temporary, the Commission stated that it was necessary and appropriate in the public interest and consistent with the protection of investors to maintain the status quo for the price test after Nasdaq becomes an exchange. As a result, Nasdaq will be able to trade its securities under its bid test. However, over￾the-counter sales of Nasdaq securities reported to a NASD facility would default to Rule 1Oa-1 's tick test unless exempted. You have requested an exemption to regulate over-the-counter short sales of Nasdaq National Market securities reported to a NASD facility under proposed NASD Rule 5100 and to permit over-the-counter short sales of Nasdaq Capital Market securities to remain uncovered by any price test. You state that the requested exemption would serve the public interest and protect investors by maintaining the status quo for short sales in Nasdaq securities during the Regulation SHO Pilot Program. Response:
We find that it is appropriate in the public interest and consistent with the protection of investors, to grant an exemption fkom Rule 10a-1, pursuant to Rule 1 Oa-1 (f) on the basis of your representations, but without necessarily concurring in your analysis, (1) to permit Nasdaq National Market securities traded over-the-counter and reported to a NASD facility to be subject to proposed NASD Rule 5100 rather than SEC Rule 10a-1; and (2) to permit Nasdaq Capital Market securities traded over-the-counter and reported to a NASD facility to remain uncovered by any price test. year Pilot Program suspending the provisions of Rule 10a-l(a) under the Exchange Act and any short sale price test of any exchange or national securities association for short sales of certain securities for certain time periods. See Securities Exchange Act Release No. 50104 (July 28,2004), 69 FR 48032 (August 6,2004) at htti~:!lu~ww.sec.nov~n1leslother!34-50104tm; Securities Exchange Act Release No. 50747 (November 29, 2004), 69 FR 70480 (December 6,2004) at http:l!\vww.sec.go~~~iuledother!34-5,0747.n. The Pilot Program commenced on May 2,2005 and is scheduled to end on August 6,2007.

June 26,2006
The Commission grants this exemption from Rule 10a-1 subject to the following conditions:

1. the continued application of NASD Rule 3350 (or, when renumbered, NASD Rule
   5 100) to Nasdaq National Market securities;
2. the NASD will issue a Notice to Members regarding what activity would not be
   deemed bona fide market making activity for purposes of claiming the exception to NASD Rule 5100's bid test; and
3. the NASD will implement a surveillance program to monitor whether firms claiming
   the bona fide market maker exception in NASD Rule 5 100 are engaged in bona fide market making activity. This exemption is effective until completion of the Pilot Program or at such other time if the Commission determines that such exemptions are no longer necessary or appropriate in the public interest or consistent with the protection of investors The foregoing exemption from Rule 10a-1 is based solely on your letter dated February 16,2006 and the representations and the facts you have presented to the staff; and is strictly limited to the application of this rule to transactions under the circumstances described above. Such transactions should be discontinued, pending presentation of the facts for our consideration, in the event that any material change occurs with respect to any of those facts or representations. The exemption granted herein is subject to modification or revocation if at any time the Commission determines that such action is necessary or appropriate in fwtherance of the purposes of the Exchange Act. In addition, your attention is directed to the anti-fraud and anti￾manipulation provisions of the Exchange Act, particularly Sections 9(a) and 10(b), and Rule lob-5 thereunder.. Responsibility for compliance with these and other applicable provisions of the federal or state securities laws must rest with participants to the transactions. The Division expresses no view with respect to other questions that the proposed transactions may raise, including, but not limited to, the applicability of other federal and state laws to the proposed transactions. For the Commission,

by the Division of Market Regulation,

pursuant to delegated authority,

Acting Associate Director cc: Attachment

SECURITIESAND EXCHANGECOMMISSION Marc Menchel RECEllVED . Executive Vice President and General Counsel

Regulatory Policy and Oversight . .

FFR 2 2 2006 .
' February 16,2006 /I
DIVISIONOF MARKET REGULATION NASD-.5~d0 e555y
James A. Brigagliano -,----..:- -----==-.@00
Assistant Director omom* 0 Division of Market Regulation

Securities and Exchange Commission

100 F Street, NE

Washington, D.C. 20549

RE: Request for Exemption fi-om Rule 10a-1 under the Securities Exchange Act of 1934 Dez Mr. Brigzglimo:
NASD, Inc. ("NASD") respectfully requests that the Securities and Exchange

Commission ("Commission" or "SEC") grant an exemption, pursuant to its authority

under Section 36 of the Securities Exchange Act of 1934 ("Exchange Act"), from the

application of Rule 10a-1 under the Exchange Act ("SEC Rule 1 Oa-1") to: (1) permit

Nasdaq National Market securities traded over-the-counter and reported to a NASD

facility to be subject to proposed NASD Rule 5 100 rather than SEC Rule 10a-1; and (2)

permit Nasdaq Capital Market securities traded over-the-counter and reported to a NASD

facility to not be subject to either SEC Rule 10a-1 or proposed NASD Rule 5100.'

Background and Discussion
As you know, the SEC approved The Nasdaq Stock Market, LLC ('Nasdaq")

application for registration as a national securities exchange under Section 6 of the

Exchange ~ct.~
As you are also aware, NASD has filed a proposed rule change to amend

its rules to reflect the anticipated operation of Nasdaq as a national securities exchange

' SEC Rule 10a-1 governs short sales of securities registered on, or admitted to unlisted trading privileges on, a national securities exchange, iftrades in such securities are reported pursuant to an "effective transaction reporting plan" as defined in Rule 600 of Regulation NMS and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information ("registered securities"). Under SEC Rule 10a-1, unless there is an exemption, short sales are prohibited at a price that is either (1) below the price at which the last sale thereof, regular way, was reported pursuant to an effective transaction reporting plan; or (2) at such price unless such price is above the next proceeding different price at which a sale of such security, regular way, was reported pursuant to an effective transaction reporting plan. Currently, NASD Rule 3350 governs . short sales in Nasdaq National Market securities and generally prohibits members horn effecting short sales'in Nasdaq National Market securities at or below the inside bid when the current inside bid is below the previous inside bid. As part of NASD's proposed rule filing related to the separation of Nasdaq hom NASD, NASD has proposed to renumber current NASD Rule 3350 as NASD Rule 5100 and, consistent with its application today, would apply to over-the-counter transactions reported to the Alternative Display Facility ("ADF") or the Trade Reporting Facility ("TRF"). 2 See Exchange Act Release No. 53 128 (Jan. 13,2006). 1735 K Street, NW tel 202 728 841 0 Washington, DC fax 202 463 0790 Investor protection. Market ~ntegrlty 20006-1 506 www nasd corn

James A. Brigagliano
February 16,2006 operation of Nasdaq as a national securities exchange and its resultant separation fiom NASD.~ Once Nasdaq begins operation as a national securities exchange, absent exemptive relief, SEC Rule 10a-1 governing short sales of registered securities would become applicable to short sales in Nasdaq National Market securities and Nasdaq Capital Market securities (collectively referred to as "Nasdaq-listed securities") wherever they are traded, including Nasdaq-listed securities traded over-the-counter. The Commission has granted Nasdaq an exemption fiom the application of SEC Rule 10a-1 to:
(1) permit Nasdaq National Market securities to become subject to Nasdaq Rule 3350 rather than SEC Rule 10a- 1 ;and (2) permit Nasdaq Capital Market securities to remain subject to neither SEC Rule 10a-1 nor Nasdaq Rule 3350. NASD is hereby requesting that the Commission grant a sirrtiiar exemption from the application of SEC Rule 10a-1 pursuant to its authority under Section 36 of the Exchange Act for short sales in Nasdaq-listed securities traded over-the-counter and reported to NASD facilities, consistent with any exemptive relief granted to Nasdaq. NASD believes the requested exemption would serve the public interest and protect investors by maintaining consistent regulation of short sales in Nasdaq-listed securities, whether traded over￾the-counter or on the Nasdaq exchange. NASD believes that denying the requested relief and subjecting Nasdaq-listed stocks traded over-the-counter to a different short sale price test than Nasdaq-listed securities traded on the Nasdaq exchange would cause investor and market participant confusion. In addition, the SEC is currently conducting a pilot program that excludes designated securities from the tick test of SEC Rule 10a-1 and any short sale price test of any exchange or national securities association for a designated period of time.4 Therefore, NASD believes that it is necessary and appropriate to maintain the status quo for the bid test applying to short sales in Nasdaq National Market securities, and to continue to not apply to Nasdaq Capital Market securities. Accordingly, NASD respectfully requests that the Commission grant the exemption described herein from SEC Rule 10a-1 for short sales in Nasdaq-listed securities traded over-the-counter and reported to an NASD facility, subject to the following two conditions: (1) NASD will issue a Notice to Members to provide further clarification to members regarding what activity would not be deemed "bona fide market making activity" for purposes of claiming the exception to NASD Rule 5 100's bid test; and (2) NASD will implement a surveillance program, consistent with the guidance provided in the aforementioned Notice to Members, to monitor whether firms claiming the bona fide market maker exception in NASD Rule 5 100 are engaged in bona fide market making activity. 3 - See Exchange Act Release No. 52049 (July 15,2005); 70 FR 42398 (July 22,2005). 4 See Exchange Act Release No. 50104 (July 28,2004), 69 FR 48032 (Aug. 6,2004). See also, Exchange Act Release No. 50747 (Nov. 29,2004), 69 FR 70480 (Dec. 6,2005).

James A. Brigagliano
February 16,2006
If there are any questions concerning this request, please contact Stephanie Dumont, Vice

President and Associate General Counsel, Office of General Counsel at (202) 728-8176.

Sincerely,
Executive Vice President ad General Counsel