SEC Division of Trading and Markets no-action letter: NASD Small Firms Advisory Board

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June 22, 2001 Richard Romano, Chair Carl P. Sherr, Co-Chair NASD Small Firms Advisory Board 1735 K Street, N.W. Washington, D.C. 20006-1500 Re: Request for Exemption from Rule 11Ac1-5 Dear Mr. Romano and Mr. Sherr: In your letter dated April 23, 2001 ("Letter") on behalf of the NASD Small Firms Advisory Board, you requested that the Commission issue an exemption from Rule 11Ac1-5 ("Rule") under the Securities Exchange Act of 1934 ("Exchange Act") for small Nasdaq market makers. This letter responds to your request. I. Background

Adopted in November 2000, 1 the Rule generally requires a "market center" (as defined in the Rule) that trades national market system securities to make available to the public monthly electronic reports that include uniform statistical measures of execution quality. The Adopting Release established a three-stage phase-in of compliance with the Rule. The first phase-in date was April 2, 2001, on which the Rule was to apply to the 1000 NYSE securities, 1000 Nasdaq securities, and 200 Amex securities with the highest average daily share volume for the quarter ending December 31, 2000. This initial compliance date for the Rule was moved back by one month until May 1, 2001. 2 On April 12, 2001, the Commission granted a temporary exemption, until July 31, 2001, from the reporting requirements of the Rule for all orders in securities that are qualified for inclusion in the National Market tier of Nasdaq. 3 The first monthly reports (for August 2001) that must include Nasdaq securities must be made available to the public by the end of September 2001. The final phase-in date is October 1, 2001, on which the Rule is scheduled to apply to all national market system securities. In the Letter, you request an exemption from the Rule for all small Nasdaq market makers. You assert that most small firms do not have the resources to collect the necessary data elements and perform the complex calculations required by the Rule on their own. Although outside vendors are available to provide this service, you represent that retaining such a vendor would be a significant cost to small firms. In addition, the Letter expresses concern that the significant additional compliance costs could cause many small firms to cease acting as market makers. Because many small firms make markets in thinly traded Nasdaq stocks that are national market system securities, you believe that their dropping out of the market could have a detrimental affect on the liquidity in these securities, and that the harm to investors from the loss of liquidity could outweigh the benefits from enhanced transparency. II. Exemptions

On the basis of your representations and the facts presented, the Commission, by the Division pursuant to delegated authority, 4 is granting the following two exemptions from the Rule, one for very inactively traded securities and one for small market centers that do not focus their business on the most actively traded securities.

The Commission is exempting any national market system security that did not average more than five reported transactions per trading day, as disseminated pursuant to an effective transaction reporting plan, for each of the preceding six months (or such shorter time that the security has been designated a national market system security). An inactive security will lose its exemption only after its average daily reported transactions have exceeded five for each of the preceding six months. Orders in exempted securities need not be included in a market center's monthly report, but a market center is free to include them if it chooses to do so. The Commission is exempting any market center that reported fewer than 200 transactions per trading day on average over the preceding six month period in securities that are covered by the Rule (that is, national market system securities that do not qualify for the inactively traded security exemption), but only if more than 90% of such transactions were in securities that are not included in the Nasdaq-100 Index or the S&P 500 Composite Stock Price Index. Once a market center's average daily reported transactions for the preceding six-month period reach 200, or the percentage of its reported transactions in Nasdaq-100 and S&P 500 securities reaches 10% or greater for the preceding six-month period, the market center would cease to qualify for the exemption. The market center then would be required to begin collecting the requisite order data for the following full month and make its monthly report for that month publicly available by the end of the next month thereafter. For example, if the market center ceased to qualify for the exemption based on trading during the six-month period from January through June, the market center must begin collecting order data for August and make its monthly report (covering August) publicly available by the end of September.

The Commission finds that the two exemptions are necessary or appropriate in the public interest, and are consistent with the protection of investors. First, the exemption for very inactively traded national market system securities is consistent with the Commission's exclusion from the Rule of Nasdaq SmallCap securities and Over-the-Counter Bulletin Board securities. In the Adopting Release, the Commission found that, given the relatively light dollar amount of trading in these securities, the value of statistical measures of trading might not justify the costs to produce the information. 5

Second, small market centers often may be significant sources of liquidity in the securities of small and medium companies, but have fewer transactions than large market centers over which to distribute the cost of generating the monthly execution quality reports. The Commission therefore is concerned that the costs of compliance for small market centers, as well as the potential costs if small market centers ceased supplying liquidity, potentially could outweigh the benefits of their monthly reports. If a small market center chooses, however, to focus a significant part of its business on the most actively traded securities, it should compete on the same terms as larger market centers that trade those securities. In addition, a broker-dealer that routes orders to a market center that does not generate monthly execution quality reports continues to have a duty to monitor the quality of executions received to obtain the best execution of those orders. III. Conclusion

The exemptions granted in this letter is subject to modification or revocation at any time if the Commission determines that such action is necessary or appropriate in the public interest or otherwise in furtherance of the purposes of the Exchange Act. If you have questions, please do not hesitate to contact me. For the Commission, by the Division of Market Regulation, pursuant to delegated authority. Annette L. Nazareth Director

Footnotes

1 Securities Exchange Act Release No. 43590 (November 17, 2000), 65 FR 75414 ("Adopting Release"). 2 Securities Exchange Act Release No. 44060 (March 9, 2001), 66 FR 15028. 3 Letter from Annette L. Nazareth, Director, Division of Market Regulation, SEC, to Stuart J. Kaswell, Senior Vice President and General Counsel, Securities Industry Association, dated April 12, 2001. 4 17 CFR 200.30-3(a)(69). 5 Adopting Release, section III.B.3.

http://www.sec.gov/interps/legal/smfirm062201.htm

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Modified: 06/25/2001