

[Federal Register: October 4, 2005 (Volume 70, Number 191)]
[Notices]               
[Page 57909-57916]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr04oc05-109]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52521; File No. SR-NASD-00-23]

 
Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Amendment No. 2 to Proposed Rule Change 
by Relating to Amendments To Order Audit Trail System Rules and Notice 
of and Order Granting Accelerated Approval to Amendment No. 3

    September 28, 2005.

I. Introduction

    On April 19, 2000, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend its rules relating to 
its Order Audit Trail System (``OATS''). On September 5, 2000, NASD 
filed Amendment No. 1 to the proposed rule change. The proposed rule 
change, as amended by Amendment No. 1, was published for comment in the 
Federal Register on October 3, 2000.\3\ The Commission received 13 
comment letters from 12 commenters in response to the publication.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 43344 (September 26, 
2000), 65 FR 59038.
    \4\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Harold M. Golz, Krys Boyle Freedman & Sawyer, P.C. on behalf of 
Rocky Mountain Securities & Investments, Inc., dated October 20, 
2000 (``Rocky Mountain Letter''); Mitchell M. Almy, President, 
Mitchell Securities Corporation of Oregon, dated October 20, 2000 
(``Mitchell Securities Letter''); Joanne Ferrari, Compliance 
Manager, Weeden & Co., dated October 23, 2000 (``Weeden Letter''); 
Bonnie K. Wachtel, CEO and Wendie L. Wachtel, COO, Wachtel & Co., 
Inc. dated October 24, 2000 and March 26, 2001 (``Watchel Letters--
1''); Laurence Storch, Storch & Brenner, LLP, dated October 24, 2000 
(``Stroch & Brenner Letter''); Allen Thomas, Vice President, A.G. 
Edwards & Sons, Inc., dated October 24, 2000 (``A.G. Edwards 
Letter''); Stuart J. Kaswell, Senior Vice President and General 
Counsel, Securities Industry Association, Ad Hoc Committee, dated 
October 24, 2000 (``SIA Letter-1''); W. Leo McBlain, Chairman and 
Thomas J. Jordan, Executive Director, Financial Information Forum, 
dated October 24, 2000 (``FIF Letter-1''); Thomas F. Guinan, Senior 
Vice President, Pershing Division of Donaldson, Lufkin & Jenrette 
Securities Corporation, dated October, 24, 2000 (``Pershing 
Letter''); Paul A Merolla, Senior Vice President and General 
Counsel, Instinet Corporation, dated October 25, 2000 (``Instinet 
Letter''); Richard E. Schell, Vice President and Assistant General 
Counsel, First Options of Chicago, dated October 25, 2000 (``First 
Options Letter''); Jill W. Ostergaard, Vice President, Morgan 
Stanley Dean Witter, dated October 27, 2000 (``MSDW Letter'').
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    In response to those comments, on June 10, 2005, NASD filed 
Amendment No. 2 to the proposed rule change. Amendment No. 2 was 
published for comment in the Federal Register on June 27, 2005.\5\ The 
Commission received six comment letters in response to the 
publication.\6\ On September 14, 2005, NASD filed Amendment No. 3 to 
the proposed rule change to address the concerns raised in those 
comment letters, and to make a technical change to the rule text. This 
order approves Amendment No. 2 to the proposed rule change. In 
addition, the Commission is publishing this notice to solicit comments 
on Amendment No. 3 to the proposed rule change and is

[[Page 57910]]

simultaneously approving the amendment on an accelerated basis.
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    \5\ See Securities Exchange Act Release No. 51890 (June 21, 
2005), 70 FR 36985.
    \6\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Chris Charles, President, Wulff, Hansen & Co., dated July 12, 2005 
(``Wulff Letter''); Bonnie K. Wachtel, CEO and Wendie L. Wachtel, 
COO, Wachtel & Co., Inc. dated July 18, 2005 (``Wachtel Letter-2''); 
Ronald C. Long, Senior Vice President, Wachovia Securities, LLC, 
dated July 18, 2005 (``Wachovia Letter''); Howard Meyerson, General 
Counsel, Liquidnet, Inc., dated July 19, 2005 (``Liquidnet 
Letter''); Bob Linville, ADP/SIS Service Bureau Committee Co-Chair, 
Deborah Mittelman, Sunguard Service Bureau Committee Co-Chair, W. 
Leo McBain, Chairman, Manisha Kulkarni, Executive Director, 
Financial Information Forum, dated July 22, 2005 (``FIF Letter-2''); 
Ira Hammerman, Senior Vice President and general Counsel, Securities 
Industry Association, dated July 26, 2005 (``SIA Letter-2'').
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II. Background

    On March 6, 1998, the Commission approved NASD Rules 6950 through 
6957 (``OATS Rules'').\7\ OATS provides information regarding orders 
and transactions that allows NASD to conduct surveillance and 
investigations of member firms for potential violations of NASD rules 
and the federal securities laws. OATS is designed,\8\ at a minimum, to: 
(1) Provide an accurate, time-sequenced record of orders and 
transactions, beginning with the receipt of an order at the first point 
of contact between the broker/dealer and the customer or counterparty 
and further documenting the life of the order through the process of 
execution; and (2) provide for market-wide synchronization of clocks 
used in connection with the recording of market events.
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    \7\ See Securities Exchange Act Release No. 39729, 63 FR 12559 
(March 13, 1998).
    \8\ OATS is intended to fulfill one of the undertakings 
contained in the order issued by the Commission relating to the 
settlement of an enforcement action against the NASD for failure to 
adequately enforce its rules. See In the Matter of National 
Association of Securities Dealers, Inc., Securities Exchange Act 
Release No. 37538, August 8, 1996; Administrative Proceeding File 
No. 3-9056.
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    The OATS Rules generally impose obligations on member firms to 
record in electronic form and report to NASD on a daily basis certain 
information with respect to orders originated or received by NASD 
members relating to securities listed on Nasdaq. OATS captures this 
order information reported by NASD members and integrates it with quote 
and transaction information to create a time-sequenced record of orders 
and transactions. This information is used by NASD staff in conducting 
surveillance and investigations of member firms for violations of 
federal securities laws and NASD rules.
    The OATS requirements were implemented in three phases. All members 
were required to synchronize their computer system clocks and all 
mechanical clocks that record times for regulatory purposes by August 
7, 1998, and July 1, 1999, respectively. In addition, electronic orders 
received at the trading department of a market maker and those received 
by ECNs were required to be reported to OATS as of March 1, 1999 
(``Phase One''). Additional information relating to market maker and 
ECN electronic orders and all other electronic orders were required to 
be reported to OATS by August 1, 1999 (``Phase Two''). Finally, 
pursuant to Rule 6957(c), the OATS Rules were to apply to all manual 
orders effective 120 days after Commission approval of the instant 
filing, SR-NASD-00-23, (``Phase Three'').\9\
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    \9\ The original effective date for Phase Three was July 31, 
2000. NASD filed a proposed amendment with the SEC for immediate 
effectiveness to extend the implementation date of Phase Three to 
120 days after SEC approval of SR-NASD-00-23. See Securities 
Exchange Act Release No. 43654 (December 1, 2000), 65 FR 77405 
(December 11, 2000).
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    During the implementation of OATS, NASD has identified several 
changes to OATS that it believes would enhance NASD's automated 
surveillance for compliance with trading and market making rules such 
as Interpretive Material (IM) 2110-2, (commonly referred to as the 
``NASD's Limit Order Protection Interpretation''), the SEC's Order 
Handling Rules \10\ and a member firm's best execution obligations. In 
addition to implementing Phase Three of OATS, NASD proposed these 
changes in SR-NASD-00-23 and Amendment No. 1 thereto. Provided below is 
a description of the original proposal, as modified by Amendment No. 1, 
a summary of the comments received in response to the proposed changes, 
and a description of NASD's response (``Amendment No. 2'').
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    \10\ See Securities Exchange Act Release No. 37619A (September 
6, 1996), 61 FR 48290 (September 12, 1996).
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III. Description of Initial Proposal and Amendment No. 1, Comments 
Received and NASD's Response Thereto (Amendment No. 2)

A. Proposed Definition of Time of Receipt

1. Description
    NASD Rule 6954 requires certain identifying information be recorded 
at various critical points during the life of an order, thereby 
assisting NASD in carrying out its regulatory responsibilities. In 
particular, NASD Rule 6954(b)(16) requires that members record and 
report the date and time the order is originated or received by a 
Reporting Member (``time of receipt''). The OATS Rules, which currently 
only apply to electronic orders, require that the time of receipt for 
an electronic order be the time an order is received by a firm's 
electronic order handling system. Upon approval of the instant proposed 
rule change, members will be required to record and report OATS 
information for manual orders as well.
    The time of receipt for manual orders is the time the order is 
received by the member from the customer, whether that is at a trading 
desk or at another location. In the original filing, NASD proposed that 
the time of receipt for manual orders be the time the order is received 
by the member firm's trading desk or trading department for execution 
or further routing purposes. NASD also proposed to codify the staff's 
position that the time of receipt for electronic orders is the time the 
order is captured by a member's electronic order-routing or execution 
system.
    In Amendment No. 1, NASD amended its original filing and proposed 
that the time of receipt for manual orders of less than 10,000 shares 
be the time the order is received by the member's trading desk or 
trading department for execution or routing purposes. For manual orders 
that are 10,000 shares or greater, the time of receipt would continue 
to be the time the order is received by the member from the 
customer.\11\
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    \11\ Because certain order handling rules may apply differently 
to block orders of 10,000 shares or greater, NASD proposed, in 
Amendment No. 1, to define the time of receipt differently depending 
on the size of the order.
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2. Comments and NASD's Response
    One commenter supported the proposed definitions,\12\ while several 
commenters opposed having two definitions of time of receipt for manual 
orders.\13\ Specifically, commenters opposed the requirement that the 
time of receipt for a manual order of 10,000 shares or greater be the 
time the order is received by the member from the customer, rather than 
the time the order is received at the member's trading desk or trading 
department for execution or routing purposes. Commenters asserted that 
eliminating the time a 10,000 share or greater order is received by the 
trading desk for OATS purposes would impede NASD surveillance 
capabilities while, conversely, the inclusion of the customer order 
receipt time for these orders would not improve significantly NASD's 
ability to oversee and enforce sales practice violations.\14\ Further, 
commenters noted that NASD, where necessary, could obtain from members 
the customer order receipt time from members, which is required to be 
maintained under Rule 17a-3(a)(6) of the Act.\15\ In addition, 
commenters indicated that the two differing definitions of receipt time 
would create unnecessary costs and burdens for members in establishing 
automated systems to capture OATS data at branch locations, as well as 
confusion for salespersons in the branches and trading

[[Page 57911]]

desk personnel of firms, and would lead to inadvertent mistakes and 
delays in executions.\16\
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    \12\ See Mitchell Securities Letter.
    \13\ See SIA Letter-1; MSDW Letter; Pershing Letter; A.G. 
Edwards Letter; and Rocky Mountain Letter.
    \14\ See SIA Letter-1 and A.G. Edwards Letter.
    \15\ 17 CFR 240.17a-3(a)(6); See SIA-1 Letter; MSDW Letter; A.G. 
Edwards Letter; and Pershing Letter.
    \16\ See SIA-1 Letter; MSDW Letter; and A.G. Edwards Letter.
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    NASD agreed with commenters that having two differing definitions 
of time of receipt based solely on the size of the order would create 
burdens for members. However, because NASD believes that it is critical 
that OATS capture the time that an order is received by the trading 
desk, and have an electronic record of when orders, especially larger 
orders, are received at a firm to enable the staff to perform 
surveillance to detect violations such as frontrunning, as reflected in 
Amendment No. 2, NASD determined that OATS should capture both the time 
the order is received by the member from the customer and the time the 
order is received by the member's trading desk or trading department, 
if those times are different.
    Given that orders may be routed to multiple locations within a firm 
prior to reaching the trading desk (or even routed outside the firm 
directly from a desk other than the trading desk), in Amendment No. 2, 
NASD proposes to capture the various receipt times (customer receipt 
time, trading desk receipt time, etc.) by expanding the OATS order 
transmittal requirements that apply to intra-firm routes to include 
orders routed to the trading department.\17\ Specifically, if an order 
were not received immediately at the trading department, members would 
be required to capture information relating to the transfer of that 
order to the trading department under the order transmittal 
requirements of NASD Rule 6954(c). To the extent that the time of 
receipt of the order from the customer and receipt of the order by the 
trading department are the same, no Desk Report would be required, 
given that the New Order Report would accurately capture the time of 
receipt at the trading department.
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    \17\ NASD Rule 6954(c) currently requires that certain 
information be recorded when an order is transmitted to a department 
within a firm, other than the trading department. In furtherance of 
this provision, the OATS Reporting Technical Specifications requires 
that this information be reported to OATS via a ``Desk Report.'' 
When the OATS Rules originally were adopted in 1998, the OATS 
reporting framework was based on NASD staff's understanding that 
most electronic orders received by members were transferred to the 
trading department for execution and that such transfer was 
instantaneous with receipt of the order. Members had indicated that 
the ``routine'' order flow from point of receipt to the trading 
department would generate a significant number of OATS Desk Reports, 
and that reporting that information to OATS would be very burdensome 
and provide little additional information, since the transfer was 
instantaneous. As a result, Desk Reports were required only in those 
instances where orders were transmitted to departments other than 
the trading department (e.g., block desk, arbitrage desk). Since 
that time, member order routing and handling systems have changed 
and a larger percentage of orders are not routed immediately to the 
trading desk. Therefore, NASD staff believes the exclusion for 
orders routed to the trading department no longer makes sense and 
may result in gaps in the audit trail.
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    The proposed rule change, as reflected in Amendment No. 2, would 
apply equally to both electronic and manual orders. In other words, the 
time of receipt for purposes of order origination would always be the 
time the order is received from the customer. Amendment No. 2 also 
would require that members provide information on the nature of the 
department to which an order was transmitted, the number of shares to 
which the transmission applies, and any special handling requests. As 
with other technical requirements relating to OATS, NASD represented 
that it will specify in the OATS Reporting Technical Specifications how 
firms should report this information.

B. Proposed Exclusion From the Definition of ``Reporting Member''

1. Description
    Certain NASD members engage in non-discretionary order routing 
processes whereby, immediately after receipt of a customer order, the 
member routes the order, by electronic or other means, to another 
member (``receiving Reporting Member'') for further routing or 
execution at the receiving Reporting Member's discretion. Currently, 
the OATS Rules require both the member with which the order originated 
and the receiving Reporting Member to create and report New Order 
Reports and possibly Route Reports. This results in the receipt of 
duplicative information by OATS. Therefore, NASD proposed in the 
original filing that the OATS Rules be amended to require, in such 
instances, that only the receiving Reporting Member report OATS data. 
NASD proposed that a member would not be required to report OATS data 
regarding an order, if the following conditions are met:
    (1) the member engages in a non-discretionary order routing 
process, pursuant to which it immediately routes, by electronic or 
other means, all of its orders to a single receiving Reporting 
Member;\18\
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    \18\ If any delay results in the routing of an order due to 
systems problems or other reasons, the member with which the order 
originated would be required to report OATS data.
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    (2) the member does not direct or maintain control over subsequent 
routing or execution by the receiving Reporting Member;
    (3) the receiving Reporting Member records and reports all 
information required under NASD Rules 6954 and 6955 with respect to the 
order; and
    (4) the member has a written agreement with the receiving Reporting 
Member specifying the respective functions and responsibilities of each 
party to effect full compliance with the requirements of NASD Rules 
6954 and 6955.
2. Comments and NASD's Response
    One commenter suggested that the exclusion from the definition of 
``Reporting Member'' for members that use a non-discretionary order 
routing process as described in the proposed rule change be expanded to 
allow for an additional exclusion for members that regularly route all 
of a particular type of order or class of securities to a single 
receiving Reporting Member pursuant to a contractual arrangement.\19\ 
For example, if a firm regularly routes to a receiving Reporting Member 
all transactions in margin accounts and the receiving Reporting Member 
otherwise has total execution discretion and meets the other 
requirements set forth in the proposed rule change, the firm should be 
excluded from reporting these orders under the OATS Rules. The 
commenter noted that such an exclusion could be limited to no more that 
two or three such relationships.\20\ One commenter also suggested an 
order-by-order exclusion.\21\ Another commenter suggested allowing 
firms to handle an occasional order in a discretionary manner, but 
still be eligible for the exclusion.\22\
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    \19\ See Rocky Mountain Letter.
    \20\ See Rocky Mountain Letter.
    \21\ See Pershing Letter.
    \22\ See FIF Letter-1.
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    Another commenter stated that it is inequitable to provide an 
exclusion to correspondent firms that send all their order flow to 
their clearing firm, but not other kinds of order entry firms.\23\ The 
commenter generally argued that this proposed exclusion is unfair to 
other firms with different business models and is likely to hasten the 
decision by some firms to entrust all of their order flow with one 
executing party.\24\ This commenter suggested that the exemption be 
extended to all reporting firms based on the number of manual orders 
they handle as a percentage of total volume.\25\
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    \23\ See SIA Letter-1.
    \24\ See SIA Letter-1.
    \25\ See SIA Letter-1.
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    In response, NASD states that the proposed exclusion from the 
definition

[[Page 57912]]

of Reporting Member is directed at those members that use a non-
discretionary order routing process whereby, immediately after receipt 
of its customer orders, the member routes all its orders, by electronic 
or other means, to a single receiving Reporting Member for further 
routing or execution at the receiving Reporting Member's discretion. 
NASD states that the proposed exclusion is not limited to 
correspondent/clearing relationships, but applies to any relationship 
that meets the proposed conditions.
    NASD explained that the goal of the proposed rule is to eliminate 
the reporting of duplicative information to OATS where all of the OATS 
data of one member would be captured by the receiving Reporting Member. 
NASD noted that if the proposed rule were to permit deviations from 
this as commenters suggest, the exclusion would, in effect, permit an 
exclusion for almost any category of orders that are routed to another 
firm. Without the condition that all orders be routed to one firm, NASD 
would not have the ability to easily identify which receiving Reporting 
Member is providing the OATS order information that corresponds to the 
orders initially received by the member. Therefore, NASD declined to 
make any further changes to this proposed rule as described by 
commenters. However, in Amendment No. 2, NASD proposes to modify the 
rule text to clarify that, to qualify for the proposed exclusion to the 
definition of ``Reporting Member,'' the member must route all of its 
orders to a single receiving Reporting Member.

C. Recording and Reporting a Routed Order Identifier

1. Description
    OATS has the capability of tracking the history of an order by 
linking such orders across firms through the use of a routed order 
identifier. If the order does not contain a routed order identifier, 
the order cannot be linked systematically to subsequent actions, such 
as further routing or execution by other firms or Nasdaq systems. In 
this regard, the complete history of a significant percentage of orders 
may not be tracked because the OATS rules do not require a receiving 
Reporting Member to capture and report a routed order identifier if the 
order is routed to it manually.
2. Comments and NASD's Response
    Several commenters opposed the proposed requirement that members be 
required to capture and report a transmitting member's unique 
identifier for all manually routed orders.\26\ Commenters stated that 
members should not be responsible for capturing accurately on a manual 
basis the routed order identifier from other firms noting that errors 
will be frequent and carried on to the next firm to which the order is 
routed.\27\
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    \26\ See SIA Letter-1; FIF Letter-1; MSDW Letter; Wachtel 
Letters-1; Pershing Letter; and Mitchell Securities Letter.
    \27\ See SIA Letter-1; FIF Letter-1; Pershing Letter; and 
Mitchell Securities Letter.
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    Commenters further noted that the proposed requirement would lead 
to delays in order communication and executions and ultimately harm 
public investors.\28\ Because orders that are transmitted manually may 
not be entered into a firm's system and no systematic order identifier 
generated, commenters indicated that the proposed requirement would 
pose serious operational and logistical problems.\29\ Commenters also 
argued that NASD could effectively link or match together routed orders 
with new orders of the firm they are routed to without the routed order 
identifier information.\30\
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    \28\ See SIA Letter-1; A.G. Edwards Letter; MSDW Letter; 
Pershing Letter; and Wachtel Letters-1.
    \29\ See SIA Letter-1.
    \30\ See SIA Letter-1 and A.G. Edwards Letter.
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    In response to these comments, NASD reiterated that the use of a 
routed order identifier reported through OATS permits NASD to track the 
history of orders routed between firms on an automated basis and that 
if the order does not contain a routed order identifier, the order 
cannot be linked systematically on an automated basis to subsequent 
actions, such as further routing or execution by other firms. In the 
case of manually routed orders, however, NASD stated that it does not 
believe that the benefits provided by such an identifier clearly 
outweigh the related costs to members. In support of this, NASD noted 
in particular the commenters' concerns that requiring routed order 
identifiers for manually-routed orders creates potential delays in the 
handling and execution of customer orders and creates the likelihood of 
high levels of data errors. Further, NASD recognized that while it 
would not be able to track the history of manual orders between firms 
on an automated basis without a routed order identifier, the staff 
could create, on an order by order basis, a process that links manual 
orders to subsequent events with an acceptable level of accuracy. 
Therefore, NASD concluded that the costs imposed by this proposed 
requirement relating to manually routed orders as described by 
commenters are not outweighed by the incremental benefits to NASD 
regulatory data and surveillance systems and in Amendment No. 2, 
deleted this proposed requirement.

D. Proposed Exemptive Relief

1. Description
    Finally, NASD proposed in Amendment No. 1 new paragraph (d) of NASD 
Rule 6955 and an amendment to NASD Rule 9610(a) to permit NASD to grant 
exemptive relief to certain members from the reporting requirements of 
the OATS Rules under the procedures set forth in the NASD Rule 9600 
series. Specifically, members that meet the following criteria would be 
eligible to request an exemption to the OATS reporting requirements for 
manual orders:
    (1) the member and current control affiliates and associated 
persons of the member have not been subject within the last five years 
to any disciplinary action, and within the last ten years to any 
disciplinary action involving fraud;
    (2) the member has annual revenues of less than $2 million;
    (3) the member does not conduct any market making activities in 
Nasdaq Stock Market equity securities;
    (4) the member does not execute principal transactions with its 
customers (with limited exceptions for error corrections); and
    (5) the member does not conduct clearing or carrying activities for 
other firms.
    Under the proposed rule change, any exemptive relief granted would 
expire no later than two years from the date the member receives the 
exemptive relief. At or prior to the expiration of a grant of exemptive 
relief, members meeting the specified criteria may request a subsequent 
exemption. In addition, under the proposed rule change, NASD's 
exemptive authority would be in effect for five years from the 
effective date of the proposed rule change.
    The proposed exemptive authority would provide NASD the ability to 
grant relief to members meeting the specified criteria in situations 
where, for example, reporting of such information would be unduly 
burdensome for the member or where temporary relief from the rules (in 
the form of additional time to achieve compliance) would permit the 
member to avoid unnecessary expense or hardship.
2. Comments and NASD's Response
    Commenters generally supported the proposed rule change that would 
provide NASD with the authority to exempt certain members from OATS 
reporting for manual orders, but opposed many of the conditions placed

[[Page 57913]]

on members in order for them to request exemptive relief.\31\ For 
example, several commenters suggested changes to the proposed condition 
that requires that members requesting exemptive relief not have been 
subject within the last five years to any disciplinary action, and 
within the last ten years to any disciplinary action involving 
fraud.\32\ One commenter indicated that the five and ten year 
disciplinary action test should commence from the date the disciplinary 
action is initiated, rather than when the disciplinary action is 
finalized.\33\ The commenter indicated that the date of initiation of 
the disciplinary action is the date most closely linked to the conduct 
that is triggering the sanction and that members should not be 
discouraged from seeking a hearing or other recourse due to the 
proposed condition on obtaining exemptive relief for OATS purposes.\34\ 
One commenter suggested a de minimis exception for single disciplinary 
action incurring a fine of not more than $10,000,\35\ while another 
commenter suggested that NASD be provided discretion to consider a 
firm's overall disciplinary history in determining whether to grant an 
exemption.\36\
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    \31\ See Mitchell Securities Letter; Wachtel Letters-1; Storch & 
Brenner Letter; and First Options Letter.
    \32\ See Watchel Letters-1.
    \33\ See Watchel Letters-1.
    \34\ See Watchel Letters-1.
    \35\ See Watchel Letters-1.
    \36\ See Storch & Brenner Letter.
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    One commenter suggested that exemptive relief be available for 
market makers that conduct principal trades.\37\ Another commenter 
recommended eliminating the condition restricting firms that clear for 
others from obtaining exemptive relief where the introducing firm is 
not a reporting member under NASD Rule 6951 (except the exclusion that 
another member report its trades) and/or the introducing firm obtains 
an exemption under NASD Rule 6955.\38\ This commenter also suggested 
that the provision stating that a firm seeking an exemption cannot 
clear for other firm might disrupt a longstanding relationship that is 
integral to the introducing firm's business.\39\
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    \37\ See Mitchell Securities Letter.
    \38\ See Wachtel Letters-1.
    \39\ See Watchel Letters-1.
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    One commenter noted that the five-year ``sunset'' provision on 
NASD's ability to grant exemptions should be extended indefinitely, 
noting that there currently is no reason to believe the rationale for 
providing NASD exemptive authority will be any different in five years. 
Moreover, the procedural impediments necessary for NASD to request that 
its exemptive authority be extended would be very burdensome.\40\
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    \40\ See Watchel Letters-1.
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    Another commenter stated that exemptive relief should be provided 
from all OATS reporting requirements for any NASD member that: (1) 
Carries no accounts for customers; (2) provides execution services in 
Nasdaq equity securities only to other dealers who are acting as market 
makers or proprietary traders and not on behalf of a customer; and (3) 
does not itself (other than in an error account) engage in market 
making or proprietary trading.\41\
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    \41\ See First Options Letter.
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    NASD did not propose any changes to this exemptive provision in 
Amendment No. 2. However, NASD staff committed to review and analyze 
closely the application of such conditions to exemptive authority and 
determine whether it would be appropriate to seek changes to these 
conditions, including the types of changes suggested by commenters.
    In Amendment No. 2, however, NASD proposes to amend NASD Rule 
6955(d)(1)(A) to clarify that the condition on members that may request 
exemptive relief under the proposed rule applies only to final 
disciplinary actions within the last five years and does not include 
minor rule violations pursuant to Rule 19d-1(c)(2) of the Act.\42\
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    \42\ 17 CFR 240.19d-1(c)(2).
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E. Comments on Implementation Schedule

    Several commenters requested additional time to comply with the 
proposed Phase Three requirements.\43\ In recognition of the 
technological burdens that may be imposed on members as a result of the 
changes proposed, in Amendment No. 2, NASD proposes to provide an 
implementation date 120 days from Commission approval of the proposed 
rule change.
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    \43\ See SIA Letter-1; FIF Letter-1; MSDW Letter; A.G. Edwards 
Letter; Weeden Letter; and Pershing Letter.
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    Amendment No. 2 was published for comment in the Federal Register 
on June 27, 2005.\44\ The Commission received six comment letters in 
response to the publication.\45\
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    \44\ See note 5, supra.
    \45\ See note 6, supra.
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IV. Summary of Comments on Amendment No. 2 and NASD's Response Thereto 
(Amendment No. 3)

A. Definition of Time of Receipt

    One commenter indicated that requiring members to capture the time 
the order is received by the member from the customer would create 
unnecessary costs and burdens for members in establishing automated 
systems to capture OATS data.\46\ In response, NASD stated that it 
recognizes that this requirement may impose additional costs on member 
firms, however NASD believes that it is critical to NASD's surveillance 
systems and regulatory program that OATS capture the full lifecycle of 
an order within a firm and, in particular, the time that an order is 
received from the customer. However, in recognition of these burdens, 
NASD proposed to extend the implementation period of the proposed rule 
change.\47\
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    \46\ See Wachovia Letter.
    \47\ See Section IV.E., infra.
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B. Exemptive Authority

    Commenters generally supported the proposed rule change that would 
provide NASD with the authority to exempt certain members from OATS 
reporting for manual orders, but opposed the limited nature of NASD's 
exemptive authority.\48\ For example, one commenter suggested that an 
exemption be provided to any member that handles a small percentage of 
manual orders as compared to its overall volume, \49\ while another 
opposed the expiration of NASD's exemptive authority in five years.\50\
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    \48\ See Wachovia Letter; SIA Letter-2; Wachtel Letter-2.
    \49\ See SIA Letter-2.
    \50\ See Wachtel Letter-2.
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    One commenter suggested revising the condition that only members 
with annual revenues of less than $2 million may request exemptive 
relief. Specifically, the commenter suggested that annual revenues for 
this purpose be based only on revenues from transactions in Nasdaq 
securities.\51\
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    \51\ See Wulff Letter.
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    In response to these comments, NASD committed to review and analyze 
closely its exemptive authority and determine whether it would be 
appropriate to seek any changes, including the types of changes 
suggested by commenters to the proposed rule change, but declined to 
make the changes suggested by commenters in Amendment No. 3.

C. Application to Preferred and Convertible Securities

    One commenter suggested that NASD grant a carve-out or phased 
implementation for preferred securities and convertible securities, 
given the manual nature of the trading in these securities.\52\ In 
response to this

[[Page 57914]]

comment, NASD stated that it does not believe it poses any additional 
burdens than those associated with manual orders of other securities. 
NASD noted that it proposed to extend the implementation time for the 
proposed rule change, which it believes will provide members adequate 
time for any technological or system changes required to address OATS 
reporting of manual orders in convertible and preferred securities.\53\
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    \52\ See SIA Letter-2.
    \53\ The Commission notes that when the OATS Rules where 
originally proposed, a commenter argued that order information on 
preferred stocks should not be required to be included in OATS. The 
NASD disagreed, as did the Commission, which stated in the original 
approval order, ``The Commission believes that NASDR's decision not 
to provide a specific exemption from OATS requirements for preferred 
stock is appropriate because the preferred stock is an equity 
security that poses many of the same surveillance concerns as common 
stock.'' See note 7, supra at 12568. The Commission believes this 
rationale continues to apply.
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D. Comments Requesting Clarification

    One commenter requested clarification on how the term ``trading 
desk'' or ``trading department'' would apply, particularly for firms 
that do not have a trading desk.\54\ In response, NASD noted that it 
had previously issued guidance relating to the term ``trading 
department'' and that this same guidance will continue to apply with 
respect to the proposed rule change.\55\
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    \54\ See FIF Letter-2.
    \55\ See Letter from NASD Regulation to Charles R. Hood, dated 
July 30, 1998. Specifically, NASD stated that the term ``trading 
department'' is intended to refer to the function within the firm 
that is responsible for executing orders in Nasdaq equity 
securities. For an ECN, for example, this may be interpreted as 
either the trading system (where orders are executed automatically 
without trader intervention) or the trading department (where orders 
are executed with the assistance of traders).
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    One commenter requested clarification as to the time parameter 
associated with the term ``immediately'' in the context of order 
receipt time under the proposed rule change.\56\ In response NASD 
explained that if an order were not received immediately at the trading 
department, members would be required to capture information relating 
to the transfer of that order to the trading department under the order 
transmittal requirements of Rule 6954(c). In Amendment No. 3, NASD 
stated that it believes that where a member receives and handles an 
order within the same second, the member would not be required to 
report a Desk Report relating to that order.
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    \56\ See FIF Letter-2.
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    One commenter requested clarification on order receipt time in the 
context of third party Internet service providers. The commenter 
indicated that a third party Internet service provider may capture 
orders on behalf of a member after trading hours and submit these 
orders in batch the next trading day. The commenter indicated that 
order receipt data is not transmitted by the third party Internet 
service provider as part of the order data.\57\ In response, NASD 
explained that, as with any requirement under the OATS Rules, the 
decision by a member to use a third party provider does not change the 
member's obligation under the rules. As such, NASD stated that the 
member is required to capture order receipt time on all orders. The 
batching or other transmittal practices of a third party vendor would 
not change this requirement.
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    \57\ See id.
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    Another commenter supported the proposed exclusion from the 
definition of ``Reporting Member'' under the OATS Rules, but suggested 
that NASD provide additional guidance in the future regarding the 
condition that the member does not direct or maintain control over 
subsequent routing or execution by the receiving Reporting Member.\58\ 
NASD responded that if the proposed rule change is approved, it would 
issue a Notice to Members announcing approval of the proposed rule 
change and, as part of that Notice, it would provide additional 
guidance on a number of issues, including the exclusion from the 
definition of ``Reporting Member.''
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    \58\ See Wachovia Letter.
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E. Implementation Issues Relating to the Proposed Rule Change

    Several commenters suggested that the proposed implementation 
period of the proposed rule change should be extended, noting the 
significant technological changes needed to implement OATS reporting 
requirements for manual orders.\59\ Commenters also requested that NASD 
promptly publish the OATS Reporting Technical Specifications relating 
to the proposed rule change and that the implementation date be linked 
to its publication, and that NASD provide adequate time for 
testing.\60\
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    \59\ See Wachovia Letter; Liquidnet Letter; FIF Letter-2; and 
SIA Letter-2.
    \60\ See id.
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    In response to commenters and in recognition of the technological 
burdens that may be imposed on members as a result of this proposal, in 
Amendment No. 3, NASD proposes to amend the text of NASD Rule 6957(c) 
to provide an implementation date that is six months after publication 
of the OATS Reporting Technical Specifications relating to SR-NASD-00-
23, rather than 120 days from Commission approval of the proposed rule 
change. In Amendment No. 3, NASD also committed to publish the OATS 
Reporting Technical Specifications within 45 days of Commission 
approval. In addition, NASD states that it would ensure that adequate 
time for testing is incorporated into the implementation schedule and 
will make the testing environment available at least six weeks prior to 
the implementation date of the proposed rule change.

F. Technical Amendments

    In Amendment No. 3, NASD also proposes to make technical amendments 
to NASD Rule 6957(c) to clarify the OATS order information required 
under NASD Rule 6954(b)(4) \61\ and (5) \62\ and the OATS order 
transmittal requirements under NASD Rule 6954(c)(1) apply to manual 
orders.\63\ NASD explained that, as stated in Amendment No. 2, the 
proposed rule change applies to both electronic and manual orders. As 
such, NASD clearly intended to have the inter-departmental order 
transmittal requirements apply to manual orders. Similarly, department 
identification information concerning where a manual order was 
originated also was intended to be included. Therefore, NASD proposes 
to eliminate the prior exclusion of this information from the OATS 
requirements for manual orders.
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    \61\ NASD Rule 6954(b)(4) requires members to record the 
identification of any department or the number of any terminal where 
an order is received directly from a customer when an order is 
received.
    \62\ NASD Rule 6954(b)(5) requires members to record, where the 
order is originated by a Reporting Member, the identification of the 
member that originates the order when an order is received.
    \63\ As proposed in Amendment No. 2, NASD Rule 6954(c)(1) would 
require members to record certain order information when a member 
transmits an order to another department within the member.
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V. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
association.\64\ Specifically, the Commission believes the proposal is 
consistent with the requirements of Section 15A(b)(6) of the Act.\65\ 
That section requires that the rules of a national securities 
association be designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of trade, to foster 
cooperation and coordination with persons engaged in

[[Page 57915]]

regulating, clearing, settling, processing information with respect to, 
and facilitating transactions in securities, and in general, to protect 
investors and the public interest.
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    \64\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \65\ 15 U.S.C. 78o-3(b)(6).
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A. Definition of Time of Receipt

    Currently, members are required to capture the time of receipt of 
an order pursuant to NASD Rule 6954(b)(16). In Amendment No. 2, NASD 
proposed to define the order origination or receipt time for an order 
as the time the order is received from the customer. The Commission 
believes that this change, along with a new requirement that members 
must record the date and time they transmit orders to their trading 
departments, should ensure that OATS captures both the time the order 
is received by the member from the customer and the time the order is 
received by the member's trading desk or trading department. 
Importantly, these changes will apply to both electronic and manual 
orders so that the time of receipt for purposes of order origination 
should always be the time the order is received from the customer.
    The Commission believes that it is important to NASD's automated 
surveillance systems that OATS capture the time that an order is 
received by the trading desk, and have an electronic record of when 
orders, especially larger orders, are received at a firm to enable NASD 
to perform surveillance to detect certain violations, such as 
frontrunning. Therefore, the Commission believes that it is appropriate 
for OATS to capture both the time the order is received by the member 
from the customer and the time the order is received by the member's 
trading desk or trading department, if those times are different.
    By proposing these changes, NASD would capture the complete 
lifecycle of an order within a firm, even in those situations where an 
order is held at the sales trading or other desk within a member firm, 
and then later routed to the trading desk. Although the Commission 
recognizes that this requirement may impose additional costs on member 
firms, the Commission agrees with NASD it is important to NASD's 
surveillance systems and regulatory program that OATS capture the full 
lifecycle of an order within a firm and, in particular, both the time 
that an order is received from the customer and the time the order is 
received by the trading desk.

B. Definition of Reporting Member

    The proposed exclusion from the definition of Reporting Member is 
directed at those members that use a non-discretionary order routing 
process whereby, immediately after receipt of its customer orders, the 
member routes all its orders, by electronic or other means, to a single 
receiving Reporting Member for further routing or execution at the 
receiving Reporting Member's discretion. The NASD has explained that 
the proposed exclusion is not limited to correspondent/clearing 
relationships, but applies to any relationship that meets the proposed 
conditions.
    The Commission believes that this proposed rule should eliminate 
the reporting of duplicative information to OATS where all of the OATS 
data of one member would be captured by the receiving Reporting Member. 
The Commission also agrees with NASD's proposal to impose a condition 
on the exclusion that all of a member's orders must be routed to a 
single firm. The Commission believes that without this requirement, 
NASD would lack the ability to easily identify which receiving 
Reporting Member is providing the OATS order information that 
corresponds to the orders initially received by the member, thus 
decreasing NASD's ability to efficiently surveil its members.
    In addition to eliminating the reporting of duplicative information 
to OATS, the Commission believes that proposed rule change should 
reduce the regulatory burdens on members, particularly smaller members, 
that route all their orders to another receiving Reporting Member by 
means of a non-discretionary order routing process, for execution or 
further routing purposes.\66\
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    \66\ This exclusion would not change a member's requirement to 
capture and retain the time an order was received from a customer 
under SEC Rule 17a-3(a)(6).
---------------------------------------------------------------------------

C. Routed Order Identifier

    After considering comments regarding the pitfalls associated with 
requiring members to capture and report a transmitting member's unique 
identifier for all manually routed orders, in Amendment No. 2, NASD 
concluded that the benefits provided by requiring the capture and 
reporting of such an identifier do not outweigh the related costs to 
members. In reaching this decision, NASD recognized the concern that 
requiring routed order identifiers for manually routed orders could 
create delays in the handling and execution of customer orders and 
could result in a high level of data errors. NASD explained that 
although it would not be able to track the history of manual orders 
between firms on an automated basis without a routed order identifier, 
the staff could create, on an order by order basis, a process that 
links manual orders to subsequent events with an acceptable level of 
accuracy.
    While the Commission believes that requiring the capture and 
reporting of a routed order identifier for all manually routed orders 
would enhance NASD's ability to track the history of orders routed 
between firms on an automated basis, the Commission understands NASD's 
reluctance to impose such a burdensome requirement on members given 
that a history of manual orders can be created, albeit in a less 
efficient fashion, and believes that it is acceptable to relieve 
members of the burden of capturing a routed order identifier for manual 
orders at this time.

D. Exemptive Relief

    The Commission believes that the exemptive authority proposed by 
the NASD is appropriate in that it is narrowly tailored to provide NASD 
the ability to grant relief to members meeting the specified criteria 
in situations where, for example, reporting of such information would 
be unduly burdensome for the member or where temporary relief from the 
rules (in the form of additional time to achieve compliance) would 
permit the member to avoid unnecessary expense or hardship.

VI. Amendment No. 3

    The Commission finds good cause for approving proposed Amendment 
No. 3 prior to the thirtieth day after the date of publication of the 
notice of filing thereof in the Federal Register. In Amendment No. 3, 
NASD proposes changes to the implementation schedule for the proposed 
new OATS Rules and proposes a technical change relating to data 
required to be reported for manual orders. Accordingly, the Commission 
believes that Amendment No. 3 raises no issues of regulatory concern.
    In Amendment No. 2, NASD proposes an implementation date for the 
proposed OATS Rules of 120 days from Commission approval of the 
proposed rule change. A number of commenters, however, argued that the 
proposed implementation schedule should be extended to allow member 
firms additional time to prepare to comply with the new OATS Rules. In 
response to these comments, NASD proposed to amend the text of NASD 
Rule 6957(c) to provide an implementation date that is six months after 
publication of the OATS Reporting Technical Specifications relating to 
SR-NASD-00-23, rather than 120 days from Commission approval of the 
proposed rule change. In Amendment No. 3, NASD also committed to 
publish the

[[Page 57916]]

OATS Reporting Technical Specifications within 45 days of Commission 
approval. In addition, NASD stated that it would ensure that adequate 
time for testing is incorporated into the implementation schedule and 
will make the testing environment available at least six weeks prior to 
the implementation date of the proposed rule change.
    The Commission believes that the proposed changes to the 
implementation schedule for the proposed OATS Rules are reasonable as 
the additional time provided should allow member firms ample 
opportunity to develop and test their systems to ensure compliance with 
the requirements of the proposed rules.
    In Amendment No. 3, NASD also proposes to make technical amendments 
to NASD Rule 6957(c) to clarify that the OATS order information 
required under NASD Rule 6954(b)(4) and (5) and the OATS order 
transmittal requirements under NASD Rule 6954(c)(1) apply to manual 
orders. Currently, NASD Rule 6957 provides that for manual orders, 
firms shall not be required to record this information. However, the 
Commission notes that in Amendment No. 2, NASD stated that the proposed 
rule change was to apply to both electronic and manual orders. As such, 
the Commission believes that NASD clearly intended to have the inter-
departmental order transmittal requirements apply to manual orders. 
Similarly, the Commission believes that it was clear that NASD intended 
that department identification information concerning where a manual 
order was originated also was intended to be included. Therefore, the 
Commission finds that it is consistent with the Act in general, and 
with Section 15A(b)(6) of the Act in particular,\67\ to approve 
Amendment No. 3 to the proposed rule change, as reflected in Amendment 
No.2, on an accelerated basis.
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    \67\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

VII. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 3, including whether the amendment 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-NASD-00-23 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-9303.
    All submissions should refer to File Number SR-NASD-00-23. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, 

all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of NASD.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to the File Number SR-NASD-00-23 
and should be submitted on or before October 25, 2005.

VIII. Conclusion

    The Commission believes that the proposed rule change, as reflected 
in Amendments No. 2 and 3, is appropriate and consistent with the 
requirements of the Act applicable to a national securities 
association, and in particular, with the requirements of Section 
15A(b)(6) of the Act \68\ and the rules and regulations thereunder.
---------------------------------------------------------------------------

    \68\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\69\ that Amendment No. 2 to the proposed rule change (SR-NASD-00-
23) is hereby approved, and Amendment No. 3 is approved on an 
accelerated basis.
---------------------------------------------------------------------------

    \69\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\70\
---------------------------------------------------------------------------

    \70\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 05-19809 Filed 10-3-05; 8:45 am]

BILLING CODE 8010-01-P
