[Federal Register: July 10, 2006 (Volume 71, Number 131)]
[Notices]
[Page 38935-38948]
[DOCID:fr10jy06-96]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54084; File No. SR-NASD-2005-087]

Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Approving Proposed Rule Change and Notice of
Filing and Order Granting Accelerated Approval to Amendment No. 1
Relating to Amendments to the NASD's Rules Following the Nasdaq
Exchange's Operation as a National Securities Exchange for Nasdaq UTP
Plan Securities

June 30, 2006

I. Introduction

    On July 11, 2005, 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 (``Exchange Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to amend various NASD rules to
reflect the Nasdaq Stock Market, Inc.'s (``Nasdaq'') separation from
the NASD following the commencement of operations of the Nasdaq Stock
Market LLC (``Nasdaq Exchange'') as a national securities exchange.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19B-4.
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    Prior to 2000, Nasdaq was wholly-owned by the NASD. The NASD
currently retains voting control of Nasdaq through an outstanding share
of Nasdaq Series D preferred stock.\3\ The NASD and Nasdaq began
restructuring their relationship in 2000 with the goal of completely
separating Nasdaq from the NASD. As part of this restructuring, Nasdaq
filed with the Commission an application to register one of its
subsidiaries, the Nasdaq Exchange, as a national securities
exchange.\4\
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    \3\ The share of Series D preferred stock gives the NASD the
right to cast one more than one-half of all votes entitled to be
cast at an election by all holders of capital stock of Nasdaq. When
Nasdaq ceases to operate pursuant to the NASD's Plan of Allocation
and Delegation of Functions by NASD to Subsidiaries (the
``Delegation Plan''), the Series D preferred share will expire
automatically. See Securities Exchange Act Release No. 53022
(December 23, 2005), 70 FR 77433 (December 30, 2005). To reflect
this change, the NASD will file a proposed rule change to revise the
Delegation Plan to remove references to Nasdaq as a subsidiary of
the NASD. Because this change to the Delegation Plan would terminate
the NASD's control under the Series D preferred share, the NASD
cannot file this proposed rule change until it can represent to the
Commission that its control of Nasdaq is no longer necessary because
the NASD can fulfill through other means its obligations with
respect to securities reported to the Consolidated Transaction
Association Plan (``CTA Plan Securities'') See Order Modifying
Nasdaq Exchange Conditions, infra note 6.
    \4\ In connection with the Nasdaq Exchange registration, Nasdaq
became a holding company with the Nasdaq Exchange as its wholly-
owned subsidiary.
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    The Commission approved the Nasdaq's Exchange's registration as a
national securities exchange on January 13, 2006.\5\ In the Nasdaq
Exchange Order, the Commission conditioned the Nasdaq Exchange's
operation as a national securities exchange on the satisfaction of
certain enumerated requirements. The Nasdaq Exchange Order and the
conditions therein reflected the Nasdaq Exchange's intentions to begin
operations as a national securities exchange for CTA Plan Securities as
well as securities listed on Nasdaq and reported to the Joint Self-
Regulatory Organization Plan Governing the Collection, Consolidation
and Dissemination of Quotation and Transaction Information for Nasdaq-
Listed Securities Traded on Exchanges on an Unlisted Trading Privileges
Basis (``Nasdaq UTP Plan Securities'').
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    \5\ See Securities Exchange Act Release No. 53128, 71 FR 3350
(January 23, 2006) (``Nasdaq Exchange Order'').
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    The Commission modified the conditions set forth in the Nasdaq
Exchange Order on June 30, 2006, to allow the Nasdaq Exchange to
operate as a national securities exchange solely with respect to Nasdaq
UTP Plan Securities.\6\ During this period, the NASD will continue to
control Nasdaq through the Series D preferred share and Nasdaq will
continue to perform obligations under the Delegation Plan with respect
to CTA Plan Securities. Accordingly, the NASD filed Amendment No. 1 to
modify the proposed rule change to reflect the Nasdaq Exchange's
operational plan.
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    \6\ See Securities Exchange Act Release No. 54085 (June 30,
2006) (``Order Modifying Nasdaq Exchange Conditions'').
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II. NASD Proposal

    In the proposed rule change, the NASD proposed to: (1) Delete
certain NASD rules that pertain to the operation of the Nasdaq Exchange
and thus reflect Nasdaq's separation from the NASD; \7\ (2) modify
certain NASD rules to clarify the NASD's continued regulation of the
over-the-counter (``OTC'') market upon the Nasdaq Exchange's operation
as an exchange; \8\ (3) amend the NASD's Order Audit Trail System
(``OATS'') to reflect the use of OATS by Nasdaq Exchange members; \9\
(4) make technical and clarifying changes to the rules governing the
NASD's Alternative Display Facility

(``ADF''); \10\ and (5) establish rules governing the NASD's proposed
new trade reporting facility (``Trade Reporting Facility'').\11\
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    \7\ See infra note 44 and accompanying section.
    \8\ See infra notes 46-53 and accompanying text.
    \9\ See infra note 55 and accompanying text.
    \10\ See infra notes 77-84 and accompanying section.
    \11\ See infra notes 85-101 and accompanying text.
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    The proposed rule change was published for comment in the Federal
Register on July 22, 2005.\12\ The Commission received 14 comment
letters from 12 commenters regarding the proposal.\13\ On November 23,
2005, and May 3, 2006, the NASD submitted responses to the comment
letters.\14\
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    \12\ See Securities Exchange Act Release No. 52049 (July 15,
2005), 70 FR 42398 (July 22, 2005).
    \13\ See letters to Jonathan G. Katz, Secretary, Commission,
from Mary Yeager, Assistant Secretary, New York Stock Exchange, Inc.
(``NYSE''), dated August 12, 2005 (``NYSE Letter I'') and November
10, 2005 (``NYSE Letter II''); Edward S. Knight, Executive Vice
President and General Counsel, Nasdaq, dated October 13, 2005
(``Nasdaq Letter''); John Boese, Vice President and Chief Regulatory
Officer, Boston Stock Exchange, Inc. (``BSE''), dated November 4,
2005 (``BSE Letter''); and Kevin J.P. O'Hara, Chief Administrative
Officer and General Counsel, Archipelago Holdings, Inc.
(``Archipelago''), dated November 10, 2005 (``Archipelago Letter'');
letters to The Honorable Christopher Cox, Chairman, Commission, from
Bart J. Ward, Chief Executive Officer, Ward & Company, dated
February 10, 2006 (``Ward Letter''); John A. Thain, Chief Executive
Officer, NYSE Group, Inc., dated April 27, 2006 (``NYSE Letter
III''). See also letters to The Honorable Christopher Cox, Chairman,
Commission, from The Honorable Geoff Davis, U.S. House of
Representatives, dated February 9, 2006 (``Davis Letter''); The
Honorable Melissa L. Bean, U.S. House of Representatives, dated
January 16, 2006 (``Bean Letter''); The Honorable Edolphus Towns,
U.S. House of Representatives, dated January 12, 2006 (``Towns
Letter''); The Honorable Michael E. Capuano, U.S. House of
Representatives, dated January 3, 2006 (``Capuano Letter''); The
Honorable Patrick T. McHenry, U.S. House of Representatives, dated
December 22, 2005 (``McHenry Letter''); The Honorable Jim Gerlach,
U.S. House of Representatives, dated December 14, 2005 (``Gerlach
Letter''); and The Honorable Richard H. Baker, Chairman,
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises, U.S. House of Representatives, dated December 13, 2005
(``Baker Letter''). The comment letters are available in the
Commission's Public Reference Room and on the Commission's Internet
Web site (http://www.sec.gov). The Commission notes that the

Archipelago Letter and NYSE Letter II also were submitted as comment
letters in response to the Nasdaq Exchange's application to register
as a national securities exchange.
    \14\ See letter to Jonathan G. Katz, Secretary, Commission, from
Barbara Z. McSweeney, Senior Vice President and Corporate Secretary,
NASD, dated November 23, 2005 (``NASD Response Letter I''); letter
to the Honorable Christopher Cox, Chairman, Commission from Robert
R. Glauber, Chairman and Chief Executive Officer, NASD, dated May 2,
2006 (``NASD Response Letter II'').
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    The NASD filed Amendment No. 1 to the proposal on June 15, 2006. In
addition to making several technical corrections and conforming
changes,\15\ the NASD proposes in Amendment No. 1 to revise its
proposal to: (1) Amend the Delegation Plan to retain the delegation to
Nasdaq of obligations with respect to CTA Plan Securities, while
eliminating Nasdaq's regulatory authority with respect to Nasdaq UTP
Plan Securities; \16\ (2) amend the Nasdaq Bylaws to reflect changes
that were approved in the Nasdaq Exchange Order; \17\ (3) retain
amended versions of the rules governing Nasdaq's BRUT and INET trading
systems; \18\ (4) provide that members may continue to quote and trade
CTA Plan Securities and participate in the Intermarket Trading System
(``ITS'') through an NASD facility by retaining in the NASD's rules
revised versions of relevant rules; \19\ (5) revise an existing NASD
rule to make clear that certain securities that will be listed on the
Nasdaq Exchange will continue to be treated as CTA Plan Securities;
\20\ and (6) delete from NASD Rule 6120 a provision allowing a national
securities exchange that trades Nasdaq securities on an unlisted
trading privileges basis (``UTP Exchange'') to participate in the Trade
Reporting Facility. In addition, the NASD has requested that this
proposal become effective only when the Nasdaq Exchange begins
operations as a national securities exchange for Nasdaq UTP Plan
Securities.
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    \15\ For example, the NASD proposes to: (1) Revise NASD Rule
5100, ``Short Sale Rule,'' to indicate that the NASD's Short Sale
Rule will continue to operate as a pilot program; (2) retain the
NASD Rule 9700 Series, ``Procedures on Grievances Concerning the
Automated Systems'' for appeals of OTC Bulletin Board eligibility
determinations and retain NASD Rule 11890, ``Clearly Erroneous
Transactions,'' and IM-11890-1 and IM-11890-2; (3) make additional
technical changes to the ADF Rules; (4) incorporate NASD rules that
have been approved since the NASD filed the proposal; (5) clarify
the termination provision in the Trade Reporting Facility LLC
agreement to correctly reflect that Nasdaq is not registered as a
self-regulatory organization (``SRO''); and (6) retain references to
Nasdaq in NASD's Delegation Plan, bylaws and rules to reflect that
Nasdaq remains a controlled subsidiary.
    \16\ See infra notes 40-41 and accompanying text.
    \17\ See infra note 42 and accompanying text.
    \18\ See infra notes 72-74 and accompanying text.
    \19\ See infra notes 58-70 and accompanying text.
    \20\ See infra note 57 and accompanying text.
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    Finally, in Amendment No. 1, the NASD also proposed to renumber
NASD Rule 6440(i) as NASD Rule 5110, ``Transactions Related to Initial
Public Offerings'' and to extend its application to transactions in
Nasdaq UTP Plan Securities.
    After careful consideration and for the reasons discussed below,
the Commission finds that the proposed rule change, as amended, is
consistent with the requirements of the Exchange Act and the rules and
regulations thereunder applicable to the NASD, and, in particular, with
the requirements of Sections 15A(b)(2), (6), and (11) of the Exchange
Act.\21\ Section 15A(b)(2) of the Exchange Act requires a registered
national securities association to be so organized and have the
capacity to be able to carry out the purposes of the Exchange Act.
Section 15A(b)(6) of the Exchange Act requires that the rules of a
registered 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 regulating, clearing, settling, processing
information with respect to and facilitating transactions in
securities, to remove impediments to and protect the mechanism of a
free and open market and a national market system and, in general, to
protect investors and the public interest. Section 15A(b)(11) of the
Exchange Act requires that the rules of a registered national
securities association be designed to produce fair and informative
quotations, to prevent fictitious or misleading quotations, and to
promote orderly procedures for collecting, distributing, and publishing
quotations.
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    \21\ 15 U.S.C. 78o-3(b)(2), (6), and (11). In approving the
proposed rule change, the Commission has considered the proposal's
impact on efficiency, competition, and capital formation.
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    In addition, the Commission is publishing notice to solicit
comments on, and is simultaneously approving, on an accelerated basis,
Amendment No. 1. Many of the changes proposed in Amendment No. 1
reflect the new implementation strategy for the Nasdaq Exchange and are
necessary for the NASD to fulfill its obligations under the Exchange
Act with regard to CTA Plan Securities.
    Specifically, the NASD proposes to retain its rules that govern its
members' quoting, trading, and transaction reporting of CTA Plan
Securities and its ITS rules related to the NASD's and its members'
compliance with the requirements of the ITS Plan. In this regard, in
Amendment No. 1, the NASD proposes to retain the portions of the NASD's
Rule 4700 Series relating to the NASD's participation in the ITS Plan.
The NASD also proposes to amend the Rule 4700 Series to delete rules
that relate to the operation of the Nasdaq Market Center trading
system, while retaining the current rules that relate to the operation
of the SuperIntermarket functionality, which facilitates NASD members'
compliance with the ITS Plan. In addition, the NASD proposes to retain
its Rule 6300 Series and Rule 5200 Series, which, among other things,
allow NASD members to enter

quotations in CTA Plan Securities by registering as Consolidated Quote
System (``CQS'') market makers and as ITS/Computer Assisted Execution
System (``ITS/CAES'') market makers. Finally, the NASD proposes to
retain its 6400 Series, which governs the reporting of transactions in
CTA Plan Securities that do not occur in the SuperIntermarket. The
retention of these rules, with changes that reflect the Nasdaq
Exchange's operation as an exchange for Nasdaq UTP Plan Securities,
maintains the current framework for OTC trading of CTA Plan Securities.
Accordingly, the Commission finds good cause to accelerate approval of
these changes.
    To reflect the new implementation strategy of the Nasdaq Exchange,
in Amendment No. 1, the NASD proposes to retain in the NASD's rules the
Nasdaq By-Laws and, rather than remove all references to Nasdaq in the
Delegation Plan, to only eliminate Nasdaq's responsibility under the
Delegation Plan with respect to Nasdaq UTP Plan Securities. By
retaining references to Nasdaq in the Delegation Plan, the NASD retains
control over Nasdaq pursuant to the Series D preferred share.\22\ The
Commission finds good cause to accelerate approval of these changes to
the Delegation Plan because they allow Nasdaq to continue to perform
the same functions it does today regarding CTA Plan Securities and
appropriately limit Nasdaq's delegated authority once it begins
operations as a national securities exchange so that it will not be
delegated responsibility regarding OTC activities in Nasdaq UTP Plan
Securities. Further, these changes ensure that the NASD retains control
over Nasdaq so that the NASD will have the means by which to fulfill
its obligations through the use of Nasdaq systems with regard to CTA
Plan Securities.
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    \22\ See supra note 3.
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    In addition, the NASD proposes, in Amendment No. 1, to retain the
rules that govern executions of CTA Plan Securities on BRUT and INET.
The Commission finds good cause to accelerate approval of these changes
because these systems must continue to operate pursuant to NASD rules
until the Nasdaq Exchange begins trading CTA Plan Securities.
    Finally, the NASD proposes to amend NASD Rule 4400 relating to
securities that are dually listed on the NYSE and the Nasdaq Exchange.
The revised rule, which reflects language currently found in NASD IM-
4400, makes clear that these dually listed securities will continue to
be treated as CTA Plan Securities under the NASD's rules and applicable
national market system plans. The Commission finds good cause to
accelerate approval of this change because it will ensure that these
securities are handled in the same manner as they are today.
    In Amendment No. 1, the NASD proposes to renumber NASD Rule 6440(i)
as NASD Rule 5110 and to extend its application to Nasdaq UTP Plan
Securities. This rule prohibits members from executing transactions in
securities that are subject to an initial public offering until such
security has opened for trading on the listing exchange, which is
indicated by the dissemination of an opening transaction by the listing
exchange via the Consolidated Tape.\23\ The Commission finds good cause
to accelerate approval of extending this rule to Nasdaq UTP Plan
Securities because it will result in uniform regulation of securities
that are subject to an initial public offering.
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    \23\ The Commission notes that the NASD committed to file a
proposed rule change to amend this rule to reflect that transactions
in Nasdaq UTP Plan Securities are reported to the Nasdaq UTP Plan.
Telephone call between Kelly Riley, Assistant Director, Division of
Market Regulation (``Division''), Commission and Lisa Horrigan,
Assistant General Counsel, NASD on June 28, 2006.
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    In Amendment No. 1, the NASD also proposes to retain the NASD Rule
9700 Series, relating to grievances concerning automated systems, and
NASD Rule 11890, relating to clearly erroneous transactions. Because
the NASD will continue to operate the OTC Bulletin Board (``OTCBB''),
it must retain the NASD Rule 9700 Series, which governs the review of
requests for OTCBB eligibility determinations. Accordingly, the
Commission finds good cause to accelerate approval of NASD's proposal
to retain this rule. The Commission notes that the NASD only proposed
to eliminate reference to a Nasdaq committee that is currently required
in the NASD Rule 9700 Series. The NASD replaced the Nasdaq committee
with an NASD committee designated by the Board that must be comprised
of at least 50% non-industry committee members. The current Nasdaq
committee requires at least five non-industry members on its committee
that may consist of between 8 and 18 members. The Commission finds good
cause to accelerate approval of this change because it reflects the
NASD's responsibility over the OTCBB.
    The NASD also proposes to retain amended paragraph (a) of Rule
11890 so that its application will be limited to transactions in CTA
Plan Securities. The NASD originally proposed to delete this rule,
which provides Nasdaq with authority to review any transaction arising
from the use of any execution or communication system owned or operated
by Nasdaq. After the Nasdaq Exchange commences operations as an
exchange for Nasdaq UTP Plan Securities, the only communication systems
of the NASD that will be covered by Rule 11890(a) will be the
SuperIntermarket, BRUT, and INET. Accordingly, the Commission finds
good cause to accelerate approval of this change that limits Nasdaq's
authority under this rule to CTA Plan Securities.
    With regard to the Trade Reporting Facility, the NASD proposes in
Amendment No. 1 to delete the provision in NASD Rule 6120 that would
have allowed a UTP Exchange to participate in the Trade Reporting
Facility. This provision is unnecessary because a UTP Exchange would
not require a means for reporting internalized trades. Accordingly, the
Commission finds good cause to accelerate the deletion of this
provision. The NASD also proposes to amend the termination provision of
the Trade Reporting Facility LLC agreement to reflect that Nasdaq is
not a registered SRO. The Commission finds good cause to accelerate
approval of this change because the agreement, as amended, accurately
reflects Nasdaq's status.
    In Amendment No. 1, the NASD also proposes several technical
changes. For example, the NASD proposes to indicate that its Short Sale
Rule is a pilot. In addition, the NASD proposes to incorporate rule
changes that have been approved or have otherwise become effective
since it filed its proposed rule change. The Commission finds good
cause to accelerate approval of these changes so that the proposal
accurately reflects the NASD's current rules.
    Finally, the NASD proposes that its proposed rule change become
effective upon the operation of the Nasdaq Exchange as an exchange for
Nasdaq UTP Plan Securities. The Commission finds good cause to
accelerate approval of this proposal because the NASD must retain its
current rules until such time as the Nadsaq Exchange begins operation
for Nasdaq UTP Plan Securities in order to continue to fulfill its
obligations under the Exchange Act.
    For the reasons discussed above, the Commission finds good cause
for approving Amendment No. 1 to the proposal prior to the 30th day
after the date of publication of notice of filing thereof in the
Federal Register. Accordingly, the Commission finds that it is
consistent with Sections 15A(b)(6)

and 19(b)(2) of the Exchange Act \24\ to approve Amendment No. 1 on an
accelerated basis.
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    \24\ 15 U.S.C. 78o-3(b)(6) and 15 U.S.C. 78s(b)(2).
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III. Discussion

A. The NASD's Obligations Under the Exchange Act and Commission Rules

    The NASD is a registered national securities association and SRO.
One of its statutory obligations as a registered national securities
association is to supervise the activities of its members that occur
otherwise than on an exchange. In particular, Section 15A(b)(11) of the
Exchange Act requires the NASD to have rules that govern the ``form and
content of quotations relating to securities sold otherwise than on a
national securities exchange. * * *'' \25\ These rules also must be
designed to produce fair and informative quotations and to promote
orderly procedures for collecting, distributing, and publishing
quotations.\26\ Rule 602 of Regulation NMS also requires the NASD to
collect bids, offers, quotation sizes, and aggregate quotation sizes
from those members who are responsible broker or dealers.\27\ The NASD
must then make available to vendors, at all times when last sale
information is reported, information about the best bids, best offers,
and quotation sizes communicated otherwise than on an exchange by its
members that act as OTC market makers, and their identity.
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    \25\ 15 U.S.C. 78o-3(b)(11).
    \26\ Id.
    \27\ 17 CFR 242.602.
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    Rule 601 of Regulation NMS \28\ requires the NASD to file a
transaction reporting plan regarding transactions in listed equity and
Nasdaq securities that are executed by its members otherwise than on a
national securities exchange.\29\ Under Rule 603 of Regulation NMS,\30\
national securities exchanges and national securities associations act
jointly pursuant to an effective national market system plan to
disseminate consolidated information, including a national best bid and
offer, and quotations for and transactions in NMS stocks.
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    \28\ 17 CFR 242.601.
    \29\ Under Rule 601(b) of Regulation NMS, broker-dealers are
prohibited from executing a transaction otherwise than on a national
securities exchange unless there is an effective transaction
reporting plan. New NASD Rule 5000 requires NASD members to report
transactions in exchange-listed securities effected otherwise than
on an exchange to the NASD.
    \30\ 17 CFR 242.603.
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    The means by which the NASD complies with these requirements today
is through operation of its Nasdaq facility \31\ and the ADF,\32\ and
by participating in the Consolidated Quotation System Plan (``CQ
Plan'') and CTA Plan for CTA Plan Securities, and the Nasdaq UTP Plan
for Nasdaq UTP Plan Securities.
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    \31\ Nasdaq systems collect quotations and transaction reports
from NASD members, including registered market makers and electronic
communication networks (``ECNs''), for both Nasdaq UTP Plan
Securities and CTA Plan Securities. The quotations and transaction
reports in Nasdaq UTP Plan Securities are reported by Nasdaq systems
to the Nasdaq UTP Plan, pursuant to the NASD's participation in the
plan for dissemination to vendors. The quotations and transaction
reports in CTA Plan Securities are reported by Nasdaq systems to the
CQ and CTA Plans, pursuant to the NASD's participation in these
plans for dissemination to vendors.
    \32\ See Securities Exchange Act Release No. 46249 (July 24,
2002), 67 FR 49822 (July 31, 2002) (File No. SR-NASD-2002-97) (order
approving the ADF on a pilot basis). See also Securities Exchange
Act Release No. 53699 (April 21, 2006), 71 FR 25271 (April 28, 2006)
(notice of filing and immediate effectiveness of File No. SR-NASD-
2006-050) (extending the ADF pilot program through January 26,
2007). The ADF was developed to provide NASD members with an
alternative to the Nasdaq systems for the reporting of quotations
and transaction reports in Nasdaq UTP Plan Securities. These
quotations and trade reports are provided to the Nasdaq UTP Plan for
dissemination to vendors.
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    The NASD proposes to continue to operate the ADF for the collection
of quotes and transaction reports in Nasdaq UTP Plan Securities.\33\ In
addition, the NASD's rules will continue to provide for the collection
of quotes and transaction reports in CTA Plan Securities.\34\ Nasdaq
systems, however, are currently the exclusive means by which NASD
members enter quotations and report trades in CTA Plan Securities.
Under the proposal, as amended, the NASD will continue, via its
delegation to Nasdaq, to use Nasdaq systems for collecting quotations
and transaction reports in CTA Plan Securities.
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    \33\ See NASD Rule 4000A Series and Rule 5000 Series. As
discussed more fully below, transaction reports for Nasdaq UTP Plan
Securities also may be submitted to the new Trade Reporting
Facility.
    \34\ See NASD Rules 4000 Series, 4700 Series, 5000 Series, 5200
Series, 6300 Series, and 6400 Series.
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    Finally, Rule 608 of Regulation NMS requires the NASD to comply
with and enforce compliance with the terms of each national market
system plan of which it is a sponsor or participant.\35\ In addition to
the CQ Plan, CTA Plan and Nasdaq UTP Plan, the NASD is a member of the
ITS Plan. The ITS Plan contains the rules pursuant to which ITS
Participants interact and contains a trade-through rule.\36\
Accordingly, most OTC transactions in CTA Plan Securities regulated by
the NASD are subject to the requirements of the ITS Plan. The NASD
expects to remain a member of the ITS Plan for the purpose of providing
access to OTC quotations communicated by its members through NASD
facilities and to provide its members with access to exchanges'
quotations.
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    \35\ 17 CFR 242.608(c).
    \36\ In June 2005, the Commission adopted Regulation NMS, which
included the new Rule 611. 17 CFR 242.611. This rule requires a
trading center to establish, maintain and enforce written policies
and procedures that are reasonably designed to prevent trade-
throughs of protected quotations in NMS stocks. Rule 611 became
effective on August 29, 2005; compliance with this rule has been
extended to a series of five dates beginning on October 16, 2006.
See Securities Exchange Act Release No. 53829 (May 18, 2006), 71 FR
100 (May 24, 2006).
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    Current NASD rules reflect the NASD's participation in the ITS
Plan.\37\ In Amendment No. 1, the NASD also proposes to retain the
rules that allow its members to enter quotations in CTA Plan Securities
by registering as CQS market makers \38\ and ITS/CAES market
makers.\39\ Accordingly, as discussed further below, the Commission
finds that these rules, as amended, are consistent with Section
15A(b)(11) of the Exchange Act and the Commission also believes that
these changes should enable the NASD to satisfy its obligation under
Rule 602 of Regulation NMS.
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    \37\ See NASD Rule 5200 Series and 4700 Series.
    \38\ See NASD Rule 6320.
    \39\ See NASD Rule 5220.
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B. Changes to the NASD's Governing Documents

    The proposal, as amended, revises the Delegation Plan to eliminate
Nasdaq's responsibility for operating the OTC market for Nasdaq UTP
Plan Securities, while continuing to delegate to Nasdaq the
responsibility for operating the OTC market for CTA Plan
Securities.\40\ This change to the Delegation Plan will accurately
reflect the scope of the delegation to Nasdaq after the Nasdaq Exchange
begins to operate as a national securities exchange for Nasdaq UTP Plan
Securities and will ensure that the NASD continues to have the ability
to fulfill its obligations with respect to CTA Plan Securities, as
described above. Further, eliminating Nasdaq's

delegation of regulatory authority with regard to Nasdaq UTP Plan
Securities satisfies one of the conditions for the Nasdaq Exchange to
begin trading Nasdaq UTP Plan Securities.\41\
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    \40\ Among other things, the Delegation Plan, as amended,
delegates to Nasdaq the responsibility for: (1) Operating the OTC
market for CTA Plan Securities and the automated systems supporting
it; (2) providing and maintaining a telecommunications network
infrastructure linking market participants for the efficient
processing and handling of quotations, orders, transaction reports,
and comparisons of transactions in the OTC market for CTA Plan
Securities; (3) developing and adopting rules applicable to the
collection, processing, and dissemination of quotation and
transaction information for securities traded in the OTC market for
CTA Plan Securities; (4) developing and adopting other rules and
policies for the OTC market for CTA Plan Securities; and (5)
establishing standards for participation in the OTC market for CTA
Plan Securities. See Delegation Plan, Section III, A.1.
    \41\ See Order Modifying Nasdaq Exchange Conditions, supra, note
6.
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    Because Nasdaq will continue to be controlled by the NASD when the
Nasdaq Exchange begins to operate as a national securities exchange for
Nasdaq UTP Plan Securities, the proposal retains Nasdaq's By-Laws in
the NASD's rules.\42\ The Nasdaq By-Laws that the NASD proposes to
retain in its rules reflect changes made to the Nasdaq By-Laws as part
of the Nasdaq Exchange application and that were approved by the
Commission in the Nasdaq Exchange Order.\43\ The Commission finds that
these changes are consistent with the Exchange Act because they ensure
that Nasdaq's By-Laws are accurately reflected in the NASD's rules,
while also ensuring that Nasdaq's governing documents reflect its
status as a parent company of an SRO.\44\
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    \42\ See Amendment No. 1.
    \43\ See supra, note 5.
    \44\ In Amendment No. 1, the NASD also proposes to retain the
references to Nasdaq in the By-Laws of NASD Dispute Resolution, NASD
Regulation, and the NASD to reflect that Nasdaq will continue to be
controlled by the NASD when the Nasdaq Exchange begins to operate as
an exchange for Nasdaq UTP Plan Securities.
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C. Deleted Rules

    The NASD also proposes to delete several rules in their entirety
because the NASD will no longer require them after the Nasdaq Exchange
commences operation as a national securities exchange for Nasdaq UTP
Plan Securities. In this regard, the NASD proposes to delete in their
entirety NASD Rules 2870 through 2885, relating to the listing and
trading of Nasdaq index options. Similarly, the NASD proposes to delete
NASD Rules 2852 and 2854 relating, respectively, to reporting
requirements and trading halts or suspensions for index warrants listed
on Nasdaq and reported to the Nasdaq UTP Plan.
    In addition, the NASD proposes to delete from NASD Rules 2841,
2850, and 2851 provisions relating to index warrants listed on Nasdaq,
while retaining provisions in those rules relating to index warrant
trading in the OTC market. Similarly, the NASD proposes to delete
provisions in NASD Rule 2860 relating to standardized options displayed
on Nasdaq, and to retain provisions relating to options trading in the
OTC market.
    Because the NASD will not list or trade index options or list
warrants after the Nasdaq Exchange commences operations as a national
securities exchange, the NASD will no longer require these rules.
Accordingly, the Commission finds that it is consistent with Section
15A(b)(6) of the Exchange Act for the NASD to delete from its rules
provisions governing the listing and trading of index options and
warrants listed on Nasdaq.
    The NASD also proposes to delete the NASD Rule 6800 Series relating
to the Mutual Fund Quotation Service because the Nasdaq Exchange will
operate this service. Finally, the NASD proposes to delete the NASD
Rule 5100 Series, ``Nasdaq International Service Rules,'' to reflect
the expiration of the Nasdaq International Service pilot program.\45\
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    \45\ The Nasdaq International Service pilot program was most
recently extended through October 9, 2003. See Securities Exchange
Act Release No. 46589 (October 2, 2002), 67 FR 63001 (October 9,
2002) (notice of filing and order granting accelerated approval of
File No. SR-NASD-2002-130).
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    Because the Nasdaq Exchange, rather than the NASD, will operate the
Mutual Fund Quotation Service, the Commission finds that the deletion
of the Mutual Fund Quotation Service rules from the NASD's rules is
consistent with Section 15A(b)(6) of the Exchange Act. Similarly, the
Commission finds that the NASD's deletion of the Nasdaq International
Service pilot program rules, which reflects the expiration of the pilot
program, is consistent with Section 15A(b)(6) of the Exchange Act.

D. OTC Reporting Facility

    The NASD proposes to establish the OTC Reporting Facility. NASD
members will use this facility to report trades in PORTAL
Securities,\46\ OTC Equity Securities,\47\ and Direct Participation
Program (``DPP'') Securities.\48\ Currently, the NASD uses Nasdaq
systems to accept these trade reports. According to the NASD, it plans
to enter into a contract with Nasdaq so that the NASD may continue to
use Nasdaq's Automated Confirmation Transaction Service (``ACT'') \49\
as its facility to collect these transaction reports.\50\
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    \46\ See NASD Rule 6732.
    \47\ See NASD Rule 6600 Series.
    \48\ See NASD Rule 6900 Series.
    \49\ In 2004, Nasdaq generally discontinued its use of the term
``ACT'' and replaced it with the term ``Nasdaq Market Center'' or
``service.'' See Securities Exchange Act Release No. 50074 (July 23,
2004), 69 FR 45866 (July 30, 2004) (notice of filing and immediate
effectiveness of File No. SR-NASD-2004-076). To be consistent with
the commenters to this proposal, this order also will use the term
``ACT.''
    \50\ See Amendment No. 1.
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1. PORTAL Securities
    The current NASD Rule 5300 Series provides qualification and
transaction reporting requirements relating to PORTAL Securities, which
are foreign and domestic securities that are eligible for resale under
Rule 144A under the Securities Act of 1933. The NASD proposes to delete
from the NASD Rule 5300 Series rules relating to the qualification
requirements for, or designation of, PORTAL Securities, a function that
the Nasdaq Exchange will perform.\51\ The new NASD Rule 6700 Series
will govern transaction reporting in PORTAL Securities and other
requirements applicable to the trading of PORTAL Securities.\52\
Because these changes will more accurately reflect the NASD's proposed
activities with regard to PORTAL Securities after the Nasdaq Exchange
begins to operate as an exchange for Nasdaq UTP Plan Securities, the
Commission finds them consistent with Section 15A(b)(5) of the Exchange
Act.
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    \51\ See Nasdaq Exchange Rule 6500 Series.
    \52\ Specifically, the new NASD Rule 6700 Series incorporates
existing NASD Rules 5330, ``Requirements Applicable to Members of
the Association,'' 5331, ``Limitations on Transactions in PORTAL
Securities,'' 5332, ``Reporting Debt and Equity Transactions in
PORTAL Securities,'' 5340, ``Arbitration,'' and 5350, ``Rules of the
Association.''
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2. OTC Equity Securities
    The NASD proposes to combine its current NASD Rule 6600 and 6700
Series into a single NASD Rule 6600 Series, which will govern reporting
requirements for certain quotations and transactions in OTC Equity
Securities. \53\ The NASD's rules define OTC Equity Securities as any
equity security not traded on an exchange and certain exchange-listed
securities that do not qualify for real-time trade reporting. Because
these changes will maintain the regulatory requirements for trading and
reporting transactions in OTC Equity Securities, the Commission
believes that they are consistent with Section 15A(b)(6) of the
Exchange Act.
---------------------------------------------------------------------------

    \53\ The NASD also proposes to make minor changes designed to
reflect Nasdaq's separation from the NASD and to identify the NASD
as the operator of the OTCBB.
---------------------------------------------------------------------------

3. DPP Securities
    The NASD Rule 6900 Series governs the trade reporting of off-
exchange secondary market transactions in DPP Securities. The NASD
proposes to amend these rules to reflect that such transactions will be
reported to the NASD's OTC Reporting Facility rather than the Nasdaq
Market Center. The Commission finds these changes consistent with the
Exchange Act because the substantive requirements of the NASD Rule 6900
Series will remain unchanged.

E. NASD Rule 9700 Series and 11890 Series

    In the original proposal, the NASD proposed to delete in its
entirety the NASD Rule 9700 Series, ``Procedures on Grievances
Concerning the Automated Systems.'' Because the NASD Rule 9700 Series
governs the review of requests for OTCBB eligibility determinations
under NASD Rule 6530, ``OTCBB-Eligible Securities,'' the NASD proposes
in Amendment No. 1 to retain a revised version of the NASD Rule 9700
Series. The NASD Rule 9700 Series, as amended, replaces references to
Nasdaq, the Nasdaq Listing and Review Hearing Council, and systems
owned by Nasdaq with references to, respectively, the NASD, a committee
designated by the NASD's Board of Governors, and NASD systems. Because
these changes to the NASD Rule 9700 Series provide for the continued
availability of existing procedures for reviewing OTCBB eligibility
determinations, the Commission finds that they are consistent with
Section 15A(b)(6) of the Exchange Act.
    In addition, Amendment No. 1 revises NASD Rule 9740,
``Consideration of Applications,'' to permit applicants seeking redress
pursuant to the NASD Rule 9700 Series to be heard telephonically by a
hearing panel, as well as in person. The Commission believes that this
change is consistent with Section 15A(b)(6) of the Exchange Act because
it will provide additional flexibility for applicants seeking redress
under the NASD Rule 9700 Series.
    In its original proposal, the NASD proposed to delete NASD Rule
11890, ``Clearly Erroneous Transactions,'' in its entirety. In
Amendment No. 1, the NASD proposes to retain a modified version of NASD
Rule 11890. NASD Rule 11890(a), ``Authority to review Transactions
Pursuant to Complaint of Market Participant,'' currently provides
Nasdaq with the authority to review any transaction arising from the
use of any execution or communication system owned or operated by
Nasdaq. Because Nasdaq will no longer operate an execution or
communication system for the NASD for Nasdaq UTP Plan Securities
pursuant to the Delegation Plan after the Nasdaq Exchange begins to
operate as an exchange for Nasdaq UTP Plan Securities, the NASD is
amending NASD Rule 11890(a) to eliminate Nasdaq's authority under the
rule to review complaints regarding transactions in Nasdaq UTP Plan
Securities. NASD Rule 11890(a) will continue to provide Nasdaq with
authority to review complaints regarding transactions in CTA Plan
Securities arising from the use of an execution or communication system
owned or operated by Nasdaq.\54\ For the same reason, NASD Rule
11890(b)(1), as amended, will continue to allow Nasdaq to review, on
its own motion, any transaction in a CTA Plan Security in the event of
extraordinary market conditions or a disruption or malfunction in the
use or operation of any quotation, execution, communication, or trade
reporting system owned or operated by Nasdaq, while eliminating this
authority with respect to Nasdaq UTP Plan Securities. The Commission
finds that these changes are consistent with Section 15A of the
Exchange Act because Nasdaq will no longer operate, or be delegated
authority with respect to, an NASD execution facility for Nasdaq UTP
Plan Securities after the Nasdaq Exchange begins to operate as an
exchange for Nasdaq UTP Plan Securities.
---------------------------------------------------------------------------

    \54\ As noted above, Nasdaq will continue to operate the
SuperIntermarket pursuant to a delegation from the NASD after the
Nasdaq Exchange begins to operate as an exchange for Nasdaq UTP Plan
securities.
---------------------------------------------------------------------------

    In addition, the NASD proposes to amend NASD Rule 11890(b)(2) to
allow it to review, on its own motion, any transaction in a Nasdaq UTP
Plan Security or an OTC Equity Security in the event of extraordinary
market conditions or a disruption or malfunction in the use or
operation of any quotation, communication, or trade reporting system
owned or operated by the NASD. Thus, NASD Rule 11890(b)(2), as amended,
will allow the NASD to declare clearly erroneous transactions in Nasdaq
UTP Plan Securities reported to the ADF or to the Trade Reporting
Facility. The NASD believes that this authority may be appropriate in
very limited circumstances, for example, when an extraordinary event
occurs and multiple SROs are canceling or modifying trades.
    The Commission finds that NASD Rule 11890(b)(2), as amended, is
consistent with Section 15A of the Exchange Act because the expansion
of the NASD's authority under NASD Rule 11890(b)(2) replaces authority
previously delegated to Nasdaq and should facilitate the fair and
efficient resolution of disputes involving clearly erroneous
transactions in Nasdaq UTP Plan Securities and OTC Equity Securities.

F. OATS

    The NASD proposes to revise its OATS rules regarding orders routed
to non-members, including the Nasdaq Exchange, to ensure that the audit
trail for transactions executed on the Nasdaq Exchange continues in the
same manner as it does today, when transactions are executed on Nasdaq
systems that are NASD facilities. Specifically, the NASD proposes that
orders routed to non-members, which includes national securities
exchanges, be identified with a routed order identifier or other unique
identifier required by the non-member receiving the order, and to
indicate the national securities exchange or registered securities
association to which the order is transmitted.\55\ In addition, the
NASD proposes to clarify existing requirements by providing that
members are permitted to use a routed order identifier that is
different from the order identifier used for origination purposes and
that a member transmitting an order to another member must provide the
routed order identifier to the member receiving the order. The
Commission finds that the proposed changes are consistent with Section
15A(b)(2) of the Exchange Act \56\ in that they are designed to ensure
that the NASD and the Nasdaq Exchange can conduct surveillance and
investigations of their members for potential violations of NASD rules,
Nasdaq Exchange rules, and the federal securities laws.
---------------------------------------------------------------------------

    \55\ See NASD Rule 6954(c)(6).
    \56\ 15 U.S.C. 78o-3(b)(2).
---------------------------------------------------------------------------

G. OTC Trading of CTA Plan Securities

1. Dually Listed Securities
    The NASD proposes to eliminate current NASD Rule 4400 and to modify
NASD IMZ-Rule 4400, which will become its new Rule 4400. New NASD Rule
4400 describes the treatment of securities that are dually listed on
the Nasdaq Exchange and the NYSE. Specifically, the rule indicates that
such dually listed securities will continue to be subject to the CQ and
CTA Plans and will continue to be treated as CTA Plan Securities under
the NASD's rules.\57\The Commission finds that new NASD Rule 4400 is
consistent with Section 15A of the Act because it clarifies that the
NASD will treat these securities in the same manner as it does today.
---------------------------------------------------------------------------

    \57\ Among other things, new NASD Rule 4400 indicates the NASD
will continue to send all quotes and transaction reports in dually
listed securities to the processor for the CTA Plan while such
securities continue to trade through the facilities of the NASD. In
addition, the rule notes that market makers in dually listed
securities will retain all of the obligations imposed by the NASD
Rule 5200, 6300, and 6400 Series regarding quoting, trading, and
transaction reporting of CQS securities, and that the NASD will
continue to honor the trade halt authority of the primary market
under the CQ and CTA Plans.
---------------------------------------------------------------------------

2. SuperIntermarket Facility
    Through its delegation to Nasdaq under the Delegation Plan, the
NASD

will continue to use technology owned by Nasdaq, i.e., the
SuperIntermarket, as its facility to collect OTC quotes and transaction
reports in CTA Plan Securities. In addition, the SuperIntermarket will
continue to permit NASD members quoting in the facility to participate
in ITS and satisfy the NASD's obligations under the ITS Plan.\58\
---------------------------------------------------------------------------

    \58\ See supra notes 25-39 and accompanying text.
---------------------------------------------------------------------------

a. Quotations

    In Amendment No. 1, the NASD proposes to retain its rules that
allow its members to register as CQS market makers \59\ and ITS/CAES
market makers.\60\ These rules are essential to the NASD's ability to
fulfill its statutory \61\ and regulatory obligations,\62\and to NASD
members' ability to fulfill their regulatory obligation to submit their
OTC quotations to the NASD.\63\ The NASD must collect quotations in
subject securities that OTC market makers communicate otherwise than on
an exchange.\64\ NASD rules currently provide that members that
communicate quotations off an exchange in CTA Plan Securities must
register as CQS market makers and ITS/CAES market makers.\65\ The NASD
has only proposed minor changes to the rules for CQS market makers and
ITS/CAES market makers, including replacing references to the Nasdaq
Market Center with references to Nasdaq. The NASD also proposes to
adopt NASD Rule 6431, ``Trading Halts,'' to provide a trading halt rule
for CTA Plan Securities.\66\
---------------------------------------------------------------------------

    \59\ See NASD Rule 6300 Series. NASD members that submit quotes
in CQS securities must be registered as CQS market makers. See NASD
Rule 6320(a). CQS market makers must also register as ITS/CAES
market makers. See NASD Rule 6320(e). See also NASD Rule 5210(e).
    \60\ See NASD Rule 5200 Series. NASD members that participate in
ITS must register as ITS/CAES market makers. See NASD Rule 5220.
ITS/CAES market makers must also register as CQS market makers. See
NASD Rule 5220(a). See also NASD Rule 6320(e).
    \61\ 15 U.S.C. 78o-3(b)(11). See supra notes 25-39 and
accompanying text.
    \62\ See Rule 602(a) under the Exchange Act, 17 CFR 242.602(a).
    \63\ See Rule 602(b) of Regulation NMS under the Exchange Act,
17 CFR 242.602(b).
    \64\ See Rule 602(b) of Regulation NMS under the Exchange Act,
17 CFR 242.602(b).
    \65\ See NASD Rules 6320(a) and 5210(e). An NASD member that
does not communicate quotations off an exchange, but that executes a
transaction in a CTA Plan Security off an exchange, may report its
transaction to the NASD through ACT, which Nasdaq will operate for
the NASD under the Delegation Plan.
    \66\ NASD Rule 4120 currently contains Nasdaq's authority to
halt OTC trading of Nasdaq UTP Plan Securities and CTA Plan
Securities. The proposal revises NASD Rule 4120 and renumbers it as
NASD Rule 4633, ``Trading Halts,'' which now relates solely to the
Trade Reporting Facility. New NASD Rule 6431, which includes the
same provisions as NASD Rule 4633, applies to CTA Plan Securities.
---------------------------------------------------------------------------

    The Commission finds that the NASD's proposal to retain, with minor
clarifying changes, its rules governing CQS and ITS/CAES market makers
is consistent with Section 15A of the Exchange Act because it will
allow the NASD to continue to fulfill its statutory and regulatory
obligations,\67\ and allow NASD members to continue to fulfill their
regulatory obligation to submit their OTC quotations to the NASD.\68\
In addition, the Commission finds that the proposal to adopt NASD Rule
6431 is consistent with Section 15A of the Exchange Act because it
could help the NASD to maintain a fair and orderly market.
---------------------------------------------------------------------------

    \67\ See supra notes 61 and 62.
    \68\ See note 63, supra, and accompanying text.
---------------------------------------------------------------------------

b. Executions

    As noted above, the NASD will remain a member of the ITS Plan. As
such, the NASD is required to comply with, and enforce compliance by
its members with, the provisions of the ITS Plan.\69\ Currently, the
NASD uses its Nasdaq SuperIntermarket facility to provide its members
with access to ITS participant exchanges and to provide ITS participant
exchanges with access to ITS/CAES market makers' quotations. The NASD
proposes to continue to use the SuperIntermarket system as its facility
for these purposes through its delegation to Nasdaq.
---------------------------------------------------------------------------

    \69\ See Rule 608(c) of Regualtions NMS under the Exchange Act,
17 CFR 242.608(c).
---------------------------------------------------------------------------

    In Amendment No. 1, the NASD proposes to retain certain parts of
its Rule 4700 Series that relate to the SuperIntermarket, and to
eliminate from the 4700 Series those rules that pertain to the trading
of Nasdaq UTP Plan Securities on the Nasdaq Market Center. The
Commission finds that these changes are consistent with the
requirements of the Exchange Act because they will permit the NASD and
its members to continue to participate in ITS as they do today.\70\ The
Commission also finds that the elimination of rules that pertain to the
trading of Nasdaq UTP Plan Securities is consistent with the Exchange
Act because the NASD will no longer be operating an execution facility
for Nasdaq UTP Plan Securities.
---------------------------------------------------------------------------

    \70\ See Securities Exchange Act Release No. 49349 (March 2,
2004), 69 FR 10775 (March 8, 2004) (order approving the use of
SuperMontage for trading ITS securities). The Commission notes that
required participation in the ITS Plan is of limited duration. See
supra note 36.
---------------------------------------------------------------------------

c. Transaction Reporting

    Members effecting trades in CTA Plan Securities off an exchange,
yet outside of the SuperIntermarket facility, will continue, as they do
today, to submit trade reports to ACT. Nasdaq will have delegated
responsibility under the Delegation Plan to operate ACT for the NASD
for this purpose. Accordingly, the NASD proposes to retain its 6400
Series, ``Reporting Transactions in Listed Securities,'' with minor
changes, including replacing references to the Nasdaq Market Center
with references to Nasdaq.\71\
---------------------------------------------------------------------------

    \71\ As described more fully above, the NASD also proposes to
adopt NASD Rule 6431, relating to trading halts for CTA Plan
Securities.
---------------------------------------------------------------------------

    The Commission finds that these changes are consistent with the
Exchange Act. With respect to CTA Plan Securities, the only means
currently available to the NASD to fulfill its statutory and regulatory
obligations is through NASD facilities owned by Nasdaq. The Commission
believes that the NASD Rule 6400 Series, as amended, will enable the
NASD to continue to satisfy its obligations under Rules 601 and 603 of
Regulation NMS and the CTA Plan to collect its members' transaction
reports for OTC trades of CTA Plan Securities.
3. BRUT and INET Rules
    Because the Nasdaq Exchange will not commence trading in CTA Plan
Securities at this time, any trading of these securities that occurs in
BRUT and INET would occur over-the-counter. Accordingly, the NASD has
proposed in Amendment No. 1 to retain its current rules that govern the
operation of the BRUT \72\ and INET \73\ systems with regard to CTA
Plan Securities. These trading platforms will continue to be facilities
of the NASD for CTA Plan Securities that are operated by Nasdaq
pursuant to the Delegation Plan. The NASD has proposed to make some
changes to these rules to reflect that NASD members may not use these
systems to execute OTC trades in Nasdaq UTP Plan Securities.\74\ The
Commission finds that these changes are consistent with the Exchange
Act because they clarify and appropriately limit the use of these
systems by NASD members after the Nasdaq Exchange begins to operate an
exchange for Nasdaq UTP Plan Securities.
---------------------------------------------------------------------------

    \72\ See NASD Rule 4900 Series.
    \73\ See NASD Rule 4950 Series.
    \74\ Once the Nasdaq Exchange begins operations as a national
securities exchange in Nasdaq UTP Plan Securities, transactions in
Nasdaq UTP Plan Securities that occur in Brut and INET will be
Nasdaq Exchange trades subject to the Nasdaq Exchange's rules and
regulatory jurisdiction.

---------------------------------------------------------------------------

H. OTC Trading of Nasdaq UTP Plan Securities

1. NASD Rule 5110
    The NASD proposes to renumber NASD Rule 6440(i) as NASD Rule 5110,
``Transactions Related to Initial Public Offerings,'' which prohibits a
member from executing, directly or indirectly, a transaction otherwise
than on an exchange in a security subject to an initial public offering
until the security has first opened for trading on the national
securities exchange listing the security, as indicated by the
dissemination, via the Consolidated Tape, of an opening transaction in
the security by the listing exchange. In addition, the NASD proposes to
extend its application to transactions in Nasdaq UTP Plan Securities.
New NASD Rule 5110 is substantially the same as current NASD Rule
6440(i).\75\ The Commission finds that new NASD Rule 5110 is consistent
with the Exchange Act because it is substantially the same as current
NASD Rule 6440(i). In addition, the Commission believes that the
application of NASD Rule 5110 to Nasdaq UTP Plan Securities, as well as
CTA Plan Securities, after the Nasdaq Exchange begins to operate as a
national securities exchange is consistent with the Exchange Act
because it will provide consistent treatment for all exchange-traded
securities.\76\
---------------------------------------------------------------------------

    \75\ NASD Rule 6440(i) prohibits members from executing,
directly or indirectly, an OTC transaction in a security subject to
an initial public offering until the security has first opened for
trading on the national securities exchange listing the security, as
indicated by the dissemination, via the Consolidated Tape, of an
opening transaction in the security by the listing exchange.
    \76\ See supra note 23.
---------------------------------------------------------------------------

2. Changes to the ADF Rules
    The ADF is an NASD facility for members to quote and report off-
exchange trades in Nasdaq UTP Plan Securities. NASD members that use
the ADF must comply with the NASD Rule 4000A Series, ``NASD Alternative
Display Facility,'' and the NASD Rule 6000A Series, ``NASD ADF Systems
and Programs.''
    The NASD proposes to make the following changes to its ADF rules.
First, the NASD proposes to clarify that the following ADF rules apply
to Registered Reporting ECNs as well as Registered Reporting ADF Market
Makers: NASD Rules 4613A(b), relating to firm quote requirements, and
4613A(c), requiring quotations to be reasonably related to the
prevailing market; NASD Rule 4617A, relating to normal business hours;
NASD Rule 4618A, relating to clearance and settlement requirements; and
NASD Rules 4621A and 4622A, relating to the NASD's ability to suspend
or terminate quotations or ADF services. The Commission finds that
these changes are consistent with Section 15A(b)(6) of the Exchange Act
\77\ because they will apply ADF rules consistently to Registered
Reporting ADF Market Makers and Registered Reporting ECNs.
---------------------------------------------------------------------------

    \77\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    Second, the NASD proposes to revise NASD Rule 4632A, ``Transactions
Reported by Members,'' to incorporate the trade reporting requirements
currently set forth in NASD Rule 5430, ``Transaction Reporting,'' which
is being deleted. The NASD proposes to delete the NASD Rule 5400
Series, ``Nasdaq Stock Market and Alternative Display Facility Trade
Reporting.'' NASD Rule 5410 states that the NASD will operate two
facilities for collecting trade reports, the Nasdaq Stock Market and
the ADF, and notes that the NASD Rule 5400 Series establishes rules
governing which member must report a trade and whether the trade must
be reported to the Nasdaq Market Center or to the ADF. The provisions
in the NASD Rule 5400 Series relating to the reporting of transactions
to the Nasdaq Market Center will be no longer relevant after the Nasdaq
Exchange commences operations as a national securities exchange for
Nasdaq UTP Plan Securities and, accordingly, the NASD proposes to
delete these provisions. Therefore, the Commission finds that
elimination of these rules is consistent with the Exchange Act.
    The NASD proposes to relocate the provisions in the NASD Rule 5400
Series relating to the ADF to NASD Rules 4630A, ``Reporting
Transactions in ADF-Eligible Securities,'' and 4632A, ``Transactions
Reported by Members,'' which will govern the reporting of transactions
in ADF-eligible securities through the NASD's Trade Reporting and
Comparison System (``TRACS''). The Commission believes that the
proposal to move the NASD Rule 5400 Series to the ADF rule series
should clarify the applicability of the NASD's rules and, therefore the
Commission finds that these changes are consistent with Section
15A(b)(6) of the Exchange Act.\78\ The Commission believes that this
change will help to consolidate the ADF's trade reporting requirements
while substantially preserving the current requirements of NASD Rule
5430.
---------------------------------------------------------------------------

    \78\ Id.
---------------------------------------------------------------------------

    Third, the NASD proposes to make the ADF's trade reporting
requirements more consistent with the trade reporting rules that apply
to Nasdaq systems. For example, the NASD proposes to require that the
execution time in hours, minutes, and seconds based on Eastern Time in
military format be included in all ADF trade reports,\79\ to add
certain trade report modifiers,\80\ and to establish provisions
relating to the reporting of cancelled trades.\81\ The NASD also
proposes to clarify that all applicable trade modifiers must be
included in ``as/of'' trades.\82\ In addition, the NASD proposes to add
to NASD Rule 4632A a provision stating that a pattern or practice of
late reporting without exceptional circumstances may be considered
conduct inconsistent with high standards of commercial honor and just
and equitable principles of trade.\83\ The Commission finds that these
changes, which currently apply to Nasdaq trade reports, are consistent
with Section 15A(b)(6) of the Exchange Act in that they are designed to
protect investors and the public interest by helping to ensure the
timeliness and accuracy of the transaction reports submitted to the
ADF.
---------------------------------------------------------------------------

    \79\ See NASD Rules 4632A(c)(2)(I) and 4632A(d)(2)(D). These
changes were proposed in Amendment No. 1.
    \80\ See NASD Rule 4632A(a)(7), (8), and (9).
    \81\ See NASD Rule 4632A(m). This was proposed in Amendment No.
1.
    \82\ See NASD Rule 4632A(a)(10).
    \83\ See NASD Rule 4632A(a)(6).
---------------------------------------------------------------------------

    Fourth, the NASD proposes to revise NASD Rule 4120A to provide that
it will halt trading in an ADF-eligible security in the OTC market when
there is extraordinary market activity in a security that is likely to
have a material effect on the market for the security and the NASD
determines, or determines after consultation with a national securities
exchange trading the security, that the activity is caused by the
misuse or malfunction of an NASD or exchange quotation, communication,
reporting, or execution system. The Commission believes that this
authority may help the NASD to maintain a fair and orderly market. In
addition, the Commission notes that current NASD Rule 4120(a)(6)
provides the NASD with comparable trading halt authority.
    Finally, the NASD proposes to eliminate the availability of passive
market making on the ADF and therefore is deleting ADF rules that
relate to passive market making.\84\ According to the NASD, passive
market making rules for the ADF are unnecessary because only Registered
Reporting ECNs participate in the ADF. The NASD notes that if a market
maker were, in the future, to quote in the ADF and participate in a
secondary offering

of a security, the ADF market maker would be required to stop quoting
in the ADF in order to comply with Regulation M. The Commission finds
that these changes are consistent with the Exchange Act because these
rules are not used currently and Rule 103 of Regulation M does not
require the NASD to make passive market making available in the ADF.
---------------------------------------------------------------------------

    \84\ See NASD Rule 4619A.
---------------------------------------------------------------------------

3. The Trade Reporting Facility
    The NASD proposes to establish a new facility, the Trade Reporting
Facility, which will provide NASD members with another facility, in
addition to the ADF,\85\ for reporting transactions in Nasdaq UTP Plan
Securities executed otherwise than on an exchange.\86\ The Trade
Reporting Facility will allow NASD members that currently internalize
customer orders through the Nasdaq Stock Market facility of the NASD to
continue to internalize such orders pursuant to NASD rules and to
report trades to the new Trade Reporting Facility of the NASD.
---------------------------------------------------------------------------

    \85\ As noted above, the ADF currently accepts quotes and
transaction reports only for Nasdaq UTP Plan Securities.
    \86\ See NASD Rule 4000 Series. See also NASD Rule 5000. New
NASD Rule 4000 would permit NASD members to report transactions in
Nasdaq UTP Plan Securities executed otherwise than on an exchange to
the NASD through the new Trade Reporting Facility. Members also may
report transactions in Nasdaq UTP Plan Securities to the ADF. These
transaction reports will then be reported to the Nasdaq UTP Plan for
dissemination pursuant to the NASD's participation in this Plan. The
Commission finds that this proposed change is consistent with Rule
601 under Regulation NMS. See also NASD Rule 4100.
---------------------------------------------------------------------------

    The Trade Reporting Facility will be operated by the Trade
Reporting Facility LLC (``TRF LLC''), which is owned by the NASD and
Nasdaq. The TRF LLC proposes to contract with the Nasdaq Exchange to
use its technology, i.e., ACT, to accept OTC trade reports from NASD
members in Nasdaq UTP Plan Securities. Accordingly, this proposal is
intended to maintain the status quo with respect to the technology used
by NASD members to report OTC transactions in Nasdaq UTP Plan
Securities. Further, the NASD proposes to maintain its current rules
for accepting transaction reports in Nasdaq UTP Plan Securities. By
keeping its current rules, NASD members will be able to continue to
choose between two facilities, the Trade Reporting Facility and the
ADF, for submitting transaction reports for OTC trades in Nasdaq UTP
Plan Securities.\87\
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    \87\ The NASD represents that it will have an integrated audit
trail and integrated surveillance facilities for members reporting
trades on both the ADF and the Trade Reporting Facility. See
Amendment No. 1. The Commission believes that an integrated audit
trail and integrated surveillance capabilities are important to the
NASD's ability to conduct effective surveillance of OTC trading in
Nasdaq UTP Plan Securities when transactions in those securities can
be reported to both the ADF and the Trade Reporting Facility.
---------------------------------------------------------------------------

    The NASD proposes that its new Rule 4000 Series \88\ and Rule 6100
Series,\89\ which contain clearing and comparison rules, will govern
the reporting of trades to its Trade Reporting Facility. Specifically,
the NASD proposes to combine in the new NASD Rule 4630 Series the trade
reporting requirements in the current NASD Rule 4630, 4640, and 4650
Series (Nasdaq National Market securities, Nasdaq Capital Market
securities, and Nasdaq convertible debt securities, respectively). The
Commission believes that the new NASD Rule 4630 Series retains the
requirements and general organization of the NASD's current trade
reporting rules. In addition, the NASD represents that it intends to
interpret and apply the trade reporting rules of the Trade Reporting
Facility in the same manner in which it interprets and applies its
current trade reporting rules.
---------------------------------------------------------------------------

    \88\ The proposal deletes from the current NASD Rule 4000 Series
rules that relate to Nasdaq, including listing standards, trading
rules for the Nasdaq National Market Center, and Nasdaq market maker
registration requirements. The proposal retains an amended version
of the NASD Rule 4700 Series, which will govern ITS/CAES members'
use of the SuperIntermarket.
    \89\ The current NASD Rules 6100 Series, which is being deleted,
contains rules for the reporting of trades that are executed on the
Nasdaq Market Center and ACES. The Commission believes that it is
consistent with the Exchange Act to eliminate the NASD Rule 6100
Series because these rules relate solely to the Nasdaq systems that
will no longer be NASD facilities after the Nasdaq Exchange begins
to trade Nasdaq UTP Plan Securities.
---------------------------------------------------------------------------

    The Commission finds that the NASD's rules governing the reporting
of trades to the Trade Reporting Facility are consistent with the
Exchange Act. The NASD's proposal is designed to allow the NASD and its
members to continue to fulfill their obligations under the Commission's
rules and the national market system plans with regard to Nasdaq UTP
Plan Securities. The Commission also believes that the establishment of
the Trade Reporting Facility is consistent with the Congressional
finding in Section 11A(a)(1)(C)(iii) of the Exchange Act that it is in
the public interest and appropriate for the protection of investors and
the maintenance of fair and orderly markets to assure the availability
of information with respect to transactions in securities.

a. TRF LLC

    As noted above, the NASD and Nasdaq will jointly own the TRF LLC,
which will operate the Trade Reporting Facility. The NASD has filed the
limited liability company agreement (``LLC Agreement'') for the TRF LLC
as part of the current proposal.\90\ The LLC Agreement makes clear that
the NASD will have sole regulatory responsibility for the activities of
NASD members related to the facility operated by the TRF LLC. The LLC
Agreement identifies the NASD as the ``SRO Member'' of the LLC and
provides the NASD with certain rights that are intended to preserve its
regulatory authority and control. Specifically, pursuant to the LLC
Agreement, the NASD must consent before certain ``Major Actions'' with
respect to the TRF LLC are effective. The LLC Agreement defines a
``Major Action'' as: (1) Approving pricing decisions that are subject
to the Commission filing process; (2) approving contracts between the
TRF LLC and Nasdaq; (3) approving director compensation; (4) selling,
licensing, leasing, or otherwise transferring material assets used in
the operation of the TRF LLC outside the ordinary course of business
with an aggregate value in excess of $3 million; (5) approving or
undertaking a merger or other reorganization of the TRF LLC with
another entity; (6) entering into any partnership, joint venture, or
other similar joint business undertaking; (7) making any fundamental
change in the market structure of the TRF LLC; (8) voluntary or
involuntary dissolution of the TRF LLC other than termination as
provided for in the LLC Agreement;\91\ (9) conversion of the TRF LLC to
any other type of entity; (10) expanding or modifying the business,
which would

result in a material change in the business of the TRF LLC; (11)
changing the number of directors or composition of the TRF LLC Board;
and (12) adopting or amending policies regarding access and credit
matters affecting the TRF LLC.\92\
---------------------------------------------------------------------------

    \90\ The Commission notes that any changes to the LLC Agreement
that are stated policies, practices, or interpretations of the NASD,
as defined in Rule 19b-4 under the Exchange Act, must be filed with
the Commission pursuant to Section 19(b) of the Exchange Act and
Rule 19b-4 thereunder.
    \91\ As set forth in Section 20 of the LLC Agreement, two years
after the effective date of the LLC Agreement, either the NASD or
Nasdaq may dissolve the TRF LLC by providing the other with prior
written notice of at least one year (unless such notice is revoked).
If the NASD provides the notice of dissolution, the NASD and Nasdaq
will negotiate in good faith to: (i) Allow Nasdaq to continue to
operate the TRF LLC or the business of the TRF LLC under the NASD's
SRO registration; (ii) restructure the TRF LLC so that Nasdaq can
operate the TRF LLC or its business under its SRO registration or
that of any of its affiliates, as the case may be; or (iii) sell the
TRF LLC or its business to the NASD based on a valuation of the TRF
LLC's business and assets as set forth in the LLC Agreement, and
consideration for the sale may include a contract for Nasdaq to
provide services to the NASD relating to the operation of the TRF
LLC and the business of the TRF LLC.
    \92\ See Section 10(e) of the LLC Agreement.
---------------------------------------------------------------------------

    Nasdaq will be primarily responsible for the management of the TRF
LLC's business affairs to the extent that those activities are not
inconsistent with the regulatory and oversight functions of the NASD.
All profits and losses from the TRF LLC will be allocated to
Nasdaq.\93\
---------------------------------------------------------------------------

    \93\ See Section 15 of the LLC Agreement.
---------------------------------------------------------------------------

    Although the TRF LLC itself will not carry out any regulatory
functions, all of its activities must be conducted in a manner that is
consistent with the Exchange Act. In this regard, under Section 9(d) of
the LLC Agreement, each member of the TRF LLC agrees to comply with the
federal securities laws and rules and regulations thereunder and to
cooperate with the Commission pursuant to its regulatory authority and
the provisions of the LLC Agreement. Section 10(b) of the LLC Agreement
imposes similar obligations on each director of the TRF LLC. Under
Section 10(b), each director agrees to comply with the federal
securities laws and the rules and regulations thereunder and to
cooperate with the Commission and the NASD in carrying out their
regulatory authority and the provisions of the LLC Agreement. In
addition, Section 10(b) states that each director agrees that in
discharging his or her responsibilities as a member of the TRF LLC
Board, each director will take into consideration whether his or her
actions as a director would cause the TRF LLC or either member to
engage in conduct that would be inconsistent with the purposes of the
Exchange Act.
    The Commission believes that these provisions reinforce the notion
that the TRF LLC, as the operator of an NASD facility, is not solely a
commercial enterprise; it is an integral part of an SRO registered
pursuant to the Exchange Act and, as such, is subject to obligations
imposed by the Exchange Act. The Commission underscores that these
obligations endure so long as the TRF LLC operates an NASD facility.
    The LLC Agreement includes additional provisions that make special
accommodations for the NASD as the SRO responsible for the NASD
facilities operated by the TRF LLC. For example, Section 10(a) of the
LLC Agreement provides that the TRF LLC Board shall, at all times,
include at least one director (the ``SRO Member Director'') designated
by the NASD. Under Section 10(e) of the LLC Agreement, no ``Major
Action,'' as defined in the LLC Agreement, will be effective unless
approved by consent of the SRO Member Director.\94\ Section 19 of the
LLC Agreement prohibits either the NASD or Nasdaq from transferring or
assigning its interest in the TRF LLC except to an affiliate, as
defined in the LLC Agreement, and the NASD may transfer its interest
only to an affiliate that has proper authority to perform the self-
regulatory responsibilities of the NASD.
---------------------------------------------------------------------------

    \94\ See supra text accompanying notes 90-92.
---------------------------------------------------------------------------

    The Commission believes that the provisions described above will
allow the NASD to carry out its self-regulatory responsibilities with
respect to its facilities operated by the TRF LLC. Moreover, the
Commission believes that the limits in Section 19 of the LLC Agreement
on transfers of interest in the TRF LLC, together with the requirements
of Section 19(b) of the Exchange Act and Rule 19b-4 thereunder, provide
the Commission with sufficient authority over changes in control of the
TRF LLC to enable the Commission to carry out its regulatory oversight
responsibilities with respect to the NASD and its facilities.
    The Commission also believes that, as highlighted by the terms of
the LLC Agreement, the Commission and the NASD have sufficient
regulatory jurisdiction over the controlling parties of the TRF LLC to
carry out their responsibilities under the Exchange Act. In Section
17(b) of the LLC Agreement, the NASD and Nasdaq acknowledge that--to
the extent directly related to the TRF LLC's activities--their books,
records, premises, officers, directors, governors, agents, and
employees will be deemed to be the books, records, premises, officers,
directors, governors, agents, and employees of the NASD itself and its
affiliates for the purposes of, and subject to oversight pursuant to,
the Exchange Act. This provision will reinforce the Commission's
ability to exercise its authority under Section 19(h)(4) of the
Exchange Act \95\ with respect to the officers and directors of the TRF
LLC because all such officers and directors-to the extent that they are
acting in matters related to the TRF LLC's activities-would be deemed
to be the officers and directors of the NASD itself. Furthermore, under
Section 17(b) of the LLC Agreement, the records of the NASD and Nasdaq,
to the extent that they are related to the TRF LLC's activities, are
deemed to be records of the NASD itself and are subject to the
Commission's examination authority under Section 17(b)(1) of the
Exchange Act.\96\
---------------------------------------------------------------------------

    \95\ 15 U.S.C. 78s(h)(4). Section 19(h)(4) of the Exchange Act
authorizes the Commission, by order, to remove from office or
censure any officer or director of an SRO if it finds after notice
and an opportunity for hearing that such officer or director has:
(1) Willfully violated any provision of the Exchange Act or the
rules and regulations thereunder, or the rules of such SRO; (2)
willfully abused his or her authority; or (3) without reasonable
justification or excuse, has failed to enforce compliance with any
such provision by a member or person associated with a member of the
SRO.
    \96\ 15 U.S.C. 78q(b)(1).
---------------------------------------------------------------------------

    In addition, under Section 17(c) of the LLC Agreement, the NASD and
Nasdaq, and each officer, director, agent, and employee thereof,
irrevocably submits to the jurisdiction of the U.S. Federal courts, the
Commission, and the NASD for the purpose of any suit, action, or
proceeding pursuant to the U.S. federal securities laws and the rules
and regulations thereunder arising from, or relating to, the TRF LLC's
activities. In addition, each Member, and each officer, director,
agent, and employee thereof, waives and agrees not to assert by way of
motion, as a defense or otherwise, in any suit, action, or proceeding,
any claim that it is not personally subject to the jurisdiction of the
Commission; that the suit, action, or proceeding is an inconvenient
forum; that the venue of the suit, action, or proceeding is improper;
or that the subject matter of the suit, action, or proceeding may not
be enforced in or by such courts or agency. Moreover, Section 17(e) of
the LLC Agreement states that the TRF LLC, the NASD, and Nasdaq will
cause their respective affiliates, officers, directors, governors,
employees, representatives, and agents to comply with these
requirements.
    The Commission also believes that, even in the absence of these
provisions of the LLC Agreement, under Section 20(a) of the Exchange
Act, \97\ any person with a controlling interest in the TRF LLC would
be jointly and severally liable with and to the same extent that the
TRF LLC is liable under any provisions of the Exchange Act, unless the
controlling person acted in good faith and did not directly or
indirectly induce the act or acts constituting the violation or cause
of action. In addition, Section 20(e) of the Exchange Act \98\ creates
aiding and abetting liability for any person who knowingly provides
substantial assistance to another person for violation of any provision
of the Exchange Act or rule thereunder. Further, Section 21C of the
Exchange Act \99\ authorizes the Commission to

enter a cease-and-desist order against any person who has been ``a
cause of'' a violation of any provision of the Exchange Act through an
act or omission that the person knew or should have known would
contribute to the violation.
---------------------------------------------------------------------------

    \97\ 15 U.S.C. 78t(a).
    \98\ 15 U.S.C. 78t(e).
    \99\ 15 U.S.C. 78u-3.
---------------------------------------------------------------------------

    The Commission believes that, together, these provisions grant the
Commission sufficient jurisdictional authority over the controlling
parties and Members of the TRF LLC. Moreover, the NASD is required to
enforce compliance with the provisions of the LLC Agreement because
they are ``rules of the association'' within the meaning of Section
3(a)(27) of the Exchange Act.\100\ A failure on the part of the NASD to
enforce its rules could result in a suspension or revocation of its
registration pursuant to Section 19(h)(1) of the Exchange Act.\101\
---------------------------------------------------------------------------

    \100\ 15 U.S.C. 78c(a)(27).
    \101\ 15 U.S.C. 78s(h)(1).
---------------------------------------------------------------------------

4. Comments
    The Commission received 13 comment letters from 12 commenters
opposing the NASD's proposal to establish the TRF LLC.\102\ In light of
its interest in the TRF LLC, Nasdaq submitted a comment letter to
address the issues raised by the NYSE.\103\ In addition, because the
Archipelago Letter and the NYSE Letter II also were submitted in
response to the Nasdaq Exchange's application to register as a national
securities exchange, Nasdaq also addressed the comments raised in those
letters in its response to comments concerning its exchange
application.\104\ The NASD also responded to the issues raised by the
commenters.\105\ The principal issues raised by commenters are
discussed below.
---------------------------------------------------------------------------

    \102\ See Archipelago Letter, BSE Letter, NYSE Letters I, II and
III, Ward Letter, Davis Letter, Bean Letter, Towns Letter, Capuano
Letter, McHenry Letter, Gerlach Letter, and Baker Letter, supra note
13.
    \103\ See Nasdaq Letter, supra note 13.
    \104\ See letter from Edward Knight, Executive Vice President
and General Counsel, Nasdaq, to Jonathan G. Katz, Secretary,
Commission, dated December 13, 2005 (``Nasdaq Letter II'').
    \105\ See NASD Response Letters I and II, supra note 14.
---------------------------------------------------------------------------

a. Trade Reporting Facility is a Facility of the NASD

    Because of the affiliation between the Nasdaq Exchange and the TRF
LLC, several commenters argue that the Trade Reporting Facility would
not truly be a facility of the NASD, but instead would be a facility of
the Nasdaq Exchange.\106\ These commenters argue that the Trade
Reporting Facility is a facility of the Nasdaq Exchange because the
Nasdaq Exchange's parent company controls the board of the TRF LLC,
directs all business decisions, provides technology, and will reap the
economic benefits of the TRF LLC. Based on the premise that the Trade
Reporting Facility is a facility of the Nasdaq Exchange, these
commenters believe that approval of the Trade Reporting Facility would
be inconsistent with what they view as the Commission's policy that an
exchange must provide an opportunity for all exchange orders to
interact with each other.\107\
---------------------------------------------------------------------------

    \106\ See Archipelago Letter, supra note 13. See also NYSE
Letter I, BSE Letter, Bean Letter, Towns Letter, Gerlach Letter,
supra note 13.
    \107\ See Bean Letter, Archipelago Letter, NYSE Letter I, BSE
Letter, and Towns Letter, supra note 13. See also Ward Letter, supra
note 13.
---------------------------------------------------------------------------

    Several commenters also argue that the Trade Reporting Facility, as
a facility of the Nasdaq Exchange, would allow an exchange to take
credit and receive remuneration for trades that do not occur on that
exchange, which these commenters maintain is inconsistent with current
law.\108\ One commenter said that allowing Nasdaq to take credit for
off-exchange trades would reduce transparency and lead to a mistaken
sense of an exchange's liquidity and depth of market.\109\
---------------------------------------------------------------------------

    \108\ See Davis Letter, Bean Letter, Archipelago Letter, NYSE
Letter I, BSE Letter, Towns Letter, McHenry Letter, Baker Letter,
Gerlach Letter, supra note 13.
    \109\ See Ward Letter, supra note 13.
---------------------------------------------------------------------------

    Commenters also argue that approval of the Trade Reporting Facility
as operated by the TRF LLC will result in the proliferation of print
facilities because other markets will seek to establish similar
arrangements.\110\ One commenter argued that this would result in less
order interaction.\111\ Several commenters also argue that providing
revenue and trade information to markets that have no nexus with the
actual trades may contravene the public interest.
---------------------------------------------------------------------------

    \110\ See Ward Letter, Bean Letter, Towns Letter, Capuano
Letter, Gerlach Letter, Baker Letter, Archipelago Letter, BSE
Letter, supra note 13.
    \111\ See Archipelago Letter, supra note 13.
---------------------------------------------------------------------------

    Section 3(a)(2) of the Exchange Act \112\ defines the term
``facility'' of an exchange to include ``its premises, tangible or
intangible property whether on the premises or not, any right to the
use to such premises or property or any service thereof for the purpose
of effecting or reporting a transaction on an exchange (including,
among other things, any system of communication to or from the
exchange, by ticker or otherwise, maintained by or with the consent of
the exchange), and any right of the exchange to the use of any property
or service.'' While the Trade Reporting Facility plainly is an
affiliate of Nasdaq, the Commission does not believe that the Trade
Reporting Facility is a facility of the Nasdaq Exchange within the
terms of the Exchange Act. Nasdaq owns the system that the TRF uses for
reporting trades; however, the Trade Reporting Facility is not a
service ``for the purpose of effecting or reporting a transaction'' on
the Nasdaq Exchange. Instead, the Trade Reporting Facility is a service
for the purpose of reporting transactions to the NASD. Therefore, the
Commission believes that the Trade Reporting Facility is a facility of
the NASD and not a facility of the Nasdaq Exchange.\113\
---------------------------------------------------------------------------

    \112\ 15 U.S.C. 78c(a)(2).
    \113\ The Commission has previously approved arrangements
similar to the Trade Reporting Facility in which a third party
technology provider operates an SRO's facility in return for payment
of related revenues. For example, the Pacific Exchange's equity
trading facility was for several years operated by an unaffiliated
third party--ArcaEx. See Securities Exchange Act Release No. 44983
(October 25, 2001), 66 FR 55225 (November 1, 2001) (order approving
the Archipelago Exchange as the equities trading facility of PCX
Equities, Inc., a subsidiary of the Pacific Exchange, Inc.)
(``ArcaEx Order''). Under the Agreement, PCX paid the parent of
ArcaEx market data revenue and transaction and listing fees. See
Archipelago Holdings, Inc. Annual Report on Form 10-K for fiscal
year ended December 31, 2004. In September 2005, the parent of
ArcaEx--Archipelago--acquired the Pacific Exchange. Accordingly, the
exchange and the facilities operator became affiliated. See
Securities Exchange Act Release No. 52497 (September 22, 2005), 70
FR 56949 (September 29, 2005). Recently, the NYSE and Archipelago
merged, and the Pacific Exchange was renamed NYSE Arca.
---------------------------------------------------------------------------

    NASD members would report trades to the Trade Reporting Facility
pursuant to NASD rules. In addition, transactions reported to the Trade
Reporting Facility will be disseminated with a modifier indicating that
they are NASD trades, which will clearly distinguish them from
transactions executed on or through the Nasdaq Exchange. Because the
Trade Reporting Facility is an NASD facility, the NASD will have the
responsibility under the Exchange Act to regulate its members'
activities related to the Trade Reporting Facility.\114\ The Commission
believes that the LLC Agreement provides the NASD with sufficient
authority to carry out its SRO responsibilities because the LLC
Agreement provides, among other things, that the NASD will have sole
regulatory responsibility for the activities of the TRF LLC, including
the right to review and approve the regulatory budget, approve rule
proposals relating to the activities of the TRF LLC prior to their
filing with the

Commission, adopt and interpret policies regarding NASD facilities, and
perform real time market surveillance. In addition, under the LLC
Agreement no ``Major Action,'' as defined in the LLC Agreement, may
become effective without the NASD's consent.\115\
---------------------------------------------------------------------------

    \114\ Similar arrangements that have been approved by the
Commission provided for the same obligations with respect to such
facilities. See Securities Exchange Act Release Nos. 49067 (January
13, 2004), 69 FR 2761 (January 20, 2004) (order approving the Boston
Options Exchange as a facility of the Boston Stock Exchange, Inc.);
and Arca Ex Order, supra note 113.
    \115\ See supra text accompanying note 92 for the LLC
Agreement's definition of ``Major Action.''
---------------------------------------------------------------------------

    To the extent that approval of the Trade Reporting Facility results
in other markets seeking to establish similar arrangements with the
NASD, the Commission notes that the NASD would have to file any
proposed rule change generated by such proposals pursuant to Section 19
of the Exchange Act, and the Commission would be required to determine
that such proposed rule change complied with the requirements of the
Exchange Act. The Commission notes, however, that the Exchange Act does
not prohibit the NASD from establishing different facilities for
purposes of fulfilling its regulatory obligations. Indeed, the
Commission notes that the NASD currently operates two facilities for
the reporting of OTC trades in Nasdaq-listed securities--the ADF and
the Nasdaq Market Center.

b. Impact on Internalization Practices

    Based on the premise that the Trade Reporting Facility is a
facility of the Nasdaq Exchange, commenters conclude that the Trade
Reporting Facility would allow Nasdaq Exchange members to execute and
report trades without regard to orders resident on the Nasdaq Exchange
book and thereby increase the internalization of orders.\116\ One
commenter objects to NASD members' current ability to execute trades in
the OTC market without interacting with other better-priced orders on
exchanges.\117\ Another Commenter suggests that NASD members would not
be required to provide the best prices in the market.\118\ Commenters
also contend that approval of the NASD's Trade Reporting Facility would
result in a different standard for the Nasdaq Exchange as compared to
other exchanges because, unlike other exchanges, the Nasdaq Exchange
would not be required to have a consolidated limit order book.\119\
---------------------------------------------------------------------------

    \116\ See Archipelago Letter, BSE Letter, NYSE Letter I, supra
note 13.
    \117\ See BSE Letter, supra note 13.
    \118\ See Capuano Letter, supra note 13.
    \119\ See Archipelago Letter, BSE Letter, NYSE Letter I, supra
note 13.
---------------------------------------------------------------------------

    As discussed above, the Commission does not believe that the Trade
Reporting Facility is a facility of the Nasdaq Exchange. Moreover, the
Commission does not believe that the Trade Reporting Facility will
increase the internalization of orders. The Trade Reporting Facility
simply preserves the ability of an NASD member, who may also be a
member of the Nasdaq Exchange or another exchange, to report trades
executed otherwise than on an exchange to the NASD through the Trade
Reporting Facility without regard to the orders on the Nasdaq Exchange
or any other exchange's consolidated limit order book. The Commission
notes that the ability to report internalized trades to an NASD
facility exists and is widely used today. In this regard, an NASD
member today may report internalized trades to the Nasdaq facilities of
the NASD without regard to the priority rules of the Nasdaq's
SuperMontage system or any exchange of which it is a member. There is
no reason to expect the Trade Reporting Facility to increase such
practices.
    Finally, the Commission notes that a broker-dealer has a legal duty
to seek to obtain the best execution of customer orders.\120\ This duty
requires broker-dealers to execute customers' trades at the most
favorable terms reasonably available under the circumstances.\121\
Further, the NASD noted that its members are subject to, among other
things, NASD Rule 2320, which would prohibit an NASD member from
disregarding the market.\122\ Accordingly, the Commission does not
agree with the commenters that argued that the Trade Reporting Facility
would permit NASD members to ignore disseminated quotes and their best
execution obligations.\123\
---------------------------------------------------------------------------

    \120\ See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner &
Smith, Inc., 135 F.3d 266, 269-70 (3d Cir.), cert denied, 525 U.S.
811 (1998); Certain Market Making Activities on Nasdaq, Securities
Exchange Act Release No. 40900 (Jan. 11, 1999) (settled case)
(citing Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971)); Arleen
Hughes, 27 SEC 629, 636 (1948), aff'd sub nom. Hughes v. SEC, 174
F.2d 969 (D.C. Cir. 1949). See also Order Execution Obligations,
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR
48290 (Sept. 12, 1996) and NASD Rule 2320, ``Best Execution and
Interpositioning.''
    \121\ Newton, 135 F.3d at 270. Newton also noted certain factors
relevant to best execution--price order size, trading
characteristics of the security, speed of execution, clearing costs,
and the cost and difficulty of executing an order in a particular
market. Id. at 270 n. 2 (citing Payment for Order Flow, Securities
Exchange Act Release No. 33026 (Oct. 6, 1993), 58 FR 52934, 52937-38
(Oct. 13, 1993) (Proposed Rules)). See In re E.F. Hutton & Co.
(``Manning''), Securities Exchange Act Release No. 25887 (July 6,
1988). See also Securities Exchange Act Release No. 34902 (Oct. 27,
1994), 59 FR 55006 at 55008-55009 (Nov. 6, 1994) (Payment for Order
Flow Final Rules).
    \122\ See Amendment No. 1.
    \123\ See BSE Letter, supra note 13. See also Capuano Letter,
supra note 13.
---------------------------------------------------------------------------

c. Unfair Competition

    Several commenters object to the NASD's payment to Nasdaq of the
market data revenue generated by trades reported to the Trade Reporting
Facility operated by the TRF LLC.\124\ One commenter argues that the
transfer of market data revenue from the NASD to Nasdaq through the TRF
LLC is inconsistent with Section 11A of the Exchange Act and Regulation
NMS.\125\ Others state that payment of market revenue would amount to a
subsidy of the Nasdaq Exchange by the NASD, which would provide the
Nasdaq Exchange with an unfair economic advantage over other national
securities exchanges.\126\ One commenter also maintains that the Nasdaq
Exchange would be able to use revenue generated by off-exchange trades
to defray its business and exchange surveillance expenses, thereby
discriminating against other exchanges.\127\
---------------------------------------------------------------------------

    \124\ See NYSE Letters I, II, and III, supra note 13. See also
Gerlach Letter, Ward Letter, supra note 13.
    \125\ See NYSE Letters I, supra note 13.
    \126\ See NYSE Letters I and II, Ward Letter, and Gerlach
Letter, supra note 13.
    \127\ See NYSE Letters I and II, supra note 13.
---------------------------------------------------------------------------

    One commenter raises competitive issues regarding the technology
that will be used by the Trade Reporting Facility to collect trade
reports.\128\ Specifically, the commenter argues that Nasdaq's ACT is
an industry utility because virtually all market participants use the
system for reporting OTC trades. This commenter argues that Nasdaq's
competitors should have equal access to ACT and the Trade Reporting
Facility to eliminate the unfair competitive advantage the commenter
believes exists due to Nasdaq's monopoly on ACT.
---------------------------------------------------------------------------

    \128\ See NYSE Letter III, supra note 13.
---------------------------------------------------------------------------

    Section 15A(b)(9) of the Exchange Act \129\ prohibits the NASD from
having rules that impose any burden on competition that is not
necessary or appropriate in furtherance of the purposes of the Exchange
Act. The Commission finds that the proposal does not impose any burden
on competition that is not necessary or appropriate in furtherance of
the purposes of the Exchange Act. As the NASD and Nasdaq note, the LLC
Agreement does not preclude the NASD from entering into similar
arrangements with other national securities exchanges.\130\ For this
reason, the Commission believes that the Trade Reporting Facility does
not impose any unfair burden on competition, as required by the
Exchange Act.
---------------------------------------------------------------------------

    \129\ 15 U.S.C. 78o-3(b)(9).
    \130\ See NASD Response Letters I and II, supra note 14 and
Nasdaq Letter, supra note 13. See also Amendment No. 1.
---------------------------------------------------------------------------

    The NASD notes that an exchange may develop its own proprietary
system for reporting trades, and the NASD

represents that it is prepared to implement a trade reporting facility
with any exchange based on the technology available to the
exchange.\131\ The NASD represents that it has, in fact, discussed
trade reporting facility arrangements with a number of exchanges.\132\
Because another exchange may develop a proprietary trade reporting
system and enter into a similar trade reporting facility arrangement
with the NASD, the Commission does not believe that the unavailability
of ACT to other exchanges imposes a burden on competition that is not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.
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    \131\ See NASD Response Letter II, supra note 14.
    \132\ See NASD Response Letter II, supra note 13.
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    The Commission notes that the NASD bears the responsibility for
overseeing the entities that report trades to the Trade Reporting
Facility and for providing regulatory services to the Trade Reporting
Facility. The TRF LLC will pay the NASD for these services using
revenues generated by the Trade Reporting Facility. Under the LLC
Agreement, Nasdaq must ensure that the TRF LLC has funds sufficient to
satisfy its regulatory obligations and must guarantee the TRF LLC's
payment of obligations relating to the costs associated with the NASD's
performance of regulatory services for the Trade Reporting
Facility.\133\ As the NASD states in its response to the commenters,
Nasdaq bears the economic risks associated with the operation of the
Trade Reporting Facility, including any losses if revenues fail to
cover regulatory and other costs associated with operating the Trade
Reporting Facility.\134\ In light of the costs, and potential losses,
that Nasdaq must bear in connection with the operation of the Trade
Reporting Facility, the Commission does not believe that allocating
revenues generated by the Trade Reporting Facility to Nasdaq, net of
costs, would provide the Nasdaq Exchange with an unfair economic
advantage over other national securities exchanges or impose a burden
on competition that is not necessary or appropriate in furtherance of
the purposes of the Exchange Act. Moreover, the Commission does not
believe that an agreement by the NASD under which it pays Nasdaq market
data revenue in exchange for Nasdaq providing the technology and
bearing other costs of operating the facility is inconsistent with
Regulation NMS or the Exchange Act and the rules and regulations
thereunder.
---------------------------------------------------------------------------

    \133\ See LLC Agreement, Section 12.
    \134\ See NASD Response Letter I, supra note 14. See also LLC
Agreement, Section 15 (allocating the profits and losses of the
Trade Reporting Facility to Nasdaq).
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    Finally, the Commission disagrees with the characterization of
Nasdaq's ACT system as an industry utility. ACT is an automated system
owned and operated by Nasdaq that, among other things, provides for the
reporting of transactions in securities. The Exchange Act, however,
does not prevent any other party, including an exchange, from
developing similar technology for use as an NASD facility. Further, the
Commission does not believe that the inability of competitors to use
ACT for purposes of receiving compensation for trades reported by their
members constitutes a denial of access under Section 19(d) of the
Exchange Act. Under the proposal, all market participants that are
members of the NASD will continue to have the ability to report
internalized trades through ACT. Thus, the proposal does not prohibit
or limit any person with respect to access to services offered by the
NASD in violation of Section 19(d) of the Exchange Act. The Commission
does not believe that Section 19(d) or any other provision of the
Exchange Act requires Nasdaq to make its proprietary trade reporting
system available to a competing exchange.

d. Impact on the NASD's Ability to Effectively Regulate

    One commenter also questions whether the payment of market data
revenue to Nasdaq would adversely impact the NASD's ability to regulate
the Trade Reporting Facility or provide NASD members with reduced
membership fees, or would impair the NASD's regulatory
independence.\135\ In particular, the commenter claims that it would
compromise the NASD's regulatory integrity and neutrality as the SRO
for the OTC market and would perpetuate the conflicts that the
separation of the Nasdaq Exchange from the NASD was designed to
ameliorate. Nasdaq asserts that it would receive the revenues
associated with the TRF LLC ``because it would provide the connectivity
and reporting technology and bear all costs associated with the
facility.'' \136\ In addition, the LLC Agreement requires Nasdaq to
ensure that the TRF LLC has funds sufficient to satisfy its regulatory
obligations and to guarantee the TRF LLC's payment obligations relating
to costs associated with the NASD's performance of its SRO
responsibilities related to the activities of the TRF LLC.\137\ This
obligation is independent of the revenue associated with the TRF LLC.
Therefore, the Commission does not believe that the LLC Agreement or
the TRF LLC would impair the NASD's ability to carry out its
obligations under Section 15A of the Exchange Act.\138\
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    \135\ See NYSE Letter I, supra note 13.
    \136\ See Nasdaq Letter II, supra note 13.
    \137\ 137 See LLC Agreement Section 12.
    \138\ 15 U.S.C. 78o-3.
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e. Compliance With CTA Plan and the Nasdaq UTP Plan

    One commenter contends that the payment of market data revenue to
the Nasdaq Exchange by the NASD would violate both the CTA and Nasdaq
UTP Plans.\139\ This commenter refers to its earlier comment letters
regarding Nasdaq's application for exchange registration, in which the
commenter opposed Nasdaq's proposed transaction reporting rules.\140\
The proposed rules would have allowed the Nasdaq Exchange to report--
and receive revenue for--internalized and other off-exchange trades.
This commenter argued that the proposed transaction reporting rules
would not comply with Section VIII(a) of the CTA Plan, which requires
each participant exchange to report all trades occurring on its floor
and requires the NASD to report all trades that do not take place on
the floor of an exchange.\141\ Similarly, the commenter maintained that
the proposed rules would violate Section VIII(B) of the Nasdaq UTP
Plan.\142\ By not complying with the terms of these plans, the
commenter concludes that both Nasdaq and the NASD would

violate Rule 608 of Regulation NMS,\143\ which requires each SRO to
comply with the terms of an effective national market system plan in
which it participates and to enforce compliance with such plan by its
members and persons associated with its members.\144\
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    \139\ See NYSE Letter I and attached letters, supra note 13.
    \140\ See letters from Darla C. Stuckey, Corporate Secretary,
NYSE, to Jonathan G. Katz, Secretary, Commission, dated February 15,
2002 (``NYSE February 2002 Letter''); and James E. Buck, Senior Vice
President and Secretary, NYSE, to Jonathan G. Katz, Secretary,
Commission, dated August 27, 2001.
    \141\ Specifically, Section VIII(a) of the CTA Plan states that
the exchange participants will each collect and report to the
Processor all last sale price information to be reported by it
relating to transactions in Eligible Securities taking place on its
floor. Section VIII(a) states, further, that the NASD shall collect
from its members all last sale price information to be included in
the consolidated tape relating to transactions in Eligible
Securities not taking place on the floor of an exchange and shall
report all such last sale price information to the Processor in
accordance with the provisions of Section VIII(b) of the CTA Plan.
    \142\ See NYSE February 2002 Letter, supra note 140. Section
VIII(B) of the Nasdaq UTP Plan states that each Participant shall be
responsible to promptly collect and transmit to the Processor
Transaction Reports in Eligible Securities executed in its Market.
Section III(E) of the Nasdaq UTP Plan defines ``Market,'' when used
in connection with Transaction Reports, to mean the Plan Participant
through whose facilities the transaction took place or was reported,
or the Plan Participant to whose facilities the order was sent for
execution.
    \143\ Rule 608 of Regulation NMS was formerly Exchange Act Rule
11Aa3-1.
    \144\ See Rule 608(c) of Regulation NMS, 17 CFR 242.608(c).
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    As noted in the Nasdaq Exchange Order, Nasdaq amended its exchange
application so that only trades executed through the systems of the
Nasdaq Exchange will be reported to the Nasdaq Exchange. \145\ Through
its Trade Reporting Facility and related rules, the NASD, rather than
Nasdaq, will report all off-exchange trades and collect transaction
reports for trades reported through the Trade Reporting Facility, as
required by the Nasdaq UTP Plan. Accordingly, the Commission believes
that the LLC Agreement and the proposed rules of the Trade Reporting
Facility are consistent with the terms of the Nasdaq UTP Plan.\146\
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    \145\ See Nasdaq Exchange Order, supra note 5.
    \146\ The Commission notes that the Trade Reporting Facility
will not accept trade reports for CTA Plan Securities and, thus, the
NASD will not report such trades to the CTA Plan through the Trade
Reporting Facility. Accordingly, the Trade Reporting Facility and
the TRF LLC will not receive CTA Plan revenue.
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f. Consistency With Market Data Revenue Allocation Formula

    One commenter states that the TRF LLC proposal is inconsistent with
the objectives of the market data revenue allocation rules adopted by
the Commission in conjunction with Regulation NMS. \147\ According to
this commenter, the new market data revenue allocation rules were
intended to decrease incentives to engage in sham trades, wash sales,
and tape shredding.
---------------------------------------------------------------------------

    \147\ See NYSE Letter II, supra note 13.
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    In addition to modifying Exchange Act rules governing the display
and distribution of market data, the Commission amended the CTA Plan,
the CQ Plan, and the Nasdaq UTP Plan (each a ``Plan'' and,
collectively, the ``Plans'') to incorporate a new net income allocation
formula into each Plan.\148\ The amendments to each of the Plans
incorporated a broad-based measure of the contribution of an SRO's
quotes and trades to the consolidated data stream.
---------------------------------------------------------------------------

    \148\ See Securities Exchange Act Release No. 51808 (June 9,
2005), 70 FR 37496 (June 29, 2005)(adopting Regulation NMS).
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    The Commission does not believe that the TRF LLC is inconsistent
with the objectives of the new Plan formulas, which included reducing
the incentives for distortive behavior, such as sham trades, wash
sales, and tape shredding. The TRF LLC does not alter the new Plan
formulas. Further, the NASD's proposed Trade Reporting Facility rules
do not appear to create any incentives for distortive behavior.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 1, including whether Amendment No. 1
is consistent with the Exchange 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<EMAIL_ADDRESS>Please include

File No. SR-NASD-2005-087 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, Station Place, 100 F
Street, NE., Washington, DC 20549-1090.

All submissions should refer to File No. SR-NASD-2005-087. 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 the 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 publicly available. All submissions should refer to
File No. SR-NASD-2005-087 and should be submitted on or before July 31,
2006.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the
Exchange Act,\149\ that the proposed rule change (SR-NASD-2005-087), as
amended, is approved.
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    \149\ 15 U.S.C. 78s(b)(2).

    By the Commission.
J. Lynn Taylor,
 Assistant Secretary.
[FR Doc. 06-6083 Filed 7-7-06; 8:45 am]

BILLING CODE 8010-01-P