I point out here that section 305 does add a new section 17(d) to the exchange act which clarifies the authority of the SEC to promulgate rules covering a composite quotation system and a consolidated tape. The exchange, to the best of my recollection, did not comment on this. Do you have any position on that particular section? Mr. NEEDHAM. My recall is not too good on this point. Mr. STERN. Let me read it to you: Rules under subsection (a) of this section may include rules (1) regulating the reporting of transactions executed on an exchange, or otherwise than on an exchange; (2) regulating the reorting of bids and offers for securities traded on an exchange or otherwise than on an exchange; and (3) prescribing uniformity of accounting procedures... which is not the question we are discussing. Mr. NEEDHAM. Perhaps the reason we did not reply, and I will consult with Mr. Calvin, since he drafted the reply, is because we share the subcommittee's concern as to whether or not the SEC in fact has a statutory authority to do that which it proposes to do. Mr. Moss. The chair will have to interrupt. The committee will stand adjourned until 1:30 this afternoon. [Whereupon, at 12:20 p.m., the subcommittee recessed, to reconvene at 1:30 p.m. the same day.] AFTER RECESS [The subcommittee reconvened at 1:30 p.m., Hon. John E. Moss presiding.] Mr. Moss. The subcommittee will be in order. Mr. Stern? Mr. STERN. Mr. Needham, I don't think you quite finished responding to my question on new section 17 (d); is that right? Mr. NEEDHAM. I believe that is right, Mr. Stern. I am trying now to recall. Mr. Moss. Will Mr. Stern rephrase the question for the purpose of the recollection of the witness? Mr. STERN. The question has to do with the exchange's apparent lack of position upon that part of section 305 which would add new section 17(d) to the Exchange Act giving the SEC the clear authority to promulgate rules regulating a composite quotation system and a consolidated tape. I believe, Mr. Needham, you were saying you thought there was some question about present authority. Mr. NEEDHAM. The exchange does not object to the section and the fact that we failed to comment should not be interpreted that way. We feel that what you are striving for in sections 1 and 2 is the direction toward a central market system, which as you know, earlier in our prepared testimony we indicated that more definition and direction was needed there. I think it would be safe to say that we would support items 1 and 2. Three, prescribing uniform accounting procedures for broker-dealers registered under this title, that is probably something that should have been done back in 1934. Although you might leave some discretion there because the industry has come a long way since then and a lot of money has been spent on putting in very sophisticated accounting systems. Maybe you could settle for uniform reporting of some type with a code of joint accounts-as an option-that might be desirable. Now, as to whether or not the SEC has the existing authority, there is a serious question in the mind of our counsel as to whether the commission under the 1934 act has the authority to promulgated rules under section 17 to deal with the questions of a composite tape and a quotation system. We have not challenged that authority, but that is our opinion. Mr. STERN. Mr. Chairman, I have only one more question that I would like to raise. Mr. Needham, in your prepared testimony you quoted from-and this is on page 35-an article appearing in the July 1971 issue of the Institutional Investor magazine on the workings of NASDAQ. I don't want to dwell on it except to point out that it indicates that there were certain abuses in the handling of quotations on the NASDAQ system, such as dealers backing away and bids and offers not in accord with current market prices, particularly on third market issues. I would just like to say that it is my understanding that in the 2 years that have gone by since the article appeared the NASD has promulgated certain rules against such practices. I would like to ask permission that the record be held open for letters of inquiry to the SEC and the NASD so that they may respond to the situation apparently pertaining at the time of the article, and answer whether these conditions have or have not been rectified today. Mr. Moss. Unanimous consent is made for the holding of the record to receive a letter of inquiry addressed to the SEC and the NASD and the responses to the letter of inquiry. Without objection the record will be so held. [The following form letter and responses thereto were received for the record:] U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, August 3, 1973. DEAR When the New York Stock Exchange testified before the Subcommittee on July 19, 1973, James J. Needham, in his prepared testimony, addressed himself to what he characterized as the unfulfilled potential of NASDAQ. Mr. Needham, in quoting from an article appearing in the July 1971 issue of the Institutional Investor magazine, and in further testimony, indicated that there were certain abuses in the handling of quotations on the NASDAQ system, such as dealers backing away and bids and offers not in accord with current market prices, particularly on third market issues. I am enclosing the relevant portion of this testimony for your reference. In the two years that have elapsed since this article appeared, I understand that the NASD has promulgated rules and taken other actions to cope with these alleged abuses. A reservation has been made in the hearings record for this letter of inquiry and your response so that you may comment upon whether the article accurately describes the situation at that time, and, if so, whether or not these conditions have been rectified today. Sincerely, Hon. JOHN E. Moss, JOHN E. Moss, Chairman, Subcommittee on Commerce and Finance. * SECURITIES AND EXCHANGE COMMISSION, Chairman, Subcommittee on Commerce and Finance, Committee on Interstate and Foreign Commerce, U.S. House of Representatives, Rayburn House Office Building, Washington, D.C. DEAR MR. CHAIRMAN: This is in response to your letter of August 3, 1973 requesting that I comment upon certain testimony of New York Stock Exchange Chairman James J. Needham before the Subcommittee of Commerce and Finance tional Investor magazine, "Is NASDAQ Really the Answer?", which was incorporated by Mr. Needham into his testimony. Before turning to the particular issues raised by Mr. Needham, it may be helpful to describe briefly a portion of the decision-making process which culminated in the development of the NASDAQ system. As you may recall, prior to the advent of the NASDAQ system, wholesale dealers who wished to advertise their buying or selling interest in an over-thecounter security placed their quotations in one of the wholesale quotation services. Principal among these services was the so-called "pink sheets" published by the National Quotation Bureau, Inc., which consisted of a daily listing of bid and ask quotations (or in some instances a mere indication of interest, without an accompanying price) supplied by the wholesale dealers. An examination of these quotation services, and the "pink sheets" in particular, by the Special Study of Securities Markets (H.R. Doc. No. 95, 88th Cong. 1st Sess., pt. 2 at p. 663) ("Special Study") revealed that, despite bona fide attempts by the operators of these services to insure the reliability and the integrity of the quotations provided, their efforts were hampered severely by insufficient authority and administrative capability and thus could not prove effective. The Special Study (pt. 2 at p. 665) also found it anomalous that the regulation of these wholesale quotation services, a matter of national public interest, was left entirely in the hands of private concerns without any provision for public review or regulation. Based on its findings, the Special Study (pt. 2 at pp. 674-78) recommended that substantial revisions be made in the operations of the wholesale quotation services and that the initiative therefor be supplied by the NASD under an express statutory mandate from Congress. In response to this recommendation, Congress in 1964 enacted Section 15A (b) (12) of the Securities Exchange Act, giving the NASD the authority to adopt rules governing its members' over-the-counter quotations, and the NASD began planning for the development of the automated quotation system which today has become known by the acronym NASDAQ. From the very inception of planning and development, however, it was recognized by both the Commission and the NASD that the creation of this automated system, which for the first time would make possible the publication of quotations in the over-the-counter market on a real time basis, would entail a variety of new problems, many of which could not be anticipated until actual operation of the system had begun. Indeed, as Commissioner Loomis indicated a year ago, neither the Commission nor the NASD "purported to reach any definitive conclusions about the appropriate form NASDAQ ultimately should take" (emphasis in original). Rather, "it was understood that a system as novel and unique as NASDAQ would evolve only after careful evaluation, not only of theory and legal concepts, but of the logistical and other pragmatic considerations inherent in an undertaking of this kind." (Response of Philip A. Loomis, Jr., Commissioner, Securities and Exchange Commission, to Questions Posed by the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs, Concerning the Inclusion of Listed Securities in NASDAQ. [October 27, 1972]) In analyzing Mr. Needham's testimony, it appears that his principal concerns with the NASDAQ system center on the currently and reliability of NASDAQ quotations, specifically the problems of "backing away" from quotations, "crossed markets" (which is the NASD's terminology for what Mr. Needham refers to as "reverses") and "locks." As for backing away, the NASDAQ rules always have required that a market maker stand behind his quotations. However, initial uncertainty as to the exact meaning of this requirement necessitated a clarification of this requirement, initially by means of a policy statement by the Board of Governors and later by means of an amendment to the NASD by-laws governing NASDAQ. Specifically, a market maker now must execute a transaction for at least a normal unit of trading (generally 100 shares) at his quoted bid and ask as they appear on the NASDAQ screens at the time of receipt of a buy or sell inquiry by phone or otherwise. An accurate accounting of the frequency of “backing away" violations is not presently available due to the impracticability of continually reviewing the records of each NASDAQ market maker and all persons with whom they do business. However, as an indication of the extent of this problem, the NASD advised the Commission staff that from the time the system commenced operations in February of 1971 until October 8, 1973 it had received 90 reports of alleged "backing away" violations from its members. Of these 90 reports, 10 were filed during the month of October 1971 (the first month after the rule was amended); only one was filed during the month of September 1973. Since February 1972, the tions based on these reports; 13 of these complaints resulted in sanctions being imposed against the violators of the rule. "Crossed markets" exist when a market maker inserts a bid quotation greater than the ask quotation of another market maker in the same stock or when he inserts an ask quotation less than the bid of another market maker in that stock. On May 1, 1973 the NASD amended its by-laws specifically to prohibit this phenomenon (absent the applicability of an exception in extraordinary circumstances). Due to the newness of this rule, however, the NASD has not yet filed any formal complaints for violations. Rather, it sends letters to all market makers who are found by the NASDAQ computers to have crossed markets requesting a report as to why the violations occurred and informing the market makers that, depending on the circumstances involved, they may be subject to disciplinary action. The NASD advised the Commission staff that it has sent approximately 250 of these letters to market makers since June 26, 1973. In addition, the NASD has advised us that the frequency of crossed markets has fallen from an average of 54 per day during the week of June 4-8, 1973 (average daily volume of 5.2 million shares and average daily updates by market makers of their quotations of 31,403) -the first week for which such figures were analyzed-to an average of 44 per day during the week of October 1-5, 1973 (average daily volume of 7.1 million shares and average daily updates by market makers of their quotations of 35,185). The majority of these lasted for one minute or less. "Locks" exist when a market maker inserts a bid quotation equal to the ask quotation of another market maker in the same stock or when he inserts an ask quotation equal to the bid quotation of another market maker in the same stock. The NASD presently has no rule directly concerning the occurrence of “locks.” Rather, the NASD states that its intention is to await experience in enforcement of the crossed markets rule before acting in this area. A further provision in the NASD by-laws requires that each quotation entered into the system by a NASDAQ market maker be reasonably related to the prevailing market. As an aid to the interpretation of this requirement, and as a means of facilitating its enforcement, the NASD published guidelines in May 1973 setting out what normally would constitute spreads reasonably related to the prevailing market (based upon the representative bid and offer for a security), in order for individual market makers to measure their performance against that of other market makers in the same security. In addition, the NASD advised the Commission staff that before it issues a formal complaint it requests the market makers to inform it of why the excess spread parameters were exceeded and advises them that, depending upon the circumstances involved, they may be subject to disciplinary action. To date, the NASD has sent 62 such letters reflecting apparent violations which have occurred since October 1, 1973. Moreover, the NASD has advised us that the incidence of excessive spreads has fallen from an average of 34 per day during the week of June 4-8, 1973 (average daily volume of 5.2 million shares and average daily updates by market makers of their quotations of 31,403)—the first week for which such figures were compiled-to an average of 5 per day during the week of October 1-5, 1973 (average daily volume of 7.1 million shares and average daily updates by market makers of their quotations of 35,185). In sum, both the Commission and the NASD are aware of the problems which have existed within the NASDAQ system in the past and, to a significantly lesser extent, may still be in existence today. As a result of the experience gained by the NASD in the actual operation of the system, and as a result of utilizing progressively stiffer sanctions, it appears that these problems are being brought under control. Nevertheless, although we generally are satisfied with the manner in which NASDAQ has been operating we intend to continue to monitor its operations and development in order to determine whether any further modifications may be necessary. I hope that the above information will be of assistance to you. Sincerely yours, LEE A. PACKARD, Director, Division of Market Regulation. * * * NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC., Hon. JOHN E. Moss, the House Subcommittee on Commerce and Finance. Mr. Needham, in quoting from an article appearing in the July 1971 issue of the Institutional Investor magazine and in further testimony, indicated that there were certain abuses in the handling of quotations in the NASDAQ system. Specifically, he mentioned dealers backing away or not standing behind their quotes, and bids and offers which are not in accord with current market prices. The article quoted by Mr. Needham was published approximately five months after the start-up of the NASDAQ system at a time when the system, linking more than 500 market makers in some 2,600 securities, was still in its infancy. We have reviewed the article quoted by Mr. Needham and agree that some of the problems discussed by the author did exist at that time. We believe, however, that the extent of these problems may have been exaggerated and possibly misunderstood, and further that regulatory efforts have resulted in their correction in large measure. The initial problems which existed at start-up of the NASDAQ system were due to the novelty of the system and an attitude of caution on the part of the market makers as to how to utilize it. Since that time, however, we believe that the market makers' experience with the system and their confidence in its reliability has resulted in a more orderly market. We believe this confidence is a result of nearly three years working experience with the NASDAQ system, the greater visibility of the over-the-counter market place, the existence of various regulatory safeguards such as the Association's market surveillance program, and the vast amount of reliable accurate information received and stored in the system on the issues in which markets are made. This information included daily and weekly volume reports, various statistical indices showing market trends, and other data necessary for regulatory purposes. In addition, we wish to point out, and to include in the hearing record, a second more recent article published in the April 1973 issue of the Institutional Investor magazine 1 written by the author of the July 1971 article quoted by Mr. Needham. In this article the author evaluates the current performance of the NASDAQ system and indicates that many of the problems he originally discussed in his July 1971 article no longer exist. He states: "To be sure, in analyzing the importance of such problems, it must be remembered that the OTC market is still undergoing the difficult-and sometimes awkward—process of rapid transformation. And it is inevitable in any such sweeping tranistion that progress will be marred by new problems which must be overcome. No mistake about it, there are problems and they are overcome. Indeed, many of the games that dealers played in the inaugural days of NASDAQ ceased-once the rest of the marketplace learned from experience who was playing and who was not. And the NASD has overcome some other weaknesses in the trading arena with stricter rules of its own...” One of these rules was being drafted by the Association at the time that the July 1971 article was published. It was concerned with one of the major problem areas cited by the article, and in Mr. Needham's testimony-that is the reliability of NASDAQ quotations and their relationship to the prevailing market. This rule was adopted by the Association's Board of Governors on September 27, 1971 and imposed a requirement with respect to the character of quotations entered into the NASDAQ system. The rule states: "A registered market maker which receives a buy or sell order must execute a trade for at least a normal unit of trading at his quotations as they appear on NASDAQ CRT screens at the time of receipt of any such buy or sell order Each quotation entered by a registered market maker must be reasonably related to the prevailing market." 3 The adoption of this rule mandated that market makers stand firm behind their quotes in the NASDAQ system and the notice to Association members announcing the adoption of the rule specifically indicated that disciplinary action would be taken against market makers who back away from their quotations.1 Indeed, such complaints have since been filed and disciplinary action has been taken against market makers who have not complied with the rule." In addi 1 Bleakly. The over-the-counter market's search for identity, Institutional Investor, April 1971 (attached). 2 Id. at 38. |