Interpretive Letter to Roger D. Blanc, Esq., Willkie Farr & Gallagher
February 8, 1999
Roger D. Blanc, Esq.
Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019-6099
Re: Rule 3350 -- Aggregation Units
Dear Mr. Blanc:
In your letter dated February 3, 1999, you request1 interpretive advice as to NASD Rule 3350, which governs short sales in Nasdaq National Market ("NNM") securities. Specifically, in your letter you inquire whether large, multi-service broker/dealers (and other similarly-organized firms) would be permitted under NASD Rule 3350 to calculate their net long and net short positions in a particular security within defined trading units ("Aggregation Units") independently from the positions held by other Aggregation Units within the firm, as more fully described below.1
In your February 3, 1999 letter, you make the following representations and requests:
NASD Rule 3350(k)(1) establishes the method for determining whether a firm is "net long" or "net short." A firm currently determines whether it is net long or net short by aggregating all of its positions in a security. Many firms perform this firm-wide netting calculation at the end of each trading day or prior to the opening of each trading day.2 The resulting firm-wide position is assigned to each trading desk at the beginning of the trading day. Thus, a particular trading desk may have a net long position in a security, but it must treat sales of that security as short sales when the firm-wide net position is short. Throughout the day, each trading desk updates the net position for its own trading activity.
Many large broker/dealers are divided into desks that pursue separate trading strategies (such as a block positioning desk). You state that firm-wide netting results in significant costs and burdens for these large, multi-service broker/dealers. At times, the firm may have a net short position in a security, but a particular desk may maintain a net long position in that security. This situation may temporarily prevent a desk from pursuing an investment strategy that calls for it to sell its long position. As a result, this can temporarily restrict the firm's ability to provide liquidity to the market.
To reduce the costs resulting from compliance with NASD Rule 3350, you request that the NASD permit an individual trading unit, or Aggregation Unit, to calculate its net position in a particular security independently from other Aggregation Units. You make a number of representations about the operations of multi-service broker/dealers to demonstrate that large firms warrant this relief. You represent that multi-service broker/dealers keep their trading records and calculate profits and losses by defined trading units. You also represent that the trading units have traders dedicated to only that unit and that each trading unit conducts its trading without regard to other trading units. Senior management of each firm establishes and modifies, if necessary, the general risk management goals and guidelines for the Aggregation Unit. You state, however, that senior management is not involved in directing or effecting individual, day-to-day trades for any Aggregation Unit.
You assert that producing a firm-wide position by netting the positions of all individual trading desks does not achieve the intended purpose of NASD Rule 3350. You support this point by stating that a desk that sells long up to their own, independently established long position, does not result in successive transactions that deliberately drive the market price down for a particular security. You state that the individual desks make decisions to sell long independent of the positions held by another trading desk.
NASD Rule 3350 governs short sales in NNM securities traded on Nasdaq. In general, Rule 3350 prohibits NASD member firms from effecting short sales (for customer or proprietary accounts) in NNM securities at or below the current inside bid whenever that bid is lower than the previous inside bid. NASD Rule 3350 is designed to prevent the market price of NNM securities from being manipulated downward by unrestricted short selling.
NASD Rule 3350(k)(1) -- which incorporates by reference SEC Rule 3b-3 -- defines the term "short sale" and establishes the method for determining whether a firm is "net long" or "net short." As you note, aggregation currently must be based on a netting of securities positions in all proprietary accounts as determined at least once each trading day.3 Therefore, unless an exemption or other form of relief is available, firms must aggregate all positions in a security within the firm.
On the basis of your representations and the facts presented, Nasdaq OGC is of the belief that it would be consistent with NASD Rule 3350 for an NASD member to designate two or more Aggregation Units for the purpose of determining net positions in particular securities as required by
NASD Rule 3350(k)(1), subject to the following conditions:
The firm must have a written plan of organization that identifies each Aggregation Unit, specifies its trading objective, and supports its independent identity.4
Each Aggregation Unit within the firm must continuously determine, on a real-time basis, its net position for every security that it trades that is subject to NASD Rule 3350.
At least once per day, the firm must reconcile the net positions of all the Aggregation Units with the firm's net position.
Individual traders must be assigned to only one Aggregation Unit at any time.
Each trader pursuing a particular trading objective or strategy must be included in one Aggregation Unit.
If a trader temporarily transfers from one Aggregation Unit to another, the firm must document the beginning and ending dates of the transfer and the business reason that the transfer was made.
If a person from one Aggregation Unit coordinates trading of proprietary positions held by another Aggregation Unit (i.e., effectively control trading by another Aggregation Unit in a particular NNM security or securities), the firm must aggregate the positions of those units to produce a combined net short or long position, prior to execution of any trades.5
As part of its compliance and internal audit routines, the firm must continually maintain and update surveillance and audit procedures that facilitate the review and surveillance programs of the firm, the NASD, the Securities and Exchange Commission ("SEC" or "Commission"), and any other responsible Self-Regulatory Organization ("SRO"). As part of these routines, the firm must:
- evaluate the trading activities of Aggregation Units undertaken in reliance on this letter for the appropriate characterization of sales treated as long sales;
- review activities that appear unusual, including, but not limited to:
- transactions leading to short positions that are unusually large in comparison with an Aggregation Unit's normal pattern of trading, or any series of transactions in a single trading session that together lead to an unusually large short position;
- a pattern of transfers of securities between or among Aggregation Units preceding long sales by the Aggregation Units that receive securities;
- trading activity that does not appear to be consistent with the stated strategy or objectives of a particular Aggregation Unit; and
- frequent movement of traders between or among Aggregation Units; and
- review any sale that is unusually large in relation to an Aggregation Unit's normal pattern of trading that merits review on one or more other bases for compliance with the short sale rule.
- The firm must establish and maintain continuous, written records for each Aggregation Unit that include the following information:
- the account number of each trading account designated as part of an Aggregation Unit;
- any permanent or temporary changes in the accounts designated as part of an Aggregation Unit;
- the name of each trader assigned to an Aggregation Unit;
- the name of each person that makes trading decisions for an Aggregation Unit;
- any transfer of securities between Aggregation Units and the reasons for the transfer;
- any transactions conducted by an Aggregation Unit on an agency basis for another Aggregation Unit;
- unusual activities that are reviewed in response to paragraph 8 of this letter.
- the information required by paragraph 6 of this letter regarding the temporarily transfers of traders from one Aggregation Unit to another (e.g., the beginning and ending dates of the transfer and the business reason that the transfer was made); and
- The records required by this paragraph must be preserved for a period of not less than six years, the first two years in an easily accessible place.
The foregoing interpretive relief with respect to NASD Rule 3350 is based solely on your representations and the facts that you have presented to staff, and is strictly limited to the application of NASD Rule 3350 to transactions involving net long positions determined within Aggregation Units in the manner described above. Such transactions should be discontinued, pending presentation of the facts for the NASD's consideration, in the event that any material change occurs with respect to any of those facts or representations.
This interpretive relief is subject to modification or revocation if at any time the NASD determines that such action is necessary or appropriate in furtherance of the purposes of NASD Rule 3350, NASD rules governing just and equitable principles of trade (NASD Rule 2110), NASD rules governing anti-manipulation and anti-fraud (NASD Rule 2120), the anti-manipulation and anti-fraud provisions of the Exchange Act (e.g. Sections 9(a) and 10(b) of the Exchange Act, and Rule 10b-5 thereunder), and any other applicable provision of the NASD's rules and federal securities laws. In addition, broker/dealers relying on this interpretive relief are directed to review carefully NASD Rule 3350 and NASD rules governing just and equitable principles of trade (NASD Rule 2110), NASD rules governing anti-manipulation and anti-fraud (NASD Rule 2120), and the anti-manipulation and anti-fraud provisions of the Exchange Act (e.g. Sections 9 (a) and 10(b) of the Exchange Act, and Rule 10b-5 thereunder).
Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of Nasdaq or NASD Regulation, or the Board of Governors of the NASD. This letter responds only to the issues that you have raised, based on the facts as described, and does not address any other rule or interpretation of the Association, or all the possible regulatory and legal issues involved.
If you have any questions, please feel free to call this office at 202-728-8294.
Robert E. Aber
Senior Vice President and
|cc:||Michael Wolk, NASDR Market Regulation
David Katz, NASDR Market Regulation
1 Your request is made on behalf of the following firms: Bear, Stearns & Co. Inc.; Credit Suisse First Boston Corporation; Deutsche Bank Securities Inc.; Donaldson, Lufkin & Jenrette Securities Corporation; Goldman, Sachs & Co.; J.P. Morgan Securities Inc.; Lehman Brothers Inc.; Merrill Lynch, Pierce, Fenner & Smith Incorporated; Morgan Stanley & Co. Incorporated; Paine Webber Incorporated; Prudential Securities Incorporated; Salomon Smith Barney Inc.; SG Cowen Securities Corporation; and Warburg Dillon Read LLC.
Nasdaq notes that the SEC recently issued a similar no action position relating to SEC Rule 10a-1. See SEC No Action Letter from Richard R. Lindsey to Roger D. Blanc, dated November 23, 1998. The interpretive relief provided herein is intended to be consistent with the aforementioned SEC no-action relief.
2 See NASD Notice to Members 94-68 (Aug. 25, 1994), questions 15 - 21.
3 See id.
4 The independence of the units will be evidenced by a variety of factors, such as separate management structures, location, business purpose, and profit and loss treatment.
5 On occasion, an Aggregation Unit in a firm may handle an order from another Aggregation Unit on an agency basis (which some firms internally book as riskless principal). These transactions would not require aggregation among the Aggregation Units involved, but they would be subject to the recordkeeping requirements in paragraph 9.f. of this letter. The term "coordinates trading" is not intended to cover instructions from a firm risk manager to adjust an Aggregation Unit's risk position without directing the disposition of specific securities.