UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 34-40900 / January 11, 1999 ADMINISTRATIVE PROCEEDING File No. 3-9803 : In the Matter of : ORDER INSTITUTING : PROCEEDINGS PURSUANT CERTAIN MARKET MAKING : TO SECTIONS 15(b) AND ACTIVITIES ON NASDAQ : 21C OF THE SECURITIES : EXCHANGE ACT OF 1934 : AND FINDINGS OF THE : COMMISSION : I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Sections 15(b)(4), 15(b)(6) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against certain individual and entity Respondents identified in Attachment A hereto (collectively, the "Respondents"). II. On the basis of this Order, the accompanying Orders as to the Respondents, and the Respondents’ Offers of Settlement, the Commission finds[1] the following: A. Respondents The Respondents are entities registered with the Commission as broker-dealers pursuant to Section 15(b) of the Exchange Act and individuals who, at relevant times, were associated with such entities or their predecessors. During the relevant time period, all of the entity Respondents or their predecessors were market makers in Nasdaq securities. All of the individual Respondents were at relevant times employed at Nasdaq market-making firms as traders or assistant traders making markets in Nasdaq stocks, institutional or retail salespeople dealing in Nasdaq stocks, or supervisors of Nasdaq trading and sales. B. Other Relevant Entities The Nasdaq Stock Market, Inc. ("Nasdaq") is an electronic interdealer quotation system owned and operated by the National Association of Securities Dealers, Inc. ("NASD"), a national securities association registered with the Commission under Section 15A of the Exchange Act. The Nasdaq market is a dealer market, in which a number of broker-dealers make markets in the same security and execute trades. Making a market consists of standing ready to buy and sell a security at prices and quantities displayed on Nasdaq’s computerized quotation system which links the market makers. The market makers in Nasdaq are required simultaneously to quote two prices: a "bid" price, at which they are willing to buy the security, and an "ask" price, at which they are willing to sell the security. The "inside bid" is the highest prevailing bid price in a stock at any given time, while the "inside ask" is the lowest prevailing asked price.[2] Together, the inside bid and inside ask represent the "inside market." The difference between the inside bid and the inside ask is commonly referred to as the "spread" or "inside spread." As noted in the Commission’s Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and Nasdaq Market, Exchange Act Release 37542 (hereinafter referred to as the "21(a) Report"), most customer orders during the time period in question were executed by market makers at the inside bid or ask.[3] Trades in the Nasdaq market can be executed in a variety of ways, including, without limitation, through telephone calls to other dealers, the Instinet trading system[4], and certain electronic order delivery and execution systems owned and operated by Nasdaq (such as SOES, SelectNet and ACES). The time, price and volume of most transactions must be reported to Nasdaq, which in turn disseminates this information publicly through its electronic network. C. Factual Summary and Legal Analysis On August 8, 1996, the Commission issued the 21(a) Report,[5] which described, among other things, coordination among market makers of quotations and trades that may have advanced or protected their proprietary interests, in a manner that may have been contrary to the best interests of their customers, and that may have created a false or misleading appearance of trading activity in the Nasdaq market. See, 21(a) Report, at Section VI.B. After the issuance of the 21(a) Report, the Commission’s investigation of market making activities in the Nasdaq market continued, and these proceedings result from the continuation of the investigation. The investigation uncovered a number of anticompetitive and improper practices by Nasdaq market makers during 1994 which violated certain provisions of the federal securities laws.[6] Nasdaq market making firms and their traders coordinated their trading and other activities with other market makers to create false or misleading appearances in, or otherwise artificially influence, the market for various Nasdaq stocks. This coordination was primarily accomplished by one market maker asking another to move its quoted prices in order to create a different appearance to the market from which the requesting market maker could benefit, and violated the antifraud provisions of Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder, and the prohibition against fictitious quotations provided in Section 15(c)(2) of the Exchange Act and Rule 15c2-7 thereunder. [7] Nasdaq market makers also engaged in other violations related to their trading of Nasdaq stocks, including failing to provide the best execution of customer orders, intentionally delaying trade reports, failing to honor their quoted prices on Nasdaq, failing to create or maintain required books and records and failing reasonably to establish and enforce policies and procedures to supervise Nasdaq trading personnel with a view to preventing violations of law. Market maker misconduct was typically, but not always, limited in duration and scope to intraday violations relating to particular stocks, but cumulatively had a detrimental impact on the fairness and efficient functioning of the Nasdaq market. Most of the conduct described herein was intended to increase the market makers’ trading profits or otherwise advance their proprietary interests, often at the expense of their customers and other market participants. The following section summarizes the violative practices uncovered and discusses the manner in which the conduct violated the federal securities laws. 1. The Fraudulent Coordination of Quote Movements The most common form of violative activity uncovered by the staff’s investigation was the coordinated entry of bid and/or ask quotations by market makers into the Nasdaq system for the purpose of artificially affecting the price of subsequent transactions. This behavior typically consisted of one market maker soliciting the agreement of a second market maker to change the Nasdaq quotations disseminated by one or both market makers. Although the specific reasons for the coordination of quote movement requests varied from transaction to transaction, all involved obtaining an unfair trading advantage for the participating market makers. These arrangements, which changed the inside spread or harmed customers or other market participants, were not disclosed by the market makers involved in the scheme to other market participants or the Nasdaq market. Such coordinated activity constituted market manipulation in violation of the antifraud provisions of Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder, and the prohibition on the entry of fictitious quotations provided in Section 15(c)(2) of the Exchange Act and Rule 15c2-7 thereunder. Market makers coordinated quote movements in order to create a false or misleading appearance of change in the supply or demand for a particular Nasdaq stock.[8] The coordinated quote movements often involved one market maker moving one of its quotations to or from the inside quotes in order to change the number of market makers at the inside quote, which other market participants could reasonably perceive as an apparent change in the level of buying or selling interest. For example, a market maker needing to buy stock because of a customer order to purchase stock, or a short inventory position, would ask another market maker to move his quote downwards to join the inside ask.[9] The purpose of the requested quote movement was to signal a downward price trend and the apparent addition of supply at the inside ask, thus misleading potential sellers on Nasdaq or Instinet into reducing their price expectations.[10] After the quote movement, the requesting market maker would purchase stock on Nasdaq or Instinet at a reduced price, at the expense of the seller.[11] The same strategy was also employed when the requesting market maker held a customer sell order, or had a long position in its inventory account. In such instances, the request was usually for the other market maker to join the inside bid, in order to signal an upward movement in price.[12] In some instances, market makers entered large orders to buy stock on Instinet that created the appearance of rising demand for the stock, in connection with requesting a quote move from another market maker, in order to induce other market participants to buy the stock on the Nasdaq market (or vice versa to induce other market participants to sell). At times, market makers also asked other market makers to move their quotes in a manner designed to create a new inside bid or ask price for a particular security in order to allow the requesting market maker to execute existing or anticipated customer orders at the new price levels, which benefitted the requesting market maker and disadvantaged its customer(s). In some instances where a customer had submitted a market order to buy stock, a trader would ask a lone market maker on the inside ask to move its ask quotation upwards. This quote movement created a higher inside ask, and the requesting market maker would then sell stock to its customer at the new, higher price.[13] Additionally, institutional investors frequently transacted at prices between the inside bid and ask by a process of negotiation with market makers. Both institutional investors and market makers viewed the prices quoted at the inside spread as benchmarks for these negotiations, and the movement of the inside quotes upwards or downwards tended to move the ultimate transaction price in the direction of the quote move. Thus, changes in the inside quotes allowed market makers in some instances to influence the price even with respect to negotiated trades that were executed between the inside spread. The undisclosed collaboration among market makers was detrimental to the interests of investors. By coordinating quote movements to move the quoted price of a stock up or down, traders facilitated trades at prices that were more favorable for the market makers, often at the expense of their customers or other market participants. Where customer orders were executed at prices detrimental to the customers, the coordinated misconduct also breached market makers’ obligation to provide best execution and deal fairly with their customers.[14] The undisclosed arrangements to move quotations also distorted the appearance of supply and demand in the Nasdaq market, potentially undermining investor confidence and the integrity of widely disseminated trading and market data. 2. Undisclosed Arrangements to Coordinate Quotations Undisclosed arrangements to coordinate quotations are prohibited by Commission rule, even in those cases where such conduct does not have a manipulative impact, such as a change in the inside market, or harm to a customer or other market participant. Section 15(c)(2) of the Exchange Act prohibits a broker or dealer from effecting any transaction or inducing or attempting to induce the purchase or sale of any security in the over-the-counter market by, inter alia, use of fictitious quotations.[15] Exchange Act Rule 15c2-7 defines the term "fictitious quotation" to include any arrangement between two market makers in furtherance of which a quotation is entered, and requires disclosure of the arrangement and of the identities of the market makers participating in the arrangement.[16] Rule 15c2-7 is designed to promote market transparency by ensuring the disclosure of, among other things, the identity of the actual dealer behind a dealer’s quotations.[17] The coordinated entry of Nasdaq quotes for the purpose of altering the inside market, painting a deceptive picture of market conditions, or inducing another market participant into buying or selling at an artificial price constitutes an "arrangement" as that term is used in Rule 15c2-7. [18] Since there was no disclosure of such arrangements to Nasdaq or other market participants, such quotations violated Section 15(c)(2) of the Exchange Act and Rule 15c2-7 thereunder.[19] The investigation also identified a practice whereby one market maker would enlist another market maker to disseminate a quotation to buy or sell Nasdaq stocks on its behalf. In many such instances, the requesting market maker asked the second market maker to join the existing inside bid or ask, or create a new inside market, in the hopes of buying or selling stock.[20] When the second market maker disseminated its quotations as requested, it and the requesting market maker would have been required by the express terms of Rule 15c2-7 to disclose the arrangement to the market.[21] Because market makers occupy a central position in the Nasdaq market, Rule 15c2-7 requires the disclosure of such arrangements among market makers in order to inform the market of the true nature of dealer activity and thereby enhance market integrity and investor confidence. The concealment of the identity of the real market maker disseminating quotes is contrary to the public policy goals of Rule 15c2-7 to promote free and open markets, and prevent fraud and deception. 3. The Intentional Delaying of Trade Reports The investigation revealed a number of instances in which market makers intentionally delayed reports of significant trades to the Nasdaq market.[22] The purpose of delaying these trade reports was to provide the relevant trader with an unfair informational and trading advantage over other market participants. The failure to properly report trades in such cases violated the antifraud provisions of Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder.[23] The investigation uncovered instances in which certain market makers entered into explicit agreements to delay reporting significant trades, and other scenarios where market makers unilaterally failed to report significant trades. This practice of intentionally delaying trade reports typically occurred when a timely report of a significant trade could have moved prices in a direction adverse to the market maker's interests. For example, a market maker that purchased a large amount from a customer selling stock would, either singly or in concert with other market makers, deliberately delay reporting the trade. The purpose of holding the trade report was to avoid the natural downward price movement that would reasonably be expected to result from the report of a large sale of stock by a customer. In order to reduce the long position resulting from its purchase from the customer, the relevant market maker would then sell stock in the open market at a price unaffected by the information contained in the withheld trade report.[24] These market sales were typically executed at higher prices than would have been available if the customer’s trade had been properly reported, to the detriment of the market as a whole, as well as the parties who purchased stock from the market maker. The delay of trade reports under such circumstances was manipulative and resulted in market makers obtaining an unfair and unlawful informational advantage in the market. 4. Other Market Maker Misconduct The investigation uncovered other manipulative activity which violated certain antifraud provisions of the federal securities laws, but did not involve an "arrangement" of the type prohibited by Rule 15c2-7.[25] In certain instances, market makers, directly or through a cooperating market maker, transacted with other market makers that were on the inside bid or inside ask, for the specific purpose of altering the prices at the inside market. In such cases, the transacting market maker was usually holding a customer order to buy or sell.[26] The execution of the customer order was delayed until the inside quote was moved as a result of the transactions. Then, the market maker with the customer order executed the order at the new inside market, which was a worse price for the customer. Such conduct improperly benefitted the market maker and harmed the interests of its customer. 5. Best Execution Violations The investigation uncovered a number of instances in which Nasdaq market makers failed to provide best execution for their customers’ orders. The duty of best execution has generally been defined as the obligation of the broker- dealer to seek to obtain the most favorable terms reasonably available under the circumstances for a customer’s order.[27] When a broker-dealer acting with scienter fails to seek the most favorable price reasonably available under the circumstances for a customer order, the broker has failed to meet its obligation of best execution in violation of the antifraud provisions of Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder.[28] During the relevant time period, best execution violations occurred in a number of different situations. A common denominator in such scenarios was the favoring by the market maker of its own interests, or those of a cooperating market maker, over the interests of its customers. First, as described in Section II.C.1. above, in many instances, market makers’ coordination of quotations allowed them to execute customer orders at artificial prices unfavorable to the customer. In other instances, market makers in the process of executing customer orders sometimes suggested to cooperating market makers on the inside bid or ask that they move away from the inside quote without executing a trade, thereby depriving the customer of a more favorable execution.[29] On occasion, market makers did not execute or cancelled customer trades at advantageous prices in order to maintain good relations with other market makers.[30] Market makers also sometimes entered into "print-splitting" arrangements with other market makers, by which they agreed to share any executions.[31] If a market maker was holding a customer order at the time which was left unfilled as a result of the print-splitting arrangement, the failure to fill the order as promptly as possible violated its best execution obligations. Other violations occurred when market makers sometimes traded with customers at prices outside of the inside spread, with no apparent justification. In certain instances, market makers delayed the execution of large customer orders in order to trade first for their own account at more favorable prices, e.g., by selling stock for their own account first, while delaying the execution of a customer sell order, and later purchasing the customer’s stock at market prices that had been depressed by the market maker’s earlier sales for its own account. Finally, market makers sometimes traded with cooperating market makers at a particular price without filling customer limit orders at the same price,[32] and without advance disclosure of and consent by their customers to their limit order policies.[33] 6. Failure to Honor Quotations Under the Commission’s "firm quote" rule,[34] a market maker is required to execute any order presented to it to buy or sell a security at a price at least as favorable to the buyer or seller as the market maker's published bid or offer and up to its published quotation size.[35] On certain occasions, Nasdaq traders failed to honor the quotations that they disseminated. Market makers backed away from orders presented to them by firms whose trading practices they disliked or for other improper reasons.[36] The failure of Nasdaq market makers to honor their quotations prevented investors from accessing the best advertised price, and reduced liquidity in the market. 7. Failure to Keep Accurate Books and Records In numerous instances, market makers failed to create or maintain records of their trading activity as required by Commission rule.[37] Order tickets frequently had inaccurate or unrecorded time(s) of execution, inaccurate or unrecorded time(s) of entry of a customer order, or failed to note all the terms and conditions of an order. In addition, a number of required records were not maintained by Nasdaq market makers for the prescribed time period. These violations hampered the ability of regulators to scrutinize broker-dealer compliance with investor protection rules. 8. Failure to Reasonably Supervise Nasdaq Trading Under Section 15(b)(4) of the Exchange Act, the Commission may sanction a broker-dealer for failing reasonably to supervise a person under its supervision. Supervision is an essential function of broker-dealers. The Commission has made it clear that it is critical for investor protection that a broker-dealer establish and enforce procedures reasonably designed to supervise its employees. In large organizations in particular, it is imperative that the system of internal control be adequate and effective. A firm’s failure to establish such procedures is symptomatic of a failure to supervise reasonably. The frequency of the violations described herein raised serious questions concerning the adequacy of supervision by the respondent firms of their Nasdaq traders, and the investigation uncovered supervisory deficiencies at numerous of the respondent firms. Most of the respondent firms failed reasonably to supervise with a view to preventing or detecting these violations, in that they did not have adequate policies or procedures in the respects described below. In addition, some respondent firms’ policies and procedures were inadequately documented, promulgated and enforced. a. Inadequate Procedures and Guidelines Concerning Quote Movements Most of the respondent firms did not prescribe procedures or guidelines for their traders or supervisors with respect to conversations with other firms about quotations, requests or offers to move quotations or the coordination of quotations. A few of the respondent firms had limited procedures or guidelines addressing the making or receipt of requests to move quotations in certain limited circumstances, but in no instance were these procedures or guidelines adequate. The procedures or guidelines that existed were sometimes not in writing, which led to differing understandings among supervisors and traders as to the meaning of the procedures or guidelines. Those procedures and guidelines that were in writing were sometimes not disseminated to all personnel engaged in trading Nasdaq stocks or supervising such trading. b. Inadequate Review of Quote Movements In addition, most respondent firms had no procedures or guidelines for reviews by supervisory or compliance personnel designed to uncover potentially violative coordination or collaboration with respect to quotations. A few firms had limited review procedures pertaining to quote movements under certain circumstances, but these procedures were inadequate because they did not sufficiently address the potential problems that could arise from a market maker’s entry of quotations. c. Certain Additional Supervisory Problems In certain respondent firms, the supervisors to whom the head Nasdaq trader reported and the Compliance Departments had little familiarity with Nasdaq market making. Such respondent firms relied on the head Nasdaq trader to perform much or most of the supervisory function, and did not require other personnel, either supervisory or compliance, to become knowledgeable about the activities of the Nasdaq traders. Rather, they expected that the head trader would notify his supervisors of any problems that arose. This supervisory structure was flawed, as the head traders of these firms sometimes themselves engaged in underlying violations, with no effective oversight by their employers. The lack of effective oversight of the head traders was one element in the breakdown of effective supervision. In establishing supervisory and compliance systems, a broker-dealer must be mindful of the risks inherent in having no effective oversight of head traders, since such persons control and often train subordinates, and set an example for subordinates. When head traders themselves engage in violative activity, the supervision process with respect to the rest of the trading desk is effectively undermined. Broker-dealers must have in place policies and procedures reasonably designed to ascertain whether or not traders having supervisory authority, including head traders and other supervisory traders, are themselves in compliance with the law. Another problem uncovered at certain of the respondent firms was that compliance resources were inadequate. Management of certain of the respondent firms purported to have either assigned certain responsibilities to or placed substantial reliance on their firms’ Compliance Departments to carry out significant responsibilities, such as monitoring and reviewing trading activity. Involving the Compliance Departments in such responsibilities may be reasonable when the Compliance Departments are sufficiently knowledgeable about the relevant activities and are provided with resources adequate to perform these tasks effectively. The complexities of the Nasdaq market and trading in Nasdaq stocks will often require, at firms with sizeable Nasdaq trading departments, a substantial commitment of compliance resources. When the Compliance Department’s resources are so limited that it cannot reasonably be expected to perform its duties effectively, both the firm and its management may bear responsibility for failure to supervise. [38] III. Each Respondent has submitted an Offer of Settlement which, as set forth in the accompanying Orders Making Findings and Imposing Sanctions, the Commission has determined to accept. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [1]: The findings herein are solely for the purpose of these proceedings, and all of the respondents did not engage in every type of violative conduct described in this Order Instituting Proceedings. As set forth in the accompanying Orders Making Findings and Imposing Sanctions, the findings herein are binding on each Respondent only to the extent specified in the applicable accompanying Order. The findings herein are not binding on any other person in this or any other proceeding. [2]: The ask price is also sometimes referred to as the "offer" price. [3]: Appendix to the 21(a) Report, p.A-5, text at note 14 (August 8, 1996). [4]: Instinet Corporation, a Delaware corporation, is a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act and a member of the NASD. At all relevant times, Instinet owned and operated a computerized trading system in which Nasdaq stocks, among others, were traded by subscribers to Instinet’s services. Subscribers to the Instinet system traded electronically by placing orders to buy and sell stock that were displayed anonymously on a video screen to other subscribers, who could electronically transact with those orders. As discussed in the 21(a) Report, Instinet was heavily used for interdealer trading of Nasdaq securities. See, 21(a) Report at 18-20. Nothing in this Order is intended to suggest improper or illegal activity by Instinet. [5]: Simultaneously with the issuance of the 21(a) Report, the Commission instituted settled administrative proceedings captioned In the Matter of National Association of Securities Dealers, Inc., Exchange Act Release No. 37538 (Aug. 8, 1996), in which, among other things, the Commission imposed remedial sanctions upon the National Association of Securities Dealers, Inc. In addition, on July 17, 1996, the United States Department of Justice filed a settled civil action against certain Nasdaq market makers which prohibited certain conduct related to market making activities and required certain additional relief. United States v. Alex Brown & Sons, Inc., et al., 96 Civ. 5313 (RWS)(S.D.N.Y. July 17, 1996). [6]: A principal source of evidence in this investigation were audio tape recordings of the telephone lines of a number of Nasdaq market makers. The Commission is not, in this Order, requiring that broker-dealers tape record their sales or trading activities, nor is it suggesting that broker-dealers must, as a matter of course, review the tape recordings they elect to make. However, when an indication of potential wrongdoing comes to the attention of a firm, review of potentially relevant tape recordings may, depending on the circumstances, be a prudent investigative step to take in the reasonable discharge of a firm’s supervisory obligations. In addition, firms that choose to tape record should evaluate their existing supervisory systems to determine whether some means of selectively monitoring such tape recordings would be appropriate in light of the firms’ obligation to reasonably supervise its employees. As a result of such evaluation, a firm may determine that its policies and procedures allow it to reasonably satisfy its supervisory obligations without selectively monitoring tape recordings. The Commission will evaluate the adequacy of a broker-dealer’s supervisory systems in light of all facts and circumstances. [7]: 15 U.S.C. § 78o(c)(1) and (2), and 17 C.F.R. §§ 240.15c1-2 and 15c2-7. [8]: A tape recorded conversation uncovered in the investigation provides an example of such conduct. In this conversation, one market maker asked another to move his bid up to create a higher inside bid in order to foster a false impression of increased demand: Trader 1: Hello. Trader 2: Can you go 1/2 bid in the [nickname] stock? Trader 1: [name of stock]? Trader 2: Yeah. Trader 1: I’m up. Trader 2: I’m trying to make a higher sale. Trader 1: You got it. Trader 2: Thanks. This quote move facilitated a sale by Trader 2 to an institutional customer at a higher price. [9]: Some traders have testified that they acceded to these requests out of an expectation that the requesting market maker would reciprocate in the future. In other cases, the requesting market maker executed a trade at terms favorable to the market maker moving its quote, as compensation for the quote change. Also, some traders received "protection" (i.e., a guarantee against loss) from the requesting market maker, so that they would be reimbursed for any trading losses incurred during the time spent at the inside quotes. In a number of instances, the coordination between cooperating market makers consisted of one volunteering to move its quotes to assist the other in securing a trading advantage. The accommodative trading relationships that existed among certain traders often led them to understand when and how to coordinate their quotations and trading so as to create an improper trading advantage. [10]: A variant of this strategy was to request a market maker already on the inside bid to move down, in order to signal a reduction in demand and a downward movement in price. In some instances, market makers coordinated quote movements with several market makers. [11]: The transactions on Nasdaq were typically executed by telephone. Transactions also occurred on Instinet’s electronic trading system. [12]: Consistent with the description in note 10, supra, if the other market maker was quoting at the inside ask price, the request typically would be to move one’s quotes up from that level, in order to show an apparent reduction in supply. [13]: This type of conduct is illustrated by a taped conversation between two market makers, in which one market maker asks the other to raise his ask price, which results in the creation of a higher inside ask, at which the requesting market maker sells stock to a customer which had previously placed an order to buy: Trader 1: [Name of broker-dealer firm]. Trader 2: Hey [expletive deleted], why don’t you go up, so we can see if we can make a 1/2 sale? Trader 1: Oh, boy, I like the way you think. Trader 2: Yeah? [Expletive deleted]. After Trader 1 raised his ask price as requested, Trader 2 made sales to his customer at the higher inside ask price created by Trader 1’s quote movement (using stock he had purchased from Trader 1 at a price $1/8 below the new inside ask). As a result, both traders benefitted at the expense of Trader 2’s customer. The same strategy was also used for customer sell orders. Sometimes, multiple quote movement requests were made if there were more than one dealer on the inside bid or ask. [14]: See also, section C.5., infra. [15]: 15 U.S.C. § 78o(c)(2). [16]: Rule 15c2-7 applies to Nasdaq quotations. Exchange Act Release No. 7275 (March 24, 1964) (proposing adoption of Rule 15c2-7), notes that "[a]lthough the discussion in this release relates primarily to the [pink] sheets, the rule is applicable to any inter-dealer-quotation-system in which broker-dealers submitting quotations are identified." Moreover, Rule 15c2-7(c)(1) defines the term "inter-dealer- quotation-system" to "mean any system of general circulation to brokers and dealers which regularly disseminates quotations of identified brokers or dealers. . . ." This definition encompasses the Nasdaq system. [17]: See, Exchange Act Release No. 7381 (August 6, 1964) (adopting Rule 15c2-7). See also, Exchange Act Release No. 7275, supra, which states, "[T]he wholesale quotations system is important because it tells at any given time and over spans of time what dealer interest exists, the basic price levels at which particular securities are being bought and sold, and the spread between these levels . . . [T]he depth of dealer interest and the identity of the dealers making a market are extremely pertinent in evaluating the marketability of a particular security." (Emphasis added) [18]: A taped conversation uncovered in the investigation is illustrative. At the time, the firm that employed Traders 1 and 3 was quoting 28 1/2 offered for the stock in question: Trader 1: Hi guy. Trader 2: Hey, tell him [Trader 3] I’m paying 1/2 for 25,000 [name of stock] if he wants to make a print. Trader 1: I’m sorry. What do you got? Trader 2: One-half for 25,000 [name of stock] if he wants to make a print. [Pause while Trader 3 gets on the line.] Trader 3: What are you looking for? Trader 2: Twenty-five. Trader 3: Are you [expletive deleted] kidding me? Trader 2: No. No. I got . . . Listen. Listen, don’t sell me anything. Move up. Trader 3: I just [expletive deleted] plugged about six guys. Trader 2: Did you? Trader 3: Oh, my god. Trader 2: Get up. Get up so I can make a higher sale at least, all right? Trader 3: Sure. In this scenario, Trader 2 refrained from insisting that Trader 3 honor his quoted ask price, but instead requested that he move his firm’s quotes up. Trader 3 moved his firm’s quotes up, as requested. This was intended to facilitate sales by Trader 2 at higher prices. In this instance, the actual benefit realized by Trader 2 from the quote move is unclear, and the scenario was, for the purposes of this proceeding, treated as a violation of Rule 15c2-7 and not the antifraud rules. [19]: The following taped conversation illustrates how market makers intended such quote movements to mislead: Trader 1: Hey, man. What's happening? Trader 2: Hey, uh, this [name of stock]? Trader 1: Yeah. Trader 2: You don't mind jockeying around in this thing for me, do you? Trader 1: Not at all. Do you want me to go up? Trader 2: I'm trying to make a sale on my offering, here. Trader 1: Let me go to the bid. In this scenario, Trader 1 moved his firm’s quotations so that he was bidding the inside bid price. This was intended to assist Trader 2 to sell at a higher price. In this instance, the actual benefit realized by Trader 2 from the quote move is unclear, and the scenario was, for the purposes of this proceeding, treated as a violation of Rule 15c2-7 and not the antifraud rules. [20]: Typically, the market maker acting as "agent" would go to the inside bid to advertise its interest in buying stock, and go to the inside ask to sell stock. Such an arrangement is illustrated by the following taped conversation: Trader 1: . . . Anyway, I got some [name of stock] for sale. Trader 2: You do? Trader 1: And I can’t go down offered at 3/4’s. Could you go down? Trader 2: Absolutely . . . . I’m . . . Trader 1: Are you doing anything at all? Trader 2: I’m working for you. Trader 1: Okay. Trader 2: I’m at 3/4’s. I’m good for at least 5, right? Trader 1: You’re good for 25. Trader 2: Okay. No, I mean, sometimes . . . Trader 1: Right, right, no. Trader 2: Guys want you to move and it’s not . . . . I figured you would be for a decent size. Trader 1: I’m the real thing. Trader 2: I understand. Trader 1: I’m going to follow you down, probably, but I’d like to see the stock down some. Trader 2: Okay. Trader 1: Okay. [21]: See, Adopting Release for Rule 15c2-7, Exchange Act Release No. 7381, at pp. 8-9, in which the Commission, for illustrative purposes, described certain types of conduct that would be deemed to violate Rule 15c2-7. [22]: By NASD rule, all transactions must be reported within ninety seconds. NASD Marketplace Rule 4632 (1998 Manual). As noted above in Section II.B., supra, transactional information is disseminated through the Nasdaq system and is widely available to investors. [23]: 15 U.S.C. § 78o(c)(1), and 17 C.F.R. § 240.15c1-2. [24]: The following taped conversation is illustrative: Trader 1: You’re as bad as me though. No problem. Keep on working. Let me know. I had to buy 15, so. . . . Trader 2: You bought 15? Trader 1: Yeah. I’m long 15,000. I haven’t printed it yet because I didn’t want to see the reaction. [25]: Such conduct violated Exchange Act § 15(c)(1), and Rule 15c1- 2 thereunder. [26]: In some cases, the purpose of moving the market was to engage in proprietary trading at advantageous prices, to the detriment of other market participants. [27]: See, e.g., Sinclair v. S.E.C., 444 F.2d 399 (2d Cir. 1971); Arleen Hughes, 27 S.E.C. 629, 636 (1948), aff’d sub nom. Hughes v. S.E.C., 174 F.2d 969 (D.C. Cir. 1949). This duty applies to market makers transacting as principal with their customers as well as to broker-dealers acting as agents for their customers. In re Merrill Lynch Securities Litigation, 911 F. Supp. 754, 760 (D.N.J. 1995); E.F. Hutton & Co., 49 S.E.C. 829, 832 (1988). Best execution for customer orders is also required by NASD Conduct Rule 2320(a) (1998 Manual) and its predecessor provisions. [28]: See, e.g., Thomson & McKinnon, 43 S.E.C. 785 (1968); Arleen Hughes, supra. See, also, Delaware Management Co., 43 S.E.C. 392 (1967); and Edward Sinclair, 44 S.E.C. 523 (1971). [29]: Under the firm quote rule, Exchange Act Rule 11Ac1-1, 17 C.F.R. § 240.11Ac1-1, a market maker at the inside quote is obligated to execute any order presented to it at that price in an amount up to its published quotation size (usually 1,000 shares during the relevant time period), absent the exceptions provided by the rule. [30]: The following taped conversation depicts a best execution violation involving the cancellation of an earlier agency sale for the account of a customer at a higher price and the re-execution of that trade at a lower price, to the customer’s detriment, for the purpose of fostering goodwill between the executing market maker and the purchasing market maker: Trader 1: OK, you bought some from us today at 8 1/8. Trader 2: Yeah. Trader 1: 5,000 shares. . . . And basically you were the only price that was way out of whack for us. So what I want to do is give you a little gimme over there, but um, hopefully you'll remember us and pay us back some day. But anyway, I want to change the price for you from 8 1/8 to 7 3/4. Trader 2: To 7 3/4. Trader 1: Yup. Trader 2: Oh, my goodness. As indicated by the conversation, Trader 1 cancelled the earlier agency sale he had made to Trader 2 at $8 1/8 per share and resold the stock to Trader 2 at $7 3/4 per share, thereby improperly disadvantaging the customer for whom Trader 1 was selling. [31]: For example, a market maker that bought 10,000 shares subject to a print-splitting arrangement would subsequently sell half that amount to the other party to the agreement, which would reduce the amount of stock available to fill the customer’s order. [32]: In at least one such instance, a trade between two collaborating market makers was done as compensation for complying with a request for a quote movement. [33]: Disclosure to and consent by customers of the firm to its limit order policies would, in any event, have been ineffective after June 29, 1994, when the Commission approved the limit order protection rule known as the first "Manning Rule." See, Securities Exchange Act Release No. 34279 (June 29, 1994). [34]: Exchange Act Rule 11Ac1-1, 17 C.F.R. § 240.11Ac1-1. [35]: A market maker who fails to meet his firm quote rule obligations is said to have "backed away" from its quote. [36]: The following taped conversation is illustrative: Trader 1: Hello. Trader 2: [Third market maker] was out there with me taking the stock? Trader 1: [Third market maker] just bid me for 10, I told him he was late. I don't want to trade with him. [37]: Exchange Act § 17(a) and Rules 17a-3 and 17a-4 thereunder, 15 U.S.C. § 78q(a) and 17 C.F.R. §§ 240.17a-3 and 17a-4. [38]: The senior management of a broker-dealer must, in all circumstances, take reasonable steps to provide for effective supervision at all levels of activity under their control. This is particularly important for firms initiating Nasdaq market making operations with no prior experience in this line of business, as was the case with certain of the respondent firms. New or start up operations pose potentially heightened risks to the firm, because senior management and compliance personnel are often not familiar with them, and particular attention must be paid to the adequacy of supervisory oversight when initiating new activities. ATTACHMENT A Bear Stearns & Co., Inc. and Philip D. Zeifer Cantor Fitzgerald & Co. S.G. Cowen Securities Corp., Kennedy M. Buckley, David D. Dube, Peter M. Gilfillan, John P. Mottes and Richard S. Streifler CS First Boston Corp. Dean Witter Reynolds, Inc. Donaldson, Lufkin & Jenrette Securities Corp. and Lawrence H. Kurtz Gruntal & Co., L.L.C. Hambrecht & Quist LLC and Edward L. Albert Herzog, Heine, Geduld, Inc., Ronald F. Cullen, Jr. and Bradley Zipper J.P. Morgan Securities, Inc., Donald A. Dunworth, Mark A. Gallagher and David J. Mottes Jefferies & Company, Inc. Legg Mason Wood Walker, Incorporated Lehman Brothers Inc. Mayer & Schweitzer, Inc., Robert Burns and Christopher D. Colgan Merrill Lynch, Pierce, Fenner & Smith Incorporated Morgan Stanley & Co., Inc., Peter W. Ferriso, Jr. and Robert S. Ranzman Olde Discount Corp., Jack G. Monopoli, Frank W. Schwarz, III, and John F. Watson, Jr. CIBC Oppenheimer Corp. and William G. Clark, Jr. PaineWebber Inc., Richard A. Bruno, Peter F. Comas, Robert D. Coppola, Gerard Kane, Joseph J. Palma, Arthur A. Raiola, Joseph H. Raiola and Reuben G. Taub Piper Jaffray Inc. and Stacey R. Rickert Prudential Securities Inc., Michael T. Burke, Jr., Joseph G. Candela and Robert D. Sprotte Raymond James & Associates, Inc., Thomas J. Dudenhoefer and Timothy J. Kane The Robinson-Humphrey Company, LLC Salomon Smith Barney Inc. (as successor to Salomon Brothers Inc) Salomon Smith Barney Inc. (formerly known as Smith Barney Inc.), Glenn Y. Blitzer, Barry J. Dusti and George C. Ross, Jr. Sherwood Securities Corp., Brian J. Deegan, Richard M. Marino, Edward G. Schmitz and David M. Zitman Spear, Leeds & Kellogg, L.P. (by virtue of the activities of its Troster Singer division), Michael J. Ling, James P. Morris, John J. Quigley and Eric J. Scherzer Tucker Anthony Inc. Warburg Dillon Read, LLC, Michael R. Antolini, Steven D. Murphy, Joel I. Zweig and David S. Rothman William P. Heenan