January 21, 2000 Mr. Jonathan Katz Secretary United States Securities and Exchange Commission 450 5th Street, N.W. Washington, D.C. 20549 Re: File No. S7-24-99 Dear Mr. Katz: The Island ECN, Inc. ("Island") appreciates the opportunity to comment on a recent concept release issued by the Securities and Exchange Commission (the "Commission") relating to the regulation of short sales of securities (hereinafter, referred to as the "Concept Release"). Island commends the Commission for its decision to examine ways to modernize its regulation of short sales of securities. Island understands and appreciates the challenges faced by the Commission with respect to amending a rule that has gone unchanged for so many years and which tends to generate more emotional than scholarly commentary. Island is an "electronic communications network" ("ECN") within the meaning of paragraph (a)(8) of Rule 11Ac1-1 (the "Quote Rule") and paragraph (a)(7) of Rule 11Ac1-4 (the "Limit Order Display Rule") under the Securities Exchange Act of 1934 (the "Exchange Act"). Island operates an automated, electronic limit order book. The Island limit order book automatically and instantaneously executes all matching orders in accordance with strict price and time priority. The best-priced orders in the Island limit order book are represented in the NASDAQ Level II quotation montage. Orders placed on the Island limit order book have the opportunity to interact with orders of other Island subscribers as well as orders delivered to Island through the Nasdaq SelectNet Linkage. INTRODUCTION Island is theoretically opposed to any regulation that inhibits the free-market pricing mechanisms found in an efficient market. Island believes there is no economic rationale for short sale regulation and that such regulation impedes overall market efficiency. A short sale is simply the use of leverage in connection with a securities transaction. Rule 10a-1 is an unnatural inhibitor of downward price movements where leverage is being employed. Currently, there are no equivalent inhibitors, or pricing restraints, where leverage is being employed in connection with an upward price movement in a security. In addition, there are no such pricing inhibitors found in foreign equity markets, in derivatives markets or in commodity markets. Furthermore, there is no empirical evidence to suggest that the absence of short sale regulations for Nasdaq SmallCap and Bulletin Board securities has resulted in unrestricted short selling activity intended as a manipulative device or as a means of "demoralizing" the market. Island believes that certain market constituents (e.g., issuers) have adopted a distorted perception of Rule 10a-1, or short sale regulation generally, as a result of fierce competition between the NYSE and Nasdaq for listings and the use of short sale regulation by those markets as a sales and marketing tool. Evidence of this is the fact that in 1994 the NASD cited "competitive pressures" as an impetus for adopting its own short sale rule and failed to show empirical evidence of a need for such a rule. In 1976, the Commission proposed the temporary suspension of Rule 10a-1 in order to evaluate the market's need for such a restrictive rule. The Commission noted as a factor in its decision to propose such a suspension "the growing support of academicians and certain self-regulatory organizations for the elimination of short sale regulation except to the extent that short selling is used as a manipulative device." The 1976 Release contained the following discussion regarding the conflict between the "efficient market" theory and the restrictive nature of Rule 10a-1: "The 'efficient markets' theory postulates that, if a market has zero transaction costs, if all available information is costless to all interested parties, and if all participants and potential participants in the market have identical time horizons and homogeneous expectations with respect to prices, that market will be efficient and prices in that market will fluctuate randomly. Those conditions cannot, of course, be met by any market, but economists suggest that a market may be characterized as efficient if information is readily available to a sufficient number of investors, transaction costs are reasonable, and there is no evidence of consistency superior or inferior performance by a significant group of investors participating in the market. Although theorists believe that the existence of even these less stringent conditions cannot be determined directly, there are indications that the necessary conditions for efficiency are reasonably descriptive of actual securities markets. Measuring the existing pattern of short sale regulation against the 'efficient markets' hypothesis, it is argued that such regulation prevents the securities markets from being as efficient as they otherwise would be. By preventing short sales on minus or zero minus ticks, it is argued that investors and market professionals are prevented from translating negative perceptions concerning the value of individual stocks or the value of stocks generally into market action as rapidly as they wish, thereby impeding the market from expressing a valuation of securities on the basis of all available information (including all buying and selling interest) and creating inefficiencies in the pricing mechanism." Island fully supports this position recognized by the Commission as far back as 1976 and the elimination of specific short sale regulations that act as inhibitors of natural market pricing mechanisms. Island does, however, fully support regulations that prohibit the use of short sales as a manipulative device. Despite Island's support for the elimination of short sale regulation, Island understands and appreciates the difficulties faced by the Commission in connection with proposing an elimination of the rule. Therefore, Island strongly recommends that, absent the complete elimination of short sale regulation, the Commission should adopt certain critical modifications to Rule 10a-1. For the reasons set forth below, Island believes that Rule 10a-1 should be amended in the following manner: (i) adopt an actively-traded exclusion for certain securities; (ii) convert the Rule 10a-1 "tick test" to a "bid test;" and (iii) modify the rule to properly function in the after-hours market. CONCEPT RELEASE The purpose of the Commission's Concept Release is to assess whether the restrictions of Rule 10a-1 produce benefits to the markets that are proportionate to the costs associated with those restrictions. While Island believes those costs outweigh the benefits, Island suggests the following modifications be made to Rule 10a-1. 1. Actively Traded Securities Island believes that the Commission should adopt an exclusion from Rule 10a-1 for certain "actively-traded" securities. The Commission has historically concluded that "Rule 10a-1 is not focused solely on preventing manipulative activity." It is this very characteristic of Rule 10a-1 that troubles Island, as well as many academicians and economists. We believe that the Commission should limit the scope of its regulations to guard against manipulation and not to create downward price inhibitors. An exclusion for actively-traded securities could provide an appropriate balance between the Commission's concerns regarding manipulative short selling and short selling used to accelerate a decline. Consistent with the Commission's findings in connection with its adoption of Regulation M, certain actively traded securities are not susceptible to undetected manipulation. Similarly, the use of short selling to accelerate a decline of an actively-trade security can be extremely costly, and thus, less likely to occur. As a result of the development of sophisticated surveillance technologies by self-regulatory organizations ("SROs") to monitor market activity on a real-time basis, short selling with manipulative intent of actively-traded securities is unlikely to go undetected. The SROs' ability to surveil in real-time trading and aggregation of short positions serves as a substantial deterrence function. As a consequence, manipulation of actively-traded securities, whether through abusive short selling or through purchasing during a Regulation M distribution has become "more costly, and its success more uncertain." Note, however, that a sale of a security that is a "short sale" is information that an efficient market should possess and digest. Therefore, Island recommends that, in connection with the adoption of an exclusion for actively-trade securities, the Commission should encourage further transparency of real-time short sale information and improvements in the redistribution of such information to all market participants. Such information is itself a critical component of the efficient market theory. 2. "Bid Test" The current tick test used by Rule 10a-1 is slightly flawed and presents serious compliance difficulties in today's highly automated trading environment. The current tick test relies on the reported last sale price as a reference price. As a result of the SROs' reporting rules, reported last sale data does not reflect real-time market movements but rather sporadic trades executed within a 90 second window of the real execution times. Therefore, the reference price used by Rule 10a-1 has substantial time disconnects with the real market price of a security. Such time disconnects create sporadic up-ticks and down-ticks that do not necessarily relate to the real-time movement of the bid/ask quotations in a security. These time disconnects, combined with current trading volumes, creates rapid-fire, up and down ticks that are extremely difficult to ensure automated compliance with Rule 10a-1. Island believes that the bid quotation contained in the consolidated quotation system reflects the current market of a security. The use of the bid quotation as a reference price would provide a real-time and more accurate depiction of the market while providing the same barrier to accelerations in declining markets. In addition, as a result of decimalization, the last sale price will potentially experience an increase in rapid-fire, up and down ticks given the variety of potential trade prices within a given spread. Such a result makes the tick test extremely difficult to comply with in a manual or highly automated market environment. Conversely, the bid price in a given security, while still volatile, statistically experiences less up and down ticks than the last sale price. Thus, Island believes that Rule 10a-1 should be amended to reflect the bid price as its reference price. Such an amendment would also be beneficial because of a need for a consistent short sale rule across both listed and over-the-counter markets. 3. Short Sales in the After-Hours Market The Commission stated in it's Concept Release that "[i]f the Consolidated Tape does not operate after the close of regular trading hours, short sales can only be executed at a price above the closing price on the Consolidated Tape for the security (or, at the closing price if that price was an up-tick)." The current application of Rule 10a-1 after the close of the consolidated tape is extremely disruptive to the development of an efficient after-hours market for listed securities. Continuous trading was never contemplated when Rule 10a-1 was originally adopted and such an application is not consistent with the rule's intent. Despite concerns over liquidity and fragmentation, the after-hours market is proving to be an extremely liquid trading environment. During this month, Island's average trading volume for its after-hours session exceeds 7,000,000 shares. The overall market has experienced daily after-hours trading volumes that exceed 70,000,000 shares in a single evening. Pursuant to the Commission's approval of the Chicago Stock Exchange's E-Session, the close of the consolidated tape was extended to 6:30 P.M. (EST). Therefore, a reference price for compliance with Rule 10a-1 will be available until 6:30 P.M. Before recommending amendments to Rule 10a-1, Island strongly recommends that the Commission take steps to encourage the consolidated tape (or the consolidated quotation system if the bid test is adopted) to extend its operating hours or to encourage the creation of alternatives to the consolidated tape and the consolidated quotation system. If Rule 10a-1 should continue to apply in the after-hours market, the Commission should modify Rule 10a-1 to allow ATSs operating in the after-hours to rely on their own bid price as a reference price for compliance with the rule. CONCLUSION As stated above, Island is theoretically opposed to any regulation that inhibits the free-market pricing mechanisms found in an efficient market. However, absent the elimination of Rule 10a-1, Island urges the Commission to (i) adopt an actively traded exclusion for certain securities; (ii) convert the Rule 10a-1 "tick test" to a "bid test;" and (iii) modify the rule to properly function in the after-hours market. Thank you for your consideration. Sincerely, Chris Concannon Associate General Counsel The Island ECN, Inc.