In the Matter of the Application of the Nasdaq Stock Market LLC for Registration as a National Securities Exchange; Findings, Opinion, and Order of the Commission

I. Introduction

On March 15, 2001, The Nasdaq Stock Market, Inc. (“Nasdaq”), a subsidiary of the National Association of Securities Dealers, Inc. (“NASD”), submitted to the Securities and Exchange Commission (“Commission”) a Form 1 application (“Form 1”) under the Securities Exchange Act of 1934 (“Exchange Act”), seeking registration as a national securities exchange pursuant to section 6 of the Exchange Act. Notice of the application was published for comment in the Federal Register on June 13, 2001. On November 13, 2001, December 5, 2001, and January 8, 2002, Nasdaq submitted Amendment Nos. 1, 2, and 3, respectively, to its Form 1. The Commission received 82 comment letters in response to the Original Notice and Amendment Nos. 1, 2, and 3.

On August 15, 2005, and September 23, 2005, Nasdaq submitted Amendment Nos. 4 and 5 respectively, to its Form 1. In Amendment Nos. 4 and 5, Nasdaq proposed, among other things, a new corporate structure whereby Nasdaq would become a holding company with two subsidiaries. Nasdaq requested that the Commission grant registration as a national securities exchange to one of its proposed subsidiaries—The Nasdaq Stock Market LLC (“Nasdaq Exchange” or “Exchange”). The Commission published notice of Amendment Nos. 4 and 5 on October 11, 2005. In response to the October 2005 Notice, the Commission received 15 comment letters. On December 13, 2005, Nasdaq submitted a response to comment letters received on Amendment Nos. 4 and 5. On January 13, 2006, Nasdaq submitted Amendment No. 6 to its Form 1.

Nasdaq's original proposal raised significant regulatory concerns. As originally proposed, Nasdaq's exchange would have expanded what has traditionally been recognized as an exchange. In particular, commenters noted that Nasdaq's original application proposed to operate an exchange without intra-market priority rules. Intra-market priority rules require orders in the same securities directed to an exchange to interact with each other. By contrast, Nasdaq had proposed to permit members to report transactions on the Nasdaq exchange without providing price protection to orders displayed in Nasdaq. Commenters argued that if the Commission approved these rules, it would have to reverse its longstanding position that exchanges have a central limit order book with priority over dealer trades on the exchange, and permit other exchanges to adopt similar rules. Commenters also took issue with Nasdaq's broad definition of what it proposed to be a “Nasdaq transaction.” In particular, Nasdaq proposed to include as a “Nasdaq transaction” certain transactions reported to Nasdaq that were executed otherwise than by using the systems of the Nasdaq exchange. In addition, Nasdaq members not required to report such transactions to Nasdaq would be permitted to do so. A number of commenters expressed significant concern about Nasdaq's proposal to permit Nasdaq members to report, to the Nasdaq exchange, trades that had always been considered over-the-counter (“OTC”) market trades.

Nasdaq proposes in Amendment Nos. 4 and 5 to address these concerns by limiting Nasdaq Exchange transactions to only those trades that are executed in the Exchange's systems and to amend its Exchange systems to require executions to occur pursuant to price priority rules. Trades that are executed otherwise than on the Nasdaq Exchange or any other national securities exchange would continue to be reported to the NASD either to its Alternative Display Facility (“ADF”) or its proposed TRF.

In response to the October 2005 Notice, the Commission received several comments in support of Nasdaq's amended application to register the Nasdaq Exchange as a national securities exchange. Specific concerns raised by other commenters are discussed below.

II. Statutory Standards

Under sections 6(b) and 19(a) of the Exchange Act, the Commission shall by order grant a registration as a national securities exchange if it finds that the exchange is so organized and has the capacity to carry out the purposes of the Exchange Act and can comply, and can enforce compliance by its members and persons associated with its members, with the provisions of the Exchange Act, the rules and regulations thereunder, and the rules of the exchange. The rules of the exchange, among other things, must be adequate to insure fair dealing and to protect investors, and may not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.

As discussed in greater detail below, the Commission finds that Nasdaq's application for exchange registration meets the requirements of the Exchange Act and the rules and regulations thereunder. Further, the Commission finds that the proposed rules of the Nasdaq Exchange as proposed in Amendment Nos. 4 and 5 and further amended by Amendment No. 6 are consistent with section 6 of the Exchange Act in that, among other things, they are designed to: (1) Assure fair representation of an exchange's members in the selection of its directors and administration of its affairs and provide that, among other things, one or more directors shall be representative of investors and not be associated with the exchange, or with a broker or dealer; (2) prevent fraudulent and manipulative acts and practices, promote just and equitable principles of trade, foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, remove impediments to and perfect the mechanisms of a free and open market and a national market system; and (3) protect investors and the public interest. The Commission also believes that the rules of the Nasdaq Exchange are consistent with 11A of the Exchange Act. Finally, the Commission finds that the proposed rules of the Nasdaq Exchange do not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.

III. Discussion

A. Corporate Structure

Prior to 2000, Nasdaq was a wholly-owned subsidiary of the NASD. In 2000, the NASD began restructuring its relationship with Nasdaq. As the result of a two-phase private placement of Nasdaq shares, a public offering completed in January 2005, and other dispositions by the NASD of Nasdaq shares, the NASD's ownership interest in Nasdaq has been reduced to about 26%. Notwithstanding its minority ownership interest in Nasdaq, the NASD has retained control of Nasdaq through its ownership of one outstanding share of Series D preferred stock, which gives the NASD the right to cast one vote more than one-half of all votes entitled to be cast at an election by all holders of capital stock of Nasdaq. This share of Series D preferred stock allows the NASD to continue to retain control over Nasdaq. The Series D preferred share will expire when Nasdaq ceases to operate pursuant to the NASD's Plan of Allocation and Delegation of Functions by the NASD to Subsidiaries (“Delegation Plan”).

As noted above, Nasdaq proposes to convert to a holding company (“Nasdaq Holding Company”), which would have two subsidiaries: (1) The Nasdaq Exchange; and (2) The Trade Reporting Facility LLC, which would operate the proposed new NASD TRF. Nasdaq filed its corporate documents for the proposed Nasdaq Holding Company and proposed Exchange. According to Nasdaq, it plans to transfer all or substantially all of its assets and liabilities to the subsidiaries of the Nasdaq Holding Company.

1. Self-Regulatory Function of the Exchange; Relationship between Nasdaq Holding Company and the Nasdaq Exchange; Jurisdiction Over Nasdaq Holding Company

Although Nasdaq Holding Company will not itself carry out regulatory functions, its activities with respect to the operation of the Exchange must be consistent with, and not interfere with, the Exchange's self-regulatory obligations. The proposed Nasdaq Holding Company corporate documents include certain provisions that are designed to maintain the independence of the Nasdaq Exchange's self-regulatory function from the Nasdaq Holding Company, enable the Exchange to operate in a manner that complies with the federal securities laws, including the objectives of sections 6(b) and 19(g) of the Exchange Act, and facilitate the ability of the Exchange and the Commission to fulfill their regulatory and oversight obligations under the Exchange Act. For example, the Nasdaq Holding Company submitted to the Commission's jurisdiction with respect to activities relating to the Nasdaq Exchange, and agreed to provide the Commission with access to its books and records. Nasdaq Holding Company also agreed to keep confidential non-public information relating to the self-regulatory function of the Exchange and not to use such information for any non-regulatory purpose. In addition, the board of directors of the Nasdaq Holding Company, as well as its officers, employees, and agents are required to give due regard to the preservation of the independence of the Exchange's self-regulatory function. Finally, the Nasdaq Holding Company By-Laws require that any changes to the Nasdaq Holding Company Certificate of Incorporation and By-Laws be submitted to the Board of Directors of the Nasdaq Exchange (“Exchange Board”), and, if the Exchange Board determines that such amendment is required to be filed with the Commission pursuant to section 19(b) of the Exchange Act, such change shall not be effective until filed with, or filed with and approved by, the Commission. The Commission believes that these provisions are consistent with the Exchange Act.

The Commission also believes that under section 20(a) of the Exchange Act any person with a controlling interest in the Nasdaq Holding Company would be jointly and severally liable with and to the same extent that Nasdaq Holding Company is liable under any provision 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 creates aiding and abetting liability for any person who knowingly provides substantial assistance to another person in violation of any provision of the Exchange Act or rule thereunder. Further, section 21C of the Exchange Act 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.

2. Changes in Control of the Nasdaq Exchange; Ownership and Voting Limitations

The Nasdaq Holding Company's Restated Certificate of Incorporation imposes limits on direct and indirect changes in control, which are designed to prevent any shareholder from exercising undue control over the operation of the Exchange and to ensure that the Exchange and the Commission are able to carry out their regulatory obligations under the Exchange Act. Specifically, no person who beneficially owns shares of common stock, preferred stock, or notes in excess of five percent of the securities generally entitled to vote may vote the shares in excess of five percent. This five percent voting limitation does not apply, however, to the NASD or its affiliates until such time as the NASD beneficially owns five percent or less of Nasdaq's outstanding stock or notes. In addition, the Nasdaq Holding Company Board may approve exemptions from the five percent voting limitation for any person that is not a broker-dealer, an affiliate of a broker-dealer, or a person subject to a statutory disqualification under section 3(a)(39) of the Exchange Act. Any such exemption from the five percent voting limitation would not be effective until approved by the Commission pursuant to section 19 of the Exchange Act.

The Nasdaq Exchange's proposed rules also prohibit Exchange members and persons associated with Exchange members from beneficially owning more than 20 percent of the then-outstanding voting securities of the Nasdaq Holding Company. Members that trade on an exchange traditionally have ownership interests in such exchange. As the Commission has noted in the past, however, a member's interest in an exchange could become so large as to cast doubt on whether the exchange can fairly and objectively exercise its self-regulatory responsibilities with respect to that member. A member that is a controlling shareholder of an exchange might be tempted to exercise that controlling influence by directing the exchange to refrain from, or the exchange may hesitate to, diligently monitor and surveil the member's conduct or diligently enforce its rules and the Federal securities laws with respect to conduct by the member that violates such provisions.

The Commission believes that these ownership and voting restrictions are consistent with the Exchange Act. These ownership limitations should minimize the potential that a person could improperly interfere with or restrict the ability of the Commission or the Exchange to effectively carry out their regulatory oversight responsibilities under the Exchange Act.

3. The Nasdaq Exchange

Nasdaq has applied to the Commission to register its wholly-owned subsidiary, the Nasdaq Exchange, as a national securities exchange. As part of its exchange application, Nasdaq has filed the proposed Nasdaq Exchange Limited Liability Company Agreement (“Exchange LLC Agreement”) and Exchange By-Laws. In these documents, among other things, Nasdaq establishes the composition of the Exchange Board and the Exchange committees.

a. The Nasdaq Exchange Board of Directors

The Exchange Board will be the governing body of the Nasdaq Exchange and possess all of the powers necessary for the management of the business and affairs of the Nasdaq Exchange and the execution of its responsibilities as an SRO. Under the Exchange By-Laws:

• Twenty percent of the directors on the Exchange Board will be “Member Representative Directors;”

• The number of “Non-Industry Directors” will equal or exceed the sum of the number of “Industry Directors” and “Member Representative Directors;”

• The Exchange Board will include at least one “Public Director;”

• The Exchange Board will include at least one issuer representative (or at least two if the Exchange Board consists of ten or more members); and

• Up to two officers of the Nasdaq Exchange (“Staff Directors”) may be elected to the Exchange Board.

On December 14, 2005, Nasdaq Holding Company elected the initial directors of the Exchange Board pursuant to the Exchange LLC Agreement. The initial Exchange Board is the current Board of Directors of the Nasdaq Holding Company who were elected pursuant to the procedures set forth in the current Nasdaq By-Laws. The initial Exchange Board is balanced: the number of Non-Industry Directors exceeds the number of Industry Directors and there are four Public Directors and four issuer representatives. These Directors were selected by the Nasdaq Nominating Committee, and elected by a majority vote of the Board of Governors of the NASD, which includes representatives of NASD members. No Nasdaq Exchange members participated in the selection of directors for the initial board because the Exchange does not yet have members. In light of these circumstances, and Nasdaq's representation that it expects to elect a new Exchange Board at the same time the Nasdaq Holding Company holds its annual meeting in Spring 2006, the Commission believes that the initial Exchange Board is consistent with the Exchange Act.

For subsequent boards, the Exchange Board will appoint a Nominating Committee and a Member Nominating Committee. The Member Nominating Committee will nominate candidates for each Member Representative Director position on the Exchange Board, as well as nominate candidates for appointment by the Exchange Board for each vacant or new position on a committee that is to be filled with a Member Representative under the Exchange By-Laws. Additional candidates may be added to the list of candidates for the Member Representative Director positions if a Nasdaq Exchange Member submits a timely and duly executed written nomination to the Secretary of the Nasdaq Exchange. These candidates, together with those nominated by the Member Nominating Committee, will then be presented to Exchange members for election. The Nominating Committee will nominate candidates for all other vacant or new Director positions on the Exchange Board, the Nasdaq Listing and Hearing Review Council, and the Nasdaq Review Council.

The Commission believes that the requirement in the Exchange By-Laws that twenty percent of the directors be “Member Representative Directors” and the means by which they are elected by members provides for the fair representation of members in the selection of directors and the administration of the Exchange consistent with the requirement in section 6(b)(3) of the Exchange Act. This requirement helps to ensure that members have a voice in the use of self-regulatory authority, and that an exchange is administered in a way that is equitable to all those who trade on its market or through its facilities.

The Commission has previously stated its belief that the inclusion of public, non-industry representatives on exchange oversight bodies is critical to an exchange's ability to protect the public interest. Further, public representatives help to ensure that no single group of market participants has the ability to systematically disadvantage other market participants through the exchange governance process. The Commission believes that public directors can provide unique, unbiased perspectives, which should enhance the ability of the Exchange Board to address issues in a non-discriminatory fashion and foster the integrity of the Nasdaq Exchange. The Commission believes that the Nasdaq Exchange Board satisfies the requirements in section 6(b)(3) of the Exchange Act, which requires that one or more directors be representative of issuers and investors and not be associated with a member of the exchange, or with a broker or dealer.

b. The Nasdaq Exchange Committees

In the Exchange By-Laws, the Nasdaq Exchange has proposed to establish several committees. Specifically, the Exchange has proposed to establish the following committees that would be composed solely of directors: An Executive Committee, a Finance Committee, a Management Compensation Committee, an Audit Committee, and a ROC. In addition, the Exchange has proposed to establish these other committees that are not required to be composed solely of directors: a Nasdaq Listing and Hearing Review Committee, a Nasdaq Review Council (“NRC”), a Nominating Committee, a Member Nominating Committee, a Quality of Markets Committee, a Market Operations Review Committee, an Arbitration and Mediation Committee, and a Market Regulation Committee. The Commission believes that the Exchange's proposed committees should enable it to carry out its responsibilities under the Exchange Act.

The Exchange has proposed that the composition of certain committees be consistent with the 1996 Settlement Order. These committees include the Nominating Committee, the Quality of Markets Committee, the Arbitration and Mediation Committee, the Market Regulation Committee, the NRC, the Management Compensation Committee, and the Audit Committee. Each of these committees is compositionally balanced as they each must be composed of at least 50 percent Non-Industry members. The Commission believes that these committees' compositional balance is consistent with the 1996 Settlement Order.

B. Regulation of the Nasdaq Exchange

As a prerequisite for the Commission's approval of an exchange's application for registration, an exchange must be organized and have the capacity to carry out the purposes of the Exchange Act. Specifically, an exchange must be able to enforce compliance by its members, and persons associated with its members, with the federal securities laws and the rules of the exchange.

1. Membership

Nasdaq proposes that the criteria for membership in the Nasdaq Exchange be substantially the same as the criteria currently applicable to firms applying for membership in the NASD. Unlike the NASD rules, however, the Nasdaq Exchange's proposed rules require a broker-dealer to be a member of at least one other SRO before applying for membership in the Exchange and to remain a member of another SRO.

Current NASD members will be able to apply through an expedited process to become a Nasdaq Exchange member, and to register with the Exchange all of their associated persons whose registrations were approved with the NASD, by submitting a Waive-in Membership Application Form and a Membership Agreement. All of the firm's associated persons who are registered in categories recognized by Exchange rules would become registered persons of a Nasdaq Exchange member firm.

Broker-dealers that are not members of the NASD and new broker-dealers that are not yet members of another SRO may apply for membership in the Nasdaq Exchange and comply with the Exchange Rule 1010 Series. Firms that apply to become both NASD and Exchange members simultaneously may file one full membership application with the NASD in compliance with the NASD Rule 1010 Series. New broker-dealers that wish to become members of the Nasdaq Exchange and an SRO other than the NASD must submit a complete application form with all of the information required of new applicants in Exchange Rule 1013(a)(2). The Nasdaq Exchange will consider the application for membership in the Exchange after its membership in the other SRO has been approved.

The Exchange has contracted with NASD Regulation (“NASDR”), the NASD's wholly-owned subsidiary, to which the NASD has delegated the performance of certain of its regulatory obligations, to perform certain regulatory functions on its behalf (the “Regulatory Contract”). Under the Regulatory Contract, NASDR will perform certain membership functions for the Nasdaq Exchange. Specifically, NASDR will accept and review all applications for membership in the Exchange, and receive and process membership applications through the Central Registration Depository (“CRD”) system pursuant to the Exchange's membership rules. NASDR will evaluate the applications and make recommendations to the Exchange about whether they should be approved or denied. The Nasdaq Exchange will make the ultimate decision on whether to accept a broker-dealer as a member.

Appeals of staff denials of membership will be heard by the NRC. Decisions of this committee will be final, but may be called for review by the Exchange Board. This process is consistent with the current process by which the NASD Board of Directors may call for review membership decisions made by the NASD's National Adjudicatory Council.

The Nasdaq Exchange also proposes to require that all broker-dealer applicants include an original Nasdaq Exchange-approved fingerprint card for each associated person of the applicant subject to section 17(f)(2) of the Exchange Act and Rule 17f-2 thereunder for whom a fingerprint card has not been filed with another SRO. The Nasdaq Exchange's rules also permit the Exchange to make the registration of a person effective pending receipt of a fingerprint card. Section 17(f)(2) of the Exchange Act and Rule 17f-2(a) thereunder states that every member of a national securities exchange shall require that each of its partners, directors, officers and employees be fingerprinted, and shall submit such fingerprints, or cause the fingerprints, to be submitted to the Attorney General of the United States for identification and appropriate processing. Exchange Act Rule 17f-2(c) permits a national securities exchange to file a fingerprint plan with the Commission that will facilitate the submission of fingerprints to the Attorney General. Because the Exchange's rules contemplate that the Exchange will facilitate the submission of fingerprints to the Attorney General on behalf of its members as permitted by Exchange Act Rule 17f-2(c), as a condition to the operation of the Nasdaq Exchange, a fingerprint plan must be filed by the Nasdaq Exchange under Exchange Act Rule 17f-2 and declared effective by the Commission.

The Commission finds that the Nasdaq Exchange's membership rules are consistent with section 6 of the Exchange Act, specifically section 6(b)(2) of the Exchange Act, which requires that a national securities exchange have rules that provide that any registered broker or dealer may become a member and any person may become associated with an exchange member. The Commission notes that pursuant to section 6(c) of the Exchange Act, an exchange must deny membership to non-registered broker-dealers and registered broker-dealers that do not satisfy certain standards, such as financial responsibility or operational capacity. As a registered exchange, the Nasdaq Exchange must independently determine if an applicant satisfies the standards set forth in the Exchange Act, regardless of whether an applicant is a member of another SRO.

2. Regulatory Independence—the Chief Regulatory Officer and Regulatory Oversight Committee

Nasdaq proposes to create an Exchange Board committee, the ROC, that would be composed of independent directors. The ROC would consist of three members, each of whom must be a Public Director and “independent director” as defined by Nasdaq Exchange Rule 4200. The ROC would be responsible for monitoring the adequacy and effectiveness of the Exchange's regulatory program, assessing the Exchange's regulatory performance, assisting the Exchange Board in reviewing the Exchange's regulatory plan and the overall effectiveness of the Exchange's regulatory functions.

The ROC would also meet with the Chief Regulatory Officer (“CRO”) in executive session at regularly scheduled meetings and at any time upon request of the CRO or any member of the ROC. The ROC would also be informed about the CRO's compensation, promotion, or termination (including reasons). Finally, the regulatory budget would be presented to the ROC so that its members may inquire as to the adequacy of resources available for the Nasdaq Exchange's regulatory program.

Nasdaq proposes that its CRO have general supervision of the regulatory operations of the Exchange, including overseeing surveillance, examination, and enforcement functions. The CRO also would administer any regulatory services agreement with another SRO to which the Nasdaq Exchange is a party. The CRO would be an Executive Vice President or Senior Vice President that reports directly to the Chief Executive Officer. The CRO may also serve as the Nasdaq Exchange's General Counsel.

In addition, the Nasdaq Exchange has created an independent regulatory department, Nasdaq Regulation, for the purpose of functionally separating its regulatory functions from its business lines. Nasdaq Regulation will carry out many of the Nasdaq Exchange's regulatory functions, including administering its membership and disciplinary rules.

In the October 2005 Notice, the Commission requested comment on whether the Nasdaq Exchange's proposed regulatory structure, including the ROC and CRO, insulate its regulatory functions from its market and other commercial interests so that it could carry out its regulatory obligations. In response, the Commission received two comment letters. Both commenters supported the Exchange's proposed regulatory structure.

The Commission believes that, in this context, the Exchange's proposal is consistent with the statutory requirements. In addition, the Commission believes that the Nasdaq Exchange's proposal is consistent with the 1996 Settlement Order.

3. The Regulatory Contract

Although the Exchange will be an SRO with all of the attendant regulatory obligations under the Exchange Act, it has entered into the Regulatory Contract with NASDR, under which NASDR will perform certain regulatory functions on its behalf. Notwithstanding the Regulatory Contract, the Exchange will retain ultimate legal responsibility for the regulation of its members and its market. This contract is intended to reflect the current relationship that Nasdaq and NASDR have and accordingly, NASDR will be performing for the Nasdaq Exchange the same regulatory functions it currently performs for Nasdaq as a facility of the NASD.

In addition to performing certain membership functions for the Nasdaq Exchange, NASDR will perform certain disciplinary and enforcement functions for the Exchange. Generally, NASDR will investigate members, issue complaints, and conduct hearings pursuant to the Exchange's rules. Appeals of disciplinary hearings, however, will be handled by the NRC.¹⁰⁹

The Commission has previously stated that it would consider whether it would be consistent with the public interest for an exchange to contract with another SRO to perform certain regulatory functions. In this case, the Commission believes that it is consistent with the Exchange Act and the public interest to allow the Exchange to contract with NASDR to perform membership, disciplinary, and enforcement functions. Membership, discipline, and enforcement are fundamental elements to a regulatory program, and constitute core self-regulatory functions. It is essential to the public interest and the protection of investors that these functions are carried out in an exemplary manner, and the Commission believes that NASDR has the expertise and experience to perform these functions on behalf of the Nasdaq Exchange.

At the same time, the Commission believes that, unless relieved by the Commission of its responsibility, the Nasdaq Exchange bears the responsibility for self-regulatory conduct and primary liability for self-regulatory failures, not the SRO retained to perform regulatory functions on the Exchange's behalf. In performing these functions, however, NASDR may nonetheless bear liability, in appropriate circumstances, for causing or aiding and abetting the failure of the Exchange to perform its regulatory functions. Accordingly, although NASDR will not act on its own behalf under its SRO responsibilities in carrying out these regulatory services for the Nasdaq Exchange, NASDR also may have secondary liability if, for example, the Commission finds that the contracted functions are being performed so inadequately as to cause a violation of the Federal securities laws by the Nasdaq Exchange.

4. Rule 17d-2 Agreements

Section 19(g)(1) of the Exchange Act requires every SRO to examine its members and persons associated with its members and to enforce compliance with the federal securities laws and the SRO's own rules, unless the SRO is relieved of this responsibility pursuant to section 17(d) of the Exchange Act. Section 17(d) was intended, in part, to eliminate unnecessary multiple examinations and regulatory duplication with respect to members of more than one SRO (“common members”). Rule 17d-2 of the Exchange Act permits SROs to propose joint plans allocating regulatory responsibilities concerning common members. These agreements, which must be filed with and approved by the Commission, generally cover such regulatory functions as personnel registration, branch office examinations, and sales practices. Commission approval of a 17d-2 plan relieves the specified SRO of those regulatory responsibilities allocated by the plan to another SRO. Many existing SROs have entered into such agreements.

Nasdaq has represented to the Commission that the Nasdaq Exchange and the NASD intend to file a Rule 17d-2 agreement with the Commission covering common members of the Nasdaq Exchange and the NASD. The Nasdaq Exchange represented that this agreement would allocate to the NASD regulatory responsibility, with respect to common members, the following:

(1) The NASD will receive and process in the CRD applications, reports, information, filings, fingerprint cards, and notices generally relating to the status of an associated person of a common member, and registration as a principle or representative of any type, or any other type of employee of a common member required to register or pass a qualification examination under the Nasdaq Exchange rules.

(2) The NASD will receive and process notices, filings, or registrations for the branch offices of common members of the Nasdaq Exchange and the NASD, including notices, filings, or registrations to designate offices of supervisory jurisdiction.

(3) The NASD will examine common members of the Nasdaq Exchange and the NASD for compliance with Federal securities laws, rules and regulations, and rules of the Nasdaq Exchange that have been certified by the Nasdaq Exchange as identical or substantially similar to the NASD rules.

(4) The NASD will investigate common members of the Nasdaq Exchange and the NASD for apparent violations of Federal securities laws, rules or regulations, or Nasdaq Exchange rules that has been certified by the Nasdaq Exchange as identical or substantially identical to an NASD rule.

(5) The NASD will enforce compliance with Federal securities laws, rules and regulations, and rules of the Nasdaq Exchange that have been certified by Nasdaq as identical or substantially similar to the NASD rules.

Because the Nasdaq Exchange anticipates entering into this 17d-2 agreement, it has not made provisions to fulfill the regulatory obligations that would be undertaken by the NASD under this agreement with respect to common members of the Nasdaq Exchange and the NASD. Accordingly, the Commission is conditioning the operation of the Nasdaq Exchange on approval by the Commission of a 17d-2 agreement between the Nasdaq Exchange and the NASD that allocates the above specified matters to the NASD.

5. Discipline and Oversight of Members

As a prerequisite for the Commission approval of an exchange's application for registration, an exchange must be organized and have the capacity to carry out the purposes of the Exchange Act. Specifically, an exchange must be able to enforce compliance by its members and persons associated with its members with Federal securities laws and the rules of the exchange. As noted above, pursuant to the Regulatory Contract, NASDR will perform many of the initial disciplinary processes on behalf of the Exchange. For example, NASDR will investigate claims of securities laws violations, issue complaints, and conduct hearings pursuant to Nasdaq Exchange rules. Appeals from disciplinary decisions will be heard by the NRC. Thereafter, the NRC may affirm, reverse, or otherwise modify the decision of the Hearing Panel, and must submit a proposed written decision to the Exchange Board, which will become final unless the matter is called for review by any Director. After review, the Exchange Board may affirm, reverse, modify, and increase or reduce any sanction, or impose any other fitting sanction.

The Nasdaq Exchange's By-Laws and rules provide that it has disciplinary jurisdiction over its members so that it can enforce its members' compliance with its rules and the Federal securities laws. The Exchange's rules also permit it to sanction members for violations of its rules and violations of the Federal securities laws by, among other things, expelling or suspending members, limiting members' activities, functions, or operations, fining or censuring members, or suspending or barring a person from being associated with a member. The Nasdaq Exchange's rules also provide for the imposition of fines for minor rule violations in lieu of commencing disciplinary proceedings. Accordingly, as a condition to the operation of the Nasdaq Exchange, a Minor Rule Violation Plan (“MRVP”) filed by the Nasdaq Exchange under Exchange Act Rule 19d-1(c)(2) must be declared effective by the Commission.

The Nasdaq Exchange will operate MarketWatch, a real-time surveillance department. MarketWatch will perform this real-time intraday surveillance over all Nasdaq Exchange-listed companies and all Nasdaq Exchange market participants. More specifically, MarketWatch will oversee the complete and timely disclosure of Nasdaq Exchange issuers' material information to determine if a trading halt is necessary to maintain an orderly market for the release of material news. In addition, MarketWatch, through its automated detection system, will monitor the trading activity of each security and will generate a price and volume alert to aid in the assessment of unusual market activity. MarketWatch will also coordinate and execute the release of initial public offerings; administer market participants' excused withdrawals and passive market making requests; and handle the clearly erroneous trade adjudication process. If MarketWatch observes any activity that may involve a violation of Commission or Nasdaq Exchange rules, MarketWatch will immediately refer the activity to NASDR's Market Regulation Department for further investigation and potential disciplinary action.

The Commission finds that the Nasdaq Exchange's By-Laws and rules concerning its disciplinary and oversight programs are consistent with the requirements of sections 6(b)(6) and 6(b)(7) of the Exchange Act in that they provide fair procedures for the disciplining of members and persons associated with members. The Commission further finds that the rules of the Exchange provide it with the ability to comply, and with the authority to enforce compliance by its members and persons associated with its members, with the provisions of the Exchange Act, the rules and regulations thereunder, and the rules of the Nasdaq Exchange.

6. Order Audit Trail System

Under the Nasdaq Exchange rules, Nasdaq Exchange members will be required to comply with the NASD's Order Audit Trail System (“OATS”) requirements. Because Exchange members will report order information to OATS pursuant to the Nasdaq Exchange rules, the Exchange will have the right of access to OATS data for regulatory purposes. In the October 2005 Notice, the Commission specifically requested comment on the extent to which the Nasdaq Exchange should be able to use OATS data for non-regulatory purposes and whether it should have access to OATS data regarding: (1) All orders its members receive, including those orders that are routed to markets other than the Exchange; and (2) reports of executions by its members that are reported to the new TRF.

The Commission received two comment letters addressing these issues. One commenter stated that it was its understanding that the Nasdaq Exchange's sole use of OATS information would be for regulatory purposes and if that understanding were incorrect, it objects to the Exchange's access to such information for non-regulatory purposes. A second commenter argued that the Nasdaq Exchange should not have access to OATS data regarding orders and executions by its members that are executed off the Exchange and that the Exchange should not be permitted to use OATS data for non-regulatory purposes. This commenter, however, said that if the Exchange is permitted to use OATS data for non-regulatory purposes, access to such data for non-regulatory purposes should be granted to other markets or any other person who requests the data.

The Commission shares commenters' concerns about the use by the Nasdaq Exchange of OATS information for non-regulatory purposes, particularly since it includes information about members' trading activities on competitors of the Exchange. The Nasdaq Exchange's OATS rules would require Exchange members to report, on a daily basis, extensive information with respect to the handling of orders for Nasdaq securities, including when all or portions of orders are executed on markets other than the Nasdaq Exchange. A member's failure to provide this information could give rise to disciplinary action by the Exchange pursuant to its authority as a self-regulatory organization under the Exchange Act. Because this information is obtained from members through the exercise of the Exchange's regulatory powers, the Commission does not believe it should be used for non-regulatory purposes, unless the NASD makes available such OATS data to other market participants on the same terms as it is provided to the Nasdaq Exchange.

C. Trading System

1. Trading Rules

In Amendment No. 4, Nasdaq proposed that only trades executed on the Nasdaq Exchange systems would be considered exchange trades. Currently, the Nasdaq systems that would be the Exchange's systems are the Nasdaq Market Center, formerly known as SuperMontage, Brut, and INET.

The Nasdaq Exchange's proposed Nasdaq Market Center rules require price priority. The rules, with limited exceptions, also require time priority. Accordingly, the Nasdaq Exchange's proposed Nasdaq Market Center rules differ from current NASD rules governing the Nasdaq Market Center as follows:

(1) The Exchange's rules do not include the priority rule that first executes an incoming order against the submitting member's own interest reflected in the Nasdaq Market Center at the best price, irrespective of whether the member has time priority; and

(2) The Exchange's rules do not permit preferenced orders by members, which permit trades to occur outside of time priority.

In addition to the Nasdaq Market Center, Nasdaq currently owns and operates two other trading systems—the Brut Facility and the INET Facility. Nasdaq proposes to integrate its three execution systems into a single trading platform with an integrated quote/order book operated in accordance with a unified price priority execution algorithm prior to the end of September 2006. Nasdaq has also represented that upon completion of this systems integration there will be a single integrated book where all orders interact with each other. If the Nasdaq Exchange satisfies each of the conditions required for it to begin operating as an exchange set forth in this Order prior to completing integration of the three systems, the Nasdaq Exchange may temporarily operate as many as three separate trading facilities, each of which trades the same securities, but do not fully interact with each other.

The Commission believes that it is beneficial for orders in the same securities directed to an exchange to interact with each other. Such interaction promotes efficient exchange trading and protects investors by assuring that orders are executed pursuant to a single set of priority rules that are consistently and fairly applied. For example, consolidating the limit orders received by an exchange within a single trading facility affords an opportunity for such orders to be executed in accordance with price priority, which may not be available when an exchange's orders are directed among multiple trading facilities.

Nasdaq's operation of three trading facilities is due to recent acquisitions by Nasdaq. Nasdaq has represented that it is in the process of combining these three trading systems into one system, which Nasdaq proposes to complete by September 30, 2006. Both Brut and INET were operating as alternative trading systems prior to Nasdaq's acquisition, and are important trading markets with participants that rely on their continuing availability. The Commission believes that it is in the public interest for Brut and INET to be available while Nasdaq is integrating them together with its Nasdaq Market Center and, thus, for this limited period of time it is consistent with the Exchange Act for the Nasdaq Exchange to operate as many as three separate trading system until September 30, 2006.

2. Trade Reporting Facility

In a separate filing with the Commission, the NASD proposes to establish a new Trade Reporting Facility to provide NASD members with a mechanism for reporting transactions in all exchange-listed securities executed otherwise than on an exchange. In commenting on Nasdaq's application for exchange registration, several commenters criticized this NASD proposal. These commenters contend, among other things, that because of the affiliation between the Nasdaq Exchange and the limited liability company that will operate the TRF, the Trade Reporting Facility would not really be a facility of the NASD, but instead would be a facility of the Nasdaq Exchange. At such time as the Commission considers the TRF proposal, it will take these comments into account.

3. Market Maker Obligations

Nasdaq Exchange members may register as Nasdaq Market Makers or ITS/CAES Market Makers. As market makers, these members must engage in a course of dealings for their own account to assist in the maintenance, insofar as reasonably practicable, of fair and orderly markets. In addition, Nasdaq Market Makers and ITS/CAES Market Makers, among other things, must maintain continuous two-sided quotes, that are firm, with a minimum quotation increment of $0.01. The Commission believes that these requirements are consistent with the Exchange Act because they should help to ensure that Nasdaq Market Makers and ITS/CAES Market Makers perform their obligations in a manner that promotes just and equitable principles of trade.

4. Section 11 of the Exchange Act

Section 11(a)(1) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on that exchange for its own account, the account of an associated person, or an account over which it or its associated person exercises discretion (collectively, “covered accounts”) unless an exception applies. Rule 11a2-2(T) under the Exchange Act, known as the “effect versus execute” rule, provides exchange members with an exemption from the section 11(a)(1) prohibition. Rule 11a2-2(T) permits an exchange member, subject to certain conditions, to effect transactions for covered accounts by arranging for an unaffiliated member to execute the transactions on the exchange. To comply with Rule 11a2-2(T)'s conditions, a member (i) must transmit the order from off the exchange floor; (ii) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution; (iii) may not be affiliated with the executing member; and (iv) with respect to an account over which the member has investment discretion, neither the member nor its associated person may retain any compensation in connection with effecting the transaction except as provided in the Rule.

In a letter to the Commission, Nasdaq requested that the Commission concur with Nasdaq's conclusion that Nasdaq Exchange members that enter orders into Nasdaq Market Center, Brut, and INET (collectively “Nasdaq Execution Systems”) satisfy the requirements of Exchange Act Rule 11a2-2(T). For reasons set forth below, the Commission believes that Nasdaq Exchange members entering orders into the Nasdaq Execution Systems would satisfy the conditions of the Rule.

The Rule's first condition is that orders for covered accounts be transmitted from off the exchange floor. The Nasdaq Execution Systems receive orders electronically through remote terminals or computer-to-computer interfaces. In the context of other automated trading systems, the Commission has found that the off-floor transmission requirement is met if a covered account order is transmitted from a remote location directly to an exchange's floor by electronic means. Since the Nasdaq Execution Systems receive orders electronically through remote terminals or computer-to-computer interfaces, the Commission believes that the Nasdaq Execution Systems satisfy the off-floor transmission requirement.

Second, the rule requires that the member not participate in the execution of its order. Nasdaq represented that at no time following the submission of an order is a member able to acquire control or influence over the result or timing of an order's execution. According to Nasdaq, the execution of a member's order is determined solely by what orders, bids, or offers are present in the system at the time the member submits the order. Accordingly, the Commission believes that a Nasdaq Exchange member does not participate in the execution of an order submitted into the Nasdaq Execution Systems.

Third, Rule 11a2-2(T) requires that the order be executed by an exchange member who is unaffiliated with the member initiating the order. The Commission has stated that the requirement is satisfied when automated exchange facilities, such as the Nasdaq Execution Systems, are used.

Fourth, in the case of a transaction effected for an account with respect to which the initiating member or an associated person thereof exercises investment discretion, neither the initiating member nor any associated person thereof may retain any compensation in connection with effecting the transaction, unless the person authorized to transact business for the account has expressly provided otherwise by written contract referring to section 11(a) of the Exchange Act and Rule 11a2-2(T). Nasdaq represented that Nasdaq Exchange members trading for covered accounts over which they exercise investment discretion must comply with this condition in order to rely on the rule's exemption.

5. Short Sale Rule

a. Background

Section 10(a) of the Exchange Act gives the Commission plenary authority over short sales of securities registered on a national securities exchange as necessary or appropriate in the public interest or for the protection of investors. The Commission adopted Rule 10a-1 in 1938 in order to restrict short selling in a declining market. Paragraph (a) of Rule 10a-1 generally covers short sales in securities registered on, or admitted to unlisted trading privileges on, a national securities exchange if trades of the securities are reported pursuant to an “effective transaction reporting plan” and information as to such trades is made available in accordance with such plan on a real-time basis to vendors of market transaction information. Paragraph (b) applies to short sales on national exchanges in securities that are not covered by paragraph (a).

Rule 10a-1(a)(1) provides that, subject to certain exceptions, an exchange-registered security may only be sold short: (1) At a price above the price at which the immediately preceding sale was effected (plus tick), or (2) at the last sale price if it is higher than the last different price (zero-plus tick). Conversely, short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions is commonly described as the “tick test.”

b. Nasdaq Securities

Current short sale regulations apply different price tests to securities trading in different markets. Rule 10a-1's “tick test,” which is based on the sale price reported pursuant to an effective transaction reporting plan, applies to short sales of securities registered on, or admitted to unlisted trading privileges on, a national securities exchange. In 1994, the Commission granted temporary approval to the NASD to apply its own short sale rule to Nasdaq National Market securities on a pilot basis. Specifically, NASD Rule 3350 prohibits short sales at or below the current best (inside) bid when the current best (inside) bid is below the previous best (inside) bid in a security. Once Nasdaq operates as an exchange, Nasdaq National Market securities and Nasdaq Capital Market securities will be exchange-registered securities reported pursuant to an effective transaction reporting plan and therefore subject to Rule 10a-1.

In the Regulation SHO Proposing Release, the Commission considered Nasdaq's request for an exemption from Rule 10a-1 in conjunction with its exchange registration to allow Nasdaq to apply Rule 3350 to Nasdaq exchange-listed securities, as well as other market developments in proposing a uniform bid test using the consolidated best bid as the reference point for permissible short sales. After considering comments to the Regulation SHO Proposing Release regarding the proposed uniform bid test, the Commission decided to defer consideration of a new uniform bid test and instead adopted Rule 202T of Regulation SHO. Rule 202T is a temporary rule that excludes designated securities from the operation of the “tick” test of Rule 10a-1(a) and any short sale price test rule of any exchange or national securities association for a designated period of time. The Commission believes that conducting a Pilot Program pursuant to Rule 202T of Regulation SHO is an important component of evaluating the overall effectiveness of price test restrictions on short sales. The empirical data obtained from the Pilot Program will help the Commission assess whether it is necessary or appropriate to amend, or possibly remove, the short sale price tests for some population of securities. The Commission will consider any further action on the adoption of a price test after the completion of the Pilot Program. In order to promote efficient regulation and to avoid unnecessarily burdening markets with the imposition of costs associated with implementing a price test that may be temporary, the Commission believes that, as discussed below, it is necessary and appropriate in the public interest and consistent with the protection of investors to maintain the status quo for the price test to apply to short sales in Nasdaq National Market securities, and to continue to not apply to short sales in Nasdaq Capital Market securities.

c. Request for exemption from Rule 10a-1

Nasdaq has requested an exemption from Rule 10a-1 to continue regulating short sales of Nasdaq National Market securities under the bid test of Nasdaq Exchange Rule 3350. Nasdaq has also requested an exemption from Rule 10a-1 for Nasdaq Capital Market securities, as current NASD Rule 3350 is inapplicable to such securities. The requested exemption would therefore allow Nasdaq Capital Market securities to continue to trade without being subject to a price test. Nasdaq proposes to continue all current exemptions to NASD Rule 3350 in its Rule 3350, including the exemption for qualified market makers in connection with bona fide market making.

Nasdaq represents that its requested exemption would serve the public interest and protect investors by enabling Nasdaq to continue regulating short sales under Nasdaq Rule 3350 as it does today under NASD Rule 3350. In addition, Nasdaq represents, among other things, that (i) its short sale rule would continue to prohibit the same conduct as Commission Rule 10a-1; (ii) Nasdaq would continue to vigorously and effectively enforce those prohibitions; and (iii) it is imperative that Nasdaq preserve its current structure to the greatest extent possible to avoid needless confusion during Nasdaq's transition to exchange status.

Commenters generally supported the Commission granting an exemption to Nasdaq from Rule 10a-1 to allow the Nasdaq Exchange to apply its own bid test once it becomes a national securities exchange. One commenter in particular noted that it is important for Nasdaq to retain the NASD short sale rule when it becomes an exchange for the following reasons, among others: (i) Because depriving market makers of the market maker exception would significantly hinder their ability to quickly adjust inventory risk positions; and (ii) because options market makers and block facilitators widely use the NASD short sale rule's options hedge exceptions as a risk management tool, the unavailability of the NASD short sale rule's exception may result in less willingness to commit capital to customer orders.

A few commenters, on the other hand, believed that Nasdaq should not be granted an exemption from Rule 10a-1, noting, among other things, that from a regulatory, fairness and competitive perspective, Nasdaq should be required to comply with all Commission rules applicable to a national securities exchange, including the Commission's short sale rule. One commenter, in particular, stated that the Commission should either propose amendments to Rule 10a-1 to apply to all exchanges equally, including Nasdaq, or require Nasdaq to amend its proposed rules to be consistent with the short sale regulatory regime applied to all other exchanges.

d. Response

The Commission appreciates the concerns expressed by such commenters; however, as discussed above, the Commission believes that it is important to maintain the status quo of short sale regulation during the Pilot Program in order to avoid unnecessarily burdening the markets. Moreover, it is important to maintain the integrity of the data obtained by the Commission during this period on the impact of short selling in the absence of a price test. This data will, among other things, assist in (i) determining the extent to which a price test is necessary to further the objectives of short sale regulation; (ii) the effects of relatively unrestricted short selling on market volatility, price efficiency, and liquidity; and (iii) whether a short sale price test should be removed, in part or in whole, for some or all securities, or if retained, should be applied to additional securities. Investor protection will be enhanced because the Commission's determination with respect to the short sale price test will be based on sound empirical data obtained from the Pilot Program.

Based upon the representations and facts Nasdaq has presented in its request for exemption, as discussed above, and as necessary and appropriate in the public interest and consistent with the protection of investors, in particular the necessity and importance of maintaining the status quo during the Pilot Program, pursuant to section 36 of the Exchange Act, the Commission hereby grants a temporary exemption from Rule 10a-1 to permit the Nasdaq Exchange to apply Nasdaq Exchange Rule 3350 to short sales in Nasdaq National Market securities occurring on the Nasdaq Exchange and to allow Nasdaq Capital Market securities to be exempt from the application of the tick test. The exemptions from Rule 10a-1 will expire upon termination of the Pilot Program or at such other time the Commission determines that such exemptions are no longer necessary or appropriate in the public interest or consistent with the protection of investors.

Because Nasdaq proposes to continue to maintain the exemption from its Rule 3350 for qualified market makers in connection with bona fide market making, the exemptions from Rule 10a-1 are subject to the following conditions:

(1) The Nasdaq Exchange is required to surveil member firms in order to monitor whether firms claiming the bona fide market maker exception in Nasdaq Exchange Rule 3350 are engaged in bona fide market making activity; and

(2) The Nasdaq Exchange will issue a Notice to Members or other appropriate communication to its members to provide further clarification to Nasdaq market makers regarding what activity would not be deemed “bona fide market making activity” for purposes of claiming the exception to Nasdaq Exchange Rule 3350's bid test.

D. Section 11A of the Exchange Act

Section 11A of the Exchange Act and the rules thereunder form the basis of our national market system and impose requirements on exchanges to implement its objectives. Specifically, national securities exchanges are required, under Rule 601 of Regulation NMS, to file transaction reporting plans regarding transactions in listed equity and Nasdaq securities that are executed on its facilities. Currently registered exchanges satisfy this requirement by participating in the Consolidated Transaction Association Plan (“CTA Plan”), for listed equities and 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”) for Nasdaq securities. Before the Nasdaq Exchange can begin operating as an exchange, it must join these plans as a participant in its own right. Currently, the transactions executed in Nasdaq trading facilities are reported to these plans as OTC trades pursuant to the NASD's participation in the plans. The NASD's continued participation in these plans is necessary for it to fulfill its obligations under section 11A of the Exchange Act and Rules 601 and 603.

National securities exchanges are required, under Rule 602 of Regulation NMS, to collect bids, offers, quotation sizes and aggregate quotation sizes from those members who are responsible broker or dealers. National securities exchanges must then make this information available to vendors at all times when the exchange is open for trading. The current exchanges satisfy this requirement by participating in the Consolidated Quotation System Plan (“CQ Plan”) for listed equity securities and the Nasdaq UTP Plan for Nasdaq securities. Before the Nasdaq Exchange can begin operating as an exchange it also must join the CQ Plan as a participant in its own right. As with transaction reports, quotations posted in Nasdaq trading facilities are currently provided to the CQ Plan and Nasdaq UTP Plan pursuant to the NASD's participation in the plans. The NASD must remain a member of these plans for OTC quotations in exchange-listed and Nasdaq securities so that it can continue to fulfill its obligations under sections 15A(b)(11) and 11A of the Exchange Act and Rules 602 and 603.

An integral part of our national market system is the means by which quotations are accessible across the competing exchanges and the NASD. Currently, the registered exchanges and the NASD are linked for the purpose of accessing quotations in exchange-listed securities via the Intermarket Trading System (“ITS”). The ITS Plan contains the rules pursuant to which its participants interact and contains the current trade-through rule. Currently, the NASD is a member of the ITS Plan and as a participant complies with, and enforces compliance by its members, with the terms of the ITS Plan. Accordingly, most OTC transactions in non-Nasdaq exchange-listed securities regulated by the NASD are subject to the requirements of the ITS Plan. The NASD plans 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 access to exchanges' quotations. The NASD's Nasdaq facility currently is the means by which the NASD and its members comply with obligations under the ITS Plan. Accordingly, the NASD must have the means to satisfy these obligations prior to completing the spin-off of its subsidiary as an independent national securities exchange. For this reason, the Commission is conditioning the operation of the Nasdaq Exchange, which will automatically terminate the NASD's control of Nasdaq, on the NASD representing to the Commission that control of Nasdaq through the Preferred D share is no longer necessary.

To provide access to quotes and orders in non-Nasdaq exchange-listed securities displayed on the Nasdaq Exchange, the Nasdaq Exchange must become a member of the ITS Plan prior to its operation as a national securities exchange for trading such securities. Although required participation in the ITS Plan is of limited duration, the Commission believes that it is necessary until the full implementation of Rule 611 that the Nasdaq Exchange join the ITS Plan to ensure that the Commission's policy of protecting limit orders and providing price protection across markets is maintained. Further, the Nasdaq Exchange participation in the ITS Plan should ensure that regulatory requirements are consistent across the markets for exchange-listed securities. Nasdaq has proposed to adopt ITS rules that are similar to the current NASD ITS Rules. The Commission notes that the Nasdaq Exchange may have to amend its ITS rules to reflect its participation in the ITS Plan. Any changes to its rules to implement its participation in the ITS Plan must be filed with and approved by the Commission prior to its commencement of operations as a national securities exchange.

The NASD currently fulfills its obligations under Rules 602 and 603, the CTA Plan, CQ Plan, Nasdaq UTP Plan, and section 15A(b)(11) of the Exchange Act through NASD facilities that are owned by the NASD's subsidiary, Nasdaq. The NASD also operates the ADF for collecting quotations and trade reports in Nasdaq securities but not exchange-listed securities. With respect to non-Nasdaq exchange-listed securities, the only means currently available to the NASD to fulfill these statutory and regulatory obligations is through NASD facilities owned by Nasdaq. Accordingly, the Commission believes that, until the NASD has alternative means to satisfy these obligations, it cannot complete its separation from Nasdaq and Nasdaq cannot cease to operate as a facility of the NASD. For this reason, the Commission is conditioning the operation of the Nasdaq Exchange, which will automatically terminate the NASD's control of Nasdaq, on the NASD representing to the Commission that control of Nasdaq through the Preferred D share is no longer necessary.

In the Original Notice, the Commission noted that the registration of the Nasdaq Exchange has implications for the NASD and its ability to satisfy its statutory and regulatory obligations. The Commission further stated that the NASD must have an operational quotation and transaction reporting facility upon the registration of the Nasdaq Exchange. The Commission received comments on the Original Notice and Amendment Nos. 1, 2, and 3 that raised significant concerns about how the NASD would continue to satisfy its statutory and regulatory obligations. In particular, one commenter expressed concern about Nasdaq's registration as an exchange because it “will eliminate the only non-exchange facilities that exist for trading NMS securities.” Therefore, this commenter believed that the Commission should withhold approval of Nasdaq's exchange registration until a viable NASD quotation display and trade reporting facility is in place because, without such a facility, market makers and electronic communication networks would essentially be mandated to become a member of the Nasdaq Exchange to meet their regulatory obligations. Similarly, another commenter noted that for several decades, Nasdaq has been the arm of the NASD through which broker-dealers satisfy their regulatory obligations for OTC transactions in NMS stocks. This commenter believed that Nasdaq's exchange application could not be reconciled with the requirements of the Exchange Act until after the NASD has in place operational facilities to permit OTC trading to continue to flourish in the U.S.

The Commission agrees with these commenters and is conditioning the operation of the Nasdaq Exchange upon the ability of the NASD to satisfy its statutory and regulatory obligations. The Commission does not believe that it would be consistent with the Exchange Act to allow the NASD to separate from the facilities by which it satisfies its regulatory obligations without having alterative means to do what the Exchange Act and the rules thereunder require. Accordingly, the Nasdaq Exchange may not begin operating as a national securities exchange and cease to operate as a facility of the NASD until NASD has the means to fulfill its regulatory obligations.

Finally, national securities exchanges must make available certain order execution information pursuant to Rule 605 of Regulation NMS. Current exchanges have standardized the required disclosure mechanisms by participating in the Order Execution Quality Disclosure Plan. The Nasdaq Exchange must join this plan before it begins operations as an exchange.

E. Listing Requirements

1. Registration Under Section 12(b) of the Exchange Act

Once the Nasdaq Exchange begins operations as a national securities exchange, a security will be considered for listing on the Nasdaq Exchange only if such security is registered pursuant to section 12(b) of the Exchange Act or such security is subject to an exemption. An issuer may register a security pursuant to section 12(b) by submitting to the Nasdaq Exchange a listing application that provides certain required information. The Exchange will review the listing application and, if the listing application is approved, will certify to the Commission that it has approved the security for listing and registration. Registration of the security will become effective thirty days after the receipt of such certification by the Commission or within a shorter period of time as the Commission may determine. Once registration is effective the security is eligible for listing on the Nasdaq Exchange.

2. Initial and Continuing Listing Standards

Nasdaq proposes that its initial and continuing listing standards be largely the same as current NASD listing rules. Nasdaq also proposes a transitional listing rule that would automatically qualify for initial listing any security trading on the Nasdaq facility of the NASD on the day prior to the Nasdaq Exchange's first day of operation as an independent exchange. The Commission believes that these rules are consistent with the requirements of the Exchange Act because they would enable current Nasdaq securities to continue trading once the Nasdaq Exchange begins operations as a national securities exchange thus providing a continuous market for investors for these securities.

3. Corporate Governance Standards

In 2003, the Commission approved a proposal to revise the NASD rules by adding new corporate governance standards for listed issuers, as contained in NASD Rules 4200 and 4350. These changes, which were applied to Nasdaq-listed issuers through the NASD as a national securities association, established enhanced requirements for audit committees of Nasdaq-listed issuers, as mandated by the Sarbanes-Oxley Act of 2002. In addition, these changes established new requirements relating to the independence of the listed issuer's board of directors and key board committees and required issuers to adopt codes of conduct for directors, officers and employees. The corporate governance listing standards proposed for the Nasdaq Exchange are the same as those previously approved by the Commission for the NASD pursuant to section 10A(m) of the Exchange Act and Rule 10A-3 and pursuant to section 15A(b)(6) of the Exchange Act.

The Commission finds that the proposed corporate governance listing standards contained in the Nasdaq Exchange's proposed rules are consistent with section 6(b)(5) of the Exchange Act and satisfy the requirements of the section 10A(m) of the Exchange Act and Rule 10A-3 thereunder. The Commission believes that the Nasdaq Exchange's corporate governance listing standards are designed to promote independent and objective review and oversight of the accounting and auditing practices of listed issuers and to enhance audit committee independence, authority, and responsibility by implementing the standards set forth in Rule 10A-3. Moreover, in the Commission's view, the listing standards should help safeguard the interests of shareholders and foster greater transparency, accountability, and objectivity in the oversight by, and the decision making processes of, the boards and key board committees of Nasdaq-listed issuers. The Nasdaq Exchange's listing standards also should help promote compliance with high standards of conduct by the issuers' directors, management, and personnel.

F. Unlisted Trading Privileges

Rule 602 of Regulation NMS requires the NASD to collect, process and make available to vendors the best bid, best offer, and quotation sizes in NMS securities communicated off an exchange by members acting in the capacity of an OTC market maker. The NASD satisfies this obligation today through its operation of the Nasdaq facility though which NASD members quote and report trades in exchange-listed securities. In offering this quote and trade reporting facility for exchange-listed securities, the NASD does not have rules that comply, in all respects, to section 12(f) of the Exchange Act and Rule 12f-5 thereunder because those provisions apply only to exchanges.

Once registered as an exchange, the Nasdaq Exchange will be permitted by section 12(f) of the Exchange Act to extend unlisted trading privileges to securities listed and registered on other exchanges, subject to Commission rules. Exchange Act Rule 12f-5 requires an exchange that extends unlisted trading privileges to securities to have in effect a rule or rules providing for transactions in the class or type of security to which the exchange extends unlisted trading privileges. The Commission notes that the Nasdaq Exchange does not have in effect rules that comply with Rule 12f-5 for all exchange-listed securities currently quoted on the Nasdaq facility of the NASD. Accordingly, to continue trading such securities, the Nasdaq Exchange would have to file a proposed rule change with the Commission and obtain Commission approval of such rules.

IV. Exemption From Section 19(b) of the Exchange Act With Regard to NASD Rules Incorporated by Reference

Nasdaq proposes to incorporate by reference many NASD rules as Exchange rules. Thus, for certain Exchange rules, Exchange members will comply with an Exchange rule by complying with the NASD rule referenced. In connection with its proposal to incorporate NASD rules by reference, Nasdaq requested, pursuant to Rule 240.0-12, an exemption under section 36 of the Exchange Act from the rule filing requirements of section 19(b) of the Exchange Act for changes to those Nasdaq Exchange rules that are effected solely by virtue of a change to a cross-referenced NASD rule. Nasdaq proposes to incorporate by reference categories of rules (rather than individual rules within a category) that are not trading rules. In addition, the Nasdaq Exchange agrees to provide written notice to its members whenever a proposed rule change to an NASD rule that is incorporated by reference is proposed.

Using its authority under section 36 of the Exchange Act, the Commission previously exempted certain SROs from the requirement to file proposed rule changes under section 19(b) of the Exchange Act. Each such exempt SRO agreed to be governed by the incorporated rules, as amended from time to time, but is not required to file a separate proposed rule change with the Commission each time the SRO whose rules are incorporated by reference seeks to modify its rules.

In addition, each SRO incorporated by reference only regulatory rules (i.e., margin, suitability, arbitration), not trading rules, and incorporated by reference whole categories of rules (i.e., did not “cherry-pick” certain individual rules within a category). Each exempt SRO had reasonable procedures in place to provide written notice to its members each time a change is proposed to the incorporated rules of another SRO in order to provide its members with notice of a proposed rule change that affects their interests, so that they would have an opportunity to comment on it.

The Commission is granting Nasdaq's request for exemption, pursuant to section 36 of the Exchange Act, from the rule filing requirements of section 19(b) of the Exchange Act with respect to the rules that the Nasdaq Exchange proposes to incorporate by reference. This exemption is conditioned upon the Nasdaq Exchange providing written notice to its members whenever the NASD proposes to change a rule that the Nasdaq Exchange has incorporated by reference. The Commission believes that this exemption will promote more efficient use of Commission and SRO resources by avoiding duplicative rule filings based on simultaneous changes to identical rule text sought by more than one SRO. Consequently, the Commission grants Nasdaq's exemption request for the Nasdaq Exchange.

V. Conclusion

It is ordered that the application of the Nasdaq Stock Market LLC for registration as a national securities exchange be, and hereby is, granted.

It is further ordered that operation of the Nasdaq Exchange is conditioned on the satisfaction of the requirements below.

A. Participation in National Market System Plans. The Nasdaq Exchange must join the CTA Plan, the CQ Plan, the Nasdaq UTP Plan, the ITS Plan, and the Order Execution Quality Disclosure Plan.

B. The NASD's Ability to Fulfill its Statutory and Regulatory Obligations. The NASD must represent to the Commission that control of Nasdaq through the Preferred D share is no longer necessary because the NASD can fulfill through other means its obligations with respect to non-Nasdaq exchange listed securities under Section 15A(b)(11) of the Exchange Act, Rules 602 and 603 of Regulation NMS, and the national market system plans in which the NASD participates.

C. Intermarket Surveillance Group. The Exchange must join the Intermarket Surveillance Group.

D. Minor Rule Violation Plan. A MRVP filed by the Nasdaq Exchange under Exchange Act Rule 19d-1(c)(2) must be declared effective by the Commission.

E. Fingerprint Plan. A fingerprint plan filed by the Nasdaq Exchange under Exchange Act Rule 17f-2 must be declared effective by the Commission.

F. 17d-2 Agreement. An agreement pursuant to Exchange Act Rule 17d-2 between the NASD and the Nasdaq Exchange that allocates to the NASD regulatory responsibility for those matters specified above must be approved by the Commission, or the Nasdaq Exchange must demonstrate that it independently has the ability fulfill all of its regulatory obligations.