November 19, 1998

The Honorable Janet Reno
Attorney General
Department of Justice
Constitution Ave. and 10th Street, N.W.
Washington, D.C. 20530

The Honorable Arthur Levitt, Jr.
Chairman
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Dear Attorney General Reno and Chairman Levitt:

I am writing with reference to your reports, in the case of the Department of Justice (the Department), on the status and effectiveness of the remedial actions implemented as a result of the Government's 1996 civil antitrust proceedings against 24 major stock dealers who operated as market makers in Nasdaq Stock Market, Inc. (Nasdaq) securities, and, in the case of the Securities and Exchange Commission (the SEC), on the status of the remedial actions undertaken by the National Association of Securities Dealers (NASD) as a result of the SEC's 1996 enforcement action against the NASD. Thank you for the thoroughness of your responses.

The regulatory structure for equity markets in the United States is prescribed under the Securities Exchange Act of 1934. Under this structure, the SEC is charged with overseeing the equity markets and its participants. Most of the day-to-day responsibility for market and broker- dealer oversight is vested in the self-regulatory organizations (SROs) which principally are the national securities exchanges under Exchange Act section 6 and the national securities associations (the NASD is the only registered association) under section 15A. The SROs are required to enforce their members' compliance with SRO rules and the federal securities laws and this is accomplished mostly through surveillance of trading in their markets and examination of the operations of their members. SRO rules must, among other things, (1) be designed to prevent fraudulent and manipulative practices; (2) promote just and equitable principles of trade; (3) perfect the mechanism of a free and open market and a national market system; (4) protect investors and the public interest; and (5) provide a process for disciplining their members. The rules also cannot impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. The SEC's oversight role has two aspects: an affirmative responsibility of assuring that delegated power is exercised effectively to meet regulatory needs in the public interest, and a negative responsibility of assuring that delegated power is not exercised in a manner inimical to the public interest or unfair to private interests. The SEC performs this role through inspections of SROs, review of SRO rule proposals, and review of final SRO disciplinary proceedings. Congress intended that the SEC step in to compel SROs to act when SROs fail to provide adequate protection to investors or otherwise to carry out the purposes of the Exchange Act. (See Exchange Act section 19 (especially subsections (g) and (h)) and S. Rep. No. 75, 94th Cong., 1st Sess. (1975) at 13-14, 34-35.) The great unasked and unanswered question in the matter of the NASD and the Nasdaq market makers is where was the SEC? Why did the SEC allow things to deteriorate so badly? Why didn't anyone know?

The Department's Complaint alleged that the named firms, through a pattern of collusion and harassment or intimidation, maintained a quoting convention that placed a restriction on the use of odd-eighths in quoting certain stocks in violation of the antitrust laws. The Consent Order required that each defendant initiate and maintain an antitrust compliance program and that each firm's Antitrust Compliance Officer report quarterly to the Department's Antitrust Division concerning activities undertaken to ensure compliance with the Consent Order. The Consent Order also required each defendant to undertake a significant program of monitoring and recording trader conversations to discourage conduct violative of the Consent Order and the federal antitrust laws and to assist the firms and the Department in enforcing compliance and investigating complaints.

The Department's September 17, 1998 report says that defendants have filed all required reports. There is no indication, however, that the Department, or, at the Department's request, the SEC or SROs in the course of their routine examinations, has conducted on-site examinations to verify that the required antitrust compliance programs are in fact in place and operation. Please verify that this has been or will be done.

The Department's report discloses that the taping obligation is not in force, having been stayed pending the outcome of an appellate process described on page 7. The Department's report also discloses that several claimed violations have been investigated but that "all indications are that the defendants are in compliance." Unless these were technical violations of the Consent Order, I am curious as to how the Department was able to determine compliance without the information that the tapes would have provided. I raise this in particular given the importance of taped conversations to the Department's 1996 charges.

The Department reports that it has undertaken a statistical review of Nasdaq trading data and concludes in its report that "adherence to the quoting convention has declined sharply since the Department filed suit" which in turn has led to "a sharp reduction in inside spreads" (p. 9) and further that the combined impact of the Department's suit, the SEC's new order handling rules, and the NASD's June 2, 1998, introduction of the use of sixteenths in quoting stocks has been "significant" (p. 10). The benefits to consumers include a substantial reduction in investor transaction costs for buying and selling Nasdaq stocks. The amounts are quantified in the report and accompanying charts.

Separately, the SEC's August 1996 Order and 21(a) Report found that the NASD did not comply with certain of its rules or satisfy its obligations under the Exchange Act to enforce its rules and the federal securities laws, noting that the NASD's inaction contributed to wide-spread allegations of illegal conduct by market makers. The SEC order required the NASD to comply with fourteen undertakings requiring remedial measures to address deficiencies in the areas of surveillance, examination, enforcement and internal audit identified in the 21(a) Report.

The SEC's August 20, 1998, report finds that "the NASD and its staff have shown a genuine commitment to improving the way the NASD functions" and that "the NASD has adopted an unprecedented number of changes to improve the fairness and efficiency of its operations." However, the SEC report concludes that "our work here is not done." The SEC report identifies the following outstanding matters or continuing deficiencies:

1. The SEC Order required NASD to provide for the autonomy and independence of the regulatory staff of the NASD and its subsidiaries. The requirements of this undertaking have been fulfilled with respect to investigative and prosecutorial authority and the regulatory autonomy of NASDR, but insulation of the regulatory staff from the commercial interests of NASD members and Nasdaq is "still evolving" (p. 5).

2. The SEC Order required NASD to promulgate and apply on a consistent basis uniform standards for regulatory and access issues and to institute safeguards to ensure fair and even- handed access to NASD services and facilities. SEC has yet to receive a draft proposal that fully describes Nasdaq listing and delisting procedures (p. 6).

3. The SEC Order required NASD to establish an independent internal audit staff to review all aspects of NASD's operations, including its regulatory function and disciplinary process. The NASD has established the required internal audit department but high staff turn-over has hampered the audit committee in carrying out its responsibilities (p. 8).

4. The SEC Order required NASD to develop an order audit trail sufficient to enable the NASD to reconstruct markets promptly, effectively surveil them, and enforce its rules. On March 6, 1998, the SEC approved the NASD's new OATS rules which are scheduled to be implemented over the next two years, with final implementation of all orders by July 31, 2000 (p.8).

5. The SEC Order required NASD to improve substantially its surveillance and examination order handling. The NASD's automated systems for surveilling market marker compliance with the order handling rules could be improved by inclusion of a feature that automatically notifies the NASD that a violation has occurred. Moreover, the Trading and Market Making Surveillance (TMMS) examination staff has been crippled by staff turnover of more than 50 percent. The TMMS exam cycle is behind schedule for the second year in a row. The TMMS supervisory structure, budget, and resources are inadequate to allow TMMS staff to properly accomplish its objectives (p. 9).

6. In its 21(a) Report, the SEC noted that the "NASD's trade reporting surveillance procedures were deficient and were hampered by insufficient automated surveillance reports." The NASD has expanded and improved its capabilities but needs to take steps to further refine and improve its surveillance of trade reporting (p. 10).

The SEC report notes that the NASD acknowledges these issues and has agreed to find ways to address them. I respectfully request that the SEC submit a report in November 1999 on the NASD's progress in resolving all open matters. I also respectfully request that the Department submit a follow-up report at that time on compliance with the antitrust undertakings.

The SEC report also responds to a question that I raised about Nasdaq market makers avoiding quoting stock prices in odd sixteenths of a dollar. The SEC report concludes that there are a number of legitimate, business-related reasons why at any given time a market maker would not quote in odd sixteenths, and contains assurances that the SEC and NASD will continue to monitor this situation and will take appropriate measures should a regulatory problem be identified. I appreciate your undertaking and respectfully request to be notified in the event that any such action is taken.

Thank you for your cooperation and attention to this important matter.

Sincerely,

JOHN D. DINGELL
RANKING MEMBER

cc: The Honorable Tom Bliley, Chairman
Committee on Commerce

The Honorable Michael Oxley, Chairman
Subcommittee on Finance and Hazardous Materials

Mr. Frank Zarb, Chairman
National Association of Securities Dealers

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