[Federal Register Volume 59, Number 199 (Monday, October 17, 1994)]
[Unknown Section]
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From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-25553]
[[Page Unknown]]
[Federal Register: October 17, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34807; File No. SR-CBOE-94-06]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 1 and 2 to the Proposed Rule Change by the Chicago Board
Options Exchange, Inc. Relating to Exercise Cut-Off Procedures for
Expiring Equity Options
October 7, 1994.
Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'').\1\ and Rule 19b-4 thereunder,\2\ on March 16, 1994, the
Chicago Board Options Exchange, Inc. (``CBOE'' or ``Exchange'')
submitted to the Securities and Exchange Commission (``Commission'') a
proposed rule change relating to the exercise procedures for expiring
equity option contracts. The proposal was published for comment in the
Federal Register on May 18, 1994.\3\ No comments were received on the
proposed rule change. The CBOE filed Amendment No. 1 to the proposal on
September 19, 1994, and Amendment No. 2 on October 5, 1994.\4\ This
order approves the proposed rule change, as amended.\5\
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\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
\3\See Securities Exchange Act Release No. 34051 (May 12, 1994),
59 FR 25970 (May 18, 1994).
\4\In Amendment Nos. 1 and 2, the CBOE proposes to make certain
clarifying amendments to Rule 11.1, as discussed herein. See Letters
from Jeffrey Schroer, Vice President, Market Regulation, Regulatory
Services Division, CBOE, to Sharon Lawson, Assistant Director,
Office of Market Supervision (``OMS''), Division of Market
Regulation (``Division''), Commission, dated September 19, 1994
(``Amendment No. 1''); and from Patricia Cerny, Director, Department
of Market Surveillance, CBOE, to Brad Ritter, Senior Counsel, OMS,
Division, Commission, and dated October 5, 1994 (``Amendment No.
2'').
\5\The Commission notes that substantively similar proposals by
the other options exchanges are being approved concurrently with the
CBOE's proposed rule change. See File Nos. SR-Amex-94-01; SR-Phlx-
93-37; and SR-PSE-94-12.
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Currently, with regard to expiring equity options, CBOE customers
and member organizations\6\ are required to indicate their exercise
decisions to clearing members no later than 5:30 p.m. Eastern Standard
Time (``E.S.T.'') on the business day immediately prior to the
expiration date of the options (``Exercise Cut-Off Time'').\7\ This is
the latest time at which an exercise instruction\8\ may be: (1)
Prepared by a clearing member for positions in its proprietary trading
account; (2) accepted by a clearing member from a market maker or floor
broker for positions in the market maker's account or the floor
broker's error account; or (3) accepted by a member organization from
any customer for positions in the customer's account.\9\ The only
exceptions to Rule 11.1 are: (1) To remedy mistakes or errors made in
good faith; (2) to take appropriate action as the result of a failure
to reconcile unmatched Exchange transactions; and (3) where exceptional
circumstances relating to a customer's or member's ability to
communicate exercise instructions to a member organization (or a member
organization's ability to receive such exercise instructions) prior to
the Exercise Cut-Off Time warrant such action.\10\ An exercise
instruction memorandum must be prepared and time stamped for the
exercise of all option contracts not automatically exercised pursuant
to OCC Rule 805.\11\ If a member organization receives an exercise
instruction or tenders an exercise notice to the OCC pursuant to one of
the exceptions described above, the member organization must maintain a
memorandum setting forth the circumstances giving rise to the
exception.\12\
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\6\As used herein, the term ``member organization'' also
includes individual members of the Exchange.
\7\See CBOE Rule 11.1. Generally, equity options may be traded
until the close of business on the last business day before
expiration, which is generally the third Friday of the expiration
month (``Expiration Friday'').
\8\For customers, an exercise instruction is a notice delivered
to a member organization to exercise an option. For a clearing
member, market maker, or floor broker, an exercise instruction is a
notice to The Options Clearing Corporation (``OCC'') to exercise an
option that would not be automatically exercised pursuant to the
OCC's exercise-by-exception procedure (``OCC Rule 805''), or not to
exercise an option that otherwise would automatically be exercised
pursuant to OCC Rule 805. See infra note 15. The OCC has separate
rules regarding the cut-off time by which exercise notices must be
delivered to the OCC by the clearing members. The proposed rule
change does not in any way affect the rules of the OCC.
\9\In most cases, exercise instructions are transmitted to
Exchange clearing members electronically through the Clearing
Management and Control System (``C/MACS''). Telephone conversation
between Jeffrey Schroer, Vice President, Market Surveillance, CBOE,
and Brad Ritter, Attorney, OMS, Division, Commission, on July 27,
1994.
\10\CBOE Rule 11.1 does not apply to expiring series of index
options on the business day immediately prior to expiration. See
CBOE Rule 11.1, Interpretation .03(e). An additional purpose of the
proposed rule change is to specifically state within Rule 11.1 that
the Exercise Cut-Off Time does not apply to expiring index options.
\11\See infra note 14. The Exchange deems the preparation, time
stamping, or submission of an exercise instruction memorandum prior
to the purchase the contracts to be exercised to be a violation of
Rule 11.1. See CBOE Rule 11.1, Interpretation .02.
\12\Should the market maker, customer or firm subsequently
determine not to exercise all or part of the advised contracts, the
member must also deliver an ``advice cancel'' in such form or manner
as prescribed by the Exchange. See CBOE Rule 11.1, Interpretation
.03(a).
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Presently, it is a violation of Rule 11.1 for clearing members to
accept exercise instructions after the Exercise Cut-Off Time, except in
reliance on one of the above exceptions. Because exercise instructions
are submitted to the clearing members and then to the OCC by the
clearing members, without having the audit trail pass directly through
the Exchange, it is difficult for the Exchange to surveil for
violations of Rule 11.1.\13\
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\13\The Commission believes that the Exercise Cut-Off Time
serves an important investor protection function. Specifically, the
Exercise Cut-Off Time protects holders of short positions in equity
options from unanticipated events occurring after the close of the
market. As the Commission has previously stated, if expiring equity
options were allowed to be exercised after the Exercise Cut-Off Time
for reasons other than the exceptions set forth above, the
Commission believes that options writers could be unfairly
disadvantaged with respect to options holders by not having the same
opportunity to react to such unanticipated events. See Securities
Exchange Act Release No. 19589 (March 10, 1983), 48 FR 11196 (March
16, 1983).
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In order to enhance the ability of the Exchange to surveil for
violations of Rule 11.1 for expiring equity options, the proposed rule
change would alter the existing exercise instruction procedures by
requiring that final exercise decisions also be submitted to the
Exchange. The clearing members would still be responsible for
delivering exercise notices to the OCC, however, the proposed rule
change would allow the Exchange to accurately document when each
exercise instruction was received by a member organization or clearing
member, or delivered by a clearing member to the OCC.\14\ The Exercise
Cut-Off Time will still be 5:30 p.m. (E.S.T.) on the business day
immediately prior to the expiration date. Pursuant to the proposal,
however, there will be two means of exercising an expiring equity
option: (1) Take no action and allow exercise determinations to be made
in accordance with OCC Rule 805;\15\ or (2) the market maker, floor
broker, or clearing member, as applicable, must submit a contrary
exercise advice (i.e., a notice committing an option holder either to
exercise an option that would not otherwise be exercised automatically
pursuant to OCC Rule 805, or not exercise an option that otherwise
would be exercised automatically pursuant to OCC Rule 805) (``Contrary
Exercise Advice''). Contrary Exercise Advice would be submitted by a
market maker, floor broker, or clearing member either: (1) In such form
or manner prescribed by the Exchange to a place designated by the
Exchange; or (2) to the Exchange via the OCC in a format prescribed by
the OCC.\16\ In those instances where OCC Rule 805 has been waived by
the OCC,\17\ the proposal requires that a Contrary Exercise Advice be
submitted prior to the Exercise Cut-Off Time by member organizations
wishing to exercise an option that would not have been automatically
exercised had the exercise-by-exception procedures been in place, or
not to exercise an option that would have been automatically exercised
had the exercise-by-exception procedure been in place.\18\ The
applicable underlying security price in such instances will normally be
the last sale price in the primary market for the underlying security.
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\14\Because the OCC's rules are not changing, the reporting of
final exercise decisions as contemplated by the revised rule does
not serve to substitute as the effective exercise notice to OCC for
the exercise or non-exercise of expiring options. The Commission
also notes that the proposed procedures discussed herein are in
addition to the Exchange's existing procedures regarding the
submission of exercise instructions to clearing members, which for
the most part, are not being amended by this proposal. See CBOE Rule
11.1.
\15\OCC Rule 805 provides for automatic exercise of in-the-money
options at expiration without the submission of an exercise notice
to the OCC if the price of the security underlying the option is at
or above a certain price (for calls) or at or below a certain price
(for puts); and the non-exercise of an option at expiration if the
price of the security underlying the option does not satisfy such
price levels. See OCC Rule 805.
\16\Even though this may be accomplished by submitting exercise
decisions directly to the Exchange, the more likely manner of
accomplishing this will be to submit the exercise decisions to the
Exchange through C/MACS. Due to the burden that would be placed on
members of having to manually process every exercise decision for
delivery directly to the Exchange, the procedures and rules being
approved herein will not be implemented by the CBOE until the OCC
submits a written representation to the Commission that C/MACS has
been modified as necessary, fully tested, and ready to go on-line,
to allow members to submit exercise decisions to the Exchange
through C/MACS. This process is expected to be completed in time for
the November 1994 expirations.
\17\The could happen where an underlying security is not traded
on its primary market on the trading day immediately preceding an
expiration date and, as a result, the OCC determines not to fix a
closing price for that security. See OCC Rule 805(l).
\18\When the OCC waives the exercise-by-exception procedure, the
OCC's rules require submission of an affirmative exercise notice for
all excercises even in circumstances where a Contrary Exercise
Advice is not required to be submitted to the Exchange. See
Amendment No. 2, supra note 4.
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The proposal would also require that members properly communicate
to the Exchange final exercise decisions in respect of positions for
which they are responsible.\19\ Member organizations may establish an
internal processing cut-off time prior to 5:30 p.m. (E.S.T) at which
time final exercise decisions from their customers will no longer be
accepted by them for expiring options.
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\19\See Amendment No. 1, supra note 4.
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The proposal maintains the current exceptions to Rule 11.1. The
proposal, however amends Rule 11.1(b) to provide that the Exercise Cut-
Off Time is the latest time at which an exercise instruction may be
submitted by a market maker or floor broker to (rather than accepted
by) a clearing member. As a result of this change, the CBOE will
interpret Rule 11.1(b) as placing the burden of establishing an
exception to the Exercise Cut-Off Time solely on the member
organization seeking to rely on such exception.\20\
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\20\Telephone conversation with Jeffrey Schroer, Vice President,
Market Regulation, Regulatory Services Division, CBOE, and Brad
Ritter, Senior Counsel, OMS, Division, Commission, on July 27, 1994.
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In the event a member organization makes a final exercise decision
after the Exercise Cut-Off Time in reliance on one of the above
exceptions, the responsible member organization must prepare a written
memorandum describing the surrounding circumstances and must promptly
file a copy of the memorandum with the Exchange.
Furthermore, in order to highlight the seriousness of violating
Rule 11.1, the proposed rule language would expressly state that
affecting an exercise decision in an expiring equity option on the
basis of material information obtained after the Exercise Cut-Off Time
is considered to be activity inconsistent with just and equitable
principles of trade.
The proposal also provides that the failure of any member to follow
the proposed procedures may be referred to the Exchange's Business
Conduct Committee and result in the assessment of a fine, which may
include, but is not limited to, disgorgement of potential economic gain
obtained or loss avoided by the subject exercise, as determined by the
Business Conduct Committee.
Finally, the proposal makes clear that the requirements specified
in the Rule 11.1 only apply to expiring equity options listed on the
Exchange.\21\
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\21\See supra note 10.
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The Commission believes that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to national securities exchanges, particularly,
Section 6(b)(5) of the Act.\22\ Specifically, the Commission believes
the Exchange's proposal is designed to prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, to foster cooperation and coordination with
persons engaged in facilitating transactions in securities, and to
protect investors and the public interest.
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\22\15 U.S.C. Sec. 78f(b)(5) (1988).
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Although all options exchanges currently have a uniform 5:30 p.m.
(E.S.T.) Exercise Cut-Off Time on Expiration Fridays for expiring
equity options, the OCC's rules permit the OCC to accept exercise
notices for expiring equity options from clearing firms until 12:00
a.m. (E.S.T.) on the expiration date (i.e., the Saturday after an
Expiration Friday). This additional time within which to receive
exercise notices from clearing members was provided to accommodate
corrections of mistakes made in good faith, trade reconciliations, and
certain exceptional circumstances that affected a customer's ability to
inform its brokerage firm or affected a firm's ability to receive final
exercise decisions before the Exercise Cut-Off Time. Nevertheless,
there have been situations where member organizations have either
delayed making exercise decisions until after 5:30 p.m. (E.S.T.) on
Expiration Friday in anticipation of the release of material news
concerning a particular underlying company, or having made decisions
prior to 5:30 p.m. (E.S.T.), changed these decisions based upon such
material news.\23\ In this regard, the Commission believes that it is
appropriate for the Exchange to make it clear in its rules that the
submission of a Contrary Exercise Advice on the basis of material
information released after the Exercise Cut-Off Time will be activity
deemed inconsistent with just and equitable principles of trade.\24\
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\23\See, e.g., In re Farmers Group Stock Options Litigation,
Master File No. 88-4994 (E.D.Pa 1989).
\24\See supra note 13.
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The Commission believes that the proposed exercise procedures
should enhance the Exchange's ability to surveil for violations of Rule
11.1 by providing an enhanced audit trail for identifying late
exercises. Specifically, every time an exercise decision is made
contrary to OCC Rule 805, a Contrary Exercise Advice must be filed with
the Exchange, in addition to submitting an exercise instruction to a
clearing member as is currently required.\25\ Similarly, the proposal
requires that documentation must be prepared and submitted to the
proper options exchange whenever a late exercise decision is made in
reliance on one of the exceptions to Rule 11.1, with the burden of
establishing the existence of the exception on the party submitting the
Contrary Exercise Advice. The proposed rule change, therefore, should
facilitate the Exchange's ability to monitor and enforce compliance
with Rule 11.1. Accordingly, because the proposed rule change
significantly bolsters the Exchange's existing procedures regarding the
exercise of expiring equity options and helps to ensure compliance with
their rules, the Commission believes that the proposal is consistent
with the Act.\26\
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\25\See supra note 14.
\26\The Commission notes that the CBOE has represented that it
will prepare (in cooperation with the other options exchanges) and
distribute a notice to member organizations describing the new
procedures set forth above, and notifying member organizations as to
when the new procedures will be fully in effect. See supra notes 5
and 16.
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Even though the proposed rule change significantly improves the
Exchange's audit trail with respect to late exercises, the Commission
believes that the Exchange should continue to examine ways of ensuring
compliance with the Exercise Cut-Off Time and the other requirements of
Rule 11.1. In this regard, the Commission encourages the Exchange to
review the permitted exceptions to Rule 11.1 and consider ways of
establishing parameters as to the extent of the exceptions.\27\
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\27\For example, the Exchange may want to define expressly in
the rule the circumstances that qualify for a good faith exception.
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The Commission finds good cause for approving Amendment Nos. 1 and
2 to the proposal prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Specifically, the Commission believes that Amendment Nos. 1 and 2 to
the proposal, as discussed above, clarify the application of the rule
and may serve to minimize confusion and disputes between and among
members and customers as to the application of this rule. Additionally,
the original proposal was noticed for the full comment period without
any comments being received by the Commission. Accordingly, the
Commission believes that it is consistent with Section 6(b)(5) of the
Act to approve Amendment Nos. 1 and 2 to the proposed rule change on an
accelerated basis.
Interested persons are invited to submit written data, views and
arguments concerning Amendment Nos. 1 and 2 to the proposed rule
change. Persons making written submissions should file six copies
thereof with the Secretary, Securities and Exchange Commission, 450
Fifth Street, N.W., Washington, D.C. 20549. Copies of the submissions,
all subsequent amendments, all written statements with respect to the
proposed rule change that are filed with the Commission, and all
written communications relating to the proposed rule change between the
Commission and any person, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. 552, will be
available for inspection and copying at the Commission's Public
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of such filings will also be available for inspection and
copying at the principal office of the CBOE. All submissions should
refer to File No. SR-CBOE-94-06 and should be submitted by November 7,
1994.
It Is Therefore Ordered, pursuant to Section 19(b)(2) of the
Act,\28\ that the proposed rule change (File No. SR-CBOE-94-06), as
amended, is hereby approved.\29\
\28\15 U.S.C. 78s(b)(2) (1982).
\29\The Commission notes, however, that the proposed rule change
will not be implemented until the Commission receives certain
written representations from the OCC regarding the operational
status of C/MACS. See supra note 16.
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\30\
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\30\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-25553 Filed 10-14-94; 8:45 am]
BILLING CODE 8010-01-M
