[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: 94-25555]
[[Page Unknown]]
[Federal Register: October 17, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34806; File No. SR-Phlx-93-37]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the
Philadelphia Stock 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 December 20, 1993, the
Philadelphia Stock Exchange, Inc. (``Phlx'' 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 February 18, 1994.\3\ No comments were received on the
proposed rule change. The Phlx filed Amendment No. 1 to the proposal on
July 12, 1994, Amendment No. 2 on September 22, 1994, and Amendment No.
3 on October 5, 1994.\4\ This order approves the proposed rule change,
as amended.\5\
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\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
\3\See Securities Exchange Act Release No. 33610 (February 9,
1994), 59 FR 8280 (February 18, 1994).
\4\In Amendment Nos. 1, 2, and 3 the Phlx proposes to make
certain clarifying amendments to Rule 1042, as discussed herein. See
Letters from Gerald O'Connell, First Vice President, Phlx, to
Michael Walinskas, Branch Chief, Office of Market Supervision
(``OMS''), Division of Market Regulation (``Division''), Commission,
dated July 12, 1994; from Gerald O'Connell, First Vice President,
Phlx, to Michael Walinskas, Branch Chief, OMS, Division, Commission,
dated September 22, 1994 (``Amendment No. 2''); and from Gerald
O'Connell, First Vice President, Phlx, to Brad Ritter, Senior
Counsel, OMS, Division, Commission, dated October 5, 1994
(``Amendment No. 3'').
\5\The Commission notes that substantively similar proposals by
the other options exchanges are being approved concurrently with the
Phlx's proposed rule change. See File Nos. SR-Amex-94-01; SR-CBOE-
94-06; SR-NYSE-94-12; and SR-PSE-94-12.
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Currently, with regard to expiring equity options, Phlx 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 by 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 non-clearing member;
or (3) accepted by a member organization from any customer.\9\ The only
exceptions to Rule 1042 are: (1) To remedy mistakes made in good faith;
(2) to take appropriate action as the result of a failure to reconcile
unmatched Exchange option transactions; (3) where exceptional
circumstances relating to a customer'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; and (4) with respect to foreign
currency options.\10\ Member organizations are required to prepare a
memorandum of every exercise instruction received from a customer
stating the time when such instruction was received. If a member
organization receives an exercise instruction or tenders an exercise
notice to the OCC pursuant to one of the first three exceptions
described above, the member organization must maintain a memorandum
setting forth the circumstances giving rise to the exception. If the
member organization is relying on either the first or third exception
described above, it must promptly file a copy of the memorandum with
the Exchange.
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\6\As used herein, the term ``member organization'' also
includes individual members of the Exchange.
\7\See Phlx Rule 1042. 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 member
organization or clearing member, 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 14. 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'').
\10\Rule 1042 also does not apply to expiring index options. See
Phlx Rules 1001A and 1042A. An additional purpose of the proposed
rule change is to specifically state within Rule 1042 that the
Exercise Cut-Off Time does not apply to either expiring foreign
currency options or index options.
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Currently under Rule 1042 it is a violation 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 1042.\11\
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\11\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 1042 for expiring equity options, the proposed rule
change would alter the existing exercise instruction procedures by
requiring that final exercise decisions be submitted to the Exchange.
The clearing members would still be responsible for delivering exercise
notices to the OCC,\12\ 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.\13\ The Exercise Cut-Off Time will still be
5:30 p.m. (Eastern Time) 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;\14\ or (2) the member organization may 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 Advices would be submitted by a member
organization either: (1) At a place designated for that purpose by any
national options exchange of which the member organization is a member
and where the option is listed; or (2) to the Exchange via the OCC in a
format prescribed by the OCC.\15\ In those instances where OCC Rule 805
has been waived by the OCC,\16\ the proposal requires that a Contrary
Exercise Advice be submitted prior to the Exercise Cut-Off Time by
member organizations wishing to exercise an options that would not have
been automatically exercised had the exercise-by-exception procedure
been in place, or not to exercise an option that would have been
automatically exercised had the exercise-by-exception procedure been in
place.\17\ The applicable underlying security price in such instances
will be as described in OCC Rule 805(1), which will normally be the
last sale price in the primary market for the underlying security.\18\
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\12\Exercise instructions will still be submitted to clearing
members, however, the requirements for this process will be
determined by each clearing member, in accordance with the OCC's
rules. This process will no longer be governed by the Phlx's rules.
Pursuant to the OCC's rules, equity options expire at 12:00 a.m. on
the third Saturday of the expiration month. As explained earlier,
the OCC has its own rules as to the latest time by which clearing
members must submit exercise notices to the OCC. These rules are
separate from the Exchange's Exercise Cut-Off Time and are not
affected by the proposed rule change.
\13\The proposed rule change also makes it clear that reporting
of final exercise decisions as contemplated by the revised rule does
not serve to substitute as the effective exercise notice to the OCC
for the exercise or non-exercise of expiring options.
\14\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.
\15\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 Phlx 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 Contrary Exercise Advices to the Exchange
through C/MACS. This process is expected to be completed in time for
the November 1994 expirations. Telephone conversation between Gerald
O'Connell, First Vice President, Phlx, and Sharon Lawson, Assistant
Director, OMS, Division, Commission, on September 16, 1994.
\16\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(1).
\17\When the OCC waives the exercise-by-exception procedure, the
OCC's rules require submission of an affirmative exercise notice for
all exercises even in circumstances where a Contrary Exercise Advice
is not required to be submitted to the Exchange. See Amendment No.
3, supra note 4.
\18\Id.
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The proposal would also require member organizations that maintain
proprietary or public customer positions in expiring options to take
necessary steps to ensure that final exercise decisions are properly
indicated to the Exchange regarding such positions.\19\ In addition,
member organizations which have accepted the responsibility to indicate
final exercise decisions on behalf of another member organization or
non-member firm shall take necessary steps to ensure that such
decisions are properly indicated in compliance with Rule 1042, as
amended.\20\ 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.\21\
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\19\See Amendment No. 2, supra note 4.
\20\Id.
\21\Id.
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With certain minor modifications, the proposal maintains the
current exceptions to Rule 1042. The proposal, however, adds language
to Rule 1042(b) to expressly state that the burden of establishing an
exception to the Exercise Cut-Off Time for a proprietary or customer
account of a member organization rests solely on the member
organization seeking to rely on such exception.
In the event a member organization does not timely submit a
Contrary Exercise Advice in accordance with the proposed procedures, or
does not timely submit a Contrary Exercise Advice pursuant to an
exception, the responsible member organization must prepare a written
memorandum describing the surrounding circumstances\22\ and must file a
copy of the memorandum with the Exchange's Market Surveillance
Department no later than 12:00 p.m. (E.S.T.) on the business day
following that expiration.
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\22\The memorandum must also include the time when such final
exercise decision was made or, in the case of a customer, was
received.
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Furthermore, in order to highlight the seriousness of violating
Rule 1042, the proposed rule language would expressly state that
effecting 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.
Finally, the proposal would state in the Commentaries to Rule 1042
that the requirements specified in the rule do not apply to foreign
currency options or index option products listed on the Exchange.\23\
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\23\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.\24\ 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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\24\15 U.S.C. 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.\25\ 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.\26\
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\25\See, e.g., In re Farmers Group Stock Options Litigation,
Master File No. 88-4994 (E.D.Pa).
\26\See supra note 11.
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The Commission believes that the proposed exercise procedures
should enhance the Exchange's ability to surveil for violations of Rule
1042 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.\27\ 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 1042, 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 1042. 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.\28\
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\27\See supra note 12.
\28\The Commission notes that the Phlx 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 15.
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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 1042.\29\ Furthermore, the Commission also encourages the Exchange
to review the permitted exceptions to Rule 1042 and consider ways of
establishing parameters as to the extent of the exceptions.\30\
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\29\For example, the Phlx may wish to consider adopting
additional penalties in those situations where a member organization
is unable to establish the existence of one of the exceptions to
Rule 1042 for a particular trade or trades.
\30\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, 2,
and 3 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, 2, and 3
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, 2, and 3 to the proposed rule change
on an accelerated basis.
Interested persons are invited to submit written data, views and
arguments concerning Amendment Nos. 1, 2, and 3 to the proposed rule
change. Persons making written submissions should file six copies
thereof with the Secretary, Securities and Exchange Commission, 450
Fifth Street, NW., Washington, DC 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, NW., Washington, DC 20549. Copies
of such filings will also be available for inspection and copying at
the principal office of the Phlx. All submissions should refer to File
No. SR-Phlx-93-37 and should be submitted by November 7, 1994.
It is therefore ordered, Pursuant to section 19(b)(2) of the
Act,\31\ that the proposed rule change (File No. SR-Phlx-93-37), as
amended, is hereby approved.\32\
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\31\15 U.S.C. 78s(b)(2) (1982).
\32\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 15.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\33\
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\33\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-25555 Filed 10-14-94; 8:45 am]
BILLING CODE 8010-01-M
