00-32652. Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the Pacific Exchange, Inc. Relating to Financial Arrangements of Options Floor Members

December 12, 2000.

Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) ^[1] and Rule 19b-4 thereunder,^[2] notice is hereby given that on July 7, 2000, the Pacific Exchange, Inc. (“PCX” or “Exchange”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) the proposed rule change as described in Items I, II and III below, which Items have been prepared by the PCX.^[3] On November 30, 2000, the Exchange submitted Amendment No. 1 to the proposed rule change.^[4] The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

The PCX is proposing to eliminate its current PCX Rule 6.40 on financial arrangements of options floor members and is also proposing to adopt supplemental rules on options floor members who are trading for the same joint account. The text of the proposed rule change follows. Additions are in italics; deletions are in [brackets].

¶ 3809 Disclosure of Financial Arrangements of Members

Rule 4.18(a)-(b)—No change.

[(c) The Exchange may restrict the trading activity of Members with financial arrangements pursuant to Rule 6.40. Such restrictions are subject to appeal, pursuant to Rule 11.7.]

[¶ 4953 Financial Arrangements of Options Floor Members]

Rule 6.40(a)—Reserved [Financial Arrangements Defined. Two Members have a “financial arrangement” with each other for purposes of this Rule if:]

[(1) One Member directly finances the other Member's dealings upon the Exchange, the amount financed is $5,000 or more, and the Member providing the financing is entitled to a share of the other Member's trading profits; or

(2) Both Members are registered with the Exchange as nominees of the same Member Organization; or

(3) Both Members are registered with the Exchange to trade on behalf of the same joint account; or

(4) Both Members' dealings upon the Exchange are financed by the same source, the amount financed is $5,000 or more, and the Member providing the financing is entitled to a share of each of the other Members' trading profits.]

[For purposes of this Rule, the term “Member” shall include both Members and Member Organizations.]

[(b) Options Floor Trading Restrictions.]

[(1) A Market Maker who has a “financial arrangement” with another Member of Member Organization (as specified herein) and the Member or Member Organization having a “financial arrangement” with that Market Maker, may not bid, offer and/or trade in the same trading crowd at the same time in the absence of an exemption from the Options Floor Trading Committee, as provided in subsection (b)(4), below.

(2) Any order of a Market Maker with an existing financial arrangement, that is represented or executed by a Floor Broker, shall be so represented or executed in accordance with the procedures set forth in Rule 6.85. Additionally, a Market Maker may not bid, offer and/or trade in a trading crowd in which a Floor Broker holds an order on behalf of a Market Maker with whom he has an existing financial arrangement may not be concurrently represented, by one or more Floor Brokers, in a particular trading crowd.

(3) Two or more Lead Market makers (LMMs) who are trading on behalf of the same Member organization may not bid, offer and/or trade in the same option series at the same time. However, two or more LMMs who do not have financial arrangements with each other, as defined in subsection (a) of this Rule, or who have been granted an exemption pursuant to subsection (b)(4), below, may bid, offer and/or trade in the same option series at the same time.

(4) Exemptions. Members with financial arrangements may be exempted from the trading restrictions set forth in this subsection, as follows:]

[(A) Long-Term Exemptions. The Options Floor Trading Committee may grant long-term exemptions to Members on a case-by-case basis if it determines that a fair and orderly market would not be impaired by allowing such Members with financial arrangements to trade in the same trading crowd at the same time. In making such determinations, the Committee shall consider the following factors: (1) The nature of the financial arrangement; (2) the degree of independence to be maintained by the applicants in making trading decisions; (3) the impact on competition in the trading crowd if an exemption were granted; (4) the applicants' prior patterns of trading if they have previously traded in the same trading crowd at the same time; (5) and any other information relevant to whether the applicants would tend collectively to dominate the market in a particular trading crowd or a particular option series. The Committee may revoke any long-term exemption granted pursuant to this subsection if it determines that a fair and orderly market would otherwise be impaired by a continuation of the exemption. The Committee will review, on at least an annual basis, all long-term exemptions that are in effect at the time.]

[(B) Short-term Exemptions. Two Floor Officials may grant short-term exemptions to Members on a case-by-case basis if such Floor Officials determine that a fair and orderly market would not be impaired and that the need for liquidity in the trading crowd warrants such action. Unless otherwise specified, any exemption granted pursuant to this Rule shall extend for no longer than the trading day on which it is provided. The Committee shall review, on a regular basis, each exemption granted pursuant to this subsection (b).]

[(c) Reporting to the Exchange. Market Makers, Floor Brokers and Member Organizations are required to report the terms of their financial arrangements to the Exchange pursuant to Rule 4.18 (“Disclosure of Financial Arrangements of Members”).]

[Commentary

.01 The purpose of Rule 6.40 is to prevent Market Makers who have financial arrangements with each other from unfairly dominating the market in any option issues or series, as prohibited by Rule 6.37(c)(2). The Options Floor Trading Committee has determined that any Market Makers who are not technically covered by the terms of Rule 6.40, but who unfairly dominate the market in any option issue or series, shall be considered to be in violation of their obligation to contribute to the maintenance of fair and orderly markets and to act in accordance with use and equitable principles of trade.]

* * * * *

¶ 5193 Joint Accounts

Rule 6.84(a)-(e)—No change.

[(f) Participants in a joint account must comply with the trading restrictions provided in Rule 6.40]

[(g)-(h)]—(f)-(g)—No change.

(h) The following trading restrictions apply to Members who are registered with the Exchange to trade on behalf of the same joint account:

(1) A joint account may be simultaneously represented in a trading crowd only by participants who are trading in-person. Orders for a joint account may not be entered in a trading crowd in which a participant of the joint account is trading in-person for the joint account. If no participant is trading in-person in the trading crowd for the joint account, then a Floor Broker may represent orders in the trading crowd on behalf of the joint account as long as the same option series is not concurrently represented for the same joint account by more than one Floor Broker.

(2) Market Makers may alternate trading in-person between their individual and joint accounts while in the trading crowd. Market Makers who alternate trading between accounts must ensure that while trading the joint account another participant does not enter orders through a Floor Broker for the joint account in the same trading crowd.

(3) Before beginning trading on behalf of a joint account, participants in the joint account are responsible for determining whether any Floor Brokers are representing orders in the same trading crowd on behalf of the same joint account.

(4) Floor Brokers may not represent a joint account of which they are a participant.

(5) Market Makers who are trading in person in a trading crowd may not enter orders with a Floor Broker either for joint accounts in which they are participants or for their individual accounts.

(6) The following trades are prohibited:

(A) Trades between a joint account participant's individual account and a joint account in which that person is a participant.

(B) Trades between two joint accounts having common participants.

(C) Trades in which the buyer and seller are representing the same joint account and are on opposite sides of the transaction.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the PCX included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. The PCX has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

The Exchange is proposing to eliminate PCX Rule 6.40 (Financial Arrangements of Options Floor Members), which currently prohibits options floor members with financial arrangements from trading in the same trading crowd without receiving either a short-term or long-term exemption from the Options Floor Trading Committee (“OFTC”). The Commission approved the most recent version of PCX Rule 6.40 in 1996.^[5] Based on its experience with the rule since that time, the PCX now believes that many of its current provisions do not prevent the activities that the rule was designed to deter. Therefore, after careful consideration, the Exchange is now proposing to replace PCX Rule 6.40 with new PCX Rule 6.84(h).

a. Definition of Financial Arrangement. PCX Rule 6.40(a) currently defines the term “financial arrangement” very broadly, so that it covers both members who are trading for the same firm as well as members who are backed by the same source (even though they may be trading for different firms).^[6]

b. Trading Prohibitions. PCX Rule 6.40(b)(1) currently prohibits market makers with common financial arrangements from trading in the same trading crowd at the same time, unless they have an exemption from the OFTC.^[7] PCX Rule 6.40(b)(2) prohibits market makers from trading in a crowed where an order is being represented by a floor broker on behalf of another market maker who is affiliated with the original market maker.^[8] In addition, PCX Rule 6.40(b)(3) restricts multiple lead market maker (“LMM”) representatives from trading simultaneously in the same option series.^[9] As discussed below, the PCX is proposing to eliminate these restrictions except for those relating to multiple representation of market maker accounts through the use of floor brokers.

c. Exemptions to Current Rule. PCX Rule 6.40(b)(4)(A) permits the OFTC to grant long-term exemptions to the trading restrictions in PCX Rule 6.40.^[10] PCX Rule 6.40(b)(4)(B) permits two floor officials to grant short-term exemptions.^[11] To obtain a long-term exemption, members are currently required to submit an application to the OFTC and to provide information relevant to the factors set forth in PCX Rule 6.40(b)(4)(A). In assessing an application, the OFTC considers the stated purpose of PCX Rule 6.40, which is “to prevent Market Makers who have financial arrangements with each other from unfairly dominating the market in any option issues or series, as prohibited by [PCX] Rule 6.37(c)(2).” ^[12]

d. Elimination of PCX Rule 6.40. The Exchange is now proposing to eliminate PCX Rule 6.40. The current rule informs the OFTC (i.e., floor officials) of common financial arrangements among other floor members. As noted above, the purpose of PCX Rule 6.40 is to prevent market makers who have financial arrangements with each other from unfairly dominating the market in any option issue or series, as prohibited by PCX Rule 6.37(c)(2). Unfair domination of the market, however, is prohibited by PCX Rule 6.37(c)(2) regardless of whether the parties involved have a “financial arrangement” with each other. The Exchange believes that the value of the current administrative process relating to exemptions is minimal with regard to assuring compliance with applicable rules.^[13] The Exchange notes that it will continue to require members to submit detailed information on their financial arrangements to Exchange staff, as currently required.^[14] This will allow the Exchange to continue to conduct its surveillance and enforcement efforts relating to any fraudulent, manipulative, or other illegal trading practices by members with financial affiliations that may occur.

The Exchange believes that eliminating PCX Rule 6.40 is consistent with the important objective of allowing market makers and other PCX members to participate freely in trading crowds to provide maximum market depth and liquidity.^[15] The Exchange does not believe that floor officials' knowledge, based on the exemption process, of other members' financial arrangements helps to deter illicit trading practices.

The Exchange also believes that the restriction on LMMs in PCX Rule 6.40(b)(3)—i.e., the prohibition against more than one LMM representative simultaneously bidding, offering, or trading in the same option series without an exemption from floor officials—is unwarranted. If there is a large influx of orders in a particular option series, an LMM may reasonably need to have more than one of its traders in the same trading crowd simultaneously trading that series.^[16] The Exchange does not believe that there is a compelling reason to require the LMM to obtain an exemption from floor officials under these circumstances.

e. New Provisions on Joint Accounts. PCX Rule 6.85 currently provides that a market maker and any orders represented by a floor broker on behalf of the market maker may not be concurrently represented at a trading post. This principle against dual representation of a market maker account has been extended to cover joint accounts, as currently provided in PCX Rule 6.84, Commentary .04.^[17] The Exchange is now proposing to adopt supplemental procedures that apply to situations where a joint account is being concurrently represented by more than one market maker representative, and to situations where a joint account is being represented by a floor broker.^[18]

Specifically, the Exchange is proposing to add new subsection (h) to PCX Rule 6.84, its current rule on joint accounts. Subsection (h)(1) of the proposed PCX Rule 6.84 states that a joint account may be simultaneously represented in a trading crowd only by participants who are trading in-person. It further provides that orders for a joint account may not be entered in a trading crowd in which a participant of the joint account is trading in-person for the joint account. If no participant is trading in-person in the trading crowd for the joint account, then a floor broker may represent orders in the trading crowd on behalf of the joint account as long as the same option series is not concurrently represented by more than one floor broker.

Subsection (h)(2) of proposed PCX Rule 6.84 provides that market makers may alternate trading in-person between their individual and joint accounts while in the trading crowd. It further provides that market makers who alternate trading between accounts must ensure that while trading the joint account another participant does not enter orders through a floor broker for the joint account in the same trading crowd.

Subsection (h)(3) of proposed PCX Rule 6.84 provides that before beginning trading on behalf of a joint account, participants in the joint account are responsible for determining whether any floor brokers are representing orders in the same trading crowd on behalf of the same joint account.^[19]

Subsection (h)(4) of proposed PCX Rule 6.84 provides that floor brokers may not represent a joint account of which they are a participant.

Subsection (h)(5) of proposed PCX Rule 6.84 provides that market makers who are trading in-person in a trading crowd may not enter orders with a floor broker either for joint accounts in which they are participants or for their individual accounts.

Subsection (h)(6) of proposed PCX Rule 6.84 provides that the following trades are prohibited: (a) Trades between a joint account participant's individual account and a joint account in which that person is a participant; (b) trades between two joint accounts having common participants; (c) trades in which the buyer and seller are representing the same joint account and are on opposite sides of the transaction.

Finally, the Exchange is proposing to make technical changes to PCX Rule 4.18 and PCX Rule 6.84 by removing cross-reference to PCX Rule 6.40.

The Exchange believes that the provisions of proposed PCX Rule 6.84 are reasonably designed to assure appropriate representation of joint accounts in the trading crowds, consistent with the PCX's current rules. In particular, the Exchange believes that proposed subsections (1) and (5) of PCX Rule 6.84 are consistent with the second and third sentences of current PCX Rule 6.84, Commentary .04, and with PCX Rule 6.85. Finally, the Exchange believes that the elimination of PCX Rule 6.40, in conjunction with the codification of new PCX Rule 6.84(h), will help to assure an appropriate balance between reasonable trading restrictions by joint account participants and the need to allow PCX members to participate freely in trading crowds to provide maximum depth and liquidity.

2. Basis

The Exchange believes that the proposal is consistent with Section 6(b) of the Act ^[20] in general and Section 6(b)(5) ^[21] in particular because it is designed to promote just and equitable principles of trade, to facilitate transactions in securities, to remove impediments to and perfect the mechanism of a free and open market, and to protect investors and the public interest.

B. Self-Regulatory Organization's Statement on Burden on Competition

The Exchange does not believe that the proposed rule change will impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

The PCX neither solicited nor received written comments on the proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:

A. by order approve such proposed rule change, or

B. institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of the submission, 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 in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the PCX. All submissions should refer to File No. SR-PCX-00-21 and should be submitted by January 12, 2001.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[22]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  The PCX subsequently submitted the text of the proposed rule change language properly formatted for publication in the Federal Register. The reformatted version did not contain any substantive changes to the proposed rule change language. See letter dated November 1, 2000, from Michael D. Pierson, PCX, to Kelly Riley, Division of Market Regulation, SEC.

4.  The PCX amended the original filing by way of letter amendment. See letter dated November 29, 2000, from Michael D. Pierson, PCX, to Nancy J. Sanow, Assistant Director, Division of Market Regulation, SEC.

5.  See Exchange Act Release No. 37543 (August 8, 1996), 61 FR 42458 (August 15, 1996). See also Exchange Act Release No. 35277 (January 25, 1995), 60 FR 6330 (February 1, 1995); Exchange Act Release No. 32775 (August 20, 1993), 58 FR 45368 (August 27, 1993).

6.  PCX Rule 6.40(a) provides:

Two Members have a ‘financial arrangement’ with each other for purposes of this Rule if: (1) One Member directly finances the other Member's dealings upon the Exchange, the amount financed is $5,000 or more, and the Member providing the financing is entitled to a share of the other Member's trading profits; or (2) Both Members are registered with the Exchange as nominees of the same Member Organization; or (3) Both Members are registered with the Exchange to trade on behalf of the same joint account; or (4) Both Members' dealings upon the Exchange are financed by the same source, the amount financed is $5,000 or more, and the Member providing the financing is entitled to a share of each of the other Members' trading profits. For purposes of this Rule, the term ‘Member’ shall include both Members and Member Organizations.

7.  PCX Rule 6.40(b)(1) provides:

A Market Maker who has a ‘financial arrangement’ with another Member or Member Organization (as specified herein) and the Member or Member Organization having a ‘financial arrangement’ with that Market Maker, may not bid, offer and/or trade in the same trading crowd at the same time in the absence of an exemption from the Options Floor Trading Committee, as provided in subsection (b)(4), below.

8.  PCX Rule 6.40(b)(2) provides:

Any order of a Market Maker with an existing financial arrangement, that is represented or executed by a Floor Broker, shall be so represented or executed in accordance with the procedures set forth in Rule 6.85. Additionally, a Market Maker may not bid, offer and/or trade in a trading crowd in which a Floor Broker holds an order on behalf of a Market Maker with whom he has an existing financial arrangement. Orders of a Market Maker having an existing financial arrangement may not be concurrently represented, by one or more Floor Brokers, in a particular trading crowd.

9.  PCX Rule 6.40(b)(3) provides:

Two or more Lead Market Makers (LMMs) who are trading on behalf of the same Member Organization may not bid, offer and/or trade in the same option series at the same time. However, two or more LMMs who do not have financial arrangements with each other, as defined in subsection (a) of this Rule, or who have been granted an exemption pursuant to subsection (b)(4), below, may bid, offer and/or trade in the same option series at the same time.

10.  PCX Rule 6.40(b)(4)(A) provides:

Long-Term Exemptions. the Options Floor Trading Committee may grant long-term exemptions to Members on a case-by-case basis if it determines that a fair and orderly market would not be impaired by allowing such Members with financial arrangements to trade in the same trading crowd at the same time. In making such determinations, the Committee shall consider the following factors: (1) The nature of the financial arrangement; (2) the degree of independence to be maintained by the applicants in making trading decisions; (3) the impact on competition in the trading crowd if an exemption were granted; (4) the applicants' prior patterns of trading if they have previously traded in the same trading crowd at the same time; (5) and any other information relevant to whether the applicants would tend collectively to dominate the market in a particular trading crowd or a particular option series. The committee may revoke any long-term exemption granted pursuant to this subsection if it determines that a fair and orderly market would otherwise be impaired by a continuation of the exemption. The Committee will review, on at least an annual basis, all long-term exemptions that are in effect at the time.

11.  PCX Rule 6.40(b)(4)(B) provides:

Short-term Exemptions. Two Floor Officials may grant short-term exemptions to Members on a case-by-case basis if such Floor Officials determine that a fair and orderly market would not be impaired and that the need for liquidity in the trading crowd warrants such action. Unless otherwise specified, any exemption granted pursuant to this Rule shall extend for no longer than the trading day on which it is provided. The Committee shall review, on a regular basis, each exemption granted pursuant to this subsection (b).

12.  See PCX Rule 6.40, Commentary .01.

13.  In that regard, the Exchange notes that it has not identified domination of the market in violation of PCX Rule 6.37(c)(2), wash sale trade violations, or any other violations as a result of the application of PCX Rule 6.40.

14.  See PCX Rule 4.18(a), which provides in part:

(a) A Market Maker, Floor Broker, Specialist or Member Organization who enters into a financial arrangement with any other person or entity shall disclose to the Exchange the identity of such person or entity and the terms of the arrangement. For the purposes of this rule, a financial arrangement is defined as:

(1) The direct financing of a Member's dealings upon the Exchange; or

(2) Any direct equity investment or profit sharing arrangement; or

(3) Any consideration over the amount of $5,000.00, including, but not limited to, gifts, loans, annual salaries or bonuses.

(b) Exchange Members with financial arrangements must submit to the Exchange notification of the initiation, modification or termination of such financial arrangements in a form, time and manner approved by the Exchange within ten business days of the effective date of such arrangements or within such shorter period of time as the Exchange may require. Failure to disclose the terms of such financial arrangements to the Exchange may result in disciplinary action.

15.  The Exchange believes that no other options exchange has a rule that prohibits affiliated members from trading in the same crowd without an exemption.

16.  The Exchange that notes the current restriction on trading in the same series previously applied to all market makers with common financial arrangements. See Exchange Act Release No. 32775 (August 20, 1993), 58 FR 45368 (August 27, 1993).

17.  This Commentary provides:

Any order of a joint account participant, which is executed by a Floor Broker, shall be in accordance with procedures set forth in Rule 6.85, except that the joint account trading number with its alpha identification should appear in the ‘executing firm’ area. Additionally, a joint account participant may not bid, offer, purchase, sell, or enter orders in an option series in which a Floor Broker holds an order on behalf of the joint account or for the proprietary account of another participant in the joint account. Orders of joint account participants in a particular option series may not be concurrently represented by one or more Floor Brokers.

18.  The Exchange believes that these procedures are substantially the same as those set forth in Regulatory Circular RG-98-94 of the Chicago Board Options Exchange (Joint Account Participant Trading in Equity Options) (September 9, 1998), CCH ¶ 5291.

19.  Cf. PCX Rule 6.85, Commentary .01 (similar requirement applicable to market makers).

20.  15 U.S.C. 78f(b).

21.  15 U.S.C. 78f(b)(5).

22.  17 CFR 200.30-3(a)(12).