02-2489. Self-Regulatory Organizations; Order Approving Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 2 to the Proposed Rule Change by the Chicago Board Options Exchange, Inc. Eliminating the ...

January 25, 2002.

I. Introduction

On August 29, 2000, the Chicago Board Options Exchange, Inc. (“CBOE” or “Exchange”) submitted to the Securities Exchange Commission (“SEC” or “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) ^[1] and Rule 19b-4 thereunder,^[2] a proposed rule change to eliminate the obligation of Designated Primary Market Makers (“DPMs”) to accord priority to non-public customers over the DPMs’ principal transactions. The proposed rule change was published for comment in the Federal Register on December 4, 2001.^[3] The Commission received no comments on the proposal. On January 8, 2002, the CBOE submitted Amendment No. 1 to the proposed rule change.^[4] On January 16, 2002, the CBOE submitted Amendment No. 2 to the proposed rule change.^[5] This order approves the proposal, as amended by Amendment No. 2. The Commission also solicits comment on Amendment No. 2 from interested persons.

II. Description of the Proposal

The CBOE proposes to amend CBOE Rule 8.85 (DPM Obligations) regarding the obligations of DPMs to represent orders. Currently, CBOE Rule 8.85(b)(iii) requires a DPM to accord priority to any order, that the DPM represents as agent over the DPM's principal transactions, unless the customer who placed the order has consented to not being accorded such priority. The CBOE proposes to amend CBOE Rule 8.85(b)(iii) to require DPMs to accord priority only to public customer orders. In Amendment No. 2 the CBOE proposes to add Interpretation .03 to CBOE Rule 8.85 to define a public customer order as not including any order in which a member, non-member participant in a joint venture with a member, or any non-member broker dealer has an interest. Accordingly, CBOE proposes to exclude these orders from a DPM's obligation under Exchange rules to accord priority.

III. Commission Findings and Order Granting Accelerated Approval of the Proposed Rule Change

After careful review, the Commission finds that the proposed rule change, as amended, is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.^[6] The Commission's approval of CBOE's proposal to amend its Rule 8.85 to eliminate a DPM's obligation, pursuant to CBOE rules, to accord priority under all circumstances to certain orders is based solely on its determination that this proposed rule change is consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange. The Commission is making no determination as to whether a DPM's failure to accord priority to non-public customer orders, when the DPM is acting as an agent, is consistent with the federal securities laws or any other applicable law. Accordingly, the Commission's approval of CBOE's proposal does not affect a DPM's fiduciary obligations under federal securities laws or agency law principles when it acts as an agent.^[7]

Currently, by requiring DPMs to accord priority to all customer orders pursuant to its Rule 8.85, unless the customer who placed the order has consented to not being accorded such priority, the CBOE creates an obligation on DPMs under Exchange rules in addition to the DPM's obligations under Federal securities laws and agency law. Accordingly, the result of CBOE's proposal is to no longer make a DPM's failure to accord priority to non-public customer orders for which it acts as agent a CBOE rule violation. The CBOE's proposal, however, does not affect a DPM's obligations to orders for which it acts as agent under Federal securities laws or any other applicable laws.

The Commission found in its Manning Decision that broker-dealers owe a fiduciary duty to their limit order customers not to trade ahead of these orders unless the customer knows of the firm's limit order policy.^[8] After the Commission issued its Manning Decision, the NASD filed a proposed rule change stating that a member firm would not be deemed to violate NASD Rules of Fair Practice if it provides to customers a statement setting forth the circumstances in which the firm accepts limit orders and the policies and procedures the firm follows in handling these orders.^[9] As part of this filing, the NASD proposed model disclosure language to be used by firms whose policy was not to grant priority to customer limit orders over the member's own proprietary trading.

This proposal was never approved by the Commission and was withdrawn by the NASD at the time it submitted a proposed rule change to prohibit member firms from trading ahead of their customers' limit orders in their market making capacity.^[10] In approving this subsequent NASD proposal, the Commission expressed concern that the prohibition did not extend to trading ahead of limit orders of other firms' customers that had been sent to the market maker for execution.^[11] Shortly thereafter, the Commission proposed its own rule to prohibit any market maker in Nasdaq National Market securities from trading ahead of the orders of other firms' customers sent to it for execution.^[12]

Shortly after the Commission's publication of its proposal, the NASD filed a proposed rule change to prohibit its member firms from trading ahead of the orders of other firms' customers, which the Commission approved.^[13] In its approval order of Manning II, the Commission also noted that:

“In a typical agency relationship, disclosure often is relied upon as an adequate means of resolving a conflict of interest between an agent and its principal. Cite omitted. Investors enjoy greater protection under the federal securities laws, however, than that afforded by common law; a general common law remedy of disclosure does not always suffice.^[14] A stricter duty may be imposed where, as here, the principles are investors and the agents control access to the trading market.”

While the NASD's limit order protections only extend to non-broker-dealer customers, the Commission questioned why the provisions of the rule should not be extended to limit orders placed by other broker-dealers, including options specialists and registered options traders. Further, the Commission specifically noted that it expected the NASD to consider extending the scope of limit order protections to orders of options specialists and market makers.^[15]

More recently, the Commission approved a New York Stock Exchange (“NYSE”) proposal to prohibit NYSE members from trading along with their customers except in limited circumstances.^[16] NYSE Rule 92 significantly restricts NYSE members' ability to enter orders to buy or sell NYSE-listed securities for any account in which such member is interested, if the person responsible for the entry of such order has knowledge of any particular unexecuted customer order to buy or sell the same security that could be executed at the same price. In its approval order, the Commission noted that proprietary trading exceptions “did not minimize the importance of a broker-dealers' duty to their customers, which requires broker-dealers to place investors' interests before their own. On the contrary,” the Commission continued, “member and member organizations remain obligated to consider their customers' interest in every customer transaction.” ^[17]

Amendment No. 2

The Commission finds good cause, consistent with Section 19(b)(2) of the Act,^[18] to approve Amendment No. 2 to the proposed rule change prior to the thirtieth day after the date of publication of notice of filing thereof in the Federal Register. The Commission notes that the notice that was published in the Federal Register ^[19] discussed CBOE's intent to define “public customer orders.” Therefore, the CBOE's proposed definition was subject to notice and comment. Accordingly, the Commission believes good cause exists, pursuant to Sections 6(b)(5) and 19(b) of the Act ^[20] to accelerate approval of Amendment No. 2 to the proposed rule change.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and arguments concerning Amendment No. 2, including whether it 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 CBOE. All submissions should refer to File No. SR-CBOE-00-42 and should be submitted by February 22, 2002.

V. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,^[21] that the proposed rule change (SR-CBOE-00-42) is approved.

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.  See Securities Exchange Act Release No. 45013 (November 26, 2001), 66 FR 63083.

4.  See letter from Steve Youhn, Legal Department, CBOE to Kelly Riley, Senior Special Counsel, Division of Market Rgulation (“Division”), Commission, dated January 7, 2002 (“Amendment No. 1”. In Amendment No. 1, the CBOE proposed a definition of “public customer orders.”

5.  See letter from Steve Youhn, Legal Department, CBOE to Kelly Riley, Seniro Special Counsel, Division, Commission, dated January 14, 2002 (“Amendment No. 2”). In Amendment NO. 2 CBOE proposed to define the term “public customer” in proposed Interpretation .03 of CBOE Rule 8.85. Amendment No. 2 supersedes and replaces Amendment No. 1 in its entirety. Telephone conversation between Steven Youhn, Legal Division, CBOE, and Kelly Riley, Senior Special Counsel, Division, Commission, on January 14, 2002. On January 18, 2002, CBOE consented to an extension of time for Commission action until January 25, 2002. See letter from Steve Youhn, Legal Department, CBOE, to Kelly Riley, Senior Special Counsel, Division, Commission, dated January 18, 2002.

6.  In approving this proposal, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

7.  Pursuant to agency law principles, a DPM that acts as agent for any customer has an obligation to act solely for the benefit of the customer in all matters connected with the customer's order, see Restatement (Second) of Agency § 387 (1958), and not compete with the customer concerning the customer's order unless the customer understands its agent is to compete, see Restatement (Second) of Agency § 393 (1958). See also In re E.F. Hutton & Company, Securities Exchange Act Release No. 25887 (July 6, 1988) (“Manning Decision”). In its opinion, the Commission noted that “absent disclosure and a contrary agreement a fiduciary cannot compete with his beneficiary with respect to the subject matter of their relationship * * *”.

8.  See supra note 7.

9.  See Securities Exchange Act Release No. 26824 (May 15, 1989), 54 FR 22046 (May 22, 1989).

10.  See Securities Exchange Act Release No. 33697 (March 1, 1994), 59 FR 45 (March 8, 1994) (“Manning I”).

11.  See Securities Exchange Act Release No. 34279 (June 29, 1994), 59 FR 34883 (July 7, 1994). See also Division of Market Regulation, SEC, Market 2000: An Examination of Current Equity Market Developments, V-8 (1994).

12.  See Securities Exchange Act Release No. 34753 (September 29, 1994), 59 FR 50867 (October 6, 1994). The Commission's proposal was never adopted.

13.  See Securities Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995) (“Manning II”).

14.  See e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 389 (1983) (“An important purpose of the federal securities statutes was to rectify perceived deficiencies in the available common law protection by establishing higher standards of conduct in the securities industry.”).

15.  See Manning II, supra note 12.

16.  See Securities Exchange Act Release No. 44139 (March 30, 2001), 66 FR 18339 (April 6, 2001). Specifically, members are only permitted to enter certain types of proprietary orders, such as liquidating positions in proprietary facilitation accounts, bona fide hedges, bona fide arbitrages and risk arbitrages, while representing a customer's order that could be executed at the same price, so long as the order is not for an individual investor and the customer has given express permission, which must include an understanding of the relative price and size of the allocated execution reports.

17.  See supra note 16.

18.   15 U.S.C. 78s(b)(2).

19.  See supra note 3.

20.  15 U.S.C. 78f(b)(5) and 15 U.S.C. 78s(b).

21.  15 U.S.C. 78s(b)(2).

22.  17 CFR 200.30-3(a)(12).