00-10258. Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; Order Approving Proposed Rule Change Regarding Specialist Enhanced Participation

April 18, 2000.

I. Introduction

On October 4, 1999, the Philadelphia Stock Exchange, Inc. (“Exchange” or “Phlx”) submitted to the Securities and Exchange Commission (“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 seeking to amend Exchange Rule 1014, “Obligations and Restrictions Applicable to Specialists and Registered Options Traders,” and its corollary Option Floor Procedure Advice B-6 to revise the enhanced participation available to Exchange specialists. The proposal was amended on November 4, 1999.^[3] Notice of the proposed rule change and Amendment No. 1 appeared in the Federal Register on November 30, 1999.^[4] The Commission received no comments on the proposal. This order approves the proposed rule change, as amended.

II. Description of the Proposal

On August 26, 1994, the Commission approved the Exchange's proposal to adopt an enhanced participation for Exchange specialists in equity options.^[5] The enhancement, or “enhanced parity split,” provides Exchange specialists with a greater participation in parity trades than the specialists would otherwise be entitled to receive.

On November 30, 1994, the Commission approved the Exchange's proposal to make the enhanced parity split available to index option specialists.^[6] The enhanced parity split was later revised with respect to situations where less than three controlled accounts are on parity with a specialist.^[7] The enhanced parity split was renewed unaltered and on a continuing pilot basis on three subsequent occasions.^[8] Thereafter, the enhanced parity split was extended until December 31, 1998, and revised so that it would apply to: (1) All index options; (2) 50% of each specialist's equity options; and (3) all new options allocated to a specialist during the year. In addition, specialists were permitted to revise the list of eligible equity options on a quarterly basis, instead of annually.^[9] Finally, in July 1999, the enhanced parity split was permanently approved.^[10]

The enhanced parity split works as follows: when an equity or index option specialist is on parity with one controlled account ^[11] and an order for more than five contracts comes into the crowd, the specialist will receive 60% of the contracts and the controlled account will receive 40%. When the specialist is on parity with two controlled accounts and the order is for more than five contracts, the specialist will receive 40% of the contracts and each controlled account will receive 30%. When the specialist is on parity with three or more controlled accounts and the order is for more than five contracts, the specialist will be counted as two crowd participants when allocating the contracts. In any of these situations, if a customer order is on parity, the customer will not be disadvantaged by receiving a lesser allotment than any other crowd participant, including the specialist. Thus, a customer on parity is assured a minimum participation that is equal to the participation of the specialist.^[12]

The Exchange now proposes to revise the manner in which the enhanced parity split operates only in those cases where the specialist is on parity with three or more controlled accounts and the order is for more than five contracts. Under the proposal, the specialist will receive 30% of the contracts instead of being counted as two crowd participants in determining the number of contracts the specialist is entitled to receive.

III. Discussion

For the reasons discussed below, the Commission finds that the proposed rule change is consistent with the Act and the rules and regulations under the Act applicable to a national securities exchange. In particular, the Commission believes the proposed rule change is consistent with the section 6(b)(5) ^[13] requirements that the rules of an exchange be designed to promote just and equitable principles of trade, prevent fraudulent and manipulative acts and practices, and protect investors and the public interest.^[14] The Commission also finds that the proposal may serve to remove impediments to and perfect the mechanism of a free and open market by helping the Exchange to attract and retain specialist units.

When an equity or index option specialist is on parity with three or more controlled accounts and the order is for more than five contracts, the proposal gives the specialist 30% of the contracts, rather than counting the specialist as two crowd participants. The proposal will significantly increase the specialist's enhanced participation when the specialist is on parity with five or more controlled accounts. Under the proposal, however, when the specialist is on parity with three or four controlled accounts, the specialist's enhanced participation will be reduced.^[15] The Exchange recognizes that the proposal will reduce the number of contracts that a specialist will receive when the specialist is on parity with three or four controlled accounts.^[16] The Exchange, however, believes that the proposal will provide a more equitable treatment to all specialists such that specialists of both small and large crowds will receive a significant enhanced participation when there are five of more controlled accounts on parity.^[17]

The Commission recognizes that the purpose of the enhanced parity split is to encourage specialists to make deep and liquid markets to attract order flow to the Exchange. The Commission has previously noted that specialists have responsibilities and costs that crowd participants do not share, such as the staff costs associated with the requirement to continually update and disseminate quotes.^[18] As a result, the Commission believes it is reasonable for the Exchange to grant certain advantages to specialists, such as the enhanced parity split, to attract and retain well capitalized specialists at the Exchange. As long as these advantages do not unreasonably restrain competition and do not harm investors, the Commission believes that the granting of such benefits to specialists, in general, is within the business judgment of the Exchange. In this regard, the Commission believes that it is reasonable for the Exchange to revise the enhanced parity split as proposed.

The Commission believes that the proposal should provide reasonable benefits to specialists, given their heightened responsibilities and costs. The Commission believes that the approval of the proposal is consistent with the Act because the newly revised enhanced parity split should not unreasonably restrain competition and should not result in harm to investors. The Commission notes that customer orders on parity will continue to be assured a minimum participation equal to any other crowd participant, including the specialist.

IV. Conclusion

It Is Therefore Ordered, pursuant to section 19(b)(2) of the Act,^[19] that the proposed rule change (SR-Phlx-99-39), as amended, is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[20]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  In Amendment No. 1, the Exchange made technical changes to the proposal. See Letter from Nandita Yagnik, Phlx, to Richard Strasser, Assistant Director, Division of Market Regulation, Commission, dated November 3, 1999 (“Amendment No. 1”).

4.  See Securities Exchange Act Release No. 42161 (November 19, 1999), 64 FR 66958.

5.  See Securities Exchange Act Release No. 34606 (August 26, 1994), 59 FR 45741 (September 2, 1994). Initially , the enhanced parity split was approved as a one year pilot expiring August 26, 1995.

6.  See Securities Exchange Act Release No. 35028 (November 30, 1994), 59 FR 63151 (December 7, 1994).

7.  See Securities Exchange Act Release No. 35429 (March 1, 1995), 60 FR 12802 (March 8, 1995).

8.  See Securities Exchange Act Release No. 36122 (August 18, 1995), 60 FR 44530 (August 28, 1995); 37254 (August 5, 1996), 61 FR 42080 (August 13, 1996); and 38924 (August 11, 1997), 62 FR 44160 (August 19, 1997).

9.  See Securities Exchange Act Release No. 39401 (December 4, 1997), 62 FR 65300 (December 11, 1997).

10.  See Securities Exchange Act Release No. 41588 (July 1, 1999), 64 FR 37185 (July 9, 1999. The Exchange also received approval to give specialists an enhanced parity split when they develop and trade a new product (“New Products Split”). Under the New Products Split, when the specialist is on parity with three or more controlled accounts, the specialist receives 40% of the contracts and the controlled accounts receive the remaining 60%. When the specialist is on parity with less than three controlled accounts in the crowd, the specialist receives 60% of the contracts and the controlled accounts receive 40%. In either of these situations, if a customer is on parity, the customer may not receive a lesser allotment than any other crowd participant including the specialist. Id.

11.  A controlled account is defined as “any account controlled by or under common control with a member broker-dealer.” Customer accounts, which include discretionary accounts, are defined as all accounts other than controlled accounts. See Exchange Rule 1014(g)(i).

12.  The application of this enhanced parity split is mandatory. Therefore, with respect to any equity or index option transaction that implicates the enhanced parity split, the specialist is required to accept the preferential allocation and may not decline the enhancement. If an equity or index option trade is on parity, but not subject to the enhanced parity split (i.e., the order is for five or less contracts), the Exchange specialist is required to allocate the contracts according to the Exchange's priority and parity rules. See Exchange Rule 119, “Precedence of Highest Bid,” and Exchange Rule 120, “Precedence of Offers at Same Price.”

13.  15 U.S.C. 78f(b)(5).

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

15.  For example, under the current enhanced participation if there is an initiating order of fifty contracts, and three controlled accounts are on parity, the Specialist will receive twenty contracts and the controlled accounts will each receive ten contracts. In contrast, under the proposal the specialist will only receive fifteen contracts.

16.  See Amendment No. 1, supra note 3.

17.  Id.

18.  See, e.g., Security Exchange Act Release No. 35177 (December 29, 1994), 60 FR 2419 (January 9, 1995).

19.  15 U.S.C. 78S(B)(2).

20.  17 CFR 200.30-3(a)(12).