[Federal Register Volume 59, Number 170 (Friday, September 2, 1994)]
[Notices]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-21703]


[[Page Unknown]]

[Federal Register: September 2, 1994]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34606; File No. SR-Phlx-94-12]

 

Self-Regulatory Organizations; Order Approving and Notice of 
Filing and Order Granting Accelerated Approval of Amendment Nos. 1 and 
2 to a Proposed Rule Change by the Philadelphia Stock Exchange, Inc., 
Relating to a Pilot Program for Enhanced Specialist Participation in 
Parity Equity Options Trades

August 26, 1994.
    On February 28, 1994, the Philadelphia Stock Exchange, Inc. 
(``Phlx'' or ``Exchange'') filed with 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 relating to enhanced specialist 
participation in parity equity options trades. Notice of the proposal 
appeared in the Federal Register on April 28, 1994.\3\ One comment 
letter was received opposing the proposed rule change.\4\ The Exchange 
filed Amendment No. 1 to the proposed rule change on April 29, 1994,\5\ 
and Amendment No. 2 on August 25, 1994.\6\ This order approves the 
Exchange's proposal, as amended.

    \1\15 U.S.C. 78s(B)(1) (1988).
    \2\17 CFR 240.19b-4 (1992).
    \3\See Securities Exchange Act Release No. 33935 (April 20, 
1994), 59 FR 22038 (April 28, 1994).
    \4\See Letter from Philip Lenowitz, to Jonathan Katz, Secretary, 
Commission, dated May 31, 1994 (``Comment Letter'').
    \5\In Amendment No. 1, the Phlx proposed to amend the proposed 
rule language to: (1) Provide in Rule 509(c), that any meeting with 
a specialist as a result of a preliminary determination by the Phlx 
Quality of Markets Subcommittee that a specialist has not satisfied 
the criteria specified in the rule will occur within five days after 
receipt of notice of such preliminary determination by the 
specialist; (2) clarify that any decision reached pursuant to Rule 
509 regarding the failure of a specialist to satisfy the 
requirements of the rule will be appealable pursuant to Article XI, 
Section 11-1(a) of the Phlx's by-laws; and (3) clarify that the 
``weakness'' referred to in Rule 509(b)(4) does not refer to any 
specific activity but to the general inability of a specialist to 
prevent and settle disputes in an orderly manner in the trading 
crowd. See Letter from Michele Weisbaum, Associate General Counsel, 
Phlx, to Brad Ritter, Attorney, Office of Market Supervision 
(``OMS''), Division of Market Regulation (``Division''), Commission, 
dated April 26, 1994 (``Amendment No. 1'').
    \6\In Amendment No. 2, the Phlx proposed to add Rule 
1014(g)(i)(3) to codify that specialists are not eligible for the 
enhanced parity treatment proposed herein until they are no longer 
eligible for the enhanced parity treatment afforded to new 
specialist units pursuant to Commentary .17 to Rule 1014. See Letter 
from William Uchimoto, First Vice President and General Counsel, 
Phlx, to Brad Ritter, Attorney, OMS, Division, Commission, dated 
August 25, 1994 (``Amendment No. 2'').
---------------------------------------------------------------------------

Description of Proposal

    Phlx Rules 119 and 120, generally, and Phlx Rule 1014(g), 
specifically, direct members in the establishment of priority and 
parity of orders on the options floor. These rules provide that when 
bids/offers are made simultaneously, or when it is impossible to 
determine clearly the order of time in which they were made, all such 
bids/offers shall be on parity, and as such shall be shared equally. 
Because all newly listed options classes are subject to multiple 
listing and all currently listed ones are or will become so eligible, 
the current parity participation rule has come under review by the 
Exchange.
    The Exchange proposes to adopt, on a one year pilot basis, a 
proposed rule change providing that in certain circumstances and for 
certain options classes, a specialist will be eligible to receive an 
enhanced participation on parity equity options trades by being counted 
as two crowd participants (``Enhanced Parity Split''). The Enhanced 
Parity Split will only apply to transactions where the contra side 
order is for more than five contracts, and where the Enhanced Parity 
Split does not disadvantage a customer order that is also on parity.\7\

    \7\The Exchange represents that one way to ensure that public 
customers are not disadvantaged is for a specialist to forego part 
or all of his second share of a trade. See Amendment No. 1, supra 
note 5.
---------------------------------------------------------------------------

    The Enhanced Parity Split will apply to all option classes that are 
listed after the rule becomes effective and for 50% of each specialist 
unit's listed issues at the time the rule becomes effective. In this 
regard, each specialist's registered issues will be divided into 
quartiles based on the most recent quarterly customer contract volume. 
The specialist will be able to choose half of his issues in each volume 
quartile rounded so that the aggregate number chosen does not exceed 
50% of the total number of issues in all four quartiles. The specialist 
will be required to submit this list to the Allocation, Evaluation and 
Securities Committee (``AES Committee'') for its review and approval. 
This list, once submitted to and approved by the AES Committee, will be 
in effect for the entire one-year period of the pilot program.
    The Phlx also proposes to adopt Phlx Rule 509 to empower the AES 
Committee to oversee each specialist's performance with respect to the 
Enhanced Parity Split. A standing subcommittee of the AES Committee 
entitled the ``Quality of Markets Subcommittee'' (``Subcommittee'') 
will be created to review each specialist's performance on a quarterly 
basis to assure that four conditions are being satisfied by a 
specialist who receives the benefit of the Enhanced Parity Split in his 
trading crowd. First, the specialist must demonstrate that he is the 
lead market maker in the trading crowd as measured by his transacting 
more contracts in an option class than any Registered Options Trader 
(``ROT'') in that issue over the review period.
    Secondly, the Subcommittee will review whether the specialist has 
provided the Phlx with adequate market share in options which are 
multiply traded. In this respect, the Subcommittee will determine 
whether the Phlx has transacted at least 10% of the aggregate customer 
volume in an issue that is traded by all five options exchanges, at 
least 15% where four exchanges trade the issue, at least 20% where 
three exchanges trade the issue, and at least 25% where only one other 
exchange trades the issue. Although this is a measure of the total 
customer volume executed on the Exchange rather than solely by the 
specialist, in the competition for multiply traded issues, the Exchange 
believes the specialist is a key party responsible for marketing the 
issue to upstairs firms, updating markets, and maintaining the limit 
order book. A specialist who performs these functions will, the 
Exchange believes, assist the Exchange in increasing order flow.
    Third, options specialist units must receive a score of at least 
five on the Exchange's quarterly specialist evaluation. Rule 515 
currently requires specialists to obtain this score for its activities 
regarding the options classes assigned to the specialist unit. A 
specialist who receives a score below five on the quarterly evaluation 
is monitored by the Exchange for continued substandard performance and 
may ultimately have one or more options classes removed and reallocated 
to another specialist. For purposes of the Enhanced Parity Split, the 
failure by a specialist to achieve a score of at least five on this 
quarterly review will cause the Enhanced Parity Split to be revoked 
even if the Exchange determines not to strip a specialist of assigned 
options classes.
    Fourth, the Subcommittee will consider whether a pattern of 
weakness has been demonstrated by such things as frequent floor 
official rulings with respect to any particular options class or crowd 
and/or by written customer complaints being received by the Exchange or 
Subcommittee regarding the specialist in any particular options 
class.\8\

    \8\Id.
---------------------------------------------------------------------------

    If the Subcommittee determines that a specialist has failed to meet 
one or more of these four conditions for any issue eligible for the 
Enhanced Parity Split, the Subcommittee must make a preliminary finding 
that the specialist should lose the Enhanced Parity Split in that 
issue. The specialist will be notified of this finding and will be 
required to appear before the Subcommittee within five business days 
after receipt by the specialist of the notice.\9\ At such meeting, the 
specialist bears the burden of overcoming the presumption of 
substandard performance.\10\

    \9\Id.
    \10\For example, a specialist might be able to overcome this 
presumption in the case where he has transacted less contracts than 
one ROT in his trading crowd during the review period. In this case, 
if the specialist can demonstrate that one large block trade 
occurred during the review period but for which that specialist 
would have been the lead market maker, the Subcommittee may 
determine that the specialist does not deserve to lose the Enhanced 
Parity Split privilege.
---------------------------------------------------------------------------

    Any decision of the Subcommittee must be in writing and must be 
delivered to the specialist on the next business day following the 
Subcommittee meeting at which the decision was made. A decision to 
revoke the privilege will be effective on the next business day after 
receipt of the decision by the specialist. A specialist who has lost 
the privilege may reapply for it at the Subcommittee's next scheduled 
review. The specialist may be reinstated if the Subcommittee finds that 
the condition which initially caused the revocation of the enhanced 
participation privilege has been cured and that no other problems 
exist. Finally, a specialist will be entitled to appeal any decisions 
made by the Subcommittee pursuant to Rule 509.\11\

    \11\See Amendment No. 1, supra note 5.
    The Exchange believes that the proposed rule change is necessary 
because the Exchange has identified the need to attract new specialist 
units and to retain and encourage existing specialists units to 
vigorously trade existing options classes as well as to aggressively 
seek and apply for newly allocated classes. The Phlx understands that 
for the most part, specialist units can seek specialist privileges or 
the equivalent lead market maker status for any particular multiply 
listed options class on other national securities exchanges. Therefore, 
in order to compete for specialist capital and market making talent 
with other national securities exchanges which list options, the Phlx 
believes it is necessary to be able to afford its specialist units with 
some form of enhanced parity split treatment. Specifically, in order to 
address these factors, the Exchange has determined to implement this 
one-year pilot program to increase the specialist's participation in 
certain trades where the specialist is on parity with one or more ROTs.
    The Exchange represents that while ROTs provide critical liquidity 
to the market making process at the Phlx, under the Phlx's specialist 
system, the role of the specialist is to provide leadership, liquidity, 
and continuity, and to satisfy market making obligations in multiply 
listed options classes, particularly at the incipiency of competition 
for a multiply traded issue. For the options classes that will be 
eligible for multiple listing, the Exchange represents that specialists 
have also taken on a larger market making obligation in order to 
accommodate customers in the hope of garnering critical loyalty that 
will lead to sustained order flow whether the class is or is not ever 
actually multiply traded.
    As a point of clarification, the Exchange states that this proposed 
rule change will operate in tandem with the enhanced specialist 
participation provided for new specialist units pursuant to Phlx Rule 
1014, Commentary .17.\12\ Upon approval of the proposed rule change, a 
specialist will only be eligible to receive the Enhanced Parity Split 
described herein once the specialist is no longer eligible for the 
enhanced treatment available pursuant to Commentary .17 to Rule 
1014.\13\

    \12\See Securities Exchange Act Release No. 34109 (May 24, 
1994), 59 FR 28570 (June 2, 1994) (``New Unit Enhanced Split 
Order'').
    \13\See Amendment No. 2, supra note 6. Pursuant to Commentary 
.17 to Rule 1014, new specialist units trading new options classes 
would be entitled to execute 50% of the contracts in transactions 
where the new specialist unit is on parity with one ROT, and 40% of 
the contracts in a transaction where the new specialist unit is on 
parity with two or more ROTs. See Securities Exchange Act Release 
No. 34109 (May 25, 1994), 59 FR 28570 (June 2, 1994).
---------------------------------------------------------------------------

Comment Letter

    The comment letter received opposing the proposed rule change 
offered two arguments as to why the proposed rule change is 
inappropriate.\14\ The commenter first argues that the proposed rule is 
anti-competitive and will ultimately harm public customers by acting as 
a disincentive for ROTs to make competitive markets. Secondly, the 
commenter argues that a floor official will be unable to determine 
whether a customer order is ``disadvantaged'' as prohibited by the 
rule. He further argues that tracking which options are entitled to the 
Enhanced Parity Split and which are not will be a difficult chore and 
that the need for elaborate review machinery to assure compliance with 
the proposed rule change is evidence that the rule is unmanageable.

    \14\See Comment Letter, supra note 4.
---------------------------------------------------------------------------

Phlx Response

    Because this commenter raises the same objections that were raised 
in connection with the Phlx proposal approved in the New Unit Enhanced 
Split Order,\15\ the Phlx relies on its previous response letter in 
order to address the objections raised in the Comment Letter.\16\ In 
response to the commenter's claims that the rule will work to the 
detriment of the trading public, the Phlx believes that the proposal 
will in fact add liquidity to the market, thus directly benefitting 
public customers. The Phlx believes the proposal will attract new 
specialists to the Exchange and will encourage new and existing 
specialists to make tight markets in their selected options classes in 
order to attract order flow to the Exchange. The Phlx argues that 
because every newly listed options class is subject to multiple 
listing, disincentives are created which discourage specialists from 
acting as specialists for those new classes of options. The Phlx 
believes that the Enhanced Parity Split will counteract these 
disincentives by offering specialists a direct benefit if they are able 
to attract order flow to the Exchange. The Exchange further believes 
the specialists will be able to attract this order flow, and thus 
capitalize on the Enhanced Parity Split, only if they maintain tight 
markets in their selected options classes. Furthermore, the proposed 
rule change provides that the Enhanced Parity Split may not 
disadvantage an order submitted by a public customer.\17\ As a result, 
the Phlx believes that public customers will directly benefit from the 
proposed rule change.

    \15\See supra note 12.
    \16\See File No. SR-Phlx-93-29; and Letter from William 
Uchimoto, Vice President and General Counsel, Phlx, to Sharon 
Lawson, Assistant Director, OMS, Division, Commission, dated 
February 23, 1994.
    \17\See Amendment No. 2, supra note 6.
---------------------------------------------------------------------------

    In response to the commenter's claims that market makers are 
unfairly disadvantaged by this proposal, the Phlx makes several 
arguments. First, the Phlx disagrees with the commenter's contention 
that any enhanced split is anti-competitive because a ROT can always 
establish priority in a trade by improving the market or by being the 
first in establishing a market that would otherwise be on parity. 
Secondly, the Phlx argues that specialists have responsibilities and 
are subject to certain costs that market makers do not have, such as, 
updating and disseminating quotes, reflecting all market interest in 
the displayed quotes, and the fixed staffing cost committed to market 
making in a particular issue whether it is active or not. In order to 
attract specialist units to the Exchange who are willing to accept 
these responsibilities, the Phlx believes it is necessary to provide 
specialists with some benefits that are not available to ROTs. The Phlx 
believes that any negative impact to ROTs that may be caused by this 
proposal is more than offset by the benefit to the Exchange and its 
customers of attracting new specialist units to the Exchange and 
retaining the services of existing specialist units.
Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 6(b)(5)\18\ in that the 
proposal is designed to promote just and equitable principles of trade, 
to remove impediments to and perfect the mechanism of a free and open 
market, and protect investors and the public interest. Specifically, 
the Commission finds that the proposal may serve to remove impediments 
to and perfect the mechanism of a free and open market by encouraging 
specialist units to maintain tight markets in selected options classes 
in order to attract order flow to the Exchange. The Commission believes 
the proposed rule change is a reasonable attempt by the Phlx to enhance 
the ability of specialist units to compete for order flow in the 
environment of multiply-traded options classes. In addition, the 
protection of investors and the public interest is maintained because 
of the procedures being adopted by the Exchange which require the 
specialist units to satisfy specific conditions to qualify for the 
Enhanced Parity Split. Further, the proposed rule change provides that 
the Enhanced Parity Split cannot disadvantage a public customer order 
that is on parity with a specialist unit.\19\

    \18\15 U.S.C. 78f(b)(5) (1988).
    \19\See Amendment No. 2, supra note 6.
---------------------------------------------------------------------------

    As the Commission stated in the new Unit Enhanced Split Order, the 
Commission agrees with the Exchange that in order to attract order flow 
to the Exchange, the Phlx needs to be able to attract and retain well 
capitalized specialist units that are willing to trade the options 
classes traded on the Exchange. Additionally, the Commission disagrees 
with the commenter that the proposed rule change will disadvantage 
public customers. On the contrary, the proposed rule change eliminates 
any direct injury to public customers by providing that customers 
orders on parity may not receive a smaller participation than any other 
crowd participant, including the specialist. Furthermore, because the 
proposal may serve to add liquidity to the market by encouraging 
specialist units to maintain tight markets in order to attract order 
flow to the Exchange, the Commission believes that public customers 
could benefit from the proposed rule change.\20\ Accordingly, the 
Commission believes there is no evidence to support a conclusion that 
the proposed rule change will disadvantage public customers.

    \20\The Commission notes that contrary to the commenter's 
contention, ROTs may in fact benefit from the Enhanced Parity Split 
if specialists are successful in attracting order flow to the 
Exchange.
---------------------------------------------------------------------------

    The Commission also acknowledges that specialist have 
responsibilities that ROTs do not have and that these responsibilities 
have certain costs associated with them, such as the staff costs 
associated with continually updating and disseminating quotes. As a 
result, the Commission believes it is reasonable for the Exchange to 
grant certain advantages, such as the Enhanced Parity Split, to 
specialists in order to attract and retain well capitalized specialists 
at the Exchange. Accordingly, as long as these advantages do no 
unreasonably restrain competition and do not harm investors, the 
Commission believes that the granting of such benefits to specialists 
is within the business judgment of the Exchange. Therefore, even though 
the proposed rule change could arguably have some negative impact on 
ROTs, for the reasons stated above, the Commission believes the 
proposal is consistent with the Act.
    Furthermore, the Commission believes that: (1) the review 
procedures proposed by the Exchange, as discussed above, adequately 
ensure that only specialists satisfying the conditions set forth in the 
proposed rule change receive the benefit of the Enhanced Parity Split; 
and (2) in cases where a specialist is found to no longer be eligible 
for the Enhanced Parity Split, the appeals procedures proposed by the 
Exchange adequately protect the due process rights of such specialists. 
The Commission believes that these criteria balance the competing 
interests of the Exchange and the specialists by ensuring regular 
review of specialist performance and that specialists' due process 
rights are protected in cases where the Subcommittee makes a 
determination that the Enhanced Specialist Split should be denied.
    Moreover, the proposal is being approved on a one-year pilot basis. 
Accordingly, prior to granting an extension or permanent approval of 
the pilot program, the Commission will be able to review the operation 
of the rule and require the Exchange to make any changes necessary to 
ensure that competition is not being unnecessarily restrained and that 
investors are not being harmed.
    The Commission finds good cause for approving Amendment Nos. 1 and 
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. 
Specifically, the Commission believes that Amendment No. 1 strengthens 
the proposal in several ways. By requiring specialists to meet with the 
Subcommittee within five days after receipt of a notice from the 
Subcommittee, the specialist is provided with time in which to prepare 
a response to the claims of substandard performance raised by the 
Subcommittee. Similarly, by clarifying that all determinations made 
pursuant to Rule 509 are appealable pursuant to the procedures in the 
Exchange's by-laws, the Commission believes that the proposal does not 
raise any significant due process concerns.
    Furthermore, even though Amendment No. 1 does not specifically 
define ``pattern of weakness'' for purposes of Rule 509(b)(4), the 
Commission does not believe that this lack of specificity will create 
undo confusion as the application of the rule. Any specialist that is 
cited for substandard performance for this reason will still be 
entitled to a meeting with the Subcommittee to discuss the reasons for 
the finding and if an adverse decision is sustained after that meeting, 
the specialist will be entitled to appeal that determination. 
Additionally, a specialist can reapply and have the Enhanced Parity 
Split reinstated once the condition which led to the suspension is 
found to no longer exist. As a result, the Commission believes that the 
lack of specificity does not raise any significant regulatory concerns.
    Finally, Amendment No. 2 merely codifies that intent stated in the 
original proposal\21\ that specialists will only become eligible for 
the Enhanced Parity Split described herein once they are no longer 
eligible to receive the enhanced parity treatment afforded to new 
specialists pursuant to Commentary .17 to Rule 1014.

    \21\See supra note 3.
---------------------------------------------------------------------------

    Based on the foregoing reasons, the Commission believes it is 
consistent with Section 6(b)(5) of the Act to approve Amendment Nos. 1 
and 2 to the Phlx's proposal 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, NW., Washington, DC 20549. 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 Section, 450 Fifth Street, NW., Washington, DC. Copies of 
such filing will also be available for inspection and copying at the 
principal office of the Exchange. All submissions should refer to File 
No. SR-Phlx-94-12 and should be submitted by September 23, 1994.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\22\ that the proposed rule change (SR-Phlx-94-12) is hereby 
approved, as amended, on a pilot basis until August 26, 1995.

    \22\15 U.S.C. 78s(b)(2) (1988).
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\23\

    \23\17 CFR 200.30-3(a)(12) (1993).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-21703 Filed 9-1-94; 8:45 am]
BILLING CODE 8010-01-M