[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