[Federal Register Volume 59, Number 221 (Thursday, November 17, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-28451]


[[Page Unknown]]

[Federal Register: November 17, 1994]


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

SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34959; File No. SR-CBOE-94-15]

 

Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving a Proposed Rule Change and Notice of Filing and 
Order Granting Accelerated Approval of Amendment No. 1 to a Proposed 
Rule Change Relating to Solicited Transactions

November 9, 1994.

I. Introduction

    On May 3, 1994, the Chicago Board Options Exchange, Inc. (``CBOE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposal to adopt a new Rule 6.9 that would regulate 
the execution of ``solicited orders''; would set forth specific 
priority principles applicable to such orders; and would restrict 
trading by members and associated persons possessing knowledge of 
imminent undisclosed solicited transactions. On September 19, 1994, the 
CBOE filed Amendment No. 1 to its proposal.\3\ The proposed rule change 
was published for comment and appeared in the Federal Register on July 
13, 1994.\4\ One comment letter was received on the proposed rule 
change,\5\ to which the CBOE responded.\6\
---------------------------------------------------------------------------

    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1993).
    \3\Amendment No. 1 to the CBOE's proposal serves to make three 
minor revisions: (1) the first paragraph of Proposed Rule 6.9 is 
amended to make it clear that the rule includes solicitations by 
floor brokers who do not represent an original order but who become 
aware of the original order when it is announced in the trading 
crowd or otherwise; (2) Proposed Interpretation and Policy .04 is 
revised to reflect that only paragraph (a) of Rule 6.9 overrides the 
Exchange's crossing rule, Rule 6.74; and (3) Proposed Interpretation 
and Policy .05 is revised by deleting the introductory clause and 
adding an example to make it clear that the priority of an original 
order is in all cases governed by the priority principals of Rule 
6.45. See letter from Michael L. Meyer, Schiff Hardin & Waite, to 
Sharon M. Lawson, Assistant Director, Division of Market Regulation, 
Commission, dated September 15, 1994 (``Amendment No. 1'').
    \4\See Securities Exchange Act Release No. 34323 (July 6, 1994), 
59 FR 35771.
    \5\See letter from John Davoli, General Partner, O'Connor & 
Associates, to Margaret H. McFarland, Deputy Secretary, Commission, 
dated August 2, 1994 (``Comment Letter'').
    \6\See letter from Joanne Moffic-Silver, Associate General 
Counsel & Chief Enforcement Attorney, CBOE, to Jonathan Katz, 
Secretary, Commission, dated September 16, 1994.
---------------------------------------------------------------------------

II. Description of the Proposal

    The purpose of the CBOE's proposal is to regulate the execution of 
``solicited'' transactions in options, i.e., options transactions 
having terms that are negotiated prior to the time the orders 
comprising the transaction are exposed to the trading crowd on the CBOE 
floor.\7\ The proposed rule change also restricts trading in any class 
of an option, as well as trading in the underlying security or any 
``related instrument,'' by CBOE members and their associated persons 
who have knowledge of an imminent solicited transaction in options of 
that class. This prohibition applies until all terms are disclosed to 
the trading crowd or until execution of the solicited transaction 
cannot reasonably be considered imminent given the passage of time 
since the transaction was agreed upon.
---------------------------------------------------------------------------

    \7\Proposed Rule 6.9 states:
    A member or member organization representing an order respecting 
an option trading on the Exchange (an ``original order''), including 
a spread, combination, or straddle order as defined in Rule 6.53 and 
a stock-option order as defined in Rule 1.1(ii), may solicit a 
member or member organization or a non-member customer or broker-
dealer (the ``solicited person'') to transact in-person or by order 
(a ``solicited order'') with the original order.
---------------------------------------------------------------------------

    Currently, the CBOE's rules are designed to promote order 
interaction in an open-outcry auction. For example, Rule 6.43 requires 
bids and offers to be made at the post by public outcry, and Rule 6.74 
imposes specific order exposure requirements on floor brokers seeking 
to cross buy orders with sell orders. The CBOE believes that if the 
orders that comprise a solicited transaction are not suitably exposed 
to the order interaction process on the CBOE floor, the execution of 
such orders would be inconsistent with the open auction market 
principles governing the execution of orders on the CBOE's floor.
    Proposed Rule 6.9 is intended to preserve the right that CBOE 
members currently enjoy the solicit orders in advance of submitting a 
proposed trade to the crowd, while at the same time assuring that 
original orders that are the subject of a solicitation are exposed to 
the auction market in a meaningful way. For instance, the proposed rule 
change would require a member representing an original order that is 
the subject of a solicitation to disclose the terms of the original 
order to the crowd before the original order can be executed.
    The CBOE's proposal establishes a series of priority principles for 
solicited transactions. Priority is accorded depending on whether the 
original order is disclosed throughout the solicitation period; whether 
the solicited order improves the best bid or offer in the crowd; and 
whether the solicited order matches the original order's limit. Thus, 
when the original order is disclosed in advance of the solicitation and 
the solicited order both matches the disclosed original order's limit 
and improves the market, the solicited order has priority over other 
orders in the crowd and may trade with the original order at the 
improved bid or offered price, subject to the customer limit order book 
priorities set forth in Rule 6.45. When a solicited order does not 
match the original order's limit and does not improve the market, 
however, it does not have priority over other bids and offers 
represented in the crowd even if the original order was disclosed to 
the crowd for the full solicitation period. Under the proposal, if an 
original order is not disclosed to the crowd, a responsive solicited 
order will not have priority to trade with the original order even if 
the solicited order improves the market; instead, in that instance, 
others in the crowd may trade ahead of the solicited person at the 
improved price, subject to the customer limit order priorities in CBOE 
Rule 6.45.
    In addition to requiring disclosure of original orders and 
clarifying the priority principles applicable to solicited 
transactions, proposed Rule 6.9(e) clarifies that it is inconsistent 
with just and equitable principles of trade for any member or 
associated person, who has knowledge of all the material terms of an 
original order and a solicited order that matches the original order's 
price, to enter an order to buy or sell an option of the same class as 
any option that is the subject of the solicitation prior to the time 
the original order's terms are disclosed to the crowd or the execution 
of the solicited transaction can no longer reasonably be considered 
imminent. This prohibition would extend to orders to buy or sell the 
underlying security or any ``related instrument,'' as that term is 
defined in the Rule.\8\ The CBOE has stated that the purpose of these 
measures is to prevent members and associated persons from using 
undisclosed information about imminent solicited option transactions to 
trade the relevant option or any closely-related instrument in advance 
of persons represented in the relevant options crowd. Moreover, the 
CBOE believes that proposed Rule 6.9 improves the CBOE's auction by 
clarifying the requirements applicable to solicited transactions and by 
enabling the CBOE to initiate enforcement proceedings in appropriate 
cases under specific rules.
---------------------------------------------------------------------------

    \8\An order to buy or sell a ``related instrument'' means, in 
reference to an index option, an order to buy or sell securities 
comprising ten percent or more of the component securities in the 
index or an order to buy or sell a futures contract on any 
economically equivalent index. In addition, with respect to an 
option of the Standard & Poor's 500 Stock Index, an option on the 
Standard & Poor's 100 Stock Index is a related instrument, and vice 
versa. See Proposed CBOE Rule 6.9(e).
---------------------------------------------------------------------------

III. Comment Letter

    The Comment Letter\9\ concerning the proposed rule change addressed 
two areas of concern. First, the letter questions whether the proposed 
rule applies to those market makers who are continuously present in a 
trading crowd. Second, the commenter claims that the terminology used 
in the proposed rule is vague and undefined.
---------------------------------------------------------------------------

    \9\See supra note 5.
---------------------------------------------------------------------------

    The commenter claims that the CBOE's proposed rule is silent with 
respect to its applicability to market makers continuously present in 
the trading crowd. Instead, the commenter claims that the proposal only 
specifically addresses those situations where a market maker decides to 
participate in a solicitation either by order or by appearing in person 
in the trading crowd, and believes the proposal should make this clear.
    The commenter, however, is concerned that if the proposed rule 
imposes solicitation-related trading restrictions on market makers who 
are physically present in a trading crowd on a continual basis, this 
would significantly affect such market makers' ability to fulfill their 
market making functions under CBOE rules. According to the commenter, 
such an interpretation conceivably could preclude any number of market 
makers in a given trading crowd from trading in their appointed option 
classes for an undetermined amount of time in instances when a 
solicited transaction never materializes into an actual order in a 
trading crowd.
    The commenter also expressed concern that the terminology used in 
the CBOE's proposal is vague or undefined, making it difficult for the 
Exchange to enforce the rule consistently. Specifically, the commenter 
believes the rule should define what comprises ``all of the material 
terms'' of an order, what establishes an order as ``imminent,'' and the 
length of time that trading restrictions remain in effect following a 
solicitation.
    In its response, the CBOE addresses each of the commenter's 
concerns.\10\ With respect to the commenter's concern that the CBOE 
proposal ignores market makers continuously present in a trading crowd, 
the CBOE states that for purposes of its proposed rule, a member's 
location at the time a solicitation is received is irrelevant. The 
proposed rule applies to all members, including market makers, whether 
or not continuously present in a trading crowd, and whether or not 
present in the crowd at the time of the solicitation.
---------------------------------------------------------------------------

    \10\See letter from Joanne Moffic-Silver, supranote 6.
---------------------------------------------------------------------------

    As for the commenter's contention that the proposal's reach is too 
broad if it is meant to apply to market makers continuously present in 
a trading crowd, the CBOE notes that the only transactions prohibited 
by its proposed rule are those that are based on knowledge of the terms 
(which requires knowledge of the price of both the original and 
responsive solicited order) of an imminent, undisclosed solicited 
transaction. Thus, general solicitations of interest that do not 
specify all material terms, or other solicitations that do not result 
in express or tacit agreement on all material terms of a trade, 
including price, do not give rise to trading restrictions under the 
rule. Further, trades not based on undisclosed knowledge of a 
solicitation are not restricted.
    Regarding the commenter's contention that the terms ``material'' 
and ``imminent'' as used in the proposal are undefined and vague, the 
CBOE responds that similar terms and concepts are used in the 
regulatory circulars of the CBOE and other exchanges prohibiting front 
running of block transactions. According to the CBOE, many of the 
principles in the proposed rule are derived from the frontrunning 
context, where compliance and enforcement has not been difficult. 
Similarly, the CBOE contents, compliance and enforcement should not be 
difficult in the context of solicited transactions.

IV. Discussion

    The Commission finds the proposed rule change consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange. Specifically, the 
proposed rule change is consistent with the requirements of Sections 
6(b)(5) of the Act, because the proposal is designed to promote just 
and equitable principles of trade, remove impediments to and perfect 
the mechanism of a free and open market, and protect investors and the 
public interest.
    The Commission believes that it is appropriate to permit 
solicitation between potential buyers and potential sellers of options 
in advance of the time they send actual orders to the trading crowd on 
the Exchange. Complex options orders, such as spreads, straddles, and 
combination orders, as well as stock-option orders and large-sized 
orders, often require the ``advance shopping'' that is characteristic 
of a solicited transaction. Therefore, the Commission agrees with the 
CBOE that such interactions between buyers and sellers and the 
resulting solicited transactions can enhance liquidity and depth at the 
CBOE by bringing orders to the floor that might otherwise be difficult 
to effect.
    Nevertheless, because solicited transactions may entail 
individualized negotiation, the orders that comprise a solicited 
transaction may not adequately be exposed to the floor auction. 
Consequently, the crowd may not have sufficient time to digest and 
react to those orders' terms, causing the parties to a solicited 
transaction to preempt the crowd by executing it at the pre-negotiated 
price.
    The Commission believes that the CBOE's proposal strikes the proper 
balance of allowing members to solicit, in advance, the other side of 
an order, while ensuring at the same time that the order will be 
exposed to the trading crowd consistent with auction market principles. 
The proposal encourages disclosure of an original order to the trading 
crowd by making the priority of a solicited order dependent upon the 
degree of disclosure to the crowd, and upon whether the order improves 
the market.\11\ Such disclosure gives members of the trading crowd the 
opportunity to participate in all transactions, including solicited 
transactions, and should ensure that customer orders receive the best 
price available on the CBOE floor. At the same time, the CBOE's 
proposal will enable members to search for contra-side interest for 
orders that will ultimately be brought down to the CBOE floor, thereby 
enhancing depth and liquidity on the CBOE floor.
---------------------------------------------------------------------------

    \11\As noted above, the priority principles set forth in the 
proposal are subject to customer limit order priorities in CBOE Rule 
6.45.
---------------------------------------------------------------------------

    Absent the proposal, the only guidelines concerning solicited 
transactions are contained in a 1988 memorandum to the CBOE's 
membership.\12\ The lack of codified Exchange rules governing such 
activity could cause uncertainty and hinder solicitation of additional 
trading interest. The Exchange's proposal introduces clear rules 
applicable to solicited transactions, and strengthens the ability of 
the Exchange to ensure that customer orders receive full consideration 
by the trading crowd. In addition, the proposed rule change will enable 
the Exchange to monitor more effectively transactions where orders have 
been solicited outside the trading crowd, and should ensure that 
transactions involving solicitation will be executed consistent with 
auction market principles.
---------------------------------------------------------------------------

    \12\See Memorandum from Market Performance Committee regarding 
Prior Knowledge of Orders/Rule 8.1 (Requirement that market maker 
transactions/order be initiated from the trading floor), dated 
January 20, 1988 (describing, among other things, situations in 
which it may be appropriate for a member representing an order to 
solicit buying or selling interest for the opposite side of the 
order).
---------------------------------------------------------------------------

    The Commission also believes that the commenter's concerns have 
been adequately addressed. In this regard, the Commission believes that 
it is appropriate for the CBOE to prohibit, as inconsistent with just 
and equitable principles of trade, transactions by members based on the 
knowledge of imminent undisclosed solicited transactions, irrespective 
of a member's location in or out of the trading crowd at the time of 
the solicitation. Without this prohibition, such trading can threaten 
the integrity of the auction market or disadvantage unwittingly other 
market participants.
    Although the Commission recognizes that the trading restrictions 
may prevent a market maker from conducting certain transactions while 
in the crowd, we do not believe the proposal inhibits CBOE market 
makers from fulfilling their market making functions. The trading 
restrictions only will apply if the member has knowledge of all 
material terms and conditions, including the price of both sides of the 
trade, of an imminent undisclosed solicited transaction. General 
solicitations will not give rise to trading restrictions under the 
proposal. Moreover, market maker trades not based on undisclosed 
knowledge of the terms of a solicited transaction are not restricted. 
Thus, a market maker only will be subject to trading restrictions when 
he or she trades based on the information regarding an imminent 
transaction that is not disclosed to the trading crowd. It is 
reasonable for the CBOE to conclude that transactions effected under 
such circumstances are inconsistent with market making obligations, and 
should be restricted. Accordingly, the Commission believes that market 
makers will still be able to perform their functions fully, and will be 
expected to do so, notwithstanding the trading restrictions imposed 
under the rule. Finally, regarding the commenter's concerns that the 
terms in the CBOE's proposed rule are vague, the Commission agrees with 
the CBOE that, although subject to interpretation, when used in other 
contexts these terms have not posed a problem for the Exchange or the 
Commission.
    In summary, the Commission believes that the CBOE proposal is a 
reasonable approach to ensure that solicited, prenegotiated orders are 
not ``hidden'' from interaction with the auction market. Such orders 
should be exposed to the trading crowd to ensure that the best price 
available is obtained. At the same time, the proposal will still 
provide market participants with flexibility to search for interest for 
unusual or complex orders. By setting forth a set of priority 
principles, subject to the priorities granted to the customer limit 
order book, to encourage disclosure of solicited orders, and by 
prohibiting market participants from trading ahead of others based on 
undisclosed knowledge of solicited orders, the proposal should benefit 
market participants and ensure investor protection consistent with 
Section 6(b)(5) of the Act.
    The Commission finds good cause for approving Amendment No. 1 to 
the proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1 effects three minor revisions to the CBOE's proposal. 
First, paragraph one of Proposed Rule 6.9 is amended to make it clear 
that the rule includes solicitations by floor brokers who do not 
represent such an original order but who become aware of the original 
order when it is announced in the trading crowd or otherwise. Second, 
Proposed Interpretation and Policy .04 is revised to reflect that only 
paragraph (a) of Rule 6.9 overrides the Exchange's crossing rule, CBOE 
Rule 6.74. Third, Proposed Interpretation and Policy .05 is revised by 
deleting the introductory clause and adding an example to make it clear 
that the priority of an original order is in all cases governed by the 
priority principals of Rule 6.45.
    The Commission believes that Amendment No. 1 strengthens the 
Exchange's proposal by refining some of the language used in its 
proposed rule. Moreover, these changes do not affect the substance of 
the Exchange's proposal. Accordingly, the Commission believes the 
Amendment raises no new or unique regulatory issues. Therefore, the 
Commission believes it is consistent with Sections 6(b)(5) and 19(b)(2) 
of the Act to approve Amendment No. 1 to the proposal on an accelerated 
basis.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 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. Sec. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 450 Fifth Street, 
N.W., Washington, D.C. 20549. 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-94-15 and should 
be submitted by [insert date 21 days from date of publication].

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act, and, in particular, Section 6 of 
the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\13\ that the proposed rule change (File No. SR-CBOE-94-15), as 
amended, is approved.
---------------------------------------------------------------------------

    \13\15 U.S.C. 78s(b)(2) (1988).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
---------------------------------------------------------------------------

    \14\17 CFR 200.30-3(a)(12) (1993).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-28451 Filed 11-16-94; 8:45 am]
BILLING CODE 8010-01-M