[Federal Register Volume 59, Number 199 (Monday, October 17, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-25553]


[[Page Unknown]]

[Federal Register: October 17, 1994]


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

SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34807; File No. SR-CBOE-94-06]

 

Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 1 and 2 to the Proposed Rule Change by the Chicago Board 
Options Exchange, Inc. Relating to Exercise Cut-Off Procedures for 
Expiring Equity Options

October 7, 1994.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'').\1\ and Rule 19b-4 thereunder,\2\ on March 16, 1994, the 
Chicago Board Options Exchange, Inc. (``CBOE'' or ``Exchange'') 
submitted to the Securities and Exchange Commission (``Commission'') a 
proposed rule change relating to the exercise procedures for expiring 
equity option contracts. The proposal was published for comment in the 
Federal Register on May 18, 1994.\3\ No comments were received on the 
proposed rule change. The CBOE filed Amendment No. 1 to the proposal on 
September 19, 1994, and Amendment No. 2 on October 5, 1994.\4\ This 
order approves the proposed rule change, as amended.\5\
---------------------------------------------------------------------------

    \1\15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1993).
    \3\See Securities Exchange Act Release No. 34051 (May 12, 1994), 
59 FR 25970 (May 18, 1994).
    \4\In Amendment Nos. 1 and 2, the CBOE proposes to make certain 
clarifying amendments to Rule 11.1, as discussed herein. See Letters 
from Jeffrey Schroer, Vice President, Market Regulation, Regulatory 
Services Division, CBOE, to Sharon Lawson, Assistant Director, 
Office of Market Supervision (``OMS''), Division of Market 
Regulation (``Division''), Commission, dated September 19, 1994 
(``Amendment No. 1''); and from Patricia Cerny, Director, Department 
of Market Surveillance, CBOE, to Brad Ritter, Senior Counsel, OMS, 
Division, Commission, and dated October 5, 1994 (``Amendment No. 
2'').
    \5\The Commission notes that substantively similar proposals by 
the other options exchanges are being approved concurrently with the 
CBOE's proposed rule change. See File Nos. SR-Amex-94-01; SR-Phlx-
93-37; and SR-PSE-94-12.
---------------------------------------------------------------------------

    Currently, with regard to expiring equity options, CBOE customers 
and member organizations\6\ are required to indicate their exercise 
decisions to clearing members no later than 5:30 p.m. Eastern Standard 
Time (``E.S.T.'') on the business day immediately prior to the 
expiration date of the options (``Exercise Cut-Off Time'').\7\ This is 
the latest time at which an exercise instruction\8\ may be: (1) 
Prepared by a clearing member for positions in its proprietary trading 
account; (2) accepted by a clearing member from a market maker or floor 
broker for positions in the market maker's account or the floor 
broker's error account; or (3) accepted by a member organization from 
any customer for positions in the customer's account.\9\ The only 
exceptions to Rule 11.1 are: (1) To remedy mistakes or errors made in 
good faith; (2) to take appropriate action as the result of a failure 
to reconcile unmatched Exchange transactions; and (3) where exceptional 
circumstances relating to a customer's or member's ability to 
communicate exercise instructions to a member organization (or a member 
organization's ability to receive such exercise instructions) prior to 
the Exercise Cut-Off Time warrant such action.\10\ An exercise 
instruction memorandum must be prepared and time stamped for the 
exercise of all option contracts not automatically exercised pursuant 
to OCC Rule 805.\11\ If a member organization receives an exercise 
instruction or tenders an exercise notice to the OCC pursuant to one of 
the exceptions described above, the member organization must maintain a 
memorandum setting forth the circumstances giving rise to the 
exception.\12\
---------------------------------------------------------------------------

    \6\As used herein, the term ``member organization'' also 
includes individual members of the Exchange.
    \7\See CBOE Rule 11.1. Generally, equity options may be traded 
until the close of business on the last business day before 
expiration, which is generally the third Friday of the expiration 
month (``Expiration Friday'').
    \8\For customers, an exercise instruction is a notice delivered 
to a member organization to exercise an option. For a clearing 
member, market maker, or floor broker, an exercise instruction is a 
notice to The Options Clearing Corporation (``OCC'') to exercise an 
option that would not be automatically exercised pursuant to the 
OCC's exercise-by-exception procedure (``OCC Rule 805''), or not to 
exercise an option that otherwise would automatically be exercised 
pursuant to OCC Rule 805. See infra note 15. The OCC has separate 
rules regarding the cut-off time by which exercise notices must be 
delivered to the OCC by the clearing members. The proposed rule 
change does not in any way affect the rules of the OCC.
    \9\In most cases, exercise instructions are transmitted to 
Exchange clearing members electronically through the Clearing 
Management and Control System (``C/MACS''). Telephone conversation 
between Jeffrey Schroer, Vice President, Market Surveillance, CBOE, 
and Brad Ritter, Attorney, OMS, Division, Commission, on July 27, 
1994.
    \10\CBOE Rule 11.1 does not apply to expiring series of index 
options on the business day immediately prior to expiration. See 
CBOE Rule 11.1, Interpretation .03(e). An additional purpose of the 
proposed rule change is to specifically state within Rule 11.1 that 
the Exercise Cut-Off Time does not apply to expiring index options.
    \11\See infra note 14. The Exchange deems the preparation, time 
stamping, or submission of an exercise instruction memorandum prior 
to the purchase the contracts to be exercised to be a violation of 
Rule 11.1. See CBOE Rule 11.1, Interpretation .02.
    \12\Should the market maker, customer or firm subsequently 
determine not to exercise all or part of the advised contracts, the 
member must also deliver an ``advice cancel'' in such form or manner 
as prescribed by the Exchange. See CBOE Rule 11.1, Interpretation 
.03(a).
---------------------------------------------------------------------------

    Presently, it is a violation of Rule 11.1 for clearing members to 
accept exercise instructions after the Exercise Cut-Off Time, except in 
reliance on one of the above exceptions. Because exercise instructions 
are submitted to the clearing members and then to the OCC by the 
clearing members, without having the audit trail pass directly through 
the Exchange, it is difficult for the Exchange to surveil for 
violations of Rule 11.1.\13\
---------------------------------------------------------------------------

    \13\The Commission believes that the Exercise Cut-Off Time 
serves an important investor protection function. Specifically, the 
Exercise Cut-Off Time protects holders of short positions in equity 
options from unanticipated events occurring after the close of the 
market. As the Commission has previously stated, if expiring equity 
options were allowed to be exercised after the Exercise Cut-Off Time 
for reasons other than the exceptions set forth above, the 
Commission believes that options writers could be unfairly 
disadvantaged with respect to options holders by not having the same 
opportunity to react to such unanticipated events. See Securities 
Exchange Act Release No. 19589 (March 10, 1983), 48 FR 11196 (March 
16, 1983).
---------------------------------------------------------------------------

    In order to enhance the ability of the Exchange to surveil for 
violations of Rule 11.1 for expiring equity options, the proposed rule 
change would alter the existing exercise instruction procedures by 
requiring that final exercise decisions also be submitted to the 
Exchange. The clearing members would still be responsible for 
delivering exercise notices to the OCC, however, the proposed rule 
change would allow the Exchange to accurately document when each 
exercise instruction was received by a member organization or clearing 
member, or delivered by a clearing member to the OCC.\14\ The Exercise 
Cut-Off Time will still be 5:30 p.m. (E.S.T.) on the business day 
immediately prior to the expiration date. Pursuant to the proposal, 
however, there will be two means of exercising an expiring equity 
option: (1) Take no action and allow exercise determinations to be made 
in accordance with OCC Rule 805;\15\ or (2) the market maker, floor 
broker, or clearing member, as applicable, must submit a contrary 
exercise advice (i.e., a notice committing an option holder either to 
exercise an option that would not otherwise be exercised automatically 
pursuant to OCC Rule 805, or not exercise an option that otherwise 
would be exercised automatically pursuant to OCC Rule 805) (``Contrary 
Exercise Advice''). Contrary Exercise Advice would be submitted by a 
market maker, floor broker, or clearing member either: (1) In such form 
or manner prescribed by the Exchange to a place designated by the 
Exchange; or (2) to the Exchange via the OCC in a format prescribed by 
the OCC.\16\ In those instances where OCC Rule 805 has been waived by 
the OCC,\17\ the proposal requires that a Contrary Exercise Advice be 
submitted prior to the Exercise Cut-Off Time by member organizations 
wishing to exercise an option that would not have been automatically 
exercised had the exercise-by-exception procedures been in place, or 
not to exercise an option that would have been automatically exercised 
had the exercise-by-exception procedure been in place.\18\ The 
applicable underlying security price in such instances will normally be 
the last sale price in the primary market for the underlying security.
---------------------------------------------------------------------------

    \14\Because the OCC's rules are not changing, the reporting of 
final exercise decisions as contemplated by the revised rule does 
not serve to substitute as the effective exercise notice to OCC for 
the exercise or non-exercise of expiring options. The Commission 
also notes that the proposed procedures discussed herein are in 
addition to the Exchange's existing procedures regarding the 
submission of exercise instructions to clearing members, which for 
the most part, are not being amended by this proposal. See CBOE Rule 
11.1.
    \15\OCC Rule 805 provides for automatic exercise of in-the-money 
options at expiration without the submission of an exercise notice 
to the OCC if the price of the security underlying the option is at 
or above a certain price (for calls) or at or below a certain price 
(for puts); and the non-exercise of an option at expiration if the 
price of the security underlying the option does not satisfy such 
price levels. See OCC Rule 805.
    \16\Even though this may be accomplished by submitting exercise 
decisions directly to the Exchange, the more likely manner of 
accomplishing this will be to submit the exercise decisions to the 
Exchange through C/MACS. Due to the burden that would be placed on 
members of having to manually process every exercise decision for 
delivery directly to the Exchange, the procedures and rules being 
approved herein will not be implemented by the CBOE until the OCC 
submits a written representation to the Commission that C/MACS has 
been modified as necessary, fully tested, and ready to go on-line, 
to allow members to submit exercise decisions to the Exchange 
through C/MACS. This process is expected to be completed in time for 
the November 1994 expirations.
    \17\The could happen where an underlying security is not traded 
on its primary market on the trading day immediately preceding an 
expiration date and, as a result, the OCC determines not to fix a 
closing price for that security. See OCC Rule 805(l).
    \18\When the OCC waives the exercise-by-exception procedure, the 
OCC's rules require submission of an affirmative exercise notice for 
all excercises even in circumstances where a Contrary Exercise 
Advice is not required to be submitted to the Exchange. See 
Amendment No. 2, supra note 4.
---------------------------------------------------------------------------

    The proposal would also require that members properly communicate 
to the Exchange final exercise decisions in respect of positions for 
which they are responsible.\19\ Member organizations may establish an 
internal processing cut-off time prior to 5:30 p.m. (E.S.T) at which 
time final exercise decisions from their customers will no longer be 
accepted by them for expiring options.
---------------------------------------------------------------------------

    \19\See Amendment No. 1, supra note 4.
---------------------------------------------------------------------------

    The proposal maintains the current exceptions to Rule 11.1. The 
proposal, however amends Rule 11.1(b) to provide that the Exercise Cut-
Off Time is the latest time at which an exercise instruction may be 
submitted by a market maker or floor broker to (rather than accepted 
by) a clearing member. As a result of this change, the CBOE will 
interpret Rule 11.1(b) as placing the burden of establishing an 
exception to the Exercise Cut-Off Time solely on the member 
organization seeking to rely on such exception.\20\
---------------------------------------------------------------------------

    \20\Telephone conversation with Jeffrey Schroer, Vice President, 
Market Regulation, Regulatory Services Division, CBOE, and Brad 
Ritter, Senior Counsel, OMS, Division, Commission, on July 27, 1994.
---------------------------------------------------------------------------

    In the event a member organization makes a final exercise decision 
after the Exercise Cut-Off Time in reliance on one of the above 
exceptions, the responsible member organization must prepare a written 
memorandum describing the surrounding circumstances and must promptly 
file a copy of the memorandum with the Exchange.
    Furthermore, in order to highlight the seriousness of violating 
Rule 11.1, the proposed rule language would expressly state that 
affecting an exercise decision in an expiring equity option on the 
basis of material information obtained after the Exercise Cut-Off Time 
is considered to be activity inconsistent with just and equitable 
principles of trade.
    The proposal also provides that the failure of any member to follow 
the proposed procedures may be referred to the Exchange's Business 
Conduct Committee and result in the assessment of a fine, which may 
include, but is not limited to, disgorgement of potential economic gain 
obtained or loss avoided by the subject exercise, as determined by the 
Business Conduct Committee.
    Finally, the proposal makes clear that the requirements specified 
in the Rule 11.1 only apply to expiring equity options listed on the 
Exchange.\21\
---------------------------------------------------------------------------

    \21\See supra note 10.
---------------------------------------------------------------------------

    The Commission believes that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to national securities exchanges, particularly, 
Section 6(b)(5) of the Act.\22\ Specifically, the Commission believes 
the Exchange's proposal is designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in facilitating transactions in securities, and to 
protect investors and the public interest.
---------------------------------------------------------------------------

    \22\15 U.S.C. Sec. 78f(b)(5) (1988).
---------------------------------------------------------------------------

    Although all options exchanges currently have a uniform 5:30 p.m. 
(E.S.T.) Exercise Cut-Off Time on Expiration Fridays for expiring 
equity options, the OCC's rules permit the OCC to accept exercise 
notices for expiring equity options from clearing firms until 12:00 
a.m. (E.S.T.) on the expiration date (i.e., the Saturday after an 
Expiration Friday). This additional time within which to receive 
exercise notices from clearing members was provided to accommodate 
corrections of mistakes made in good faith, trade reconciliations, and 
certain exceptional circumstances that affected a customer's ability to 
inform its brokerage firm or affected a firm's ability to receive final 
exercise decisions before the Exercise Cut-Off Time. Nevertheless, 
there have been situations where member organizations have either 
delayed making exercise decisions until after 5:30 p.m. (E.S.T.) on 
Expiration Friday in anticipation of the release of material news 
concerning a particular underlying company, or having made decisions 
prior to 5:30 p.m. (E.S.T.), changed these decisions based upon such 
material news.\23\ In this regard, the Commission believes that it is 
appropriate for the Exchange to make it clear in its rules that the 
submission of a Contrary Exercise Advice on the basis of material 
information released after the Exercise Cut-Off Time will be activity 
deemed inconsistent with just and equitable principles of trade.\24\
---------------------------------------------------------------------------

    \23\See, e.g., In re Farmers Group Stock Options Litigation, 
Master File No. 88-4994 (E.D.Pa 1989).
    \24\See supra note 13.
---------------------------------------------------------------------------

    The Commission believes that the proposed exercise procedures 
should enhance the Exchange's ability to surveil for violations of Rule 
11.1 by providing an enhanced audit trail for identifying late 
exercises. Specifically, every time an exercise decision is made 
contrary to OCC Rule 805, a Contrary Exercise Advice must be filed with 
the Exchange, in addition to submitting an exercise instruction to a 
clearing member as is currently required.\25\ Similarly, the proposal 
requires that documentation must be prepared and submitted to the 
proper options exchange whenever a late exercise decision is made in 
reliance on one of the exceptions to Rule 11.1, with the burden of 
establishing the existence of the exception on the party submitting the 
Contrary Exercise Advice. The proposed rule change, therefore, should 
facilitate the Exchange's ability to monitor and enforce compliance 
with Rule 11.1. Accordingly, because the proposed rule change 
significantly bolsters the Exchange's existing procedures regarding the 
exercise of expiring equity options and helps to ensure compliance with 
their rules, the Commission believes that the proposal is consistent 
with the Act.\26\
---------------------------------------------------------------------------

    \25\See supra note 14.
    \26\The Commission notes that the CBOE has represented that it 
will prepare (in cooperation with the other options exchanges) and 
distribute a notice to member organizations describing the new 
procedures set forth above, and notifying member organizations as to 
when the new procedures will be fully in effect. See supra notes 5 
and 16.
---------------------------------------------------------------------------

    Even though the proposed rule change significantly improves the 
Exchange's audit trail with respect to late exercises, the Commission 
believes that the Exchange should continue to examine ways of ensuring 
compliance with the Exercise Cut-Off Time and the other requirements of 
Rule 11.1. In this regard, the Commission encourages the Exchange to 
review the permitted exceptions to Rule 11.1 and consider ways of 
establishing parameters as to the extent of the exceptions.\27\
---------------------------------------------------------------------------

    \27\For example, the Exchange may want to define expressly in 
the rule the circumstances that qualify for a good faith exception.
---------------------------------------------------------------------------

    The Commission finds good cause for approving Amendment Nos. 1 and 
2 to the proposal 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 Nos. 1 and 2 to 
the proposal, as discussed above, clarify the application of the rule 
and may serve to minimize confusion and disputes between and among 
members and customers as to the application of this rule. Additionally, 
the original proposal was noticed for the full comment period without 
any comments being received by the Commission. Accordingly, the 
Commission believes that it is consistent with Section 6(b)(5) of the 
Act to approve Amendment Nos. 1 and 2 to the proposed rule change 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, N.W., Washington, D.C. 20549. Copies of the submissions, 
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 at the Commission's Public 
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of such filings will also be available for inspection and 
copying at the principal office of the CBOE. All submissions should 
refer to File No. SR-CBOE-94-06 and should be submitted by November 7, 
1994.
    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\28\ that the proposed rule change (File No. SR-CBOE-94-06), as 
amended, is hereby approved.\29\

    \28\15 U.S.C. 78s(b)(2) (1982).
    \29\The Commission notes, however, that the proposed rule change 
will not be implemented until the Commission receives certain 
written representations from the OCC regarding the operational 
status of C/MACS. See supra note 16.
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\30\
---------------------------------------------------------------------------

    \30\17 CFR 200.30-3(a)(12) (1993).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-25553 Filed 10-14-94; 8:45 am]
BILLING CODE 8010-01-M