[Federal Register Volume 59, Number 199 (Monday, October 17, 1994)]
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From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-25555]


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[Federal Register: October 17, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34806; File No. SR-Phlx-93-37]

 

Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the 
Philadelphia Stock 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 December 20, 1993, the 
Philadelphia Stock Exchange, Inc. (``Phlx'' 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 February 18, 1994.\3\ No comments were received on the 
proposed rule change. The Phlx filed Amendment No. 1 to the proposal on 
July 12, 1994, Amendment No. 2 on September 22, 1994, and Amendment No. 
3 on October 5, 1994.\4\ This order approves the proposed rule change, 
as amended.\5\
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1993).
    \3\See Securities Exchange Act Release No. 33610 (February 9, 
1994), 59 FR 8280 (February 18, 1994).
    \4\In Amendment Nos. 1, 2, and 3 the Phlx proposes to make 
certain clarifying amendments to Rule 1042, as discussed herein. See 
Letters from Gerald O'Connell, First Vice President, Phlx, to 
Michael Walinskas, Branch Chief, Office of Market Supervision 
(``OMS''), Division of Market Regulation (``Division''), Commission, 
dated July 12, 1994; from Gerald O'Connell, First Vice President, 
Phlx, to Michael Walinskas, Branch Chief, OMS, Division, Commission, 
dated September 22, 1994 (``Amendment No. 2''); and from Gerald 
O'Connell, First Vice President, Phlx, to Brad Ritter, Senior 
Counsel, OMS, Division, Commission, dated October 5, 1994 
(``Amendment No. 3'').
    \5\The Commission notes that substantively similar proposals by 
the other options exchanges are being approved concurrently with the 
Phlx's proposed rule change. See File Nos. SR-Amex-94-01; SR-CBOE-
94-06; SR-NYSE-94-12; and SR-PSE-94-12.
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    Currently, with regard to expiring equity options, Phlx 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 by 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 non-clearing member; 
or (3) accepted by a member organization from any customer.\9\ The only 
exceptions to Rule 1042 are: (1) To remedy mistakes made in good faith; 
(2) to take appropriate action as the result of a failure to reconcile 
unmatched Exchange option transactions; (3) where exceptional 
circumstances relating to a customer'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; and (4) with respect to foreign 
currency options.\10\ Member organizations are required to prepare a 
memorandum of every exercise instruction received from a customer 
stating the time when such instruction was received. If a member 
organization receives an exercise instruction or tenders an exercise 
notice to the OCC pursuant to one of the first three exceptions 
described above, the member organization must maintain a memorandum 
setting forth the circumstances giving rise to the exception. If the 
member organization is relying on either the first or third exception 
described above, it must promptly file a copy of the memorandum with 
the Exchange.
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    \6\As used herein, the term ``member organization'' also 
includes individual members of the Exchange.
    \7\See Phlx Rule 1042. 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 member 
organization or clearing member, 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 14. 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'').
    \10\Rule 1042 also does not apply to expiring index options. See 
Phlx Rules 1001A and 1042A. An additional purpose of the proposed 
rule change is to specifically state within Rule 1042 that the 
Exercise Cut-Off Time does not apply to either expiring foreign 
currency options or index options.
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    Currently under Rule 1042 it is a violation 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 1042.\11\
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    \11\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).
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    In order to enhance the ability of the Exchange to surveil for 
violations of Rule 1042 for expiring equity options, the proposed rule 
change would alter the existing exercise instruction procedures by 
requiring that final exercise decisions be submitted to the Exchange. 
The clearing members would still be responsible for delivering exercise 
notices to the OCC,\12\ 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.\13\ The Exercise Cut-Off Time will still be 
5:30 p.m. (Eastern Time) 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;\14\ or (2) the member organization may 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 Advices would be submitted by a member 
organization either: (1) At a place designated for that purpose by any 
national options exchange of which the member organization is a member 
and where the option is listed; or (2) to the Exchange via the OCC in a 
format prescribed by the OCC.\15\ In those instances where OCC Rule 805 
has been waived by the OCC,\16\ the proposal requires that a Contrary 
Exercise Advice be submitted prior to the Exercise Cut-Off Time by 
member organizations wishing to exercise an options that would not have 
been automatically exercised had the exercise-by-exception procedure 
been in place, or not to exercise an option that would have been 
automatically exercised had the exercise-by-exception procedure been in 
place.\17\ The applicable underlying security price in such instances 
will be as described in OCC Rule 805(1), which will normally be the 
last sale price in the primary market for the underlying security.\18\
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    \12\Exercise instructions will still be submitted to clearing 
members, however, the requirements for this process will be 
determined by each clearing member, in accordance with the OCC's 
rules. This process will no longer be governed by the Phlx's rules. 
Pursuant to the OCC's rules, equity options expire at 12:00 a.m. on 
the third Saturday of the expiration month. As explained earlier, 
the OCC has its own rules as to the latest time by which clearing 
members must submit exercise notices to the OCC. These rules are 
separate from the Exchange's Exercise Cut-Off Time and are not 
affected by the proposed rule change.
    \13\The proposed rule change also makes it clear that reporting 
of final exercise decisions as contemplated by the revised rule does 
not serve to substitute as the effective exercise notice to the OCC 
for the exercise or non-exercise of expiring options.
    \14\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.
    \15\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 Phlx 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 Contrary Exercise Advices to the Exchange 
through C/MACS. This process is expected to be completed in time for 
the November 1994 expirations. Telephone conversation between Gerald 
O'Connell, First Vice President, Phlx, and Sharon Lawson, Assistant 
Director, OMS, Division, Commission, on September 16, 1994.
    \16\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(1).
    \17\When the OCC waives the exercise-by-exception procedure, the 
OCC's rules require submission of an affirmative exercise notice for 
all exercises even in circumstances where a Contrary Exercise Advice 
is not required to be submitted to the Exchange. See Amendment No. 
3, supra note 4.
    \18\Id.
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    The proposal would also require member organizations that maintain 
proprietary or public customer positions in expiring options to take 
necessary steps to ensure that final exercise decisions are properly 
indicated to the Exchange regarding such positions.\19\ In addition, 
member organizations which have accepted the responsibility to indicate 
final exercise decisions on behalf of another member organization or 
non-member firm shall take necessary steps to ensure that such 
decisions are properly indicated in compliance with Rule 1042, as 
amended.\20\ 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.\21\
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    \19\See Amendment No. 2, supra note 4.
    \20\Id.
    \21\Id.
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    With certain minor modifications, the proposal maintains the 
current exceptions to Rule 1042. The proposal, however, adds language 
to Rule 1042(b) to expressly state that the burden of establishing an 
exception to the Exercise Cut-Off Time for a proprietary or customer 
account of a member organization rests solely on the member 
organization seeking to rely on such exception.
    In the event a member organization does not timely submit a 
Contrary Exercise Advice in accordance with the proposed procedures, or 
does not timely submit a Contrary Exercise Advice pursuant to an 
exception, the responsible member organization must prepare a written 
memorandum describing the surrounding circumstances\22\ and must file a 
copy of the memorandum with the Exchange's Market Surveillance 
Department no later than 12:00 p.m. (E.S.T.) on the business day 
following that expiration.
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    \22\The memorandum must also include the time when such final 
exercise decision was made or, in the case of a customer, was 
received.
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    Furthermore, in order to highlight the seriousness of violating 
Rule 1042, the proposed rule language would expressly state that 
effecting 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.
    Finally, the proposal would state in the Commentaries to Rule 1042 
that the requirements specified in the rule do not apply to foreign 
currency options or index option products listed on the Exchange.\23\
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    \23\See supra note 10.
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    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.\24\ 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.
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    \24\15 U.S.C. 78f(b)(5) (1988).
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    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.\25\ 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.\26\
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    \25\See, e.g., In re Farmers Group Stock Options Litigation, 
Master File No. 88-4994 (E.D.Pa).
    \26\See supra note 11.
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    The Commission believes that the proposed exercise procedures 
should enhance the Exchange's ability to surveil for violations of Rule 
1042 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.\27\ 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 1042, 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 1042. 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.\28\
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    \27\See supra note 12.
    \28\The Commission notes that the Phlx 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 15.
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    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 1042.\29\ Furthermore, the Commission also encourages the Exchange 
to review the permitted exceptions to Rule 1042 and consider ways of 
establishing parameters as to the extent of the exceptions.\30\
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    \29\For example, the Phlx may wish to consider adopting 
additional penalties in those situations where a member organization 
is unable to establish the existence of one of the exceptions to 
Rule 1042 for a particular trade or trades.
    \30\For example, the Exchange may want to define expressly in 
the rule the circumstances that qualify for a good faith exception.
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    The Commission finds good cause for approving Amendment Nos. 1, 2, 
and 3 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, 2, and 3 
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, 2, and 3 to the proposed rule change 
on an accelerated basis.
    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1, 2, and 3 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 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, NW., Washington, DC 20549. Copies 
of such filings will also be available for inspection and copying at 
the principal office of the Phlx. All submissions should refer to File 
No. SR-Phlx-93-37 and should be submitted by November 7, 1994.
    It is therefore ordered, Pursuant to section 19(b)(2) of the 
Act,\31\ that the proposed rule change (File No. SR-Phlx-93-37), as 
amended, is hereby approved.\32\
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    \31\15 U.S.C. 78s(b)(2) (1982).
    \32\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 15.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\33\
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    \33\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-25555 Filed 10-14-94; 8:45 am]
BILLING CODE 8010-01-M