[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: 94-25604]


[[Page Unknown]]

[Federal Register: October 17, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34818; File No. SR-NYSE-94-12]

 

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 New York 
Stock Exchange, Inc. Relating to Exercise Cut-Off Procedures for 
Expiring Equity Options

October 11, 1994.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``ACT''),\1\ and Rule 19b-4 thereunder,\2\ on March 23, 1994, the New 
York Stock Exchange, Inc. (``NYSE'' 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 NYSE filed Amendment No. 1 to the proposal on 
September 19, 1994, Amendment No. 2 on September 27, 1994, and 
Amendment No. 3 on October 7, 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. 34050 (May 12, 1994), 
59 FR 25978 (May 18, 1994).
    \4\In Amendment Nos. 1, 2, and 3, the NYSE proposes to make 
certain clarifying amendments to Rule 780, as discussed herein. See 
Letters from Hope Duffy, Director, Options and Special Products, 
NYSE, to Sharon Lawson, Assistant Director, Office of Market 
Supervision (``OMS''), Division of Market Regulation (``Division''), 
Commission, dated September 19, 1994 (``Amendment No. 1''), dated 
September 27, 1994 (``Amendment No. 2''); and Letter from James 
Buck, Senior Vice President and Secretary, NYSE, to Sharon Lawson, 
Assistant Director, OMS, Division, Commission, dated October 7, 1994 
(``Amendment No. 3'').
    \5\The Commission notes that substantively similar proposals by 
the other options exchanges have been approved. See Securities 
Exchange Act Release Nos. 34806 (October 7, 1994) (Order approving 
File No. SR-Phlx-93-37), 34807 (October 7, 1994) (order approving 
File No. SR-CBOE-94-06), 34808 (October 7, 1994) (approving File No. 
SR-Amex-94-01), and 34810 (October 7, 1994) (approving File No. SR-
PSE-94-12).
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    Currently, with regard to expiring equity options, NYSE 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 an options specialist 
or competitive options trader for positions is its account or from a 
floor broker for positions in its 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 780 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 option 
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\ Member organizations are required to time stamp each 
exercise instruction at the time it is prepared.
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    \6\As used herein, the term ``member organization'' also 
includes individual members of the Exchange.
    \7\See NYSE Rule 780. 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, options specialist, or competitive options trader (as 
defined in NYSE rules), 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-exercise 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 780 also does not apply to expiring index options. See 
NYSE Rule 780, Supplementary Material .10(c).
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    Presently, it is a violation of Rule 780 for clearing members to 
accept 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 780.\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 780 for expiring equity option, 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,\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. (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;\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 80-5 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 option that would not be automatically exercised in the 
absence of such a waiver, or not to exercise an option that would be 
automatically exercised in the absence of such a waiver.\17\ The 
applicable price of the underlying security in such instances shall be 
the last sale price in the primary market for the underlying security, 
except as OCC Rule 805(l) otherwise provides.\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 NYSE'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 rules 
does not serve to substitute as the effective exercise notice to 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 submissions 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 NYSE 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.
    \16\This 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).
    \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 customer account positions in expiring options to be 
responsible for ensuring that final exercise decisions are communicated 
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 reasonable steps to ensure that such decisions 
are properly indicated to the Exchange. 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.\20\
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    \19\See Amendment No. 1, supra note 4.
    \20\See Amendment Nos. 1 and 2, supra note 4.
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    With certain minor modifications, the proposal maintains the 
current exceptions to Rule 780. The proposal, however, adds language to 
Rule 780(b) to expressly state that the burden of establishing an 
exception to the Exercise Cut-Off Time rests solely on the member 
organization seeking to rely on such exception.
    As proposed, each member organization shall prepare a memorandum of 
every final exercise decision for which a Contrary Exercise Advice is 
required.\21\ 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 
file a copy of the memorandum with the Exchange's Market Surveillance 
Department not later than 12:00 p.m. (E.S.T.) on the business day 
following that expiration.\22\
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    \21\The memorandum must also include the time when such final 
exercise decision was made or, in the case of a customer, was 
received.
    \22\The Exchange has represented that effecting an exercise 
decision in an expiring equity option on the basis of material 
information obtained after the Exercise Cut-Off Time would be deemed 
to be activity inconsistent with just and equitable principles of 
trade. Telephone conversation between Holly Duffy, Director, Options 
and Special Products, NYSE, and Sharon Lawson, Assistant Director, 
OMS, Division, Commission, on September 16, 1994.
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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.\23\ 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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    \23\15 U.S.C. Sec. 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 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.\24\ In this regard, the Commission believes that it is 
consistent with this approval for the Exchange to interpret its rules 
to deem the submission of a Contrary Exercise Advice on the basis of 
material information released after the Exercise Cut-Off Time as 
activity inconsistent with just and equitable principles of trade.\25\
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    \24\See, e.g., In re Farmers Group Stock Options Litigation, 
Master File No. 88-4994 (E.D.Pa).
    \25\See supra notes 11 and 22.
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    The Commission believes that the proposed exercise procedures 
should enhance the Exchange's ability to surveil for violations of Rule 
780 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.\26\ 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 780, 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 780. 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.\27\
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    \26\See supra note 12.
    \27\The Commission notes that the NYSE 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 780.\28\ Furthermore, the Commission also encourages the Exchange 
to review the permitted exceptions to Rule 780 and consider ways of 
establishing parameters as to the extent of the exceptions.\29\
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    \28\For example, the NYSE 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 780 for a particular trade or trades.
    \29\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 clarifies 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 NYSE. All submissions should refer to File 
No. SR-NYSE-94-12 and should be submitted by November 7, 1994.
    It is therefore ordered, Pursuant to Section 19(b)(2) of the 
Act,\30\ that the proposed rule change (File No SR-NYSE-94-12), as 
amended, is hereby approved.\31\
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    \30\15 U.S.C. 78s(b)(2) (1982).
    \31\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.\32\
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    \32\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-25604 Filed 10-14-94; 8:45 am]
BILLING CODE 8010-01-M