[Federal Register Volume 60, Number 16 (Wednesday, January 25, 1995)]
[Notices]
[Pages 4936-4938]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-1783]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35235; File No. SR-NASD-94-78]


Self-Regulatory Organizations; Notice of Filing of a Proposed 
Rule Change by the National Association of Securities Dealers, Inc., 
Relating to Exercise Cut-Off Procedures for Expiring Equity Options 
Contracts

January 18, 1995.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on December 
23, 1994, the National Association of Securities Dealers, Inc. 
(``NASD'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the NASD. 
The Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD proposes to amend Section 63 of the NASD's Uniform 
Practice Code (``Practice Code'') relating to the exercise of expiring 
standardized equity options contracts. The text of the proposed rule 
change is available at the Office of the Secretary, NASD, and at the 
Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and the 
Statutory Basis for, the Proposed Rule Change

    Currently, with regard to expiring standardized equity options, 
Section 63 of the Practice Code provides that NASD members and their 
customers are required to indicate their exercise decisions to clearing 
members no later than 5:30 p.m., E.S.T., on the business day 
immediately prior to the expiration date of the options (``Exercise 
Cut-Off Time'').\1\ this is the latest time by which an exercise 
instruction\2\ 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 from any 
customer.\3\

    \1\Generally, the rules of the options exchanges provide that 
equity options may be traded up until the close of business on the 
last business day before expiration, which is generally the third 
Friday of the expiration month (``Expiration Friday''), See, e.g., 
CBOE Rule 11.1 and Phlx Rule 1042.
    \2\For customers, an exercise instruction is a notice delivered 
to a member to exercise an option. for a clearing member of The 
Options Clearing Corporation (``OCC'') or a market maker or floor 
broker on a national options exchange, an exercise instruction is a 
notice to OCC to exercise an option that would not be automatically 
exercised pursuant to OCC's exercise-by-exception procedure (``OCC 
Rule 805''), or not to exercise an option that would otherwise be 
automatically exercised pursuant to OCC Rule 805. See infra note 6. 
The OCC has separate rules regarding cut-off time by which exercise 
notices must be delivered to OCC by OCC clearing members. The 
proposed rule change does not in any way affect OCC rules.
    \3\In most cases, exercise instructions are electronically 
transmitted to OCC clearing members through the Clearing Management 
and Control System (``C/MACS'').
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    The only exemptions to the Exercise Cut-Off Times contained in 
Section 63 of the Practice Code are: (1) To remedy mistakes or errors 
made in good faith; (2) to take appropriate action as the result of a 
failure to reconcile an unmatched option transaction; (3) where 
exceptional circumstances relating to a customer's or member's ability 
to communicate exercise instructions to a member (or a member's ability 
to receive such exercise instructions) prior to the Exercise Cut-Off 
Time warrant such action; and (4) with respect to options contracts in 
an account maintained for another member in which only positions of 
customers of such other member are carried. Members are required to 
prepare a memorandum of every exercise instruction received from a 
customer stating the time when such instruction was received. In 
addition, in the event a member receives and acts on an exercise 
instruction pursuant to one of the exceptions noted above, the member 
must prepare a memorandum setting forth the circumstances giving rise 
to the exception. If the member is relying on either the first or the 
third exception described above, the member must promptly file a copy 
of the memorandum with the NASD.
    Thus, it is presently a violation of Section 63 of the Practice 
Code for clearing members to accept exercise instructions after the 
Exercise Cut-Off Time, except in reliance on one of the exceptions 
noted above. Because exercise instructions are submitted to the 
clearing members, without having the audit trail pass directly through 
the NASD or the particular options exchange(s) trading the expiring 
option, it is difficult for the NASD to surveil for violations of 
Section 63. In fact, there have been some situations where members have 
either delayed making exercise decisions until after the Exercise Cut-
Off Time in anticipation of the release of significant news concerning 
a particular underlying company or, havig made exercise decisions prior 
to the Exercise Cut-Off Time, changed these decisions based upon such 
news. In one notable situation, the NASD notes that certain firms that 
anticipated the release of material news regarding a particular company 
allegedly delayed making their exercise decisions until after the 
Exercise Cut-Off Time, causing firms who claimed to have been 
disadvantaged by such conduct to commence a series of highly publicized 
arbitration proceedings and lawsuits.\4\

    \4\See, e.g., In re Farmers Group Stock Options Litigation, 
Master File No. 88-4994 (E.D.Pa).
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    Accordingly, in order to enable the options exchanges and the NASD 
to determine whether options holders have made their final exercise 
decisions no later than the prescribed Exercise Cut-Off Time and not on 
the basis of market developments occurring after the Exercise Cut-Off 
Time, the NASD proposes to amend Section 63 of the 
[[Page 4937]] Practice Code to provide for an exercise advice 
procedure. Specifically, the proposed rule change will alter the 
existing exercise instruction procedures by requiring that final 
exercise decisions also be submitted to the relevant options 
exchange(s) trading a particular equity option. The clearing members 
will still be responsible for delivering exercise notices to OCC, 
however, the proposed rule change will allow the NASD, in conjunction 
with the options exchanges, to accurately document when each exercise 
instruction was received by a member or clearing member or delivered by 
a clearing member to OCC.\5\ 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.

    \5\Because OCC's rules are not affected by this rule proposal, 
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.
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    In particular, under the proposal, 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;\6\ 
or (2) members 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 
to exercise an option that otherwise would be exercised automatically 
pursuant to OCC Rule 805) (``Contrary Exercise Advice''). A Contrary 
Exercise Advice will be submitted by NASD members either: (1) To a 
place designated for that purpose by any national options exchange of 
which they are a member and where the particular equity option is 
listed; (2) to a place designated for that purpose by any national 
options exchange that lists and trades that equity option via a member 
of such exchange if the member is not a member of such exchange; (3) to 
any national options exchange of which they are a member and where the 
equity option is listed via OCC in a form prescribed by OCC;\7\ or (4) 
to any national options exchange where the equity option is listed via 
OCC in a form prescribed by OCC, provided the member is a member of 
OCC. In those instances where OCC Rule 805 has been waived by OCC,\8\ 
the proposal provides that a Contrary Exercise Advice must be submitted 
prior to the Exercise Cut-Off Time by members wanting to exercise an 
option that would not have been automatically exercised, or not to 
exercise an option that would have been automatically exercised, had 
OCC's exercise-by-exception procedure been in effect.\9\ The applicable 
underlying security price in such instances will be as described in OCC 
Rule 805(1), which is normally the last sale price in the primary 
market for the underlying security.

    \6\OCC Rule 805 provides for the automatic exercise of in-the-
money options of expiration without the submission of an exercise 
notice to 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.
    \7\Even though this may be accomplished by submitting exercise 
decisions directly to the relevant options exchange, the more likely 
manner of accomplishing this will be to submit the exercise 
decisions to the options exchanges through C/MACS. Due to the burden 
that would be placed on members by having to manually process every 
exercise decision for delivery directly to the relevant options 
exchange, the procedures and rules being proposed herein will not be 
implemented by the NASD until 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 options exchanges through C/MACS. The Commission 
notes that the procedures and rules proposed herein are scheduled 
for implementation in time for the February 1995 equity option 
expirations.
    \8\This could happen when an underlying security is not traded 
on its primary market on the trading day immediately preceding an 
expiration date and, as a result, OCC determines not to fix a 
closing price for that security. See OCC Rule 805(1).
    \9\See supra note 6.
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    The proposal also requires that members maintaining proprietary or 
public customer positions in expiring options take necessary steps to 
ensure that final exercise decisions are properly indicated to the 
relevant national options exchange with respect to such positions. In 
addition, the proposal provides that members who have accepted the 
responsibility to indicate final exercise decisions on behalf of 
another member also shall take necessary steps to ensure that such 
decisions are properly indicated to the relevant national options 
exchange. In this connection, the proposal also provides that members 
may establish an internal processing cut-off time prior to 5:30 p.m. 
E.S.T., at which time the member will no longer accept final exercise 
decisions from its customers in expiring options.
    With certain minor modifications,\10\ the proposal maintains the 
current exceptions to Section 63 of the Practice Code. The proposal, 
however, does add language to Section 63(b)(3) 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 rests solely on the 
member seeking to rely on such exception.

    \10\Specifically, in order to conform the NASD's proposed rule 
with the rules of the options exchanges, the NASD proposes to delete 
the exemption that applies to ``option contracts carried in an 
account maintained for another member in which only positions of 
customers of such other member are carried.''
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    In the event a member does not timely submit a Contrary Exercise 
Advice pursuant to an exception, the responsible member must prepare a 
written memorandum describing the circumstances surrounding the late 
submission of the Contrary Exercise Advice and stating the time when 
such final exercise decision was made or, in the case of a customer, 
was received. The member must also file a copy of the memorandum with 
the market surveillance department of the national options exchange 
trading the option, if it is a member of such exchange, or the NASD's 
Market Surveillance Department if it is not a member of such exchange, 
no later than 12:00 p.m., E.S.T., on the business day following that 
expiration.
    Furthermore, in order to highlight the seriousness of violating 
Section 63 of the Practice Code, the proposed rule language expressly 
states that submitting or preparing an exercise instruction after the 
Exercise Cut-Off Time in any expiring equity option on the basis of 
material information released after the Exercise Cut-Off Time is 
activity inconsistent with just and equitable principles of trade. The 
proposal also states that the requirements specified in Section 63(b) 
will not apply to standardized foreign currency options or standardized 
index option products.
    The NASD represents that the proposed rule change reflects a 
coordinated effort among all the options exchanges, the NASD, and OCC. 
In particular, the NASD represents that the proposed exercise advice 
procedure has been reviewed and endorsed by the Intermarket 
Surveillance Group (``ISG''),\11\ which is in the process of issuing a 
joint circular explaining the operation of the new exercise cut-off 
provisions. The NASD notes that the Commission has already approved 
similar rule proposals from each of the national options exchanges.\12\

    \11\ISG was formed on July 14, 1983 to, among other things, 
coordinate more effectively surveillance information sharing 
arrangements in the stock and options markets. See Intermarket 
Surveillance Sharing Group Agreement, July 14, 1983. The members of 
ISG are the American Stock Exchange, Inc., the Boston Stock 
Exchange, Inc., the Chicago Board Options Exchange, Inc., the 
Chicago Stock Exchange, Inc., the Cincinnati Stock Exchange, Inc., 
the NASD, the New York Stock Exchange, Inc., the Pacific Stock 
Exchange, Inc., and the Philadelphia Stock Exchange, Inc.
    \12\See Securities Exchange Act Release Nos. 34806 (October 7, 
1994), 59 FR 52339 (October 17, 1994) (order approving File No. SR-
PHLX-93-37); 34807 (October 7, 1994), 59 FR 52329 (October 17, 1994) 
(order approving File No. SR-CBOE-94-06); 34808 (October 7, 1994), 
59 FR 52324 (October 17, 1994) (order approving File No. SR-AMEX-94-
01); 34810 (October 7, 1994), 59 FR 52334 (October 17, 1994) (order 
approving File No. SR-PSE-94-12); and 34818 (October 11, 1994), 59 
FR 52331 (October 17, 1994) (order approving File No. SR-NYSE-94-
12). [[Page 4938]] 
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    The NASD believes that the proposal is consistent with Section 
15A(b)(6) of the Act. Section 15A(b)(6) requires that the rules of a 
national securities association be 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 regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and, in general, to 
protect investors and the public interest. Specifically, the NASD 
believes the proposal is consistent with Section 15A(b)(6) of the Act 
because it should improve the NASD's ability to surveil for and deter 
violations of the Exercise Cut-Off Time for expiring equity options. In 
addition, the NASD believes that the requirement that a member must 
submit a written memorandum describing the circumstances surrounding 
the late submission of a Contrary Exercise Advice will better enable 
the NASD to surveil for instances where exercise decisions are 
impermissibly made or changed on the basis of material information 
released after the Exercise Cut-Off Time.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will impose 
any burden on competition.

C. Self-Regulatory Organization's Statement on Comment on the Proposed 
Rule Change Received From Members, Participants or Others

    No written comments were either solicited or received with respect 
to the proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:

(A) By order approve such proposed rule change, or
(B) institute proceedings to determine whether the proposed rule change 
should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing. 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. 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 NASD. All 
submissions should refer to File Number SR-NASD-94-78 and should be 
submitted by February 15, 1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\

    \13\17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-1783 Filed 1-24-95; 8:45 am]
BILLING CODE 8010-01-M