[Federal Register Volume 60, Number 36 (Thursday, February 23, 1995)]
[Notices]
[Pages 10135-10138]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-4400]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35389; File No. SR-NASD-94-78]
Self-Regulatory Organizations; Order Granting Accelerated
Approval of a Proposed Rule Change by the National Association of
Securities Dealers, Inc., Relating to Exercise Cut-Off Procedures for
Expiring Equity Options Contracts
February 16, 1995.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ on December 23, 1994, the
National Association of Securities Dealers, Inc. (``NASD'') submitted
to the securities and Exchange Commission (``Commission'') a proposed
rule change relating to the exercise procedures for expiring equity
options contracts. The proposal was published for comment in the
Federal Register on January 25, 1995.\3\ No comments were received on
the proposed rule change. This order approves the proposed rule change.
\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
\3\See Securities Exchange Act Release No. 35235 (January 18,
1995), 60 FR 4936 (January 25, 1995).
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Currently, with regard to expiring standardized equity options,
Section 63 of the NASD's Uniform Practice Code (``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'').\4\ This is the latest time
by which an exercise instruction\5\ 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.\6\
\4\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.
\5\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 9.
The OCC has separate rules regarding the 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.
\6\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 exceptions 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 [[Page 10136]] 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, having made exercise
decisions prior to the Exercise Cut-Off Time, changed these decisions
based upon such news. In one notable situation, 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.\7\
\7\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 Practice Code to
provide for an exercise advice procedure. Specifically, the proposed
rule change will alter the existing exercise instruction procedures by
requiring the 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.\8\ 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.
\8\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 nonexercise 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;\9\
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: (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;\10\ 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,\11\ 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.\12\ 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.
\9\OCC Rule 805 provides for the automatic exercise of in-the-
money options at 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.
\10\Even through 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. The OCC has
represented that all necessary systems modifications have been made
and fully tested in order for the proposed exercise procedures
described herein to be implemented for the next Expiration Friday on
February 17, 1995. See Letter from James Young, First Vice President
and General Counsel, OCC, to Brad Ritter, Senior Counsel, Office of
Market Supervision, Division of Market Regulation, Commission, dated
February 13, 1995.
\11\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(l).
\12\See supra note 9.
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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 of indicating 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 regard, 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,\13\ 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.
\13\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 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 [[Page 10137]] 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''),\14\ which has approved the issuance by
the options exchanges of a 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.\15\
\14\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.
\15\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).
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The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular, the requirements of Section 15A(b)(6) of the Act.\16\
Specifically, the Commission believes that the NASD'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.
\16\15 U.S.C. 78o(b)(6) (1982).
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Although, as noted by the NASD, 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, OCC's rules permit 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, in
order to prevent situations such as the one cited by the NASD,\17\ 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.\18\
\17\See supra note 7.
\18\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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The Commission believes that the proposed exercise procedures
should enhance the NASD's ability to surveil for violations of Section
63 of the Practice Code 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 as discussed above, in addition to submitting an exercise
instruction to a clearing member as is currently required by either the
rules of the options exchanges or by exchange clearing members.\19\
Similarly, the proposal requires that documentation must be prepared
and submitted either to the proper options exchange or to the NASD
whenever a late exercise decision is made in reliance on one of the
exceptions to Section 63, 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 Section 63. Accordingly,
because the proposed rule change significantly bolsters the NASD'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.\20\
\19\See supra note 5.
\20\The Commission notes that the NASD has distributed a notice
to member organizations describing the new procedures set forth
above and notifying member organizations as to the scheduled
implementation of those procedures in time for the next Expiration
Friday on February 17, 1995. See NASD Notice to Members 94-102,
``New Exercise Advice Procedures for Expiring Equity Options,''
dated December 23, 1994.
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Even though the proposed rule change significantly improves the
NASD's audit trail with respect to late exercises, the Commission
believes that the NASD should continue to examine ways of ensuring
compliance with the Exercise Cut-Off Time and the other requirements of
Section 63.\21\ Furthermore, the Commission also encourages the NASD to
review the permitted exceptions to Section 63 and consider ways of
establishing parameters as to the extent of the exceptions.\22\
\21\For example, the NASD 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
Section 63 of the Practice Code for a particular trade or trades.
\22\For example, the NASD 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 the proposed rule
change prior to the thirtieth day after the date of publication of
notice of filing thereof in the Federal Register. Specifically, the
Commission notes that the proposed rule change is substantively similar
to proposals submitted by the national options exchanges and recently
approved by the Commission.\23\ Additionally, the proposals by the
other options exchanges are being implemented in time for the next
Expiration Friday on February 17, 1995.\24\ Accelerated approval of the
NASD's proposal is therefore necessary in order to ensure that the
options exchanges and their members as well as the NASD and its members
are operating under uniform procedures for exercising expiring equity
options. Finally, the proposal was noticed for the full 21-day comment
period without any comments being received by the Commission.
Accordingly, the Commission believes that it is consistent with Section
15A(b)(6) of the Act to approve the proposed rule change on an
accelerated basis.
\23\See supra note 15.
\24\See supra note 10.
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It Is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\25\ that the [[Page 10138]] proposed rule change (File No. SR-
NASD-94-78) is hereby approved.
\25\15 U.S.C. 78s(b)(2). (1982).
For the Commission, by the Division of Market Regulati0n,
pursuant to delegated authority.\26\
\26\17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-4400 Filed 2-22-95; 8:45 am]
BILLING CODE 8010-01-M