[Federal Register Volume 61, Number 175 (Monday, September 9, 1996)]
[Notices]
[Pages 47537-47541]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-22936]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37628; File No. SR-Phlx-96-37]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Philadelphia Stock Exchange, Inc. Relating to Rule 452, 
Limitations on Members' Trading Because of Customers' Orders

September 3, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. Sec. 78s(b)(1), notice is hereby given that on 
August 22, 1996, the Philadelphia Stock Exchange, Inc. (``Phlx'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') filed with the Securities and Exchange Commission

[[Page 47538]]

(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the self-regulatory 
organization. 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 Phlx, pursuant to Rule 19b-4 of the Act, proposes to amend Rule 
452, Limitations on Members' Trading Because of Customers' Orders, 
which prohibits members from trading along with their customers on the 
same side of the market. Specifically, Rule 452 is proposed to be 
amended and reorganized as follows: paragraph (a) restates the 
prohibitions and extends such to member organizations; paragraph (b) 
exempts certain consensual arrangements between firms and customers; 
and paragraph (c) exempts odd-lot orders, trades specifying delivery 
other than regular way, and certain market making activity.
    Proposed paragraph (a) will continue to prohibit a member's 
proprietary trades while the member is holding a customer order 
executable at the same price, except that the prohibition will be 
extended to member organizations. Paragraph (b) provides that a member 
or member organization may enter a proprietary order if the customer 
has given express permission, agreeing and understanding the method of 
allocating executions, including the prices and sizes, with respect to 
three categories of trading activities. The first exempted activity 
relates to a member or member organization liquidating a position held 
in a proprietary facilitation account where the customer's order is for 
10,000 shares or more. The term ``proprietary facilitation account'' is 
an account used to record transactions whereby the member organization 
acquires positions in the course of facilitating customer orders. Thus, 
only those positions which are recorded in a proprietary facilitation 
account may be liquidated in accordance with this provision.
    The second exempted activity relates to a member or member 
organization effecting one or more transactions for the purpose of 
facilitating or hedging the grant of a stop for 10,000 shares or more 
to the customer, or facilitating or hedging one or more principal 
transactions of 10,000 shares or more in the aggregate with the 
customer. The third exempted activity relates to a member or member 
organization trading for its own proprietary account and for the 
account(s) of one or more customers in an agreed-upon strategy or 
course of trading, such as bona fide arbitrage or risk arbitrage. A 
member organization that seeks to rely on the exclusion in paragraph 
(b)(3) may do so only if the member organization reasonably believes 
that the customer, alone or together with an investment representative, 
understands the nature of the transaction with respect to which he or 
she is giving consent. In addition, the reference to bona fide 
arbitrage and risk arbitrage in paragraph (b)(3) is intended to be 
illustrative and not exclusive.
    Paragraph (c) provides an unqualified exemption for transactions by 
a member or member organization acting in the capacity of: (A) a market 
maker pursuant to Rule 19c-3 of the Commission in a security traded on 
the Exchange; or (B) a specialist or market maker on a national 
securities exchange. The Exchange notes that Phlx specialists and 
alternate specialists would be exempt from the prohibitions of the Rule 
pursuant to this provision.
    Supplementary Material sections .01 and .02 are proposed to be 
adopted. Supplementary Material .01 states that a member or employee of 
a member organization responsible for entering proprietary orders shall 
be presumed to have knowledge of a particular customer order unless the 
member organization has implemented a reasonable system of internal 
policies and procedures to prevent the misuse of information about 
customer orders by those responsible for entering such proprietary 
orders.
    Supplementary Material .02 provides that the Rule applies to a 
member on the Floor who may not execute a proprietary order at the same 
price, or at a better price, as an unexecuted customer order that he or 
she is representing, except to the extent that the member organization 
itself could do so under this Rule.
    The Exchange notes that Supplementary Material .03 contains the 
current version of Supplementary Material .01, relating to a commitment 
to trade through the Intermarket Trading System (``ITS''), which is 
deemed to be initiating a purchase or sale of a security on the 
Exchange as referred to in this Rule.
    The proposal will take effect upon notice to the membership. The 
text of the proposed rule change is as follows [new text is italicized; 
deleted text is bracketed]:

    Rule 452. (a) Except as provided in this Rule, n[N]o member or 
member organization  shall cause the entry of an order to buy (sell) 
[(1) personally buy or initiate the purchase of] any security on the 
Exchange for any account in which such member or member organization 
or approved person thereof is directly or indirectly interested (a 
``proprietary order''), if the person responsible for the entry of 
such order has knowledge of any particular unexecuted customer's 
order to buy (sell) such security which could be executed at the 
same price.

[His account or for any account in which he, or the firm of which he 
is partner or any partner of such firm, is directly or indirectly 
interested, while such member personally holds or has knowledge that 
his firm or any partner thereof holds an unexecuted market order to 
buy such security in the unit of trading for a customer, or (2) 
personally sell or initiate the sale of any security on the Exchange 
for any such account, while he personally holds or has knowledge 
that his firm or any partner thereof holds an unexecuted market 
order to sell such security in the unit of trading for a customer.]
    (b)  A member or member organization may enter a proprietary 
order if the customer has given express permission, agreeing and 
understanding the method of allocating executions, including the 
prices and sizes, with respect to the following trading strategies:
    (1) The member or member organization is liquidating a position 
held in a proprietary facilitation account, and the customer's order 
is for 10,000 shares or more.
    The term ``proprietary facilitation account'' shall mean an 
account in which a member organization has a direct interest and 
which is used to record transactions whereby the member organization 
acquires positions in the course of facilitating customer orders. 
Only those positions which are recorded in a proprietary 
facilitation account may be liquidated as provided herein;
    (2) The member or member organization is effecting one or more 
transactions for the purpose of facilitating or hedging the grant of 
a stop for 10,000 shares or more to the customer or facilitating or 
hedging one or more principal transactions of 10,000 shares or more 
in the aggregate with the customer; or
    (3) The member or member organization is trading for its own 
proprietary account and for the account(s) of one or more customers 
in an agreed-upon strategy or course of trading, such as bona fide 
arbitrage or risk arbitrage. A member organization that seeks to 
rely on this exemption may do so only if the member organization 
reasonably believes that the customer, alone or together with an 
investment representative, understands the nature of the transaction 
with respect to which he or she is giving consent. The reference to 
bona fide arbitrage and risk arbitrage is intended to be 
illustrative and not exclusive.
    [No member shall (1) personally buy or initiate the purchase of 
any security on the Exchange for any such account, at or below the 
price at which he personally holds or has knowledge that his firm or 
any partner thereof holds an unexecuted limited price order to buy 
such security in the unit of trading for a customer, or (2) 
personally sell or initiate the sale of any security on the Exchange 
for any such account at or above the price at which he personally 
holds or has

[[Page 47539]]

knowledge that his firm or any partner thereof holds an unexecuted 
limited price order to sell such security in the unit of trading for 
a customer.]

[Exceptions]
    (c) The provisions of this Rule shall not apply to:
    (1) [To] any purchase or sale of any security in an amount of 
less than the unit of trading made by an odd-lot dealer to offset 
odd-lot orders of customers [, or];
    (2) [To] any purchase or sale of any security, delivery which is 
to be upon a day other than the day of delivery provided in such 
unexecuted market or limited price order [.]; or
    (3) transactions by a member or member organization acting in 
the capacity of:
    (A) A market maker pursuant to Regulation 240.19c-3 of the 
Securities and Exchange Commission in a security traded on the 
Exchange; or
    (B) A specialist or market maker on a national securities 
exchange.

Supplementary Material

    .01  A member or employee of a member organization responsible 
for entering proprietary orders shall be presumed to have knowledge 
or a particular customer order unless the member organization has 
implemented a reasonable system of internal policies and procedures 
to prevent the misuse of information about customer orders by those 
responsible for entering such proprietary orders.
    .02  This Rule shall also apply to a member organization's 
member on the Floor who may not execute a proprietary order at the 
same price, or at a better price, as an unexecuted customer order 
that he or she is representing, except to the extent that the member 
organization itself could do so under this Rule.
    .03  A member who issues a commitment to trade from the Exchange 
through ITS or any other Application of the System shall, as a 
consequence thereof, be deemed to be initiating a purchase or sale 
of a security on the Exchange as referred to in this Rule.

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 self-regulatory organization 
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 self-regulatory organization 
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 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    In 1994, the NYSE filed a proposed rule change with the Commission 
to amend NYSE Rule 92 to: (1) extend the prohibition against trading 
along with customers to member organizations and NYSE member trading on 
other market centers; and (2) exempt the liquidation of block 
facilitation positions in NYSE securities, subject to specified 
conditions. Following publication of the proposal for notice and 
comment,\1\ the Phlx, as well as other commenters, sought clarification 
of the reach of the proposal.\2\ The Exchange commented that a 
significant burden on competition would result due to the impact on 
regional trading operations.\3\
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    \1\ Securities Exchange Act Release No. 35139 (Dec. 22, 1994), 
60 FR 156 (SR-NYSE-94-34).
    \2\ See letter from William W. Uchimoto, General Counsel, Phlx, 
to Margaret H. McFarland, Deputy Secretary, Commission, dated 
February 15, 1995.
    \3\ See letter from William W. Uchimoto, General Counsel, Phlx, 
to Margaret H. McFarland, Deputy Secretary, Commission, dated April 
4, 1995.
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    Thereafter, the NYSE filed Amendment No. 2 to their proposal on 
July 13, 1995, specifically excluding: (1) securities not listed on the 
NYSE; (2) transactions by Rule 19c-3 market makers, and regional 
specialists if the principal trade is liquidated immediately at the 
same price to a customer on that exchange; and (3) certain bona fide or 
risk arbitrage transactions.\4\ In response, the Exchange commented 
that the exemption for regional specialists should be unqualified, 
similar to the exemption for Rule 19c-3 market makers.\5\ The Exchange 
further explained how the restrictions on specialist trades would be 
unduly disruptive to regional exchange market operations, and 
questioned the application of a NYSE rule to Phlx members affiliated 
with NYSE member organizations where there is no connection to NYSE 
floor trading.\6\
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    \4\ Securities Exchange Act Release No. 36015 (July 21, 1995), 
60 FR 38875 (Notice of Filing of Amendment No. 2 to SR-NYSE-94-34).
    \5\ See letter from William W. Uchimoto, General Counsel, Phlx, 
to Margaret H. McFarland, Deputy Secretary, Commission, dated August 
11, 1995.
    \6\ See letter from William W. Uchimoto, General Counsel, Phlx, 
to Margaret H. McFarland, Deputy Secretary, Commission, dated 
October 27, 1995.
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    Recently, the NYSE filed Amendment No. 3 to the proposal, exempting 
without qualification regional exchange specialists and market makers 
from the provisions of the rule when acting as such on that exchange, 
deleting the limitation that the principal trade must be liquidated 
immediately at the same price to a customer on that exchange.\7\ To 
date, the proposed amendments to NYSE Rule 92 continue to extend the 
rule to transactions on other market centers. The Phlx has commented 
adversely on this aspect of the amendments.\8\
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    \7\ Securities Exchange Act Release No. 37428 (July 11, 1996) 
(notice of Filing of Amendment No. 3 to SR-NYSE-94-34).
    \8\ See letter from Michele R. Weisbaum, Associate General 
Counsel, Phlx, to Margaret H. McFarland, Deputy Secretary, 
Commission, dated August 8, 1996.
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    At this time, the Exchange is adopting its own rule amendments 
governing the restricted activities and exempting certain transactions, 
which would otherwise have been governed by the NYSE rule, noting that 
the Rule 92 exemptions are limited to NYSE transactions. The Phlx's 
proposal at hand is conditioned upon the NYSE amending its proposal to 
delete application to other market centers. In this regard, the Phlx 
does not intend to take any disciplinary action against Phlx members or 
member organizations for violation of the Phlx rule for engaging in 
trading on another market center that is consistent with the rules of 
such market center. Moreover, although many Phlx member organizations 
also trade on other exchanges, the Exchange does not profess that its 
Rule 452 should extend to those transactions in view of Commission 
policy against the application of exchange rules to trading on another 
market center.\9\
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    \9\ Securities Exchange Act Release No. 12249 (Mar. 23, 1976).
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    In light of the conduct restricted and exemptions contained in the 
NYSE's proposal, the Exchange reviewed its own comparable rule, noting 
that currently, Phlx Rule 452 is divided into three paragraphs, with 
paragraph (a) prohibiting trading for a member's own account if the 
member's firm has an unexecuted market order on the same side of the 
market in that security; paragraph (b) containing the same prohibition 
for limit orders at that price or better; and paragraph (c) exempting 
odd-lot orders and transactions other than regular way.
    In conjunction with the expected amendment to the NYSE's proposal 
limiting its application to NYSE members' and member organizations' 
transactions on the NYSE floor, the Phlx is proposing to amend its own 
rule to adopt similar exceptions to permit certain types of proprietary 
trading activity that the Phlx believes is consistent with the purposes 
of Phlx Rule 452 and the analogous NYSE Rule 92. Phlx Rule 452, as well 
as the

[[Page 47540]]

comparable rules of other exchanges, was intended to prevent members 
from taking advantage of their customers. Although customer protection 
is of paramount importance in furthering the purposes of the Act, 
fulfilling the self-regulatory mission and promoting an auction 
marketplace, the Exchange recognizes that it should not impair the 
business of trading by drafting away a customer's ability to enter into 
voluntary and consensual agreements with a member or member 
organization.
    At this time, the Exchange proposes to adopt three exemptions in 
paragraph (b) requiring customer disclosure and consent: (1) 
liquidating block facilitation positions, (2) facilitating or hedging 
the grant of a stop in connection with executing a customer block 
order, and (3) any other consensual transactions agreed upon with the 
customer, including bona fide and risk arbitrage. All three exemptions 
are predicated upon the customer giving express permission for the firm 
to trade along with that customer. The express permission must also 
include the method of allocating executions, such as the prices and 
sizes of execution reports. The Exchange believes that these three 
transactions reflect the reality of today's trading environment, 
balanced against the need to preserve agency principles and promote 
customer protection by requiring the consent of the customer. Moreover, 
the Exchange believes that its proposal recognizes that informed 
consent, which reflects the true objectives of the customer, should 
prevail over arbitrary prohibitions. The Exchange believes that the 
enumerated exemptions are crafted to be consistent with a member's 
fiduciary relationship with its customer. For the purposes of Rule 452, 
the Exchange does not believe that informed consent can only be given 
by certain types of customers, nor should the exemption be premised on 
sophistication or wealth. In fact, the exemptions involving block 
orders by virtue of their size create a wealth standard. The Exchange 
believes that consensual arrangements should be available for all 
informed investors.
    The first two consent-based exemptions codify current block trade 
practices, which the Exchange has included, because they are a 
universally accepted and common type of trading activity involving 
trading along with a customer. Block facilitation business, where 
positioning firms facilitate their institutional customers, by 
definition, involve customer disclosure and consent. The exemption in 
paragraph (b)(2) is designed to apply where a member organization may 
need to effect certain proprietary transactions in advance of trading 
with or stopping a customer block-sized order, in anticipation of 
accepting such market risk. Thus, this exemption goes beyond mere 
liquidation, as contemplated by the paragraph (b)(1) exemption, by 
permitting proprietary transactions to, for example, hedge or 
facilitate the execution of the block order.
    The third exemption covers other transactions agreed upon by the 
customer, predicated upon consent. Recognizing the importance of 
informed consent, this provision specifically requires that the member 
organization reasonably believe that the customer, alone or together 
with an investment representative, understands the nature of the 
transactions with respect to which consent is given. For example, a 
customer may consent to a transaction subject to Rule 452 to adjust the 
risk allocation with a member organization, thus achieving certain 
economic objectives without resorting to off-exchange or other venues.
    Bona fide and risk arbitrage are examples of strategies covered by 
the third exemption, where customers desire to trade along with the 
member in a potentially lucrative trading strategy. These specific 
strategies, however, are listed as nonexclusive examples. Because 
arbitrage strategies are listed as an example, Rule 452 does not 
purport to define these strategies nor list all other strategies 
covered by this exemption. The Exchange anticipates that other 
strategies will fall under this exemption. The Exchange believes that 
it is inefficient and ineffective to list every possible type of 
trading strategy that could be exempt, because trading strategies are 
constantly evolving in response to market conditions, constantly honed 
to specific economic circumstances. Because the premise behind 
exempting any such strategy that may evolve is that customer consent to 
trade with the customer is given, the Exchange believes that its third 
exemption is appropriate and would facilitate other shared trading 
arrangements that customers may require in the future.
    The strategies proposed to be exempted involve the allocation of 
risk between firms and their customers. Because of the shared risk and 
the informed consent involved, these types of transactions have 
historically been viewed as integrally related to the customers' own 
trading objectives, which need not be disclosed generally to the 
market. Nevertheless, in relying upon the exemptive provisions of Rule 
452, members and member organizations must be mindful of potential 
front-running situations; if they take advantage of their knowledge of 
customer trading objectives outside of efforts to facilitate customer 
trading objectives outside of efforts to facilitate customer trades, 
such member or member organization trading may violate Phlx Rule 707, 
Just and Equitable Principles of Trade. Of course, in crafting the 
proposed exemptions to Rule 452, the Exchange does not endeavor to 
exempt certain activity from existing front-running proscriptions.
    The Exchange also proposes to exempt two types of market making 
activity: specialists and market makers on a national securities 
exchange as well as upstairs market makers acting as such pursuant to 
SEC Rule 19c-3. These market makers are proposed to be exempted because 
they foster depth and liquidity in the marketplace, and, at least with 
respect to specialists and market makers on a national securities 
exchange, are extensively monitored and subject to affirmative and 
negative obligations imposed by the various exchanges. Thus, such 
market makers are integral to the auction market.
    The burden of proof to demonstrate that customer consent was 
obtained and the conditions of each exemption were met falls upon the 
member or member organization relying on the respective exemptive 
provision. The Exchange expects that internal procedures be adopted to 
assure compliance with the exemptive provisions.
    With respect to the prohibitions of Rule 452, the Exchange proposes 
to extend such to member organizations in order to capture trading 
within a Phlx member organization, without limitation to the floor 
members involved.\10\ Thus, whenever a member organization is 
representing an agency order, its own proprietary trading could be 
restricted. In this regard, new Supplementary Material .01 acknowledges 
that the agency order could be held in a different organizational 
component than the proprietary order such that a reasonable system of 
internal policies and procedures to prevent the misuse of customer 
information operates to dispel the presumption of knowledge by all 
employees of the member organization. Where such a system is in place, 
if an employee did not in fact know of the customer's order, then no 
violation occurred. The Exchange notes that a member organization would 
implement

[[Page 47541]]

information barriers appropriate to its business activity in accordance 
with this provision, taking into account that organization's 
supervisory/staffing structure and business operations, as well as the 
scope and nature of its business. The Exchange also notes that the 
prohibitions of Rule 452 apply once customer ``orders'' exist, such 
that proprietary trading is not impacted until customer interest takes 
the form of an order.
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    \10\ The Exchange notes that adding ``member organization'' to 
Rule 452 does not suggest that other Phlx rules do not apply to Phlx 
member organizations, but that the Exchange is intending to parallel 
the language of NYSE Rule 92 to prevent confusion.
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2. Statutory Basis
    The proposed rule change is consistent with Section 6 of the Act in 
general, and in particular, with Section 6(b)(5), in that it is 
designed to promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system, as well as to protect investors and the 
public interest by preserving the customer protection principle that 
members and member organizations should place a customer's interests 
ahead of the firm's, yet facilitating consensual arrangements with 
customers demanded by the evolving marketplace. Permitting certain 
proprietary trading coincident with customer trading, with a customer's 
consent, should contribute to the depth and liquidity of the 
marketplace, which should also be fostered by exempting specialist and 
market making activity.

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

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

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

    No written comments were either solicited or received.

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

    Within 35 days of the publication of this notice in the Federal 
Register or within such other 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 the 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 at 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 Exchange. All 
submissions should refer to File No. SR-Phlx-96-37 and should be 
submitted by September 30, 1996.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-22936 Filed 9-6-96; 8:45 am]
BILLING CODE 8010-01-M