[Federal Register Volume 62, Number 250 (Wednesday, December 31, 1997)]
[Notices]
[Pages 68334-68338]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33995]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39477; File No. SR-PCX-97-43]


Self-Regulatory Organizations; Order Granting Accelerated 
Approval of Proposed Rule Change and Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 2 to Proposed Rule 
Change by the Pacific Exchange, Inc. Relating to Its Specialist 
Evaluation Program

December 22, 1997.
    On November 17, 1997, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to extend its pilot program 
regarding the evaluation of its equity specialists until January 1, 
1999, and to implement certain changes to the pilot program.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in Securities 
Exchange Act Release No. 39358 (November 25, 1997), 62 FR 64035 
(December 3, 1997). No comments were received on the proposal. The 
Exchange filed Amendment No. 2 to the proposed rule filing on December 
5, 1997.\3\ This order approves the proposed rule change, as amended, 
on an accelerated basis.
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    \3\ Amendment No. 2 states that the Equity Allocation Committee 
(``EAC'') will consider mitigating circumstances on a case-by-case 
basis. The restrictions will apply in all cases in which the 
specialist fails to meet the standards; any failure to impose the 
restrictions should not be routine and should only occur in 
exceptional circumstances which demonstrate that imposing the 
restrictions is not justified. For example, the EAC may consider a 
systems problem to be a mitigating circumstance in a particular 
case. See letter from Jeffrey S. Norris, Manager, Regulatory 
Development, PCX, to Heather Seidel, Attorney, Market Regulation, 
Commission, dated December 4, 1997 (``Amendment No. 2'').
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I. Description

    On October 1, 1996, the Commission approved a nine-month pilot 
program for the evaluation of PCX equity specialists.\4\ On June 3, 
1997, the

[[Page 68335]]

 Commission approved a six-month extension of that pilot program.\5\ 
The reason for the extension was to allow the PCX more time to evaluate 
the impact of the SEC's new order handling rules on the performance 
criteria and to determine an appropriate overall passing score and 
individual passing scores for each criterion. The Exchange now is 
proposing to extend the pilot program until January 1, 1999. The PCX 
has established an overall passing score and individual passing scores 
for each criterion and has determined when specialists that do not 
attain the minimum passing scores should meet with the EAC. The 
Exchange is also proposing to replace the ``Bettering the Quote'' 
criterion with Price Improvement and to lower the weighting of the 
Specialist Evaluation Questionnaire from 15% to 10% so that Price 
Improvement can be given a weight of 10%.
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    \4\ Prior to the adoption of the pilot program, PCX Rule 5.37(a) 
provided that the Exchange's EAC evaluate all registered specialists 
on a quarterly basis and that each specialist receive an overall 
evaluation rating based on three criteria of specialist performance: 
(1) Specialist Evaluation Questionnaire Survey (``Questionnaire'') 
(45% of overall score); (2) SCOREX Limit Order Acceptance 
Performance (10%); and (3) National Market System Quote Performance 
(45%). See PSE Rule 5.37 (July 1995).
    The original pilot program modified Rule 5.37(a) by adding three 
new criteria of performance and eliminating one performance 
criterion. Prior to this proposed rule change, the pilot contained 
the following criteria: (1) Executions (50%) (itself consisting of 
four criteria: (a) Turnaround Time (15%); (b) Holding Orders Without 
Action (15%); (c) Trading Between the Quote (10%); and (d) 
Executions in Size Greater Than BBO (10%)); (2) Book Display Time 
(15%); and (3) Post-1 p.m.Parameters (10%). The pilot also 
eliminated the SCOREX Limit Order Acceptance Performance criterion. 
Further, the pilot added more questions to the Questionnaire, and 
reduces its weight from 45% to 15% of the overall score. Finally, 
the National Market System Quote Performance criterion (renamed 
Quote Performance under the pilot) was amended to include within it 
an additional submeasure for bettering the quote (each of the two 
submeasures under this criterion is accorded a weight of 5% of the 
overall score). For a more detailed description of the performance 
criteria utilized in the PCX's pilot program, see Securities 
Exchange Act Release No. 37770 (October 1, 1996), 61 FR 52820 
(October 8, 1996) (File NO. SR-PSE-96-28). See also generally PCX 
Rule 5.37 (description of the standards and procedures applicable to 
the EAC's evaluation of specialists).
    \5\ See Securities Exchange Act Release No. 38712 (June 3, 
1997), 62 FR 17941 (July 8, 1997).
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Price Improvement

    ``Price Improvement'' measures the number of trades involving 
market and marketable limit orders that improve the national best bid 
or offer (``NBBO'') if the NBBO quote spread at the time the original 
order is received is greater than or equal to two trading 
differentials, but less than or equal to eight trading differentials 
for that security. The execution price for stopped market or marketable 
limit orders will be compared with the guaranteed price (which is the 
NBBO at the time the order was received).
    Orders completely or partially executed will be considered for 
price improvement. All one-sided market or marketable limit orders \6\ 
with an NBBO quote spread greater than \1/8\ point are eligible for 
price improvement. Only agency orders entered or received by an 
exchange are eligible for price improvement. Orders with time-in-force 
designations such as good until canceled (GTC), good through day of 
entry (DAY), immediate or cancel (IOC), and good until executed will be 
eligible for price improvement. In addition, stocks, rights, warrants, 
preferred stock, when issued, and when distributed equity securities 
will be eligible for price improvement.
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    \6\ According to the PCX, the regional exchanges have agreed to 
the following definition for marketable limit orders: A marketable 
limit order to buy is priced at or above the NBBO offer, a 
marketable limit order to sell is priced at or below the NBBO bid.
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    The following types of orders will not be considered under the 
category of price improvement: all preopening market and limit orders, 
limit order executions out of the limit book (i.e., booked orders), 
electronically entered limit orders whose price falls in between the 
NBBO, non-regular-way trades (i.e., cash, next day and seller's 
option), negotiated trades or trades identified as crosses, bonds, 
orders designated as possible duplicates (POSS DUPE  or try to stop 
(TTS), canceled orders, odd-lot market and odd-lot limit orders, orders 
designated as all or none (AON), all tick sensitive executions (i.e., 
buy minus, sell plus, sell short, etc.), market quotations under 200 
shares, and principal an program trade account types.\7\
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    \7\ The PCX states that preopening market and limit orders were 
excluded because all such orders are entered prior to there being a 
market that is trading, so there is no market to improve upon. Limit 
order executions out of the limit book (i.e., booked orders) were 
not included because they are filled as the market moves toward 
them, not when they are outside of the NBBO. Electronically entered 
limit orders whose price falls in between the NBBO were excluded 
because these are not executable at the time they are entered, 
unless the specialist chooses to fill them. Non-regular-way trades 
(i.e., cash, next day and seller's option) and negotiated trades are 
not included because they are negotiated and the price does not 
necessarily depend upon the NBBO. Trades identified as crosses were 
excluded because specialists do not participate in crosses, by 
definition. Bonds and orders designated as possible duplicates (POSS 
DUPE) were not included because they are entered manually. Canceled 
orders were excluded because orders cannot be improved upon if they 
are not allowed to be executed. Odd-lot market and odd-lot limit 
orders were not included because they are executed automatically in 
the background, and the specialist never has the opportunity to 
improve upon them. Orders designated as all or none (AON) and all 
tick sensitive executions (i.e., buy minus, sell plus, sell short, 
etc.) were excluded because they are conditional orders. Market 
quotations under 200 shares were not included because they are 
usually computer generated and the specialists generally have no 
opportunity to improve them. Principal orders were excluded because 
they cannot be sent via PCOAST. Program trades were not included 
because they involve a large portfolio of stocks and derivative 
index products, which are not generally routed to a regional 
exchange for execution.
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    Specialists will be measured on the percentage of trades that are 
price improved. The following table gives the parameters and 
corresponding point values:

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              Percent of eligible trades improved                 Points
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40+............................................................       10
36-39.99.......................................................        9
32-35.99.......................................................        8
28-31.99.......................................................        7
24-27.99.......................................................        6
20-23.99.......................................................        5
16-19.99.......................................................        4
12-15.99.......................................................        3
  8-11.99......................................................        2
  4-  7.99.....................................................        1
Below 4........................................................        0
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Overall Passing Score

    The PCX has established an overall passing score of 60 as the 
minimum standard that each specialist must attain each quarter. A 
specialist will have to obtain better than a passing score in each 
individual criterion (see minimum passing scores shown below) to obtain 
a minimum passing score of 60. Any specialist who falls below the 
minimum passing score will have to appear before the EAC and will be 
subject to the following restrictions: no new allocations and no 
trading in alternate specialist stocks for the quarter following the 
quarter that the specialist was evaluated. Any specialist who does not 
attain a passing score in any three out of four quarters will also be 
subject to other restrictions imposed by the EAC, including 
reallocation of one or more stocks. The EAC will evaluate the 
effectiveness of the overall passing score and will adjust it 
accordingly.

Individual Criterion Passing Scores

    The PCX has established individual passing scores for each 
individual criterion based upon third quarter 1997 evaluation results. 
The third quarter of 1997 was the first evaluation period that the 
Trading Between the Quote, Book Display Time, and Quote Performance 
calculations were based upon the NBBO instead of the primary market. In 
addition, the evaluation results in the third quarter were based upon 
one-sixteenth trading increments instead of one-eighth increments. As a 
result of the NBBO changes and the change to

[[Page 68336]]

sixteenths, individual passing scores in the affected criteria were 
lower than in previous quarters. Previous quarter scores were not used 
to determine individual criterion passing scores because of the 
aforementioned changes. PCX states that the EAC will evaluate the 
effectiveness of the individual passing scores and will adjust them 
accordingly. The individual passing scores for each criterion are as 
follows:

------------------------------------------------------------------------
                                                                Passing 
                     Evaluation criterion                        score  
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Turnaround Time..............................................       12  
Holding Orders Without Action................................        7.5
Trading Between the Quote....................................        5  
Executions in Size Greater Than NBBO.........................        2  
Specialist Evaluation Questionnaire Survey...................        5  
Book Display Time............................................       10.5
Equal or Better Quote Performance............................        1  
Post 1 P.M. Parameters.......................................        3  
Price Improvement............................................        4  
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    Any specialist who does not attain a minimum passing score in a 
particular criterion for two or more consecutive quarters or more will 
be subject to the following:
    1. If a specialist does not attain a passing score in any 
particular individual criterion for 2 consecutive quarters, the 
specialist will have to appear before the EAC. The EAC will meet with 
the specialist with the intent of helping the specialist to improve the 
score.
    2. If a specialist does not attain a passing score in any 
particular individual criterion for 3 out of 4 consecutive quarters, 
the specialist will either not be permitted to trade any alternate 
specialist stocks or not be able to apply for any new stocks for one 
quarter. The Equity Allocation Committee will decide which restriction 
will apply.
    3. If a specialist does not attain a passing score in any 
particular individual criterion for 4 out of 5 consecutive quarters, 5 
out of 6 quarters, etc., the specialist will be subject to both the 
alternate specialist and no new stock restrictions for one quarter. The 
EAC may also, at its discretion, impose other restrictions, including 
reallocating one or more of the specialist stocks.
    The EAC will consider mitigating circumstances on a case-by-case 
basis. The restrictions will apply in all cases in which the specialist 
fails to meet the standards; any failure to impose the restrictions 
should not be routine and should only occur in exceptional 
circumstances which demonstrates that imposing the restrictions is not 
justified. For example, the EAC may consider a systems problem to be a 
mitigating circumstance in a particular case.

II. Discussion

    The Commission believes that specialists play a crucial role in 
providing stability, liquidity, and continuity to the trading of 
stocks. Among the obligations imposed upon specialists by the Exchange, 
and by the Act and the rules promulgated thereunder, is the maintenance 
of fair and orderly markets in their designated securities.\8\ To 
ensure that specialists fulfill these obligations, it is important that 
the Exchange conduct effective oversight of their performance. The 
PCX's specialist evaluation program is critical to this oversight.
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    \8\ Rule 11b-1, 17 CFR 240.11b-1; PSE Rule 5.29(f).
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    In its order initially approving the specialist evaluation pilot 
program,\9\ the Commission asked the Exchange to monitor the 
effectiveness of the amended program. Specifically, the Commission 
requested information about the number of specialists who fell into the 
bottom 10% of all registered specialists on their respective trading 
floors in the overall program, whether they subsequently appeared 
before the EAC, and any restrictions placed upon, or further action 
taken against, such specialists. The Commission also requested 
information as to the number of specialists who appeared before the EAC 
as a result of scoring in the bottom 10% in any two out of four 
consecutive quarterly evaluations, whether any restrictions were 
imposed on such specialists, and the results of any formal proceedings 
that were initiated against them.
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    \9\ For a description of the Commission's rationale for 
initially approving the PCX's adoption of its specialist evaluation 
pilot program, see Securities Exchange Act Release No. 37770, supra 
note 4. The discussion in the aforementioned order is incorporated 
by reference into this order.
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    In May 1997, the PCX submitted to the Commission its monitoring 
report regarding its specialist evaluation pilot program. The report 
described the PCX's experience with the pilot program during the 
initial two quarters of its operation (i.e., the fourth quarter of 1996 
and the first quarter of 1997). In terms of the overall scope of the 
program, the Commission continues to believe that the objective 
measures, together with the floor broker questionnaire, should generate 
sufficiently detailed information to enable the Exchange to make 
accurate assessments of specialist performance. In this regard, the 
increased emphasis on objective criteria under the pilot has been 
useful in identifying how well specialists carry out certain aspects 
(i.e., timeliness of execution, price improvement, and market making 
quality) of their responsibilities as specialists.
    In June 1997, the Commission approved an extension of the pilot to 
January 1, 1997.\10\ Since that time, the Exchange has begun (starting 
with the third quarter of 1997) to utilize the NBBO instead of the 
primary market quote in Trading Between the Quote, Book Display Time, 
and Quote Performance criteria, and the PCX is proposing to continue to 
utilize the NBBO for these criteria during the pilot extension. The 
Commission continues to believe that the NBBO is a more appropriate 
standard in this context in that it will enable the Exchange to gauge 
the performance of PCX specialists in comparison with their competitors 
not only in the primary market, but in the national market system as a 
whole.\11\ Therefore, the Commission finds that the PCX's proposal is 
responsive to the Commission's request for such an amendment.
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    \10\ See supra note 5.
    \11\ The Exchange's use of the primary market quote in these 
three measures did not allow for such comparisons to be made in 
instances where the primary market quote is not equal to the NBBO. 
See Id. at n.16.
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    The Commission believes that the proposed overall passing score and 
the individual criterion passing scores are consistent with the Act. 
The Commission believes that minimum adequate performance thresholds 
are an important part of any specialist performance evaluation program 
because they allow the Exchange to identify specialists who are not 
operating at an acceptable level of performance, both overall and in 
individual objective criterion. The Commission has stated that an 
effective evaluation program should subject specialists who meet 
minimum performance levels on the overall program, but need help or 
guidance in improving their performance in a particular area, to 
review. While the PCX's current specialist evaluation program subjects 
those specialists falling into the bottom 10% of all specialists on his 
or her trading floor to review by the EAC, it did not set a minimum 
performance level on the overall program, or for the individual 
criterion. The proposed rule change rectifies this situation by 
imposing overall and individual criterion passing scores.
    The Commission notes that the Exchange must apply certain 
restrictions on any specialist who fails the overall passing score and 
the

[[Page 68337]]

individual criterion passing scores for certain specified time periods. 
In addition, the Commission notes that the Exchange has represented 
that the EAC will evaluate the effectiveness of the overall and 
individual criterion passing scores and will adjust them as necessary. 
Finally, the Commission emphasizes that the EAC will consider 
mitigating circumstances only on a case-by-case basis and that the 
restrictions will apply in all cases in which the specialist fails to 
meet the standards, unless exceptional circumstances demonstrate that 
imposing the restrictions is not justified. The Commission expects that 
any failure to impose the restrictions should not be routine and should 
only occur when the exceptional circumstances, such as a systems 
problem in a particular case, justify not imposing the 
restrictions.\12\
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    \12\ See Amendment No. 2, supra note 3.
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    The Commission believes that replacing the ``Bettering the Quote'' 
criterion with Price Improvement, and lowering the Specialist 
Evaluation Questionnaire weighting to 10% and according Price 
Improvement a 10% weighting, is reasonable under the Act. The 
Commission notes that price improvement will measure the number of 
trades involving market and marketable limit orders that improve the 
NBBO; \13\ Bettering the Quote was originally measured against the 
primary market and is now measured against the NBBO. The Commission 
also notes that there is still a category for ``Equal or Better Quote 
Performance.'' Finally, the Commission notes that Price Improvement 
provides an additional objective criterion to measure specialist 
performance.
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    \13\ The NBBO quote spread at the time of the original order is 
received must be greater than or equal to two trading differentials, 
but less than or equal to eight trading differentials for that 
security. The execution price for stopped market or marketable limit 
orders will be compared with the guaranteed price (which is the NBBO 
at the time the order was received).
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    The Commission believes that it is appropriate to extend the 
current pilot program for an additional year, until January 1, 1999. 
This period will allow the Exchange to respond to evaluate the 
effectiveness of the overall passing score and the individual criterion 
passing scores, and the specialist performance program as a whole. 
Moreover, the Commission expects the Exchange to conduct an ongoing 
examination of the parameter ranges and corresponding points allotted 
under each criterion to ensure that they continue to be set at 
appropriate levels.
    The Commission therefore requests that the PCX submit by October 
30, 1998 a proposed rule change pursuant to Rule 19b-4 to include any 
proposal by the PCX to extend the pilot beyond January 1, 1999.
    In addition, the Commission requests that the PCX submit a report 
to the Commission, by October 30, 1998, describing its continuing 
experience with the pilot. At a minimum, this report should contain 
data, for the first, second and third quarters of 1998, on (1) the 
number of specialists who, as a result of failing the overall passing 
score in any one quarterly evaluation, appeared before the EAC, and the 
type of restrictions that were imposed on such specialists (i.e., 
restriction on new allocations or acting as an alternate specialist), 
or any further action that was taken against such specialists; (2) the 
number of specialists who, as a result of failing the overall passing 
score in any three out of four quarters, appeared before the EAC, and 
the type of restrictions that were imposed on such specialists (i.e., 
reallocation of new stocks), or any further action that was taken 
against such specialists; (3) the number of specialists who, as a 
result of failing any individual criterion passing score for two 
consecutive quarters, or three out of four consecutive quarters, four 
out of five consecutive quarters, and so on, appeared before the EAC, 
and the type of restrictions that were imposed on such specialists; (4) 
the number of specialists for whom formal proceedings were initiated, 
the results of such proceedings, including a list of any stocks 
reallocated from a particular unit; (5) the number of registered 
specialists who scored in the bottom 10% of all registered specialists 
on his or her trading floor in the overall program; (6) the number of 
specialists who, as a result of scoring in the bottom 10% in any one 
quarterly evaluation, appeared before the EAC, and the type of 
restrictions that were imposed on such specialists (i.e., restrictions 
on new allocations or acting as an alternate specialist), or any 
further action that was taken against such specialists; (7) the number 
of specialists who, as a result of scoring in the bottom 10% in any two 
out of four consecutive quarterly evaluations, appeared before the EAC, 
whether any restrictions were imposed on such specialists, and whether 
formal proceedings were initiated against such specialists; and (8) any 
situation in which the restrictions were not imposed due to mitigating 
circumstances, what those circumstances where, and the reasoning as to 
why the restrictions were not imposed.
    The Commission notes that the Exchange's pilot program only 
modifies the performance criteria of PCX Rule 5.37(a). Consequently, 
the Commission expects the EAC to continue to evaluate the performance 
of specialists during the pilot period in accordance with the standards 
and procedures found in the PCX rules.\14\
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    \14\ In this regard, all specialists falling within the bottom 
10% of specialists on their respective floors in any review period 
are required to meet with the EAC. See also PCX Rule 5.37 (standards 
applicable to specialists falling into the bottom 10% in any two out 
of four review periods, including those pertaining to the initiation 
of formal reallocation proceedings). Moreover, PCX Rule 5.36(d), 
Commentary .03 requires that all specialists falling into the bottom 
10% in a review period must be precluded from acting as alternate 
specialists until their ranking rises above the bottom 10%, unless 
the EAC determines otherwise. In addition, PCX Rule 5.37(b), 
Commentary .01 requires that all such specialists shall not be 
eligible for new allocations until their ranking rises above the 
bottom 10%. Consequently, the Commission expects that appropriate 
action in accordance with PCX rules will be taken with regard to 
those specialists falling into the bottom 10%. The Commission notes 
that the PCX stated its intention to file a rule change to PCX Rule 
5.37 to reflect all of the aforementioned changes to its Specialist 
Evaluation Pilot Program.
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    For the reasons discussed above, the Commission finds that the 
PCX's proposal to extend its pilot program is consistent with the 
requirements of Sections 6(b) and 11 of the Act \15\ and the rules and 
regulations thereunder applicable to a national securities exchange. 
Specifically, the Commission finds that the proposed rule change is 
consistent with the Section 6(b)(5) requirement that the rules of an 
exchange be designed to promote just and equitable principles of trade, 
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.\16\
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    \15\ 15 U.S.C. 78f(b) and 78k.
    \16\ In approving this rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
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    Further, the Commission finds that the proposal is consistent with 
Section 11(b) of the Act \17\ and Rule 11b-1 thereunder which allow 
securities exchanges to promulgate rules relating to specialists in 
order to maintain fair and orderly markets and to remove impediments to 
and perfect the mechanism of a national market system.
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    \17\ 15 U.S.C. 78k(b).
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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 thereof in the Federal Register. This will permit the pilot 
program to continue both on an uninterrupted basis and with the use of 
overall and individual criterion passing scores, and a new measure, 
Price Improvement. In addition, the rule

[[Page 68338]]

change that implemented the pilot program initially was published in 
the Federal Register for the full comment period, and no comments were 
received.\18\ The Commission also finds good cause for approving 
Amendment No. 2 prior to the thirtieth day after the date of 
publication of notice in the Federal Register. Amendment No. 2 
strengthened the proposed rule change by clarifying that the EAC will 
consider mitigating circumstances only an a case-by-case basis, and 
will only apply them in exceptional circumstances which demonstrate 
that imposing the restrictions is not justified. Accordingly, the 
Commission believes good cause exists, consistent with the Act, to 
accelerate approval of the proposed rule change and of Amendment No. 2.
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    \18\ See Securities Exchange Act Release 37770, supra note 4.
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    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2 to the rule proposal. 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. Sec. 552, will 
be available for inspection and copying at the Commission's Public 
Reference Room. Copies of such filing also will be available for 
inspection and copying at the principal office of the Exchange. All 
submissions should refer to File No. SR-PCX-97-43 and should be 
submitted by January 21, 1998.

III. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) \19\ that the 
proposed rule change, as amended, is hereby approved on an accelerated 
basis.

    \19\ 19 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-33995 Filed 12-30-97; 8:45 am]
BILLING CODE 8010-01-M