[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] ----------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \1\ 15 U.S.C. 78s(b)(1). \2\ 17 CFR 240.19b-4. --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \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''). --------------------------------------------------------------------------- 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%. --------------------------------------------------------------------------- \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). --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \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. --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \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. --------------------------------------------------------------------------- Specialists will be measured on the percentage of trades that are price improved. The following table gives the parameters and corresponding point values: ------------------------------------------------------------------------ Percent of eligible trades improved Points ------------------------------------------------------------------------ 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 ------------------------------------------------------------------------ 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 ------------------------------------------------------------------------ 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 ------------------------------------------------------------------------ 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. --------------------------------------------------------------------------- \8\ Rule 11b-1, 17 CFR 240.11b-1; PSE Rule 5.29(f). --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \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. --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \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. --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \12\ See Amendment No. 2, supra note 3. --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \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). --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \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. --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \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). --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \17\ 15 U.S.C. 78k(b). --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \18\ See Securities Exchange Act Release 37770, supra note 4. --------------------------------------------------------------------------- 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). --------------------------------------------------------------------------- For the Commission, by the Division of Market Regulation, pursuant to delegated authority.\20\ --------------------------------------------------------------------------- \20\ 17 CFR 200.30-3(a)(12). --------------------------------------------------------------------------- Margaret H. McFarland, Deputy Secretary. [FR Doc. 97-33995 Filed 12-30-97; 8:45 am] BILLING CODE 8010-01-M