[Federal Register Volume 65, Number 42 (Thursday, March 2, 2000)]
[Notices]
[Pages 11388-11401]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-4976]



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Part III





Securities and Exchange Commission





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In the Matter of the Application of The International Securities 
Exchange LLC for Registration as a National Securities Exchange; 
Findings and Opinion of the Commission and Order Granting Registration; 
Notices



Joint Industry Plan; Notice of Filing of Proposed Option Market Linkage 
Plans by the American Stock Exchange, Chicago Board Options Exchange, 
Pacific Exchange, and Philadelphia Stock Exchange; Notice

  Federal Register/Vol. 65, No. 42/Thursday, March 2, 2000/Notices  

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42455; File No. 10-127]


In the Matter of the Application of The International Securities 
Exchange LLC for Registration as a National Securities Exchange; 
Findings and Opinion of the Commission

February 24, 2000.

I. Introduction

    On February 2, 1999, the International Securities Exchange LLC 
(``ISE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``Commission'') a Form 1 application (``Form 1'') under the 
Securities Exchange Act of 1934 (``Exchange Act''), seeking 
registration as a national securities exchange pursuant to Section 6 of 
the Exchange Act. Notice of the application was published for comment 
in the Federal Register on June 1, 1999.\1\ The Commission received 
twenty-one comments on the proposal.\2\ The ISE filed an amendment to 
its application on September 27, 1999.\3\ Notice of the amendment was 
published for comment in the Federal Register on October 26, 1999.\4\ 
The Commission received nine comments on Amendment No. 1.\5\ On 
February 23, 2000, the ISE filed another amendment to its 
application.\6\ This order approves the ISE's application for 
registration as a national securities exchange, as amended.
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    \1\See Exchange Act Release No. 41439 (May 24, 1999), 64 FR 
29367 (June 1, 1999).
    \2\A summary of comments received on the original application is 
available in the Public Reference Room at the Commission (File No. 
10-127).
    \3\See Letter from David Krell, President and CEO, ISE, to 
Jonathan G. Katz, Secretary, Commission, dated September 23, 1999 
(``Amendment No. 1''). The ISE included a narrative response to the 
comment letters in Amendment No. 1. See Amendment No. 1, Exhibit 6.
    \4\See Exchange Act Release No. 42042 (October 20, 1999), 64 FR 
57668 (October 26, 1999).
    \5\A summary of comments received on Amendment No. 1 is 
available in the Public Reference Room at the Commission (File No. 
10-127).
    \6\See Letter from David Krell, President and CEO, ISE, to 
Jonathan G. Katz, Secretary, Commission, dated February 17, 2000 
(``Amendment No. 2''). Although Amendment No. 2 was not published 
for comment, the changes are either responsive to comment letters 
and the concerns of the Commission or technical in nature. Any other 
substantive changes to the ISE's rules will be published in the 
Federal Register for notice and comment.
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II. Discussion

    Under Sections 6 and 19(a) of the Exchange Act, the Commission will 
grant an order for registration as a national securities exchange if it 
finds that the exchange is so organized and has the capacity to carry 
out the purposes of the Exchange Act and can comply, and can enforce 
compliance by its members and persons associated with its members, with 
the provisions of the Exchange Act, the rules and regulations 
thereunder, and the rules of the exchange. The rules of the exchange 
must be adequate to insure fair dealing and to protect investors, and 
may not impose any burden on competition not necessary or appropriate 
in furtherance of the purposes of the Exchange Act.
    After a review of the ISE's amended application in accordance with 
these standards, the Commission has determined to grant the 
registration of the Exchange. In taking this action, the Commission 
notes that the ISE will not be permitted to begin trading until after 
it satisfies a number of conditions, which are discussed below.
    The Commission finds that the ISE's Constitution and rules are 
consistent with Section 6 of the Exchange Act in that they are designed 
to: (1) Assure fair representation of an exchange's members in the 
selection of its directors and administration of its affairs and 
provide that, among other things, one or more directors shall be 
representative of investors and not be associated with the exchange, or 
with a broker or dealer; (2) to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of trade, 
to foster cooperation and coordination with persons engaged in 
regulating, clearing, settling, processing information with respect to, 
and facilitating transactions in securities, to remove impediments to 
and perfect the mechanisms of a free and open market and a national 
market system; and (3) to protect investors and the public interest. 
Finally, the Exchange's rules do not impose any burden on competition 
not necessary or appropriate in furtherance of the purposes of the 
Exchange Act.
    Overall, the Commission believes that granting registration to the 
ISE as a national securities exchange offers the promise of important 
benefits to the public and should provide U.S. market participants with 
a new, innovative method of trading options. As a fully electronic 
options market, the ISE's entrance to the marketplace should 
potentially reduce the costs of trading to investors and market 
professionals, enhance innovation, and increase competition between and 
among the options exchanges, resulting in better prices and executions 
for investors.
    This discussion does not review every rule and representation made 
by the ISE that has been filed as a part of its application; rather, it 
focuses on the most prominent rules and policy issues considered in 
review of the ISE's application.

III. Consideration of Certain of ISE's Governance Provisions and 
Trading Rules

A. Corporate Structure

    The ISE is organized as a limited liability company (``LLC'') under 
New York law and will be owned by certain of its members. This 
corporate structure is substantially the same as the existing exchanges 
are structured, with one exception. As an LLC, the Exchange will not 
pay state and federal taxes on its income. Instead, the income will be 
``allocated'' to the Class A and Class B memberships (described below), 
and the owner of each membership will pay taxes on the income. The 
Exchange will distribute to each owner of a membership the amount 
necessary to pay the taxes on its allocated portion of the Exchange's 
net income.
    Several commenters believed that, because ISE is organized as a 
for-profit entity,\7\ it is structured to provide owners of memberships 
a profit from Exchange-generated revenue. Although ISE's expectation is 
to have net income and it will create a budget and set fees based upon 
that expectation, it will not distribute profits to its owners. Net 
income will be used by the ISE to finance capital improvements and to 
provide for financial reserves. Generally, existing exchanges control 
the amount of annual net income by adjusting their fees. Some exchanges 
rebate fees collected, or reduce or eliminate fees temporarily when 
they exceed projected earnings. ISE's LLC structure provides for a 
similar financial model as the existing exchanges with the exception of 
the manner in which taxes are paid.
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    \7\Seven of the eight current U.S. exchanges are ``not-for-
profit'' organizations. In its release concerning the regulation of 
exchanges and alternative trading systems, the Commission expressed 
its view that registered exchanges may structure themselves as for-
profit exchanges. See Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998) (``ATS Release'').
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    Many commenters also suggested that because the ISE is organized as 
a ``for-profit'' entity, its structure creates the potential for 
conflicts of interest. The Commission notes that conflicts of interest 
are an inherent part of self-regulation. To the extent that ISE's 
organization as an LLC, rather than as a not-for-profit corporation, 
heightens or changes those conflicts of interest, the Commission has 
evaluated the conflicts of interests and believes that a number

[[Page 11389]]

of factors alleviate these concerns.\8\ First, ISE will not be the 
Designated Examining Authority (``DEA'') or Designated Options 
Examining Authority (``DOEA'') for its members. In other words, ISE is 
not the primary SRO and, therefore, will not be responsible for the 
financial oversight of its members, or for disciplining or enforcing 
common SRO rules. Nor will ISE be responsible for enforcing the rules 
of another SRO. This alleviates concerns that possible profit-making 
motives could influence ISE to use its examining authority to profit 
its members or to harm a competitor-SRO for which it had assumed 
regulatory obligations. Second, the ISE has filed an interpretation, 
which will be considered a rule of the Exchange pursuant to Section 
3(a)(27) of the Exchange Act, that states that the ISE will make 
distributions solely to cover members' tax liability for the ISE's 
income. Cash available for distributions to members will not include 
revenues received by the Exchange from regulatory fees or regulatory 
penalties. This will prevent the possibility that regulatory fines and 
fees might be ``dividended'' out to members.\9\ Third, non-industry 
directors comprise a majority (eight out of fifteen) of the ISE's Board 
of Directors. Because these non-industry directors are not affiliated 
with members of the Exchange, they provide a significant safeguard 
against possible abuse by limiting the influence and control of any one 
group over the activities of the Exchange. In sum, given that ISE is 
not a DEA or DOEA, is not a publicly-owned entity, and is not 
structured to provide its members a profit from Exchange-generated 
revenue, the Commission does not believe that the concerns regarding a 
``for-profit'' exchange functioning as an SRO are serious in the ISE 
context.
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    \8\The Commission believes that assessing conflicts of interest 
concerns in the context of an SRO can be highly dependent on, among 
other things, corporate and membership structure, which must be 
analyzed on a continuous case-by-case basis. Although the factors 
described in this release are helpful in allaying concerns over the 
ISE's for-profit status, the Commission recognizes that there may be 
other factors that could be considered in addressing these concerns 
in the future.
    \9\See Amendment No. 2.
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B. Corporate Governance

1. Fair Representation
    Section 6(b)(3) of the Exchange Act requires that the rules of an 
exchange assure fair representation of its members in the selection of 
its directors and administration of its affairs and, among other 
things, provide that one or more directors be representative of issuers 
and investors and not be associated with a member of the exchange, or 
with a broker or dealer. Public representation and individuals who are 
not affiliated with broker-dealers on an exchange's board of directors 
helps to satisfy this requirement. This provision is designed to ensure 
that members have a voice in the use of self-regulatory authority that 
may affect the members, and to protect members from unfair, unfettered 
disciplinary actions under the rules of the exchange.

a. ISE's Board of Directors

    The Commission finds that the ISE has been structured in such a 
manner as to satisfy the principles of fair representation as required 
by Section 6(b)(3) of the Exchange Act. The ISE's Board of Directors 
will be the governing body of the Exchange and possess all the powers 
necessary for the management of the business and affairs of the 
Exchange and for the promotion of its welfare, objects and purposes. 
The Board will consist of 15 directors: (i) 6 member representatives, 
comprised of two Class A member representatives (``Primary Market 
Maker'' or ``PMM''), two Class B member representatives (``Competitive 
Market Maker'' or ``CMM''), two Class C member representatives 
(``Electronic Access Member'' or ``EAM''); (ii) eight non-industry 
directors,\10\ at least two of whom must be representatives of the 
public;\11\ and (iii) the President of ISE. Thus, the Board provides 
members six representatives, yet still consists of a majority of non-
industry representatives.
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    \10\A ``non-industry representative'' means any person that 
would not be considered an ``industry representative,'' as well as 
(i) a person affiliated with a broker or dealer that operates solely 
to assist the securities-related activities of the business of non-
member affiliates, (ii) an employee of an entity that is affiliated 
with a broker or dealer that does not account for a material portion 
of the revenues of the consolidated entity and who is primarily 
engaged in the business of the non-member entity. See ISE 
Constitution, Article I, Section 1(r).
    \11\A ``representative of the public'' means a non-industry 
representative who has no material business relationship with a 
broker or dealer or the Exchange. See ISE Constitution, Article I, 
Section (1)(v).
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    Representatives of Class A, B, and C members will be nominated by a 
nominating committee\12\ and elected to the Board by a plurality of 
their respective classes.\13\ No member organization may have more than 
one representative elected to the Board.\14\ Non-industry directors 
will be nominated by the nominating committee and elected by an 
affirmative vote of a majority of the Class A members, a majority of 
the Class B members and a majority of the Class C members voting by 
class if the election is uncontested.\15\ Industry and non-industry 
candidates may also be placed on the ballot by petition.\16\ All 
directors will serve for a two-year term,\17\ except that the President 
will serve until removed. No director, other than the President, who 
has been elected to three consecutive terms is eligible for election as 
a director again except after a minimum of a two-year interval.
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    \12\See ISE Constitution, Article VI, Section 3(c). See, e.g., 
National Association of Securities Dealers, Inc. (``NASD'') Bylaws, 
Article VII, Section 10. The Nominating Committee is composed of a 
representative from each class, as well as three non-industry 
representatives, at least one of which must be public.
    \13\See ISE Constitution, Article IV, Section 1(a).
    \14\See ISE Constitution, Article IV, Section 1(c).
    \15\If there are more candidates than the number of vacancies to 
be filled, non-industry directors are elected by a plurality of all 
members using a weighting system. See ISE Constitution, Article V, 
Section 1(d).
    \16\See ISE Constitution, Article VI, Section 3(e).
    \17\One half of each class of directors will be elected at each 
annual meeting of the members. See ISE Constitution, Article IV, 
Sec. 1(b). At the initial election meeting, the Board will randomly 
select one Class A director, one Class B director, one Class C 
director, and four non-industry directors (at least one of which 
must be a public director) who will serve for an initial term of 
three years. See ISE Constitution, Article IV, Sec. 1(e)(6).
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    The Chairman and Vice Chairman of the Board will be appointed from 
among the directors by the affirmative vote of at least two-thirds of 
the directors then in office. The Chairman and Vice Chairman each will 
serve for a one-year term and will not be officers of the Exchange.
    PMM and CMM directors have special voting rights regarding the 
approval of proposed rule changes by the Board. Specifically, in order 
to adopt, amend or repeal certain governance and trading rule changes, 
there must be a majority of the entire Board that votes in favor of the 
proposed change. In addition, at least one PMM director and one CMM 
director must vote in favor of the proposed change.\18\ One commenter 
asserts that this provision gives an effective veto power to the PMM 
and CMM classes.\19\ In response to this comment, the ISE has amended 
its Constitution to reflect that approval of a proposed rule change 
will now require a favorable vote by a majority of the Board, including 
either one PMM director and one CMM director or five out of eight of 
the non-industry directors.\20\ The revised provision therefore permits 
an override of the objecting PMM and CMM directors in a situation where 
a majority of the non-industry directors vote in favor of the

[[Page 11390]]

proposed rule change.\21\ Essentially, a PMM director and a CMM 
director who vote against a proposed rule change will only succeed in 
vetoing the proposed change if four or more non-industry directors also 
vote against the proposal.
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    \18\See ISE Constitution, Article VII, Sec. 1.
    \19\See American Stock Exchange (``Amex'') Letter.
    \20\See Amendment No. 2.
    \21\See Amendment No. 2.
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    Although this special voting provision provides a limited veto 
power to PMMs and CMMs with regard to proposed rule changes, the 
Commission believes that a certain level of protection to the equity 
owners-members in the Exchange is reasonable.\22\ Inherent in the 
concept of a for-profit entity is the notion that those with equity 
interests in the entity should be afforded rights to protect those 
interests. It is impractical to expect persons to take up an equity 
interest in an exchange if they are not permitted to protect that 
interest in some fair and reasonable manner. In the scheme of self-
regulation, however, this notion must be balanced with the requirement 
of fair representation of all members, not just those with equity 
interests. The Commission believes that the ISE's voting provision with 
respect to approval of proposed rule changes reaches an acceptable 
balance between protecting owner-members, non-owner-members, and the 
public interest.
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    \22\The Commission notes that this analysis applies only to 
situations where the equity owners are also members of the exchange. 
The analysis would be different where equity owners in an exchange 
were not also members of the exchange. In the event that equity 
owners were not also members of an exchange, the Commission might 
find that the non-equity members of the exchange were entitled to 
further special protections or rights.
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b. Rights to Vote on Certain Corporate Actions

    Each of the current exchanges has several different types of 
memberships with differing equity interests and voting rights.\23\ 
ISE's voting structure is set up to recognize the difference in 
ownership interests among its members. PMMs and CMMs own memberships 
that represent equity interests in the Exchange. These memberships may 
be leased or sold to approved persons or entities. In contrast, EAMs do 
not own an equity interest in the Exchange. EAMs essentially have 
rights to trade on the Exchange, which are not transferable. Although 
all three classes of memberships elect representatives to the Board, as 
well as participate in the election of the non-industry directors,\24\ 
when a vote of the membership is required to take certain action, the 
EAMs do not have the same rights as the PMMs and CMMs. Specifically, 
PMM members and CMM members have the right to vote on corporate actions 
like mergers, consolidations or dissolution of the Exchange, changes to 
the structure of the Exchange such as adding additional classes of 
members or increasing the number of memberships in a class, and 
amendments to the Constitution.\25\ EAMs, however, do not generally 
have the right to vote on such actions.\26\ EAMs only have the right to 
vote on changes to the Constitution or Operating Agreement that would 
affect their economic status on the Exchange, alter their voting 
rights, or change the composition of the Board of Directors.\27\
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    \23\See, e.g., New York Stock Exchange (``NYSE'') Constitution, 
Article II, Section 1 (concerning regular memberships, electronic 
access members and physical access members).
    \24\See ISE Constitution, Article IV, Section 1(a) and (d).
    \25\See ISE Constitution, Article III, Section 11(a).
    \26\See ISE Constitution, Article III, Section 11(b).
    \27\See ISE Constitution, Article III, Section 11(b).
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c. ISE's Structure Provides Fair Representation

    Two commenters believe that the ISE's proposed governance structure 
provides the two classes of market makers, PMMs and CMMs, with undue 
influence over the operation of the Exchange, thereby not satisfying 
the fair representation requirement of the Exchange Act.\28\ The 
Commission disagrees. First, only four out of the fifteen Board members 
will be representative of market makers (who are the equity owners). 
Second, the nominating committee is composed of a representative from 
each class and three non-industry representatives, at least one of whom 
must be a public representative, thereby providing for input in the 
nominating process from more than just the market makers. Third, the 
Board is composed of a majority of non-industry directors. Finally, 
although voting rights are determined by the type of ownership interest 
in the Exchange, i.e., equity versus non-equity, all members and 
classes have an input in Exchange governance. Specifically, each class 
of members elects two representatives to the Board of Directors and 
participates equally in the election of the non-industry directors. 
Given these provisions, the Commission believes that the ISE's 
governance structure satisfies the fair representation requirement 
under the Exchange Act.
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    \28\See Chicago Board Options Exchange (``CBOE'') Letter I, Amex 
Letter.
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2. Chairman's Affiliation with a Member
    The rules of certain national securities exchanges currently do not 
permit their respective chairmen to be a member of the exchange or 
affiliated with a member of the exchange.\29\ The ISE's first Chairman, 
however, is affiliated with a member of the Exchange.\30\
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    \1\See, e.g., CBOE Constitution, Article VIII, Section 8.1; Amex 
Constitution, Article II, Section 3. But see File No. SR-Amex-99-25. 
Amex has filed a proposed rule change with the Commission that would 
permit the Amex Chairman to be affiliated with a member.
    \30\The ISE's Chairman is Mr. William Porter. Mr. Porter is also 
Chairman of Adirondack Trading Partners, LLC (``ATP''), a founding 
member of the ISE and a proposed PMM on the Exchange. See ISE Form 
1, Exhibit G.
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    As many commenters note, the affiliation of the Chairman with one 
of the Exchange's members implicates certain conflicts of interest, or 
at least gives the appearance of such conflicts. ISE asserts that the 
choice of their first chairman is very important to the success and 
credibility of the Exchange. To address the conflicts raised, the ISE's 
Constitution provides certain protections limiting the functions and 
role of the Chairman. First, the Chairman of the ISE is not an officer 
of the Exchange.\31\ Thus, the Chairman does not have the authority to 
bind the Exchange. Second, no later than two years after the start-up 
of trading on the ISE, the Chairman will be appointed from among the 
non-industry directors.\32\ Third, the functions that the Chairman will 
perform are substantially limited. The Chairman may preside over 
meetings of the Board of Directors, vote at meetings of the Board, 
serve on the Executive Committee of the Exchange,\33\ call a special 
meeting of the ISE's members,\34\ and receive resignations from Board 
members.\35\ Given these safeguards and given the highly limited role 
of the Chairman, the Commission believes that the conflict concerns 
related to an affiliated chairman have been adequately addressed. 
Furthermore, the Commission notes that an interested director is 
prohibited from participating as a member of the Board or of any 
committee in any matter that would substantially affect his interest or 
the interests of any person in whom he is directly or indirectly 
interested.\36\ This prohibition provides additional assurance that the 
Chairman will not participate in a matter in which he may have an 
interest by virtue of his

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affiliation with a member of the Exchange.
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    \31\See ISE Constitution, Article IV, Section 2.
    \32\Id.
    \33\The ISE's Executive Committee is composed of six directors, 
including the Chairman, the Vice Chairman, President of the 
Exchange, and three non-industry directors (at least one of whom 
must be public). The President of the Exchange is the Chairman of 
the Executive Committee. See ISE Constitution, Article VI, Section 
2(a).
    \34\A majority of the Board, as well as a set number of members 
may also call a special meeting. See ISE Constitution, Article III, 
Section 3.
    \35\See ISE Constitution, Article IV, Section 4(a).
    \36\See ISE Constitution, Article IV, Section 11. Interested 
directors may be counted in determining the presence of a quorum.
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3. Officers
    The Exchange will have a President, one or more Vice Presidents, a 
Treasurer, a Secretary and any other officers as may be appointed by 
the President. The President will be elected by a majority of the Board 
and is the Chief Executive Officer.
    Generally, officers of the Exchange are not permitted to be members 
of the Exchange or be affiliated with members of the Exchange. If an 
officer owns a membership or is affiliated with a member upon his 
election to office, the officer must abstain from exercising voting 
rights with respect to the membership and must also lease the 
membership. The terms of the lease by an officer must be reasonable and 
approved by a majority of the non-industry directors.\37\
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    \37\See ISE Constitution, Article V, Section 2.
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    An exception to the general prohibition on officers owning 
memberships has been provided with respect to two individuals who are 
founders and who own CMM memberships.\38\ Specifically, the initial 
President and Chief Executive Officer of the ISE is Mr. David Krell. 
The initial Senior Vice President of Marketing and Business Development 
is Mr. Gary Katz. As founders of ISE, Mr. Krell and Mr. Katz are to be 
compensated with memberships. Mr. Krell will receive four memberships 
and Mr. Katz will receive two. Again, commenters note that conflicts of 
interest arise where officers are permitted to own memberships or be 
affiliated with members. The ISE has provided a number of safeguards to 
protect against such conflicts. First, an officer of the Exchange who 
owns one or more memberships must abstain from exercising any voting 
rights associated with the membership(s).\39\ Second, an officer who 
owns a membership must lease that membership and the terms of the lease 
must be reasonable and approved by a majority of non-industry 
directors.\40\ Finally, except in the case where one or more officers 
is also a founder, the ISE will only permit one officer to be an owner 
of one or more memberships.\41\ The Commission believes that these 
provisions should protect against an officer allowing his economic 
interest in the success of his membership from affecting his duties as 
an officer of the Exchange.
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    \38\See ISE Form 1, Exhibit I.
    \39\See ISE Constitution, Article V, Section 2.
    \40\Id. As founders, Mr. Krell and Mr. Katz will not be required 
to immediately lease or sell their respective memberships. See ISE 
Rules 300(a)(5) and 310. During the time that their memberships are 
held without being leased, however, there will be no voting rights 
associated with the memberships.
    \41\See ISE Constitution, Article V, Section 2.
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4. Delegation of Authority
    Several commenters criticize the manner in which the ISE will 
delegate decision-making authority within the Exchange. These 
commenters believe that the ISE should be required to specify who or 
what will have the relevant decision-making authority, rather than 
stating that such authority resides with ``the Exchange.'' In response, 
the ISE has amended several of its rules to provide more 
specificity.\42\ The Commission believes that these and other rules are 
sufficiently specific to insure fair dealing and to protect investors.
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    \42\See Amendment No. 2. Specifically, the ISE has amended the 
following rules: (1) Rule 411(h) (Significant Business Transaction) 
has been amended to specify that any exemption from the requirements 
of the rule receive approval by the Chief Regulatory Officer of the 
ISE; (2) Rule 417 (Limit on Uncovered Short Positions) has been 
amended to specify that the Board or a committee or Exchange 
official designated by the Board will make determinations or take 
action under this rule; (3) Rules 702 (Trading Halts), 704 (Unusual 
Market Conditions) and 717(g) (Limitations on Orders--Orders for the 
Account of Another Member) have been amended to specify that an 
Exchange official designated by the Board will make determinations 
and take actions under these rules; (4) Rule 802 (Appointment of 
Market Makers) has been amended to specify that the Exchange's Board 
or a committee designated by the Board will have responsibility for 
appointing, reviewing and suspending market makers; (5) Rule 
804(e)(2)(iii) (Market Maker Quotations) has been amended to specify 
that an official designated by the Board will be responsible for 
calling upon a CMM to submit a single quote or to maintain 
continuous quotes in options when in the judgment of such official, 
it is necessary to do so in the interest of fair and orderly 
markets; and (6) Rule 1500 (Imposition of Suspension) has been 
amended to specify that the Board or a committee or Exchange 
official designated by the Board will determine when and if summary 
suspension is necessary or whether access to services by the 
Exchange may be limited or prohibited with respect to any person or 
member. In addition, ISE Rule 801 (Designated Trading 
Representatives) has been amended to remove reference to a 
``registration'' requirement for Designated Trading Representatives 
(``DTR''). The text of the rule now makes clear that a DTR must be 
approved by the Exchange before he or she will be permitted to enter 
quotations and orders into the ISE's system on behalf of an ISE 
market maker member. The reference to a ``registration'' requirement 
had implied that the ISE was creating a new registration category 
for purposes of Form U-4, which it was not. ISE Rule 801(b)(4) also 
has been amended to specify that any conditional approvals of DTRs 
will be made by the Chief Regulatory Officer.
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C. Membership

    As noted above, there will be three types or classes of members at 
the ISE: PMMs, CMMs, and EAMs.\43\ The Exchange has established 
limitations on the number of memberships that a member may own, as well 
as on the number of memberships for which a member may be approved to 
trade on the Exchange.
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    \43\Brokers that clear for other members must be approved EAMs. 
See ISE Constitution, Article I, Section 1(a)(f).
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1. Concentration Limits on Memberships
    Several commenters criticize the concentrated ownership of the ISE 
in a few founders. Specifically, these commenters contend that a large 
portion of the ISE will be controlled or owned for a significant number 
of years by individuals, namely the ISE's founders, who will own the 
memberships for investment purposes and not for the purpose of 
conducting a securities business. Commenters also criticize the ISE for 
not requiring members to lease memberships if they are not engaged in 
trading on the ISE.\44\
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    \44\See, e.g., CBOE Letter 1.
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    The ISE has adopted concentration limits to restrict the number of 
memberships that one person, together with any person who directly or 
indirectly controls, is controlled by, or is under common control with 
the person, may own or lease. Generally, one person may not own or 
lease more than twenty percent of any class of memberships. The 
Exchange has the authority to further limit the number of Class A and 
Class B memberships that may be owned or leased by a member.\45\ 
Specifically, ISE Rule 303(g) states that an applicant will be denied 
approval to purchase a membership if, together with any person who 
directly or indirectly controls, is controlled by, or is under common 
control with the applicant, that approval would result in the applicant 
owning and/or leasing more than one PMM membership or more than ten CMM 
memberships, unless the restriction is waived by the Board for good 
cause shown.
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    \45\See ISE Constitution, Article II, Section 11(a); ISE Rule 
303(g).
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    Many commenters noted that the ISE's Rules 303(g) and 317(a)\46\ 
failed to define ``good cause shown.'' In response, the ISE has defined 
``good cause shown'' to mean a demonstrated operational, business or 
regulatory need. The ISE states that in those cases where such a need 
has been demonstrated to the Board, the Board will also consider any 
operational, business or regulatory concerns that might be raised if 
such a waiver were granted. Furthermore, the Board will only waive such 
limitations when, in its judgment, such action is in

[[Page 11392]]

the best interest of the Exchange.\47\ As a general matter, the 
Exchange states that it anticipates granting such waivers primarily on 
a temporary basis when needed to address mergers, acquisitions and 
similar business combinations.\48\ Accordingly, only in truly necessary 
circumstances will the Exchange permit a member to own or operate more 
than one PMM membership, and even in that case the member may not own 
or operate more than two PMM memberships.
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    \46\ISE Rule 317(a), discussed below, concerns the limitation on 
the number of memberships with respect to which a member may be 
approved to trade on the Exchange.
    \47\See Amendment No. 2.
    \48\The ISE states that the Exchange's management currently 
anticipates recommending that the Board grant a waiver of this 
provision only to ATP, a founder of the Exchange. This 
recommendation is due to ATP's position in funding the Exchange, and 
also due to the unique nature of ATP's membership. Specifically, ATP 
is owned by a consortium of broker-dealers and other entities, and 
thus ATP itself represents widespread ownership in the securities 
industry. The Board, which will have a majority of non-industry 
Directors, must determine that approval of management's 
recommendation is in the best interest of the ISE.
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    Although founders of the Exchange have a temporary exemption from 
the above ownership concentration limits, not to exceed ten years,\49\ 
a number of other limitations have been placed on founders' ownership 
of memberships. First, founders may not vote on changes to the 
Constitution (other than those that fall within ownership voting 
rights, i.e., mergers, consolidations, dissolution). Second, founders 
may not exercise the right to vote for directors except with respect to 
those memberships that have been approved for trading on the Exchange. 
Third, when a founder leases a membership, it is required to transfer 
the membership voting rights to the lessee. Fourth, membership voting 
rights with respect to memberships for which a founder has not been 
approved to trade on the Exchange or which have not been leased are not 
considered ``active'' or ``outstanding'' either for voting or quorum 
purposes. Finally, to address the concern that founders might retain 
control of the exchange indefinitely, they are required to sell all of 
their memberships that exceed the concentration limitations within ten 
years of initiation of trading on the Exchange. The Commission believes 
that these restrictions adequately prevent the founders from having an 
undue ability to control the election of directors or the operation of 
the Exchange. In the Commission's view, the ISE's concentration limits 
and divestiture requirements address both the economic needs of the 
Exchange as a start-up venture and the statutory requirements that all 
members are fairly represented and that conflicts of interest are 
minimized.
---------------------------------------------------------------------------

    \49\See ISE Constitution, Article II, Section 11(c).
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2. Restrictions on the Number of Memberships That May Be Approve for 
Trading

a. Generally

    The Exchange has established limitations on the number of 
memberships with respect to which the Exchange will approve a member to 
trade on the Exchange. Generally, the Exchange will approve a member to 
effect Exchange transactions pursuant to only one PMM membership. If a 
member can show good cause,\50\ the Exchange may approve a member to 
effect Exchange transactions with respect to two PMM memberships.\51\ 
Founders are subject to the same limits on how many memberships they 
may use for trading.
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    \50\See supra notes 46-48 and accompanying text (defining ``good 
cause shown'').
    \51\See ISE Rule 317(a).
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b. Initial Approval of Memberships

    The Exchange also has established further limitations on the number 
of memberships that a member initially may use for trading.\52\ These 
limits are based upon the number of members in each class that have 
been approved to effect Exchange transactions. Specifically, the 
Exchange will not initially approve a member to effect Exchange 
transactions with respect to more than one PMM membership until the 
Exchange has approved at least five other members to effect exchange 
transactions with respect to PMM memberships.\53\ In addition, the 
Exchange has adopted a tiered approach with respect to multiple CMM 
memberships. The Exchange will not initially approve a member to use 
multiple CMM memberships for trading until the Exchange has approved a 
minimum number of different members to effect Exchange transactions 
with respect to CMM memberships.\54\ The Commission believes that the 
ISE's approach to activating trading rights will protect against one or 
a few market makers dominating trading on the Exchange and, therefore, 
will promote competition.
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    \52\See ISE Constitution, Article II, Section 11(b); ISE Rule 
317(b)(1) and (2).
    \53\See ISE Rule 317(b)(1).
    \54\See ISE Rule 317(b)(2). To reiterate, although founders are 
exempt from the concentration limits on ownership of memberships for 
ten years, they are not exempt with respect to limitations on the 
number of memberships for which they may approve for trading on the 
Exchange. See ISE Constitution, Article II, Section 11(b).
---------------------------------------------------------------------------

3. Divestiture of Memberships Owned by Founders
    To diversify the Exchange's membership, the Exchange's rules 
require the transfer of the memberships owned by founders that exceed 
the concentration limits over a certain timeframe. As noted above, 
founders will be permitted to exceed the ownership concentration limits 
on a temporary basis. The Exchange, however, has the authority to 
assure that founders make memberships available and divest their 
ownership of memberships within a reasonable time period where they 
exceed the concentration limits. Specifically, six years after trading 
begins on the ISE, the Exchange can offer those membership(s) for sale 
if a founder fails to lease or sell at least forty percent of the 
memberships that exceed the concentration limitations.\55\ Within ten 
years of initiation of trading on the Exchange, founders must sell all 
memberships that exceed the concentration limitations. Again, if a 
founder does not meet this requirement, the Exchange may sell the 
number of memberships that exceed the concentration limits for the 
benefit of the founder.\56\ The Commission believes that providing the 
ISE with the authority to sell off memberships where a founder does not 
dispose of memberships exceeding the concentration limits is 
appropriate to ensure that, over time, the interests on, and control 
over, the Exchange become increasingly diversified.
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    \55\See ISE Rule 310(b)(5).
    \56\See ISE Rule 310(b)(4). For example, if a member owned 
twenty CMM memberships, it would be required to lease or sell at 
least four (40% of 10 is 4) prior to six years after the date 
trading on the Exchange commences. If that member only leases or 
sells two of the memberships by six years after the date trading 
began on the Exchange, the Exchange would take control of two 
memberships and sell them for the member's benefit.
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D. Discipline and Oversight of Members

    As a prerequisite for the Commission's approval of an exchange's 
application for registration, the exchange must be organized and have 
the capacity to carry out the purposes of the Exchange Act. 
Specifically, an exchange must be able to enforce compliance by its 
members, and persons associated with its members, with the federal 
securities laws and the rules of the exchange.\57\
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    \57\Section 6(b)(1) of the Exchange Act, 15 U.S.C. 78f(b)(1). 
For purposes of ISE's regulatory authority and rules, EAMs are 
``Members'' of the Exchange. See also Section 3(a)(3)(A) of the 
Exchange Act, 15 U.S.C. 78c(a)(3)(A) (defining the term ``member'').
---------------------------------------------------------------------------

    The ISE's rules generally provide that it has disciplinary 
jurisdiction over its

[[Page 11393]]

members to enforce their compliance with the ISE's rules and the 
federal securities laws.\58\ The ISE's rules also permit it to sanction 
members for violations of the Exchange's rules and violations of the 
federal securities laws by, among other things, expelling or suspending 
members, limiting members' activities, functions or operations, fining 
or censuring members, or suspending or barring a person from being 
associated with a member.\59\ The Exchange's rules also provide for the 
imposition of fines for minor rule violations in lieu of commencing 
disciplinary proceedings.\60\
---------------------------------------------------------------------------

    \58\See ISE Rules, Chapter 16.
    \59\See ISE Rules, Chapter 15.
    \60\See ISE Rule 1614. Minor ISE rule violations include, for 
example, violating the position limit rules, failing to file FOCUS 
reports, failing to provide trade data, violating conduct and 
decorum policies, violating the order entry rules (Rule 717(a), 
(c)--(e)), violating the quotation parameters, or failing to execute 
orders in appointed options.
---------------------------------------------------------------------------

    The Commission finds that the ISE's Constitution and rules 
concerning its disciplinary and oversight programs are consistent with 
the requirements of Sections 6(b)(7) and 6(d) of the Exchange Act in 
that they provide for fair procedures for the disciplining of members 
and persons associated with members. The Commission further finds that 
the rules of the Exchange adequately provide it with the ability to 
comply, and with the authority to enforce compliance by its members and 
persons associated with its members, with the provisions of the 
Exchange Act, the rules and regulations thereunder, and the rules of 
the Exchange.
1. Exchange Act Rule 17d-2 Agreements
    Section 17 of the Exchange Act and Rule 17d-2 thereunder permit 
self-regulatory organizations (``SROs''), through so-called Rule 17d-2 
agreements, to allocate certain regulatory responsibilities. Under 
Exchange Act Rule 17d-1,\61\ a broker-dealer that is a member of more 
than one SRO has only one DEA, an SRO that is responsible for financial 
aspects of that broker-dealer's regulatory oversight. Exchange Act Rule 
17d-2\62\ permits SROs to enter into agreements whereby one SRO assumes 
regulatory responsibilities for member firms (so-called ``joint 
members'') that are members of both the examining SRO and another SRO. 
SROs that delegate an area of regulation to another SRO under a Rule 
17d-2 arrangement are relieved of regulatory responsibility under the 
Exchange Act for that area. These agreements help to avoid duplicative 
oversight and regulation. Generally, these agreements cover such 
regulatory functions as personnel registration, branch office 
examinations and sales practices. All existing SROs have entered into 
such agreements. These agreements must be filed with and approved by 
the Commission.\63\
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    \61\17 CFR 240.17d-1.
    \62\17 CFR 240.17d-2.
    \63\For example, the Commission has approved a regulatory plan 
(``Options Designation Plan'') filed by the Amex, CBOE, NASD, NYSE, 
Pacific Exchange (``PCX'') and Philadelphia Stock Exchange 
(``Phlx'') that allocates the regulatory responsibilities among 
these SROs for common members, by designating four of the 
participating SROs as the options examination authority for a 
portion of the common members. The SRO designated under the plan as 
a broker-dealer's options examination authority is responsible for 
conducting options-related sales practice examinations and 
investigating option-related customer complaints and terminations 
for cause of associated persons. The designated SRO is also 
responsible for examining a firm's compliance with the provisions of 
applicable federal securities laws and the rules and regulations 
thereunder, its own rules, and the rules of any SRO of which the 
firm is a member. See Exchange Act Release No. 20158 (September 8, 
1983), 48 FR 41265 (September 14, 1983).
---------------------------------------------------------------------------

    The ISE intends to enter into a Rule 17d-2 agreement with NASD 
Regulation and with the DOEAs under the Options Designation Plan 
(``examining SROs''). The ISE's rules require that all EAMs be members 
of at least one of the examining SROs.\64\ Under these agreements, the 
examining SROs will examine firms that are joint members of the ISE and 
the particular examining SRO for compliance with certain provisions of 
the Exchange Act, certain of the rules and regulations adopted 
thereunder, certain examining SRO rules, and certain ISE rules. As 
noted above, these agreements must be filed with, and approved by, the 
Commission. Once filed, the Commission will publish these agreements 
for comment.
---------------------------------------------------------------------------

    \64\See ISE Rule 600. Although the rules of the ISE do not 
require that PMMs and CMMs be members of an SRO with which the ISE 
has entered into a Rule 17d-2 agreement, the ISE's membership 
application, which has been included as part of the Exchange's Form 
1, states such a requirement. Accordingly, the ISE is not accepting 
membership applications from entities seeking to be members solely 
of the ISE. To change this requirement, the ISE would have to file a 
proposed rule change with the Commission under Exchange Act Rule 
19b-4.
---------------------------------------------------------------------------

2. ``Contracting Out'' of Certain Regulatory Functions
    Not all of the ISE's regulatory responsibilities will be allocated 
to another SRO under a Rule 17d-2 agreement. For those responsibilities 
that fall outside the scope of any Rule 17d-2 agreement, the ISE has 
contracted with NASD Regulation on a payment for services basis 
(``Regulatory Services Agreement'').\65\ Under the Regulatory Services 
Agreement, NASD Regulation will perform certain regulatory functions as 
an agent on behalf of the ISE. Specifically, NASD Regulation will 
process membership applications, will conduct certain ``upstairs'' 
investigations and will prosecute ISE enforcement actions. The ISE also 
intends to use the hearing panel infrastructure of NASD Regulation to 
conduct enforcement hearings.\66\ Notwithstanding the fact that the 
Exchange will contract with NASD Regulation to perform these functions, 
the Exchange continues to bear ultimate regulatory responsibility.
---------------------------------------------------------------------------

    \65\Although the ISE's rules provide for disciplinary 
jurisdiction and procedures, investigatory processes, and 
arbitration procedures, the Exchange's Constitution provides it with 
the authority to contract with an SRO to perform some or all of 
these functions. See ISE Rules 1615 (disciplinary functions); 1706 
(hearings and review); and 1835 (arbitration).
    \66\See Amendment No. 1.
---------------------------------------------------------------------------

    Several commenters suggest that the ISE is attempting to abdicate 
its self-regulatory responsibilities by contracting out many of these 
functions to another SRO. The Commission disagrees. The Commission has 
previously recognized that contractual regulatory agreements between 
SROs outside of the Rule 17d-2 context may be permissible in instances 
where it is consistent with the public interest.\67\ The Commission 
believes that it is reasonable and consistent with the public interest 
to allow an SRO to contract with another SRO to perform disciplinary 
and enforcement functions. Discipline and enforcement are fundamental 
elements to a regulatory program, and constitute core self-regulatory 
functions. It is essential to the public interest and the protection of 
investors that these functions are carried out in an exemplary manner, 
and the Commission believes that NASD Regulation has the expertise and 
experience to perform these functions.
---------------------------------------------------------------------------

    \67\See ATS Release, supra note 7.
---------------------------------------------------------------------------

    At the same time, the Commission believes that it is important for, 
and that the Exchange Act requires, the ultimate responsibility and 
primary liability for self-regulatory failures to rest with the 
Exchange itself, rather than the SRO retained to perform the 
disciplinary and enforcement functions. Thus, the ISE will bear 
ultimate legal responsibility for the performance of its self-
regulatory obligations. The SRO performing the function, however, may 
nonetheless bear liability for causing or, in appropriate 
circumstances, aiding and abetting the Exchange's violations.\68\

[[Page 11394]]

Accordingly, although NASD Regulation will not act on its own behalf 
under its SRO responsibilities in carrying out these regulatory 
services for the ISE, NASD Regulation also may have secondary liability 
if the Commission finds that the contracted functions are being 
performed so inadequately as to cause a violation of the federal 
securities laws by the ISE.
---------------------------------------------------------------------------

    \68\For example, if failings by NASD Regulation have the effect 
of leaving ISE in violation of any aspect of the Exchange's self-
regulatory obligations, ISE would bear direct liability for the 
violation, while NASD Regulation may bear liability for causing or 
aiding and abetting the violation.
---------------------------------------------------------------------------

    The Commission has reviewed the terms of the Regulatory Services 
Agreement, which provides a detailed description of the functions NASD 
Regulation agrees to perform.\69\ The Commission believes that this 
agreement provides for oversight of ISE members and enforcement of ISE 
rules and federal securities laws in a manner consistent with the 
public interest. Moreover, the terms under which NASD Regulation will 
perform certain regulatory functions for the ISE are sufficiently 
described so as to ensure a regulatory program that will satisfy the 
statutory requirements, including safeguarding against manipulation and 
fraud. Under this agreement, NASD Regulation will perform various 
regulatory functions, whereas the ISE will retain decision-making 
authority. For example, although NASD Regulation will process 
membership applications to ensure their completeness, the ISE will make 
all determinations regarding approval or denial of membership on the 
Exchange. The ISE will also determine whether to bring enforcement 
actions. Any hearing will be before an ISE hearing panel, consisting of 
a hearing officer (likely hired from NASD Regulation) and 
representatives of ISE members. In addition, the ISE's Board will have 
the opportunity to consider all appeals of ISE disciplinary actions 
before they can become final actions of the Exchange.
---------------------------------------------------------------------------

    \69\The ISE and NASD Regulation have requested confidential 
treatment for their contractual agreement pursuant to Section 
24(b)(2) of the Exchange Act and 17 CFR 240.24b-2 thereunder.
---------------------------------------------------------------------------

3. Surveillance
    A number of commenters expressed concern about ISE's surveillance 
program, stating that they did not have enough information about it to 
make a determination concerning its adequacy. The Commission notes 
that, as a matter of Commission policy, surveillance programs and 
procedures are generally kept confidential.\70\ The ISE has represented 
that it intends to administer its own surveillance system for trading 
on the Exchange. The ISE's staff will operate the system and be 
responsible for conducting all aspects of the daily surveillance of 
trading and its market activities.\71\ These responsibilities will 
include, among other things, a real-time audit trail to monitor market 
participants and to detect abusive trading activity.
---------------------------------------------------------------------------

    \70\Disclosure of specific surveillance procedures could provide 
market participants with information that could aid potential 
attempts at avoiding regulatory detection of inappropriate trading 
activity.
    \71\The ISE's operations are subject to inspection by the 
Commission. In addition, the ISE's surveillance plan and procedures, 
as well as the implementation of them, are subject to Commission 
inspection to ensure that the ISE adequately monitors its market and 
its members, and enforces its rules and the federal securities laws, 
including the anti-fraud provisions.
---------------------------------------------------------------------------

4. ``Information Barrier'' Between Market Making and ``Other Business 
Activities''
    Currently, the rules of several of the SROs impose certain 
restrictions on the business activities of a member or member 
organization that is affiliated with a specialist or member 
organization. However, a member or member organization that is 
affiliated with a specialist or market maker may obtain an exemption 
from these restrictions if certain procedures are established that 
restrict the flow of material, non-public information between the 
affiliated member and the specialist or market maker, i.e., an 
``information barrier.'' For example, the rules of the NYSE provide 
that in order to obtain such an exemption, a member or member 
organization affiliated with a specialist or market maker must, among 
other things, establish another organization separate and distinct from 
the specialist or market making business. That is, ``[t]he specialist 
member organization must function as an entirely freestanding, separate 
entity responsible for its own trading decisions, and may not function 
in any manner as a `downstairs' extension of the `upstairs' trading 
desk.''\72\ The rules of the PCX, however, do not require that a 
separate corporate entity be formed with respect to these business 
activities. PCX requires only functional separation, not organizational 
separation.\73\
---------------------------------------------------------------------------

    \72\See NYSE Rule 98 (and subsequent Guidelines).
    \73\See PCX Rule 4.20.
---------------------------------------------------------------------------

    Similar to the rules of the PCX, the ISE will permit its market 
makers to engage in other business activities, or to be affiliated with 
broker-dealers that engage in other business activities,\74\ if there 
is an information barrier between the market making activities and the 
other business activities, i.e., functional separation.\75\ In other 
words, the ISE will not require a separate, affiliated broker-dealer 
organization to be established. Thus, a market maker on the ISE will be 
permitted to also be an EAM provided sufficient procedures are in place 
to ensure that the flow of material, non-public information between the 
two businesses is restricted. As with the rules of the other SROs, a 
member seeking an exemption from the restrictions on engaging in other 
business activities must obtain approval of its information barrier 
procedures from the Exchange.
---------------------------------------------------------------------------

    \74\``Other Business Activities'' means (1) conducting an 
investment or banking or public securities business; (2) making 
markets in the stock underlying the options in which it makes 
markets; or (3) functioning as an Electronic Access Member. See ISE 
Rule 810(a).
    \75\See ISE Rule 810.
---------------------------------------------------------------------------

    The Commission finds that the provisions governing ``other business 
activities'' of market makers are consistent with Section 6(b)(5) of 
the Exchange Act in that they are designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, and to protect investors and the public interest. 
The Commission believes that the ISE's Constitution and rules provide 
for a clear separation of the market making activities of a firm and 
its affiliated brokerage business.\76\ The information barrier between 
a market maker and affiliated EAM should protect against an 
inappropriate sharing of information that could result in market 
manipulation. The Commission expects the ISE to be vigilant in 
monitoring for possible abuses in this context.
---------------------------------------------------------------------------

    \76\One of the commenters asserts that the information barrier 
requirement is not sufficient to address concerns over 
internalization of order flow. See Sutherland Asbill Letter 2. This 
concern is discussed in conjunction with internalization below.
---------------------------------------------------------------------------

E. The ISE Trading System

    The ISE will operate an automated trading system for standardized 
equity options. It will conduct an agency auction market similar to the 
exchange markets currently in operation, although the auction will 
occur electronically and not on a floor. This section describes the 
most significant rules and procedures governing trading on the ISE.
1. Generally
    Generally, each PMM and CMM on the ISE will enter its own 
independent quotations into the ISE System (``System''). PMMs and CMMs 
will enter size with their quotations, which must meet the minimum size 
requirements, established by the Exchange for the execution of customer 
orders. EAMs will enter agency and principal orders into the System. 
PMMs will have terminals that provide them with

[[Page 11395]]

information on all of the orders and quotations pending in the System, 
while CMMs and EAMs will have terminals that display the best bid and 
offer (``BBO'') currently quoted on the ISE in each options series, as 
well as the aggregate size of the BBO.
    On the existing exchanges, market makers are appointed to options 
classes within particular physical ``zones'' on the trading floor.\77\ 
Because the ISE will not have a physical trading floor, options classes 
will be divided into Groups of options classes.\78\ Each Class A 
membership will represent the right to be the PMM in one Group,\79\ and 
each Class B membership will represent the right to be a CMM in one 
Group.\80\ One PMM and at least two CMMs will be appointed to each 
options class traded on the Exchange.\81\
---------------------------------------------------------------------------

    \77\See, e.g., PCX Rule 6.35 (providing that market makers may 
select up to six contiguous posts to comprise a ``Primary 
Appointment Zone)''.
    \78\See ISE Rule 802(b). The ISE intends to trade all of the 
series of approximately six hundred actively-traded options classes, 
which it will divide into ten Groups of approximately sixty classes 
each. See ISE Form 1, Exhibit N.
    \79\See ISE Constitution, Article II, Section 1(c).
    \80\See ISE Constitution, Article II, Section 2(c).
    \81\See ISE Rule 802(c).
---------------------------------------------------------------------------

    Overall, there will be a total of 10 PMMs (one in each Group) and 
100 CMMs (ultimately 10 in each Group). In addition to being able to 
enter quotations, PMMs and CMMs will be able to enter ``immediate or 
cancel'' orders\82\ for options in their assigned Groups. Subject to 
certain limitations, PMMs and CMMs also will be permitted to place 
orders in any of the other Groups of options classes, but will not be 
allowed to enter quotations outside their assigned Group(s).\83\ EAMs 
will not be permitted to enter orders that would effectively result in 
market making on the Exchange.\84\
---------------------------------------------------------------------------

    \82\An ``immediate-or-cancel'' order requires that all or part 
of the order be executed as soon as the broker enters a bid or 
offer; the portion not executed is automatically canceled.
    \83\See ISE Rules 805(b) and 804(a).
    \84\See ISE Rule 717(b).
---------------------------------------------------------------------------

2. Order Execution and Priority Rules

a. Generally

    Trades will occur when orders or quotations match in the System. A 
customer order in the System (on the book) will always have priority. 
If more than one customer order has been entered into the System at the 
same price, priority will be based on the time of order entry. The 
System will not automatically execute a public customer order at a 
price inferior to the price quoted on another options exchange.\85\ In 
this situation, the PMM must address such orders either by establishing 
parameters for matching away-market quotations or by handling them 
individually. The ISE states that, if a PMM decides to attempt to get 
the better price from the away market for the customer order, the order 
will remain in the System during this process. Thus, while a PMM may be 
seeking the away market price for the order, that order can be executed 
against a new incoming ISE market order at a price that would not 
``trade through'' the away market.\86\
---------------------------------------------------------------------------

    \85\See ISE Rule 714(a).
    \86\See Amendment No. 1, Exhibit 6. The Commission notes that 
ISE may need to address certain of its order execution and priority 
rules when a national linkage is developed for the options markets. 
See infra note 108 and accompanying text and section E.2.c 
(discussing the proposed options linkage plans).
---------------------------------------------------------------------------

    If a member enters a limit order into the System that crosses 
trading interest already in the System, a trade will occur, to the 
extent that size is available, at the price of the trading interest 
already in the System. After executing against that trading interest, 
the limit order will trade against other trading interest in the System 
until the limit order is filled in its entirety or the order depletes 
the available size at that price. If any amount of the limit order 
remains unexecuted, the balance of the order will become the best bid 
or offer.\87\
---------------------------------------------------------------------------

    \87\In addition, trades will not necessarily occur when quotes 
of PMMs and CMMs match or cross each other. Such matches or crosses 
possibly could occur because market maker auto-quotation systems 
respond at different speeds. To address this issue, a trade between 
two or more market makers will only occur after the quotes remain 
matched for a defined amount of time, which will be less than one 
second.
---------------------------------------------------------------------------

b. Internalization Issues

    With the increase of multiple trading of options classes, the 
options markets are under significant pressure to attract or retain 
business. One approach to increasing business on an exchange is to 
allow members, including primary market makers and order entry firms, a 
preference in trading with customer orders they bring to the market. 
These preferences have the effect of reducing intramarket price 
competition by giving priority to a member based on its status as a 
specialist or as the firm that brought the order to the exchange as 
opposed to giving priority to a member first to quote at the best 
price. If exchange rules do not provide a fair opportunity to compete 
for orders based on price, firms and individuals could have less 
incentive to be competing market makers on an exchange and price 
competition may suffer. Eventually, if execution guarantees to 
particular exchange members become too great, competitive market makers 
within markets could diminish, and with them active or potential 
intramarket price competition. As a result, the published quotations, 
and the prices available on a market, could deteriorate--ultimately 
harming investors.
    A number of commenters expressed concerns that the ISE's trading 
system would not foster vigorous intramarket competition, and would 
permit an inordinate amount of internalization of order flow on the 
ISE.\88\ The Commission does not view the basic trading structure of 
the ISE as inconsistent with intramarket competition, or necessarily 
resulting in the pervasive internalization of order flow.\89\ 
Therefore, the Commission finds that the ISE's trading system is 
consistent with Section 6(b)(5) of the Exchange Act in that it is 
designed to promote just and equitable principles of trade, to remove 
impediments to and perfect the mechanism of a free and open market, 
and, in general, to protect investors and the public interest.\90\ As 
with any other options market, however, the degree of intramarket 
competition is determined by the market's specific trading procedures, 
which will be set forth in the ISE's rules. As explained further below, 
for purposes of beginning trading, the ISE will need to file certain 
rule change proposals with the Commission pursuant to Exchange Act Rule 
19b-4 to specify in the rules how it intends to allocate order 
flow.\91\
---------------------------------------------------------------------------

    \88\See, e.g., Sutherland, Asbill and Brennan Letters 2 and 3, 
CBOE Letters 1 and 2, and Timber Hill Letter.
    \89\``Internalization'' is generally known as the direction of 
order flow by a broker-dealer to an affiliated specialist or order 
flow executed by that broker-dealer as market maker. See Exchange 
Act Release No. 37619A (September 6, 1996), 61 FR 48290 (September 
12, 1996) at n.357 (File No. S7-30-95).
    \90\See 15 U.S.C. 78f(b)(5).
    \91\The Commission intends to publish these proposals in the 
Federal Register for comment.
---------------------------------------------------------------------------

(i) Allocation Algorithm

    ISE Rule 713(e) states that the Exchange will determine a procedure 
for allocating executions among non-customer orders and market makers 
in cases where all public customer orders have been executed and there 
are two or more non-customer orders or market maker quotes at the best 
price. The ISE, however, did not include this allocation algorithm in 
its Form 1 registration application. Commenters assert that the absence 
of the algorithm from the rule made meaningful comment unfeasible. The 
Commission does not believe it is necessary to address the allocation 
algorithm referred to in this provision for the purposes of registering 
the ISE as a national securities exchange. Following the approval of 
the ISE's

[[Page 11396]]

registration application, the ISE will need to file a rule proposal 
with the Commission pursuant to Rule 19b-4 under the Exchange Act to 
establish the Exchange's order allocation algorithm.\92\ Although the 
ISE has not included the allocation algorithm in its rules as currently 
proposed, it describes generally in its narrative response to the 
comment letters the principles by which the allocation algorithm will 
operate.\93\ Specifically, all customer orders must be executed in full 
before any market maker quotes or professional orders are executed. In 
addition, a market maker quote or professional order must be at the ISE 
BBO to participate in an execution, and a market maker quote or 
professional order may never execute in an amount greater than the 
number of contracts in the quote or order. Priority among CMM quotes 
and professional orders at the ISE BBO will be based on size, 
participating in an execution based upon their proportion of the inside 
displayed size. A PMM, however, will participate in an execution in a 
somewhat greater proportion in relation to its quote size than a CMM, 
and when at the BBO will be guaranteed the right to trade against an 
entire order up to a size determined by the Exchange.\94\ In other 
words, if the PMM is quoting at the ISE's BBO, it will have precedence 
over non-customer orders and CMM quotes for the execution of orders 
that are for a specified number of contracts or less (``Minimum 
Size''). The ISE did not include in its registration application what 
number of contracts would constitute the Minimum Size for purposes of 
this provision in ISE Rule 713(e). Two commenters assert that this 
provision granting PMMs the right to trade ahead of all other market 
participants (other than public customers) on all orders of less than 
the Minimum Size not only lacks specificity, but also could discourage 
other market participants, including CMMs and EAMs, from improving the 
quotes of a particular option series.\95\ The Commission does not 
believe that failing to specify the Minimum Size referred to in this 
provision precludes registering the ISE as a national securities 
exchange because allocating some small orders exclusively to a PMM is 
not necessarily inconsistent with adequate intramarket competition. 
Following the approval of the ISE's registration application, however, 
the ISE will need to file a rule proposal with 
theCommissionpursuanttoRule19b-4 under the Exchange Act to establish 
the Exchange's Minimum Size referred to in this Rule.\96\ This rule 
proposal must be consistent with statutory standards.
---------------------------------------------------------------------------

    \92\The Commission intends to publish the proposal in the 
Federal Register for comment.
    \93\The ISE's narrative response is included in Amendment No. 1. 
See Amendment No. 1, Exhibit 6.
    \94\See ISE Rule 713(e).
    \95\See CBOE Letter and Amex Letter.
    \96\The Commission intends to publish the proposal in the 
Federal Register for comment.
---------------------------------------------------------------------------

(ii) Block Order Mechanism

    The ISE's rules provide a mechanism for handling block-size orders 
on the Exchange.\97\ This mechanism generally adapts the block trading 
procedures followed on the existing options exchanges to the ISE's 
electronic system.\98\ Specifically, a special ``block order trading 
mechanism'' (``BOM'') will be available to EAMs to enable them to 
solicit market participation for block-size orders of fifty or more 
contracts.\99\ As on the other exchanges, this mechanism is intended to 
minimize the market impact of large orders and uses a ``quote request'' 
methodology.
---------------------------------------------------------------------------

    \97\See ISE Rule 716. The ISE defines a block-size order as an 
order for fifty (50) contracts or more. See ISE Rule 716(a).
    \98\Generally, on a traditional options exchange, a broker will 
represent a block-size order in the trading crowd (located on the 
trading floor) to discover what price and associated size is 
available to trade with the block order.
    \99\See ISE Rule 716. Use of the BOM is not required for block-
size orders. The fact that this feature is optional is similar to 
the other options exchanges where a broker has the option of 
representing a customer order at a trading post on a floor versus 
entering the order into an exchange's electronic order routing 
system.
---------------------------------------------------------------------------

    In general, the BOM will permit an EAM to seek out liquidity for 
the execution of block-size orders by electronically soliciting 
indications of the prices and sizes at which ``crowd 
participants''\100\ would be willing to trade with block-size orders. 
The BOM will enable an EAM to enter a block order along with a limit 
price.\101\ The System will then broadcast an anonymous message to the 
crowd participants. The members of the trading crowd will have a 
specified amount of time in which to respond to the broadcast message 
with their indications.\102\ The ISE represents that the responses are 
internal to the System and are not disclosed to any market 
participants, including the EAM entering the block-size order. At the 
end of the response period, the order will automatically be executed, 
unless there is insufficient size to execute the order consistent with 
the terms of the order.
---------------------------------------------------------------------------

    \100\``Crowd Participants'' is defined as market makers 
appointed to an options class under Rule 803, as well as other 
members with proprietary orders at the ISE BBO for a particular 
series. See ISE Rule 716(b).
    \101\The functionality of the System allows the EAM to specify 
exactly what information will be disseminated to the market. The EAM 
using the BOM may determine the amount of information that will be 
disclosed in the broadcast to crowd participants. For example, the 
broadcast can disclose that there is a sell or a buy order, or it 
could ask for size on either side. The broadcast also may or may not 
display size or price or any conditions on the block-size order.
    \102\The ISE's registration application did not contain the time 
period that crowd participants would have to respond to a block 
trade broadcast. The ISE will file a rule change prior to beginning 
trading to establish this time period.
---------------------------------------------------------------------------

    Bids (offers) on the ISE at the time the block order is executed 
that are priced higher (lower) than the block execution price, as well 
as responses to the broadcast message that are priced higher (lower) 
than the block execution price, will be executed at the block execution 
price. Responses to broadcast messages, quotes and non-customer orders 
at the block execution price will participate in the execution of the 
block-size order.\103\ After the trade is executed (or if there is no 
trade), all unexecuted responses are removed from the System and have 
no further standing.
---------------------------------------------------------------------------

    \103\As noted above, the ISE will be required to file a rule 
change with the Commission proposing the Exchange's order allocation 
algorithm. See supra note 91.
---------------------------------------------------------------------------

    One commenter contends that fifty contracts is a relatively small 
order size to be called block-size.\104\ The Commission believes that 
fifty contracts is a reasonable size for use of a special execution 
mechanism like the BOM. First, the BOM is a mechanism by which EAMs 
must take the time to work an order on an order-by-order basis. Such 
effort should encourage EAMs to use this mechanism for larger orders 
they believe require special handling. Second, given that the average 
retail order is for less than ten contracts (thereby falling outside 
the definition of block), the BOM will not be available for most small 
retail orders.
---------------------------------------------------------------------------

    \104\See CBOE Letter 1.
---------------------------------------------------------------------------

    Three commenters also criticize the ISE's limited dissemination of 
broadcast messages.\105\ They assert that such a limitation inhibits 
opportunities for price improvement. The ISE responds that its limited 
broadcast is designed to involve those ISE members who express an 
active interest in trading the options series. The ISE also asserts 
that limiting the broadcast to market makers and members at the ISE BBO 
acts as an incentive to those members to provide additional liquidity 
at that price.\106\ It appears that the ISE is attempting to emulate 
electronically the floor environment by limiting the persons to

[[Page 11397]]

whom a block (or facilitation) broadcast message is sent. Currently, 
block and facilitated executions occur on the floors of the options 
exchanges without ever being exposed to anyone other than those persons 
standing in the trading crowd. The Commission believes that it may 
ultimately be desirable to expose block-size and facilitated orders 
more broadly than to a narrow, privileged audience in order to provide 
price improvement opportunities prior to their execution. Nonetheless, 
the floor-based exchanges do not currently operate in that manner. The 
Commission does not believe that an automated exchange like the ISE 
should be held to a higher display standard in this particular context 
by being required to expose these orders to participants that are not 
displaying interest in the option. To do so could favor non-automated 
markets. Because the ISE, as an all-electronic auction market for 
options, is the first of its kind in the options industry, the 
Commission believes it is appropriate to allow the ISE to limit its 
definition of ``crowd participants'' as described above. As electronic 
trading of options becomes more widespread, this issue of limited 
display may warrant reexamination.
---------------------------------------------------------------------------

    \105\See CBOE Letter 1, Amex Letter, and Sutherland, Asbill and 
Brennan Letter 2.
    \106\See Amendment No. 1, Exhibit 6.
---------------------------------------------------------------------------

    Two commenters also expressed concerns that an order of as small as 
fifty contracts may be executed outside the NBBO, thereby failing to 
provide intermarket price protection for the person entering the block-
size order.\107\ The Commission notes that some block orders, by virtue 
of their larger size, may indeed need to be executed outside of the 
NBBO in order to be executed in full. Customers buying or selling large 
size orders are generally aware that the order may not be filled at the 
NBBO. This can often be the cost of getting a full execution. The ISE, 
however, will provide block protection to orders on the ISE book. In 
the event that there are better-priced quotes and orders on the ISE 
book at the time the block order is executed, those quotes and orders 
will have priority, and will receive price protection by being executed 
at the block price. They will not be executed at a worse price than the 
block price. It is true that the ISE will not provide intermarket price 
protection for persons entering block size orders, but, as noted above, 
this is often the cost of getting an execution in full. This is a cost 
that market participants entering block size orders generally are 
willing to pay so as to not grossly impact the market price while 
trying to have their order executed. Moreover, such orders are still 
subject to a broker's duty of best execution for its customer.
---------------------------------------------------------------------------

    \107\See CBOE Letter 1 and Amex Letter.
---------------------------------------------------------------------------

    The Commission notes that it is currently considering several 
proposed options linkage plans,\108\ all of which provide for 
intermarket price protection by containing a prohibition against trade-
throughs.\109\ Each of the plans provides that, in the event that a 
block trade trades through a better-priced market,\110\ the better-
priced market must be satisfied at the price of the transaction that 
caused the trade-through (i.e., the block price). However, because the 
ISE's definition of ``block'' is for fifty contracts or more, block-
size orders executed on the ISE that do not satisfy the plans' 
definition of ``block trade'' would be required to satisfy the price of 
the bid or offer that was traded through, rather than the block 
price.\111\
---------------------------------------------------------------------------

    \108\The Commission recently ordered the current options markets 
to work jointly toward establishing a national market system plan 
providing for the linkage of all the options markets. See Exchange 
Act Release No. 42029 (October 19, 1999), 64 FR 57674 (October 26, 
1999) (``Options Linkage Order''). Three plans were filed by CBOE/
Amex, Phlx and PCX. Copies of these proposed plans are available in 
the Commission's Public Reference Room under File No. 4-429.
    \109\A trade-thorough occurs where a customer's order is 
executed on one exchange at a price inferior to that available on 
another exchange. Currently, intermarket trade-throughs can occur in 
the options markets because there is no efficient means for 
accessing quotes across these markets.
    \110\The proposed plans uniformly define a ``block trade'' as a 
trade that: (i) is of block size, defined as 500 contracts or more 
and a premium value of at least $150,000; (ii) is effected at a 
price outside of the NBBO; and (iii) involves either a cross (where 
a member of the exchange represents all or a portion of both sides 
of the trade) or any other transaction that is not the result of an 
execution at the current bid or offer on the exchange.
    \111\The plans differ with respect to the appropriate size of 
satisfaction.
---------------------------------------------------------------------------

    (iii) Facilitation Mechanism
    The existing options markets have procedures governing the manner 
in which a member may facilitate a customer's order by trading with the 
order using its proprietary account.\112\ This is referred to as a 
``firm facilitation.'' These procedures generally are tailored to 
exchanges with physical trading floors and traditional open outcry 
systems. Because the ISE will function as a fully automated auction 
market and will not have a trading floor, it has adapted a ``firm 
facilitation'' mechanism to an electronic context.
---------------------------------------------------------------------------

    \112\See, e.g., Amex Rule 950(d), Commentary .02, and CBOE Rule 
6.74(b).
---------------------------------------------------------------------------

    Specifically, ISE Rule 716(d) provides an EAM with the ability to 
use a special ``facilitation mechanism'' to enter a block size customer 
order (minimum of 50 contracts) and execute the order as principal. An 
EAM is not otherwise permitted to execute an agency order as principal 
unless the order is first permitted to interact with other interest on 
the ISE. When an order is entered into the facilitation mechanism, the 
ISE will send a facilitation broadcast to crowd participants.\113\ The 
broadcast message is anonymous and informs crowd participants of the 
proposed transaction. The facilitation broadcast will contain 
information on the terms and conditions of the order, including the 
facilitation price. The identity of the EAM will not be disclosed. The 
recipients of the broadcast will have a designated amount of time, set 
by the Exchange, to respond.\114\ The responses must be priced at the 
price of the order being facilitated and must not exceed the size of 
the order being facilitated. The responses will not be disseminated. If 
a crowd participant is willing to improve the price of a facilitation 
order, it may do so by entering its quote or order in the ISE order 
book at least ten seconds prior to the expiration of the facilitation 
broadcast, which provides the facilitating member the opportunity to 
consider whether it is willing to facilitate the customer order at that 
better price.
---------------------------------------------------------------------------

    \113\See supra note 100 (defining crowd participants).
    \114\The ISE's registration application did not contain the time 
period that crowd participants would have to respond to a 
facilitation broadcast. The ISE will file a rule proposal prior to 
beginning trading to establish this time period. The Commission 
understands that the ISE intends this time period to be thirty 
seconds. The Commission intends to publish the proposal in the 
Federal Register for comment.
---------------------------------------------------------------------------

    At the end of the set time period given, the facilitation order 
will be automatically executed in full. The facilitation order will be 
executed at the facilitation price unless there is sufficient interest 
on the ISE order book to execute the order in its entirety at a better 
price. If the order is executed at the facilitation price, any better-
priced orders or quotes on the order book will receive price protection 
in the same manner as the BOM, and thus will be executed at the price 
of the facilitation order. The EAM entering the facilitation order will 
be allocated a minimum of forty percent of the original size of the 
facilitation order, but only after better-priced orders and quotes, as 
well as public customer orders at the facilitation price are 
executed.\115\ Responses to the broadcast, quotes and non-customer 
orders at the facilitation price will participate in the execution of 
the facilitation order according to an

[[Page 11398]]

allocation algorithm that will be established in ISE Rule 713(e).\116\
    The Commission notes that the ISE has adopted an interpretive 
amendment to Rule 716(d).\117\ Under this interpretation, it would be a 
violation of a member's duty of best execution to its customer if it 
were to cancel a facilitation order to avoid execution of the order at 
the better price. Use of the facilitation mechanism does not modify a 
member's best execution duty to obtain the best price for its customer. 
Accordingly, while facilitation orders may be canceled during the 
facilitation timeframe, if a member were to cancel a facilitation order 
when there was a superior price available on the ISE and subsequently 
re-enter the facilitation order at the same facilitation price after 
the better price was no longer available without attempting to obtain 
that better price for its customer, there would be a presumption that 
the member did so to avoid execution of its customer order by other 
market participants. This would violate the member's duty of best 
execution.
---------------------------------------------------------------------------

    \115\In Amendment No. 1, the ISE proposed to give the EAM a 
guaranteed minimum participation right of fifty percent of the 
original size of the facilitation order. The ISE has reduced this 
participation right to forty percent. See Amendment No. 2.
    \116\See supra note 92 and accompanying text.
    \117\See Amendment No. 2.
---------------------------------------------------------------------------

    The Commission believes that this interpretation is important to 
ensure that brokers proposing to facilitate orders as principal fulfill 
their best execution duties to their customers. In the Commission's 
view, withdrawing a facilitated order that may be price improved simply 
to avoid executing the order at the superior price is a violation of a 
broker's duty of best execution. The Commission expects the ISE to 
establish procedures to surveil for violations of this best execution 
obligation.\118\
---------------------------------------------------------------------------

    \118\The Commission realizes that ensuring that ISE members do 
not re-enter facilitated orders on markets other than the ISE may be 
difficult. Nevertheless, the Commission expects the ISE to work with 
the other options markets through the Intermarket Surveillance Group 
to develop methods and procedures to monitor their members trading 
on other markets for possible best execution violations in this 
context.
---------------------------------------------------------------------------

    Commenters expressed concern that the ISE's facilitation mechanism 
would permit an EAM to internalize a significant amount of order flow. 
As mentioned above, the Commission is concerned about locking up large 
portions of order flow from intramarket price competition by granting 
certain market participants extensive participation guarantees. To 
address the concerns of the Commission and the commenters, the ISE has 
amended Rule 716(d)(4)(ii) to reduce a facilitating EAM's minimum 
participation right to forty percent of the facilitated order. This 
will leave at least sixty percent of each facilitated order available 
for participation by other market participants.
    It is difficult to assess the precise level at which guarantees may 
begin to erode competitive market maker participation and potential 
price competition within a given market. In the future, after the 
Commission has studied the impact of guarantees, the Commission may 
need to reassess the level of these guarantees. For the immediate term, 
the Commission believes that forty percent is not clearly inconsistent 
with the statutory standards of competition and free and open markets.

c. Trade-or-Fade

    PMMs and CMMs will have the ability to set parameters regarding 
their willingness to trade generally with a broker-dealer's proprietary 
order. When the Exchange receives such an order, any CMM or PMM 
quotations in the System will be executable only up to the size of the 
PMM's or CMM's pre-set parameters. The matching rules discussed above 
otherwise would remain the same. Upon completion of the trade, if a PMM 
or CMM that has established parameters for trading against a 
proprietary order does not provide a complete fill of the order, the 
PMM or CMM cannot continue to quote at that price and must move its 
quotation to the next level.\119\ Orders of market makers on other 
options exchanges will be handled on an order-by-order basis by the PMM 
and CMMs.
---------------------------------------------------------------------------

    \119\This provision is akin to the ``trade-or-fade'' rules of 
the other options exchanges. See, e.g., CBOE Rule 8.51(b).
---------------------------------------------------------------------------

    One commenter criticizes the ISE's ``trade-or-fade'' rule.\120\ It 
argues that the ISE's ``trade-or-fade'' rule, which replicates an 
identical rule on the other options exchanges, should not be permitted. 
It suggests that a ``trade-or-fade'' rule results in phantom quoting by 
market makers, which, in its opinion, invites market manipulation. It 
further asserts that a ``trade-or-fade'' rule would be particularly 
problematic on the ISE, given that the ISE intends to tally and display 
to members the aggregate size of all orders and quotes entered into the 
system at the BBO. The commenter argues that, if market makers are 
permitted to retreat from their quotes when they receive a broker-
dealer order, then the quoted market will be illusory to broker-
dealers.\121\
---------------------------------------------------------------------------

    \120\See Timber Hill Letter.
    \121\See Timber Hill Letter.
---------------------------------------------------------------------------

    Although the Commission agrees that the concept of ``trade-or-
fade'' raises some concern, for purposes of registration it will not 
hold the ISE to a different standard than that to which all of the 
existing options markets are currently held. Requiring the ISE to 
maintain firm quotes for non-customer orders at this time would put it 
at a competitive disadvantage in relation to the other options markets. 
The proposed options linkage plans would limit ``trade-or-fade'' 
policies with respect to principal and customer orders from other 
markets up to a certain size.\122\ The Commission expects the options 
markets, including the ISE, to reassess the relevance of their internal 
``trade-or-fade'' provisions at the time the linkage is implemented.
---------------------------------------------------------------------------

    \122\See supra note 108.
---------------------------------------------------------------------------

3. Limitations on EAMs and Non-Customer Orders
    The ISE's rules contain certain unique provisions restricting 
competition by EAMs and highly automated customers.\123\ The ISE 
asserts that these provisions are needed in light of its business model 
and the electronic nature of the Exchange. The ISE business model 
depends on competition between one PMM and ten CMMs per options class. 
To encourage participation by these market makers, it limits the 
ability of non-CMMs/PMMs to compete as market makers on equal terms in 
its automated system. The Commission does not believe that, given the 
ISE's fully automated auction market, this balance between market 
makers and non-market makers is inconsistent with the Exchange Act's 
requirements. The Commission believes that this determination, however, 
may require review in light of subsequent rule changes or experience 
with the extent of competition that develops within the ISE's 
structure.
---------------------------------------------------------------------------

    \123\See ISE Rule 717.
---------------------------------------------------------------------------

a. Limitations on Market and Marketable Limit Orders

    ISE Rule 717(a) prohibits EAMs from entering into the System, as 
principal or agent, non-customer market orders or non-customer limit 
orders that cross the market and that cannot be executed within two 
minimum trading increments of the best bid or offer. These orders will 
be canceled by the System. The ISE has represented that this provision 
is designed to limit volatility. The ISE believes that, in an 
electronic market, non-customer market orders have the potential to 
create market volatility by trading at different price levels until 
executed in their entirety.
    One commenter asserts that this is the type of limitation that the 
Commission generally has been unwilling to approve

[[Page 11399]]

in the past.\124\ However, the Commission believes that this provision 
may be more appropriate in a fully automated auction market. Without 
such a restriction, it would be possible for non-customers to use 
large-size orders to quickly take out the entire electronic order book. 
Ultimately, a non-customer order could walk through the entire ISE book 
without other market participants having an opportunity to react. 
Because the book is wholly accessible electronically, the ISE's 
displayed prices could be eliminated without an opportunity for market 
makers to respond. In contrast, customer orders are much less likely to 
have this effect given their typically smaller size. Furthermore, it 
would be extremely difficult for customer orders to quickly take out 
the book because these orders receive intermarket price protection. The 
Commission is concerned that this provision may excessively limit 
access to broker-dealers to trade with the ISE's published prices. 
Nonetheless, in view of the untested nature of the ISE's electronic 
market, the Commission has no reason to believe at this time that this 
provision is inconsistent with the statute. Once experience is gained 
in the ISE market, this provision may need to be reassessed.
---------------------------------------------------------------------------

    \124\See CBOE Letter 1.
---------------------------------------------------------------------------

b. Restrictions on EAMs Acting as Market Makers

    ISE Rule 717(b) prohibits EAMs from entering into the System, as 
principal or agent, limit orders in the same options series, for the 
account or accounts of the same or related beneficial owners, in such a 
manner that the EAM or the beneficial owner(s) effectively is operating 
as a market maker by holding himself out as willing to buy and sell 
such options contracts on a regular or continuous basis.\125\ 
Essentially, this provision prevents EAMs from using limit orders to 
effectively quote and make markets on the ISE.
---------------------------------------------------------------------------

    \125\The provision provides several factors that the Exchange 
will consider, among other things, in determining whether an EAM or 
beneficial owner effectively is operating as a market maker. See ISE 
Rule 717(b).
---------------------------------------------------------------------------

    One commenter criticizes this provision.\126\ It asserts that the 
regulatory costs and benefits likely to result from an exchange's 
prohibition of ``off-floor market making'' must be analyzed on an 
exchange-by-exchange or crowd-by-crowd basis. It suggests that the 
European electronic exchange model, which encourages market makers by 
charging them lower transaction fees rather than giving them monopoly 
rights, would be more appropriate.\126\
---------------------------------------------------------------------------

    \126\See Timber Hill Letter.
    \127\See Timber Hill Letter.
---------------------------------------------------------------------------

    The Commission believes that this provision is reasonable in an 
effort to prevent EAMs from reaping the benefits of market making 
activities without having any of the concomitant obligations. 
Specifically, PMMs and CMMs have affirmative market making obligations, 
including providing continuous quotations during all market 
conditions.\128\ The Commission also believes that the provision is 
designed to prevent customers from acting as unregistered market 
makers, and obtaining an unfair advantage by their orders always 
appearing at the top of the book by virtue of their public customer 
status. Moreover, this prohibition is appropriate to prevent public 
customers from continually entering limit orders of fewer than ten 
contracts, triggering certain PMM obligations. A PMM has the 
responsibility to assure that each ISE BBO disseminated market quote in 
each series of options is for a minimum of ten contracts. When the ISE 
BBO represents one or more public customer orders for less than a total 
of ten contracts at that price, the PMM is obligated to buy or sell at 
that price the number of contracts needed to make the disseminated 
quote firm for ten contracts.\129\ This responsibility arises when the 
ISE receives a public customer limit order for fewer than ten contracts 
that would improve the ISE BBO.\130\ The Commission believes that, if 
EAMs or beneficial owners were permitted to enter multiple customer 
limit orders to such an extent that they were effectively acting as 
market makers, and, at the same time, jump ahead of all other orders on 
the book, they would have an inordinate advantage over other 
participants on the Exchange.
---------------------------------------------------------------------------

    \128\See ISE Rule 804(e)(1) and (2).
    \129\See ISE Rule 803(c)(1).
    \130\This responsibility arises only when the aggregate ISE BBO 
falls below ten contracts, not when the size of an individual quote 
or order falls below this level. Hence, multiple quotes or orders 
for less than ten contracts may be on the order book at the ISE BBO 
without creating the need for the PMM to step in, so long as the 
aggregate size of the ISE BBO is equal to or greater than ten 
contracts.
---------------------------------------------------------------------------

c. Restrictions on Order Size

    ISE Rule 717(c) prohibits EAMs from entering into the System, as 
principal or agent, multiple orders for a single trading interest if 
one or more orders is for less than ten contracts. This rule is 
designed to prevent EAMs from abusing a PMM's responsibilities. As 
noted above, a PMM has the responsibility to assure that each ISE BBO 
is always firm for a minimum of ten contracts. When the ISE BBO 
represents one or more public customer orders for less than a total of 
ten contracts at that price, the PMM is obligated to buy or sell at 
that price the number of contracts needed to make the disseminated 
quote firm for ten contracts.\131\ Absent this prohibition, an EAM 
feasibly could break up an order for a single trading interest into 
several different orders of less than ten contracts each and trigger 
the PMM's obligation either to trade with each order at the improved 
price or to make up the difference in the size of the disseminated 
quote. The Commission believes that, if EAMs, as principal or agent, 
were permitted to enter multiple orders of less than ten contracts for 
a single trading interest, this would give them the ability to take 
advantage of the PMMs.
---------------------------------------------------------------------------

    \131\See ISE Rule 803(c)(1).
---------------------------------------------------------------------------

    This provision also provides that non-customer orders for less than 
ten contracts will be rejected or cancelled automatically if such 
orders would cause the size of the ISE's BBO to be fewer than ten 
contracts. The Commission believes that, absent this provision, non-
customer orders for less than ten contracts could cause the ISE BBO to 
be firm for less than ten contracts, in conflict with the ISE's 
business model of continually displaying a minimum of ten contracts. 
PMMs are not obligated to trade with these orders or to make up the 
difference in the disseminated size of the ISE BBO. This provision does 
not mean that all non-customer orders must be for ten or more 
contracts. It simply means that if a non-customer wants to improve the 
ISE BBO, it must do so for at least ten contracts.

d. Limits on Internalization

(i) Restrictions on Principal Transactions

    ISE Rule 717(d) limits an EAM's ability to execute as principal 
orders it represents as agent. Specifically, an EAM may only execute as 
principal an order it represents as agent if (i) the agency order is 
first exposed on the ISE for at least two minutes, (ii) the EAM has 
been bidding or offering on the ISE for at least two minutes prior to 
receiving an agency order that is executable against such bid or offer, 
or (iii) the EAM uses the facilitation mechanism.\132\ This provision 
is an attempt to prohibit an EAM from executing, as principal, an order 
it represents as agent unless the order is

[[Page 11400]]

first given the opportunity to interact with other trading interest on 
the Exchange. It is designed to prevent an EAM from internalizing order 
flow and to provide added opportunity for price competition.
---------------------------------------------------------------------------

    \132\The Commission notes that the ISE intends to propose, 
through a Rule 19b-4 rule filing, that this timeframe be reduced to 
thirty seconds. The Commission intends to publish the proposal in 
the Federal Register for comment.
---------------------------------------------------------------------------

    Several commenters express concern that the System would permit its 
members to internalize a significant amount of order flow.\133\ They 
assert that the ISE's rules contain loopholes that would permit members 
to internalize order flow. The ISE, in order to preclude 
internalization of a significant amount of order flow, has rules that 
would prevent an EAM from entering nearly simultaneous customer and 
proprietary orders before there is an opportunity for the customer 
order to interact with other trading interest on the ISE.
---------------------------------------------------------------------------

    \1\See, e.g., Sutherland, Asbill, and Brennan Letters 2, and 3; 
CBOE Letter 1.
---------------------------------------------------------------------------

    The Commission believes that the restrictions on EAMs trading as 
principal with orders they represent as agent, the limitations on 
solicited orders, as well as the three interpretations (discussed 
below) that the ISE has adopted should adequately protect against the 
internalization of order flow by an EAM.\134\
---------------------------------------------------------------------------

    \134\See Amendment No. 2.
---------------------------------------------------------------------------

(1) Prohibition on the Disclosure of Agency Orders

    Commenters have said that under the ISE's rules, an EAM might be 
able to internalize orders indirectly through arrangements with third 
parties. In response, the ISE has adopted supplementary material to 
Rule 400 (Just and Equitable Principles of Trade) to address the 
concerns that a member might disclose certain information to a third 
party regarding agency orders.\135\ Specifically, a member will be 
prohibited from disclosing to a third party\136\ information regarding 
agency orders represented by the member prior to entering such orders 
into the ISE's System in order to allow the third party to attempt to 
execute against the member's agency orders. A member's disclosing 
information regarding agency orders prior to the execution of such 
orders on the ISE would provide an inappropriate informational 
advantage to the third party in violation of Rule 400.
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    \135\See Amendment No. 2.
    \136\For purposes of this provision, a third party includes any 
other person or entity, including affiliates of the member.
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    The Commission believes that this interpretation should help to 
prevent an EAM from doing indirectly what it is prohibited from doing 
directly. The provision should prove beneficial in preventing members 
from ``gaming'' the System. Specifically, the interpretation is 
designed to ensure that members do not circumvent the intent to 
prohibit a firm from acting as both principal and agent unless the 
firm's agency orders have been exposed on the ISE for at least two 
minutes. An EAM generally must expose orders it represents as agent 
before it may execute them as principal. Absent the prohibition on the 
disclosure of this type of information, a member and a third party 
could potentially use the ISE to execute their orders with each other 
without exposing these orders to other trading interest. The Commission 
believes that this interpretation will do much to prevent a firm from 
trading as principal with orders it represents as agent with a third 
party with whom it shares a beneficial interest. In the Commission's 
view, this interpretation should prove helpful in curbing a firm's 
ability to internalize order flow.

(2) Prohibition on Trading Via Prearranged Transactions

    The ISE represents that the intent of Rule 717(d) is to prevent an 
EAM from executing agency orders to increase its economic gain by 
trading against an order without first giving other trading interest on 
the ISE an opportunity to either trade with the agency order or to 
trade at the execution price when the EAM was already bidding or 
offering on the ISE book. Nevertheless, the ISE recognizes that it may 
be possible for an EAM to establish a relationship with a customer to 
realize similar economic benefits as it would achieve by executing 
agency orders as principal. To address this issue, the ISE has adopted 
supplementary material to provide that it will be a violation of Rule 
717(d) for an EAM to be a party to any arrangement designed to 
circumvent Rule 717(d) by providing an opportunity for a customer to 
regularly execute against agency orders handled by the EAM immediately 
upon their entry into the System.\137\ The Commission believes that 
this interpretation should be helpful in preventing an EAM from 
thwarting the restrictions on trading as principal. This interpretation 
is also a suitable prophylactic measure against possible gaming, 
mentioned above, of trading in the System.
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    \137\See Amendment No. 2.
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e. Limits on Solicited Orders

    ISE Rule 717(e) requires EAMs to expose orders they represent as 
agent on the ISE for at least two minutes before they may be executed 
in whole or in part by orders solicited from members and non-member 
broker-dealers to interact with such orders. This effectively requires 
an EAM to give agency orders an opportunity to interact with trading 
interest on the ISE before executing such orders against orders the EAM 
solicits from other broker-dealers. This provision does not limit an 
EAM's ability to cross an agency order with a solicited customer order.
    One commenter questioned whether the ISE was attempting to 
distinguish between the solicitation of public customer orders from the 
solicitation of broker-dealer orders for the purposes of this 
rule.\138\ The ISE represents that it distinguishes between public 
customer orders and broker-dealer orders in order to achieve a balance 
between the interests of EAMs and market makers.
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    \138\See CBOE Letter 1.
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    The Commission notes that solicited public customer orders are 
currently treated differently on the CBOE and the Amex. The CBOE 
requires that orders solicited from a public customer be exposed to the 
trading crowd prior to an upstairs firm executing an order it 
represents as agent with that solicited order. In contrast, the Amex 
does not require an upstairs firm to present to the trading crowd an 
order solicited from a public customer prior to the upstairs firm 
crossing that order with an order it represents as agent.\139\ The ISE 
has opted to follow the rule as it exists on Amex.
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    \139\The Commission notes that in 1998 the Amex proposed to 
adopt a rule similar to the CBOE's regarding the treatment of 
solicited public customer orders. The filing was withdrawn by the 
Amex. See File No. SR-Amex-98-19.
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    The ISE has adopted supplementary material to clarify that it will 
be a violation of ISE Rule 717(e) for an EAM to cause the execution of 
an order it represents as agent on the ISE by orders it solicited from 
members and non-member broker-dealers to transact with such orders, 
whether such solicited orders are entered into the System directly by 
the EAM or by the solicited party (either directly or through another 
member), if the member fails to expose those orders on the Exchange as 
required by ISE Rule 717(e).\140\ The Commission believes that this 
interpretation is appropriate because it clarifies that solicited 
orders must be exposed on the System regardless of who enters such 
orders.
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    \140\See Amendment No. 2.
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    Overall, the Commission believes that requiring exposure on the ISE 
of orders solicited by an EAM should help to proscribe potential 
internalization of customer order flow by a firm representing an order 
as agent.

[[Page 11401]]

f. Restrictions on the Electronic Generation of Orders

    ISE Rule 717(f) prohibits members from entering, or permitting the 
entry of, orders created and communicated electronically without manual 
input unless such orders are non-marketable limit orders to buy (sell) 
that are priced higher (lower) than the best bid (offer) on the ISE 
(i.e., limit orders that improve the best price available on the 
Exchange).\141\ This provision is not designed, however, to prohibit 
EAMs from electronically communicating to the ISE orders manually 
entered by customer orders into front-end communications systems (e.g., 
internet gateways, online networks).
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    \141\See Amendment No. 2.
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    Certain commenters criticize this provision by noting that the rule 
was likely created to prevent day traders with automated trading 
systems from sending orders to the ISE whenever they identify an 
arbitrage opportunity that could be capitalized by trading the option 
on the ISE and another related option on another exchange.\142\ One 
commenter argues that because the Commission has rejected similar rule 
proposals in the past, the ISE should not be permitted to have such a 
rule.\143\
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    \142\See, e.g., CBOE Letters 1 and 2.
    \143\See CBOE Letters 1 and 2. The Commission notes that the 
proposals that the CBOE is referring to dealt primarily with the 
definition of a ``public customer.'' See File Nos. SR-CBOE-93-20, 
SR-CBOE-95-23, and SR-CBOE-96-07.
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    The Commission shares commenters' concerns that these provisions 
inhibit competition between automated customers and ISE market makers. 
In the equity markets, limit orders from active customers have been a 
valuable source of quote competition. Nonetheless, the Commission 
recognizes that the ISE's business model depends on market makers for 
competition and liquidity. Unlike flat open systems used elsewhere in 
the world, customer orders in ISE receive priority over market makers. 
Allowing electronic entry directly into a fully automated system could 
give automated customers a significant advantage over market makers. 
This could undercut the ISE business model. Moreover, the ISE's 
prohibition on electronically entered limit orders matching the best 
bid and offer still allows limit orders at improved prices. For these 
reasons, the Commission is unable to conclude that this limitation 
violates the statutory requirements. In the future, however, this 
limitation may need to be reviewed in light of experience with the ISE.

F. Listing Procedures

    The Commission notes that the ISE has filed its proposed listing 
procedures in Amendment No. 2. These procedures reflect those used by 
the existing exchanges trading standardized options and under which The 
Options Clearing Corporation (``OCC'') operates. Although these 
procedures were not published in the Federal Register for notice and 
comment, the Commission notes that they have previously been approved 
for use by other exchanges after notice and comment.\144\ Accordingly, 
the Commission believes that, in the interest of uniformity, it is 
appropriate to approve these procedures as part of the ISE's exchange 
registration.
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    \144\See Exchange Act Release No. 29698 (September 17, 1991), 56 
FR 48594 (September 25, 1991) (order approving the Joint-Exchange 
Options Plan).
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G. Fees

    The ISE has not included its proposed fee schedule in its 
registration application. Generally, changes to exchange fees are filed 
pursuant to Section 19(b)(3)(A) of the Exchange Act and are effective 
upon filing.\145\ The ISE, however, will submit a rule filing regarding 
its fees pursuant to Section 19(b)(1)\146\ and Rule 19b-4\147\ 
thereunder prior to beginning trading. This will enable the fees to be 
published in the Federal Register for notice and comment, prior to 
Commission action. The Commission must find that the ISE's proposed 
fees are consistent with Section 6(b) of the Act,\148\ in general, and 
further the objectives of Section 6(b)(4)\149\ in particular, in that 
they will provide for the equitable allocation of reasonable dues, 
fees, and other charges among the Exchange's members and other persons 
using its facilities.
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    \145\15 U.S.C. 78s(b)(3)(A).
    \146\15 U.S.C. 78s(b)(1).
    \147\17 CFR 240.19b-4.
    \148\15 U.S.C. 78f(b).
    \149\15 U.S.C. 78f(b)(4).
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H. Miscellaneous

    Recognizing that the ISE is a new, fully electronic options 
exchange, the Commission believes it would be unwise and impracticable, 
at the outset, to cast the Exchange into a preconceived mold. The 
Commission believes that the ISE's governance provisions and trading 
rules are sufficiently clear for the purposes of granting it exchange 
registration. Requiring the ISE to provide a high degree of specificity 
with respect to certain of its rules before registration as an exchange 
is likely unfeasible because it will be difficult for the ISE to 
determine exactly who or what decisions may need to be made until the 
Exchange actually begins operating. As the ISE gains experience, the 
Commission expects that the Exchange will take appropriate steps to 
ensure, among other things, that its rules continue to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and to protect investors and the public 
interest. However, as noted above, the ISE will be required to file 
certain rule changes with the Commission pursuant to Rule 19b-4 under 
the Exchange Act prior to beginning trading.\150\
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    \150\See 17 CFR 240.19b-4.
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    The Commission also notes that the ISE will need to enter into 
several regulatory agreements and plans before it may begin trading. 
Specifically, the ISE must join the Plan for the Reporting of 
Consolidated Options Last Sale Reports and Quotation Information (known 
as the Options Price Reporting Authority), the OCC, the Intermarket 
Surveillance Group Agreement, the Joint-Exchange Options Plan, and the 
Options Sales Practice Agreement. In addition, as mentioned above the 
ISE intends to enter into a Rule 17d-2 agreement with NASD Regulation. 
This agreement must be filed with and approved by the Commission.

IV. Conclusion

    An appropriate order granting exchange registration will issue.

    By the Commission (Chairman Levitt and Commissioners Johnson, 
Hunt, Carey and Unger).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-4976 Filed 3-1-00; 8:45 am]
BILLING CODE 8010-01-P