[Federal Register Volume 66, Number 220 (Wednesday, November 14, 2001)]
[Notices]
[Pages 57145-57148]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-28491]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45032; File No. SR-PCX-00-05]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Amendment No. 4 to the Proposed Rule 
Change by the Pacific Exchange, Inc. Relating to Its Automatic 
Execution System

November 6, 2001.

I. Introduction

    On March 8, 2000, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to allow broker-dealer orders to 
be eligible for automatic execution through the Exchange's Automatic 
Execution System (``Auto-Ex'') on an issue-by-issue basis. The Exchange 
also proposed to adopt rules to establish means of improving compliance 
with rules pertaining to the use of Auto-Ex. After publishing the 
proposal for notice and comment in the Federal Register,\3\ the 
Commission partially approved the proposal and granted accelerated 
approval to Amendment Nos. 2 and 3.\4\ Specifically, the Commission 
approved the portion of the proposal relating to the establishment of 
provisions to improve compliance with the Exchange's Auto-Ex rules; the 
Commission did not approve the portion of the proposal that would allow 
orders for the accounts of broker-dealers to be executed on Auto-Ex on 
an issue-by-issue basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 43049 (July 18, 2000), 
65 FR 45810 (July 25, 2000) (``Initial Proposal'').
    \4\ Securities Exchange Act Release No. 43971 (February 15, 
2001), 66 FR 11344 (February 23, 2001) (``Partial Approval Order'').
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    On October 29, 2001, the PCX filed Amendment No. 4 to the proposed 
rule change.\5\ In Amendment No. 4, PCX addressed the remaining portion 
of proposed rule change regarding the eligibility of broker-dealer 
orders for automatic execution through Auto-Ex on an issue-by-issue 
basis. This order grants accelerated approval to Amendment No. 4 to the 
proposed rule change and solicits comments from interested persons on 
that Amendment.
    Below is the proposed text of the portion of the proposed rule 
change relating to the eligibility of broker-dealer orders for 
automatic execution through Auto-Ex, as amended by Amendment No. 4.\6\ 
Proposed new language is italicized; proposed deletions are in 
brackets.
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    \5\ See letter from Michael D. Pierson, Vice President, 
Regulatory Policy, PCX, to Nancy J. Sanow, Assistant Director, 
Division of Market Regulation (``Division''), Commission, dated 
October 26, 2001 (``Amendment No. 4'').
    \6\ The text of this rule change is based upon current PCX Rule 
6.87(b). It disregards previously proposed amendments to PCX Rule 
6.87(b) that were included in the Initial Proposal and approved in 
the Partial Approval Order.
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* * * * *

para. 5231  Automatic Execution System

Rule 6.87(a)--No change
    (b) Eligible Orders.

[[Page 57146]]

    (1) Only non-broker/dealer customer orders are eligible for 
execution on the Exchange's Auto-Ex System, except that the Options 
Floor Trading Committee (``OFTC'') may determine, on an issue-by-issue 
basis, to allow the following types of orders to be executed on Auto-
Ex:
    (A) Broker-dealer orders; or
    (B) Broker-dealer orders that are not for the accounts of Market 
Makers or Specialists on an exchange who are exempt from the provisions 
of Regulation T of the Federal Reserve Board pursuant to Section 
7(c)(2) of the Securities Exchange Act of 1934.
    Broker-dealer orders entered through the Exchange's Member Firm 
Interface (MFI) will not be automatically executed against orders in 
the limit order book. Broker-dealer orders may interact with orders in 
the limit order book only after being re-routed to a floor broker for 
representation in the trading crowd. Broker-dealer orders are not 
eligible to be placed in the limit order book pursuant to Rule 6.52.
    (2) If the OFTC permits broker-dealer orders to be automatically 
executed in an issue pursuant to this Rule, then it may also permit the 
following with respect to such orders:
    (A) The maximum order size eligibility for broker-dealer orders may 
be less than the applicable order size eligibility for non-broker-
dealer customer orders.
    (B) Non-broker-dealer customer orders may be eligible for automatic 
execution at the NBBO pursuant to Rule 6.87(i) while broker-dealer 
orders are not so eligible.
    (C) Broker-dealer orders may be re-routed for manual representation 
when the NBBO is crossed or locked pursuant to Rule 6.87(j) when non-
broker-dealer customer orders would not be re-routed for manual 
handling in such circumstances.
    (3) PCX Marker Makers must assure that orders for their own 
accounts are not entered on the PCX and represented or executed in 
violation of the following provisions: Rule 6.84(h) (concurrent 
representation of a joint account), Rule 6.85(a) (concurrent 
representation of a market maker account), and Section 9 of the 
Securities Exchange Act of 1934 (wash sales).
    (4) For purposes of this Rule, the term ``broker/dealer'' includes 
foreign broker/dealers.
    [(2)-(3)]-(5)-(6)--No change.
* * * * *

II. Description of the Proposal

    In 1990, the Commission approved the Exchange's POETS system on a 
pilot program basis and, in 1993, POETS was approved permanently.\7\ 
POETS is comprised of an options order routing system (``ORS''), an 
automatic and semi-automatic execution system, Auto-Ex, an on-line book 
system (``Auto-Book''), and an automatic market quote update system 
(``Auto-Quote'').
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    \7\ See Securities Exchange Act Release No. 27633 (January 18, 
1990), 55 FR 2466 (January 24, 1990) (approving POETS on a pilot 
basis); Securities Exchange Act Release No. 32703 (July 30, 1993), 
58 FR 42117 (August 6, 1993), (approving POETS on a permanent 
basis). The Auto-Ex system permits eligible market or marketable 
limit orders sent from member firms to be executed automatically at 
the displayed bid or offering price. Participating market makers are 
designated as the contra side to each Auto-Ex order. Participating 
market makers are assigned by Auto-Ex on a rotating basis, with the 
first market maker selected at random from the list of signed-on 
market makers. Automatic executions through Auto-Ex are currently 
available for public customer orders of twenty contracts or less (or 
in certain issues, for up to one hundred contracts) in all series of 
options traded on the Options Floor of the Exchange.
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    In its Initial Proposal, PCX had proposed, among other things, that 
broker-dealer orders be permitted, on an issue-by-issue basis, to be 
executed on Auto-Ex. Furthermore, under the Initial Proposal, only 
broker-dealer orders that were not for the accounts of registered 
specialists and registered market makers would be eligible for 
automatic execution through Auto-Ex, subject to approval by the OFTC. 
Pursuant to Amendment No. 4, the Exchange is now proposing to allow all 
types of broker-dealer orders to be eligible for automatic execution, 
subject to OFTC approval. Specifically, under the amendment, the OFTC 
would be permitted to approve Lead Market Makers' requests to allow 
either: (a) automatic execution of broker-dealer orders, regardless of 
type, in particular option issues; or (b) automatic execution of 
broker-dealer orders in particular option issues, exclusing those 
orders that are for the accounts of registered specialists and 
registered market makers.
    Pursuant to Amendment No. 4, if the OFTC approves the automatic 
execution of broker-dealer orders, regardless of type, in a particular 
option issue, then any orders for the accounts of registered market 
makers or specialists, including orders for PCX options markets makers 
and PCX Lead Market Makers, would be eligible for automatic execution 
on the PCX in that issue. However, inbound broker-dealer orders would 
not be eligible to be executed against orders residing in the limit 
order book (as inbound ``customer'' orders are currently permitted to 
do). If there is a customer limit order in the PCX's limit order book 
that is priced at the National Best Bid or Offer (``NBBO''), then an 
inbound market or marketable limit order for the account of a broker-
dealer will be re-routed to a Floor Broker Hand-Held Terminal for 
execution by a floor broker. However, in certain rare circumstances, 
such orders will be re-routed to a member firm booth on the trading 
floor.\8\ Accordingly, the Exchange is adding the following provisions 
to the text of PCX Rule 6.87(b)(1):

    \8\ The PCX represents that such broker-dealer orders will be 
routed to the trading floor if a firm has specified such treatment 
of the order, or as a default designation if the firm has not made a 
specification as to where such order should be routed. Telephone 
conversation between Michael D. Pierson, Vice President, Regulatory 
Policy, PCX, and Sapna C. Patel, Division, Commission, on November 
5, 2001.
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    Broker-dealer orders entered through the Exchange's Member Firm 
Interface (MFI) will not be automatically executed against orders in 
the limit order book. Broker-dealer orders may interact with orders 
in the limit order book only after being re-routed to a floor broker 
for representation in the trading crowd. Broker-dealer orders are 
not eligible to be placed in the limit order book pursuant to Rule 
6.52.

    The POETS system currently distinguishes between customer and non-
customer orders based upon the clearing information provided as part of 
each order. Manual and electronic order tickets must designate, for 
each order, whether the order is for a ``customer'' account, a ``firm'' 
account or a ``market maker'' account, by the designators ``C,'' ``F'' 
or ``M,'' respectively. These designators are intended to assure that 
the orders executed on the PCX clear in the proper margin accounts at 
the Options Clearing Corporation. They are also intended to assure that 
the orders are handled in a manner that is consistent with various PCX 
rules on eligibility for placement in the limit order book (PCX Rule 
6.52(a)), order identification requirements (PCX Rule 6.66), priority 
of bids and offers (PCX Rule 6.75), firm quote size guarantees (PCX 
Rule 6.86), and eligibility for automatic execution (PCX Rule 6.87).
    The Exchange notes that orders for the accounts of PCX market 
makers and Lead Market Makers that are entered for automatic execution 
will be subject to certain limitations under PCX rules. Currently, 
under PCX Rule 6.85(a), a market maker and any orders represented by a 
floor broker on behalf of that market may not be represented 
concurrently at the same trading post. This prohibition against ``dual 
representation'' would be violated, for example, in the following 
situation: A market maker in the XYZ trading crowd enters an order in 
XYZ options for his or her own account with a floor broker (via 
telephone, electronically or in-

[[Page 57147]]

person), and the floor broker then represents the order while the 
market maker is still present in the XYZ trading crowd. A similar 
violation would occur if, under the proposed rule change, a market 
maker in the XYZ trading crowd entered an order in XYZ options with his 
or her upstairs brokerage firm via the internet, and the brokerage firm 
then re-routed the order back to the PCX, where it was either 
automatically executed or defaulted for manual handling by a floor 
broker. In either case, the market maker will have violated PCX Rule 
6.85(a) because all orders entered for automatic execution are 
ultimately represented by designated floor brokers, even if they are 
automatically executed. However, if the market maker were trading for a 
joint account in that situation, then that market maker would have 
violated PCX Rule 6.84(h), which provides a similar prohibition on 
concurrent representation when a market maker is trading in a joint 
account. Furthermore, if a market maker enters an order for his or her 
own account with a brokerage firm, and the order is re-routed back to 
the PCX where it is executed against the same market maker's account, 
there will be a possible ``wash sale'' violation regardless of whether 
the trade was subsequently nullified.
    For these reasons, the Exchange is proposing to adopt new PCX Rule 
6.87(b)(3), which will provide as follows:
    PCX Market Makers must assure that orders for their own accounts 
are not entered on the PCX and represented or executed in violation of 
the following provisions: Rule 6.84(h) (concurrent representation of a 
joint account), Rule 6.85(a) (concurrent representation of a market 
maker account), and Section 9 of the Act (wash sales).
    The Exchange notes that, pursuant to PCX Rule 6.87(e)(3), market 
makers may not remain on the Auto-Ex ``wheel'' unless they are present 
in the trading crowd, except under certain very limited circumstances.
    Pursuant to Amendment No. 4 to the proposed rule change, the OFTC 
would also have the ability to permit certain limitations on the 
automatic execution of broker-dealer orders. First, broker-dealer 
orders may have a smaller order size eligibility parameter for 
automatic execution than customer orders. For example, the OFTC may 
approve a size limitation in a particular issue of twenty contracts for 
broker-dealer orders and fifty contracts for customer orders.\9\ 
Second, broker-dealer orders in an issue may be ineligible for NBBO 
step-up while customer orders in that issue may be eligible for NBBO 
step-up pursuant to PCX Rule 6.87(i). For example, if the PCX's best 
bid is 5 and the national best bid is 5.10, a customer order to sell at 
5.10 entered on the PCX may receive an automatic execution of 5.10, 
while a broker-dealer order in the same issue to sell at 5.10 would not 
be automatically executed, but instead would be re-routed to a floor 
broker for execution. Third, a customer order in a particular issue by 
be automatically executed even though the NBBO is crossed or locked, 
while a broker-dealer order in the same issue would be re-routed to a 
floor broker for execution if the NBBO is crossed or locked, pursuant 
to PCX Rule 6.87(j).
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    \9\ The Exchange notes that a Lead Market Maker's minimum Auto-
Ex size guarantee in an issue is established at the time that the 
Options Allocation Committee (``OAC'') allocates that issue to the 
Lead Market Maker. Pursuant to PCX Rule 6.82(c)(2), Lead Market 
Makers are required to ``[h]onor guaranteed markets, including 
markets required by Rule 6.86 [``firm quotes''] and any markets 
pledged during he allocation process.'' Therefore, if a Lead Market 
Maker were to seek to establish an Auto-Ex size guarantee for 
broker-dealer orders that is less than the Auto-Ex size established 
during the allocation process, the Lead Market Maker would have to 
obtain approval of both the OFTC and the OAC for that size 
guarantee.
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    The Exchange represents that the proposed rule change is consistent 
with the Act and rules and regulations thereunder. In particular, the 
Exchange represents in its Initial Proposal that the proposed rule 
change is consistent with Section 6(b) \10\ of the Act, in general, and 
furthers the objectives of Section 6(b)(5),\11\ in that it is designed 
to promote just and equitable principles of trade, to enhance 
competition and to protect investors and the public interest. In 
addition, the Exchange represents that the proposal is consistent with 
Section 11(a) of the Act \12\ and Rule 11a2-2(T) under the Act \13\ for 
the reasons stated in the Exchange's letter to the Commission.\14\
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    \10\ 15 U.S.C. 78f.
    \11\ 15 U.S.C. 78f(b)(5).
    \12\ 15 U.S.C. 78k(a).
    \13\ 17 CFR 240.11a2-2(T).
    \14\ See letter to Catherine McGuire, Chief Counsel, Division, 
Commission, from Michael D. Pierson, Vice President, Regulatory 
Policy, PCX, dated October 26, 2001 (``PCX Request Letter'').
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    The Exchange further notes that the amendment to the proposed rule 
change is consistent with the Commission's approval of the Options 
Intermarket Linkage Plan (``Linkage Plan'').\15\ PCX notes that the 
Linkage Plan Release states:

    \15\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000) (``Linkage Plan Release''). The 
Commission notes that only proprietary orders of ``eligible market 
makers,'' as that term is defined in the Linkage Plan Release, and 
not proprietary orders of all market makers and broker-dealers, may 
be sent through the linkage. An eligible market maker must meet the 
criteria and volume requirements set forth in the Linkage Plan 
Release in order to utilize the linkage for proprietary orders.
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    The * * * plan would allow eligible market makers to send 
proprietary orders through the linkage. [However, if] the principal 
order is not larger than the Firm Principal Quote Size, the exchange 
receiving such order through the linkage must execute it in its 
automatic execution system, if its disseminated quote is equal to or 
better than the reference price at the time the order arrives.\16\

    \16\ Id. (emphasis added.)
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    The Exchange notes that the Commission found that ``allow[ing] 
eligible market makers to use the linkage to hit quotes on an away 
market [helps] to protect the priority of the better displayed price.'' 
\17\ The Exchange also believes that allowing market makers and 
specialists on other exchanges to promptly access the PCX's markets via 
the Auto-Ex system will further the goals of a national market system 
by assuring that quotes can be promptly accessed by other market 
participants. This, in turn, should serve to reduce the number of 
trade-throughs as well as locked and crossed quotes in the options 
markets.
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    \17\ Id. The Linkage Plan Release also stated that ``the 
Commission would support broader access between options markets'' 
than is provided for in the linkage Plan. Id.
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    The Exchange also notes that its rules currently permit the 
Exchange, or an issue-by-issue basis, to automatically execute inbound 
orders of registered eligible market makers on other exchanges, via 
Auto-Ex, pursuant to the Interim Intermarket Linkage Program. Under 
this program, ``two or more Participating Exchange [may] mutually agree 
that they will automatically execute * * * orders sent for the 
principal account of a market maker, an [Eligible Away Market Maker] or 
an [Eligible Away Principal Market Maker] that does not correspond to 
an Underlying Customer Order.'' \18\
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    \18\ See PCX Rule 6.91(a)(9) (emphasis added); see also PCX Rule 
6.91(b); Securities Exchange Act Release No. 43986 (February 20, 
2001), 66 FR 12578 (February 27, 2001) (File No. SR-PCX-01-10) 
(notice of filing and immediate effectiveness of Interim Intermarket 
Linkage Program).
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    Finally, the Exchange believes that its Amendment No. 4 to the 
proposed rule change to allow automatic execution of all broker-dealer 
orders, subject to OFTC approval, is a legitimate means for the PCX to 
compete for orders for the accounts of broker-dealers to be executed on 
the PCX. The Exchange notes that another exchange already has

[[Page 57148]]

the ability to automatically execute broker-dealer orders.\19\
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    \19\ Specifically, the PCX notes that on the International 
Securities Exchange (``ISE''): ``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.'' See 
Securities Exchange Act Release No. 42455
    (February 24, 2000), 65 FR 11388 (March 2, 2000) (order 
approving ISE's application for registration as a national 
securities exchange) (File No. 10-127).
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III. Discussion

    After careful review, the Commission finds that Amendment No. 4 to 
the proposed rule change is consistent with the Act and the rules and 
regulations promulgated thereunder applicable to a national securities 
exchange and, in particular, with the requirements of Section 6(b).\20\ 
Specifically, the Commission finds that approval of Amendment No. 4 is 
consistent with Section 6(b)(5) \21\ of the Act in that it is designed 
to promote just and equitable principles of trade, to remove 
impediments and to perfect the mechanism of a free and open market and 
a national market system, and in general, to protect investors and the 
public interest. The Commission finds that it is appropriate to allow 
broker-dealer orders to be eligible for automatic execution through the 
Exchange's Auto-Ex system, subject to the approval of the OFTC.\22\
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    \20\ 15 U.S.C. 78f(b). In approving this proposal, the 
Commission has considered the proposed rule's impact on efficiency, 
competition and capital formation. 15 U.S.C. 78c(f).
    \21\ 15 U.S.C. 78f(b)(5).
    \22\ In response to the Exchange's request in the PCX Request 
Letter, Commission staff has provided interpretive guidance to the 
Exchange under Section 11(a) of the Act, 15 U.S.C. 78k(a). See 
letter from Paula R. Jenson, Deputy Chief Counsel, Division, 
Commission, to Michael D. Pierson, Vice President, Regulatory 
Policy, PCX, dated October 30, 2001.
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    The Commission finds good cause for approving Amendment No. 4 to 
the proposed rule change prior to the thirtieth day after the Amendment 
is published for comment in the Federal Register pursuant to Section 
19(b)(2) of the Act.\23\ Amendment No. 4 allows all broker-dealer 
orders to be executed through Auto-Ex, subject to OFTC approval. The 
Commission finds that this Amendment is necessary to accomplish the 
intended goals of the Exchange's proposal and to allow the Exchange to 
compete with another exchange that currently allows the electronic 
execution of broker-dealer orders. The Commission therefore believes 
that acceleration of Amendment No. 4 to the proposed rule change is 
appropriate.
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    \23\ 15 U.S.C. 78s(b)(2).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 4, including whether the Amendment 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Copies of 
the submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the PCX. All 
submissions should refer to File No. SR-PCX-00-05 and should be 
submitted by December 5, 2001.

V. Conclusion

    For the foregoing reasons, the Commission finds that Amendment No. 
4 to the proposed rule change is consistent with the Act and the rules 
and regulations thereunder applicable to a national securities 
exchange, and, in particular, with Section 6(b)(5).\24\
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    \24\ 15 U.S.C. 78f(b)(5).
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    It Is Therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\25\ that Amendment No. 4 to the proposed rule change (SR-PCX-00-5) 
is approved on an accelerated basis.
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    \25\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\26\
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    \26\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-28491 Filed 11-13-01; 8:45 am]
BILLING CODE 8010-01-M