[Federal Register Volume 67, Number 5 (Tuesday, January 8, 2002)]
[Notices]
[Pages 947-951]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-403]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45221; File No. SR-CBOE-99-45]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
2 to Proposed Rule Change by the Chicago Board Options Exchange, Inc. 
to Clarify Certain Aspects of Interpretation and Policy .02 to Exchange 
Rule 6.8

January 2, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 19, 2001, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') Amendment No. 2 to the proposed rule 
change, as described in Items I, II, and III below, which Items have 
been prepared by the CBOE.\3\ On December 28, 1999, the proposed rule 
change was published for comment in the Federal Register.\4\ On October 
30, 2000, the CBOE filed Amendment No. 1 to the proposed rule 
change.\5\ Amendment No. 2 supersedes and replaces Amendment No. 1 in 
its entirety.\6\ The Commission is publishing this notice to solicit 
comments on Amendment No. 2 to the proposed rule change from interested 
persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Joanne Moffic-Silver, General Counsel and 
Corporate Secretary, Legal Department, CBOE to Stephen M. Cutler, 
Director, Division of Enforcement, Commission, Annette L. Nazareth, 
Director, Division of Market Regulation (``Division''), Commission, 
and Lori A. Richards, Director, Office of Compliance, Inspections 
and Examination, Commission, dated November 19, 2001 (``Amendment 
No. 2''). In Amendment No. 2, the CBOE proposes to set forth 
specific, objective criteria describing the circumstances in which 
Exchange Floor Officials may determine that quotes from one or more 
markets in one or more particular classes of options are not 
reliable and, thus, may be excluded from CBOE's Retail Automatic 
Execution System (``RAES'') determination of the National Best Bid 
and Offer (``NBBO'').
    \4\ See Securities Exchange Act Release No. 42256 (December 20, 
1999), 64 FR 72707 (December 28, 1999).
    \5\ See letter from Christopher R. Hill, Attorney II, Legal 
Department, CBOE to Terri Evans, Special Counsel, Division, 
Commission, dated October 24, 2000 (``Amendment No. 1'').
    \6\ Telephone conversation between Patrick Sexton, Legal 
Division, CBOE, and Deborah Flynn, Assistant Director, Division, 
Commission, on December 14, 2001.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange proposes to change its Interpretation and Policy .01 
to CBOE Rule 6.8 (RAES Operations) in order to add specific, objective 
criteria describing the circumstances in which Exchange Floor Officials 
may determine that quotes from one or more markets in one or more 
particular classes of options are not reliable, and, thus, may be 
excluded from CBOE's Retail Automatic Execution System (``RAES'') 
determination of the National Best Bid and Offer (``NBBO''). The text 
of Amendment No. 2 to the proposed rule change is provided below. 
Changes to the current rule text are in italics; deletions from the 
current rule text are in brackets.

RAES Operations in Equity Options

Rule 6.8  [No change]
    * * * Interpretation and Policy
.01  [No change]
    .02 (a) Orders to buy or sell options that are multiply traded in 
one or more markets in addition to the Exchange will not be 
automatically executed on RAES at prices inferior to the current best 
bid or offer in any other market, as such best bids or offers are 
identified in RAES.
    Under circumstances where two Floor Officials determine that quotes 
from one or more particular markets in one or more classes of options 
are not reliable, the Floor Officials may direct the senior person in 
charge of the Exchange's Control Room to exclude the unreliable quotes 
from the RAES determination of the NBBO in the particular option 
class(es).
    I. Two Floor Officials may determine quotes in one or more 
particular options classes in a market are not reliable under any of 
the following circumstances:
    (a) Quotes Not Firm: A market's quotes in a particular options 
class are not firm based upon direct communication to the Exchange from

[[Page 948]]

the market or the dissemination through OPRA of a message indicating 
that disseminated quotes are not firm;
    (b) Confirmed Quote Problems: A market has directly communicated to 
the Exchange or otherwise confirmed that the market is experiencing 
systems or other problems affecting the reliability of its disseminated 
quotes;
    (c) Crossed or Locked Markets: One or more floor officials observe 
that the market's quotes in six or more option series in a particular 
options class are crossed or locked with the disseminated quotes of two 
or more other markets (which may include the Exchange), and continue to 
be crossed or locked for 30 seconds or more, provided that the quotes 
must be crossed or locked at the time. Floor Officials determine to 
exclude the unreliable quotes from the RAES determination of the NBBO; 
or
    (d) Documented Firm Quote Issues: One or more floor officials 
observe any of the following:
    (1) One or more orders originating from an Exchange DPM or market-
maker for a particular options class that are filled by the market at a 
worse price than its disseminated quote without a required quote 
change;
    (2) One or more market orders or marketable limit orders 
originating from an Exchange DPM or market-maker for a particular 
options class that are confirmed to be unfilled or partially unfilled 
by the market without a required quote change; or
    (3) One or more market orders or marketable limit orders 
originating from an Exchange DPM or market-maker for a particular 
options class partially filled by a ``responsible broker or dealer'' at 
its disseminated quote, followed by a quote change and a redisplay of 
the previously disseminated quote by the same ``responsible broker or 
dealer'' in less than 30 seconds.
    In all such cases, the situation will be documented by the Exchange 
Control Room and reported to regulatory authorities at the appropriate 
market.
    II. In all cases where floor officials exclude a market or any of 
its quotes from the RAES determination of the NBBO due to quote 
unreliability, the Exchange Control Room will promptly notify the 
market of the action, continue to monitor the reliability of the 
excluded quotes in consultation with Floor Officials, and maintain 
records showing the date, time, duration, and reasons for each such 
action, as well as the identity of the Floor Officials who authorized 
the action. Any determination to exclude a market or any of its quotes 
from the RAES determination of the NBBO pursuant to I(a) and (b) above 
will expire at the end of the trading day, or at such time as the 
quotes are confirmed by the market to be reliable again--whichever 
occurs first. Any determination to exclude a market or any of its 
quotes from the RAES determination of the NBBO pursuant to I(c) and (d) 
above will expire not later than 30 minutes after the initial 
determination, unless two Floor Officials determine that the excluded 
quotes continue to be unreliable in which case the quotes will continue 
to be excluded for an additional period of time not to exceed 30 
minutes pending further Floor Official review. Exclusion of a market or 
its quotes from the RAES determination of the NBBO will be reported to 
Exchange member firms.
    (b) In respect of those classes of options that have been 
specifically designated by the appropriate Floor Procedure Committee as 
coming within the scope of [this] the first sentence of .02(a) 
(``automatic step-up classes''), under circumstances where the 
Exchange's best bid or offer is inferior to the current best bid or 
offer in another market by no more than the ``step-up amount'' as 
defined below, such orders will be automatically executed on RAES at 
the current best bid or offer in the other market.
    (i) In respect of automatic step-up classes of options under 
circumstances where the Exchange's best bid or offer is inferior to the 
current best bid or offer in another market by more than the step-up 
amount, or
    (ii) In respect of series of option classes designated by the 
appropriate Floor Procedure Committee or its Chairman under 
circumstances where the NBBO for one of the series is crossed (e.g., 
6.10 bid, 6 asked) or locked (e.g., 6 bid, 6 asked), or
    (iii) In respect of specified automatic step-up classes or series 
of options or specified markets under circumstances where the Chairman 
of the appropriate Floor Procedure Committee or his designee has 
determined that automatic step-up should not apply because quotes in 
such options or markets are deemed not to be reliable, or
    (iv) In respect of classes of equity options other than automatic 
step-up classes where the Exchange's best bid or offer is inferior to 
the current best bid or offer in another market by any amount, such 
orders will be rerouted for non-automated handling to the DPM or OBO 
for that class of options, or to any other location in the event of 
system problems or contrary routing instructions from the firm that 
forwarded the order to RAES. If the order has been rerouted to the DPM 
or OBO, the DPM or OBO will report the execution or non-execution of 
such orders to the firm that originally forwarded the order to RAES. 
With respect to the orders that are rerouted for manual handling 
pursuant to (ii) above, the appropriate Floor Procedure Committee may 
determine to have the orders for a particular series within a 
designated class of options executed on RAES notwithstanding the fact 
that the NBBO is either crossed or locked. Also, with respect to (ii) 
above, the appropriate Floor Procedure Committee may determine to have 
the orders rerouted for manual handling only when the CBOE RAES becomes 
crossed or locked as a result of applying the step-up amount.
    As used in this Interpretation and Policy .02, the term ``step-up 
amount'' shall be expressed in an amount consistent with the minimum 
trading increment for options of that series established pursuant to 
Rule 6.42. The appropriate Floor Procedure Committee shall determine 
the step-up amount in respect of specified automatic step-up classes or 
series of options and may vary the ``step-up amount''on the basis of 
order size parameters. The procedures described in this Interpretation 
.02(b) shall not apply in circumstances where a ``fast market'' in the 
options that are the subject of the orders in question has been 
declared on the Exchange or where comparable conditions exist in the 
other market such that firm quote requirements do not apply.
    (c) For purposes of this Interpretation and Policy .02, the term 
``Exchange's best bid or offer'' shall mean the price for the series as 
established by the DPM's Autoquote or proprietary automated quotation 
updating system. Classes of options in which Autoquote or a proprietary 
automated quotation updating system are not operative shall not be 
deemed to be ``automatic step-up classes,'' as that term is defined in 
paragraph [(a)] (b) of this Interpretation.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filings with the Commission, the CBOE included statements 
concerning the purpose of and basis for the proposed rule change, as 
amended by Amendment No. 2, and discussed any comments it received on 
the proposed rule change, as amended. The text of these statements may 
be examined at the places specified in Item IV below. The CBOE has 
prepared summaries, set in Sections A, B, and C below, of the most 
significant aspects of such statements.

[[Page 949]]

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Interpretation and Policy .02 to CBOE Rule 6.8 provides that orders 
to buy or sell equity options that are multiply traded in one or more 
markets in addition to the CBOE will not be executed on RAES at prices 
inferior to the current best bid or offer in any other market, as the 
NBBO is identified in RAES.
    Amendment No. 2 is designed to clarify procedures and specifically 
describe the circumstances under which the Exchange will be permitted 
to remove another market's quotes from the NBBO calculation. 
Specifically, removal will occur only when specific conditions set 
forth in this amendment allow Exchange Floor Officials to make a 
determination based on objective criteria that quotes in one or more 
options classes in a market are not reliable.

Reliable NBBO Calculations Benefit Public Customers

    The CBOE believes that the presence of inaccurate and unreliable 
quotes is a significant problem because incorrect quotes undermine the 
integrity of the NBBO and by doing so, impede the very purpose of the 
National Market System, as well as inhibit the ability of public 
customers to obtain best execution for their orders. Removal of 
unreliable quotes, effected through objective criteria and well-defined 
procedures, is an appropriate function of the Exchange, necessary to 
protect the integrity and fairness of the market.
    An NBBO is critical to the National Market System because it serve 
as the reference point for almost every options transaction effected on 
the Exchange. An accurate NBBO is essential because it allows market 
makers to compete actively with traders at other markets to offer 
improved pricing, which in turn, allows brokers to compare prices 
across markets to ensure that customers are getting the best prices. 
For example, CBOE's RAES system uses the Exchange's internally 
calculated NBBO to ensure that customer orders executed on RAES are 
executed quickly and at the best available price. Thus, CBOE rules 
generally provide for an automatic execution for customer orders for 
RAES eligible orders at the NBBO, if the NBBO is not more than one 
``tick'' better than the prevailing price at CBOE. If the NBBO is more 
than one ``tick'' better than the current CBOE price, however, the 
order is removed from the RAES system and is routed to the trading 
floor for manual handling.
    If the NBBO includes ``unreliable'' quotes, i.e., quotes that do 
not accurately reflect prevailing quotes at another market, and such 
unreliable quotes are more than one tick better than CBOE's quotes, 
customer orders will be removed from CBOE's RAES system. According to 
the CBOE, such orders will not be executed at the quoted NBBO, however, 
because no market actually will be trading at the unreliable NBBO 
quote. The presence of the unreliable quote in the NBBO therefore 
needlessly will deprive the customer of a fast, automatic execution 
through RAES. In fact, depending on the speed and direction of the 
market's movement, a rejected order may end up being executed at a 
price inferior to the CBOE's market at the time the order was entered. 
An incorrect NBBO may even prevent a customer order from being filled 
at all. For example, if a customer submitted a RAES-eligible marketable 
limit order, but the order was removed from RAES because of an 
unreliable quote in the NBBO that was more than one tick better than 
CBOE's quote, the market may move away from the customer's limit order 
price during the process of rerouting and manual handling of the 
customer's order. As a result, the customer's order may not get filled 
at all, or may receive a price less favorable than what would have been 
obtained had the customer's order been executed on RAES without the 
``unreliable'' quotes.
    The presence of unreliable quotes in the NBBO calculation therefore 
harms public customers, and it is the goal of the proposed rule change, 
as amended, to clarify the procedures for preventing such harm by 
removing unreliable quotes from the NBBO.

Specific Criteria for Unreliability Determinations

    As indicated in new Subsection .02(A)(I) of the proposed rule 
change, as amended, two Floor Officials may determine that quotes in 
one or more particular option classes in a market are not reliable and 
thus may be excluded from the NBBO determination under any of the 
following circumstances:
    (a) Where a market confirms that its quotes are not firm based upon 
direct communication to CBOE from the market or the disssemination 
through OPRA of a message indicating that disseminated quotes are not 
firm;
    (b) Where a market directly communicates to CBOE or otherwise 
confirms that it is experiencing systems or other problems affecting 
the reliability of its disseminated quotes;
    (c) Where one or more Floor Officials observe that six or more 
option series in a particular options class are crossed or locked with 
the disseminated quotes of two or more other markets, and continue to 
be crossed or locked for 30 seconds or more, provided that the quotes 
are crossed or locked at the time Floor Officials determine to exclude 
the unreliable quote from the RAES determination of the NBBO; or
    (d) Where a Floor Official observes any of the following:
    (1) One or more orders originating from an Exchange DPM or market-
maker for a particular options class that are filled by the market at a 
worse price than its disseminated quote without a required quote 
change;
    (2) One or more market orders or marketable limit orders 
originating from an Exchange DPM or market-maker for a particular 
options class that are confirmed to be unfilled or partially unfilled 
by the market without a required quote change; or
    (3) One or more market orders or marketable limit orders 
originating from an Exchange DPM or market-maker for a particular 
options class partially filled by a ``responsible broker or dealer'' at 
a worse price than its disseminated quote, followed by a quote change 
and a redisplay of the previously disseminated quote by the same 
``responsible broker or dealer'' in less than 30 seconds.
    The Exchange believes that proposed new subsections I(a)-(d) to 
Interpretation .02 to Rule 6.8 provide Floor Officials with specific, 
objective criteria when making a determination that another market's 
quote are unreliable. In addition, the Exchange believes that the 
criteria set forth above are consistent with recent amendments to Rule 
11Ac1-1 under the Act,\7\ which require options exchanges and options 
market makers to publish firm quotes.\8\ Specifically, in new 
subsections I(a) and (b), two Exchange Floor Officials may determine 
that another market's quotes are not reliable based on direct 
communication from that other market that its quotes are not firm or 
that it is experiencing systems or other problems affecting the 
reliability of its disseminated quotes.
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    \7\ 17 CFR 240.11Ac1-1.
    \8\ Securities Exchange Act Release No. 43591 (November 17, 
2000), 65 FR 75439 (December 1, 2000).
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    In new subsection I(c), two Exchange Floor Officials may determine 
that another market's quotes are not reliable only after one or more 
Floor Officials observe that six or more option series in a particular 
options class are crossed or

[[Page 950]]

locked with the disseminated quotes of two of more other markets, and 
continue to be crossed or locked for 30 seconds or more, provided that 
the quotes are crossed or locked at the time Floor Officials determine 
to exclude the unreliable quote from RAES determination of the NBBO. In 
new subsection I(d), two Exchange Floor Officials may determine that 
another market's quotes are not reliable only after one or more Floor 
Officials observe certain specific action with respect to the execution 
of orders originating from CBOE Designated Primary Market-makers or 
market-makers.
    The Exchange believes that the objective criteria set forth in new 
subsection I provide an appropriate basis for Floor Officials to make a 
determination that another market's quotes are not reliable.

Procedures for Applying the Criteria

    In developing these objective criteria for determining that another 
market's quotes are not reliable and, thus, may be excluded from the 
RAES determination of the NBBO, the Exchange has vested complete 
authority to make such determinations with Exchange Floor Officials. 
The market participants who are impacted by unreliable quotes have no 
authority or power to make determinations of unreliability.
    As specified in Subsection (a)II, in all instances where Floor 
Officials exclude a market or any of its quotes from the RAES 
determination of the NBBO due to quote unreliability, the Exchange 
Control Room will promptly notify the market of the action and continue 
to actively monitor the reliability of the excluded quotes in 
consultation with Floor Officials. Any determination to exclude a 
market or any of its quotes pursuant to Subsections I(a) and (b) will 
expire at the end of the trading day, or at such time as the quotes are 
confirmed by the market to be reliable again--whichever occurs first.
    Any determination to exclude a market or any of its quotes pursuant 
to Subsections I(c) and (d) will expire not later than 30 minutes after 
the initial determination, unless two Floor Officials determine that 
the excluded quotes continue to be unreliable, in which case the quotes 
will continue to be excluded for an additional period of time not to 
exceed 30 minutes pending further Floor Official review. This 
provisions is consistent with CBOE Rule 8.51(e)(iv),\9\ which similarly 
requires CBOE Floor Officials to monitor options classes that are in 
non-firm mode every 30 minutes. Under CBOE Rule 8.51(e)(iv), 
continuation of the non-firm mode for longer than 30 minutes requires 
that Floor Officials reaffirm that the conditions which formed the 
basis for the determination to operate in non-firm mode continue to be 
present. Exclusion of a market or its quotes from the RAES 
determination of the NBBO will be reported to Exchange member firms.
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    \9\ CBOE Rule 8.51(e)(iv) states that ``[d]uring any period that 
the market in a reported security is in a non-firm mode, the Floor 
Officials shall monitor the activity or condition, which formed the 
basis for their determination. No more than 30 minutes after such 
market has been designated to be in a non-firm mode, the DPM shall 
review the condition of such market with the Floor Officials. 
Continuation of the non-firm mode for longer than 30 minutes shall 
require the reaffirmation of the reviewing Floor Officials. Such 
review and reaffirmation shall occur not less frequently than every 
30 minutes thereafter while the non-firm mode is in effect.''
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    Also, CBOE rules currently provide that CBOE will document in its 
Control Room log any action taken to disengage RAES or to operate RAES 
in a manner other than normal, the option classes affected by such 
action, the time such action was taken, the Exchange officials who 
undertook such action, and the reasons why such action was taken.\10\ 
As a result, any determination by Floor Officials to exclude unreliable 
quotes from the RAES determination of the NBBO in particular option 
classes pursuant to subsections I(a) through (d) of Interpretation .02 
will be documented in the Exchange's Control Room log.
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    \10\ CBOE Rule 6.8, Interpretation .08.
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    As also indicated, this proposal relabels a portion of the previous 
Interpretation .02(a) text as .02(b) for greater ease of reference and 
relabels the previous Interpretation .02(b) text as .02(c).
2. Statutory Basis
    CBOE believes that the proposed rule change, as amended, is 
consistent section 6(b) of the Act,\11\ in general, and further the 
objectives of Section 6(b)(5),\12\ in particular. By setting forth 
specific criteria that will be used to protect the integrity of the 
Exchange's NBBO calculations, public customers will receive better 
executions of their orders more frequently. This will improve the 
efficiency of RAES, thereby removing impediments to, and perfecting the 
mechanism of, a free and open market and a national market system, and 
thus protecting investors and the public interest.
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    \11\ 15 U.S.C. 78f(b).
    \12\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The CBOE does not believe that the proposed rule change, as 
amended, will impose any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act.

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

    The Exchange has neither solicited nor received written comments on 
the proposed rule change, as amended.

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

    Within 35 days of the publication of this notice in the Federal 
Register or within such other period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the CBOE consents, the Commission will:
    (A) By order approve the proposed rule change, as amended, or
    (B) Institute proceedings to determine whether the proposed rule 
change, as amended, should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether Amendment No. 2 
is consistent with the Act. The Commission notes, in particular, that 
CBOE is a party to the intermarket options market linkage plan 
(``Linkage Plan'') approved by the Commission in July 2000.\13\ The 
Commission specifically seeks comment on the potential implications of 
this proposal on the implementation and operation of the Linkage Plan. 
Specifically, the Commission seeks comment on whether proposed 
Amendment No. 2 is consistent with the requirements of the linkage 
Plan.
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    \13\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000).
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    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

[[Page 951]]

the Commission's Public Reference Room. Copies of such filing will also 
be available for inspection and copying at the principal office of the 
CBOE. All submissions should refer to File Number SR-CBOE-99-45 and 
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should be submitted by January 24, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-2(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-403 Filed 1-7-02; 8:45 am]
BILLING CODE 8010-01-M