[Federal Register Volume 67, Number 22 (Friday, February 1, 2002)]
[Notices]
[Pages 5016-5018]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-2489]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45341; File No. SR-CBOE-00-42]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment No. 2 to the Proposed Rule Change by the Chicago Board 
Options Exchange, Inc. Eliminating the Obligation of Designated Primary 
Market Makers to Accord Priority to Non-Public Customer Orders

January 25, 2002.

I. Introduction

    On August 29, 2000, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to eliminate the obligation of 
Designated Primary Market Makers (``DPMs'') to accord priority to non-
public customers over the DPMs' principal transactions. The proposed 
rule change was published for comment in the Federal Register on 
December 4, 2001.\3\ The Commission received no comments on the 
proposal. On January 8, 2002, the CBOE submitted Amendment No. 1 to the 
proposed rule change.\4\ On January 16, 2002, the CBOE submitted 
Amendment No. 2 to the proposed rule change.\5\ This order approves the 
proposal, as amended by Amendment No. 2. The Commission also solicits 
comment on Amendment No. 2 from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 45013 (November 26, 
2001), 66 FR 63083.
    \4\ See letter from Steve Youhn, Legal Department, CBOE to Kelly 
Riley, Senior Special Counsel, Division of Market Rgulation 
(``Division''), Commission, dated January 7, 2002 (``Amendment No. 
1''. In Amendment No. 1, the CBOE proposed a definition of ``public 
customer orders.''
    \5\ See letter from Steve Youhn, Legal Department, CBOE to Kelly 
Riley, Seniro Special Counsel, Division, Commission, dated January 
14, 2002 (``Amendment No. 2''). In Amendment NO. 2 CBOE proposed to 
define the term ``public customer'' in proposed Interpretation .03 
of CBOE Rule 8.85. Amendment No. 2 supersedes and replaces Amendment 
No. 1 in its entirety. Telephone conversation between Steven Youhn, 
Legal Division, CBOE, and Kelly Riley, Senior Special Counsel, 
Division, Commission, on January 14, 2002. On January 18, 2002, CBOE 
consented to an extension of time for Commission action until 
January 25, 2002. See letter from Steve Youhn, Legal Department, 
CBOE, to Kelly Riley, Senior Special Counsel, Division, Commission, 
dated January 18, 2002.

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[[Page 5017]]

II. Description of the Proposal

    The CBOE proposes to amend CBOE Rule 8.85 (DPM Obligations) 
regarding the obligations of DPMs to represent orders. Currently, CBOE 
Rule 8.85(b)(iii) requires a DPM to accord priority to any order, that 
the DPM represents as agent over the DPM's principal transactions, 
unless the customer who placed the order has consented to not being 
accorded such priority. The CBOE proposes to amend CBOE Rule 
8.85(b)(iii) to require DPMs to accord priority only to public customer 
orders. In Amendment No. 2 the CBOE proposes to add Interpretation .03 
to CBOE Rule 8.85 to define a public customer order as not including 
any order in which a member, non-member participant in a joint venture 
with a member, or any non-member broker dealer has an interest. 
Accordingly, CBOE proposes to exclude these orders from a DPM's 
obligation under Exchange rules to accord priority.

III. Commission Findings and Order Granting Accelerated Approval of 
the Proposed Rule Change

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\6\ The Commission's approval of CBOE's proposal to 
amend its Rule 8.85 to eliminate a DPM's obligation, pursuant to CBOE 
rules, to accord priority under all circumstances to certain orders is 
based solely on its determination that this proposed rule change is 
consistent with the Act and the rules and regulations thereunder 
applicable to a national securities exchange. The Commission is making 
no determination as to whether a DPM's failure to accord priority to 
non-public customer orders, when the DPM is acting as an agent, is 
consistent with the federal securities laws or any other applicable 
law. Accordingly, the Commission's approval of CBOE's proposal does not 
affect a DPM's fiduciary obligations under federal securities laws or 
agency law principles when it acts as an agent.\7\
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    \6\ 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).
    \7\ Pursuant to agency law principles, a DPM that acts as agent 
for any customer has an obligation to act solely for the benefit of 
the customer in all matters connected with the customer's order, see 
Restatement (Second) of Agency Sec. 387 (1958), and not compete with 
the customer concerning the customer's order unless the customer 
understands its agent is to compete, see Restatement (Second) of 
Agency Sec. 393 (1958). See also In re E.F. Hutton & Company, 
Securities Exchange Act Release No. 25887 (July 6, 1988) (``Manning 
Decision''). In its opinion, the Commission noted that ``absent 
disclosure and a contrary agreement a fiduciary cannot compete with 
his beneficiary with respect to the subject matter of their 
relationship * * *''.
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    Currently, by requiring DPMs to accord priority to all customer 
orders pursuant to its Rule 8.85, unless the customer who placed the 
order has consented to not being accorded such priority, the CBOE 
creates an obligation on DPMs under Exchange rules in addition to the 
DPM's obligations under Federal securities laws and agency law. 
Accordingly, the result of CBOE's proposal is to no longer make a DPM's 
failure to accord priority to non-public customer orders for which it 
acts as agent a CBOE rule violation. The CBOE's proposal, however, does 
not affect a DPM's obligations to orders for which it acts as agent 
under Federal securities laws or any other applicable laws.
    The Commission found in its Manning Decision that broker-dealers 
owe a fiduciary duty to their limit order customers not to trade ahead 
of these orders unless the customer knows of the firm's limit order 
policy.\8\ After the Commission issued its Manning Decision, the NASD 
filed a proposed rule change stating that a member firm would not be 
deemed to violate NASD Rules of Fair Practice if it provides to 
customers a statement setting forth the circumstances in which the firm 
accepts limit orders and the policies and procedures the firm follows 
in handling these orders.\9\ As part of this filing, the NASD proposed 
model disclosure language to be used by firms whose policy was not to 
grant priority to customer limit orders over the member's own 
proprietary trading.
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    \8\ See supra note 7.
    \9\ See Securities Exchange Act Release No. 26824 (May 15, 
1989), 54 FR 22046 (May 22, 1989).
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    This proposal was never approved by the Commission and was 
withdrawn by the NASD at the time it submitted a proposed rule change 
to prohibit member firms from trading ahead of their customers' limit 
orders in their market making capacity.\10\ In approving this 
subsequent NASD proposal, the Commission expressed concern that the 
prohibition did not extend to trading ahead of limit orders of other 
firms' customers that had been sent to the market maker for 
execution.\11\ Shortly thereafter, the Commission proposed its own rule 
to prohibit any market maker in Nasdaq National Market securities from 
trading ahead of the orders of other firms' customers sent to it for 
execution.\12\
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    \10\ See Securities Exchange Act Release No. 33697 (March 1, 
1994), 59 FR 45 (March 8, 1994) (``Manning I'').
    \11\ See Securities Exchange Act Release No. 34279 (June 29, 
1994), 59 FR 34883 (July 7, 1994). See also Division of Market 
Regulation, SEC, Market 2000: An Examination of Current Equity 
Market Developments, V-8 (1994).
    \12\ See Securities Exchange Act Release No. 34753 (September 
29, 1994), 59 FR 50867 (October 6, 1994). The Commission's proposal 
was never adopted.
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    Shortly after the Commission's publication of its proposal, the 
NASD filed a proposed rule change to prohibit its member firms from 
trading ahead of the orders of other firms' customers, which the 
Commission approved.\13\ In its approval order of Manning II, the 
Commission also noted that:
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    \13\ See Securities Exchange Act Release No. 35751 (May 22, 
1995), 60 FR 27997 (May 26, 1995) (``Manning II'').
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    ``In a typical agency relationship, disclosure often is relied upon 
as an adequate means of resolving a conflict of interest between an 
agent and its principal. Cite omitted. Investors enjoy greater 
protection under the federal securities laws, however, than that 
afforded by common law; a general common law remedy of disclosure does 
not always suffice.\14\ A stricter duty may be imposed where, as here, 
the principles are investors and the agents control access to the 
trading market.''
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    \14\ See e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 389 
(1983) (``An important purpose of the federal securities statutes 
was to rectify perceived deficiencies in the available common law 
protection by establishing higher standards of conduct in the 
securities industry.'').
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    While the NASD's limit order protections only extend to non-broker-
dealer customers, the Commission questioned why the provisions of the 
rule should not be extended to limit orders placed by other broker-
dealers, including options specialists and registered options traders. 
Further, the Commission specifically noted that it expected the NASD to 
consider extending the scope of limit order protections to orders of 
options specialists and market makers.\15\
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    \15\ See Manning II, supra note 12.
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    More recently, the Commission approved a New York Stock Exchange 
(``NYSE'') proposal to prohibit NYSE members from trading along with 
their customers except in limited circumstances.\16\ NYSE Rule 92 
significantly restricts NYSE members'

[[Page 5018]]

ability to enter orders to buy or sell NYSE-listed securities for any 
account in which such member is interested, if the person responsible 
for the entry of such order has knowledge of any particular unexecuted 
customer order to buy or sell the same security that could be executed 
at the same price. In its approval order, the Commission noted that 
proprietary trading exceptions ``did not minimize the importance of a 
broker-dealers' duty to their customers, which requires broker-dealers 
to place investors' interests before their own. On the contrary,'' the 
Commission continued, ``member and member organizations remain 
obligated to consider their customers' interest in every customer 
transaction.'' \17\
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    \16\ See Securities Exchange Act Release No. 44139 (March 30, 
2001), 66 FR 18339 (April 6, 2001). Specifically, members are only 
permitted to enter certain types of proprietary orders, such as 
liquidating positions in proprietary facilitation accounts, bona 
fide hedges, bona fide arbitrages and risk arbitrages, while 
representing a customer's order that could be executed at the same 
price, so long as the order is not for an individual investor and 
the customer has given express permission, which must include an 
understanding of the relative price and size of the allocated 
execution reports.
    \17\ See supra note 16.
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Amendment No. 2

    The Commission finds good cause, consistent with Section 19(b)(2) 
of the Act,\18\ to approve Amendment No. 2 to the proposed rule change 
prior to the thirtieth day after the date of publication of notice of 
filing thereof in the Federal Register. The Commission notes that the 
notice that was published in the Federal Register \19\ discussed CBOE's 
intent to define ``public customer orders.'' Therefore, the CBOE's 
proposed definition was subject to notice and comment. Accordingly, the 
Commission believes good cause exists, pursuant to Sections 6(b)(5) and 
19(b) of the Act \20\ to accelerate approval of Amendment No. 2 to the 
proposed rule change.
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    \18\ 15 U.S.C. 78s(b)(2).
    \19\ See supra note 3.
    \20\ 15 U.S.C. 78f(b)(5) and 15 U.S.C. 78s(b).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 2, including whether it 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 CBOE. All 
submissions should refer to File No. SR-CBOE-00-42 and should be 
submitted by February 22, 2002.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-CBOE-00-42) is approved.
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    \21\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-2489 Filed 1-31-02; 8:45 am]
BILLING CODE 8010-01-P