[Federal Register Volume 67, Number 74 (Wednesday, April 17, 2002)]
[Notices]
[Pages 18975-18977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-9308]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45737; File No. SR-PCX-00-45]


Self Regulatory Organizations; Pacific Exchange, Inc.; Order 
Approving Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval to Amendment No. 1 to the Proposed Rule Change 
Relating to the Expansion of the Equity Hedge Exemption From Position 
and Exercise Limits

April 11, 2002.

I. Introduction

    On December 11, 2000, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``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 expand the current equity hedge exemption to 
eliminate position and exercise limits for certain qualified hedge 
strategies. The proposed rule change was published for comment in the 
Federal Register on August 17, 2001.\3\ The Commission received no 
comments on the proposal. On April 9, 2002, the PCX submitted Amendment 
No. 1 to the proposal.\4\
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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. 44680 (August 10, 
2001), 66 FR 43283.
    \4\ See Letter from Cindy Sink, Senior Attorney, Regulatory 
Policy, PCX, to John Riedel, Attorney, Division of Market 
Regulation, Commission, dated April 9, 2002 (``Amendment No. 1''). 
In Amendment No. 1, the PCX established a position and exercise 
limit equal to no greater than five times the standard limit for 
those hedge strategies that include an OTC option component.
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II. Description of the Proposal

    The Exchange is proposing to eliminate position and exercise limits 
when certain qualified strategies are employed to establish a hedged 
equity option position and to establish a position and exercise limit 
of five times the standard limit for those strategies that include an 
OTC option contract. Accordingly, the PCX proposes to amend Commentary 
.07 of Exchange Rule 6.8(a) to expand the definition of a ``qualified'' 
hedged position. The proposed qualified hedged strategies are as 
follows:
    1. Where each option contract is ``hedged'' by the number of shares 
underlying the option contract or securities convertible into the 
underlying security or, in the case of an adjusted option, the same 
number of shares represented by the adjusted contract: (a) Long call 
and short stock; (b) short call and long stock; (c) long put and long 
stock; or (d) short put and short stock.
    2. Reverse Conversions--A long call position accompanied by a short 
put position, where the long call expires with the short put and the 
strike price of the long call and short put is the same, and where each 
long call and short put contract is hedged with 100 shares (or other 
adjusted number of shares) of the underlying security or securities 
convertible into such underlying security.\5\
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    \5\ For these strategies one of the option components can be an 
OTC option guaranteed or endorsed by the firm maintaining the 
proprietary position or carrying the customer account. Hedge 
transactions and positions established pursuant to these strategies 
and using an OTC option contract as part of the hedge are subject to 
a position limit equal to five times the standards limit established 
under Commentary .05 to PCX Rule 6.8(a). For purposes of this rule 
filing, an OTC option contract is defined as an option that is not 
listed on a National Securities Exchange or cleared at the Options 
Clearing Corporation.
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    3. Conversions--A short call position accompanied by a long put 
position, where the short call expires with the long put and the strike 
price of the short call and long put is the same, and where each short 
call and long put contract is hedged with 100 shares (or other adjusted 
number of shares) of the underlying security or securities convertible 
into such underlying security.\6\
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    \6\ Id.
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    4. Collars--A short call position accompanied by a long put 
position, where the short call expires at the same time as the long put 
and the strike price of the short call equals or exceeds the strike 
price of the long put position and where each short call and long put 
position, is hedged with 100 shares of the underlying security (or 
other adjusted number of shares).\7\ Neither side of the short call/
long put position can be in-the-money at the time the position is 
established.
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    \7\ Id.
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    5. Box Spreads--A long call position accompanied by a short put 
position, where both the long call and short put have the same strike 
price, and a short call position accompanied by a long put position, 
where the short call and long put have the same strike price as each 
other, but a different strike price than the long call/short put 
position.
    6. Back-to-Back Options--A listed option position hedged on a one-
for-one basis with an over-the-counter (``OTC'') option position on the 
same underlying security.\8\ The strike price of the listed

[[Page 18976]]

option position and corresponding OTC option position must be within 
one strike price interval of each other and no more than one expiration 
month apart.
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    \8\ Hedge transactions and positions established pursuant to 
this strategy are subject to a position limit equal to five times 
the standards limit established under Commentary .05 to PCX Rule 
6.8(a).
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    For reverse conversion, conversion and collar strategies, one of 
the option components can be an OTC option guaranteed or endorsed by 
the firm maintaining the proprietary position or carrying the customer 
account.
    Within the list of proposed hedge strategies eligible for the 
equity hedge exemption, the Exchange proposes that the option component 
of a reversal, a conversion or a collar position can be treated as one 
contract rather than as two (2) contracts. All three strategies serve 
to hedge a related stock portfolio. Because these strategies require 
the contemporaneous \9\ purchase/sale of both a call and put component, 
against the appropriate number of shares underlying the option 
(generally 100 shares) the Exchange believes that the position should 
be treated as one contract for hedging purposes.
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    \9\ At or about the same time.
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    Under the proposed rule change, the standard position and exercise 
limits will remain in place for unhedged equity option positions. Once 
an account nears or reaches the standard limit, positions identified as 
a qualified hedge strategy will be exempted from position limit 
calculations. The exemption will be automatic (i.e. does not require 
pre-approval from the Exchange) to the extent that the member 
identifies that a pre-existing qualified hedge strategy is in place or 
is employed from the point that an account's position reaches the 
standard limit and provides the required supporting documentation to 
the Exchange.
    The exemption will remain in effect to the extent that the exempt 
positions remain intact and the Exchange is provided with any required 
supporting documentation. Procedures to demonstrate that the option 
position remains qualified are similar to those currently in place. 
Exchange procedures currently require a qualified account to report to 
the Exchange hedge information each time the option position changes. 
Hedge information for member firm and customer accounts having 200 or 
more contracts are electronically reported via the Large Options 
Positions Report. Market maker account information is also reported to 
the Exchange electronically by the member's clearing firm. The existing 
requirement imposed on member firms to report hedge information for 
proprietary and customer accounts that maintain an options position in 
excess of 10,000 contracts will continue to apply.

III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange \10\ and, in 
particular, the requirements of section 6 of the Act \11\ and the rules 
and regulations thereunder. The Commission finds specifically that the 
proposed rule change is consistent with section 6(b)(5) of the Act \12\ 
in that it is designed to promote just and equitable principles of 
trade, to foster cooperation and coordination with persons engaged in 
facilitating transactions in securities, and to remove impediments to 
and perfect the mechanism of a free and open market and a national 
market system.
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    \10\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f.
    \12\ 15 U.S.C. 78f(b)(5).
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    Position and exercise limits serve as a regulatory tool designed to 
address potential manipulative schemes and adverse market impact 
surrounding the use of options. In general, the Commission has taken a 
gradual, evolutionary approach toward expansion of position and 
exercise limits. The Commission has been careful to balance two 
competing concerns when considering the appropriate level at which to 
set position and exercise limits. The Commission has recognized that 
the limits must be sufficient to prevent investors from disrupting the 
market in the component securities comprising the indexes. At the same 
time, the Commission has determined that limits must not be established 
at levels that are so low as to discourage participation in the options 
market by institutions and other investors with substantial hedging 
needs or to prevent specialists and market makers from adequately 
meeting their obligations to maintain a fair and orderly market.\13\
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    \13\ Id.
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    The Commission has carefully considered the PCX's proposal to 
expand the hedge exemption from position and exercise limits. Given the 
market neutral characteristic of all the proposed qualified hedge 
strategies (except covered stock positions), the Commission believes it 
is permissible to expand the current equity hedge exemption without 
risk of disruption to the options or underlying cash markets. 
Specifically, the Commission believes that existing position and 
exercise limits, procedures for maintaining the exemption, and the 
reporting requirements imposed by the Exchange will help protect 
against potential manipulation. The Commission notes that the existing 
standard position and exercise limits will remain in place for unhedged 
equity option positions. To further ensure against market disruption, 
the PCX will establish a position and exercise limit equal to no 
greater than five times the standard limit for those hedge strategies 
that include an OTC option component.
    Once an account nears or reaches the standard limit, positions 
identified as one or more of the proposed qualified hedge strategies 
will be exempted from limit calculations. Although the exemption will 
be automatic (i.e., does not require pre-approval from the Exchange), 
the exemption will remain in effect only to the extent that the 
exempted position remains intact and that the Exchange is provided with 
any required supporting documentation.
    In addition, as described above, a qualified account must report 
hedge information each time the option position changes. Hedge 
information for member firm and customer accounts are reported to the 
Exchange electronically, via the Large Options Position Report. Market 
maker account information is also reported to the Exchange 
electronically by the member's clearing firm. For those option 
positions that do not change, a filing is generally required on a 
weekly basis. Finally, the existing requirement imposed on member firms 
to report hedge information for proprietary and customer accounts that 
maintain an options position in excess of 10,000 contracts will remain 
in place.
    The Commission believes these reporting requirements will help the 
PCX to monitor options positions and ensure that only qualified hedges 
are being exempt from position and exercise limits. To the extent that 
any position raises concerns, the Commission believes that the PCX, 
through its monitoring, will be promptly notified, and the Commission 
would expect the PCX to take any appropriate action, as permitted by 
its rules.
    Finally, the Commission notes that the proposal, as amended, is 
substantially identical to proposed rule changes submitted by the 
Chicago Board Options Exchange, Inc. (``CBOE'') and the American Stock 
Exchange LLC (``Amex''), which the Commission has

[[Page 18977]]

approved.\14\ The Commission does not believe that the proposed rule 
changes raises novel regulatory issues that were not already addressed 
and should benefit Exchange members by permitting them greater 
flexibility in using hedge strategies advantageously, while providing 
an adequate level of protection against the opportunity for 
manipulation of these securities and disruption in the underlying 
market.
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    \14\ See Securities Exchange Act Release No. 45650 (March 26, 
2002), 67 FR 15638 (April 2, 2002) (SR-Amex-2001-72); Securities 
Exhange Act Release No. 44503 (March 20, 2002), 67 FR 14751 (March 
27, 2002) (SR-CBOE-00-12).
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    The Commission finds good cause, pursuant to section 19(b)(2) of 
the Act,\15\ for approving Amendment No. 1 to the proposal prior to the 
thirtieth day after the date of publication of notice of filing thereof 
in the Federal Register. Amendment No. 1 establishes a position and 
exercise limit equal to no greater than five times the standard limit 
for those hedge strategies that include an OTC option component. 
Setting the position and exercise limit at this level should provide 
Exchange members greater flexibility in using hedge strategies 
advantageously, while providing an adequate level of protection against 
the opportunity for manipulation of these securities and disruption in 
the underlying market. Accordingly, the Commission finds good cause, 
consistent with sections 6(b)(5) \16\ and 19(b)(2) \17\ of the Act to 
accelerate approval of Amendment No. 1 to the proposed rule change.
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    \15\ 15 U.S.C. 78s(b)(2).
    \16\ 15 U.S.C. 78f(b)(5).
    \17\ 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. 1, 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 PCX. All 
submissions should refer to File No. SR-PCX-00-45 and should be 
submitted by May 8, 2002.

V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\18\ that the proposed rule change (File No. SR-PCX-00-45), as 
amended, be and hereby is, approved.
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    \ 18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-9308 Filed 4-16-02; 8:45 am]
BILLING CODE 8010-01-P