[Federal Register Volume 68, Number 1 (Thursday, January 2, 2003)]
[Notices]
[Pages 141-144]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-33119]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47090; File No. SR-Phlx-2002-75]


Self-Regulatory Organizations; Notice of Filing and Immediate 
Effectiveness of Proposed Rule Change and Amendment No. 1 Thereto by 
the Philadelphia Stock Exchange, Inc. Relating to Its Payment for Order 
Flow Program

December 23, 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 15, 2002, the Philadelphia Stock Exchange, Inc. (``Phlx'') 
filed with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I, II, and III, below, which 
the Phlx has prepared. On December 23, 2002, the Phlx filed Amendment 
No. 1 to the proposed rule change, which replaced the original filing 
in its entirety. The Commission is publishing this notice to solicit 
comments from interested persons on the proposed rule change, as 
amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Phlx proposes to amend its schedule of dues, fees, and charges 
to reinstate an options payment for order flow program. The text of the 
proposed rule change is available at the principal offices of the Phlx 
and at the Commission.

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

    In its filing with the Commission, the Phlx included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it had received. The text of these statements 
may be examined at the places specified in Item IV below. The Phlx has 
prepared summaries, set forth in sections A, B, and C below, of the 
most significant aspects of such statements.

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

1. Purpose
    The purpose of the proposed rule change is to generate a source of

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revenue that specialists may use to attract order flow to the Phlx, and 
to maintain and enhance the Phlx's competitive position. The Phlx notes 
that two other options exchanges currently have payment for order flow 
programs.\3\
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    \3\ The Phlx states that two other options exchanges currently 
have payment for order flow programs. See Securities Exchange Act 
Release Nos. 46485 (September 10, 2002), 67 FR 58668 (September 17, 
2002) (SR-PCX-2002-59); and 45857 (May 1, 2002), 67 FR 30988 (May 8, 
2002) (SR-ISE-2002-12).
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    The Phlx first instituted a payment for order flow fee in August 
2000, imposing a $1.00 per contract fee, with some exceptions, on 
transactions of Phlx specialists and ROTs in the top 120 options on the 
Phlx.\4\ The top 120 options were the 120 most actively traded equity 
options, based on national trading volume. The Phlx recalculated the 
list of top 120 options every six months, based on volume information 
that the Options Clearing Corporation provided.\5\ The payment for 
order flow fee did not apply to index or foreign currency options. The 
Phlx later suspended the imposition of payment for order flow fees.\6\
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    \4\ See Securities Exchange Act Release No. 43177 (August 18, 
2000), 65 FR 51889 (August 25, 2000) (SR-Phlx-00-77). Transactions 
in top 120 options that were excepted from the $1.00 fee were 
transactions between: (1) a specialist and a ROT; (2) a ROT and a 
ROT; (3) a specialist and a firm; (4) a ROT and a firm; (5) a 
specialist and a broker-dealer; and (6) a ROT and a broker-dealer. 
See Securities Exchange Act Release Nos. 43177 (August 18, 2000), 65 
FR 51889 (August 25, 2000) (SR-Phlx-00-77); 43480 (October 25, 
2000), 65 FR 66275 (November 3, 2000) (SR-Phlx-00-86 and SR-Phlx-00-
87); and 43481 (October 25, 2000), 65 FR 66277 (November 3, 2000) 
(SR-Phlx-00-88 and SR-Phlx-00-89).
    \5\ For the period from April 2, 2001 through June 30, 2001, 
there was a total of 121 Options on the Exchange's list of the top 
120 options when the QQQ options were added to the Exchange's 
payment for order flow fee program prior to the next six-month 
measuring period. See Securities Exchange Act Release No. 44237 
(April 30, 2001), 66 FR 23308 (May 8, 2001) (SR-Phlx-2001-43).
    \6\ See Securities Exchange Act Release No. 44716 (August 16, 
2001), 66 FR 44393 (August 23, 2001) (SR-Phlx-2001-73).
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    The Phlx is now proposing to impose a payment for order flow fee, 
per-contract, per-issue, on the transactions of Phlx Registered Options 
Traders (``ROTs''),\7\ as set forth in the Phlx's ROT Equity 
OptionPayment for Order Flow Charges Schedule and subject to the 
exceptions listed below. The fee would be assessed on ROTs on the top 
120 most actively traded equity options in terms of the total number of 
contracts that are traded nationally, based on volume statistics 
provided by the Options Clearing Corporation.\8\ Initially, for trade 
months November, December, and January, the payment for order flow fee 
assessed on ROTs would be $1.00 on the top-ranked option, the Nasdaq-
100 Index Tracking Stock\sm\ (which trades under the symbol 
``QQQ'').\9\ The fee on the next 49 options would be $0.50, and the 
remaining top 120 options would be assessed $0.00.\10\ After the 
January 2003 trade month, the Chairman of the Phlx would establish the 
fees in $0.05 increments after receiving recommendations from a payment 
for order flow subcommittee of the Finance Committee and a payment for 
order flow subcommittee of the Options Committee.\11\
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    \7\ ROT transactions include those identified as ``on-floor ROT 
orders'' entered through a hand-held device for execution on the 
Phlx trading floor. See Phlx Rule 1080.
    \8\ The measuring periods for the top 120 options would be 
calculated every three months. For example, for trade months 
November, December, and January, the measuring period to determine 
the top 120 options would be based on volume statistics from July, 
August, and September. The subsequent measuring period would be 
October, November, and December for trade months February, March, 
and April. This cycle would continue every three months. Members 
would be notified of the top 120 options and applicable fees 
approximately two weeks before the beginning of a new three-month 
trading period.
    \9\ The Nasdaq-100[reg], Nasdaq-100 Index[reg], Nasdaq[reg], The 
Nasdaq Stock Market[reg], Nasdaq-100 SharesSM, Nasdaq-100 
TrustSM, Nasdaq-100 Index Tracking StockSM, 
and QQQSM are trademarks or service marks of The Nasdaq 
Stock Market, Inc. (Nasdaq) and have been licensed for use for 
certain purposes by the Philadelphia Stock Exchange pursuant to a 
License Agreement with Nasdaq. The Nasdaq-100 Index[reg] (the Index) 
is determined, composed, and calculated by Nasdaq without regard to 
the Licensee, the Nasdaq-100 TrustSM, or the beneficial 
owners of Nasdaq-100 SharesSM. The Phlx represents that 
Nasdaq has complete control and sole discretion in determining or 
calculating the Index or in modifying in any way its method for 
determining or calculating the Index in the future.
    \10\ To avoid confusion, the ROT Equity Option Payment for Order 
Flow Charges Schedule reflects only those options being charged more 
than $0.00.
    \11\ The Phlx will file with the Commission a proposed rule 
change addressed to any changes in its fee schedule. The 
subcommittees and Chairman of the Phlx may take into account the 
following factors when setting payment for order flow rates: (1) 
Trading volume per issue; (2) Phlx market share per option; (3) 
disposition of previous payment for order flow fees collected; (4) 
relative size of the trading crowd; and (5) other such information 
as deemed necessary.
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    In its original proposal, filed with the Commission on November 15, 
2002, the Phlx proposed to impose a 500-contract cap per individual 
cleared side of a transaction. In this Amendment No. 1, which replaces 
the original filing in its entirety, the Phlx proposes to remove the 
500 contract cap after December 31, 2002. Accordingly, the 500 contract 
cap would be in effect for trades executed on or after November 18, 
2002 and settling through December 31, 2002. The Phlx believes that 
keeping the contract cap through December 31, 2002 should minimize 
member confusion as to the applicable date for the contract cap and 
will avoid making costly changes to the billing system for the last six 
trading days of the month of December. The Phlx intends to file a 
separate proposal pursuant to Section 19(b)(2) of the Act to impose the 
500 contract cap for trades settling on or after January 2, 2003.
    The proposed payment for order flow fee would not apply to 
transactions between: (1) A specialist and a ROT; (2) a ROT and a ROT; 
(3) a ROT and a firm; \12\ and (4) a ROT and a broker-dealer. \13\ The 
Phlx continues to believe that these are not the transactions the fee 
is designed to attract. Indeed, because the primary focus of the 
program is to attract order flow from customers, the proposed fee would 
not be imposed on the above-specified transactions. The payment for 
order flow fee would also not apply to index or foreign currency 
options.
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    \12\ For purposes of this filing, a firm is defined as a 
proprietary account of a member firm, and not the account of an 
individual member. Therefore, if a ROT trades with a member firm 
that was effecting trades for its proprietary account and not on 
behalf of customers, the payment for order flow fee would not apply.
    \13\ For purposes of this filing, broker-dealer orders are 
orders, entered from other than the floor of the Phlx, for any 
account (i) in which the holder of beneficial interest is a member 
or non-member broker-dealer or (ii) in which the holder of 
beneficial interest is a person associated with or employed by a 
member or non-member broker-dealer. This includes orders for the 
account of an ROT entered from off-the-floor.
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    The Phlx would bill and collect the fee on a monthly basis and 
account for the funds received from the ROTs by option. The specialist 
units would be able to use the funds collected in relation to a given 
option to make payments to order flow providers for the purpose of 
attracting options orders to the Phlx. \14\ The specialist units for 
each option would establish the amounts to be paid to order flow 
providers in respect of order flow for that option. The specialist 
units would receive these funds after submitting a Phlx form 
identifying the amount of the requested funds. \15\ Because the 
specialist units are not being charged the payment for order flow fee 
for their own transactions, they may not request reimbursement or 
payment for order flow funds in

[[Page 143]]

connection with any transactions to which they were a party.
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    \14\ The Phlx is using the terms ``specialist'' and ``specialist 
unit'' interchangeably here.
    \15\ The purpose of the form is to assist the Phlx in accurately 
accounting for and tracking funds transferred to specialists 
consistent with normal bookkeeping and auditing practices. The 
specialists will certify on the form that the funds requested and 
received are used to reimburse the specialist for payments made in 
connection with attracting order flow to the Phlx, consistent with 
this filing. However, as discussed below, all determinations 
concerning the amount that will be paid for orders and which order 
flow providers shall receive these payments will be made by 
specialists.
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    Under the Phlx's proposed payment for order flow program, 
specialists would request reimbursement for funds that they have paid 
to order flow providers for order flow. Under the Phlx's original 
payment for order flow program, both specialists and ROTs paid the 
payment for order flow fee and then were reimbursed these funds at a 
later date. \16\ Under that program, the specialist both expended funds 
to pay for order flow and also paid into the payment for order flow 
pool by paying the payment for order flow fee, only to request 
reimbursement at a later date, thereby reimbursing themselves, in part, 
for funds collected from themselves. The Phlx believes that this 
resulted in an unfair and unnecessary burden on specialists because 
they expended funds twice, until they were able to claim reimbursement.
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    \16\ See Securities Exchange Act Release No. 43177 (August 18, 
2000), 65 FR 51889 (August 25, 2000) (SR-Phlx-00-77)).
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    Under the proposed program, the Phlx would not charge the 
specialists the payment for order flow. The Phlx believes that the 
proposed program would achieve an economic effect similar to the old 
program, without the financial burden on specialists. Under the terms 
of the proposed program, specialists may request reimbursement for 
payment for order flow funds in connection with any transactions to 
which they were not a party, based on the percentage of ROT monthly 
volume to total specialist and ROT monthly volume. For example, if the 
monthly volume in an option to which the specialist was a party was 
100,000 contracts and the monthly volume in that same option to which 
ROTs were a party was 75,000 contracts, the specialist may receive up 
to 43 percent of the total requested reimbursement amount (75,000/
175,000). This amount may be further limited by the amount collected in 
the payment for order flow pool for that option, as specialists may not 
receive more than the amount collected from the ROTs. The Phlx believes 
that this methodology should help to ensure that ROTs are not unfairly 
burdened by paying the payment for order flow fee.
    In the proposed program, the specialists would make all 
determinations concerning the amount to be paid for orders and the 
order flow providers that should receive the payments. The specialists 
would account to the Phlx for the use they make of the funds. The Phlx 
believes that this would help it to determine the effectiveness of the 
proposed fee. In addition, the Phlx would provide certain 
administrative duties to assist the specialists, including keeping 
track of the number of qualified transactions \17\ that firms execute 
on the Phlx and performing any necessary accounting functions.
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    \17\ The term ``qualified transactions'' refers to transactions 
by ROTs on which a payment for order flow fee is assessed.
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    In addition, in connection with its payment for order flow program, 
the Phlx intends to rebate to ROTs, on a monthly basis, the amount of 
payment for order flow fees that the specialists have not requested for 
use in paying order flow providers.\18\ The amount to be refunded to 
each ROT would be based on the percentage of the total payment for 
order flow charges the ROT paid for each option during the rebate time 
period. The ROTs percentage of the total payment for order flow charges 
for each option would then be multiplied by the rebate amount. For 
example, if a ROT contributed 5% of the total payment for order flow 
charges for a particular option during the rebate time period, the ROT 
would receive 5% of that option's overall rebate amount for that month.
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    \18\ The Phlx will not rebate more than the amount that has 
actually been collected from the ROTs.
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    The Phlx will continue to implement a quality of execution 
program.\19\ Any changes to the options to which this proposed fee 
applies, to the rate or rates at which the fee is assessed, or to the 
Phlx's disposition of funds generated by the fee will be the subject of 
separate filings with the Commission. The Phlx intends to implement the 
payment for order flow fee for trades executed on and after November 
18, 2002.\20\
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    \19\ See e.g., Securities Exchange Act Release No. 43436 
(October 11, 2000), 65 FR 63281 (October 23, 2000) (SR-Phlx-2000-
83).
    \20\ This fee is not eligible for the monthly credit of up to 
$1,000 to be applied against certain fees, dues, and charges and 
other amounts that certain members owe to the Phlx. See Securities 
Exchange Act Release No. 44292 (May 11, 2001), 66 FR 27715 (May 18, 
2001) (SR-Phlx-2001-49).
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2. Statutory Basis
    The Phlx believes that its proposal to amend its schedule of dues, 
fees, and charges is an equitable allocation of reasonable fees among 
Phlx members consistent with Section 6(b) of the Act \21\ and furthers 
the objectives of Sections 6(b)(4) and 6(b)(5) of the Act.\22\ The Phlx 
believes that the ROTs paying the proposed payment for order flow fee 
will also receive the benefits of increased order flow. Moreover, the 
Phlx believes that attracting more order flow to the Phlx should result 
in increased liquidity, tighter markets, and more competition among 
exchange members, and thereby serve to promote just and equitable 
principles of trade, remove impediments to and perfect the mechanism of 
a free and open market, and protect investors and the public interest, 
consistent with Section 6(b)(5) of the Act.\23\
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    \21\ 15 U.S.C. 78f(b).
    \22\ 15 U.S.C. 78f(b)(4) and 78f(b)(5).
    \23\ 15 U.S.C.78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Phlx does not believe that the proposed rule change will impose 
any inappropriate burden on competition.

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

    The Phlx received a petition signed by various Phlx members who 
requested a formal vote of the Phlx Board of Governors on the 
appropriateness of implementing ``payment for order flow'' and 
``urge[d] the Board of Governors to vote against such 
implementation.''\24\ As stated above, the Executive Committee, 
pursuant to delegated authority, authorized the filing of this proposed 
rule change.
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    \24\ Petition from Phlx members to the Chairman and the Board of 
Governors of the Phlx, dated October 2002.
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    The Phlx also received a letter from a Phlx member who questioned 
the procedures relating to the accounting by specialists for the funds 
that they receive from the Phlx, including that this information is not 
publicly available, and the possible appearance that one group of 
members is being favored over another group.\25\ The Phlx believes that 
its accounting and certification procedures as discussed herein are 
necessary and appropriate and that the individual relationships between 
the specialists and order flow providers should remain confidential in 
order to preserve the integrity of the contractual business 
relationship between those parties. In addition, the Phlx believes that 
the proposed fee is an equitable allocation of fees among Phlx ROTs 
because the ROTs paying the payment for order flow fee should also 
receive the benefits of increased order flow. Also, specialists are not 
allowed to request reimbursement for payment for order flow funds in 
connection with any transactions to which they were a party.
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    \25\ Correspondence from Gary R. Smolen to Meyer S. Frucher, 
dated November 12, 2002.
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    The Phlx states that it has been and continues to be a vocal 
opponent to any exchange-sponsored payment for order flow programs. The 
Phlx believes,

[[Page 144]]

however, that it must reinstate a payment for order flow program to 
remain competitive. As previously discussed, two exchanges currently 
have a payment for order flow program.

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

    The Phlx has designated the proposal as changing a Phlx due, fee, 
or other charge. Accordingly, the proposed rule change, as amended, has 
become immediately effective upon filing with the Commission pursuant 
to Section 19(b)(3)(A)(ii) of the Act \26\ and Rule 19b-4(f)(2) 
thereunder.\27\ At any time within 60 days after the filing of 
Amendment No. 1 to the proposed rule change, the Commission may 
summarily abrogate the proposed rule change if it appears to the 
Commission that such action is necessary or appropriate in the public 
interest, for the protection of investors, or otherwise in furtherance 
of the purposes of the Act.
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    \26\ 15 U.S.C. 78(s)(b)(3)(A)(ii).
    \27\ 17 CFR 240.19b-4(f)(2).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, 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 the filing 
will also be available for inspection and copying at the principal 
office of the Phlx. All submissions should refer to File No. SR-Phlx-
2002-75 and should be submitted by January 23, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-33119 Filed 12-31-02; 8:45 am]
BILLING CODE 8010-01-P