[Federal Register Volume 68, Number 29 (Wednesday, February 12, 2003)]
[Notices]
[Pages 7156-7159]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-3487]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47319]


Order Exempting Options Specialists From Section 11(b) of the 
Securities Exchange Act of 1934 When Accepting Certain Types of Complex 
Orders

February 5, 2003.

I. Background

    Section 11(b) of the Securities Exchange Act of 1934 (``Exchange 
Act'') \1\ prohibits a specialist \2\ effecting as broker any 
transaction except upon a market or limited price order. Section 11(b) 
was designed, in part, to address potential conflicts of interest that 
may arise as a result of the specialist's dual

[[Page 7157]]

role as agent and principal in executing transactions. In particular, 
Congress intended to prevent specialists from unduly influencing market 
trends through their knowledge of market interest from the specialists' 
books and their handling of discretionary agency orders.\3\ Although 
the Securities and Exchange Commission (``Commission'') has interpreted 
Section 11(b) to mean that all orders, other than market or limit 
orders, are discretionary and therefore cannot be accepted by a 
specialist, it has made certain exceptions. For example, the Commission 
has concluded that it is appropriate to treat percentage orders \4\ and 
stopped orders \5\ as equivalent to limit orders because, although 
these orders permit a specialist to use his or her judgment to some 
extent, the exchange rules applicable to these orders impose 
sufficiently stringent guidelines to ensure that a specialist would 
handle the orders in a manner consistent with his or her market making 
duties and Exchange Act Section 11(b). Accordingly, the Commission 
approved exchanges' proposals to permit specialists to accept 
percentage orders under certain circumstances \6\ and to engage in the 
practice of ``stopping'' stock.\7\ Specifically, in approving the 
NYSE's proposal to allow specialists to convert a percentage order on a 
destabilizing tick and to convert a percentage order into a limit order 
to enter a quotation that betters the market,\8\ the Commission 
acknowledged that the NYSE's proposal permitted specialists to employ 
their judgment to a greater extent than the existing percentage order 
rule.\9\ However, the Commission concluded that the requirements 
imposed on a specialist when converting a percentage order for 
execution or quotation purposes provided sufficient limits on the 
specialist to ensure that the specialist would implement the conversion 
provisions in a manner consistent with his or her market making duties 
and Section 11(b) of the Exchange Act.\10\ These requirements are 
intended to minimize a specialist's discretion and to ensure that the 
specialist cannot, through his or her use of the conversion process, 
unduly influence market trends.
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    \1\ 15 U.S.C. 78k(b).
    \2\ For purposes of this order, the term ``specialist'' includes 
Designated Primary Market Makers on the Chicago Board Options 
Exchange, Lead Market Makers on the Pacific Exchange, and Primary 
Market Makers on the International Securities Exchange.
    \3\ See H. Rep. No. 1383, 73d Cong., 22; S. Rep. 792, 73d Cong., 
2d Sess. 18 (1934).
    \4\ A percentage order is a limited price order to buy or sell 
50% of the volume of a specified stock after the percentage order is 
received by a specialist. A percentage order is essentially a 
memorandum entry left with a specialist that becomes a ``live'' 
order capable of execution when either: (i) All or part of the order 
is elected as a limit order on the specialist's book based on trades 
in the market; or (ii) a specialist holding a percentage order with 
a conversion instruction converts all or part of the percentage 
order into a limit order to make a bid or offer or to participate 
directly in a trade. See New York Stock Exchange, Inc. (``NYSE'') 
Rules 13 and 123A and American Stock Exchange LLC (``Amex'') Rules 
131 and 154. The conversion instruction authorizes the specialist to 
convert all or part of a percentage order into a limit order and to 
be on parity with the converted percentage order.
    \5\ An agreement by a specialist to ``stop'' securities at a 
specified price constitutes a guarantee by the specialist of the 
purchase or sale of the securities at the specified price or better. 
``Stopping'' stock should not be confused with a stop order, which 
is an order designated as such by the customer that requires the 
specialist to buy (sell) a security once a certain price level has 
been reached.
    \6\ See Exchange Act Release Nos. 40722 (November 30, 1998), 63 
FR 67966 (December 9, 1998) (permitting a NYSE specialist to elect a 
percentage order based on the election of a previously elected or 
converted percentage order on the opposite side of the market); 
39837 (April 8, 1998), 63 FR 18244 (April 14, 1998) (approving the 
NYSE's proposal to permit ``immediate execution or cancel election'' 
percentage orders); 39009 (September 3, 1997), 62 FR 47715 
(September 10, 1997) (approving the NYSE's proposal to allow a 
converted percentage order to retain its priority on the book when a 
higher bid (lower offer) is made) and to permit a ``last sale-
cumulative volume'' instruction, which provides that if an elected 
portion of a percentage order placed on the book at the price of the 
electing sale is not executed, the elected portion of the order 
shall be cancelled and re-entered on the book at the price of 
subsequent transactions on the NYSE, if the price of the subsequent 
transactions is at or better than the limit specified in the order; 
30265 (January 17, 1992), 57 FR 3228 (January 28, 1992) (approving 
an Amex proposal to permit a specialist to accept ``last sale'' and 
``buy minus-sell plus'' percentage orders, permit the conversion of 
a percentage order into a limit order on a destabilizing tick, and 
allow conversions that better the market); 24505 (May 22, 1987), 52 
FR 20484 (June 1, 1987) (``1987 Order'') (permitting a NYSE 
specialist to convert a percentage order into a limit order on a 
destabilizing tick and to convert a percentage order into a limit 
order to enter a quote that betters the market); 20738 (March 8, 
1984), 49 FR 9666 (March 14, 1984) (allowing an entering broker to 
instruct an Amex specialist to convert half of a percentage order 
rather than the full amount of the percentage order); 19652 (April 
5, 1983), 48 FR 15756 (April 12, 1983) (approving an Amex proposal 
to permit percentage orders to be converted and executed on zero 
plus ticks (for buy orders) and zero minus ticks (for sell orders) 
when the order causing the conversion is at least 5,000 shares); and 
19466 (January 28, 1983), 48 FR 5627 (February 7, 1983) (amending 
the Amex's definition of percentage order to differentiate among 
straight limit, last sale, and buy minus-sell plus percentage orders 
and adopting procedures for the handling of percentage orders).
    \7\ The Commission granted permanent approval to the pilot 
programs of several exchanges that permit specialists to stop stock 
in minimum variation markets. See Exchange Act Release Nos. 37134 
(April 22, 1996), 61 FR 18634 (April 26, 1996) (``BSE 1996 Order''); 
36400 (October 20, 1995), 60 FR 54886 (October 26, 1995) (``Amex 
1995 Order''); 36401 (October 20, 1995), 60 FR 54893 (October 26, 
1995) (``CHX 1995 Order''); and 36399 (October 20, 1995), 60 FR 
54900 (October 26, 1995) (``NYSE 1995 Order''). See also Exchange 
Act Release No. 40728 (November 30, 1998), 63 FR 67972 (December 9, 
1998) (approving a Philadelphia Stock Exchange, Inc. (``PHLX'') rule 
setting forth procedures for stopping stock where the spread in the 
quotation is greater than twice the minimum variation and for 
stopping orders in minimum variation markets). The rules of several 
exchanges permit specialists to stop stock when the spread is twice 
the minimum variation. See Amex Rule 109(c); Boston Stock Exchange 
(``BSE'') Rule Chapter II, Section 38(b); NYSE Rule 116.30; and PHLX 
Rule 220. In addition, Chicago Board Options Exchange, Inc. market 
makers may stop options orders. See CBOE Rule 8.17.
    \8\ A conversion that betters the market narrows the spread, 
adds depth to a prevailing bid or offer, or establishes a new bid or 
offer immediately after a transaction has cleared the floor of bids 
and offers.
    \9\ See 1987 Order, supra note 5.
    \10\ Specifically, the 1987 Order noted that the NYSE's proposal 
imposed three basic limitations on the conversion of percentage 
orders on a destabilizing tick: (1) An order may be converted on a 
destabilizing tick for the purpose of participating in a trade of 
10,000 or more shares; (2) the execution effected by the conversion 
may occur no more than \1/4\ point away from the last sale, although 
this requirement may be waived with the approval of an NYSE Floor 
Official; and (3) the specialist cannot convert percentage orders 
for consecutive, or contemporaneous, trades on destabilizing ticks 
without the approval of a Floor Governor. See also NYSE Rule 
123A.30. With regard to conversions made to better the market, the 
1987 Order noted that the NYSE's proposal permitted a specialist to: 
(1) Convert an order on a stabilizing tick to better the market in 
such size as was appropriate to further the specialist's market 
making duties; (2) convert an order on a destabilizing tick to 
narrow the spread or to establish a new bid or offer immediately 
after a transaction had cleared the floor of bids and offers, 
provided that the conversion was within 1/8 point of the last sale; 
and (3) convert an order on a destabilizing tick, exclusive of the 
1/8 point requirement, to add size to a prevailing bid or offer. The 
NYSE's rules provide additional restrictions on bettering the market 
conversions. See NYSE Rule 123A.30.
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    In addition, in approving exchanges' rules permitting specialists 
to stop stock in minimum variation markets, the Commission found it 
appropriate to treat stopped orders as equivalent to limit orders 
because a stopped order would be automatically elected at the best bid 
or offer, or better if obtainable.\11\ The Commission noted that 
although stopped orders permit a specialist to employ his or her 
judgment to some extent, the requirements imposed on a specialist for 
granting stops in minimum variation markets provide that the specialist 
will implement the stopping stock provisions in a manner consistent 
with his or her market making duties and Section 11(b).\12\
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    \11\ See Amex 1995 Order and NYSE 1995 Order, supra note 6. See 
also BSE 1996 Order and CHX 1995 Order, supra note 6 (finding that 
stopped orders are equivalent to limit orders because they would be 
elected automatically after a transaction takes place on the primary 
market at the stopped price).
    \12\ Specifically, on the Amex and the NYSE, a specialist may 
stop an order in a minimum variation market only where there is a 
substantial imbalance on the opposite side of the market from the 
order being stopped. In this situation there is an increased 
likelihood of price improvement for the stopped order. In addition, 
NYSE Rule 116.30 and Amex Rule 109(c) provide that an order to which 
a specialist grants a stop may not exceed 2,000 shares and the 
aggregate number of shares as to which stops are in effect may not 
exceed 5,000 shares. The 5,000-share limit is designed to ensure 
that the amount of stopped stock does not become so large that there 
would, in effect, cease to be an imbalance on the opposite side of 
the market from the order being stopped (i.e., less likelihood of 
price improvement for the order being stopped). See Amex 1995 Order 
and NYSE Order, supra note 6. With regard to the rules of the 
Chicago Stock Exchange (``CHX'') and the BSE, the Commission 
concluded that because stopped orders would be elected automatically 
after a transaction takes place on the primary market at the stopped 
price, the requirements imposed on specialists under the CHX and BSE 
rules provided sufficient guidelines to ensure that a specialist 
would implement the rules for stopping stock in minimum variation 
markets in a manner consistent with his or her market making duties 
and Section 11(b). See BSE 1996 Order and CHX 1995 Order, supra note 
6.

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[[Page 7158]]

II. Complex Orders

    Current exchange rules permit floor brokers to represent complex 
options orders, including, among others, spread,\13\ straddle,\14\ and 
combination orders.\15\ According to two exchanges, there are fewer 
floor brokers today on the exchange floors than there were in the past. 
As a result, there may be times when, under current rules, such orders 
may not be able to be represented or executed on a national securities 
exchange. As a result of these concerns, on July 19, 2001, the Amex 
filed a proposal with the Commission, pursuant to Section 19(b)(1) of 
the Exchange Act \16\ and Rule 19b-4 thereunder,\17\ to amend its rules 
to permit Amex options specialists to accept spread orders.\18\ The 
Commission determined that consideration of the Amex proposal required 
addressing issues related to Exchange Act Section 11(b).
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    \13\ A spread order is an order to buy a stated number of option 
contracts and to sell the same number of option contracts, or 
contracts representing the same number of shares at option, in a 
different series of the same class of options.
    \14\ A straddle order is an order to buy (sell) a number of call 
option contracts and to buy (sell) the same number of put option 
contracts on the same underlying security, which contracts have the 
same exercise price and expiration date.
    \15\ A combination order is an order involving a number of call 
option contracts and the same number of put option contracts on the 
same underlying security and representing the same number of shares 
at option. In the case of adjusted option contracts, a combination 
order need not consist of the same number of put and call contracts 
if the contracts both represent the same number of shares at option. 
A adjusted option contract is a contract whose terms are changed to 
reflect certain fundamental changes to the underlying security. For 
example, after an adjustment for a 2 for 1 stock split, an investor 
who held an option on 100 shares of XYZ stock with an exercise price 
of $60 may hold two options, each on 100 shares of XYZ stock and 
with an exercise price of $30.
    \16\ 15 U.S.C. 78s(b)(1).
    \17\ 17 CFR 240.19b-4.
    \18\ See File No. SR-Amex-2001-48.
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    According to the Amex, the Amex floor brokers who focused primarily 
on executing spread orders (``spread brokers'') were unable to remain 
in business and the loss of the spread brokers has reduced spread order 
executions on the Amex.\19\ Other exchanges have also expressed concern 
that the disappearance of floor brokers has meant a shift in business 
to the over-the-counter (``OTC'') market.\20\
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    \19\ See letter from Jeffrey P. Burns, Assistant General 
Counsel, Amex, to Sharon M. Lawson, Senior Special Counsel, Division 
of Market Regulation, Commission, dated October 18, 2001.
    \20\ For example, the Philadelphia Stock Exchange, Inc. 
(``PHLX'') has stated that the number of foreign currency options 
(``FCO'') participants and firms clearing FCOs has declined steadily 
since the 1980s as the market has increasingly shifted to OTC 
trading. See Exchange Act Release No. 44372 (May 31, 2001), 66 FR 
30780 (June 7, 2001) (approving on a one-year pilot basis a PHLX 
proposal to permit FCO participants to, among other things, contact 
the specialist to negotiate the total debit or credit for 
transacting a spread, straddle, or combination FCO order). The PHLX 
allowed the pilot program to expire because there is at least one 
PHLX floor broker available to handle customer FCO orders and, 
accordingly, the relief provided by the pilot program currently is 
not necessary.
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    As noted above, the Commission previously has permitted specialists 
to accept percentage orders and to stop orders in part because the 
exchange rules allowing specialists to accept percentage orders and to 
stop orders sufficiently limited a specialist's discretion and ensured 
that a specialist's handling of those orders was consistent with his or 
her market making duties and Section 11(b) of the Exchange Act. 
Similarly, the Commission believes that it is appropriate in the public 
interest and consistent with the protection of investors to exempt, 
subject to certain conditions, options specialists from the provisions 
of Section 11(b) of the Exchange Act to allow them to accept orders in 
option contracts on the same underlying security where the customer 
specifies the number of contracts for each series and the net debit or 
credit at which the order will be executed (``Complex Orders''), 
including spread, straddle, and combination orders.\21\ Such an 
exemption would allow market participants to continue to have the 
ability to purchase and sell Complex Orders on an exchange market, 
under conditions that would reduce the discretion the specialist has in 
executing these orders.
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    \21\ For purposes of this order, the term Complex Order does not 
include orders that have a non-option component.
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    The Commission believes it is necessary for the protection of 
investors and appropriate in the public interest to condition a 
specialist's handling of Complex Orders, as indicated below. These 
conditions will limit a specialist's discretion in the handling of such 
orders. The conditions also require the exchange on which a specialist 
trades to have surveillance procedures in place to monitor specialists' 
handling of these orders for compliance with the exchange's rules and 
the conditions in this exception.
    More specifically, the conditions set forth below should help to 
ensure that a specialist is not able to unduly influence market trends 
through his or her handling of Complex Orders. In this regard, the 
conditions limit a specialist's discretion by providing that an 
exchange's rules must require a specialist to execute a Complex Order 
as soon as it becomes possible to execute the order at the net debit or 
credit specified by the customer, consistent with its priority rules. 
The conditions also provide that an exchange's rules must require a 
specialist who accepts a Complex Order to announce the terms of the 
order to the trading crowd immediately after receiving the order. In 
addition, to address concerns regarding a potential conflict of 
interest that may arise if a specialist handles the orders of customers 
of his or her own firm, as well as the orders of other brokers' 
customers that are given to the specialist for execution, an exchange 
must have rules that prohibit a specialist from accepting orders from 
customers of the firm with which the specialist is associated.\22\
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    \22\ The Commission has stated previously that specialists 
should not be permitted to have their own customers, as opposed to 
customers of other brokers whose orders are given to the specialist 
for execution. In this regard, the Commission stated that 
transactions for a specialist's own customers do not affirmatively 
assist his market making activities and are fraught with 
possibilities of abuse. See SEC, Special Study of the Securities 
Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess., Part 2, 166 
(1963).
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    As noted above, the conditions set forth below are designed to 
reduce the specialist's discretion in handling Complex Orders. As a 
result, the conditions should help to provide the type of protection 
that the prohibition in Exchange Act Section 11(b) was enacted to 
provide, and at the same time permit exchange specialists, not solely 
floor brokers, of which there are relatively few, to accept Complex 
Orders.
    For these reasons, the Commission finds that it is appropriate in 
the public interest and consistent with the protection of investors to 
exempt a specialist from the provision in Section 11(b) of the Exchange 
Act that prohibits a specialist from effecting on the exchange as 
broker any transaction except upon a market or limit order, provided 
that:
    (1) The order effected by such specialist: (i) Is comprised solely 
of options on the same underlying security and the customer specifies 
the number

[[Page 7159]]

of contracts and the net credit or debt at which the order is to be 
executed (``Complex Order'');
    (2) The rules of the exchange on which a specialist trades: (a) 
Prohibit the specialist from accepting Complex Orders from customers of 
the firm with which the specialist is associated; (b) require the 
specialist to time stamp a Complex Order upon receipt of the order; (c) 
require the specialist who accepts a Complex Order to announce 
immediately after receipt of the order the price, terms, and size of 
the Complex Order to the trading crowd; (d) require the specialist to 
execute the Complex Order as soon as it is possible to execute, 
consistent with the exchange's priority rules, at the net debit or 
credit specified by the customer; and
    (3) The exchange on which the specialist trades has surveillance 
procedures in place for monitoring specialists' compliance with the 
exchange's rules governing the handling of Complex Orders.
    Accordingly, it is ordered, pursuant to Section 36 of the Exchange 
Act,\23\ that a specialist is exempt from the prohibition in Section 
11(b) of the Exchange Act from effecting on the exchange as broker any 
transaction except upon a market or limit order, subject to the 
conditions set forth above.
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    \23\ 15 U.S.C. 78mm. Section 36 of the Exchange Act authorizes 
the Commission, by rule, regulation, or order, to exempt, either 
conditionally or unconditionally, any person, security, or 
transaction, or any class or classes of persons, securities, or 
transactions, from any provision or provisions of the Exchange Act 
or any rule or regulation thereunder, to the extent that such 
exemption is necessary or appropriate in the public interest, and is 
consistent with the protection of investors.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-3487 Filed 2-11-03; 8:45 am]
BILLING CODE 8010-01-P