[Federal Register Volume 68, Number 94 (Thursday, May 15, 2003)]
[Notices]
[Pages 26366-26369]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-12146]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47817; File No. SR-ISE-2003-10]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment No. 1 Thereto by the International Securities 
Exchange, Inc. To Amend Its Obvious Error Rule

May 8, 2003.
    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 February 28, 2003, the International Securities Exchange, Inc. 
(``ISE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the 
Exchange. On May 1, 2003, the ISE submitted Amendment No. 1 to the 
proposed rule change.\3\ The Commission is publishing this notice to 
solicit comments on the proposed rule change, as amended, 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 Michael Simon, Senior Vice President and 
General Counsel, ISE, to Nancy Sanow, Assistant Director, Division 
of Market Regulation, Commission, dated April 30, 2003 (``Amendment 
No. 1''). In Amendment No. 1, the ISE replaced the proposed rule 
text in its entirety.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange is proposing to amend ISE Rule 720 (the ``Obvious 
Error Rule''). Proposed new language is italicized; proposed deletions 
are in [brackets].
* * * * *
Rule 720. Obvious Errors
    The Exchange shall either bust a transaction or adjust the 
execution price of a transaction that results from an Obvious Error as 
provided in this Rule.
    (a) Definition of Obvious Error. For purposes of this Rule only, an 
Obvious Error will be deemed to have occurred when the execution price 
of a transaction is higher or lower than the Theoretical Price for the 
series by an amount equal to at least the amount shown below:

------------------------------------------------------------------------
                                                               Minimum
                     Theoretical price                          amount
------------------------------------------------------------------------
Below $2...................................................          .25
$2 to $5...................................................          .40
Above $5 to $10............................................          .50
Above $10 to $20...........................................          .80
Above $20..................................................         1.00
------------------------------------------------------------------------

    [(1) If the Theoretical Price of the option is less than $3.00:
    (i) During regular market conditions (including rotations), the 
execution price of a transaction is higher or lower than the 
Theoretical Price for the series by an amount of 35 cents or more; or
    (ii) During fast market conditions (i.e., the Exchange has declared 
a fast market status for the option in question), the execution price 
of a transaction is higher or lower than the Theoretical Price for the 
series by an amount of 50 cents or more.
    (2) If the Theoretical Price of the option is $3.00 or higher:
    (i) During regular market conditions (including rotations), the 
execution

[[Page 26367]]

price of a transaction is higher or lower than the Theoretical Price 
for the series by an amount equal to at least two (2) times the maximum 
bid/ask spread allowed for the option, so long as such amount is 50 
cents or more; or
    (ii) During fast market conditions (i.e., the Exchange has declared 
a fast market status for the option in question), the execution price 
of a transaction is higher or lower than the Theoretical Price for the 
series by an amount equal to at least three (3) times the maximum bid/
ask spread allowed for the option, so long as such amount is 50 cents 
or more.]
    (b) Definition of Theoretical Price. For purposes of this Rule 
only, the Theoretical Price of an options series is:
    (1) If the series is traded on at least one other options exchange, 
the last bid price with respect to an erroneous sell transaction, [or] 
and last offer price with respect to an erroneous buy transaction, just 
prior to the trade, [found on] disseminated by the competing options 
exchange that has the most liquidity in that option [as provided in 
Supplementary Material .02 below]; or
    (2) If there are no quotes for comparison purposes, as determined 
by designated personnel in the Exchange's market control center 
(``Market Control'').
    [(c) Adjustments. Where the execution price of a transaction 
executed as the result of an Obvious Error is adjusted, the adjusted 
price will be:
    (1) The Theoretical Price of the option in the case where the 
erroneous price is displayed in the market and subsequently executed by 
quotes or orders that did not exist in the System at the time the 
erroneous price was entered; or
    (2) The last bid or offer, just prior to the trade, found on the 
exchange that has the most liquidity in that option as provided in 
Supplementary Material .03 below in the case where an erroneous price 
executes against quotes or orders already existing in the System at the 
time the erroneous price was entered.
    (d)] (c) Obvious Error Procedure. Market Control shall administer 
the application of this Rule as follows.
    (1) Notification. If a market maker on the Exchange believes that 
it participated in a transaction that was the result of an Obvious 
Error, it must notify Market Control within five (5) minutes of the 
execution. If an Electronic Access Member believes an order it executed 
on the Exchange was the result of an Obvious Error, it must notify 
Market Control within twenty (20) minutes of the execution. Absent 
unusual circumstances, Market Control will not grant relief under this 
Rule unless notification is made within the prescribed time periods.
    (2) Adjust or Bust. Market Control will determine whether there was 
an Obvious Error as defined above. If it is determined that an Obvious 
Error has occurred, Market Control shall take one of the [following] 
actions listed below.[:] Upon taking final action, Market Control shall 
promptly notify both parties to the trade.
    (i) [w]Where each party to the transaction is a market maker on the 
Exchange, the execution price of the transaction will be adjusted by 
Market Control to the prices provided in paragraphs (A) and (B) below 
unless both parties agree to adjust the transaction to a different 
price or agree to bust the trade within ten (10) minutes of being 
notified by Market Control of the Obvious Error.[; or]
    (A) Erroneous buy transactions will be adjusted to their 
Theoretical Price (1) plus $.15 if the Theoretical Price is under $3, 
and (2) plus $.30 if the Theoretical Price is at or above $3.
    (B) Erroneous sell transactions will be adjusted to their 
Theoretical Price (1) minus $.15 if the Theoretical Price is under $3, 
and (2) minus $.30 if the Theoretical Price is at or above $3.
    (ii) [w]Where at least one party to the Obvious Error is not a 
market maker on the Exchange, the trade will be busted by Market 
Control unless both parties agree to [adjust the] an adjustment price 
[of] for the transaction within thirty (30) minutes of being notified 
by Market Control of the Obvious Error. [Upon taking final action, 
Market Control shall promptly notify both parties to the trade.]
    (e) Obvious Error Panel.
    (1) Composition. An Obvious Error Panel will be comprised of 
representatives from four (4) Members. Two (2) of the representatives 
must be directly engaged in market making activity and two (2) of the 
representatives must be employed by an Electronic Access Member.
    (2) [Request for] Scope of Panel's Review. If a party affected by a 
determination made under this Rule so requests within the time 
permitted in (3) below, the Obvious Error Panel will review decisions 
made by Market Control under this Rule, including whether an Obvious 
Error occurred, whether the correct Theoretical Price was used, and 
whether an adjustment was made at the correct price. A party may also 
request that the Obvious Error Panel provide relief [under] as provided 
in this Rule in cases where the party failed to provide the 
notification required in paragraph [(d)](c)(1) and Market Control 
declined to grant an extension, but unusual circumstances must merit 
special consideration.
    (3) Procedure for Requesting Review. A request for review must be 
made in writing within thirty (30) minutes after a party receives 
verbal notification of a final determination by Market Control under 
this Rule, except that if notification is made after 3:30 p.m. Eastern 
Time, either party has until 9:30 a.m. Eastern Time the next trading 
day to request review. The Obvious Error Panel shall review the facts 
and render a decision on the day of the transaction, or the next trade 
day in the case where a request is properly made after 3:30 on the day 
of the transaction or where the request is properly made the next trade 
day.
    [(3)] (4) Panel Decision. The Obvious Error Panel may overturn or 
modify an action taken by Market Control under this Rule upon agreement 
by a majority of the Panel representatives. All determinations by the 
Obvious Error Panel shall constitute final Exchange action on the 
matter at issue.
Supplementary Material to Rule 720
    [.01 For purposes of paragraph (a) of this Rule, the maximum bid/
ask spread shall be the maximum bid/ask spread allowed under Rule 
803(b), unless a wider spread has been allowed by the Exchange for the 
option because of unusual market conditions, such as high market 
volatility.
    .02 The Theoretical Price will be determined under paragraph (b)(1) 
above as follows: (i) The bid price from the exchange providing the 
most volume will be used with respect to an erroneous bid price entered 
on the Exchange, and (ii) the offer price from the exchange providing 
the most volume will be used with respect to an erroneous offer price 
entered on the Exchange.
    .03 The price to which a transaction is adjusted under paragraph 
(c)(2) above will be as follows: (i) The bid price from the exchange 
providing the most volume for the option will be used with respect to 
an erroneous offer price entered on the Exchange, and (ii) the offer 
price from the exchange providing the most volume for the option will 
be used with respect to an erroneous bid price entered on the Exchange. 
If there are no quotes for comparison purposes, the adjustment price 
will be determined by Market Control.]
    [.04] .01 When Market Control determines that an Obvious Error has 
occurred and action is warranted under paragraph [(d)](c)(2) above, the 
identity of the parties to the trade will be disclosed to each other in 
order to encourage conflict resolution.

[[Page 26368]]

    [.05] .02 To qualify as a representative of an Electronic Access 
Member on an Obvious Error Panel, a person must (i) be employed by a 
Member whose revenues from options market making activity do not exceed 
ten percent (10%) of its total revenues; or (ii) have as his or her 
primary responsibility the handling of Public Customer orders or 
supervisory responsibility over persons with such responsibility, and 
not have any responsibilities with respect to market making activities.
    [.06] .03 The Exchange shall designate at least ten (10) market 
maker representatives and at least ten (10) Electronic Access 
representatives to be called upon to serve on Obvious Error Panels as 
needed. In no case shall an Obvious Error Panel include a person 
related to a party to the trade in question. To the extent reasonably 
possible, the Exchange shall call upon the designated representatives 
to participate on an Obvious Error Panel on an equally frequent basis.
    [.07] .04 All determinations made by the Exchange, Market Control 
or an Obvious Error Panel under this Rule shall be rendered without 
prejudice as to the rights of the parties to the transaction to submit 
a dispute to arbitration.
    .05 Buyers of options with a zero bid and $.05 offer (i.e., a 
Theoretical Price of $.05) may request that their execution be busted 
if at least the three strikes below (for calls) or above (for puts) in 
the same options class were quoted with a zero bid and $.05 offer at 
the time of the execution. Such buyers must follow the procedures of 
paragraph (c)(1) above.
    .06 For purposes of paragraph (b)(1) of Rule 720, the competing 
options exchange with the most liquidity will be the options exchange 
that had the highest total contract volume in the options class for the 
previous two months (e.g., if an obvious error occurs on March 9, the 
total contract volume from January 8 to March 8 will be used).
    .07 For purposes of Rule 720, an ``erroneous sell transaction'' is 
one in which the price received by the person selling the option is 
erroneously low, and an ``erroneous buy transaction'' is one in which 
the price received by the person purchasing the option is erroneously 
high.
* * * * *

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 Exchange included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange 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 Exchange proposes to amend ISE Rule 720 to simplify its 
application. When the Exchange first adopted the Obvious Error Rule,\4\ 
it was the first such rule of its kind on any options exchange. During 
the nearly two-year period since the Rule was approved by the 
Commission, the Exchange made minor adjustments to the Rule to address 
specific issues that arose.\5\
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    \4\ See Securities Exchange Act Release No. 44376 (June 1, 
2001), 66 FR 30772 (June 7, 2001).
    \5\ See Securities Exchange Act Release No. 46110 (June 25, 
2002), 67 FR 44487 (July 2, 2002).
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    The current proposed rule change represents the result of a 
comprehensive analysis of the effectiveness of the Rule in addressing 
obvious error situations. After consultation with Members, the Exchange 
believes that the structure and standards of the Rule have worked very 
well. However, the Rule itself is unnecessarily complex, which can 
create confusion and uncertainty regarding when trades qualify as 
obvious errors and the prices to which qualifying trades may be 
adjusted. Accordingly, the Exchange proposes the changes described 
herein.

Determining Whether or Not an Obvious Error Has Occurred

    Currently, under paragraph (b) of the Rule and Supplementary 
Material .02, the Theoretical Price for an option is determined by the 
bid price on the options exchange other than ISE that has the most 
volume in the option for erroneous buy orders or bid quotes. Similarly, 
the Theoretical Price for an option is determined by the offer price on 
the other options exchange for erroneous sell orders or offer quotes. 
Determining the Theoretical Price in this manner is counter-intuitive 
to market participants, which generally look to the offer as the price 
at which one can buy and the bid as the price at which one can sell. 
Moreover, under paragraph (a) of the Rule, the required deviation from 
the Theoretical Price necessary to qualify the trade as an obvious 
error is a multiple of the option's maximum allowable bid/ask spread, 
with a greater multiple applied in fast market conditions.
    The Exchange proposes to amend the Rule to provide that the 
Theoretical Price for trades caused by erroneous buy orders or bid 
quotes will be determined by the offer from the other options exchange, 
and that the Theoretical Price of trades caused by erroneous sell 
orders or offer quotes will be determined by the bid from the other 
options exchange. Because the side to which the Rule will look to 
determine the Theoretical Price is switched, the Exchange proposes to 
reduce the required deviation necessary for a trade to qualify as an 
obvious error to the amount equivalent to the maximum bid/ask spread 
for the series, rather than a multiple of the allowable spread. The 
result of these two changes taken together is not material for options 
priced $3 and higher, as the price at which a trade must occur to 
qualify as an obvious error does not change.\6\ For options priced 
under $3, the proposed rule change will increase the deviation required 
for a trade to qualify as an obvious error.
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    \6\ For example, assume the quote on the options exchange other 
than ISE for an option is $6 to $6.50. Under the current Rule, the 
execution price of a buy order must be $7 higher, i.e., the 
Theoretical Price (the bid from the other options exchange) plus an 
amount equal to twice the allowable spread ($.50). Under the amended 
Rule, the execution price of the buy order must still be $7 or 
higher, i.e., the Theoretical Price (the offer from the other 
options exchanges) plus an amount equal to the allowable spread 
($.50).
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    As described below, the Exchange is also proposing a manner in 
which to address obvious errors in the purchase of certain very low-
priced options. Finally, the Exchange proposes to eliminate entirely 
the current rule's distinction between regular market condition and 
fast market condition, as the higher standard for fast market 
conditions is unnecessary in the Exchange's electronic environment.

Adjusting Prices

    Paragraph (c) in Supplementary Material .03 of the current Rule 
governs the price to which a trade is adjusted when there is an obvious 
error. Currently, the price used is dependent on whether the erroneous 
price existed in the market first, or whether the erroneous price 
executed against an existing order or quote in the book. The Exchange 
proposes to apply a single adjustment standard to all executions that 
qualify as an obvious error: erroneous buy executions will be adjusted 
to the Theoretical Price (the offer) plus $.15 for options under $3, 
and plus $.30 for options as or above $3.

[[Page 26369]]

Erroneous sell executions will be adjusted to the Theoretical Price 
(the bid) minus $.15 for options under $3, and minus $.30 for options 
at or above $3. This change addresses two issues under the current 
Rule. First, it simplifies the determination of the appropriate 
adjustment price and creates certainty for Members who generally do not 
know which price was first in the market at the time a trade occurs. 
Second, it protects against abuse of the Rule, as the adjustment price 
is not as favorable as what the party making the error would have 
received had it not made an error.

The ``Nickel Rule''

    The current obvious error Rule does not contain any special 
criteria for executions in options with a quote of $0 to $.05 (no bid, 
offered at a nickel). The Exchange proposes to create a special 
standard for no-bid buyers, as a purchase of these options is extremely 
rare and most often the result of an error. Under proposed 
Supplementary Material .05, buyers of options priced at no bid, offered 
at a nickel, may request that their execution be busted if at least the 
three strike prices below (for calls) or above (for puts) in the same 
class were quoted no bid, offered at a nickel at the time of the 
erroneous execution. The buyer must notify market control as otherwise 
required under the Rule.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with section 6(b) of the Act \7\ in general, and furthers the 
objectives of section 6(b)(5)\8\ in particular, in that it is designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, to remove impediments to and 
perfect the mechanism for a free and open market and a national market 
system, and, in general, to protect investors and the public interest.
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    \7\ 15 U.S.C. 78f(b).
    \8\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change 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 did not solicit or receive written comments on the 
proposed rule change.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer 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 Exchange consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

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 at the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the Exchange. All submissions should refer to File 
No. SR-ISE-2003-10 and should be submitted by June 5, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-12146 Filed 5-14-03; 8:45 am]
BILLING CODE 8010-01-P