[Federal Register Volume 69, Number 17 (Tuesday, January 27, 2004)]
[Notices]
[Pages 3974-3987]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-1668]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49098; File No. SR-PHLX-2003-73]


Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; 
Order Approving Proposed Rule Change and Notice of Filing and Order 
Granting Accelerated Approval of Amendment No. 3 Thereto Relating to 
the Demutualization of the Philadelphia Stock Exchange, Inc.

January 16, 2004.

I. Introduction

    On November 17, 2003, the Philadelphia Stock Exchange, Inc. 
(``Phlx'' 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: (1) Amend its Certificate of 
Incorporation to eliminate a reference to ``not for profit'' and a 
restriction on the payment of dividends (``Plan of Conversion'' and 
such amendments to the Certificate of Incorporation, the ``Conversion 
Amendment''); and (2) merge a newly-created, wholly-owned shell 
subsidiary of the Phlx with and into the Phlx, with the Phlx surviving 
as a demutualized Delaware stock corporation (``Merger'' and together 
with the Plan of Conversion, the ``Plan of Demutualization'') pursuant 
to an Agreement and Plan of Merger (``Merger Agreement''). On November 
24, 2003, the Phlx submitted Amendment No. 1 to the proposed rule 
change.\3\ On November 26, 2003, the Phlx submitted Amendment No. 2 to 
the proposed rule change.\4\ On December 3, 2003, the proposed rule 
change was published for comment in the Federal Register.\5\ On 
December 29, 2003, the Phlx submitted Amendment No. 3 to the proposed 
rule change.\6\ The Commission received one comment letter in response 
to the proposed rule change.\7\ This order approves the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Edith Halihan, Deputy General Counsel, Phlx, 
to Nancy Sanow, Assistant Director, Division of Market Regulation 
(``Division''), Commission, dated November 21, 2003. (``Amendment 
No. 1''). In Amendment No. 1, the Phlx made technical conforming 
changes to the exhibits to the proposed rule change.
    \4\ See Letter from Edith Halihan, Deputy General Counsel, Phlx, 
to Nancy Sanow, Assistant Director, Division, Commission, dated 
November 26, 2003 (``Amendment No. 2''). In Amendment No. 2, the 
Phlx amended the proposed rule change to reflect that on November 
25, 2003, the members of the Phlx (as that term is defined in 
Section I-1(b) of the current By-laws of the Phlx, the ``Members'') 
approved the Plan of Conversion, the Merger, and all transactions to 
be effected in connection therewith. Also, on November 18, 2003, 
holders of equitable title (``Owners'') to memberships in the Phlx 
(each such membership a ``Seat'') voted to approve the Plan of 
Demutualization as a whole.
    \5\ See Securities Exchange Act Release No. 48847 (November 26, 
2003), 68 FR 67720 (``Notice'').
    \6\ See Letter from Edith Halihan, Deputy General Counsel, Phlx, 
to Nancy Sanow, Assistant Director, Division, Commission, dated 
December 23, 2003 (``Amendment No. 3''). In Amendment No. 3 the Phlx 
formally submitted the Conversion Amendment as part of the proposed 
rule change.
    \7\ See Letter from Joseph Carapico, General Partner, Andrew W. 
Snyder, General Partner and Richard B. Feinberg, Limited Partner, 
Penn Mont Securities, to Jonathan G. Katz, Secretary, Commission, 
dated December 19, 2003 (``Penn Mont Letter'').
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II. Description of Proposed Rule Change

    The purpose of the proposed rule change is to implement the Plan of 
Demutualization. In connection with the Plan of Demutualization, 
trading privileges will be separated from corporate ownership of the 
Phlx and will be made available exclusively through trading permits. 
\8\
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    \8\ The Exchange, however, plans to retain its existing Foreign 
Currency Option (``FCO'') participations (as defined in section 1-
1(i) of the amended By-laws). After the demutualization, the ability 
to trade FCOs on the Phlx will also be available through a Series A-
1 Permit, as set forth in proposed Rule 908(b).
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    As a result of the demutualization, a total of 50,500 shares of 
Class A Common Stock (100 shares per Seat) will be issued to existing 
equitable Seat holders and will represent 100% of the common equity 
ownership in the Phlx outstanding immediately after the 
demutualization. In addition, all Members and holders of equity trading 
permits (``ETPs'') who are affiliated with Member Organizations and are 
not suspended will be entitled to receive

[[Page 3975]]

new Series A-1 Permits (``Permits'') to enable them to continue their 
trading activities on the Exchange without interruption.\9\ Similarly, 
Member Organizations will maintain their status as members of the Phlx 
upon their compliance with certain deposit and registration 
requirements.
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    \9\ Pursuant to Rule 23 of the current Phlx Rules, the Exchange 
has issued ETPs, four of which are currently outstanding. In the 
demutualization, these ETPs will be eliminated in accordance with 
current Rule 23 and pursuant to proposed Rule 971, and the rights 
and privileges of ETPs will be conferred on existing ETP holders by 
Permits.
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    The Exchange proposes to effect the Plan of Demutualization for a 
number of reasons, including to expand its sources of capital and 
revenue; to facilitate its ability to enter into relationships with 
strategic or financial partners who may be crucial for the Exchange's 
future development, capital formation and viability; to facilitate the 
introduction of new products and thus potentially increase transaction 
volume and Exchange revenues; and to better position itself to react to 
new opportunities and challenges.
    The Exchange represents that, after the effective date of the 
demutualization, it will continue to be a national securities exchange 
registered under section 6 of the Act.\10\ The Exchange also represents 
that, except as is necessary to implement the new permit structure to 
replace the existing structure of owning and leasing seats as a basis 
for trading rights and Exchange memberships, it is not proposing any 
significant changes to its existing operational and trading structure 
in connection with the demutualization. The Exchange further states 
that the demutualization will not affect its functions as a self-
regulatory organization (``SRO'') and will not affect the designation 
of the Exchange as ``designated examining authority'' (``DEA'') for 
those Member Organizations for which the Exchange currently is the DEA. 
Moreover, the Exchange notes that it is not proposing any changes to 
its existing disciplinary system, fines or the related appellate 
process in connection with the Plan of Demutualization.\11\
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    \10\ 15 U.S.C. 78f.
    \11\ On January 7, 2004 the Exchange filed a proposed rule 
change pursuant to section 19(b) of the Act, SR-Phlx-2004-02, to 
adopt fees applicable to Series A-1 Permits and to make conforming 
changes to its fee schedule as a result of the demutualization. The 
Merger Agreement provides that the effectiveness of the Merger (and 
thus the Plan of Demutualization in general), among other things, is 
conditioned upon such filing becoming effective or being approved by 
the Commission, as the case may be. This proposed rule change was 
filed as a fee change pursuant to Section 19(b)(3)(A)(ii) of the 
Act, 15 U.S.C. 78(s)(b)(3)(A)(ii).
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A. Capital Structure of the Demutualized Phlx

    Changes to the capital structure of the Phlx, as set forth in 
Article FOURTH of the proposed Certificate of Incorporation, generally 
reflect the proposed conversion of the Phlx from a non-stock Delaware 
corporation to a demutualized Delaware stock corporation.
    Pursuant to Article FOURTH of the proposed Certificate of 
Incorporation, after the Merger, the authorized capital stock of the 
Phlx will consist of:
     50,500 shares of Class A Common Stock;
     949,500 shares of Class B Common Stock, par 
value $0.01 per share (``Class B Common Stock,'' and together with the 
Class A Common Stock, the ``Common Stock''); and
     100,000 shares of preferred stock, par value 
$0.01 per share, one of which will be designated as ``Series A 
Preferred Stock.''
    Upon consummation of the demutualization, the only capital stock 
outstanding will be the 50,500 shares of Class A Common Stock and the 
single share of Series A Preferred Stock. The Exchange proposes to 
authorize more shares of common stock (in the form of the Class B 
Common Stock) and preferred stock to allow for a more flexible approach 
to third-party investments and strategic relationships, which the 
Exchange believes will be critically important to its survival. The 
proposed Certificate of Incorporation will allow the Board of Governors 
to create and issue in the future additional classes or series of 
preferred stock without stockholder approval. In a separate 
undertaking, however, the Exchange has agreed to submit any such 
creation and issuance of additional classes or series of preferred 
stock to the Commission pursuant to section 19(b) of the Act.\12\ The 
issuance and the sale, transfer or other disposition of the Exchange's 
capital stock will be subject to certain voting and ownership 
limitations, described below.
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    \12\ 15 U.S.C. 78s(b).
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1. Common Stock
a. Class A Common Stock and Class B Common Stock
    Pursuant to Article FOURTH (b)(i) of the proposed Certificate of 
Incorporation, the Class A Common Stock and the Class B Common Stock 
will be identical in all respects and will have equal rights and 
privileges, except for the right to receive the Contingent Dividend (as 
defined below). Pursuant to Article FOURTH (b)(vi) of the proposed 
Certificate of Incorporation, each share of Class A Common Stock will 
automatically convert into one share of Class B Common Stock on the 
third anniversary of the closing of the Plan of Demutualization (the 
``Dividend Termination Date''). \13\ The proposed Certificate of 
Incorporation will provide that, before the automatic conversion, the 
Exchange will have to notify the holders of the Class A Common Stock in 
accordance with certain specific requirements set forth in the 
Certificate of Incorporation.
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    \13\ The automatic conversion will be effected as a matter of 
administrative convenience to consolidate the Common Stock into a 
single class after the Contingent Dividend will no longer be 
potentially payable (i.e., on the Dividend Termination Date). At the 
time of conversion, because the Contingent Dividend will no longer 
be potentially payable, the Class A Common Stock and the Class B 
Common Stock will have identical rights and privileges.
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b. Dividends (Including the Contingent Dividend)
    Currently, the existing Certificate of Incorporation provides that 
the Phlx is ``not for profit'' and ``no capital stock shall ever be 
issued and no dividend shall ever be paid'' by the Phlx. After the 
demutualization, this restriction on paying dividends will be removed, 
and the Phlx's stockholders will have all dividend and other 
distribution rights of a stockholder in a Delaware stock corporation 
(except as may be limited by the rights any preferred stock may have, 
once issued).
    Section 30-4 of the proposed By-laws, however, will prohibit the 
payment of dividends from any revenues the Phlx derives from regulatory 
fines, fees or penalties. The Exchange will apply this limitation to 
its net income, prospectively only, commencing with the fiscal year in 
which the Merger occurs.\14\ To determine the amount of the limitation, 
the Phlx will first calculate: (i) the amount of regulatory fines, fees 
and penalties that it has accrued for the fiscal year in which the 
Merger occurs and later time periods (collectively, ``Regulatory Fee 
Amount'');\15\ and (ii) the amount of

[[Page 3976]]

regulatory costs and expenses \16\ accrued for the same time period 
(collectively, ``Regulatory Cost Amount''). The Exchange will determine 
the applicable restriction by determining the excess, if any, of the 
Regulatory Fee Amount over the Regulatory Cost Amount, and applying 
that to the amount of its net income for the fiscal year in which the 
Merger occurs and later periods. The Exchange advises that this 
restriction concerning the payment of dividends shall not prevent it 
from paying dividends from: (i) Capital, surplus or retained earnings 
of the Exchange which were (without regard to this restriction) 
available for the payment of dividends at the time of the Merger; or 
(ii) capital contributions or other capital items, in each case, no 
portion of which is attributable to Regulatory Fees.
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    \14\ The Exchange indicates that its rationales for applying 
this restriction prospectively are: (i) Prior to the effectiveness 
of the Conversion Amendment, the Exchange's Certificate of 
Incorporation has provided that the Exchange is ``not for profit'' 
and has prohibited the payment of dividends altogether; and (ii) the 
Exchange has not compiled, and could not reasonably reconstruct, the 
information necessary for determining Regulatory Costs and 
Regulatory Fee Amounts (as defined herein) for prior periods.
    \15\ According to the Exchange, regulatory fines and penalties 
will include such amounts imposed by the Business Conduct Committee 
and/or the Phlx's Board of Governors (``Board''), but not late 
charges or interest charged. Regulatory fees shall include the 
Exchange's fees relating to registered representative registration 
(currently, initial, renewal and transfer fees), as well as its off-
floor trader (currently, initial and annual) and examinations fees.
    \16\ In the Phlx's view, these amounts include costs reasonably 
related to the Exchange's regulatory function. Specifically, the 
Exchange intends to include the direct and allocated costs and 
expenses of the regulatory and enforcement groups as well as an 
allocation of the direct and allocated costs of technology, legal, 
compliance and other departments that support the regulatory and 
enforcement groups and work on regulatory projects. The Exchange's 
cost allocation methodology includes an employee's compensation and 
benefits-related costs and the overhead attributable to that 
employee, such as, for example, occupancy costs, office supplies, 
and administrative support and an allocation of management costs 
(again, adding, for example, the secretary's and managers' direct 
and allocated costs).
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    Pursuant to Article FOURTH (b)(ii) of the proposed Certificate of 
Incorporation, the Class A Common Stock will carry with it the right to 
a contingent dividend (the ``Contingent Dividend'') payable in cash if 
a Liquidity Event occurs on or before the Dividend Termination Date. A 
``Liquidity Event'' will be any investment of net cash proceeds in the 
Phlx's capital or that of one of its subsidiaries, either by means of a 
public offering or private placement of the common or preferred stock 
of the Phlx or the common stock or other securities of the subsidiary. 
The amount payable as the Contingent Dividend will depend, as follows, 
on the aggregate amount of net cash proceeds received by the Phlx and/
or the subsidiary from all Liquidity Events occurring on or before the 
Dividend Termination Date:
     If the aggregate net cash proceeds will be at 
least $50 million but less than $100 million, the amount payable as a 
Contingent Dividend will be $7,500 for each 100 shares of Class A 
Common Stock ($3,787,500 in the aggregate).
     If the aggregate net cash proceeds will be at 
least $100 million but less than $150 million, the amount payable as a 
Contingent Dividend will be $17,500 for each 100 shares of Class A 
Common Stock then outstanding ($8,837,500 in the aggregate).
     If the aggregate net cash proceeds will be at 
least $150 million, the amount payable as a Contingent Dividend will be 
$29,700 for each 100 shares of Class A Common Stock then outstanding 
($14,998,500 million in the aggregate).
    If no Liquidity Event occurs on or before the Dividend Termination 
Date, the right to receive the Contingent Dividend will terminate 
without further action on behalf of the Exchange and the Class A Common 
Stock will be automatically converted into Class B Common Stock, as 
indicated above.
c. Liquidation Rights and Preferences
    Currently, Owners have the right to receive all distributions upon 
a liquidation of the Exchange, on the basis of their pro-rata interest 
in the Phlx, except as such right may be limited by certain rights of 
the holders of FCO participations. After the demutualization, the Phlx 
Common Stock will have the right to receive all distributions upon a 
liquidation of the Phlx, subject to the rights of any preferred stock 
that may be issued in the future and the rights of the holder of the 
Series A Preferred Stock.
d. Voting Rights/Election of Directors
    Currently, non-Member Owners do not have voting rights under the 
Exchange's existing Certificate of Incorporation, By-laws and Rules 
with respect to any matters relating to the Exchange, with certain very 
limited exceptions.\17\ After the demutualization, pursuant to Article 
FOURTH (b)(iii) of the proposed Certificate of Incorporation, the 
holders of Phlx Common Stock will vote on all matters on which 
stockholders are entitled to vote except for the election and removal 
of the On-Floor Governors, and, in the case of a contest for the 
position, the selection of the On-Floor Vice Chairman of the Exchange.
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    \17\ In addition, existing contractual arrangements between 
Owners of Seats or Member Organizations, on the one hand, and non-
Owner Members, on the other hand, such as leases or A-B-C 
agreements, in all but one case contain a provision that entitles 
the Seat Owner or the Member Organization, respectively, to direct 
the Member's vote with respect to the Plan of Demutualization.
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    The holders of the Class A Common Stock and Class B Common Stock 
will vote together as a single class on all matters, except that: (i) 
any amendment, alteration or repeal of any of the provisions of the 
proposed Certificate of Incorporation that adversely affects the 
rights, powers or privileges of the Class A Common Stock (but not of 
the Class B Common Stock) will require the affirmative vote of a 
majority of the shares of the Class A Common Stock then outstanding, 
voting separately as a class; and (ii) any amendment, alteration or 
repeal of any of the provisions of the proposed Certificate of 
Incorporation that adversely affects the rights, powers or privileges 
of the Class B Common Stock (but not of the Class A Common Stock) will 
require the affirmative vote of a majority of the shares of Class B 
Common Stock then outstanding, voting separately as a class.
    In addition, pursuant to Section 22-1 of the proposed By-laws, the 
By-Laws may be amended by the affirmative vote of a majority of the 
entire Board of Governors, or by the affirmative vote of the holders of 
a majority of the shares of common stock then issued and outstanding, 
at any regular or special meeting of the Board of Governors or the 
stockholders (as the case may be). Unlike pursuant to Section 22-1 of 
the existing By-laws, after the demutualization, Members (or Member 
Organizations) will have no right to vote in relation to By-law 
amendments or to propose By-law amendments. The Phlx states that such 
change is consistent with the Exchange's proposed post-demutualization 
structure as a Delaware stock corporation in accordance with applicable 
Delaware law.
    With respect to management equity awards, Section 6-1 of the 
proposed By-laws provides that, the Exchange will not at any time adopt 
any stock incentive or option plan or arrangement, or any other equity 
based compensation plan or arrangement, for the benefit of its 
governors or officers that authorizes the issuance of stock, stock 
options or any other securities exercisable or exchangeable for or 
convertible into any equity interest in the Exchange representing more 
than 10% of the Common Stock outstanding at such time.
e. Voting Limitations Regarding the Common Stock
    Article FOURTH (b)(iii)(A) of the proposed Certificate of 
Incorporation provides that each stockholder will be entitled to one 
vote for each share of Common Stock held of record on the books of the 
Phlx, subject to the applicable voting restrictions as described below. 
In connection with the demutualization, the Exchange proposes to 
include certain voting limitations as set forth in Article FOURTH 
(b)(iii)(B) of the proposed Certificate of Incorporation. The 
limitations will provide that, if any Person (as defined

[[Page 3977]]

below) either alone or together with its Related Persons (as defined 
below), at any time owns of record or beneficially, whether directly or 
indirectly, more than 20% of the then outstanding shares of Common 
Stock (such shares of Common Stock in excess of such 20% limit being 
hereinafter referred to as ``Excess Shares''), that Person and its 
Related Persons will not have any right to vote, or to give any consent 
or proxy with respect to, the Excess Shares, and the Excess Shares will 
be deemed not to be present for the purposes of determining whether a 
quorum is present at any meeting or vote of the stockholders of the 
Exchange. For purposes of the proposed Certificate of Incorporation, 
``Related Persons'' means: (i) with respect to any Person, all 
``affiliates'' and ``associates'' of such Person (as such terms are 
defined in Rule 12b-2 under the Act);\18\ (ii) with respect to any 
natural person constituting a ``member'' (as such term is defined in 
the Act) of the Exchange, any broker or dealer with which such member 
is associated; and (iii) any two or more Persons that have any 
agreement, arrangement or understanding (whether or not in writing) to 
act together for the purpose of acquiring, holding, voting or disposing 
of shares of common stock. The term ``Person'' will be defined in the 
proposed Certificate of Incorporation to mean an individual, 
partnership (general or limited), joint-stock company, corporation, 
limited liability company, trust or unincorporated organization, and a 
government or agency or political subdivision thereof.
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    \18\ 17 CFR 240.12b-2.
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    Notwithstanding the foregoing, a Person, either alone or together 
with its Related Persons, owning of record or beneficially, whether 
directly or indirectly, more than 20% of the then outstanding shares of 
Common Stock will be allowed to exercise voting rights, and give 
proxies and consents, with respect to those shares exceeding 20%, 
provided that:
     such Person (and its Related Persons owning any 
Common Stock) has delivered to the Board of Governors a notice in 
writing, not less than 45 days (or any shorter period to which the 
Board of Governors shall expressly consent) before the proposed 
exercise of its voting rights, of its intention to do so; and
     before the intended exercise, the Board of 
Governors has adopted an amendment to the By-Laws adding a provision to 
expressly permit such Person's exercise of voting rights in excess of 
20%; and the amendment has been filed with the Commission as a proposed 
rule change under Section 19(b) of the Act \19\ and has become 
effective.
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    \19\ 15 U.S.C. 78s(b).
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    The Board of Governors will not be permitted to adopt any amendment 
to the proposed By-laws described in the foregoing paragraph unless the 
Board of Governors has determined that: (i) the exercise of those 
voting rights by the Person in question and/or its Related Persons will 
not impair the Exchange's ability to discharge its responsibilities 
under the Act and the rules and regulations thereunder and is otherwise 
in the best interests of the Exchange and its stockholders; (ii) the 
exercise of those voting rights by that Person and its Related Persons 
will not impair the Commission's ability to enforce the Act; and (iii) 
that Person and its relevant Related Persons are not subject to any 
applicable statutory disqualification. In making those determinations, 
the Board of Governors may impose on the Person in question and its 
Related Persons such conditions and restrictions as it may in its sole 
discretion deem necessary, appropriate or desirable in furtherance of 
the objectives of the Act and the governance of the Exchange. Under the 
proposed Certificate of Incorporation, however, in no event will a 
Person who is a Member of the Exchange, either alone or together with 
its Related Persons, be permitted to vote shares in excess of 20% of 
the outstanding Common Stock.\20\
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    \20\ See Section II.A.1.f. for a discussion regarding the 
ownership limitations placed on Members under the proposed 
Certificate of Incorporation.
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f. Ownership Limitations, Notification Requirements and Transfer 
Requirements Regarding the Common Stock
    Pursuant to Article FOURTH (b)(v) of the proposed Certificate of 
Incorporation, no Person, either alone or together with its Related 
Persons, will be allowed to own, of record or beneficially, directly or 
indirectly, more than 40% of the then outstanding shares of Common 
Stock of the Phlx and to the extent any Person (or its Related Persons) 
purports to own more than 40% of the then outstanding shares of common 
stock, that Person (and its Related Persons) will not be allowed to 
exercise any of the rights or privileges incident to the ownership of 
shares of common stock with respect to the shares exceeding the 40% 
limit, unless:
     such Person (as well as its Related Persons) has 
delivered to the Board of Governors a notice in writing, not less than 
45 days (or such shorter period to which the Board of Governors 
expressly consents) before the acquisition of that ownership, of its 
intention to acquire the ownership; and
     before the intended exercise, the Board of 
Governors has adopted an amendment to the By-Laws, adding a provision 
to expressly permit that Person's ownership in excess of 40%, and the 
amendment has been filed with the Commission as a proposed rule change 
under Section 19(b) of the Act, which has become effective.
    The Board of Governors will not be permitted to adopt any amendment 
to the proposed By-laws described in the foregoing paragraph unless the 
Board of Governors has determined that: (i) Such acquisition of such 
ownership by such Person in question and/or its Related Persons will 
not impair the Exchange's ability to discharge its responsibilities 
under the Act and the rules and regulations thereunder and is otherwise 
in the best interests of the Exchange and its stockholders; (ii) such 
acquisition of such ownership by such Person and its Related Persons 
will not impair the Commission's ability to enforce the Act; and (iii) 
that Person and its relevant Related Persons are not subject to any 
applicable statutory disqualification. In making those determinations, 
the Board of Governors may impose on the Person in question and its 
Related Persons such conditions and restrictions as it may in its sole 
discretion deem necessary, appropriate or desirable in furtherance of 
the objectives of the Act and the governance of the Exchange.
    Unless the conditions specified above are met, if any Person 
exceeds the 40% threshold, either alone or together with its Related 
Persons, the Phlx will have the right, but not the obligation, to 
purchase from that Person and its Related Persons the shares of Common 
Stock that exceed the 40% threshold for a price equal to the par value 
of the shares of Common Stock.
    In addition, pursuant to Article FOURTH (b)(v)(B) of the proposed 
Certificate of Incorporation, no Member, either alone or together with 
its Related Persons, will be allowed to own, of record or beneficially, 
directly or indirectly, more than 20% of the then outstanding shares of 
Common Stock of the Exchange. To the extent that any Member (or its 
Related Persons) purports to so own more than 20% of the then 
outstanding shares of Common Stock, that Member (and its Related 
Persons) will not be allowed to exercise any of the rights or 
privileges incident to the ownership of shares of Common Stock with 
respect to the shares exceeding the 20% limit.

[[Page 3978]]

    If any Member exceeds the 20% threshold, either alone or together 
with its Related Persons, the Phlx will have the right, but not the 
obligation, to purchase from that Member and its Related Persons the 
shares of Common Stock that exceed the 20% threshold for a price equal 
to the par value of the shares of Common Stock. Also, unlike ownership 
by non-Members in excess of 40%, the proposed Certificate of 
Incorporation does not contain a proviso allowing for Members to own 
shares in excess of 20% with appropriate notification and a By-law 
amendment sanctioned by the Commission.
    In addition, pursuant to Article FOURTH (b)(iv) and (v) of the 
proposed Certificate of Incorporation, any Person, either alone or 
together with its Related Persons, that at any time owns (whether by 
acquisition or by a change in the number of shares outstanding) of 
record or beneficially, directly or indirectly, 5% or more of the then 
outstanding shares of Common Stock will be required, immediately upon 
so owning 5% or more of the then outstanding shares of Common Stock, to 
give the Board of Governors written notice of that ownership and will 
be required to update the notice promptly after any ownership change. 
However, an updated notice will not have to be provided to the Board of 
Governors in the event of an increase or decrease of less than 1% (of 
the then outstanding shares of Common Stock) in the ownership 
percentage so reported (for that purpose, the increase or decrease will 
be measured cumulatively from the amount shown on the immediately 
preceding report) unless such increase or decrease of less than 1% 
results in such Person's owning more than 20% or more than 40% of the 
shares of Common Stock then outstanding (at a time when such Person so 
owned less than those percentages) or results in such Person's owning 
less than 20% or less than 40% of the shares of Common Stock then 
outstanding (at a time when such Person so owned more than those 
percentages). These voting and ownership limitations, together with the 
notification requirements, are intended to establish a system of 
supervision and control to effectively prevent acquisition of voting 
power of or assertion of control over the Exchange without the approval 
of both the Board of Governors and the Commission. In addition, the 
proposed 20% threshold on member ownership is designed to prevent any 
Member Organization from dominating the Exchange. These notification 
requirements will also allow the Exchange to fulfill its reporting 
obligations to the Commission \21\ and to better monitor the voting and 
ownership limitations in the proposed Certificate of Incorporation 
described above.
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    \21\ 17 CFR 249.1a.
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g. Transfer Restrictions
    Pursuant to Section 29-1 of the proposed By-laws, no stockholder of 
the Exchange may sell, transfer (by operation of law or otherwise) or 
otherwise dispose of any shares of Class A Common Stock except in 
blocks of 100 shares per sale, transfer or disposition. This transfer 
restriction is intended to ensure that the number of holders of common 
stock of the Exchange will not exceed the threshold for having to 
register the Exchange with the Commission under Section 12 of the 
Act.\22\ The Exchange believes that, at least for some period of time 
after the demutualization, the obligation of being a public reporting 
company would be overly burdensome on the Exchange as compared to the 
advantages conferred by that status.
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    \22\ 15 U.S.C. 78l.
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    In addition, the Phlx states that Article 29 of the proposed By-
laws contains other restrictions typical for a Delaware stock 
corporation to ensure compliance with the Securities Act of 1933 
(``Securities Act''),\23\ and to allow for efficient future marketing 
of the capital stock by an underwriter in connection with and after a 
potential initial public offering of shares of capital stock of the 
Exchange.\24\ Accordingly, Section 29-2 of the proposed By-laws 
provides that after the demutualization, no sale, transfer or other 
disposition of the capital stock of the Exchange may be effected 
except: (i) Pursuant to an effective registration statement under the 
Securities Act and in accordance with all applicable state securities 
laws; (ii) upon delivery to the Exchange of an opinion of counsel 
satisfactory to the Board that such sale, transfer or other disposition 
may be effected pursuant to a valid exemption from the registration 
requirements of the Securities Act and all applicable state securities 
laws; (iii) upon delivery to the Exchange of such certificates or other 
documentation as counsel to the Exchange shall deem necessary or 
appropriate in order to ensure that such sale, transfer or other 
disposition complies with the Securities Act and all applicable state 
securities laws; or (iv) pursuant to such procedures as the Chairman of 
the Board (or his designee) may adopt from time to time with respect to 
such transactions. In addition, no sale, transfer or other disposition 
of the capital stock of the Exchange may be effected by any holder of 
such stock until all amounts due and owing by such holder to the 
Exchange (whether any such amounts relate to such holder's status as a 
stockholder, Member, participant or Member (or participant) 
Organization of the Exchange or otherwise) shall have been paid in 
full.
---------------------------------------------------------------------------

    \23\ 15 U.S.C. 77.
    \24\ The Phlx notes that no such transaction is currently 
contemplated at this time.
---------------------------------------------------------------------------

    In addition, Section 29-3 of the proposed By-laws provides that no 
stockholders, if requested by the Exchange or any underwriter of equity 
securities of the Exchange, may sell or otherwise transfer or dispose 
of any shares of capital stock of the Exchange held by such stockholder 
during the 180-day period following the effective date of a 
registration statement of the Exchange filed under the Securities Act 
in respect of that class of capital stock. If requested by the Exchange 
or any such underwriters, each stockholder will be required to execute 
an agreement to the foregoing effect. The Exchange may impose stop-
transfer instructions with respect to the shares (or securities) 
subject to the foregoing restriction until the end of said 180-day 
period.
2. Series A Preferred Stock/Phlx Member Voting Trust
a. Designation and Issuance of Series A Preferred Stock to Phlx Member 
Voting Trust/Trust Agreement
    Article FOURTH of the proposed Certificate of Incorporation will 
designate one share of preferred stock as the ``Series A Preferred 
Stock.'' The Series A Preferred Stock will have the sole power to: (i) 
Select the On-Floor Governors, and (ii) remove the On-Floor Governors 
in accordance with specified procedures in connection with the removal 
of Governors.
    As set forth in the Trust Agreement, at the effective time of the 
Merger, the Exchange will issue the share of Series A Preferred Stock 
to the Trust. Pursuant to Section 4.1 of the Trust Agreement, the 
Trustee of the Trust will have to vote the share of Series A Preferred 
Stock with respect to the designated nominees for election as On-Floor 
Governors, or the removal of On-Floor Governors, as the case may be, as 
directed by the vote of the Member Organization Representatives of 
Member Organizations entitled to vote.
    The single share of the Series A Preferred Stock, issued to the 
Trust governed by the Trust Agreement, is designed to facilitate the 
exercise by Members and Member Organizations of their rights to fair 
representation in the

[[Page 3979]]

selection and removal of On-Floor Governors of the Exchange and to 
facilitate the administration of the affairs of the Exchange in 
accordance with the Act. The voting arrangements implemented through 
the Trust Agreement and the Series A Preferred Stock are designed to 
give ``members'' (as defined in Section 3(a)(3)(A) of the Act) \25\ a 
voice in the management of the Exchange after the demutualization. 
These arrangements are necessary for two reasons: (i) Under Delaware 
law, only stockholders can elect the directors of a Delaware 
corporation; and (ii) after the demutualization, Members and Member 
Organizations that were not Owners at the time of the demutualization 
will not be stockholders of the Exchange.
---------------------------------------------------------------------------

    \25\ 15 U.S.C. 78c(a)(3)(A).
---------------------------------------------------------------------------

b. Dividend Rights
    Because the Series A Preferred Stock will be issued only to enable 
the non-stockholder Member Organizations to vote indirectly for the On-
Floor Governors, Article FOURTH (a)(i) of the proposed Certificate of 
Incorporation will provide that the Series A Preferred Stock will not 
have the right to receive any dividends.
c. Liquidation Preferences
    Pursuant to Article FOURTH (a)(ii) of the proposed Certificate of 
Incorporation, upon liquidation of the Phlx the holder of the share of 
Series A Preferred Stock will be entitled to receive an amount equal to 
the par value of the share of Series A Preferred Stock (or $0.01) held 
by the holder after the payment of, or provision for, obligations of 
the Phlx and any preferential amounts payable to holders of any other 
class or series of outstanding shares of preferred stock.
d. Transferability
    Article FOURTH (a)(iv) of the proposed Certificate of Incorporation 
will provide that the Series A Preferred Stock will not be transferable 
(whether by sale, pledge, operation of law or any other disposition) 
without the prior written consent of the Board. If the Board determines 
that it is in the best interests of the Exchange or its stockholders 
for any holder of the share of Series A Preferred Stock to sell the 
share to the Exchange or any other person, the holder will be required 
under Article FOURTH (a)(iii) of the proposed Certificate of 
Incorporation to effect the sale as directed by the Board.\26\
---------------------------------------------------------------------------

    \26\ Any proposal to sell the Series A Preferred Stock would 
have to be filed with the Commission pursuant to Section 19(b) of 
the Act.
---------------------------------------------------------------------------

B. Corporate Governance of the Demutualized Phlx

    According to Article SIXTH of the proposed Certificate of 
Incorporation and Sections 4-1 and 4-4 of the proposed By-laws, the 
principal management of the Phlx after demutualization will continue to 
rest with the Board and the Standing Committees of the Exchange. To 
ensure compliance with the Act in the context of a demutualized 
Exchange, Article SIXTH of the proposed Certificate of Incorporation 
will provide that, in managing the business and affairs of the Phlx, 
the Governors will have to consider applicable requirements for 
registration as a national securities exchange under Section 6(b) of 
the Act,\27\ including the requirements that: (i) the rules of the Phlx 
be designed to protect investors and the public interest, and (ii) the 
Phlx be so organized and have the capacity to carry out the purposes of 
the Act and (except as otherwise provided in the Act or the rules and 
regulations thereunder) to enforce compliance by its Members and 
persons associated with its Members with the Act, the rules and 
regulations thereunder, and the rules of the Phlx.
---------------------------------------------------------------------------

    \27\ 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

1. Board of Governors--Composition; Eligibility
    Article SIXTH of the proposed Certificate of Incorporation, 
together with Section 4 of the proposed By-laws, will set forth the 
required number and composition of the Board. Pursuant to Section 4-1 
of the proposed By-laws, the composition of the Board will be the same 
as before the demutualization and, as set forth in Section 4-3(b) of 
the proposed By-laws, will consist initially of the same individuals in 
office at the time of the demutualization. According to Article SIXTH 
(a) of the proposed Certificate of Incorporation, the Board will 
continue to have a total of 22 Governors and be composed as follows:
     the Chairman of the Board, who will be the 
individual then holding the office of Chief Executive Officer 
(``CEO'');
     11 Non-Industry Governors (of whom at least five 
will have to be public Governors); and
     10 Industry Governors (of whom five will have to 
be On-Floor Governors and five will have to be Off-Floor Governors).
    The criteria set forth in the Exchange's current By-laws for 
eligibility of persons to serve as a Governor within each category of 
Governor will remain the same after demutualization.
2. Board of Governors--Classification and Term Limits
    According to Section 4-3(a) of the proposed By-laws, the Board will 
remain classified, with Governors serving staggered three-year terms. 
Governors (other than the Chairman) may serve for up to two consecutive 
three-year terms starting from the effective time of the Merger. In 
order to preserve continuity post-demutualization, Section 4-3(b) of 
the proposed By-laws will provide that Governors who hold their 
positions at the effective time of the Merger will continue to hold 
those positions, in their respective classes, until their original 
terms expire and that the term limits will not take into consideration 
any service as Governor before the demutualization but will only apply 
from and after the effective time of the Merger. The Exchange believes 
that this provision serves to ensure continuity in the governing body 
of the Exchange through such a significant corporate event as the 
demutualization.
3. Nomination and Election of Governors
    According to the Phlx, the Exchange's nomination and election 
procedures are revised to ensure continuing fair representation for 
Members and Member Organizations in the context of the demutualized 
Exchange, while at the same time adapting the Exchange to its proposed 
status as a demutualized business corporation with stockholders. 
Generally, the new nomination and election structure of the Exchange 
will be as follows:
     The Non-Industry Governors, Off-Floor Governors 
and the Chairman of the Board will continue to be nominated by the 
Nominating and Elections Committee and will be elected by the holders 
of the Common Stock at meetings of stockholders.
     Stockholders will be permitted to make 
independent nominations of Non-Industry and Off-Floor Governors upon 
written notice of the nominations not less than 90 nor more than 120 
days before the first Monday in February of each year (or such other 
date as the Board may establish). These nominations will be subject to 
review by the Nominating and Elections Committee.
    Member Organizations, as described below, will designate the On-
Floor Governors in accordance with the following procedures:
     On-Floor Governors will be nominated by the 
Nominating and Elections Committee from recommendations made: (i) By 
members

[[Page 3980]]

of the Nominating and Elections Committee; or (ii) by any Member, 
participant or Member Organization Representative.
     Independent nominations by Member Organization 
Representatives will be valid only if signed by Member Organization 
Representatives representing no less than 50 votes.
     Member Organizations, through their authorized 
Member Organization Representative, will vote for designated On-Floor 
Governors among nominees so selected at the annual meeting of Members 
and Member Organizations.
     Nominees for Governors receiving the highest 
numbers of votes for the category of Governor for which they were 
respectively nominated as candidates will be declared the ``Designated 
Nominees'' for those offices. In case of a tie, the Nominating and 
Elections Committee will make the selection as to who among the tying 
nominees shall be designated.
     On-Floor Governors will then be elected by the 
Trust owning the share of Series A Preferred Stock based on the 
``Designated Nominees'' elected by the Member Organization 
Representatives as described above.
4. Governors--Vacancies and Removal
    In accordance with Section 3-8 of the proposed By-laws, vacancies 
(including vacancies created by increases in the size of the Board of 
Governors) will continue to be filled by the Nominating and Elections 
Committee, upon approval by a majority of the Governors. With respect 
to the removal of Governors, Article SIXTH (b) of the proposed 
Certificate of Incorporation and Sections 3-3 and 4-4 of the proposed 
By-laws will provide that Governors may be removed only for cause or, 
under certain circumstances, upon recommendation by a majority of the 
Board of Governors. In addition, Governors may be removed only by a 
66\2/3\% vote of the group that elected them (i.e., the holders of 
common stock, in the case of the Non-Industry or Off-Floor Governors, 
or the share of Series A Preferred Stock as instructed by a vote of the 
Member Organization Representatives, in the case of the On-Floor 
Governors).
    An On-Floor Governor may be removed at any annual or special 
meeting. A special meeting for the removal of an On-Floor Governor may 
be called by the Chairman of the Board of Governors or the Board of 
Governors or, only in the case of a special meeting of Member 
Organization Representatives for the purpose of voting on the removal 
of an On-Floor Governor, by the Member Organization Representatives 
representing a majority of the then issued and outstanding permits. If 
such a meeting is proposed to be called by Member Organization 
Representatives, such Member Organization Representatives must provide 
the Chairman written notice prior to calling any such meeting stating 
in reasonable detail the basis for, and the facts and circumstances 
purported to warrant, such removal of the relevant On-Floor Governor.
5. Committees
    No changes will be made in Board committee structure or composition 
as part of the demutualization process, except as follows:
     pursuant to Sections 10-6 and 10-17 of the 
proposed By-laws, respectively, at least half of the Admissions 
Committee and the Foreign Currency Options Committee, respectively, 
will have to be Members, participants or persons affiliated with Member 
Organizations or participant organizations;
     pursuant to Sections 10-20 and 10-16 of the 
proposed By-laws, respectively, at least half of the Options Committee 
and the Floor Procedure Committee, respectively, will have to be 
Members or persons affiliated with Member Organizations;
     pursuant to Section 10-6 of the proposed By-
laws, the Business Conduct Committee will share with the Admissions 
Committee jurisdiction over the revocation of permits and foreign 
currency options participations in connection with disciplinary 
matters; and
     pursuant to Section 10-7(a) and (b) of the 
proposed By-laws, certain term limits applicable to members of the 
Allocations Committees will be eliminated.
    The existing Certificate of Incorporation and By-laws do not 
include any specification as to the composition of the Admissions 
Committee, Foreign Currency Options Committee, the Options Committee or 
the Floor Procedure Committee and, therefore, do not require the 
committees to include any Industry Governors. Accordingly, the Phlx 
states that the proposed rule change will ensure participation of 
Industry Governors on each of these committees, thereby allowing 
Industry Governors to take part in decisions made in vital areas of 
day-to-day trading operations and membership matters. The elimination 
of term limits respecting the Allocations Committees is intended to 
achieve consistency with most other committees, which do not have such 
limits.
6. Management and Executive Officers
    The management structure of the Exchange, including its executive 
officers, will remain unchanged in the demutualization in accordance 
with Article V of the proposed By-laws. The CEO position will continue 
to be a full-time position to be appointed by the Board, and the holder 
of this position will act as the Board's Chairman. The person acting as 
CEO at the time of the demutualization will be the only nominee for the 
position of Chairman of the Board, and will be elected by the votes of 
the holders of the Common Stock. The existing requirement that the CEO 
may not be a partner of a Member (or participant) Organization, nor an 
employee, agent, consultant, officer, director or stockholder of a 
Member (or participant) Organization will be retained. The CEO will 
appoint the other officers of the Exchange.
7. Limitation of Liability and Indemnification
    Articles FIFTEENTH and SIXTEENTH of the proposed Certificate of 
Incorporation and Section 4-18 of the proposed By-laws will include 
provisions substantially similar to the Article EIGHTEENTH of the 
existing Certificate of Incorporation, in accordance with Section 145 
of the Delaware General Corporation Law. Such provisions eliminate the 
personal liability of Governors (and other persons mentioned below) for 
monetary damages for breach of fiduciary duty as a Governor, except for 
liability:
     for any breach of the Governor's duty of loyalty 
to the Phlx or its stockholders;
     for acts or omissions not in good faith or that 
involve intentional misconduct or a knowing violation of law;
     under Section 174 of the Delaware General 
Corporation Law regarding unlawful dividends and stock purchases; or
     for any transaction from which the Governor 
obtained an improper personal benefit.
    The proposed Certificate of Incorporation and By-laws will further 
permit the Phlx to indemnify to the fullest extent permitted under and 
in accordance with the laws of the State of Delaware any Governor (or 
director) or officer of the Phlx, and any person that is or was serving 
at the request of the Phlx as a Governor, committee member or in-house 
legal counsel, officer, director (or person in similar position), 
employee or agent of another corporation or of a partnership (general 
or limited), limited liability company,

[[Page 3981]]

joint venture, trust or other enterprise or business entity, against 
expenses (including attorneys' fees), judgments, fines and amounts paid 
in settlement actually and reasonably incurred by the person in 
connection with any action, suit or proceeding if the person acted in 
good faith and in a manner the person reasonably believed to be in or 
not opposed to the best interests of the Phlx, and, with respect to any 
criminal action or proceeding, had no reasonable cause to believe the 
person's conduct was unlawful. The Phlx may also pay the expenses of 
indemnified persons incurred in defending a suit or proceeding in 
advance of the final disposition of the suit or proceeding. The 
proposed Certificate of Incorporation will also permit the Phlx to 
secure insurance on behalf of any officer, director, employee or other 
agent for any liability arising out of his or her actions in that 
capacity. The Exchange believes that these indemnification provisions 
are substantially similar to those generally employed by other Delaware 
stock corporations and the scope of the persons covered is intended to 
continue to attract and retain qualified personnel.

C. Members and Member Organizations

1. Member Organizations and Member Organization Representatives
    As under the current structure, a Member will continue to be 
permitted to be associated with more than one Member Organization.\28\ 
In accordance with proposed Rule 908(c)(ii), each holder of a permit 
will be obliged, however, to designate only a single eligible 
organization with which the Member is associated as the Member's 
``primary affiliation'' for the purposes of voting, as will be provided 
in Article III of the proposed By-laws. A Member will be allowed to 
qualify as a Member Organization only the entity the Member has 
designated as his or her primary affiliation. Accordingly, every Member 
shall have one primarily-affiliated Member Organization and may have 
more than one associated Member Organization.
---------------------------------------------------------------------------

    \28\ See Phlx Rule 793.
---------------------------------------------------------------------------

    Unlike the current Phlx regime, after demutualization, individual 
Members will not directly be accorded voting rights. Rather, in regard 
to the election and removal of On-Floor Governors, Member Organizations 
will be entitled to exercise voting rights in respect of the permits 
held by those Members who have designated the Member Organization as 
their primary affiliation. Specifically, pursuant to proposed Rule 921 
and Section 12-8 of the proposed By-laws, each Member Organization will 
have to register with the Exchange and designate a single individual as 
its ``Member Organization Representative.'' The concept of a Member 
Organization Representative is designed to facilitate the post-
demutualization voting process. Permit holders, or Members, themselves 
will not exercise any voting rights. Instead, voting rights associated 
with a permit will be exercised by the Member Organization with which 
the Member is primarily associated and, as noted above, will be 
exercised by the Member Organization's Member Organization 
Representative. The Member Organization Representative will be the only 
person who may exercise the voting rights in respect of the Member 
Organization in respect of matters on which Member Organizations may 
vote. Proposed Rule 921 also will provide that a Member Organization 
Representative will have to accept the designation by filling out a 
registration documentation required by the Exchange.
    Pursuant to proposed Rules 921 and 972, with the exception of 
certain provisions in proposed Rule 921(c) retaining the existing 
concept of ``inactive nominees'' in order to alleviate hardships, 
failure to qualify a Member Organization Representative at any time 
will prevent a Member Organization from exercising any rights in 
connection with the Exchange, including the right to vote for 
designated On-Floor Governors as described below.
    According to proposed Rule 924, Members \29\ will be liable with 
respect to any fees, fines, dues, penalties or other amounts imposed by 
the Exchange in connection with such Member's permit or any activities 
conducted in connection with such permit, whether or not any such 
obligation was incurred on behalf of his account or on behalf of his 
Member Organization. In addition, proposed Rule 924 will provide that 
Member Organizations will be liable with respect to any fees, fines, 
dues, penalties or other amounts imposed by the Exchange in connection 
with such Member Organization and any Member associated with such 
Member Organization in connection with a permit or any activities 
conducted in connection with such permit by such Member on behalf or 
for the account of such Member Organization. Under proposed Rule 
924(b), similar to the rule in effect today, Member Organizations will 
have the ability to allocate responsibilities among themselves 
regarding Members associated with more than one Member Organization, 
provided that any such arrangements have been provided to the Exchange 
in the form required by it at least 30 days prior to their desired 
effectiveness.
---------------------------------------------------------------------------

    \29\ This rule also applies to FCO participants and participant 
organizations with respect to FCO participations.
---------------------------------------------------------------------------

2. Voting Rights
    After the demutualization, holders of permits will not have any 
voting rights. Member Organizations will have the right to:
     designate the five On-Floor Governors for 
election to the Board in accordance with Section 3-12 of the proposed 
By-laws;
     remove the On-Floor Governors in accordance with 
Sections 3-2(c) and 3-3 of the proposed By-laws (together with the 
right to designate the On-Floor Governors, the ``Designation Rights''); 
and
     designate the On-Floor Vice-Chair in a contested 
election as described below.
    Each permit will carry one vote. As discussed above, the vote may 
be exercised only by the qualified Member Organization Representative 
of a Member Organization designated by a holder of a permit as its 
primary affiliation.
    The Designation Rights will be exercised in accordance with the 
following procedure:
     based on input from the membership or others, 
the Nominating and Elections Committee will propose a slate of 
qualified On-Floor Governors;
     in addition, the Member Organization 
Representatives, representing at least 50 permits, will be permitted to 
propose qualified alternative candidates;
     the Member Organization Representatives, at an 
annual meeting of Members and Member Organizations, will then elect the 
designated On-Floor Governors from among the Nominating and Elections 
Committee's slate and any qualified individuals nominated by Member 
Organization Representatives in accordance with the nomination 
procedures.
    The winners of this election will then be eligible for designation 
as On-Floor Governors. In compliance with Delaware corporate law, the 
designated On-Floor Governors will be formally elected by the Trust 
that holds the single outstanding share of Series A Preferred Stock in 
accordance with Article FOURTH (a)(iii) of the proposed Certificate of 
Incorporation.

[[Page 3982]]

3. Contested Election of the On-Floor Vice Chairman
    With respect to the election of the On-Floor Vice Chairman, Section 
4-2 of proposed By-laws will provide that, if there is a contest for 
the position of On-Floor Vice Chairman of the Board, the On-Floor Vice 
Chairman of the Board may be selected from the On-Floor Governors by a 
vote of the Member Organization Representatives, as promptly as 
possible after the annual meeting of stockholders at a special meeting 
of Members and Member Organizations called for that purpose.
4. Voting Concentration Limits
    In order to prevent any group of Members of Member Organizations 
from dominating elections of the Member Organization Representatives, 
the proposed By-laws will provide in Section 3-12(c) that if any Member 
Organization, directly or indirectly, possesses the right to vote more 
than 20% of the then outstanding permits, that Member Organization will 
not have any right to vote, or to give any consent or proxy with 
respect to, any permits exceeding the 20% (``Excess Permits''), and the 
Excess Permits will not be considered present for the purposes of 
determining whether a quorum is present at any meeting or vote of the 
Members or Member Organizations, and will not be entitled to vote in 
determining the number of permits required for a quorum or to be voted 
for approval of or to give consent with respect to any matter presented 
to the Members or the Member Organizations.
5. Member and Member Organization Meetings and Actions
    Pursuant to Section 3-2 of the proposed By-laws, annual meetings of 
Members and Member Organizations will be held on the second Monday in 
March of each year to designate nominees for On-Floor Governors. Except 
with respect to a special meeting called for the purpose of removing an 
On-Floor Governor, special meetings of Members or the Member 
Organization Representatives may be called at any time only by the 
Chairman of the Board or by a majority of the Board.
    At all meetings of Members and Member Organizations, each Member 
Organization Representative may cast his or her vote in person or by 
proxy, provided that no action will become effective unless there shall 
have been voted a majority of the number of permits outstanding at such 
time, not including any Excess Permits. Each Member Organization 
Representative may cast the number of votes equal to the number of 
permits held by Members having designated the Member Organization 
Representative's Member Organization as its primary affiliation 
(subject to the voting restrictions described above).
    Section 3-11 of the proposed By-laws will provide that notice of 
any meeting of Members and Member Organizations must be given to each 
Member Organization Representative entitled to vote at such meeting not 
less than 10 days nor more than 50 days before the date of the meeting.
6. Disciplinary Actions and Appeal Process
    The Exchange states that enforcement of any disciplinary action and 
appeals of any disciplinary action will be conducted in the same manner 
as before the demutualization.

D. Permits and Trading Rights

1. Issuance of Permits and Application Process
    Under the proposed Plan of Demutualization, access to the Exchange 
facilities and the right to trade will be conferred by the newly-issued 
permits rather than by ownership or leasing of Seats of the Exchange. 
As discussed above, trading of foreign currency options will continue 
to be allowed through the existing FCO participations, but, following 
the demutualization, will also be permitted through permits, as will be 
provided in proposed Rule 908(c)(i).
    Proposed Rule 971 will provide that all ETPs and ETP use agreements 
will terminate with immediate effect as of the close of trading on the 
day the Merger becomes effective without any further action on the part 
of any party thereto. Similarly, proposed Rule 971 will also provide 
that all leases of Seats and all leases and A-B-C agreements with 
respect to such Seats, will terminate with immediate effect as of the 
close of trading on the day the Merger becomes effective without any 
further action on the part of any party thereto. All provisions in the 
Certificate of Incorporation, By-laws and Rules relating to the 
transfer or lease of a Seat or A-B-C agreement, and all defined terms 
related thereto (such as ``Lessor'' and ``Lessee'') will be amended as 
necessary to reflect that, after the demutualization, these provisions 
and defined terms will only apply to FCO participations. These 
provisions will no longer be applicable to permits, because permits 
(including the Series A-1 Permits) will not constitute property that 
can be transferred by its holder (except within the same member 
Organization). Similarly, the provisions relating to ETPs, such as Rule 
23, will be deleted.
    To provide an orderly transition from Seats to permits, proposed 
Rule 972 will allow each Member (including, without limitation, each 
holder of an ETP), inactive nominee and Member Organization holding 
that status immediately before the effective time of the Merger that, 
at that time, is not subject to any suspension of that status, to 
maintain that status. All Members and ETP holders who fulfill the 
requirements described in the previous sentence will receive Series A-1 
Permits immediately upon the demutualization.
    Proposed Rule 972 will also provide that existing Member 
Organizations will maintain their status for a period of 15 days 
following the Merger. Each Member Organization, however, will have to 
provide to the Admissions Committee and the Exchange, as applicable, 
before the end of the 15-day period, the following:
     the security deposit or alternative compliance 
with proposed Rule 909 (the ``security requirement'') (as described 
below);
     the form to be filed by the Member 
Organization's qualifying permit holder; and
     the designation of the Member Organization's 
Member Organization Representative in the form prescribed by the 
Exchange.
    If a Member Organization fails within that period to comply with 
the security requirement and/or to furnish the form to be filed by the 
Member Organization's qualifying Member, the Member Organization's 
status as such will immediately be suspended. If a Member Organization 
fails to designate a Member Organization Representative, the Member 
Organization may not exercise any voting rights with respect to any 
permits held by persons who are associated with the Member 
Organization.
2. Classes or Series of Trading Permits
    Immediately after the demutualization, pursuant to Section 12-1 of 
the proposed By-laws and proposed Rule 908, there will be only one 
series of permit, called the ``Series A-1 Permit,'' which will confer 
upon its holder all the rights and privileges of a Member of the 
Exchange. An individual will be allowed to hold a Series A-1 Permit if 
he or she meets the qualification criteria that will be set forth in 
Article XII of the proposed By-laws and Rules 901 and 908 and/or may be 
imposed by the Admissions Committee (which criteria the Exchange 
intends will remain largely the same as

[[Page 3983]]

they were before the demutualization), including the requirements that 
a Member be an individual at least 21 years of age and be associated 
with a Member Organization.\30\ Pursuant to Sections 12-1 and 12-4 of 
the proposed By-laws and proposed Rule 908(b), Series A-1 Permits will 
be limited or unlimited in number and may be issued from time to time 
by the Exchange, as determined by the Board in its sole discretion.
---------------------------------------------------------------------------

    \30\ Under Sections 12-2 and 12-4 of the proposed By-laws, Stock 
Clearing Corporation of Philadelphia (``SCCP''), as an eligible 
corporation, may hold a permit but will continue not to be subject 
to the qualification criteria applicable to persons seeking a 
permit. SCCP, a subsidiary of the Phlx, is a registered clearing 
agency.
---------------------------------------------------------------------------

    After demutualization, Section 12-1 of the proposed By-laws will 
empower the Board to:
     authorize the issuance of an unlimited or 
restricted number of additional permits;
     terminate or eliminate any class or series of 
permits; and
     create additional classes or series of permits.
    The Exchange represents that any of these actions will continue to 
be subject to Commission review and/or approval. In accordance with 
Section 12-3 of the proposed By-laws, no person will be allowed to hold 
more than one permit.
3. Qualifications
    Initially, except to the extent provided in applicable product and/
or activity criteria set forth in the proposed Rules, qualifications 
and other requirements for Members to conduct certain activities (e.g., 
to act as a specialist or a floor broker), to trade certain products 
(e.g., special capital requirements for specialists for certain equity 
securities, allocation of books and Registered Options Trader 
assignments) or to use specific facilities of the Exchange (e.g., 
testing requirements for use of certain Exchange technology) will 
remain largely the same as they were before the demutualization.
4. Security Requirement
    According to proposed Rule 909, each Member Organization will have 
to provide to, and maintain security with, the Exchange (or alternative 
compliance) for the payment of any claims owed to the Exchange, to 
SCCP, and to Members and/or other Member Organizations. Currently, 
Section 14-5 of the By-laws provides that the Exchange (through the 
Admissions Committee) may dispose of any Seat upon written notice if 
amounts owed to the Exchange exceed a certain threshold amount and have 
been outstanding for at least one year. This possibility will be 
eliminated in connection with the elimination of Seats in the 
demutualization. Accordingly, the Exchange proposes the security 
requirement to protect itself in the case of non-payment of certain 
amounts owed. The proposed security requirement will consist of:
    (i) excess net capital of at least the amount required by the 
Exchange, as will be published by the Exchange from time to time; \31\
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    \31\ In accordance with the By-laws and Rules, the Member 
Organization will be subject to monthly reporting obligations to 
evidence the maintenance of that excess net capital requirement.
---------------------------------------------------------------------------

    (ii) an acceptable guaranty by a clearing Member Organization that 
is acceptable to the Exchange; or
    (iii) a deposit with the Exchange in an amount not to exceed 
$50,000.
    The amount of the security for a Member Organization will remain 
the same regardless of the number of permits issued to affiliates of 
the Member Organization. If a Member Organization's registration is 
terminated and no Members remain associated with the Member 
Organization, the Exchange will be permitted to apply the proceeds of 
any remaining security to the payment of any amounts owed by or on 
behalf of the Member Organization to, or claimed by, the Exchange, to 
SCCP, and to other Member Organizations, and any balance of the 
security thereafter remaining will be returned to the Member 
Organization or, in the case of a guaranty, the guaranty will be 
returned to the guarantor Member Organization.
    The proposed By-laws will also provide in Section 12-9(b) that 
following the demutualization, Members, Member Organizations and 
holders of FCO participations will have to pledge in writing to abide 
by the proposed Certificate of Incorporation, the proposed By-laws, the 
proposed Rules and any other rules and regulations of the Exchange.
5. Term and Termination of Permits
    Pursuant to proposed Rule 908(e), the holder of a permit will be 
allowed to terminate the permit at any time upon written notice to the 
Exchange. The Exchange will be allowed to terminate any individual 
permit in accordance with the By-laws and Rules of the Exchange only 
upon:
     the non-payment of any dues, foreign currency 
options users' fees, fees, fines, penalties, other charges, and/or 
other monies due and owed the Exchange;
     the insolvency of a Member or Member 
Organization (or if the Business Conduct Committee has determined the 
Member or Member Organization to be financially unsafe to continue 
trading); or
     the Exchange's imposition of a disciplinary 
sanction.
    The terminating permit holder and each Member Organization with 
which the holder is associated will remain responsible for all 
obligations of the terminating Member, including, without limitation, 
all applicable dues, fees, charges, fines, penalties and other 
obligations arising from the holding or use of a permit before its 
termination.
    Pursuant to proposed Rule 908(f), the Exchange will be able to 
terminate the entire series of Series A-1 Permits on no less than 60 
days' notice to the permit holders.\32\ If, however, within six months 
after any such termination of the entire series of Series A-1 Permits, 
the Exchange issues any other class or series of permit with respect to 
any securities product previously covered by the Series A-1 Permit, any 
permit holder of a terminated Series A-1 Permit, who meets the 
applicable eligibility requirements with respect to such new class or 
series of permit, will be entitled to receive on terms no less 
favorable than those applicable to other persons such new class or 
series of permit so long as such permit holder will trade with such new 
class or series of permit such product in the same capacity as he had 
done with a Series A-1 Permit before such termination (but only if he 
had continuously traded such product in such capacity for at least one 
year prior to such termination). In addition, such holder of the 
terminated Series A-1 Permit will be required to apply for such new 
permit within 30 days of the later to occur of: (i) The termination of 
the series of Series A-1 Permits; or (ii) the initial issuance of the 
new class or series of permit.
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    \32\ As noted above, the Exchange represents that certain 
actions with respect to the permits, including termination of any 
class or series of permits will be subject to Commission review and 
approval.
---------------------------------------------------------------------------

6. Transfer of Permits
    Section 12-1(b) of the proposed By-laws, as well as proposed Rule 
908(h), will provide that, unless the Board resolves otherwise, no 
permit may be sold, transferred (by operation of law or otherwise), 
leased or otherwise encumbered by any person to whom such permit is 
issued by the Exchange. However, proposed Rule 908(h) provides that the 
existing concept of ``inactive nominees'' will be retained to alleviate 
certain administrative hardships for Member Organizations,

[[Page 3984]]

such that a permit can be transferred to and from an inactive nominee.

E. Fees, Dues and Charges

    Currently, the Board of Phlx has the authority to set fees, dues 
and other charges \33\ in its sole discretion, subject to the 
requirements under the Act, including filing requirements. Pursuant to 
lease agreements, Members who lease Seats from Owners are ordinarily 
required to make lease payments in respect of the lease.
---------------------------------------------------------------------------

    \33\ According to the Exchange, the existing and proposed By-
laws and Rules may refer to ``dues, fees and other charges'' to 
cover various types of monies owed to the Exchange; however, no 
substantive difference is intended.
---------------------------------------------------------------------------

    After the demutualization, the Board of the Phlx will continue to 
have the authority to set Member fees, dues and other charges in its 
sole discretion in accordance with Section 14-1 of the proposed By-
laws. However, seat leases and lease payments (other than with respect 
to FCO participations) will no longer exist. All other Exchange charges 
in effect at the time of the demutualization will continue to apply 
until changed.\34\ The Exchange notes that all fees are subject to 
change, both before and after demutualization, subject to approval by 
the Board and filing with the Commission.
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    \34\ Separately, with the elimination of Seats and leases 
thereof, the Exchange filed a proposed rule change pursuant to 
Section 19(b) of the Act to adopt fees applicable to Series A-1 
Permits and to make conforming changes to its fee schedule as a 
result of the demutualization. See supra note 11.
---------------------------------------------------------------------------

    In connection with the demutualization, the Exchange proposes to 
make certain corresponding changes to the defined terms applicable to 
its By-laws and Rules. These changes, reflected in Section 1-1 of the 
existing and the proposed By-laws, as well as in Rules 1 through 21 of 
the existing Rules and 1 through 22 of the proposed Rules, are 
generally designed to adapt such defined terms to the proposed post-
demutualization structure of the Exchange, as described herein.

F. Summary of Non-Demutualization-Related Changes

    Certain aspects of the proposed rule change are not directly 
related to the Plan of Demutualization. According to the Exchange, 
these changes are principally of a clean-up nature and are intended to 
delete obsolete provisions that relate mainly to membership, to provide 
clarity and to avoid confusion following the demutualization.
1. Definition of Member Firm, Member Corporation and Member 
Organization
    The Exchange proposes to harmonize the use of the defined terms 
Member Firm, Member Corporation and Member Organization throughout its 
By-laws and Rules by eliminating the separate defined terms ``Member 
Firm'' (Rule 3 of the existing Rules) and ``Member Corporation'' (Rule 
4 of the existing Rules) and amending the defined term ``Member 
Organization'' (Rule 6 of the existing Rules and Rule 3 of the proposed 
Rules) to include any Member Firm and Member Corporation, as they were 
previously defined. Wherever such defined terms appear in either the 
By-laws or the Rules, the Exchange proposes to make the corresponding 
change to Member Organization. The Exchange believes that these changes 
eliminate certain definitional inconsistencies.
2. Convertible Memberships
    The Exchange proposes to delete the parts of Article XII of the 
existing By-laws that relate to ``convertible memberships'' on the 
Exchange, together with any references to any classes of memberships 
that existed in connection with the Exchange's pre-1975 status as an 
unincorporated entity. No such convertible membership has been 
outstanding at any time and any transitional rules relating to the 
Exchange's previous unincorporated status are obviously no longer 
required.
3. Commissions
    The Exchange proposes to delete Article XIX of the existing By-laws 
in its entirety, which relates to certain requirements for fixed rates 
of commissions for transactions effected on or by the use of the 
facilities of the Exchange. The Exchange believes these provisions do 
not comport with Section 6(e) of the Act.\35\ To avoid confusion, the 
Phlx proposes that these provisions be deleted without replacement. The 
Exchange also proposes to delete related Rule 248.
---------------------------------------------------------------------------

    \35\ 15 U.S.C. 78f(e).
---------------------------------------------------------------------------

4. Market-Maker Membership
    The Exchange proposes to delete Article XXIII of the existing By-
laws, relating to Market-Maker Memberships, in its entirety. The Phlx 
advises that no such Market-Maker Membership has been issued since the 
1970s and none is currently outstanding. Following the demutualization, 
the Exchange is not initially proposing to create a specific permit for 
market-makers; any rights and privileges required to engage in market 
making on the Exchange initially will be granted through the proposed 
Series A-1 Permit. The Exchange also proposes to delete related Rules 
456-459. The Phlx advises that these deletions are intended to avoid 
confusion with respect to these unused membership-related provisions.
5. Exchange Options Trading
    The Exchange proposes to delete Article XXVI of the existing By-
laws, relating to Exchange options trading through a classification of 
membership named ``Options Membership'' in its entirety. The Phlx 
states that no such Options Membership has at any time been issued and 
outstanding. Following the demutualization, the Exchange will not 
initially create a specific permit to trade options on the Exchange; 
any rights and privileges required to engage in trading options on the 
Exchange initially will be granted through the proposed Series A-1 
Permit. Accordingly, this deletion is also intended to avoid confusion.
6. References to the Exchange's Constitution
    The Exchange proposes to delete references to the ``Constitution of 
the Exchange'' from the Rules 111, 201A and 960.2, as well as from the 
Commentary to Rule 803. Where applicable, the references will be either 
deleted in their entirety or will be replaced by references to the 
Certificate of Incorporation. The Exchange advises that it has not had 
a Constitution since its incorporation in 1972 and, since that time, 
has been governed exclusively by its Certificate of Incorporation and 
By-laws.
7. References to the Exchange's President
    The Exchange proposes to delete references to the Exchange's 
``President'' from the Rules and replace such references with 
``Chairman of the Board of Governors.'' The Exchange indicates that it 
has not established the position of a President and has no immediate 
plans to establish such a position after the demutualization.
8. Participation in Mandatory Decimalization Testing
    The Exchange proposes to delete Rule 650 in its entirety, which 
relates to the mandatory participation of Members in certain programs 
concerning the testing of the Exchange's system in connection with 
decimalization. According to the Phlx, such tests have been performed, 
and, therefore, Rule 650 has become obsolete.

III. Summary of Comments

    The Commission received one comment letter in response to the

[[Page 3985]]

proposed rule change.\36\ The Penn Mont Letter stated that the Plan of 
Demutualization was flawed for two reasons. First, the letter noted 
that, after the demutualization, members no longer would have the 
ability to propose and vote on rulemaking initiatives. Second, the Penn 
Mont Letter stated that, in light of the Commission's recent approval 
of the two-board structure for the New York Stock Exchange, Inc. 
(``NYSE''), the Phlx should adopt the same structure for its Board of 
Governors.
---------------------------------------------------------------------------

    \36\ See Penn Mont Letter, infra note 7.
---------------------------------------------------------------------------

    In responding to the Penn Mont Letter, the Exchange noted that the 
reason for eliminating Members' right to petition with respect to 
changes to the By-laws is that Delaware law requires that stockholders 
amend the By-laws.\37\ The Phlx pointed out that Members will continue 
to have the same voice in rulemaking at the Exchange through the 
various committees of the Board of Governors. Specifically, the Phlx 
noted that Members, either by serving on such committees or by 
contacting committee members, can raise issues for discussion or rules 
for adoption. The Exchange noted that, in connection with the 
demutualization, it proposed to increase member involvement on several 
committees and that, in its view, the current and proposed committee 
structure and the Exchange's governance structure are consistent with 
the fair representation requirements of Section 6(b)(3) of the Act.\38\
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    \37\ Letter from Edith Hallahan, Deputy General Counsel, Phlx, 
to Nancy Sanow, Assistant Director, Division, Commission, dated 
January 11, 2004.
    \38\ 15 U.S.C. 78f(b)(3).
---------------------------------------------------------------------------

    Regarding the Penn Mont Letter's recommendation that the Phlx adopt 
the same dual-board structure that was recently approved for the NYSE, 
the Exchange noted its belief that at this time the governance 
structure proposed in its filing is consistent with the Act and the 
structures of other SROs and is appropriate on a going forward basis. 
The Exchange stated that both the NYSE's governance specifically and 
the governance structure of SROs in general are important policy 
issues, separate from the Exchange's immediate plan to demutualize. The 
Phlx noted that it would be unfair to delay its efforts to demutualize 
for this reason alone because the Exchange can and should continue to 
evaluate its governance structure in the future.

IV. Discussion

    After careful review, 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.\39\ In particular, the Commission finds that the proposed 
rule change is consistent with Section 6(b)(1) of the Act,\40\ which 
requires a national securities exchange to be so organized and have the 
capacity to carry out the purposes of the Act and to enforce compliance 
by its members and persons associated with its members with the 
provisions of the Act. The Commission also finds that the proposed rule 
change is consistent with Section 6(b)(3) of the Act, which requires 
that the rules of a national securities exchange assure the fair 
representation of its members in the selection of its directors and 
administration of its affairs, and provide that one or more directors 
shall be representative of issuers and investors and not be associated 
with a member of the exchange, broker, or dealer. Further, the 
Commission finds that the proposed rule change is consistent with 
Section 6(b)(5) of the Act,\41\ in that it is designed, among other 
things, to prevent fraudulent and manipulative acts and practices; to 
promote just and equitable principles of trade; to remove impediments 
to and perfect the mechanism of a free and open market and a national 
market system; and, in general, to protect investors and the public 
interest.
---------------------------------------------------------------------------

    \39\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \40\ 15 U.S.C. 78f(b).
    \41\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

A. Changes in Control of the Phlx

    The proposed Certificate of Incorporation imposes limitations on 
direct and indirect changes in control of the Phlx through voting and 
ownership limitations placed on the Common Stock, and monitors 
potential changes in control through a notification requirement, once a 
threshold percentage of ownership of the Common Stock is reached. The 
Commission believes that the limitations on direct and indirect changes 
in control of the Phlx are sufficient to enable the Phlx to carry out 
its self-regulatory responsibilities, and to enable the Commission to 
fulfill its responsibilities under the Act.\42\
---------------------------------------------------------------------------

    \42\ The Commission has not formally established the standards 
for control persons of shareholder-owned national securities 
exchanges. It expects, however, to consider providing guidance on 
this issue in the future.
---------------------------------------------------------------------------

    The proposed Certificate of Incorporation provides that, unless 
approved by the Board and effective under Section 19(b) of the Act, no 
Person, either alone or together with its Related Persons, has any 
right to vote, or to give any consent or proxy with respect to, more 
than 20% of the then outstanding shares of Common Stock (any shares of 
Common Stock owned in excess of 20% are referred to as ``Excess 
Shares''). In addition, such Excess Shares will be deemed not to be 
present for the purposes of determining whether a quorum is present at 
any meeting or vote of the stockholders of the Exchange.\43\
---------------------------------------------------------------------------

    \43\ Phlx Certificate of Incorporate, Article FOURTH, paragraph 
(b)(iii)(B).
---------------------------------------------------------------------------

    Moreover, no Person (either alone or together with its Related 
Persons, unless approved by the Board and effective under Section 19(b) 
of the Act) may own, of record or beneficially, whether directly or 
indirectly, more than 40% of the then outstanding shares of Common 
Stock of the Phlx. To the extent that such Person (or its Related 
Persons) purports to own more than 40% of the then outstanding shares 
of Common Stock, the Person (and its Related Persons) will not be 
entitled to exercise any rights and privileges incident to ownership of 
shares in excess of the 40% limit.\44\ Finally, the Exchange has the 
right, but not the obligation, to purchase the shares in excess of the 
40% threshold for a price equal to the par value of the Common Stock.
---------------------------------------------------------------------------

    \44\ Phlx Certificate of Incorporation, Article FOURTH, 
paragraph (b)(v)(A).
---------------------------------------------------------------------------

    Article FOURTH of the Phlx Certificate of Incorporation will 
require the Board to approve a By-law amendment to permit any Person, 
together with its Related Persons, to exercise voting rights with 
respect to their excess shares or to own more than 40% of the 
outstanding shares. This amendment to the By-laws would have to be 
filed with the Commission pursuant to Section 19(b) of the Act. The 
proposed rule change would present the Commission with an opportunity 
to determine what additional measures, if any, might be necessary to 
provide sufficient regulatory jurisdiction over the proposed 
controlling persons.
    The proposed Certificate of Incorporation provides that no Member 
(either alone or together with its Related Persons) will be allowed to 
own, of record or beneficially, whether directly or indirectly, more 
than 20% of the then outstanding shares of Common Stock of the 
Phlx.\45\ To the extent any Member (or its Related Persons) purports to 
own more than 20% of the then outstanding shares of Common Stock, that 
Member (and its Related Persons) will not be allowed to exercise any of 
the rights or

[[Page 3986]]

privileges incident to the ownership of shares of Common Stock with 
respect to the shares exceeding the 20% limit. If any Member exceeds 
the 20% threshold, the Phlx will have the right, but not the 
obligation, to purchase from that Person and its Related Persons either 
the shares of Common Stock that exceed the 20% threshold for a price 
equal to the par value of the shares of such Common Stock.
---------------------------------------------------------------------------

    \45\ Phlx Certificate of Incorporation, Article FOURTH, 
paragraph (b)(v)(B).
---------------------------------------------------------------------------

    The Commission finds that the limitation on member ownership is 
consistent with the Act. Today, a member who trades on an exchange can 
have an ownership interest in the exchange. However, a member's 
interest could become so large as to cast doubt on whether the exchange 
can fairly and objectively exercise its self-regulatory 
responsibilities with respect to that member. A member that also is a 
controlling shareholder of an exchange might be tempted to exercise 
that controlling influence by directing the exchange to refrain from 
diligently surveiling the member's conduct or from punishing any 
conduct that violates the rules of the exchange or the federal 
securities laws. An exchange also might be reluctant to surveil and 
enforce its rules zealously against a member that the exchange relies 
on as its largest source of capital.
    The proposed Certificate of Incorporation requires any Person 
(either alone or together with its Related Persons) that at any time 
owns (whether by acquisition or by a change in the number of shares 
outstanding) of record or beneficially, directly or indirectly, 5% or 
more of the then outstanding shares of the Common Stock to immediately 
give the Board of Governors written notice of that ownership and update 
the notice promptly after an ownership change of a specified 
percentage.\46\ The Commission believes that this approach is 
consistent with the Act in that it allows the Phlx to comply with the 
reporting requirements of Form 1, the application for (and amendments 
to application for) registration as a national securities exchange. 
Exhibit K of Form 1 requires any exchange that is a corporation or 
partnership to list any persons that have an ownership interest of 5% 
or more in the exchange; and Rule 6a-2(a)(2) under the Act requires an 
exchange to update its Form 1 within ten days after any action that 
renders inaccurate the information previously filed in Exhibit K.\47\ 
Exhibit K imposes no obligation on an exchange to report parties whose 
ownership interests in the exchange is less than 5%. Similarly, the 
proposed Certificate of Incorporation requires the Phlx to monitor 
changes in its ownership structure only when a Person acquires an 
interest that equals or exceeds 5%.\48\
---------------------------------------------------------------------------

    \46\ Phlx Certificate of Incorporation, Article FOURTH, 
paragraph (b)(iv) and (v).
    \47\ 17 CFR 240.6a-2(a)(2).
    \48\ The Commission notes, however, that the Exchange should 
disclose periodically, or otherwise make available upon request, 
information regarding the number of outstanding shares of Common 
Stock, so that persons with a stake in the Common Stock can 
determine whether they are reaching or have reached any of the 
thresholds that restrict that person's ability to vote or own the 
shares.
---------------------------------------------------------------------------

B. Fair Representation

    Section 6(b)(3) of the Act requires that the rules of an exchange 
assure fair representation of its members in the selection of its 
directors and administration of its affairs and provide that one or 
more directors be representative of issuers and investors and not be 
associated with a member of the exchange, or with a broker or dealer.
    Under the proposed Certificate of Incorporation, the Exchange will 
continue to have a total of 22 Governors and will be composed of 11 
Non-Industry Governors (of whom at least five must be Public 
Governors); 10 Industry Governors (of whom five must be On-Floor 
Governors and five must be Off-Floor Governors); and the Chairman of 
the Board, who will be the individual then holding the office of CEO. 
The Non-Industry Governors, Off-Floor Governors, and the Chairman of 
the Board will continue to be nominated by the Nominating and Elections 
Committee and will be elected by the holders of the Common Stock. On-
Floor Governors will be nominated by the Nominating and Elections 
Committee from recommendations made by members of that committee or by 
any Member, participant, or Member Organization Representative. Also, 
independent nominations by Member Organization Representatives will be 
valid if signed by Member Organization Representatives representing no 
less than 50 votes. Member Organizations, through their authorized 
Member Organization Representative, will vote for designated On-Floor 
Governors among nominees selected at the annual meeting of Member and 
Member Organizations. The nominees for On-Floor Governors who received 
the highest number of votes will be the Designated Nominees, who will 
then be elected by the Trust owning the share of Series A Preferred 
Stock
    In addition, pursuant to the proposed By-laws, at least half of the 
Admissions Committee and the Foreign Currency Options Committee will 
have to be Members, participants or persons affiliated with Member 
Organizations and at least half of the Options Committee and the Floor 
Procedure Committee will have to be Members or persons affiliated with 
Member Organizations. Further, the proposed By-laws require that the 
Business Conduct Committee share jurisdiction over the revocation of 
permits and foreign currency options participations in connection with 
disciplinary matters with the Admissions Committee. The Commission 
finds that the selection of the five On-Floor Governors out of a total 
of 22 Governors of the Phlx Board and the manner in which such 
Governors will be nominated and elected, together with the 
representation of members on key committees, satisfies the fair 
representation requirements in Section 6(b)(3) of the Act.\49\
---------------------------------------------------------------------------

    \49\ 15 U.S.C. 78f(b)(3).
---------------------------------------------------------------------------

    The Commission notes that the proposal does not require that 
holders of foreign currency options (``FCO'') participations expressly 
be represented on the committees or on the Board of Governors, although 
representation on various committees and on the Board as On-Floor 
Governors is open to them. According to the Phlx, members holding 
solely FCO participations represent a de minimis amount of the 
membership and most Members that trade foreign currency options also 
hold regular memberships. In addition, the Phlx will retain its Foreign 
Currency Options Committee, of which at least 50% of its members must 
be permit holders or participants or be associated with a member or 
participant organization. In light of these provisions and the small 
number of FCO participants currently at the Exchange, the Commission 
believes that the provisions relating to FCO participations are 
consistent with the fair representation requirements of the Act. The 
Commission also finds that the requirement that the Board be composed 
of 11 Non-Industry Governors, of whom at least five must be Public 
Governors, is consistent with Section 6(b)(3) of the Act, which 
requires that one or more directors be representative of issuers and 
investors.
    The Commission also notes that the proposed Certificate of 
Incorporation expressly requires the Governors, in managing the 
business and affairs of the Phlx, to consider applicable requirements 
for registration as a national securities exchange under Section 6(b) 
of the Act, including the requirements that the rules of the Phlx be 
designed to protect investors and the public interest and the Phlx 
shall be so organized and have the capacity to carry

[[Page 3987]]

out the purposes of the Act and (subject to exceptions set forth in the 
Act and rules and regulations thereunder) to enforce compliance with 
its members and persons associated with its members, with the 
provisions of the Act and rules and regulations thereunder and with the 
Phlx's rules. In the Commission's view, this provision will serve to 
remind the Governors that they must consider the requirements of the 
Act when taking actions on behalf of the Phlx.
    The Penn Mont Letter, the sole comment letter received by the 
Commission on the proposal, pointed to the Commission's recent approval 
of a dual-board governance structure for the NYSE \50\ and urged that 
the Exchange amend its filing to take into account this new structure. 
The Commission notes that SROs, such as the Phlx, just recently have 
had the opportunity to review and assess the governance changes made by 
the NYSE in light of their own governance structures. Although the 
Exchange should be assessing its own governance structure in light of 
the recently-approved changes for the NYSE and in light of governance 
reforms recently approved for listed issuers,\51\ the Commission 
believes that these issues can be addressed separately from the 
demutualization.\52\
---------------------------------------------------------------------------

    \50\ Securities Exchange Act Release No. 48946 (December 18, 
2003), 68 FR 75012 (December 29, 2003).
    \51\ Securities Exchange Act Release No. 48745 (November 4, 
2003), 68 FR 64154 (November 12, 2003).
    \52\ In March 2003, the Commission's Chairman sent a letter to 
the SROs, including the Phlx, asking that they review their own 
corporate governance practices in light of new listing standards for 
publicly traded companies. See Letter from William H. Donaldson, 
Chairman, Commission, to Meyer S. Frucher, Chairman and Chief 
Executive Officer, Phlx, dated March 26, 2003. In September 2003, 
the Commission's Chairman sent another letter to the SROs, including 
the Phlx, asking that they review the extent of public 
representation on their boards and key committees, decision-making 
processes relating to the nomination of directors and compensation 
of executives, and public disclosure of these processes and 
compensation arrangements. See Letter from William H. Donaldson, 
Chairman, Commission, to Meyer S. Frucher, Chairman and Chief 
Executive Officer, Phlx, dated September 23, 2003.
---------------------------------------------------------------------------

    Finally, the Penn Mont Letter stated that the Plan of 
Demutualization is flawed because members no longer will have the 
ability to propose independent rulemaking based on a vote of the 
membership. The Commission believes that the Phlx's response to this 
comment is persuasive, namely, that Delaware law requires that 
stockholders amend the By-laws. Moreover, as the Exchange points out, 
Members will retain a voice in Exchange rulemaking through 
participation on various Board Committees, some of which now will 
require at least half of the Committees' composition be Members or 
persons affiliated with Member Organizations.

C. Dividends

    With the demutualization, the holders of Common Stock will have the 
dividend and other distribution rights of a stockholder in a Delaware 
stock corporation (except as may be limited by the rights any preferred 
stock may have, if any such stock is issued). The proposed By-laws, 
however, will prohibit the payment of dividends from any revenues 
received by the Exchange from regulatory fines, fees or penalties.\53\ 
In the proposed rule change, the Phlx describes the methodology it will 
use to determine the amount of regulatory fines, fees and penalties 
that are subject to the dividend limitation, taking into account the 
amount of regulatory costs and expenses. The Commission finds that the 
prohibition on the use of regulatory fines, fees or penalties to fund 
dividends is consistent with Section 6(b)(3) of the Act because it will 
ensure that the regulatory authority of the Exchange is not used 
improperly to benefit the shareholders.
---------------------------------------------------------------------------

    \53\ Phlx By-Laws, Section 30-4.
---------------------------------------------------------------------------

V. Accelerated Approval of Amendment No. 3

    The Commission finds good cause exists for approving Amendment No. 
3 to the proposed rule change prior to the thirtieth day after the 
amendment is published for comment in the Federal Register, pursuant to 
Section 19(b)(2) of the Act.\54\ In Amendment No. 3, the Phlx formally 
submitted the Conversion Amendment as part of the proposed rule change 
in order to clarify that it is, in fact, a part of the proposed rule 
change. Also, the Phlx noted that the Conversion Amendment was briefly 
described in the proposed rule change and that it will be in effect 
just a very brief period of time prior to consummation of the Merger.
---------------------------------------------------------------------------

    \54\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    In the amendment, the Phlx also submitted copies of written 
comments received from market participants regarding the Plan of 
Demutualization after the Phlx had filed the proposed rule change with 
the Commission on November 17, 2003, and copies of the Exchange's 
responses to those comments.\55\
---------------------------------------------------------------------------

    \55\ Instruction D to Form 19b-4 states that if, after the 
proposed rule change is filed but before the Commission takes final 
action, the SRO receives or prepares any correspondence or other 
communications reduced to writing (including any comment letters) to 
and from the SRO concerning the proposed rule change, copies of the 
communications must be filed in accordance with Instruction F to the 
form.
---------------------------------------------------------------------------

    The Commission believes that acceleration of the amendment is 
appropriate. The Conversion Amendment was described in the Notice and 
the filing of its actual rule text presents no new issues.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 3, including whether the amendment 
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. Comments 
may also be submitted electronically at the following e-mail address: 
[email protected]. All comment letters should refer to File No. SR-
Phlx-2003-73. This file number should be included on the subject line 
if e-mail is used. To help the Commission process and review comments 
more efficiently, comments should be sent in hardcopy or by e-mail but 
not by both methods. 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 Phlx. All 
submissions should refer to refer to File No. SR-Phlx-2003-73, and 
should be submitted by February 17, 2004.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\56\ that the proposed rule change (SR-PHLX-03-73), as amended, be 
and hereby is, approved, and Amendment No. 3 is approved on an 
accelerated basis.
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    \56\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\57\
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    \57\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-1668 Filed 1-26-04; 8:45 am]
BILLING CODE 8010-01-P