[Federal Register Volume 70, Number 9 (Thursday, January 13, 2005)]
[Notices]
[Pages 2436-2439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-128]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50996; File No. SR-CBOE-2004-77]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Chicago Board Options Exchange, Inc., Relating to the 
Systematizing of Orders in Connection With the Requirement To Design 
and Implement a Consolidated Options Audit Trail System

January 7, 2005.

I. Introduction

    On November 24, 2004, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities Exchange 
Commission (``SEC'' or ``Commission''), pursuant to section 19(b)(1) of 
the Securities Exchange Act

[[Page 2437]]

of 1934 (the ``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule 
change to amend its rules relating to the systematization of orders in 
connection with the requirement to design and implement a consolidated 
options audit trail system (``COATS''). The proposed rule change was 
published for notice and comment in the Federal Register on December 6, 
2004.\3\ The Commission received 2 comment letters on the proposed rule 
change.\4\ This order approves the proposed rule change.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 50755 (November 30, 
2004), 69 FR 70482.
    \4\ See e-mail from Brian Meister, CBOE Floor Broker, O'Connor 
and Co., LLC, dated December 26, 2004 and Richard T. Marneris, CBOE 
Floor Broker, dated December 21, 2004.
---------------------------------------------------------------------------

II. Background

    The proposed rule change is intended to fulfill certain of the 
undertakings contained in an order issued by the Commission relating to 
the settlement of an enforcement action against the American Stock 
Exchange LLC, CBOE, Pacific Exchange, Inc., and Philadelphia Stock 
Exchange, Inc. (collectively ``Options Exchanges'') for failure to 
comply with their own rules and to enforce compliance with their own 
rules by their members and persons associated with their members \5\ as 
is required by section 19(g) of the Act.\6\ The Order found that the 
Options Exchanges impaired the operations of the options market by: (i) 
Following a course of conduct under which they refrained from multiply 
listing a large number of options; and (ii) inadequately discharging 
their obligations as self-regulatory organizations by failing 
adequately to enforce compliance with (a) certain of their rules, 
including order handling rules, that promote competition as well as 
investor protection, and (b) certain of the rules prohibiting 
anticompetitive conduct, such as harassment, intimidation, refusals to 
deal and retaliation directed at market participants who sought to act 
competitively. In addition, the Commission found that the Options 
Exchanges failed to enforce compliance with their trade reporting 
rules, which promote transparency of the market and facilitate 
surveillance and enforcement of other exchange rules and the Federal 
securities laws.
---------------------------------------------------------------------------

    \5\ See Order Instituting Public Administrative Proceedings 
Pursuant to Section 19(h)(1) of the Securities Exchange Act of 1934, 
Making Findings and Imposing Sanctions, Securities Exchange Act 
Release No. 43268 (September 11, 2000) and Administrative Proceeding 
File 3-10282 (the ``Order'').
    \6\ 15 U.S.C. 78s(g).
---------------------------------------------------------------------------

    As part of the Order, the Options Exchanges agreed to, and were 
ordered to comply with, a variety of undertakings. Among other things, 
they agreed to, and were ordered to, design and implement COATS to 
enable the Options Exchanges to reconstruct markets promptly, 
effectively surveil them and enforce order handling, firm quote, 
trading reporting and other rules. The Options Exchanges were required 
to complete this undertaking in five phases. The Options Exchanges have 
completed the first four phases. The final phase of the undertaking to 
implement COATS requires that each exchange incorporate into its audit 
trail all non-electronic orders. This proposed rule change addresses 
that aspect of the undertaking.

III. Description of Proposed Rule Change

    To assure that all non-electronic orders are incorporated into 
COATS for Phase V, the CBOE proposes to amend CBOE Rule 6.24, which 
currently requires orders to be in written form. The proposed rule 
change generally would require that each order, change to an order, or 
cancellation of an order transmitted to the Exchange be 
``systematized,'' in a format approved by the Exchange, either before 
it is sent to the Exchange or contemporaneously upon receipt on the 
floor of the Exchange, and prior to representation of the order.
    CBOE proposes that each order, change to an order, or cancellation 
of an order may be systematized in one of two ways. First, if an order, 
change to an order, or cancellation of an order is sent electronically 
to the Exchange, would be considered to be systematized. Second, if an 
order, change to an order, or cancellation of an order that is sent to 
the Exchange non-electronically is input electronically into the 
Exchange's systems contemporaneously upon receipt on the Exchange and 
prior to representation, it would be considered to be systematized. The 
requirement would proposed to commence on January 10, 2005. With 
respect to non-electronic orders received in the S&P 100 index option 
class (OEX), the S&P 500 index option class (SPX), and the European-
style S&P 100 index option class (XEO), however, CBOE proposes that the 
requirement to systematize orders prior to representation would 
commence on March 28, 2005.
    Although the proposed rule change generally requires that each 
order be systematized prior to representation, the Exchange proposes to 
treat market and marketable orders differently than other orders so 
that marketable orders may be represented immediately in the 
marketplace. Specifically, with respect to non-electronic market and 
marketable orders sent to the Exchange, CBOE proposes to provide that 
the member responsible for systematizing the order must input into the 
Exchange's systems the following specific information with respect to a 
market or marketable order prior to the representation of the order: 
(i) The option symbol; (ii) the expiration month; (iii) the expiration 
year; (iv) the strike price; (v) buy or sell; (vi) call or put; (vii) 
the number of contracts; and (viii) the Clearing Member. Any additional 
information with respect to the order would be inputted into the 
Exchange's systems contemporaneously thereafter, which may occur after 
the representation and execution of the order.
    CBOE also proposes to amend Interpretation .04 to CBOE Rule 6.73, 
to make explicit that a broker's responsibility to immediately and 
continuously represent market and marketable orders would be subject to 
the requirement that each order must be systematized prior to 
representation.
    In proposed new subparagraph (a)(4) of CBOE Rule 6.24, the Exchange 
proposes that in the event of a malfunction or disruption of the 
Exchange's systems such that a member is unable to systematize an 
order, the member or member organization would be required to use paper 
trade tickets to record order information during the time period that 
the malfunction or disruption occurs. Upon the cessation of the 
malfunction or disruption, the member would be required to immediately 
resume systematizing orders. In addition, the member would be required 
to exert best efforts to input electronically into the Exchange's 
systems all relevant order information received during the time period 
when there was a malfunction or disruption of the Exchange's systems as 
soon as possible, and in any event would be required to input such data 
electronically into the Exchange's systems not later than the close of 
business on the day that the malfunction or disruption ceases.
    The Exchange proposes to keep the current Interpretation and Policy 
.02(a) of CBOE Rule 6.24, which permits the use of hand signal 
communications on the floor to, among other things, initiate an order, 
cancel an order or to change material terms of an order. However, the 
Exchange proposes to clarify that any initiation, cancellation, or 
change of an order relayed to a floor broker through the use of hand 
signals also must be

[[Page 2438]]

systematized upon receipt in accordance with paragraph (a) of CBOE Rule 
6.24. The proposed rule change also deletes paragraph (b) of 
Interpretation .02 as paragraph (a) of that interpretation is being 
amended to delete the reference to exempt classes.
    The Exchange proposes to add a new Interpretation and Policy .04 to 
CBOE Rule 6.24, which states that accommodation liquidations as defined 
in CBOE Rule 6.54 are exempted from the systematization requirement. 
However, the Exchange commits to maintain quotation, order and 
transaction information for accommodation liquidations in the same 
format as the COATS data is maintained, and will make such information 
available to the SEC upon request.
    The Exchange also proposes to add a new Interpretation and Policy 
.05 to CBOE Rule 6.24, which states that FLEX options, as described in 
Chapter 24A of the Exchange's rules, are exempt from the requirements 
of the Rule. However, the Exchange commits to maintain as part of its 
audit trail quotation, order and transaction information for FLEX 
options in a form and manner that is substantially similar to the form 
and manner as the COATS data is maintained, and will make such 
information available to the SEC upon request.
    The Exchange proposes to include a new Interpretation .06 to CBOE 
Rule 6.24, which provides that any proprietary system approved by the 
Exchange on the Exchange's trading floor that receives orders would be 
considered an Exchange system for purposes of paragraph (a)(1) of this 
Rule. This proposed rule would require that any proprietary system 
approved by the Exchange must comply with the requirements of COATS.
    Finally, the Exchange has proposed a new Interpretation .07 to CBOE 
Rule 6.24, which would require that each order transmitted by a Market-
Maker while on the floor, including any cancellation of or change to 
such order, must be systematized in accordance with the procedures 
described in Paragraph (a) and (b) of this Rule, as applicable. 
Currently, paragraph (d) of CBOE Rule 6.24 requires that each order 
transmitted by a Market-Maker while on the floor, including any 
cancellation of or change to such order, must be recorded legibly in a 
written form that has been approved by the Exchange, and must be time 
stamped immediately prior to its transmission. The new proposed 
interpretation thus would require that each order transmitted by a 
Market-Maker while on the floor, including any cancellation of or 
change to such order, be systematized in accordance with CBOE Rule 
6.24.

IV. Summary of Comments

    The Commission received comment letters from 2 CBOE floor brokers 
opposing the systematization prior to representation of an order 
requirement.\7\ Both commenters were concerned that this requirement 
might harm customers by delaying the execution and possibly causing the 
customer orders to lose the market.
---------------------------------------------------------------------------

    \7\ See supra Note 4.
---------------------------------------------------------------------------

V. Discussion

    After careful consideration, the Commission finds that the proposed 
rule change is consistent with the Act and the rules and regulations 
thereunder applicable to a national securities exchange. In particular 
the Commission finds that the proposed rule change is consistent with 
section 6(b)(5) of the Act,\8\ which requires among other things, that 
the Exchange's rules be designed to promote just and equitable 
principles of trade, to remove impediments and to perfect the mechanism 
of a free and open market and a national market system, and in general, 
to protect investors and the public interest.\9\
---------------------------------------------------------------------------

    \8\ 8 15 U.S.C. 78f(b)(5).
    \9\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition and capital 
formation. 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    The Commission believes that the rules as proposed should allow the 
Exchange to comply with its obligations under the Order in that they 
will result in the creation of an audit trail that incorporates manual 
orders sent to CBOE. Specifically, the proposed rules will require that 
each order, change to an order, or cancellation of an order must be 
systematized prior to representation.
    With respect to market and marketable orders, the Exchange proposes 
to require that floor brokers must enter only eight order data elements 
into the Exchange's systems prior to representation. These elements 
are: (i) The option symbol; (ii) the expiration month; (iii) the 
expiration year; (iv) the strike price; (v) buy or sell; (vi) call or 
put; (vii) the number of contracts; and (viii) the Clearing Member. The 
Exchange represents that limiting the number of elements that must be 
entered prior to representation will permit marketable orders to be 
represented immediately in the marketplace as customers expect and as 
members representing those orders are obligated to do. The Commission 
notes that two commenters expressed concern that the requirement to 
systematize certain information prior to representation would harm 
investors.\10\ The Commission notes, however, that only a limited 
amount of information about an order would be required to be 
systematized prior to representation under the proposal. Moreover, the 
Commission believes that the order elements proposed to be captured for 
market and marketable orders should be sufficient to distinguish one 
order from another order that a member may receive at or about the same 
time to ensure an accurate audit trail. Therefore, the Commission 
believes that it is appropriate and consistent with the goals of 
investor protection to permit the capture of only the above-referenced 
order data elements prior to representation for market and marketable 
orders.
---------------------------------------------------------------------------

    \10\ See supra note 4.
---------------------------------------------------------------------------

    The Commission also believes that the Exchange's plan for recording 
order details in the event of a systems outage or malfunction is 
reasonable. In the event of a systems outage or malfunction, floor 
brokers would revert to the use of trade tickets and would record on 
those tickets the times that various events occur in the life of the 
order. Further, the Exchange would ensure that the information recorded 
on trade tickets is entered into the Exchange's electronic systems in a 
timely manner so that it can be incorporated into the electronic audit 
trail.
    The Commission notes that the Exchange has acknowledged the need 
for effective and proactive surveillance for activities such as trading 
ahead and front-running in connection with the creation of its audit 
trail. The Exchange represents that it currently conducts automated 
surveillance for such activities and will incorporate a review of order 
systemization as part of such surveillance. The Exchange also states 
that it intends to implement supplementary surveillance and examination 
programs related to the systemization of orders requirement promptly 
after this requirement is instituted, which are designed to address, 
among other things, trading ahead and front-running. The Commission 
views effective surveillance as critical to the integrity of COATS and 
expects that the Exchange will inform the Commission of any problems it 
encounters in conducting effective surveillance.

[[Page 2439]]

VI. Conclusion

    For all of the aforementioned reasons, 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.
    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\11\ that the proposed rule change (SR-CBOE-2004-77) is approved.
---------------------------------------------------------------------------

    \11\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
---------------------------------------------------------------------------

    \12\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jill M. Peterson,
Assistant Secretary.
 [FR Doc. E5-128 Filed 1-12-05; 8:45 am]
BILLING CODE 8010-01-P