[Federal Register Volume 70, Number 107 (Monday, June 6, 2005)]
[Notices]
[Pages 32860-32863]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-2871]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51759; File No. SR-Phlx-2004-91]


Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; 
Order Approving Proposed Rule Change and Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 1 Thereto To Establish a 
Directed Order Process for Orders Delivered to the Phlx Via AUTOM

May 27, 2005.

I. Introduction

    On December 9, 2004, the Philadelphia Stock Exchange, Inc. 
(``Phlx'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') a proposed rule change pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 
19b-4 thereunder,\2\ to establish a directed order process for orders 
delivered to the Exchange via the Automated Options Market (``AUTOM''). 
The proposed rule change was published for comment in the Federal 
Register on December 22, 2004.\3\ The Commission received three comment 
letters on the proposal.\4\ On January 18, 2005, the Phlx sent a 
response to the comment letters.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 50856 (December 14, 
2004), 69 FR 76817.
    \4\ See letter from Michael J. Simon, General Counsel and 
Secretary, International Securities Exchange, Inc. (``ISE''), to 
Jonathan G. Katz, Secretary, Commission, dated January 13, 2005 
(``ISE Letter''); letter from Philip D. DeFeo, Chairman and Chief 
Executive Officer, Pacific Exchange, Inc. (``PCX''), to Jonathan G. 
Katz, Secretary, Commission, dated March 22, 2005 (``PCX Letter''); 
and letter from Matthew Hinerfeld, Managing Director and Deputy 
General Counsel, Citadel Investment Group, L.L.C., on behalf of 
Citadel Derivatives Group LLC (``Citadel''), to Jonathan G. Katz, 
Secretary, Commission, dated April 6, 2005 (``Citadel Letter'').
    \5\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Jonathan G. Katz, Secretary, Commission, dated January 18, 
2005 (``Phlx Letter'').
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    On April 27, 2005, the Phlx filed Amendment No. 1 to the proposed 
rule change.\6\ This order approves the proposed rule change and 
simultaneously provides notice of filing and grants accelerated 
approval of Amendment No. 1.
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    \6\ Amendment No. 1 added language to clarify the application of 
the allocation algorithm and to note that Phlx Rule 707, Just and 
Equitable Principles of Trade, would prohibit coordinated actions 
between a Phlx directed participant and an OFP involving Directed 
Orders.
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II. Description of the Proposed Rule Change

    The Phlx proposes to establish, for a one-year pilot period, rules 
that permit Exchange specialists, Streaming Quote Traders (``SQTs''), 
and Remote Streaming Quote Traders (``RSQTs'') assigned in options 
trading on the Phlx XL system (``Streaming Quote Options'') to receive 
directed orders. The Phlx proposes to define the term ``Directed 
Order'' to mean any customer order to buy or sell that has been 
directed to a particular specialist, SQT, or RSQT by an Order Flow 
Provider (``OFP'').\7\ The Phlx also proposes to establish a trade 
algorithm for electronically executed and allocated trades involving 
Directed Orders, which would provide a participation guarantee to the 
Directed Specialist, SQT, or RSQT (collectively ``Phlx directed 
participants'').
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    \7\ The term Order Flow Provider under proposed Phlx Rule 
1080(l)(i)(B) would mean any member or member organization that 
submits, as agent, customer orders to the Exchange.
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    To qualify as a Directed Order, an order must be delivered to the 
Exchange via AUTOM. AUTOM currently functions to provide automatic 
executions in Streaming Quote Options only when the Exchange's 
disseminated bid or offer is the National Best Bid or Offer (``NBBO''). 
Therefore, to participate in automatic executions of Directed Orders, 
Phlx directed participants would be required to be quoting the NBBO at 
the time the Directed Order is received.
    Currently, an SQT or RSQT must quote continuous, two-sided markets 
in not less than 60% of the series in each Streaming Quote Option 
traded on Phlx XL in which such SQT or RSQT is assigned. A specialist 
must quote

[[Page 32861]]

continuous, two-sided markets in not less than 100% of the series in 
each Streaming Quote Option in which such specialist is assigned.\8\ 
Under the proposal, like specialists, Directed SQTs or RSQTs would be 
required to quote continuous, two-sided markets in not less than 100% 
of the series in each Streaming Quote Option in which they receive 
Directed Orders.
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    \8\ See Phlx Rule 1014(b)(ii)(B).
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    Directed Orders would first be allocated to customer limit orders 
resting on the limit order book at the execution price. Any remaining 
contracts would be allocated as follows:
     If the specialist were directed an order, it would be 
allocated a number of contracts that is the greater of: (1) Its size 
pro rata share; (2) the Enhanced Specialist Participation; \9\ or (3) 
40% of the contracts to be allocated.
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    \9\ See Phlx Rule 1014(g)(ii).
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     If an SQT or RSQT were directed an order, it would be 
allocated a number of contracts that is the greater of: (1) Its size 
pro rata share; or (2) 40% of the contracts to be allocated.
     After a specialist, SQT, or RSQT is allocated contracts, 
other market makers quoting at the disseminated price, and non-SQT 
Registered Options Traders (``ROTs'') that have placed limit orders on 
the limit order book via electronic interface would be allocated their 
size pro rata of the remaining contracts.
     If any contracts still remain, off-floor broker-dealers 
that have placed limit orders on the limit order book that represent 
the Exchange's disseminated price would be allocated contracts on a 
size pro rata basis.
     Finally, if the Directed Order is for a size that is 
greater than the Exchange's disseminated size, remaining contracts 
would be allocated manually in accordance with Phlx Rule 1014(g)(v), 
which sets forth the rules and contract allocation algorithm for trades 
that are executed in the trading crowd. A market maker directed an 
order would not be entitled to receive a number of contracts that is 
greater than the size associated with its quotation, nor would a ROT or 
off-floor broker-dealer be entitled to receive a number of contracts 
that is greater than the size associated with its limit order.
    The allocation algorithm would apply to Directed Orders in lieu of 
the current allocation algorithm applicable to orders other than 
Directed Orders contained in Exchange Rule 1014(g)(vii). Specialists 
that are not Directed Specialists participating in trades involving a 
Directed SQT or a Directed RSQT would be entitled to receive a number 
of contracts as specified in proposed rule 1014(g)(viii), and would not 
be entitled to receive an Enhanced Specialist Participation on the 
remaining contracts.

III. Discussion and Commission Findings

    The Commission has reviewed carefully the proposed rule change, 
comment letters, and the Phlx's response and finds that the proposed 
rule change is consistent with the requirements of section 6 of the Act 
\10\ and the rules and regulations thereunder applicable to a national 
securities exchange \11\ and, in particular, the requirements of 
Section 6(b)(5) of the Act.\12\ section 6(b)(5) requires, among other 
things, that the rules of a national securities exchange be designed to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade, to remove impediments to and perfect 
the mechanism of a free and open market and a national market system, 
and, in general, to protect investors and the public interest.
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    \10\ 15 U.S.C. 78f.
    \11\ 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).
    \12\ 15 U.S.C. 78f(b)(5).
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    The Commission received three comment letters regarding the 
proposal, all of which opposed the proposal.\13\ The commenters 
criticized the proposal because they believe it would allow a Phlx 
directed participant a guarantee based solely on its relationships with 
order entry firms rather than on such Phlx directed participant's 
obligations.\14\ The commenters assert that the proposal would reward a 
Phlx directed participant for its payment for order flow arrangements 
rather than the quality of its quotes, and therefore the proposal would 
have a negative impact on price competition.\15\ In addition, two 
commenters note that the proposal would not limit the allocation 
entitlement to specialists, but extend it to SQTs and RSQTs, which have 
fewer obligations to the market.\16\ Two commenters also believed that 
the proposal did not address the possibility of coordinated actions 
between a directed market maker and an OFP.\17\
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    \13\ See supra note 4.
    \14\ See, e.g., ISE Letter, supra note 4 at 1-2; PCX Letter, 
supra note 4 at 1-2; Citadel Letter, supra note 4 at 2.
    \15\ Id.
    \16\ ISE Letter (``The Phlx proposal is not limited to 
specialist[s], and the Phlx does not attempt to justify this 
proposal other than as a way to reward market makers that attract 
order-flow to the Phlx.''), supra note 4 at 1, 3-4; Citadel Letter, 
supra note 4 at 2.
    \17\ ISE Letter, supra note 4 at 3; PCX Letter, supra note 4 at 
2.
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    The Commission has previously approved rules that guarantee a Phlx 
specialist a portion of each order when the specialist's quote is equal 
to the NBBO.\18\ The Commission has closely scrutinized exchange rule 
proposals to adopt or amend a specialist guarantee where the percentage 
of specialist participation would rise to a level that could have a 
material adverse impact on quote competition within a particular 
exchange.\19\ Because the proposal would not increase the overall 
percentage of an order that is guaranteed to the specialist beyond the 
currently acceptable threshold, but instead would allow SQTs and RSQTs 
to share in that guarantee, the Commission does not believe that the 
proposal will negatively impact quote competition on the Phlx. Under 
the proposal, the remaining portion of each order will still be 
allocated based on the competitive bidding of market participants.
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    \18\ See Securities Exchange Act Release No. 34606 (August 26, 
1994), 59 FR 45741 (September 2, 1994) (SR-Phlx-94-12) (order 
approving the enhanced specialist participation in Phlx Rule 
1014(g)(ii) for a one-year pilot basis); see Securities Exchange Act 
Release No. 41588 (July 1, 1999), 64 FR 37185 (July 9, 1999) (SR-
Phlx-98-56) (order approving the enhanced specialist participation 
in Phlx Rule 1014(g)(ii) on a permanent basis).
    \19\ See Securities Exchange Act Release No. 43100 (July 31, 
2000), 65 FR 48788 (August 9, 2000).
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    In addition, a Phlx directed participant will have to be quoting at 
the NBBO at the time the order is received to capitalize on the 
guarantee. The Commission believes it is critical that the Phlx 
directed participant cannot step up and match the NBBO after it 
receives an order, but must be publicly quoting at that price when the 
order is received. In this regard, the Phlx's proposal prohibits from 
notifying a Phlx directed participant regarding its intention to submit 
a Directed Order so that such Phlx directed participant could change 
its quotation to match the NBBO immediately prior to submission of the 
preferenced order, and then fade its quote. In response to commenters' 
concerns that its proposal failed to protect against coordinated 
actions between a Phlx directed participant and an OFP, the Phlx stated 
it believes its Rule 707, Just and Equitable Principles of Trade, 
already provides the necessary protections against that type of 
conduct, and will proactively conduct surveillance for, and enforce 
against, such violations.\20\
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    \20\ See Amendment No. 1; letter from Edith Hallahan, Deputy 
General Counsel, and Edward Deitzel, Vice President, Phlx, to John 
Roeser, Assistant Director, Division of Market Regulation, 
Commission, dated May 26, 2005.

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[[Page 32862]]

    One commenter states that specialists currently receive 
participation entitlements based on their obligations to the market. 
The commenter believes that the proposal, by allowing any directed 
market maker quoting at the NBBO to receive a guaranteed percentage of 
an order without in turn increasing the market maker's obligations to 
the market, would ``eliminate the incentive to be a specialist, thereby 
potentially leaving the obligations of the specialist to the market 
unfulfilled.'' \21\ The Commission does not believe that the proposal 
will result in the role of the specialist going unfulfilled, and notes 
that it recently approved an options exchange without specialists.\22\ 
Moreover, specialists' obligations to the market have been reduced 
through other changes, including greater automation of functions 
previously handled manually by the specialist. While this proposal may 
reduce the incentive to be a specialist, the Commission does not 
believe that makes the proposal inconsistent with the Act. Finally, the 
Commission notes that Phlx specialists and Directed SQTs and RSQTs have 
greater quoting obligations than other Phlx market makers who cannot be 
Phlx directed participants. Specifically, Phlx specialists must submit 
continuous, two-sided quotations in 100% of the series of options in 
which it is assigned,\23\ and a Directed SQTs or RSQTs must submit 
continuous, two-sided quotations in 100% of the series of options in 
which it receives Directed Orders. To receive an allocation under this 
rule filing, the Phlx directed participant must be quoting at the NBBO 
for the size of the allocation received.
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    \21\ Citadel Letter, supra note 4 at 2.
    \22\ See Securities Exchange Act Release No. 49068 (January 13, 
2004), 69 FR 2775 (January 20, 2004) (SR-BSE-2002-15) (order 
approving trading rules for the Boston Options Exchange Facility).
    \23\ See Phlx Rule 1014(b)(ii)(B).
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    Two commenters believe that the proposal is similar to facilitation 
guarantees and other directed order programs approved by the 
Commission.\24\ However, unlike those programs, the commenters 
criticize that the instant proposal does not include certain 
protections for customers, such as providing the opportunity for price 
improvement, or limiting the program to a minimum number of 
contracts.\25\
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    \24\ ISE Letter (``There is no distinction between a broker 
`facilitating' an order and a broker directing an order to a 
particular market maker for execution. * * *''), supra note 4 at 3-
4; PCX Letter, supra note 4 at 2.
    \25\ ISE Letter, supra note 4 at 3-4; PCX Letter, supra note 4 
at 2.
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    The Commission believes that the proposal is more akin to current 
participation entitlements, for specialists, than the facilitation 
guarantee programs and other directed order programs cited by the 
commenters. Unlike exchange facilitation guarantee programs,\26\ under 
the proposal, the Phlx directed participant would not be eligible for a 
participation entitlement unless it is publicly quoting at the NBBO at 
the time an order is received. Instead of changing its facilitation 
program rules, this proposal allows Phlx directed participants to share 
in the participation entitlement currently available only for 
specialists. The Commission believes this reallocation is consistent 
with the Act and will not affect the incentives of the trading crowd to 
compete aggressively for orders based on price.
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    \26\ See CBOE Rule 6.74(d); ISE Rule 716(d); Pacific Exchange, 
Inc. Rule 6.47(b); American Stock Exchange, Inc. Rule 950(d), 
Commentary .02(d); and Philadelphia Stock Exchange, Inc. Rule 1064, 
Commentary .02.
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    The Commission emphasizes that approval of this proposal does not 
affect a broker-dealer's duty of best execution. A broker-dealer has a 
legal duty to seek to obtain best execution of customer orders, and any 
decision to preference a particular specialist, SQT, or RSQT must be 
consistent with this duty.\27\ A broker-dealer's duty of best execution 
derives from common law agency principles and fiduciary obligations, 
and is incorporated in SRO rules and, through judicial and Commission 
decisions, the antifraud provisions of the federal securities laws.\28\
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    \27\ 27 See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & 
Smith, Inc., 135 F.3d 266, 269-70, 274 (3d Cir.), cert. denied, 525 
U.S. 811 (1998); Certain Market Making Activities on Nasdaq, 
Securities Exchange Act Release No. 40900 (Jan. 11, 1999) (settled 
case) (citing Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Arleen 
Hughes, 27 SEC 629, 636 (1948), aff'd sub nom. Hughes v. SEC, 174 
F.2d 969 (D.C. Cir. 1949)). See also Order Execution Obligations, 
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 
48290 (Sept. 12, 1996) (``Order Handling Rules Release'').
    \28\ Order Handling Rules Release, 61 FR at 48322. See also 
Newton, 135 F.3d at 270. Failure to satisfy the duty of best 
execution can constitute fraud because a broker-dealer, in agreeing 
to execute a customer's order, makes an implied representation that 
it will execute it in a manner that maximizes the customer's 
economic gain in the transaction. See Newton, 135 F.3d at 273 
(``[T]he basis for the duty of best execution is the mutual 
understanding that the client is engaging in the trade--and 
retaining the services of the broker as his agent--solely for the 
purpose of maximizing his own economic benefit, and that the broker 
receives her compensation because she assists the client in reaching 
that goal.''); Marc N. Geman, Securities Exchange Act Release No. 
43963 (Feb. 14, 2001) (citing Newton, but concluding that respondent 
fulfilled his duty of best execution). See also Payment for Order 
Flow, Securities Exchange Act Release No. 34902 (Oct. 27, 1994), 59 
FR 55006, 55009 (Nov. 2, 1994) (``Payment for Order Flow Final 
Rules''). If the broker-dealer intends not to act in a manner that 
maximizes the customer's benefit when he accepts the order and does 
not disclose this to the customer, the broker-dealer's implied 
representation is false. See Newton, 135 F.3d at 273-274.
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    The duty of best execution requires broker-dealers to execute 
customers' trades at the most favorable terms reasonably available 
under the circumstances, i.e., at the best reasonably available 
price.\29\ The duty of best execution requires broker-dealers to 
periodically assess the quality of competing markets to assure that 
order flow is directed to the markets providing the most beneficial 
terms for their customer orders.\30\ Broker-dealers must examine their 
procedures for seeking to obtain best execution in light of market and 
technology changes and modify those practices if necessary to enable 
their customers to obtain the best reasonably available prices.\31\ In 
doing so, broker-dealers must take into account price improvement 
opportunities, and whether different markets may be more suitable for 
different types of orders or particular securities.\32\
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    \29\ Newton, 135 F.3d at 270. Newton also noted certain factors 
relevant to best execution--order size, trading characteristics of 
the security, speed of execution, clearing costs, and the cost and 
difficulty of executing an order in a particular market. Id. at 270 
n. 2 (citing Payment for Order Flow, Securities Exchange Act Release 
No. 33026 (Oct. 6, 1993), 58 FR 52934, 52937-38 (Oct. 13, 1993) 
(Proposed Rules)). See In re E.F. Hutton & Co. (``Manning''), 
Securities Exchange Act Release No. 25887 (July 6, 1988). See also 
Payment for Order Flow Final Rules, 59 FR at 55008-55009.
    \30\ Order Handling Rules Release, 61 FR at 48322-48333 (``In 
conducting the requisite evaluation of its internal order handling 
procedures, a broker-dealer must regularly and rigorously examine 
execution quality likely to be obtained from different markets or 
market makers trading a security.''). See also Newton, 135 F.3d at 
271; Market 2000: An Examination of Current Equity Market 
Developments V-4 (SEC Division of Market Regulation January 1994) 
(``Without specific instructions from a customer, however, a broker-
dealer should periodically assess the quality of competing markets 
to ensure that its order flow is directed to markets providing the 
most advantageous terms for the customer's order.''); Payment for 
Order Flow Final Rules, 59 FR at 55009.
    \31\ Order Handling Rules, 61 FR at 48323.
    \32\ Order Handling Rules, 61 FR at 48323. For example, in 
connection with orders that are to be executed at a market opening 
price, ``[b]roker-dealers are subject to a best execution duty in 
executing customer orders at the opening, and should take into 
account the alternative methods in determining how to obtain best 
execution for their customer orders.'' Disclosure of Order Execution 
and Routing Practices, Securities Exchange Act Release No. 43590 
(Nov. 17, 2000), 65 FR 75414, 75422 (Dec. 1, 2000) (adopting new 
Exchange Act Rules 11Ac1-5 and 11Ac1-6 and noting that alternative 
methods offered by some Nasdaq market centers for pre-open orders 
included the mid-point of the spread or at the bid or offer).

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[[Page 32863]]

    The Commission notes that the proposed rule change would be 
implemented on a pilot basis for one year. During this time, the 
Commission intends to evaluate the impact of the proposal on the 
options markets to determine whether it would be beneficial to 
customers and to the options markets as a whole before approving any 
request for permanent approval of the pilot program.
    For these reasons, the Commission believes that the proposal is 
consistent with the requirements of Section 6(b)(5) of the Act,\33\ and 
will not jeopardize market integrity or the incentive for market 
participants to post competitive quotes.\34\
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    \33\ 15 U.S.C. 78f(b)(5).
    \34\ Approval of this proposal is in no way an endorsement of 
payment for order flow by the Commission.
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IV. Accelerated Approval of Amendment No. 1

    Pursuant to Section 19(b)(2) of the Act,\35\ the Commission may not 
approve any proposed rule change, or amendment thereto, prior to the 
30th day after the date of publication of notice of the filing thereof, 
unless the Commission finds good cause for so doing and publishes its 
reasons for so finding. The Commission hereby finds good cause for 
approving Amendment No. 1 to the proposal, prior to the 30th day after 
publishing notice of Amendment No. 1 in the Federal Register.
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    \35\ 15 U.S.C. 78s(b)(2).
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    The Commission believes that it has received and fully considered 
meaningful comments with respect to the proposal, and that Amendment 
No. 1 does not raise any new regulatory issues that warrant further 
delay. In Amendment No. 1, the Exchange added language to clarify the 
application of the allocation algorithm. In addition, Amendment No. 1 
added language to note that Phlx Rule 707, Just and Equitable 
Principles of Trade, prohibits coordinated actions between the Phlx 
directed participant and the OFP involving Directed Orders. The 
Commission believes that the addition of the language is appropriate to 
clarify the proposed Directed Order process.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether Amendment No. 1 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-Phlx-2004-91 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-Phlx-2004-91. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of the 
Phlx. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
publicly available. All submissions should refer to File Number SR-
Phlx-2004-91 and should be submitted on or before June 27, 2005.

VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\36\ that the proposed rule change (SR-Phlx-2004-91) be, and hereby 
is, approved, and that Amendment No. 1 to the proposed rule change be, 
and hereby is, approved on an accelerated basis, for a pilot period to 
expire on May 27, 2006.
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    \36\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\37\
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    \37\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-2871 Filed 6-3-05; 8:45 am]
BILLING CODE 8010-01-P