[Federal Register Volume 70, Number 115 (Thursday, June 16, 2005)]
[Notices]
[Pages 35146-35151]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3095]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51818; File No. SR-ISE-2005-18]


Self-Regulatory Organizations; International Securities Exchange, 
Inc.; Notice of Filing and Order Granting Accelerated Approval of a 
Proposed Rule Change and Amendment Nos. 1 and 2 Thereto Relating to the 
Preferencing of Orders to Exchange Market Makers

June 10, 2005.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on March 31, 2005, the International Securities Exchange, Inc. (``ISE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I and 
II below, which Items have been prepared by the Exchange. On May 31, 
2005, the Exchange filed Amendment No. 1 to the proposed rule 
change.\3\ On June 7, 2005, the Exchange filed Amendment No. 2.\4\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons and is 
approving the proposal, as amended, on an accelerated basis, for a 
pilot period through July 22, 2005.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Form 19b-4 dated May 31, 2005 (``Amendment No. 1''). 
Amendment No. 1 replaced and superseded the original filing in its 
entirety.
    \4\ See Partial Amendment dated June 6, 2005 (``Amendment No. 
2''). In Amendment No. 2, the Exchange proposed that the length of 
the pilot period for the proposed rule change be reduced from one 
year from the date of approval to six weeks from the date of 
approval. Amendment No. 2 also modified the Exchange's 
representations regarding surveillance in note 10 infra.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to amend the allocation procedures contained 
in Exchange Rule 713 to allow Electronic Access Members to designate 
``Preferred Market Makers'' on the Electronic Access Members'' orders 
(i.e., ``preference'' orders to a particular market maker), who would 
receive an enhanced allocation if such market maker is quoting at the 
national best bid or offer (``NBBO'') at the time such order is 
received by the Exchange. The text of the proposed rule change is set 
forth below. Italics indicate additions; [brackets] indicate deletions.
* * * * *

[[Page 35147]]

Rule 713. Priority of Quotes and Orders
    No change.

Supplementary Material to Rule 713

    .01 no change.
    (a) Subject to the two limitations in subparagraphs (b) and (c) 
below and subject to paragraph .03 (Preferenced Orders), Non-Customer 
Orders and market maker quotes at the best price receive allocations 
based upon the percentage of the total number of contracts available at 
the best price that is represented by the size of the Non-Customer 
Order or quote;
    (b) no change.
    (c) no change.
    .02 no change.
    .03 Preferenced Orders. For a pilot period ending [insert date six-
weeks from approval], an Electronic Access Member may designate a 
``Preferred Market Maker'' on orders it enters into the System 
(``Preferenced Orders'').
    (a) A Preferred Market Maker may be the Primary Market Maker 
appointed to the options class or any Competitive Market Maker 
appointed to the options class.
    (b) If the Preferred Market Maker is not quoting at a price equal 
to the NBBO at the time the Preferenced Order is received, the 
allocation procedure contained in paragraph .01 shall be applied to the 
execution of the Preferenced Order.
    (c) If the Preferred Market Maker is quoting at the NBBO at the 
time the Preferenced Order is received, the allocation procedure 
contained in paragraph .01 shall be applied to the execution of the 
Preferenced Order except that the Primary Market Maker will not receive 
the participation rights described in paragraphs .01(b) and (c), and 
instead the Preferred Market Maker shall have participation rights 
equal to the greater of:
    (i) the proportion of the total size at the best price represented 
by the size of its quote, or
    (ii) sixty percent (60%) of the contracts to be allocated if there 
is only one (1) other Non-Customer Order or market maker quotation at 
the best price and forty percent (40%) if there are two (2) or more 
other Non-Customer Orders and/or market maker quotes at the best price.
* * * * *
Rule 804. Market Maker Quotations
    (a) through (d) no change.
    (e) Continuous Quotes. A market maker must enter continuous 
quotations for the options classes to which it is appointed pursuant to 
the following:
    (1) Primary Market Makers. Primary Market Makers must enter 
continuous quotations and enter into any resulting transactions in all 
of the series listed on the Exchange of the options classes to which he 
is appointed on a daily basis.
    (2) Competitive Market Makers. (i) On any given day, a Competitive 
Market Maker must participate in the opening rotation and make markets 
and enter into any resulting transactions on a continuous basis in all 
of the series listed on the Exchange of at least sixty percent (60%) of 
the options classes for the Group to which the Competitive Market Maker 
is appointed or 60 options classes in the Group, whichever is lesser. 
[and all the series of such options classes listed on the Exchange.]
    (ii) Whenever a Competitive Market Maker enters a quote [or order] 
in an options class to which it is appointed, it must maintain 
continuous quotations for all series of the options class listed on the 
Exchange [within the same expiration month] until the close of trading 
that day[; provided, however, if such quote or order is entered in an 
options series during the month in which such series expires, the 
Competitive Market Maker must participate in the opening rotation and 
maintain continuous quotations for all series in that month each day 
through their expiration].
    (iii) A Competitive Market Maker may be called upon by an Exchange 
official designated by the Board to submit a single quote or maintain 
continuous quotes in one or more of the series of an options class to 
which the Competitive Market Maker is appointed whenever, in the 
judgment of such official, it is necessary to do so in the interest of 
fair and orderly markets.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The Exchange has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    According to the Exchange, the purpose of the proposed rule change 
is to assure that the Exchange remains competitive with other options 
exchanges that have proposed to allow order-flow providers to designate 
or ``preference'' non-specialist market makers, and to provide enhanced 
allocations to those preferenced market makers in order to reward them 
for attracting order flow to the Exchange.\5\ The Exchange proposes to 
implement the rule change on a six-week pilot basis.
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    \5\ See Securities Exchange Act Release Nos. 51759 (May 27, 
2005), 70 FR 32860 (June 6, 2005) (order approving SR-Phlx-2004-91); 
and 51779 (June 2, 2005), 70 FR 33564 (June 8, 2005) (order 
approving SR-CBOE-2004-71).
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    The proposal amends the Exchange's procedure for allocating trades 
among market makers and non-customer orders under Exchange Rule 713 to 
provide an enhanced allocation to a ``Preferred Market Maker'' when the 
Preferred Market Maker is quoting at the NBBO. Specifically, under the 
proposal, an Electronic Access Member may designate any market maker 
appointed to an options class to be a Preferred Market Maker on orders 
the Electronic Access Member enters into the Exchange's system 
(``Preferenced Orders''). If the Preferred Market Maker is not quoting 
at the NBBO at the time the Preferenced Order is received, the 
Exchange's existing allocation and execution procedures would be 
applied to the execution.\6\
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    \6\ Marketable customer orders are not automatically executed at 
prices inferior to the NBBO. If the Exchange's best bid or offer is 
inferior to the NBBO, the marketable customer order is handled by 
the Primary Market Maker according to Exchange Rule 803(c).
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    Under existing Exchange Rule 713, Supplementary Material .01, no 
market participant can execute a greater number of contracts than is 
associated with the price of the market participant's existing 
interest. After all Public Customer Orders are filled, Non-Customer 
Orders and market maker quotes at the best price automatically receive 
allocations based upon the percentage of the total number of contracts 
available at the best price that is represented by the size of the Non-
Customer Order or quote (i.e., pro-rata based on size). However, if the 
Primary Market Maker is quoting at the best price, it automatically 
receives an enhanced participation equal to the greater of: (i) The 
proportion of the total

[[Page 35148]]

size at the best price represented by the size of the Primary Market 
Maker's quote, or (ii) 60 percent of the contracts to be allocated if 
there is only one other Non-Customer Order or market maker quote at the 
best price, 40 percent if there are two other Non-Customer Orders and/
or market maker quotes at the best price, and 30 percent if there are 
more than two other Non-Customer Orders and/or market maker quotes at 
the best price. In addition, the Primary Market Maker has priority to 
execute orders for five contracts or fewer if the Primary Market Maker 
is quoting at the best price.\7\
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    \7\ According to the Exchange, all allocations are automatically 
performed by the Exchange's system.
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    Under the proposal, if a Preferred Market Maker is quoting at the 
NBBO at the time a Preferenced Order is received, the allocation 
procedure would be modified so that the Preferred Market Maker--instead 
of the Primary Market Maker \8\--would receive an enhanced allocation 
equal to the greater of: (i) The proportion of the total size at the 
best price represented by the size of its quote, or (ii) 60 percent of 
the contracts to be allocated if there is only one other Non-Customer 
Order or market maker quote at the best price and 40 percent if there 
are two or more other Non-Customer Orders and/or market maker quotes at 
the best price.\9\ Unexecuted contracts remaining after the Preferred 
Market Maker's allocation would be allocated pro-rata based on size as 
described above.\10\
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    \8\ A Primary Market Maker may be the Preferred Market Maker, in 
which case such market maker would receive the enhanced allocation 
for Preferred Market Makers.
    \9\ According to the Exchange, all allocations are automatically 
performed by the Exchange's system.
    \10\ In Amendment No. 2, the Exchange stated that Electronic 
Access Members and Preferred Market Makers may not coordinate their 
actions. Such conduct would be a violation of Exchange Rule 400 
(Just and Equitable Principles of Trade). The Exchange represented 
that it will proactively conduct surveillance for, and enforce 
against, such violations.
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    As part of this proposal, the Exchange also proposes to increase 
the quotation obligations of Competitive Market Makers. Pursuant to 
current Exchange Rule 802, the Exchange allocates options classes into 
ten Groups and then appoints Primary Market Makers and Competitive 
Market Makers to the Groups. Under current Exchange Rule 804(e), a 
Primary Market Maker is required to maintain continuous quotations in 
all of the series of all of the options classes to which the Primary 
Market Maker is appointed, i.e., all of the series in all of the 
options classes in the Primary Market Maker's appointed Group. 
Competitive Market Makers are required to maintain continuous 
quotations in all of the series in at least 60 percent of the options 
classes in the Group to which they are appointed. However, a 
Competitive Market Maker may enter continuous quotes in less than all 
of the series in the remaining 40 percent of the classes in its 
appointed Group, subject to a requirement to maintain continuous quotes 
in those and related series through the end of the day and, in certain 
circumstances, through expiration of the series.
    Because under the proposal, all Competitive Market Makers would be 
eligible to be designated as a Preferred Market Maker by Electronic 
Access Members and receive an enhanced allocation in any options series 
in which the Competitive Market Maker is quoting at the NBBO, the 
Exchange proposes to amend Exchange Rule 804(e) to require that a 
Competitive Market Maker maintain continuous quotes in all of the 
series of any options class it is quoting. Specifically, under the 
proposed amendment to Exchange Rule 804(e), a Competitive Market Maker 
would continue to be required to make markets in all of the series of a 
minimum number of options classes in its appointed Group, but also 
would be required to enter continuous quotes in all of the series of 
any options class in which it seeks to make markets above the minimum 
requirement. Accordingly, a Competitive Market Maker would be required 
to maintain continuous quotations in all of the series of any options 
classes in which it might receive an enhanced participation as the 
result of being designated as a Preferred Market Maker.\11\
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    \11\ The Exchange proposes to eliminate the requirement that a 
market maker start quoting if the market maker enters an order in an 
options series. Under Exchange Rule 805(a), Competitive Market 
Makers are not permitted to enter limit orders that would sit on the 
limit order book in options in their appointed Group. The entry of 
an immediate-or-cancel limit order, which either executes 
immediately against existing bids or offers in the market or is 
cancelled, does not cause a market maker to disseminate a bid or 
offer. Accordingly, a Competitive Market Maker that enters an order 
would not become eligible to receive an enhanced allocation as a 
Preferred Market Maker, and therefore should not become subject to 
the increased obligation to quote all of the series of an options 
class.
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    The proposal also seeks to amend the 60 percent requirement to more 
fairly apply the minimum quotation requirement on Competitive Market 
Makers. The number of options classes allocated to the ten different 
Groups changes as options classes are listed and delisted by the 
Exchange. Because the minimum requirement is a percentage of the number 
of options classes in a Group, some Competitive Market Makers are 
required to maintain continuous quotes in a much larger number of 
options classes than others. While the Exchange believes a percentage-
based minimum requirement remains appropriate, it believes there should 
be a limit to the number of options classes a Competitive Market Maker 
is required to continuously quote. Accordingly, the Exchange proposes 
to amend Exchange Rule 804(e)(2) to provide that a Competitive Market 
Maker must quote at least 60 percent of the options classes in the 
Group or 60 options classes, whichever is lesser. The Exchange believes 
that this change would assure that Competitive Market Makers appointed 
to Groups with more than 100 options classes would not be required to 
quote more than 60 options classes. The proposed amendment would not 
change the minimum requirement for any Competitive Market Maker 
appointed to a Group with less than 100 options classes, which, 
according to the Exchange, currently is the case in eight of the ten 
Groups.
    The Exchange believes the proposed rule change is a necessary 
competitive response to the preferencing proposals filed by other 
options exchanges and will help the Exchange attract and retain order 
flow. The Exchange further believes that such order flow will add depth 
and liquidity to the Exchange's markets and enable the Exchange to 
continue to compete effectively with other options exchanges.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b)(5) of the Act,\12\ in that the proposed rule change 
is designed to promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system because a Preferred Market Maker must be 
quoting at the NBBO in order to receive the proposed enhanced 
allocation.
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    \12\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange believes that the proposed rule change does not impose 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

[[Page 35149]]

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange has not solicited, and does not intend to solicit 
comments on the proposed rule change. The Exchange has not received any 
written comments from members or other interested parties. However, on 
April 6, 2005, written comments were submitted to the Commission by a 
member regarding the proposed rule change.\13\ This written comment 
opposed the proposed rule change, as well as similar proposals by the 
Philadelphia Stock Exchange, Inc. (``Phlx'') and the Chicago Board 
Options Exchange, Incorporated (``CBOE'').\14\
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    \13\ Letter from Matthew B. Hinerfeld, Managing Director and 
Deputy General Counsel, Citadel Investment Group, L.L.C., on behalf 
of Citadel Derivatives Group LLC, to Jonathan G. Katz, Secretary, 
Commission, dated April 6, 2005.
    \14\ Supra note 5.
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III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act and whether the pilot 
time frame is appropriate. 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-ISE-2005-18 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-9303. All submissions should refer to File Number 
SR-ISE-2005-18. 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 Room. Copies of such filing also will be available for 
inspection and copying at the principal office of the Exchange. 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 available publicly. All 
submissions should refer to File Number SR-ISE-2005-18 and should be 
submitted on or before July 7, 2005.

IV. Commission's Findings and Order Granting Accelerated Approval of 
the Proposed Rule Change

    The Exchange has asked the Commission to approve the proposed rule 
change on an accelerated basis for six weeks while the Commission seeks 
comment on the proposed rule change. The Exchange believes the proposed 
rule change is substantially similar to rule changes by Phlx and CBOE 
that were recently approved by the Commission.\15\ After careful 
consideration, the Commission finds that the proposed rule change is 
consistent with the requirements of Section 6 of the Act\16\ and the 
rules and regulations thereunder applicable to a national securities 
exchange\17\, and, in particular, the requirements of Section 6(b)(5) 
of the Act.\18\ 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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    \15\ Supra note 5.
    \16\ 15 U.S.C. 78f.
    \17\ 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).
    \18\ 15 U.S.C. 78f(b)(5).
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    Pursuant to Section 19(b)(2) of the Act,\19\ 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 the proposed rule change, as amended, prior to the 30th day 
after publishing notice thereof in the Federal Register.
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    \19\ 15 U.S.C. 78s(b)(2).
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    The Commission received one comment letter opposing the 
proposal.\20\ This commenter criticized the proposal because the 
commenter believes the proposal would grant a Preferred Market Maker a 
guarantee based solely on being at the NBBO rather than on such 
Preferred Market Maker's obligations.\21\ The commenter asserts that 
the proposal would reward a Preferred Market Maker for the Preferred 
Market Maker's relationships with order flow providers rather than the 
quality of the Preferred Market Maker's quotes, and therefore the 
proposal would have a negative impact on price competition.\22\ In 
addition, this commenter notes that the proposal would extend the 
allocation entitlement to Competitive Market Makers, who have fewer 
obligations to the market than Primary Market Makers.\23\
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    \20\ See supra note 13. This written comment opposed the 
proposed rule change, as well as similar proposals by the Phlx and 
the CBOE. See supra note 5.
    \21\ See supra note 13 at 1 and 2.
    \22\ See supra note 13 at 2.
    \23\ See supra note 13 at 2. The Exchange refers to its 
specialists as ``Primary Market Makers.''
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    The Commission has previously approved rules that guarantee a 
Primary Market Maker a portion of each order when the Primary Market 
Maker's quote is equal to the NBBO.\24\ The Commission has closely 
scrutinized exchange rule proposals to adopt or amend a participation 
guarantee where the percentage of participation would rise to a level 
that could have a material adverse impact on quote competition within a 
particular exchange.\25\ Because the proposal would not increase the 
overall percentage of an order that is guaranteed beyond the currently 
acceptable threshold, but instead would allow any Competitive Market 
Maker appointed to an options class to be designated as a Preferred 
Market Maker and be eligible to receive a participation guarantee 
instead of the Primary Market Maker, the Commission does not believe 
that the proposal will negatively impact quote competition on the 
Exchange. 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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    \24\ See Securities Exchange Act Release Nos. 42808 (May 22, 
2000), 65 FR 34515 (May 30, 2000) (SR-ISSE-2000-01); 44340 (May 22, 
2001), 66 FR 29373 (May 30, 2001) (SR-ISE-2001-46); and 44641 
(August 2, 2001), 65 FR 41643 (August 8, 2001) (SR-ISE-2001-17).
    \25\ See, e.g., Securities Exchange Act Release No. 43100 (July 
31, 2000), 65 FR 48788 (August 9, 2000).
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    In addition, a Preferred Market Maker will have to be quoting at 
the NBBO at

[[Page 35150]]

the time the Preferenced Order is received to capitalize on the 
participation guarantee. The Commission believes it is critical that 
the Preferred Market Maker 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 Exchange's proposal prohibits 
Electronic Access Members and Preferred Market Makers from coordinating 
their actions. The Exchange has stated that such coordinated actions 
would violate Exchange Rule 400, Just and Equitable Principles of 
Trade, and will proactively conduct surveillance for, and enforce 
against, such violations.\26\
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    \26\ See Amendment No. 2.
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    The commenter also states that specialists (i.e., Primary Market 
Makers) currently receive participation entitlements based on their 
obligations to the market. The commenter believes that the proposal, by 
allowing any 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.'' \27\ 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.\28\ 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, as part of this proposal, 
the Exchange proposes to increase the quotation obligations of 
Competitive Market Makers. Currently, a Primary Market Maker is 
required to maintain continuous quotations in all of the series of all 
of the options classes to which the Primary Market Maker is appointed. 
Competitive Market Makers are required to maintain continuous 
quotations in all of the series in at least 60 percent of the options 
classes in the Group to which they are appointed. However, a 
Competitive Market Maker may enter continuous quotes in less than all 
of the series in the remaining 40 percent of the classes in its 
appointed Group, subject to a requirement to maintain continuous quotes 
in those and related series through the end of the day and, in certain 
circumstances, through expiration of the series.\29\
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    \27\ Supra note 13 at 2.
    \28\ 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).
    \29\ See Exchange Rule 804(e).
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    Under the proposal, since all Competitive Market Makers would be 
eligible to be designated as a Preferred Market Maker by Electronic 
Access Members and receive an enhanced allocation in any options series 
in which the Competitive Market Maker is quoting at the NBBO, the 
Exchange proposes to require that a Competitive Market Maker maintain 
continuous quotes in all of the series of any options class it is 
quoting. Specifically, with respect to any series of any options class 
in which a Competitive Market Maker seeks to make markets above the 
minimum requirement, the proposal would require a Competitive Market 
Maker to enter continuous quotes in all of the series of any options 
class in which it enters quotes. Accordingly, the proposed rule change 
would require a Competitive Market Maker to maintain continuous 
quotations in all of the series of any options classes in which it 
might receive an enhanced participation as the result of being 
designated as a Preferred Market Maker.\30\
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    \30\ See proposed Exchange Rule 804(e).
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    The proposal also seeks to amend the minimum quotation requirement 
on Competitive Market Makers to provide that a Competitive Market Maker 
must quote at least 60 percent of the options classes in the Group or 
60 options classes, whichever is lesser.\31\ Under the current rule, 
because the minimum quotation requirement is 60 percent of the number 
of options classes in a Group, and the number of options classes in a 
Group varies, according to the Exchange, some Competitive Market Makers 
are required to maintain continuous quotes in a much larger number of 
options classes than other Competitive Market Makers. The Commission 
notes that this change to the quotation requirement only affects 
Competitive Market Makers appointed to Groups with more than 100 
options classes and that such Competitive Market Makers would still be 
required to quote continuous in 60 options classes.\32\ The Commission 
also notes that the proposed change to the quotation requirement does 
not affect the proposed requirement that a Competitive Market Maker 
maintain continuous quotes in a series in order to be eligible to 
receive a participation guarantee for that series.
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    \31\ See proposed Exchange Rule 804(e)(2).
    \32\ The proposed amendment would not change the minimum 
requirement for any Competitive Market Maker appointed to a Group 
with less than 100 options classes.
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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 Primary Market Maker or Competitive 
Market Maker must be consistent with this duty.\33\ 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.\34\
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    \33\ See, e.g., Newton v. Merrille, 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 (January 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 (September 
6, 1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules 
Release'').
    \34\ 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 
(February 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 (October 27, 1994), 
59 FR 55006, 55009 (November 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.\35\ The duty of best execution requires broker-dealers

[[Page 35151]]

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.\36\ 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.\37\ 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.\38\
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    \35\ 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 (October 6, 1993), 58 FR 52934, 52937-38 (October 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.
    \36\ 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.
    \37\ Order Handling Rules, 61 FR at 48323.
    \38\ 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 
(November 17, 2000), 65 FR 75414, 75422 (December 1, 2000) (adopting 
new Rules 11Ac1-5 and 11Ac1-6 under the Act 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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    The Commission notes that the proposed rule change would be 
implemented on a pilot basis for six weeks. 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 to extend the pilot program. The Commission believes that the 
proposed rule change's six-week pilot period will allow the Commission 
an opportunity of solicit comments on the proposed rule change prior to 
considering whether the approve such pilot program for an extended 
period. Therefore, the Commission finds good cause, consistent with 
Section 19(b)(2) of the Act,\39\ to approve the proposal, as amended, 
on an accelerated basis.
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    \39\ 15 U.S.C. 78s(b)(2).
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    For these reasons, the Commission believes that the proposal is 
consistent with the requirements of Section 6(b)(5) of the Act,\40\ and 
will not jeopardize market integrity or the incentive for market 
participants to post competitive quotes.\41\
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    \40\ 15 U.S.C. 78f(b)(5).
    \41\ Approval of this proposal is in no way an endorsement of 
payment for order flow by the Commission.
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\42\ that the proposed rule change (SR-ISE-2005-18), as amended, 
which institutes the pilot program until July 22, 2005, is hereby 
approved on an accelerated basis.
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    \42\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\43\
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    \43\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E5-3095 Filed 6-15-05; 8:45 am]
BILLING CODE 8010-01-P