Self-Regulatory Organizations; Chicago Board Options Exchange, Inc.; Order Approving a Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 1 to a Proposed Rule Change Relating to Solicited Transactions

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34959; File No. SR-CBOE-94-15]

Self-Regulatory Organizations; Chicago Board Options Exchange,

Inc.; Order Approving a Proposed Rule Change and Notice of Filing and

Order Granting Accelerated Approval of Amendment No. 1 to a Proposed

Rule Change Relating to Solicited Transactions

November 9, 1994.

I. Introduction

On May 3, 1994, the Chicago Board Options Exchange, Inc. (``CBOE''

or ``Exchange'') filed with the Securities and Exchange Commission

(``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4

thereunder,\2\ a proposal to adopt a new Rule 6.9 that would regulate

the execution of ``solicited orders''; would set forth specific

priority principles applicable to such orders; and would restrict

trading by members and associated persons possessing knowledge of

imminent undisclosed solicited transactions. On September 19, 1994, the

CBOE filed Amendment No. 1 to its proposal.\3\ The proposed rule change

was published for comment and appeared in the Federal Register on July

13, 1994.\4\ One comment letter was received on the proposed rule

change,\5\ to which the CBOE responded.\6\

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\1\15 U.S.C. 78s(b)(1) (1988).

\2\17 CFR 240.19b-4 (1993).

\3\Amendment No. 1 to the CBOE's proposal serves to make three

minor revisions: (1) the first paragraph of Proposed Rule 6.9 is

amended to make it clear that the rule includes solicitations by

floor brokers who do not represent an original order but who become

aware of the original order when it is announced in the trading

crowd or otherwise; (2) Proposed Interpretation and Policy .04 is

revised to reflect that only paragraph (a) of Rule 6.9 overrides the

Exchange's crossing rule, Rule 6.74; and (3) Proposed Interpretation

and Policy .05 is revised by deleting the introductory clause and

adding an example to make it clear that the priority of an original

order is in all cases governed by the priority principals of Rule

6.45. See letter from Michael L. Meyer, Schiff Hardin & Waite, to

Sharon M. Lawson, Assistant Director, Division of Market Regulation,

Commission, dated September 15, 1994 (``Amendment No. 1'').

\4\See Securities Exchange Act Release No. 34323 (July 6, 1994),

59 FR 35771.

\5\See letter from John Davoli, General Partner, O'Connor &

Associates, to Margaret H. McFarland, Deputy Secretary, Commission,

dated August 2, 1994 (``Comment Letter'').

\6\See letter from Joanne Moffic-Silver, Associate General

Counsel & Chief Enforcement Attorney, CBOE, to Jonathan Katz,

Secretary, Commission, dated September 16, 1994.

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II. Description of the Proposal

The purpose of the CBOE's proposal is to regulate the execution of

``solicited'' transactions in options, i.e., options transactions

having terms that are negotiated prior to the time the orders

comprising the transaction are exposed to the trading crowd on the CBOE

floor.\7\ The proposed rule change also restricts trading in any class

of an option, as well as trading in the underlying security or any

``related instrument,'' by CBOE members and their associated persons

who have knowledge of an imminent solicited transaction in options of

that class. This prohibition applies until all terms are disclosed to

the trading crowd or until execution of the solicited transaction

cannot reasonably be considered imminent given the passage of time

since the transaction was agreed upon.

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\7\Proposed Rule 6.9 states:

A member or member organization representing an order respecting

an option trading on the Exchange (an ``original order''), including

a spread, combination, or straddle order as defined in Rule 6.53 and

a stock-option order as defined in Rule 1.1(ii), may solicit a

member or member organization or a non-member customer or broker-

dealer (the ``solicited person'') to transact in-person or by order

(a ``solicited order'') with the original order.

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Currently, the CBOE's rules are designed to promote order

interaction in an open-outcry auction. For example, Rule 6.43 requires

bids and offers to be made at the post by public outcry, and Rule 6.74

imposes specific order exposure requirements on floor brokers seeking

to cross buy orders with sell orders. The CBOE believes that if the

orders that comprise a solicited transaction are not suitably exposed

to the order interaction process on the CBOE floor, the execution of

such orders would be inconsistent with the open auction market

principles governing the execution of orders on the CBOE's floor.

Proposed Rule 6.9 is intended to preserve the right that CBOE

members currently enjoy the solicit orders in advance of submitting a

proposed trade to the crowd, while at the same time assuring that

original orders that are the subject of a solicitation are exposed to

the auction market in a meaningful way. For instance, the proposed rule

change would require a member representing an original order that is

the subject of a solicitation to disclose the terms of the original

order to the crowd before the original order can be executed.

The CBOE's proposal establishes a series of priority principles for

solicited transactions. Priority is accorded depending on whether the

original order is disclosed throughout the solicitation period; whether

the solicited order improves the best bid or offer in the crowd; and

whether the solicited order matches the original order's limit. Thus,

when the original order is disclosed in advance of the solicitation and

the solicited order both matches the disclosed original order's limit

and improves the market, the solicited order has priority over other

orders in the crowd and may trade with the original order at the

improved bid or offered price, subject to the customer limit order book

priorities set forth in Rule 6.45. When a solicited order does not

match the original order's limit and does not improve the market,

however, it does not have priority over other bids and offers

represented in the crowd even if the original order was disclosed to

the crowd for the full solicitation period. Under the proposal, if an

original order is not disclosed to the crowd, a responsive solicited

order will not have priority to trade with the original order even if

the solicited order improves the market; instead, in that instance,

others in the crowd may trade ahead of the solicited person at the

improved price, subject to the customer limit order priorities in CBOE

Rule 6.45.

In addition to requiring disclosure of original orders and

clarifying the priority principles applicable to solicited

transactions, proposed Rule 6.9(e) clarifies that it is inconsistent

with just and equitable principles of trade for any member or

associated person, who has knowledge of all the material terms of an

original order and a solicited order that matches the original order's

price, to enter an order to buy or sell an option of the same class as

any option that is the subject of the solicitation prior to the time

the original order's terms are disclosed to the crowd or the execution

of the solicited transaction can no longer reasonably be considered

imminent. This prohibition would extend to orders to buy or sell the

underlying security or any ``related instrument,'' as that term is

defined in the Rule.\8\ The CBOE has stated that the purpose of these

measures is to prevent members and associated persons from using

undisclosed information about imminent solicited option transactions to

trade the relevant option or any closely-related instrument in advance

of persons represented in the relevant options crowd. Moreover, the

CBOE believes that proposed Rule 6.9 improves the CBOE's auction by

clarifying the requirements applicable to solicited transactions and by

enabling the CBOE to initiate enforcement proceedings in appropriate

cases under specific rules.

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\8\An order to buy or sell a ``related instrument'' means, in

reference to an index option, an order to buy or sell securities

comprising ten percent or more of the component securities in the

index or an order to buy or sell a futures contract on any

economically equivalent index. In addition, with respect to an

option of the Standard & Poor's 500 Stock Index, an option on the

Standard & Poor's 100 Stock Index is a related instrument, and vice

versa. See Proposed CBOE Rule 6.9(e).

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III. Comment Letter

The Comment Letter\9\ concerning the proposed rule change addressed

two areas of concern. First, the letter questions whether the proposed

rule applies to those market makers who are continuously present in a

trading crowd. Second, the commenter claims that the terminology used

in the proposed rule is vague and undefined.

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\9\See supra note 5.

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The commenter claims that the CBOE's proposed rule is silent with

respect to its applicability to market makers continuously present in

the trading crowd. Instead, the commenter claims that the proposal only

specifically addresses those situations where a market maker decides to

participate in a solicitation either by order or by appearing in person

in the trading crowd, and believes the proposal should make this clear.

The commenter, however, is concerned that if the proposed rule

imposes solicitation-related trading restrictions on market makers who

are physically present in a trading crowd on a continual basis, this

would significantly affect such market makers' ability to fulfill their

market making functions under CBOE rules. According to the commenter,

such an interpretation conceivably could preclude any number of market

makers in a given trading crowd from trading in their appointed option

classes for an undetermined amount of time in instances when a

solicited transaction never materializes into an actual order in a

trading crowd.

The commenter also expressed concern that the terminology used in

the CBOE's proposal is vague or undefined, making it difficult for the

Exchange to enforce the rule consistently. Specifically, the commenter

believes the rule should define what comprises ``all of the material

terms'' of an order, what establishes an order as ``imminent,'' and the

length of time that trading restrictions remain in effect following a

solicitation.

In its response, the CBOE addresses each of the commenter's

concerns.\10\ With respect to the commenter's concern that the CBOE

proposal ignores market makers continuously present in a trading crowd,

the CBOE states that for purposes of its proposed rule, a member's

location at the time a solicitation is received is irrelevant. The

proposed rule applies to all members, including market makers, whether

or not continuously present in a trading crowd, and whether or not

present in the crowd at the time of the solicitation.

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\10\See letter from Joanne Moffic-Silver, supranote 6.

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As for the commenter's contention that the proposal's reach is too

broad if it is meant to apply to market makers continuously present in

a trading crowd, the CBOE notes that the only transactions prohibited

by its proposed rule are those that are based on knowledge of the terms

(which requires knowledge of the price of both the original and

responsive solicited order) of an imminent, undisclosed solicited

transaction. Thus, general solicitations of interest that do not

specify all material terms, or other solicitations that do not result

in express or tacit agreement on all material terms of a trade,

including price, do not give rise to trading restrictions under the

rule. Further, trades not based on undisclosed knowledge of a

solicitation are not restricted.

Regarding the commenter's contention that the terms ``material''

and ``imminent'' as used in the proposal are undefined and vague, the

CBOE responds that similar terms and concepts are used in the

regulatory circulars of the CBOE and other exchanges prohibiting front

running of block transactions. According to the CBOE, many of the

principles in the proposed rule are derived from the frontrunning

context, where compliance and enforcement has not been difficult.

Similarly, the CBOE contents, compliance and enforcement should not be

difficult in the context of solicited transactions.

IV. Discussion

The Commission finds the proposed rule change consistent with the

requirements of the Act and the rules and regulations thereunder

applicable to a national securities exchange. Specifically, the

proposed rule change is consistent with the requirements of Sections

6(b)(5) of the Act, because the proposal is designed to promote just

and equitable principles of trade, remove impediments to and perfect

the mechanism of a free and open market, and protect investors and the

public interest.

The Commission believes that it is appropriate to permit

solicitation between potential buyers and potential sellers of options

in advance of the time they send actual orders to the trading crowd on

the Exchange. Complex options orders, such as spreads, straddles, and

combination orders, as well as stock-option orders and large-sized

orders, often require the ``advance shopping'' that is characteristic

of a solicited transaction. Therefore, the Commission agrees with the

CBOE that such interactions between buyers and sellers and the

resulting solicited transactions can enhance liquidity and depth at the

CBOE by bringing orders to the floor that might otherwise be difficult

to effect.

Nevertheless, because solicited transactions may entail

individualized negotiation, the orders that comprise a solicited

transaction may not adequately be exposed to the floor auction.

Consequently, the crowd may not have sufficient time to digest and

react to those orders' terms, causing the parties to a solicited

transaction to preempt the crowd by executing it at the pre-negotiated

price.

The Commission believes that the CBOE's proposal strikes the proper

balance of allowing members to solicit, in advance, the other side of

an order, while ensuring at the same time that the order will be

exposed to the trading crowd consistent with auction market principles.

The proposal encourages disclosure of an original order to the trading

crowd by making the priority of a solicited order dependent upon the

degree of disclosure to the crowd, and upon whether the order improves

the market.\11\ Such disclosure gives members of the trading crowd the

opportunity to participate in all transactions, including solicited

transactions, and should ensure that customer orders receive the best

price available on the CBOE floor. At the same time, the CBOE's

proposal will enable members to search for contra-side interest for

orders that will ultimately be brought down to the CBOE floor, thereby

enhancing depth and liquidity on the CBOE floor.

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\11\As noted above, the priority principles set forth in the

proposal are subject to customer limit order priorities in CBOE Rule

6.45.

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Absent the proposal, the only guidelines concerning solicited

transactions are contained in a 1988 memorandum to the CBOE's

membership.\12\ The lack of codified Exchange rules governing such

activity could cause uncertainty and hinder solicitation of additional

trading interest. The Exchange's proposal introduces clear rules

applicable to solicited transactions, and strengthens the ability of

the Exchange to ensure that customer orders receive full consideration

by the trading crowd. In addition, the proposed rule change will enable

the Exchange to monitor more effectively transactions where orders have

been solicited outside the trading crowd, and should ensure that

transactions involving solicitation will be executed consistent with

auction market principles.

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\12\See Memorandum from Market Performance Committee regarding

Prior Knowledge of Orders/Rule 8.1 (Requirement that market maker

transactions/order be initiated from the trading floor), dated

January 20, 1988 (describing, among other things, situations in

which it may be appropriate for a member representing an order to

solicit buying or selling interest for the opposite side of the

order).

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The Commission also believes that the commenter's concerns have

been adequately addressed. In this regard, the Commission believes that

it is appropriate for the CBOE to prohibit, as inconsistent with just

and equitable principles of trade, transactions by members based on the

knowledge of imminent undisclosed solicited transactions, irrespective

of a member's location in or out of the trading crowd at the time of

the solicitation. Without this prohibition, such trading can threaten

the integrity of the auction market or disadvantage unwittingly other

market participants.

Although the Commission recognizes that the trading restrictions

may prevent a market maker from conducting certain transactions while

in the crowd, we do not believe the proposal inhibits CBOE market

makers from fulfilling their market making functions. The trading

restrictions only will apply if the member has knowledge of all

material terms and conditions, including the price of both sides of the

trade, of an imminent undisclosed solicited transaction. General

solicitations will not give rise to trading restrictions under the

proposal. Moreover, market maker trades not based on undisclosed

knowledge of the terms of a solicited transaction are not restricted.

Thus, a market maker only will be subject to trading restrictions when

he or she trades based on the information regarding an imminent

transaction that is not disclosed to the trading crowd. It is

reasonable for the CBOE to conclude that transactions effected under

such circumstances are inconsistent with market making obligations, and

should be restricted. Accordingly, the Commission believes that market

makers will still be able to perform their functions fully, and will be

expected to do so, notwithstanding the trading restrictions imposed

under the rule. Finally, regarding the commenter's concerns that the

terms in the CBOE's proposed rule are vague, the Commission agrees with

the CBOE that, although subject to interpretation, when used in other

contexts these terms have not posed a problem for the Exchange or the

Commission.

In summary, the Commission believes that the CBOE proposal is a

reasonable approach to ensure that solicited, prenegotiated orders are

not ``hidden'' from interaction with the auction market. Such orders

should be exposed to the trading crowd to ensure that the best price

available is obtained. At the same time, the proposal will still

provide market participants with flexibility to search for interest for

unusual or complex orders. By setting forth a set of priority

principles, subject to the priorities granted to the customer limit

order book, to encourage disclosure of solicited orders, and by

prohibiting market participants from trading ahead of others based on

undisclosed knowledge of solicited orders, the proposal should benefit

market participants and ensure investor protection consistent with

Section 6(b)(5) of the Act.

The Commission finds good cause for approving Amendment No. 1 to

the proposed rule change prior to the thirtieth day after the date of

publication of notice of filing thereof in the Federal Register.

Amendment No. 1 effects three minor revisions to the CBOE's proposal.

First, paragraph one of Proposed Rule 6.9 is amended to make it clear

that the rule includes solicitations by floor brokers who do not

represent such an original order but who become aware of the original

order when it is announced in the trading crowd or otherwise. Second,

Proposed Interpretation and Policy .04 is revised to reflect that only

paragraph (a) of Rule 6.9 overrides the Exchange's crossing rule, CBOE

Rule 6.74. Third, Proposed Interpretation and Policy .05 is revised by

deleting the introductory clause and adding an example to make it clear

that the priority of an original order is in all cases governed by the

priority principals of Rule 6.45.

The Commission believes that Amendment No. 1 strengthens the

Exchange's proposal by refining some of the language used in its

proposed rule. Moreover, these changes do not affect the substance of

the Exchange's proposal. Accordingly, the Commission believes the

Amendment raises no new or unique regulatory issues. Therefore, the

Commission believes it is consistent with Sections 6(b)(5) and 19(b)(2)

of the Act to approve Amendment No. 1 to the proposal on an accelerated

basis.

V. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning Amendment No. 1. Persons making written

submissions should file six copies thereof with the Secretary,

Securities and Exchange Commission, 450 Fifth Street, N.W., Washington,

D.C. 20549. 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. Sec. 552, will be available for inspection and

copying in the Commission's Public Reference Section, 450 Fifth Street,

N.W., Washington, D.C. 20549. Copies of such filing will also be

available for inspection and copying at the principal office of the

CBOE. All submissions should refer to File No. SR-CBOE-94-15 and should

be submitted by [insert date 21 days from date of publication].

VI. Conclusion

For the reasons discussed above, the Commission finds that the

proposal is consistent with the Act, and, in particular, Section 6 of

the Act.

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\13\ that the proposed rule change (File No. SR-CBOE-94-15), as

amended, is approved.

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\13\15 U.S.C. 78s(b)(2) (1988).

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\14\

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\14\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-28451 Filed 11-16-94; 8:45 am]

BILLING CODE 8010-01-M