# 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

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URL: https://www.frixlaw.com/law-library/documents/fr%3A94-28451

## Record

- **Collection:** Federal Register
- **Document type:** Uncategorized Document
- **Published:** November 17, 1994

## Text

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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A94-28451. Public record. Not legal advice.