Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the Philadelphia Stock Exchange, Inc., Relating to the Exercise Cut-Off Procedure for Equity Options Contracts

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33610; File No. SR-Phlx-93-37]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by the Philadelphia Stock Exchange, Inc., Relating to the

Exercise Cut-Off Procedure for Equity Options Contracts

February 9, 1994.

Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on December

20, 1993, the Philadelphia Stock Exchange, Inc. (``Phlx'' or

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

(``Commission'') the proposed rule change as described in Items I, II,

and III below, which Items have been prepared by the Phlx. The

Commission is publishing this notice to solicit comments on the

proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule Change

The Phlx, pursuant to Rule 196-4 of the Act, proposes to amend Phlx

Rule 1042 (Exercise of Option Contracts) by incorporating a new

exercise cut-off procedure.

Specifically, the Exchange proposes to require that an option

holder's final exercise decision (i.e., whether or not to exercise an

expiring equity option)\1\ be indicated to the Exchange by either

submitting a Contrary Exercise Advice (``Advice'') form (to a

designated place at the Exchange or to the Options Clearing Corporation

(``OCC'') pursuant to OCC procedures) or by choosing to rely on OCC's

exercise-by-exception procedure, which automatically makes an exercise

determination for applicable option holders.\2\ The deadline for the

submission of a final exercise decision would remain at 5:30 p.m.

Eastern Standard Time on the business day immediately preceding the

expiration date (``exercise cut-off time'').

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\1\The term ``final exercise decision'' would generally replace

the term ``exercise instructions'' in the amended rule.

\2\Specifically, exercise-by-exception is the system which

allows OCC clearing members to exercise in-the-money options at

expiration which are at or above the predetermined threshold without

submitting input entries into OCC. See OCC Rule 805.

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To implement this new procedure, proposed Rule 1042(b) would

require members and member organizations to take steps to ensure that

final exercise decisions respecting their proprietary positions, and

the positions of members and non-members for whom the responsibility to

make such indications has been accepted by them, are properly indicated

to the Exchange. In addition, to allow time for processing, each member

organization would be required to establish a deadline prior to the

exercise cut-off time after which it will no longer accept final

exercise decisions in expiring equity options from customers.

Rule 1042(b) will continue to provide the following exceptions to

the exercise cut-off procedure: (i) To remedy mistakes made in good

faith; (ii) to respond to a failure to reconcile an unmatched Exchange

option transaction; and (iii) where exceptional circumstances

restricted either a customer's ability to inform the respective member

organization or a member organization's ability to receive final

exercise decisions before the exercise cut-off time.\3\ The current

exception respecting foreign currency options is proposed to be deleted

and replaced with Commentary .03 to Rule 1042, which provides that Rule

1042(b) does not apply to foreign currency options or index options. In

this regard, the following new title to Rule 1042 is proposed:

``Exercise of Equity Option Contracts.''

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\3\Under the current rule, only a customer's ability to send and

a member's ability to receive final exercise decisions could serve

as an exception. Because a customer can submit exercise decisions to

a member organization who in turn submits them to OCC, that member

organization's ability to receive the customer's decision can also

qualify as an exemption under the rule. Under the proposal, a

member's ability to send decisions could also qualify as an

exception.

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In addition, Rule 1042 as amended would require that a memorandum

setting forth the circumstances surrounding the exercise be prepared

and a copy filed with the Exchange's Market Surveillance Department in

any instance of an equity option exercise not submitted

``automatically'' through OCC's exercise-by-exception procedure, and

for which a Contrary Exercise Advice was either not timely submitted or

amended after the exercise cut-off time. Each such memorandum must

reflect the time the final exercise decision was made, or in the case

of a customer, the time the final exercise decision was received, and

must be kept in accordance with SEC Rules 17a-3(a)(6) and 17a-4. Under

the proposal, all of the exceptions listed in Rule 1042(b) would

require a written memorandum setting forth the circumstances giving

rise to the exception.\4\

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\4\Rule 1042 currently only requires a memorandum with respect

to the first and third exception to the Rule. See Rule 1042,

Commentary .02.

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Pursuant to the proposed rule change, the burden of establishing an

exception would rest solely on the member or member organization

seeking to rely on one of the exemptive provisions. Current procedure

requires clearing organizations to record the receipt of exercise

decisions in connection with the exercise cut-off rule. The proposed

procedure would allow members to either submit Contrary Exercise

Advices directly to the Exchange or to the firm responsible for

processing such Advices on their behalf. Thus, since members would have

the ability to submit Advices directly to the Exchange, it is the

member (and not necessarily the clearing agent) who must establish that

an exception relied upon by that member is consistent with the rule. To

address possible instances where no Advice is submitted while an

exercise notice is nonetheless tendered for a strike price outside the

exercise-by-exception parameters and where none of the exceptions

apply, Commentary .02 specifies that such exercises would be deemed

conduct inconsistent with just and equitable principles of trade if

effected on the basis of material information obtained after the

exercise cut-off time.

The Exchange notes that the exercise cut-off time as well as the

actual exercise procedure remain unchanged, including the submission of

exercise notices to OCC contained in Rule 1042(a), which would still be

governed by OCC rules.\5\ In this regard, Commentary .01 as amended

expressly states that the reporting of final exercise decisions

pursuant to Rule 1042 does not serve to substitute as the effective

``exercise notice'' to OCC regarding the exercise or non-exercise of

expiring equity options. A technical amendment changing several

references in Rule 1042(a) to read ``OCC'' is also proposed herein.

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\5\See generally OCC rules and Phlx Rules 1002, 1004, and 1005.

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The text of the proposed rule change is available at the Office of

the Secretary, the Phlx, and at the Commission.

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 IV below. The Phlx 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 the

Statutory Basis for, the Proposed Rule Change

Phlx Rule 1042 governs the exercise of option contracts traded on

the Exchange. Specifically, Rule 1042(a) refers to OCC rules and

procedures regarding the actual exercise of option contracts as well as

the submission of exercise notices to OCC for trade dates prior to the

last day of business prior to expiration. Rule 1042(b) concerns the

exercise cut-off time and submission of exercise instructions to the

Exchange for expiring options on the last day of trading in such

options. At this time, the Phlx proposes to incorporate a new exercise

cut-off procedure into Rule 1042, featuring the use of a Contrary

Exercise Advice for the submission of final exercise decisions and the

ability to submit such Advices directly to the Exchange. The Exchange

represents that the purposes behind these amendments are to bolster the

audit trail requirements of Rule 1042, to incorporate a more convenient

process for members to indicate exercise intentions to the Exchange,

and to further ensure that the exercise cut-off time efficiently

provides a level playing field among market participants with respect

to final exercise decisions.

The new procedure would enable option holders to bypass the

clearing firm when submitting a Contrary Exercise Advice directly to

the Exchange. The Exchange will designate a place on the trading floor

for the submission of these Advices, similar to the current procedure

for the submission of index option exercise notices.\6\ In those

instances where a member holding an expiring option submits an Advice

directly to the Exchange, the responsibility for the timely and proper

submission of such Advice shifts from the option holder's clearing

agent to the option holder himself. For example, a Registered Option

Trader's (``ROT'') clearing agent would not be held responsible for

direct submissions by the ROT to the Exchange.

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\6\See Phlx Rule 1042A and Floor Procedure Advice G-1.

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Under the proposal, Exchange members would still be able to submit

their final exercise decisions, on a Contrary Exercise Advice, to the

respective clearing member. The clearing member would then be required

to either submit the Advice directly to the Exchange at the designated

place or to OCC pursuant to OCC procedures, and would be required to do

so prior to the exercise cut-off time. Regardless of to whom the

submission is made, the Exchange believes that the proposed changes

would result in an efficient audit trail being generated for purposes

of identifying late entries. The Exchange believes the proposal would

constitute an important change in current procedures by enabling a

self-regulatory organization (``SRO'') to confirm the timeliness of

option exercise instruction submissions.

The Exchange further believes that the proposed memorandum

requirement of Rule 1042 should also bolster the Exchange's audit trail

by requiring that a memorandum be prepared and filed with the

Exchange's Market Surveillance Department detailing the circumstances

surrounding any non-automatic exercise that was not submitted on a

Contrary Exercise Advice in a timely manner. In addition, with respect

to the exceptions to the exercise cut-off procedure, the Exchange

believes that the proposed change expressly stating that the burden of

establishing such an exception lies with the person seeking the

exception should also improve the Exchange's ability to surveil for

violations of the procedure.

The Exchange believes that the proposed changes to the exercise

cut-off procedure for expiring equity options reflect a coordinated

effort among the options exchanges and OCC. Accordingly, because the

Phlx expects similar proposed rule changes to be filed with the

Commission in the near future,7 uniformity among options exchanges

should help option holders and other members adjust to the new

procedure and incorporate the changes into their respective procedures.

In this regard, the Exchange will recognize Contrary Exercise Advices

submitted to other national options exchanges for any option listed

both on the Phlx and that other exchange.

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\7\See, e.g., File No. SR-Amex-94-01.

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The Exchange believes that the proposed rule change is consistent

with section 6 of the Act in general, and with section 6(b)(5), in

particular, in that it is designed to prevent fraudulent and

manipulative acts and practices, to promote just and equitable

principles of trade, to foster cooperation and coordination with

persons engaged in regulating, clearing, settling, processing

information with respect to, and facilitating transactions in

securities, and to protect investors and the public interest.

Specifically, the Exchange believes that consistent with section

6(b)(5) of the Act, the proposed change to Rule 1042 should improve the

Exchange's ability to surveil for violations of the exercise cut-off

time because the submission of Contrary Exercise Advices directly to

the Exchange as well to OCC should provide an accurate audit trail to

identify late entries. In addition, the Exchange believes that the

proposed procedure should reduce the onus on clearing firms of

collecting exercise instructions, because the new procedure will enable

option holders to bypass the clearing firm by submitting a Contrary

Exercise Advice directly to the Exchange.

In summary, the Exchange believes that Phlx investigations into

late entries of exercise decisions should ensure compliance with Rule

1042, and, accordingly, promote just and equitable principles of trade.

(B) Self-Regulatory Organization's Statement on Burden on Competition

The Phlx does not believe that the proposed rule change will impose

any burden on competition.

(C) Self-Regulatory Organization's Statement on Comments on the

Proposed Rule Change Received From Members, Participants or Others

No written comments were solicited or received with respect to the

proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing

for Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the self-regulatory organization consents, the Commission will:

(A) By order approve such proposed rule change, or

(B) Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, NW., Washington, DC 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. 552, will be available for inspection and copying in the

Commission's Public Reference Section, 450 Fifth Street, NW.,

Washington, DC. Copies of such filing will also be available for

inspection and copying at the principal office of the Phlx. All

submissions should refer to File No. SR-Phlx-93-37 and should be

submitted March 11, 1994.

For the Commission, by the Division of market Regulation,

pursuant to delegated authority.8

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\8\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-3701 Filed 2-17-94; 8:45 am]

BILLING CODE 8010-01-M