Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Granting Approval and Notice of Filing and Order Granting Accelerated Approval of Amendments No. 1 and 2 of Proposed Rule Change Relating to Position and Exercise Limits for Equity Options Overlying Equity Securities Not Subject to Standardized Options Trading

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35634; File No. SR-NASD-94-54]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc.; Order Granting Approval and Notice of Filing and Order

Granting Accelerated Approval of Amendments No. 1 and 2 of Proposed

Rule Change Relating to Position and Exercise Limits for Equity Options

Overlying Equity Securities Not Subject to Standardized Options Trading

April 20, 1995.

I. Introduction

On October 12, 1994, the National Association of Securities

Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities

and Exchange Commission (``SEC'' or `` Commission'') a proposed rule

change pursuant to Section 19(b)(1) of the Securities Exchange Act of

1934 (``Act'')\1\ and Rule 19b-4 thereunder.\2\ On March 3 and 22,

1995, and NASD submitted amendments to the proposal.\3\ The NASD

proposes to amend its Rules of Fair Practice to allow, under certain

circumstances, members to increase the applicable position and exercise

limits\4\ for conventional options\5\ overlying those equity securities

that are not subject to standardized options trading.\6\

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

\2\17 CFR 240.19b-4 (1994).

\3\Letters from Joan Conley, Corporate Secretary, NASD, to Mark

Barracca, Branch Chief, SEC (Mar. 3, 1995) and Thomas R. Gira,

Assistant General Counsel, Nasdaq, to Mark Barracca, Branch Chief,

SEC (Mar. 22, 1995). The NASD amended its filing to provide, most

significantly that: (1) To be eligible to qualify for a higher

position limit, the underlying security must satisfy the initial

listing standards for standardized options trading; (2) to continue

to be eligible to qualify for a higher position limit, the

underlying security must satisfy the maintenance criteria for

standardized options trading; and (3) if the position limit is

lowered, members will not be required to liquidate their position

but will be prohibited from increasing it if it is above the new

limit.

\4\Under NASD rules, exercise limits placed on options trading

equal the limits imposed for options positions. NASD Manual, Rules

of Fair Practice, Art. III, Sec. 33(b)(3)(A), (CCH) 2183.

\5\A conventional option is any option contract not issued, or

subject to issuance, by The Options Clearing Corporation. NASD

Manual, Rules of Fair Practice, Art. III, Sec. 33(b)(1)(GG), (CCH)

2183.

\6\Position limits impose a ceiling on the number of option

contracts in each class on the same side of the market (i.e.,

aggregating long calls and short puts and long puts and short calls)

that can be held or written by an investor or group of investors

acting in concert. Exercise limits restrict the number of options

contracts which an investor or group of investors acting in concert

can exercise within five consecutive business days. Under NASD

Rules, exercise limits correspond to position limits, such that

investors in options classes on the same side of the market are

allowed to exercise, during any five consecutive business days, only

the number of options contracts set forth as the applicable position

limit for those options classes. See NASD Manual, Rules of Fair

Practice, Art. III, Sec. 33(b) (3) & (4), (CCH)

2183. [[Page 20783]]

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Notice of the proposed rule change appeared in the Federal Register

on January 9, 1995.\7\ The Commission did not receive any comments on

the proposal. For the reasons discussed below, this order approves the

proposed change, as amended.

\7\Securities Exchange Act Release No. 35180 (Dec. 30, 1994), 60

FR 2413 (Jan. 9, 1995).

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II. Description of the Proposed Rule

A. Background and Purpose

As indicated above, the NASD proposes to allow members to increase

the applicable position and exercise limits for conventional options

overlying those equity securities that are not subject to standardized

options trading if certain conditions are satisfied. For conventional

equity options traded by any NASD member, if the underlying security is

subject to standardized options trading, the NASD's position limit for

conventional options on that security is the same position limit

imposed by the options exchange(s) trading the option. Specifically

under NASD rules, position and exercise limits for exchange-listed

options traded by access firms\8\ or their customers are determined

according to a ``three-tiered'' system, where, depending upon the float

and trading volume of the underlying security, the position limit for

options on that security is 4,500, 7,500, or 10,500 contracts.\9\

However, if the security underlying the option is not subject to

standardized options trading, the applicable position limit for

conventional options on the security is the lowest tier, i.e., 4,500

contracts.

\8\``Access'' firms are NASD members which conduct a business in

exchange-listed options but which are not members of any of the

options exchanges upon which the options are listed and traded.

\9\In this connection, the NASD's rules do not specifically

govern how a specific equity option falls within one of the three

position limit tiers. Rather, the NASD's position limit rule

provides that the position limit established by an options

exchange(s) for a particular equity option is the applicable

position limit for purposes of the NASD's rule. Under the rules of

each of the options exchanges, if the security underlying a

standardized option has trading volume of 40,000,000 shares over the

most recent six-month period or trading volume of 30,000,000 shares

over the most recent six-month period and float of 120,000,000, it

is subject to a position limit of 10,500 contracts; if the security

underlying a standardized option has trading volume of 20,000,000

shares over the most recent six-month period or trading volume of

15,000,000 shares over the most recent six-month period and float of

40,000,000, it is subject to a position limit of 7,500 contracts;

and, if the underlying security is ineligible for a 10,500 or 7,500

contract position limit, it is subject to a 4,500-contract position

limit. The rules of each options exchange are uniform in regard to

the above. See, e.g., Commentary .07 to American Stock Exchange Rule

904 and Interpretation and Policy .02 to Chicago Board Options

Exchange Rule 4.11.

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In some instances, however, a security could be eligible for

standardized options trading and qualify for an options exchange

position limit of 7,500 or 10,500 contracts but, for purposes of NASD

position limits, it is subject to a position and exercise limit of

4,500 contracts because it does not underlie an exchange-listed

standardized option. Given that these securities could qualify for

higher position limits but are not eligible for them solely because

there is no standardized option traded on them in the U.S., the NASD

believes its option position limit rule may be unduly restrictive for

these securities and unnecessarily constrain members' legitimate

hedging activity. Accordingly, the NASD proposes to amend Section 33 to

provide that the position limit for options on a security shall be

determined by the position limit tier the security falls under,

regardless of whether the security is subject to standardized options

trading, as long as the security meets the initial and maintenance

standards for standardized options trading.

The NASD believes its proposal is warranted for the following

reasons. First, if a security has sufficient trading volume and public

float to satisfy the standards for a position limit of 7,500 contracts

or 10,500 contracts, the NASD does not believe that raising the

position and exercise limits for conventional options on the security

will adversely affect the cash market for that security. In the NASD's

view, if the cash market for a security is large enough to qualify for

an options position limit of 7,500 contracts or 10,500 contracts, it is

irrelevant whether that security is only subject to conventional

options trading and not standardized options trading. The NASD believes

the primary consideration governing the appropriate position limit

level for options on a security should be the characteristics and size

of the underlying cash market for that security, not whether the

options overlying the security are standardized or conventional.

Second, the NASD does not believe its members' activities in the

conventional options market should be linked to or constrained by

decisions of the options exchanges concerning whether or not to trade

options on particular securities.

Moreover, the NASD believes that its proposal will not compromise

the stability of the securities markets underlying the conventional

options eligible for the higher position limits. In this regard, for

those securities that will be eligible for higher position limits under

the proposal, there will only be a slight increase in the percentage of

their capitalization that an investor or group of investors acting in

concert can control under the new position limits.

B. New Proposal

The NASD proposes to permit position and exercise limits of up to

either 7,500 or 10,500 contracts, whichever is applicable, for

conventional options, if the equity security satisfies the initial

criteria and other listing standards for standardized options trading

and otherwise qualifies for a higher position and exercise limits of

7,500 or 10,500 contracts.\10\ Prior to establishing such a higher

position, the member first must demonstrate to the NASD's Market

Surveillance Department that the underlying equity security satisfies

the initial listing criteria for standardized options trading and

qualifies for a higher position and exercise limit of 7,500 or 10,500

contracts. The initial listing criteria for standardized options

trading are uniform among the five U.S. options exchanges (collectively

referred to as the ``options exchanges''). \11\ Likewise, the criteria

for qualifying for a higher position and exercise limit of 7,500 or

10,500 contracts is uniform among the options exchanges.\12\

\10\For foreign securities, before an option is eligible for

standardized options trading, market surveillance sharing

arrangements must be satisfied. For the NASD to satisfy these

requirements under its proposal, prior to allowing higher (7,500 or

10,500) position and exercise limits for options overlying a foreign

security, the NASD will need to ensure that: (1) It has in place a

comprehensive surveillance sharing agreement with the primary

exchange in the home country where the foreign security is primarily

traded; or (2) the combined trading volume of the foreign security

(and other related securities) occurring in the U.S. markets

represents at least 50% of the combined worldwide trading volume in

the underlying security (including other related securities). See

Securities Exchange Act Release No. 35554 (Jan. 31, 1994), 59 FR

5622 (Feb. 7, 1994).

\11\The five options exchanges are: Chicago Board Options

Exchange (``CBOE''); American Stock Exchange (``Amex''); New York

Stock Exchange (``NYSE''); Philadelphia Stock Exchange (``Phlx'');

and Pacific Stock Exchange (``PSE''). See CBOE Rules, Rule 5.3,

(CCH) 2113; Amex Rules, Rule 915, (CCH) 9715; NYSE Rules, Rule

715, (CCH) 2715; Phlx Rules, Rule 1009, (CCH) 3009; PSE Rules,

Rule 3.6, (CCH) 3591.

\12\See CBOE Rules, Rules 4.11 & 4.12, (CCH) 2091 & 2092; Amex

Rules, Rules 904 & 905, (CCH) 9704 & 9705; NYSE Rules, Rules 704 &

705, (CCH) 2704 & 2705; Phlx Rules, Rules 1001 & 1002, (CCH) 3001

& 3002; PSE Rules, Rules 6.8 & 6.9, (CCH) 4769 & 4775.

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After a member has demonstrated that an equity security meets the

criteria for increased position and exercise limits, the increased

limit will remain in effect for all other conventional options

positions established by the same or other NASD members on that equity

[[Page 20784]] security, subject to a review to be conducted by the

NASD on the Monday following the third Friday of the next January or

July, whichever occurs first, and each successive January and July. The

NASD's periodic reviews will be conducted to determine whether: (a) The

underlying equity security continues to satisfy the options exchanges'

maintenance criteria for listing standardized options upon such

security;\13\ and (b) the equity security continues to satisfy the

criteria for higher position and exercise limits. If either test is not

satisfied, the position and exercise limit will be lowered to the

applicable level,\14\ effective on the Monday following the third

Friday of January or July.\15\ If position and exercise limits are

lowered, a member will not be required to reduce its position to meet

the new position limit level; however, a member will not be permitted

to increase its existing position if such position is greater than the

new limit.\16\

\13\See CBOE Rules, Rule 5.4, (CCH) 2114; Amex Rules, Rule 916,

(CCH) 9716; NYSE Rules, Rule 716, (CCH) 2716; Phlx Rules, Rule

1010, (CCH) 3010; PSE Rules, Rule 3.7, (CCH) 3597.

\14\If the maintenance criteria is not satisfied, the security

would not be eligible for standardized option listing and,

therefore, the position and exercise limits would return to 4,500

contracts, regardless of whether the volume and float data of the

security continue to meet the criteria for a higher position and

exercise limit.

\15\If, however, subsequent to the six-month review, the

security becomes eligible for a higher limit prior to the next

review, the NASD may increase immediately the position and exercise

limit to the applicable level.

\16\Letters from Joan Conley, Corporate Secretary, NASD, to Mark

Barracca, Branch Chief, SEC (Mar. 3, 1995) and Thomas R. Gira,

Assistant General Counsel, Nasdaq, to Mark Barracca, Branch Chief,

SEC (Mar. 22, 1995).

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Finally, the NASD recognizes that its proposal allows for the

possibility that a NASD member complying with the new position limit

standards might nonetheless be deemed in violation of options exchange

position limit standards. Specifically, if an NASD member is also a

member of one or more of the options exchanges, the member could be in

violation of the respective option exchange's position and exercise

limits if standardized options trading commences covering an underlying

equity security for which the NASD previously granted a higher (7,500

or 10,500 contracts) limit. The potential risk arises if the options

exchange position and exercise limits are lower than the NASD's limits

and the member exceeds the exchange's limit.\17\ While the member would

not violate the NASD's rule,\18\ the NASD cannot exempt its members

from the options exchanges' rules. To address this potential issue, the

NASD has committed to notifying its members\19\ that they could be in

violation of the options exchanges' rules if the options exchanges do

not grant an exemption under the above described circumstances.\20\

\17\This could occur if from the time the NASD granted a higher

position and exercise limit and the time the standardized option was

introduced the trading characteristics of the security changed so

that the standardized option was introduced at a lower position

limit.

\18\If a position limit is lowered, the NASD will not require

liquidation to the new limit, but will prohibit increasing further

the position. Letter from Joan Conley, Corporate Secretary, NASD, to

Mark Barracca, Branch Chief, SEC (Mar. 22, 1995).

\19\The NASD will provide this notification in its Notice to

Members announcing the Commission's approval of this proposal.

Letter from Thomas R. Gira, Assistant General Counsel, Nasdaq, to

Mark Barracca, Branch Chief, SEC (Mar. 22, 1995).

\20\NASD rules provide that, for purposes of assessing whether a

member is complying with limits on options positions, standardized

and conventional options positions must be aggregated. NASD manual,

Rules of Fair Practice, Rule 33(b)(3)(A), (CCH)  2183.

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III. Discussion

The Commission believes that the rule change is consistent with the

requirements of Section 15A of the Act of the rules and regulations

thereunder applicable to the NASD, and therefore, has determined to

approve the proposal. Section 15A requires that the rules of the NASD,

among other things, be 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, to remove impediments to

and perfect the mechanism of a free and open market, and, in general,

to protect investors and the public interest.\21\

\21\15 U.S.C. 78o-3(b)(6).

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Currently, NASD members trading conventional equity options for

which there is no standardized options trading covering the underlying

equity security are limited to a position of 4,500 contracts.

Nonetheless, some of the equity securities underlying these

conventional options meet the standards for standardized options

trading but, for business or other reasons, none of the options

exchanges have decided to list standardized options upon them.

Moreover, some of these equity securities satisfy the criteria to

qualify for options position and exercise limits of 7,500 or 10,500

contracts. However, because there are no standardized options traded

upon them, the position and exercise limits remain at 4,500 contracts.

The Commission believes it is appropriate for the NASD to increase,

as proposed, its applicable equity option position and exercise limits

to allow its members that establish positions in conventional options

the benefit of those higher limits where the underlying security fully

qualifies\22\ to be eligible for standardized options trading and the

trading volume and/or shares outstanding for the underlying equity

security warrant such increase. Moreover, the NASD has essentially

agreed to review and apply the equity option maintenance standards used

by the options exchanges, as well as the position and exercise limit

standards, using procedures that basically mirror those that have been

instituted by the options exchanges. The monitoring standards outlined

above will provide that position and exercise limits are maintained at

appropriate levels. Accordingly, this substitute review will allow the

NASD to address those instances where the options exchange could list

and trade equity options, subject to the 7,500 or 10,500 position and

exercise limit tier but, for business or other non-regulatory reasons,

have decided not to list such options.

\22\The Commission notes that, with regard to options overlying

foreign securities, the surveillance related requirements that apply

to standardized options trading on foreign securities must also be

met by the NASD before it allows increased conventional option

position and exercise limits. See supra note 10.

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Moreover, the Commission believes that the NASD proposal should not

adversely affect the cash market for the underlying security. The

options overlying these securities will continue to have position

limits determined based on established standards.\23\ In addition, NASD

members will be required to aggregate with other conventional options

as well as standardized options if they are subsequently listed.

Accordingly, the Commission believes that this rule change will not

undermine the objective of preventing the establishment of large option

positions that can be used to manipulate or disrupt the underlying

market to the benefit of the option position.

\23\See NASD Notice to Members 94-64, NASD Reminds Members of

Their Obligations When Trading Options (June 1994).

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IV. Solicitation of Comments

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

arguments concerning Amendments No. 1 and 2. Persons making written

submissions should file six copies thereof with the Secretary,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549. [[Page 20785]] 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 Room. Copies of such filing will also be available for

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

submissions should refer to the file number SR-NASD-94-54 and should be

submitted by May 18, 1995.

V. Conclusion

For the reasons stated above, the Commission finds that the rule

change is consistent with the Act and the rules and regulations

thereunder applicable to the NASD, in particular, Section 15A(b)(6). In

addition, pursuant to Section 19(b)(2) of the Act,\24\ the Commission

finds good cause for approving the proposed rule change, as amended,

prior to the 30th day after publication of Amendments No. 1 and 2 in

the Federal Register. These amendments provide that the NASD will apply

initial listing and maintenance criteria consistent with the

application of these criteria by the options exchanges for determining

whether a security qualifies for standardized options trading. The

Commission finds that no new regulatory issues are raised by these

amendments and notes that prior to them, the proposed rule change was

published in the Federal Register for the full statutory period and no

comments were received.

\24\15 U.S.C. 78s(b)(2).

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

that the proposed rule change SR-NASD-94-54 be, and hereby is,

approved, as amended.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\25\

\25\17 CFR 200.30-3(a)(12) (1994).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-10295 Filed 4-26-95; 8:45 am]

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