[Federal Register Volume 70, Number 107 (Monday, June 6, 2005)]
[Notices]
[Pages 32860-32863]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-2871]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-51759; File No. SR-Phlx-2004-91]
Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.;
Order Approving Proposed Rule Change and Notice of Filing and Order
Granting Accelerated Approval to Amendment No. 1 Thereto To Establish a
Directed Order Process for Orders Delivered to the Phlx Via AUTOM
May 27, 2005.
I. Introduction
On December 9, 2004, the Philadelphia Stock Exchange, Inc.
(``Phlx'' or ``Exchange'') filed with the Securities and Exchange
Commission (``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\ to establish a directed order process for orders
delivered to the Exchange via the Automated Options Market (``AUTOM'').
The proposed rule change was published for comment in the Federal
Register on December 22, 2004.\3\ The Commission received three comment
letters on the proposal.\4\ On January 18, 2005, the Phlx sent a
response to the comment letters.\5\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 50856 (December 14,
2004), 69 FR 76817.
\4\ See letter from Michael J. Simon, General Counsel and
Secretary, International Securities Exchange, Inc. (``ISE''), to
Jonathan G. Katz, Secretary, Commission, dated January 13, 2005
(``ISE Letter''); letter from Philip D. DeFeo, Chairman and Chief
Executive Officer, Pacific Exchange, Inc. (``PCX''), to Jonathan G.
Katz, Secretary, Commission, dated March 22, 2005 (``PCX Letter'');
and letter from Matthew Hinerfeld, Managing Director and Deputy
General Counsel, Citadel Investment Group, L.L.C., on behalf of
Citadel Derivatives Group LLC (``Citadel''), to Jonathan G. Katz,
Secretary, Commission, dated April 6, 2005 (``Citadel Letter'').
\5\ See letter from Richard S. Rudolph, Director and Counsel,
Phlx, to Jonathan G. Katz, Secretary, Commission, dated January 18,
2005 (``Phlx Letter'').
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On April 27, 2005, the Phlx filed Amendment No. 1 to the proposed
rule change.\6\ This order approves the proposed rule change and
simultaneously provides notice of filing and grants accelerated
approval of Amendment No. 1.
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\6\ Amendment No. 1 added language to clarify the application of
the allocation algorithm and to note that Phlx Rule 707, Just and
Equitable Principles of Trade, would prohibit coordinated actions
between a Phlx directed participant and an OFP involving Directed
Orders.
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II. Description of the Proposed Rule Change
The Phlx proposes to establish, for a one-year pilot period, rules
that permit Exchange specialists, Streaming Quote Traders (``SQTs''),
and Remote Streaming Quote Traders (``RSQTs'') assigned in options
trading on the Phlx XL system (``Streaming Quote Options'') to receive
directed orders. The Phlx proposes to define the term ``Directed
Order'' to mean any customer order to buy or sell that has been
directed to a particular specialist, SQT, or RSQT by an Order Flow
Provider (``OFP'').\7\ The Phlx also proposes to establish a trade
algorithm for electronically executed and allocated trades involving
Directed Orders, which would provide a participation guarantee to the
Directed Specialist, SQT, or RSQT (collectively ``Phlx directed
participants'').
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\7\ The term Order Flow Provider under proposed Phlx Rule
1080(l)(i)(B) would mean any member or member organization that
submits, as agent, customer orders to the Exchange.
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To qualify as a Directed Order, an order must be delivered to the
Exchange via AUTOM. AUTOM currently functions to provide automatic
executions in Streaming Quote Options only when the Exchange's
disseminated bid or offer is the National Best Bid or Offer (``NBBO'').
Therefore, to participate in automatic executions of Directed Orders,
Phlx directed participants would be required to be quoting the NBBO at
the time the Directed Order is received.
Currently, an SQT or RSQT must quote continuous, two-sided markets
in not less than 60% of the series in each Streaming Quote Option
traded on Phlx XL in which such SQT or RSQT is assigned. A specialist
must quote
[[Page 32861]]
continuous, two-sided markets in not less than 100% of the series in
each Streaming Quote Option in which such specialist is assigned.\8\
Under the proposal, like specialists, Directed SQTs or RSQTs would be
required to quote continuous, two-sided markets in not less than 100%
of the series in each Streaming Quote Option in which they receive
Directed Orders.
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\8\ See Phlx Rule 1014(b)(ii)(B).
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Directed Orders would first be allocated to customer limit orders
resting on the limit order book at the execution price. Any remaining
contracts would be allocated as follows:
If the specialist were directed an order, it would be
allocated a number of contracts that is the greater of: (1) Its size
pro rata share; (2) the Enhanced Specialist Participation; \9\ or (3)
40% of the contracts to be allocated.
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\9\ See Phlx Rule 1014(g)(ii).
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If an SQT or RSQT were directed an order, it would be
allocated a number of contracts that is the greater of: (1) Its size
pro rata share; or (2) 40% of the contracts to be allocated.
After a specialist, SQT, or RSQT is allocated contracts,
other market makers quoting at the disseminated price, and non-SQT
Registered Options Traders (``ROTs'') that have placed limit orders on
the limit order book via electronic interface would be allocated their
size pro rata of the remaining contracts.
If any contracts still remain, off-floor broker-dealers
that have placed limit orders on the limit order book that represent
the Exchange's disseminated price would be allocated contracts on a
size pro rata basis.
Finally, if the Directed Order is for a size that is
greater than the Exchange's disseminated size, remaining contracts
would be allocated manually in accordance with Phlx Rule 1014(g)(v),
which sets forth the rules and contract allocation algorithm for trades
that are executed in the trading crowd. A market maker directed an
order would not be entitled to receive a number of contracts that is
greater than the size associated with its quotation, nor would a ROT or
off-floor broker-dealer be entitled to receive a number of contracts
that is greater than the size associated with its limit order.
The allocation algorithm would apply to Directed Orders in lieu of
the current allocation algorithm applicable to orders other than
Directed Orders contained in Exchange Rule 1014(g)(vii). Specialists
that are not Directed Specialists participating in trades involving a
Directed SQT or a Directed RSQT would be entitled to receive a number
of contracts as specified in proposed rule 1014(g)(viii), and would not
be entitled to receive an Enhanced Specialist Participation on the
remaining contracts.
III. Discussion and Commission Findings
The Commission has reviewed carefully the proposed rule change,
comment letters, and the Phlx's response and finds that the proposed
rule change is consistent with the requirements of section 6 of the Act
\10\ and the rules and regulations thereunder applicable to a national
securities exchange \11\ and, in particular, the requirements of
Section 6(b)(5) of the Act.\12\ 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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\10\ 15 U.S.C. 78f.
\11\ 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).
\12\ 15 U.S.C. 78f(b)(5).
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The Commission received three comment letters regarding the
proposal, all of which opposed the proposal.\13\ The commenters
criticized the proposal because they believe it would allow a Phlx
directed participant a guarantee based solely on its relationships with
order entry firms rather than on such Phlx directed participant's
obligations.\14\ The commenters assert that the proposal would reward a
Phlx directed participant for its payment for order flow arrangements
rather than the quality of its quotes, and therefore the proposal would
have a negative impact on price competition.\15\ In addition, two
commenters note that the proposal would not limit the allocation
entitlement to specialists, but extend it to SQTs and RSQTs, which have
fewer obligations to the market.\16\ Two commenters also believed that
the proposal did not address the possibility of coordinated actions
between a directed market maker and an OFP.\17\
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\13\ See supra note 4.
\14\ See, e.g., ISE Letter, supra note 4 at 1-2; PCX Letter,
supra note 4 at 1-2; Citadel Letter, supra note 4 at 2.
\15\ Id.
\16\ ISE Letter (``The Phlx proposal is not limited to
specialist[s], and the Phlx does not attempt to justify this
proposal other than as a way to reward market makers that attract
order-flow to the Phlx.''), supra note 4 at 1, 3-4; Citadel Letter,
supra note 4 at 2.
\17\ ISE Letter, supra note 4 at 3; PCX Letter, supra note 4 at
2.
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The Commission has previously approved rules that guarantee a Phlx
specialist a portion of each order when the specialist's quote is equal
to the NBBO.\18\ The Commission has closely scrutinized exchange rule
proposals to adopt or amend a specialist guarantee where the percentage
of specialist participation would rise to a level that could have a
material adverse impact on quote competition within a particular
exchange.\19\ Because the proposal would not increase the overall
percentage of an order that is guaranteed to the specialist beyond the
currently acceptable threshold, but instead would allow SQTs and RSQTs
to share in that guarantee, the Commission does not believe that the
proposal will negatively impact quote competition on the Phlx. 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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\18\ See Securities Exchange Act Release No. 34606 (August 26,
1994), 59 FR 45741 (September 2, 1994) (SR-Phlx-94-12) (order
approving the enhanced specialist participation in Phlx Rule
1014(g)(ii) for a one-year pilot basis); see Securities Exchange Act
Release No. 41588 (July 1, 1999), 64 FR 37185 (July 9, 1999) (SR-
Phlx-98-56) (order approving the enhanced specialist participation
in Phlx Rule 1014(g)(ii) on a permanent basis).
\19\ See Securities Exchange Act Release No. 43100 (July 31,
2000), 65 FR 48788 (August 9, 2000).
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In addition, a Phlx directed participant will have to be quoting at
the NBBO at the time the order is received to capitalize on the
guarantee. The Commission believes it is critical that the Phlx
directed participant 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 Phlx's proposal prohibits from
notifying a Phlx directed participant regarding its intention to submit
a Directed Order so that such Phlx directed participant could change
its quotation to match the NBBO immediately prior to submission of the
preferenced order, and then fade its quote. In response to commenters'
concerns that its proposal failed to protect against coordinated
actions between a Phlx directed participant and an OFP, the Phlx stated
it believes its Rule 707, Just and Equitable Principles of Trade,
already provides the necessary protections against that type of
conduct, and will proactively conduct surveillance for, and enforce
against, such violations.\20\
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\20\ See Amendment No. 1; letter from Edith Hallahan, Deputy
General Counsel, and Edward Deitzel, Vice President, Phlx, to John
Roeser, Assistant Director, Division of Market Regulation,
Commission, dated May 26, 2005.
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[[Page 32862]]
One commenter states that specialists currently receive
participation entitlements based on their obligations to the market.
The commenter believes that the proposal, by allowing any directed
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.'' \21\ 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.\22\
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 Phlx specialists and Directed SQTs and RSQTs have
greater quoting obligations than other Phlx market makers who cannot be
Phlx directed participants. Specifically, Phlx specialists must submit
continuous, two-sided quotations in 100% of the series of options in
which it is assigned,\23\ and a Directed SQTs or RSQTs must submit
continuous, two-sided quotations in 100% of the series of options in
which it receives Directed Orders. To receive an allocation under this
rule filing, the Phlx directed participant must be quoting at the NBBO
for the size of the allocation received.
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\21\ Citadel Letter, supra note 4 at 2.
\22\ 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).
\23\ See Phlx Rule 1014(b)(ii)(B).
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Two commenters believe that the proposal is similar to facilitation
guarantees and other directed order programs approved by the
Commission.\24\ However, unlike those programs, the commenters
criticize that the instant proposal does not include certain
protections for customers, such as providing the opportunity for price
improvement, or limiting the program to a minimum number of
contracts.\25\
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\24\ ISE Letter (``There is no distinction between a broker
`facilitating' an order and a broker directing an order to a
particular market maker for execution. * * *''), supra note 4 at 3-
4; PCX Letter, supra note 4 at 2.
\25\ ISE Letter, supra note 4 at 3-4; PCX Letter, supra note 4
at 2.
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The Commission believes that the proposal is more akin to current
participation entitlements, for specialists, than the facilitation
guarantee programs and other directed order programs cited by the
commenters. Unlike exchange facilitation guarantee programs,\26\ under
the proposal, the Phlx directed participant would not be eligible for a
participation entitlement unless it is publicly quoting at the NBBO at
the time an order is received. Instead of changing its facilitation
program rules, this proposal allows Phlx directed participants to share
in the participation entitlement currently available only for
specialists. The Commission believes this reallocation is consistent
with the Act and will not affect the incentives of the trading crowd to
compete aggressively for orders based on price.
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\26\ See CBOE Rule 6.74(d); ISE Rule 716(d); Pacific Exchange,
Inc. Rule 6.47(b); American Stock Exchange, Inc. Rule 950(d),
Commentary .02(d); and Philadelphia Stock Exchange, Inc. Rule 1064,
Commentary .02.
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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 specialist, SQT, or RSQT must be
consistent with this duty.\27\ 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.\28\
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\27\ 27 See, e.g., Newton v. Merrill, 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 (Jan. 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 (Sept. 6, 1996), 61 FR
48290 (Sept. 12, 1996) (``Order Handling Rules Release'').
\28\ 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 (Feb. 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 (Oct. 27, 1994), 59
FR 55006, 55009 (Nov. 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.\29\ The duty of best execution requires broker-dealers 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.\30\ 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.\31\ 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.\32\
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\29\ 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 (Oct. 6, 1993), 58 FR 52934, 52937-38 (Oct. 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.
\30\ 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.
\31\ Order Handling Rules, 61 FR at 48323.
\32\ 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
(Nov. 17, 2000), 65 FR 75414, 75422 (Dec. 1, 2000) (adopting new
Exchange Act Rules 11Ac1-5 and 11Ac1-6 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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[[Page 32863]]
The Commission notes that the proposed rule change would be
implemented on a pilot basis for one year. 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 for permanent approval of the pilot program.
For these reasons, the Commission believes that the proposal is
consistent with the requirements of Section 6(b)(5) of the Act,\33\ and
will not jeopardize market integrity or the incentive for market
participants to post competitive quotes.\34\
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\33\ 15 U.S.C. 78f(b)(5).
\34\ Approval of this proposal is in no way an endorsement of
payment for order flow by the Commission.
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IV. Accelerated Approval of Amendment No. 1
Pursuant to Section 19(b)(2) of the Act,\35\ 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 Amendment No. 1 to the proposal, prior to the 30th day after
publishing notice of Amendment No. 1 in the Federal Register.
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\35\ 15 U.S.C. 78s(b)(2).
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The Commission believes that it has received and fully considered
meaningful comments with respect to the proposal, and that Amendment
No. 1 does not raise any new regulatory issues that warrant further
delay. In Amendment No. 1, the Exchange added language to clarify the
application of the allocation algorithm. In addition, Amendment No. 1
added language to note that Phlx Rule 707, Just and Equitable
Principles of Trade, prohibits coordinated actions between the Phlx
directed participant and the OFP involving Directed Orders. The
Commission believes that the addition of the language is appropriate to
clarify the proposed Directed Order process.
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether Amendment No. 1
is consistent with the Act. 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-Phlx-2004-91 on the subject line.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609.
All submissions should refer to File Number SR-Phlx-2004-91. 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 Section, 450 Fifth
Street, NW., Washington, DC 20549. Copies of such filing also will be
available for inspection and copying at the principal office of the
Phlx. 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
publicly available. All submissions should refer to File Number SR-
Phlx-2004-91 and should be submitted on or before June 27, 2005.
VI. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\36\ that the proposed rule change (SR-Phlx-2004-91) be, and hereby
is, approved, and that Amendment No. 1 to the proposed rule change be,
and hereby is, approved on an accelerated basis, for a pilot period to
expire on May 27, 2006.
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\36\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\37\
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\37\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-2871 Filed 6-3-05; 8:45 am]
BILLING CODE 8010-01-P