Self-Regulatory Organizations; Chicago Board Options Exchange, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 Thereto Relating to Exercise Advice Procedures

[Federal Register Volume 64, Number 18 (Thursday, January 28, 1999)]
[Notices]
[Pages 4482-4485]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-2001]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40951; File No. SR-CBOE-98-33]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving Proposed Rule Change and Amendment No. 1 Thereto 
Relating to Exercise Advice Procedures

January 15, 1999.

I. Introduction

    On July 27, 1998, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change. The Exchange proposes to clarify 
certain existing exercise procedures for cash-settled and noncash-
settled options and to provide that the failure to submit an exercise 
advice in a timely manner will be designated as a minor rule violation 
subject to summary fines set forth in CBOE Rule 17.50. Amendment No. 1 
was submitted to the Commission on November 3, 1998.\3\ The proposed 
rule change was published for comment in the Federal Register on 
November 16, 1998.\4\ The Commission received no comments on the 
proposal. This order approves the proposal, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Letter from Arthur B. Reinstein, Assistant General Counsel, 
CBOE, to Kelly McCormick, Attorney, Division of Market Regulation, 
SEC, dated October 27, 1998 (``Amendment No. 1''). Amendment No. 1 
clarifies the Business Conduct Committee's authority to impose 
sanctions under proposed rules 17.50(c)(2) and (d)(2); makes 
technical corrections to the proposed rule language; clarifies 
amendments to proposed rules 11.1.05 and 11.1.07; and elaborates on 
the statutory basis for the proposed rule change.
    \4\ Exchange Act Release No. 40645 (November 6, 1998) 63 FR 
63761 (November 16, 1998).
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II. Description of the Proposal

Restrictions on the Exercise of Cash-Settled Index Options

    Currently, a cash-settled index option cannot be exercised during a 
trading delay, halt or suspension. This policy does not apply if the 
trading delay, halt, or suspension occurs on the last business day 
prior to expiration or if the President of the Exchange or his designee 
determines otherwise. The Exchange proposes to amend CBOE Rule 11.1.05 
to codify this policy.\5\ In

[[Page 4483]]

addition, the Exchange proposes to allow processing of an exercised 
cash-settled index option during a trading delay, halt, or suspension 
if it can be documented that the decision to exercise the option was 
made during an allowable time frame, before the delay, halt, or 
suspension. The Exchange proposes to codify this policy in proposed 
CBOE Rule 4.16(b), which is the general rule regarding exercise 
restrictions.\6\
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    \5\ The Exchange note that the restriction of the exercise of 
cash-settled index options is currently reflected in Exchange 
Regulatory Circular RG-91-11.
    \6\ Proposed CBOE Rule 11.1.05 will also cross reference 
proposed CBOE Rule 4.16(b).
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Exercise Notice Procedures for Cash-Settled Index Options

    CBOE Rule 11.1.03 currently requires members to notify the Exchange 
of certain exercise decisions concerning cash-settled index options and 
sets forth procedures for providing such notification. The Exchange 
proposes to amend CBOE Rule 11.1.03 that the rule only applies to 
American-style, cash-settled index options and dies not apply to 
European-style, cash settled index options.\7\
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    \7\ The proposed rule does not apply to European-style options 
because European-style options cannot be exercised early. Moreover, 
their value is fixed on their expiration day and cannot be changed 
or effected by subsequent news. Therefore, the Exchange does not 
require exercise advices to be filed.
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Exercise Notices Inconsistent with Just and Equitable Principles of 
Trade

    Currently, CBOE Rule 11.1.07 states that submitting or preparing an 
exercise instruction after the exercise cutoff time for any expiring 
option on the basis of material information released after the cutoff 
time is inconsistent with just and equitable principles of trade. CBOE 
Rule 11.1.07 applies to expiring noncash-settled equity options. The 
Exchange has also considered preparing or submitting an exercise advice 
or advice cancel after the applicable deadline for any non-expiring 
American-style, cash-settled index option based on material information 
released after the deadline to be inconsistent with just and equitable 
principles of trade.
    The Exchange believes this policy would be more effectively 
communicated to members if it is moved to proposed Rule 11.1.03(e), for 
American-style, cash-settled index options and repeated in proposed 
CBOE Rule 11.1.06(f) for noncash-settled equity options. By adding 
these new subdivisions, the Exchange believes members will be made 
aware of the policy without having to refer to other interpretations of 
the Rule.
    Therefore, the Exchange proposes to add new paragraph (e) to Rule 
11.1.03 to specify for non-expiring American-style, cash-settled index 
options that preparing or submitting an exercise advice or advice 
cancel after the applicable deadline on the basis of material 
information released after the deadline, in addition to constituting a 
violation of Rule 11.1, is an activity inconsistent with just and 
equitable principles of trade. Moreover, the Exchange proposes to add 
new paragraph (f) to CBOE Rule 11.1.06 to specify that preparing or 
submitting an exercise instruction, contrary exercise advice, or advice 
cancel after 4:30 p.m. Chicago Time on the basis of material 
information released after such time, in addition to constituting a 
violation of CBOE Rule 11.1, is an activity inconsistent with just and 
equitable principles of trade. Accordingly, the general provision 
currently found in CBOE Rule 11.1.07 will no longer be necessary and 
will be deleted.

Options Not Subject to Exercise by Exception

    The Exchange proposes to clarify the requirements in CBOE Rule 
11.1.06(c) which applies to exercise decisions and instructions for 
noncash-settled equity options that are not subject to the exercise by 
exception provisions of the Options Clearing Corporation's Rule 805. 
Proposed CBOE Rule 11.1.06(c) will clarify that a member must deliver 
to the Exchange, no later than 4:30 p.m. Chicago Time, each exercise 
instruction prepared, submitted, or accepted by the member for all 
noncash-settled equity options that are not subject to the automatic 
exercise procedures of exercise by exception. Proposed CBOE Rule 
11.1.06(d) clarifies that a member is excused from compliance with the 
exercise instruction requirements if one of the exceptions set forth in 
CBOE Rule 11.1(b) applies and the member complies with Interpretation 
.01 of the Rule. Accordingly, the Exchange proposes to delete 
paragraphs (c)-(e) of CBOE Rule 11.1.06 and replace them with new 
paragraphs (c) and (d).

Other Clarifications

    The Exchange also proposes to revise CBOE Rule 11.1.03(c) 
concerning the preparation of exercise advices before the purchase of 
American-style, cash-settled index option contracts to mirror the same 
provision that applies to noncash-settled equity options in CBOE Rule 
11.1(d). In addition, the Exchange proposes to amend CBOE Rule 11.1 to 
accurately reference the definitions of preparation, submission and 
acceptance of exercise instructions. As amended, the Exchange believes 
the proposed rule reflects the different sources of exercise 
instructions (i.e., Clearing Members prepare exercise instructions for 
proprietary accounts, members submit exercise instructions to Clearing 
Members, and members accept exercise instructions from customer 
accounts). Finally, the Exchange has corrected references to defined 
terms. For example, references to ``Member'' or ``Member Organization'' 
have been corrected to refer to the term member as defined in Section 
1.1 of the Exchange Constitution.

Summary Fines for Failure to Submit an Exercise Advice

    The Exchange proposes to make the failure to submit a contrary 
exercise advice, advice cancel, or exercise instruction in a timely 
manner pursuant to CBOE Rule 11.1.06, relating to the exercise or 
nonexercise of a noncash-settled equity option, a minor rule violation 
subject to the procedures and summary fine provisions of CBOE Rule 
17.50. The Exchange proposes to add new paragraph (8) to CBOE Rule 
17.50(g) to provide that any member that fails to follow the advice 
procedures in CBOE Rule 11.1.06 will be subject to summary fines 
specified in CBOE Rule 17.50. A member will receive a Letter of 
Information for the first infraction, in any twelve-month period. A 
member will receive a Letter of Caution for a second infraction, and 
for any subsequent infractions a member will receive a $500 fine.
    Members will be able to contest a summary fine decision for 
violation of proposed CBOE Rule 17.50(g)(8). CBOE Rule 17.50(c)(1), 
which permits members to seek review by the Business Conduct Committee 
(`BCC''), has been amended to provide review of fines imposed under new 
paragraph (g)(8).

Calculation of Summary Fines for Failure to Submit Accurate Trade 
Information

    CBOE Rules 17.50(g)(4)(b) and (5)(b) provide for the escalation of 
total fines for repeated violations of CBOE Rule 6.51. CBOE Rule 6.51 
sets forth the reporting duties of members. The Exchange proposes to 
amend paragraphs (4)(b) and (5)(b) regarding the calculation of the 
total fine imposed on a member after 2 fines for failing to submit or 
report accurate trade information in any 18-month period. If a member 
incurs two fines under CBOE Rule 17.50(g)(4) or, similarly CBOE Rule 
17.50(g)(5), in any 18-month period, any subsequent fine will be 
calculated by adding the amount of the fine assessed

[[Page 4484]]

for the current violation to the amount of the next most recently 
incurred fine.\8\
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    \8\ The Exchange provided the following example: In January, 
Member XYZ incurs a fine of $100 under CBOE Rule 17.50(g)(4) for 
violation of CBOE Rule 6.51 (based on the percentage of times that 
the member submitted inaccurate or no transaction times). In 
February, Member XYZ incurs a second fine under CBOE Rule 
17.50(g)(4) and the appropriate fine is deemed to be $250. In March, 
Member XYZ incurs a third fine for $100 and, pursuant to CBOE Rule 
17.50(g)(4)(b), must pay a total fine of $350, which is calculated 
by adding the third fine incurred ($100) to the next most recently 
incurred fine ($250). In April, Member XYZ incurs a fourth fine of 
$250 and, pursuant to CBOE Rule 17.50(g)(4)(b), must pay a total of 
$600 calculated by adding the fourth fine ($250) to the total fine 
most recently incurred ($350).
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    The Exchange also proposes to amend CBOE Rule 17.50.03(a) to change 
from the fifth day of the month to the tenth day of the month the date 
by which the Exchange shall attempt to serve members who incur fines 
under CBOE Rule 17.50(g)(4) or (g)(5). The proposed rule change also 
amends the day by which a member may request verification of the fine 
from the Exchange. The member will now have to make such a request by 
the twenty-fifth of the month instead of the twentieth of the month, as 
currently required. The Exchange believes these changes will provide 
more time to process the fines at the beginning of the month while 
preserving the current time period by which a member may request 
verification of the fines.

Exchange Discretion to Bring Disciplinary Action

    The Exchange is proposing to modify the summary fine appeal 
provisions found in CBOE Rule 17.50(c)(2) and (d)(2). The Exchange 
proposes to clarify the BCC's and the Appeals Committee's authority to 
impose sanctions in an appeal of a minor rule violation. The appellate 
panel must determine that the conduct serving as the basis for the 
action under review is in fact a violation of an Exchange rule before a 
sanction may be imposed. The BCC and the Appeals Committee, however, 
may only review the alleged conduct to determine if the conduct 
violates the rule charged and appealed. If the alleged conduct would 
constitute a violation, the BCC or the Appeals Committee could 
determine that the conduct at issue did not rise to the level that 
would trigger a summary fine but was, nonetheless, in violation of the 
Exchange Rule alleged to have been violated. In such a case, the BCC or 
the Appeals Committee could impose a disciplinary sanction for the 
violating conduct as part of its decision concerning the summary fine 
appeal.
    The Exchange also proposes to modify CBOE Rule 17.50(f) the conform 
it to a rule of the Chicago Stock Exchange.\9\ Proposed CBOE Rule 
17.50(f) has been amended to clarify that the Exchange has the 
discretion not to issue a summary fine under CBOE Rule 17.50 in 
appropriate circumstances such as when extenuating circumstances exist 
or when no remedial purpose would be served by the issuance of the 
fine. In addition, the Exchange would have the discretion to commerce a 
formal disciplinary proceeding under CBOE Rule 17.2 whenever the 
Exchange determines that a rule violation is not minor in nature.
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    \9\ See Exchange Act Release No. 37255 (May 30, 1996) 61 FR 
28918 (June 6, 1996) (approving Chicago Stock Exchange Article XII, 
Rule 9).
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    The Exchange proposes to implement the proposed rule change within 
45 days after its approval by the Commission. The Exchange notes the 
reason for the time interval is to give the Exchange the opportunity to 
inform members in the Exchange's Regulatory Bulletin before the changes 
are put into effect. The Exchange proposes to publish the effective 
date in the Exchange's Regulatory Bulletin and will notify the 
Commission of the effective date by letter.

III. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
exchange.\10\ In particular, the Commission finds that the proposed 
rule change is consistent with the requirements of Sections 6(b)(5) and 
6(b)(6) \11\ of the Act.
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    \10\ In reviewing this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f(b)(5); 15 U.S.C. 78f(b)(6)
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    Section 6(b)(5) of the Act \12\ provides, among other things, that 
the rules of an exchange be designed to promote just and equitable 
principles of trade, to prevent fraudulent and manipulative acts and 
practices, to foster cooperation and coordination with persons engaged 
in regulating, clearing, and settling securities transactions, and to 
protect investors and the public interest. The proposed rule change 
clarifies and codifies options exercise procedures and the disciplinary 
procedures for certain violations. By clarifying and codifying these 
procedures, the Exchange provides notice of Exchange rules, which 
should discourage fraudulent and manipulative acts and practices and 
facilitate Exchange members' compliance with exercise procedures.
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    \12\ 15 U.S.C. 78f(b)(5).
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    The proposed rule change further clarifies and classifies the 
exercise procedures for both cash-settle index options and noncash-
settled equity options. The proposed rule change further clarifies the 
appropriate rules for each type of product by expressly stating the 
procedures and policies applicable to each type of product under 
independent subsections. For example, the exercise rules for American-
style cash-settled index options, found in CBOE Rule 11.1.03(d), have 
been amended to reflect the policy that an exercise advice may not be 
prepared before the purchase of the option contract. This amendment 
mirrors the same provision found in CBOE Rule 11.1(d), which applies to 
noncash-settled equity options. By further grouping these rules 
together based upon the type of product, members will have a clearer 
picture of applicable exercise procedures, which should prevent 
fraudulent and manipulative acts and practices and thereby foster 
investor protection.
    The mandates of Section 6(b)(5) are also furthered because the 
proposed rule change clarifies that submitting or preparing an exercise 
instruction for either non-expiring American-style, cash-settled index 
options or expiring noncash settled equity options on the basis of 
material information released after the cutoff time is inconsistent 
with just and equitable principles of trade. This policy will now be 
found in proposed CBOE Rule 11.1.03(e), for American-style, cash-
settled index options and repeated in proposed CBOE Rule 11.1.06(f). 
The policy ensures that options are exercised justly and equitably by 
preventing the improper use of material information.
    The Commission also finds that the proposed rule change is 
consistent with the requirements of Section 6(b)(6) of the Act,\13\ 
which requires that members shall be appropriately disciplined for 
violation of the provisions of the Act, the rules and regulations 
thereunder, or the rules of the exchange. The Exchange proposes to make 
the failure to submit a contrary exercise advice, advice cancel, or 
exercise instruction in a timely manner pursuant to CBOE Rule 11.1.06, 
relating to the exercise or nonexercise of a noncash-settled equity 
option, a minor rule violation subject to the procedures and summary 
fine provisions of CBOE Rule 17.50. By making the violation of CBOE 
Rule 11.1.06 a minor rule violation, members will be appropriately 
disciplined in a

[[Page 4485]]

timely manner, which should quickly prevent future violations. Members 
should not be prejudiced by the rule because their right of review by 
the BCC remains intact.
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    \13\ 15 U.S.C. 78f(b)(6).
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    The proposed CBOE Rules 17.50(c)(2) and (d)(2) are also consistent 
with the disciplinary requirements of Section 6(b)(6). These provisions 
are amended to reflect the BCC's and the Appeals Committee's authority 
to review conduct and impose sanctions during a summary fine appeal. If 
the BCC or the Appeals Committee determines that a member's conduct is 
in violation of the Exchange rule alleged to have been violated, either 
appellate panel has the authority to impose sanctions even if the 
conduct does not rise to the level of triggering a summary fine. The 
Exchange explained that it believes these appellate panels have the 
authority to impose alternate sanctions even if the conduct does not 
reach the level to trigger a summary fine.\14\ The BCC and the Appeals 
Committee are, however, limited to reviewing the alleged conduct as it 
refers to the rule originally charged and appealed and to imposing 
sanctions for violations found of such rule. The Commission believes 
that these rules are designed to appropriately and fairly discipline 
members of violations of Exchange rules. The proposed rule change 
should ensure that members who repeatedly commit minor violations will 
not be able to avoid discipline. Moreover, the proposed rule protects 
members by limiting the appellate panel to review the member's conduct 
as it relates to violations of the rule originally charged and 
appealed.
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    \14\ See CBOE Rule 17.50(f), which provides that the Exchange 
may, whenever it determines that any violation is not minor in 
nature, proceed under CBOE Rule 17.2.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\15\ that the proposed rule change (SR-CBOE-98-33) is approved, as 
amended.

    \15\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-2001 Filed 1-27-99; 8:45 am]
BILLING CODE 8010-01-M