[Federal Register Volume 66, Number 12 (Thursday, January 18, 2001)]
[Notices]
[Pages 4880-4882]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1409]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43830; File No. SR-ISE-00-19]


Self Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the International Securities Exchange LLC Adopting an Obvious 
Error Rule

January 10, 2001.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 20, 2000, the International Securities Exchange LLC 
(``ISE'' 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 
Exchange. The Commission is publishing this notice to solicit comments 
on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organizations Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to adopt new ISE Rule 720, which gives 
the Exchange the authority to bust or adjust trades that result from 
clearly erroneous orders or quotations. Proposed new language is 
italicized.
* * * * *

Rule 720. Obvious Errors

    The Exchange shall either bust a transaction or adjust the 
execution price of a transaction that results from an Obvious Error as 
provided in this Rule.
    (a) Definition of obvious Error. For purposes of this Rule only, 
Obvious Error will be deemed to have occurred when:
    (1) during regular market conditions (including rotations), the 
execution price of a transaction is higher or lower than the 
Theoretical Price for the series by an amount equal to at least two (2) 
times the maximum bid/ask spread allowed for the option, so long as 
such amount is 50 cents or more; or
    (2) during fast market conditions (i.e., the Exchange has declared 
a fast market status for the option in question), the execution price 
of a transaction is higher or lower than the Theoretical Price for the 
series by an amount equal to at least three (3) times the maximum bid/
ask spread allowed for the option, so long as such amount is 50 cents 
or more.
    (b) Definition of Theoretical Price. For purposes of this Rule 
only, the Theoretical Price of an option is:
    (1) if the series is traded on at least one other options exchange, 
the last bid or offer, just prior to the trade, found on the exchange 
that has the most liquidity in that option as provided in Supplementary 
Material .02 below; or 
    (2) if there are no quotes for comparison purposes,as determined by 
the Obvious Error Panel.
    (c) Adjustments. Where the execution price of a transaction 
executed as the result of an Obvious Error is adjusted, the adjusted 
price will be:
    (1) the Theoretical Price of the option in the case where the 
erroneous price is displayed in the market and subsequently executed by 
quotes or orders that did not exist in the System at the time of the 
erroneous price was entered; or
    (2) the last bid or offer, just prior to the trade, found on the 
exchange that has the most liquidity in that option as provided in 
Supplementary Material .03 below in the case where an erroneous price 
executes against quotes or orders already existing in the System at the 
time the erroneous price was entered.
    (d) Obvious Error Procedure. Designated personnel in the Exchange's 
market control center (``Market Control'') shall administer the 
application of this Rule as follows.
    (1) Notification. If a market maker on the Exchange believes that 
it participated in a transaction that was the result of an Obvious 
Error, it must notify Market Control within five (5) minutes of the 
execution. If an Electronic Access Member believes an order it executed 
on the Exchange was the result of an Obvious Error, it must notify 
Market Control within twenty (20) minutes of the execution. Except as 
provided below, no relief under this Rule will be provided unless 
notification is made within the prescribed time periods.
    (2) Adjust or Bust. Market Control will determine whether there was 
an Obvious Error as defined above. If it is determined that an Obvious 
Error has occurred, Market Control shall take one of the following 
actions: (i) where each party to the transaction is a market maker on 
the Exchange, the execution price of the transaction will be adjusted 
unless both parties agree to bust the trade within ten (10 minutes of 
being notified by Market Control of the Obvious Error, or \3\ (ii) 
where at least one party to the Obvious Error is not a market maker on 
the Exchange, the trade will be busted unless both parties agree to 
adjust the price of the transaction within thirty (30) minutes of being 
notified by Market Control of the Obvious Error.
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    \3\ The ISE corrected a typographical error that appeared in the 
proposed rule language. Telephone conversation between Katherine 
Simmons, Vice President and Associate General Counsel, ISE, and 
Susie Cho, Attorney, Division of Market Regulation, Commission, 
January 10,2 001.
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    (e) Obvious Error Panel.
    (1) Composition. An Obvious Error Panel will be comprised of 
representatives from three (3) Members that are market makers on the 
Exchange, at least one (1) of which shall be a representative from a 
Member that is a Competitive Market Maker and not also a Primary market 
Maker.
    (2) Request for Review. If a party affected by a determination made 
under this Rule so requests, the Obvious Error Panel will review 
decisions made by market Control under this Rule, including whether an 
Obvious Error occurred, whether the correct Theoretical Price was used, 
and whether an adjustment was made at the correct price. A party may 
also request that the Obvious Error Panel provide relief under this 
Rule in cases where the party failed to provide the notification 
required in paragraph (d)(1), but unusual circumstances must merit 
special consideration. The Obvious Error Panel shall review the facts 
and render a decision on the day of the transaction. All determinations 
by the Obvious Error Panel shall be final.

Supplementary Material to Rule 720

    .01  For purposes of paragraph (a) of this Rule, the maximum bid/
ask spread shall be the maximum bid/ask spread allowed under Rule 
803(b), unless a wider spread has been allowed by the Exchange for the 
option because of unusual market conditions, such as high market 
volatility.
    .02  The Theoretical Price will be determined under paragraph 
(b)(1) above as follows: (i) the bid price from the exchange providing 
the most volume will be used with respect to an erroneous bid price 
entered on the Exchange, and (ii) the offer price from the exchange 
providing the most volume will be used with respect to an erroneous 
offer price entered on the Exchange.
    .03  The price to which a transaction is adjusted under paragraph 
(c)(2) above will be as follows: (i) the bid price from the exchange 
providing the most volume for the option will be used with respect to 
an erroneous offer price entered on the Exchange, and (ii) the offer 
price from the exchange providing the most volume for the option will 
be used with

[[Page 4881]]

respect to an erroneous bid price entered on the Exchange. If there are 
no quotes for comparison purposes, the adjustment price will be 
determined by the Obvious Error Panel.
    .04  When Market Control determines that an Obvious Error has 
occurred and action is warranted under paragraph (d)(2) above, the 
identity of the parties to the trade will be disclosed to each other in 
order to encourage conflict resolution.
    .05  Each market maker firm shall designate at least one person 
that is knowledgeable about options market making on the ISE to be 
called upon by the Exchange to participate on an Obvious Error Panel. 
In no case shall an Obvious Error Panel include a person related to a 
party to the Obvious Error in question. To the extent reasonably 
possible, the Exchange shall call upon representatives of each market 
maker to participate on an Obvious Error Panel on an equally frequent 
basis.
* * * * *

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 Exchange 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 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The Exchange proposes to adopt new ISE Rule 720 that would allow it 
to either adjust or bust a transaction in circumstances where a member 
or its customer has made an error and the price of the execution is 
``obviously'' not correct.\4\ In such situations, the Exchange does not 
believe it is consistent with just and equitable principles of trade to 
permit one market participant to receive a wind-fall at the expense of 
another market participant that made an obvious error. Conversely, the 
Exchange does not seek to permit market participants to reconsider poor 
trading decisions. The ISE believes that the proposed rule contains 
objective standards regarding when a transaction was clearly the result 
of an ``obvious error,'' under what circumstances a trade will be 
adjusted or busted, and to what price a trade will be adjusted if 
adjustment is appropriate under the circumstances.
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    \4\ While current ISE Rule 804(d)(2) gives the Exchange some 
flexibility with respect to customer orders when a market maker's 
quote is obviously an error, it only states that an obviously 
erroneous quote may not be ``firm'' for customer orders. ISE Rule 
804 does not expressly give the Exchange authority to bust an 
executed transaction, nor does it contain any guidelines for 
determining when a quotation is obviously erroneous.
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    Under proposed ISE Rule 720, when a member believes that it has 
participated in a transaction that was the result of an obvious error, 
it must notify ISE Market Control within a specified time of the 
execution. The proposed rule requires Exchange market makers, who are 
continuously monitoring their transactions on the ISE, to notify ISE 
Market Control within five minutes of an execution. The proposed rule 
allows Electronic Access Members, which may handle customer orders on 
multiple exchanges simultaneously and which may need to contact 
customers for instruction, up to twenty minutes to notify ISE Market 
Control.
    ISE Market Control will determine whether there was an obvious 
error according to the following objective criteria: (1) An obvious 
error will be deemed to have occurred during normal market conditions 
when the execution price of a transaction is higher or lower than the 
theoretical price \5\ for the series by an amount equal to at least two 
times the maximum bid/ask spread allowed for the option, so long as 
such amount is 50 cents or more; and (2) an obvious error will be 
deemed to have occurred during fast market conditions when the 
execution price of a transaction is higher or lower than the 
theoretical price for the series by an amount equal to at least three 
times the maximum bid/ask spread allowed for the option, so long as 
such amount is 50 cents or more.\6\ ISE Market Control is not given any 
discretion under proposed ISE Rule 720 to take actions with respect to 
transactions that do not come within the objective obvious error 
criteria. In situations where the theoretical price is not objectively 
determinable, a panel of member representatives will be convened to 
determine the theoretical price.
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    \5\ The theoretical price of an option in the case of an 
erroneous bid (offer) is the last bid (offer), just prior to the 
trade, found on the exchange that has the most liquidity in that 
option other than the ISE. If there are no quotes for comparison 
purposes, the theoretical price will be determined by an obvious 
error panel.
    \6\ The reason for requiring a greater deviation from the 
theoretical price during fast market conditions is that when the 
price of an underlying is moving rapidly, it is not as ``obvious'' 
that an option price might be in error.
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    If it is determined that a transaction is the result of an obvious 
error, ISE Market Control will take one of the following actions: (1) 
Where each party to the transaction is an Exchange market maker,\7\ the 
execution price of the transaction will be adjusted unless both parties 
agree to bust the trade; or (2) where at least one party to the obvious 
error is not a market maker on the Exchange, the trade will be busted 
unless both parties agree to adjust the price of the transaction. In 
the first instance, Exchange market makers, who commonly hedge 
transactions immediately, have indicated a preference for adjusting the 
price of a transaction rather than changing their positions. Thus, the 
default action will be to adjust the price of the execution according 
to the objective criteria discussed below. In the second instance, 
where customer limit orders may be involved, the Exchange does not 
believe it appropriate to adjust the price of a transaction without the 
consent of the market participants. Accordingly, the default will be to 
bust the trade unless both sides agree to adjust the price. The default 
action will be taken unless agreement is reached within ten minutes in 
the case where both parties are Exchange market makers, and within 
thirty minutes where at least one party is not an Exchange market 
maker.
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    \7\ A party to a transaction will be considered an Exchange 
market maker under proposed ISE Rule 720 if the resulting position 
is booked in an ISE market maker account. For example, under ISE 
Rule 803, a Competitive Market Maker (``CMM'') on the ISE may 
execute up to 25 percent of its total volume in securities to which 
it is not appointed. An obvious error involving two CMMs will be 
adjusted under proposed ISE Rule 720 unless both agree to bust the 
trade.
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    Where an adjustment is made to a transaction price, the adjusted 
price will be determined by objective criteria. The adjusted price will 
be equal to the theoretical price of the option in the case where the 
erroneous price is displayed in the market and subsequently executed by 
quotes or orders that did not exist in the system at the time the price 
was entered. For example, if an option had a bid of $5 and offer of 
$5.20 on the options exchange with the most volume in that option and 
due to an erroneous quotation, the ISE displayed a bid of $7 that was 
executed against by an incoming sell order or market maker offer, the 
adjustment price would be $5, which is the fair price at which a market 
participant could have sold the option at the time of the transaction. 
The ISE would presume that, in this situation, the seller knew that the 
price was

[[Page 4882]]

obviously erroneous as compared to the price being displayed by the 
primary options exchange for the option.
    Where a participant enters a quotation or order in error that 
executes against standing interest on the Exchange, the contra side to 
the transaction had no notice of an erroneous price and took no action 
to execute at the erroneous price. In this instance, the adjustment 
price will be the bid (offer) price from the exchange providing the 
most volume in the case of an erroneous offer (bid) price entered on 
the Exchange. The ISE believes that this will result in a more 
favorable adjustment price for the participant with standing interest 
in the book than the participant that made the error. As a result, in 
the previous example, if the erroneous bid of $7 executed against an 
offer in the system at $6.50, the adjustment price would be $5.20 (the 
offer price) instead of 5 (the bid price). Again, the only time an 
adjustment will be made to the price of a transaction is in the case 
where both parties were ISE market makers or where both parties agree 
to the adjustment.
    Finally, proposed ISE Rule 720 specifies that each market maker 
firm will designate at least one person that is knowledgeable about 
options market making on the ISE to be called upon by the Exchange to 
participate on an obvious error panel.\8\ Proposed ISE Rule 720 
provides that an obvious error panel will have the authority to: (1) 
Determine a theoretical price when there is no quote for an option on 
another options exchanges; and (2) upon request by a party to a 
potential obvious error, review whether the correct theoretical price 
was used and whether an adjustment was made at the correct price. A 
party to a potential obvious error may also request that the obvious 
error panel provide relief under the proposed rule in cases where the 
party failed to give notice within the required time periods, but there 
must be unusual circumstances to merit this special consideration. All 
determinations by an obvious error panel will be made on the same day 
as the transaction in question and shall be final.
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    \8\ In no case shall an obvious error panel include a person 
related to a party to the obvious error in question. To the extent 
reasonably possible, the Exchange shall call upon representatives of 
each market maker to participate on an obvious error panel on an 
equally frequent basis.
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2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b) of the Act \9\ in general, and furthers the 
objectives of Section 6(b)(5) \10\ in particular, in that it is 
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 for a free an open market and a national 
market system, and, in general, to protect investors and the public 
interest.
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    \9\ 15 U.S.C. 78f(b).
    \10\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The Exchange did not solicit or receive written comments on 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 Exchange 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, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
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 at the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
Exchange. All submissions should refer to File No. SR-ISE-00-19 and 
should be submitted by February 8, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\1\
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    \1\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-1409 Filed 1-17-01; 8:45 am]
BILLING CODE 8010-01-M