[Federal Register Volume 66, Number 110 (Thursday, June 7, 2001)]
[Notices]
[Pages 30772-30775]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-14332]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44376; File No. SR-ISE-00-19]


Self Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval to Amendment No. 1 Thereto by the International 
Securities Exchange LLC Adopting an Obvious Error Rule

June 1, 2001.

I. Introduction

    On November 20, 2000, the International Securities Exchange LLC 
(``ISE'' or ``Exchange''), submitted to the Securities and Exchange 
Commission (``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 to give the ISE the authority to 
bust or adjust trades that result from clearly erroneous orders or 
quotations.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on January 18, 2001.\3\ One comment letter was received on the 
proposal.\4\ On May 30, 2001, the ISE submitted Amendment No. 1 to the 
proposed rule change to the Commission.\5\ This Order approves the 
proposed rule change. In addition, the Commission is issuing notice of, 
granting accelerated approval to, and soliciting comments on, Amendment 
No. 1 to the proposed rule change.
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    \3\ Securities Exchange Act Release No. 43830 (January 10, 
2001), 66 FR 4880 (January 18, 2001).
    \4\ This comment letter is more fully discussed below in Section 
III, Comment and Response. See Letter from George Brunelle, Brunelle 
& Hadjikow, to Jonathan G. Katz, Secretary, Commission, dated 
February 6, 2001 (``Brunelle Letter'').
    \5\ Letter from Michael Simon, Senior Vice President and General 
Counsel, ISE, to Susie Cho, Division of Market Regulation 
(``Division''), Commission, dated May 29, 2001 (``Amendment No. 
1''). In Amendment No. 1, the ISE proposed to change the composition 
of the Obvious Error Panel to comprise two Electronic Access Members 
and two members that are market makers on the Exchange. The ISE also 
amended the proposed rule change to state that the ISE Market 
Control, not the Obvious Error Panel, would determine the 
theoretical price of an option where there are no quotes to be 
relied on for comparison purposes. Finally, the ISE clarified its 
procedures for appeal of a decision by ISE Market Control to the 
Obvious Error Panel.
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II. Description of the Proposal

    The Exchange proposes to adopt new ISE Rule 720, as amended, 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. The proposed rule contains 
objective standards regarding when a transaction was clearly the result 
of an ``obvious error,'' under what circumstances a trade would be 
adjusted or busted, and to what price a trade would be adjusted if 
adjustment were appropriate under the circumstances.
    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 (``EAMs''), who may handle customer 
orders on multiple exchanges simultaneously and who may need to contact 
customers for instruction, up to twenty minutes to notify ISE Market 
Control. Absent unusual circumstances, ISE Market Control would not 
grant relief unless notification is made within the prescribed time 
periods.\6\
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    \6\ The provision permitting ISE Market Control to grant relief 
in ``unusual circumstances'' is intended primarily to encompass 
situations where EAMs and market-makers might make a request a few 
minutes outside the set time limits, if they have a legitimate 
reason for the delay. According to the ISE, one such situation would 
be, for example, if a firm's system was down and after trying to fix 
it, the firm finds an obvious error among the orders that have 
queued up. On the other hand, EAMs and market makers who fail to 
make a timely request because they failed to monitor their trades 
would not be granted relief. Telephone conversation between 
Katherine Simmons, Vice President and Associate General Counsel, 
ISE, and Susie Cho, Special Counsel, Division, Commission, on May 
29, 2001.

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[[Page 30773]]

    ISE Market Control would determine whether there was an obvious 
error according to the following objective criteria: (1) An obvious 
error would be deemed to have occurred during normal market conditions 
when the execution price of a transaction is higher or lower than the 
theoretical price \7\ 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 would 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.
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    \7\ 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 ISE Market 
Control.
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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, the 
execution price of the transaction would 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 would be 
busted unless both parties agree to adjust the price of the 
transaction. The default action would 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. Upon taking final action, Market Control 
would be required to promptly notify both parties to the trade.
    Where an adjustment is made to a transaction price, the adjusted 
price would be determined by objective criteria. The adjusted price 
would 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.
    Proposed ISE Rule 720 further specifies that the Exchange must 
designate a least ten market maker representatives and at least ten EAM 
representatives to ISE to be called upon to serve on an Obvious Error 
Panel, as needed.\8\ The Obvious Error Panel would be comprised of four 
members. Two of the representatives must be directly engaged in market 
making activity and two of the representatives must be employed by an 
EAM. Proposed ISE Rule 720 provides that an Obvious Error Pannel would 
have the authority to, upon request by a party to a potential obvious 
error, review whether ISE Market Control used the correct theoretical 
price and whether an adjustment was made at the correct price. A 
request for a review must be made in writing within thirty minutes 
after a party receives verbal notification of a final determination by 
ISE Market Control, except that if notification is made after 3:30 p.m. 
Eastern time, either party would have until 9:30 a.m. Eastern time the 
next trading day to request review. The Obvious Error Panel would be 
permitted to overturn or modify an action taken by ISE Market Control 
upon agreement by a majority of the panel representatives; if the 
Obvious Error Panel vote were split 2-2, then the decision of ISE 
Market Control would stand.\9\ All determinations by an Obvious Error 
Panel will be made on the same day as the transaction in question, or 
the next trading day in the case where a request is properly made after 
3:30 p.m. on the day of the transaction or where the request is 
properly made the next trading day. The determination of the Obvious 
Error Panel would be final.
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    \8\ Under proposed Supplementary Material .05 to ISE Rule 720, 
in no case would an Obvious Error Panel include a person related to 
a party to the obvious error in question.
    \9\ See Amendment No. 1, supra note 5.
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III. Comment and Response

A. Comment Letter

    The Commission received one comment letter regarding the 
proposal.\10\ Overall, the commenter believed that the proposed rule 
would unfairly injure public investors, would damage the public options 
markets and would subvert the Commission's newly amended Quote 
Rule.\11\
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    \10\ Brunelle Letter, supra note 4.
    \11\ Rule 11Ac1-1, 17 CFR 240.11 Ac1-1.
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    Specifically, the commenter argued that the concept of 
``theoretical price'' is arbitrary.\12\ The commenter believed that the 
proposed rule change ignores the fact that many different theoretical 
pricing formulae exist and their application by different parties to 
the same trading situations can produce widely divergent calculations 
of the theoretical price.\13\ The commenter also stated that even in 
situations where the ISE recognizes that the theoretical price is not 
objectively determinable, the ISE had proposed to allow an Obvious 
Error Panel comprised entirely of market makers to determine the 
theoretial price without third-party oversight.\14\
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    \12\ Brunelle Letter, supra note 4 at 4.
    \13\ Id.
    \14\ Id. at 5.
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    The commenter also objected that the limitation on the composition 
of the Obvious Error Panel to market makers would tend to create 
opportunities for reciprocity and would constitute, in itself, a 
conflict of interest.\15\ The commenter worried that the proposal would 
give members an incentive and opportunity to take unfair advantage of 
the public by manipulating the ``obvious error'' process to entice 
public investors into trading at prices deliberately set in excess of 
the maximum bid/ask limits.\16\ The commenter stated that the proposal 
contains no mechanism for disclosing to public investors the facts 
underlying a decision to cancel one of their trades, nor any procedure 
for appealing from such a decision to an impartial tribunal.\17\ 
Finally, the commenter argued that the proposal would unfairly impose 
losses from obvious error trades only on the public investor and not on 
market makers who commit ``obvious'' trading errors.\18\
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    \15\ Id.
    \16\ Id. at 6.
    \17\ Id.
    \18\ Id. at 6-7.
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B. ISE Response

    The ISE responded by stating that the protection afforded by the 
proposal is applied equally to all market participants, whether they 
are market makers entering quotations or investors entering limit 
orders.\19\ The ISE later submitted Amendment No. 1 to the 
proposal.\20\
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    \19\ Letter from Michael Simon, Senior Vice President and 
General Counsel, ISE, to Jonathan G. Katz, Secretary, Commission, 
dated February 27, 2001 (``ISE Response'').
    \20\ See Amendment No. 1, supra note 5.
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    In response to the commenter's argument that the proposal would 
violate the Commission's Quote Rule, the ISE argued that its proposal 
is consistent with the Quote Rule, because it is narrowly crafted to 
apply in a fair and even-handed manner only in cases where any 
objective person would agree that the error was obvious.\21\ The ISE 
stated that there is no support for the

[[Page 30774]]

argument that trades done at a price obviously in error must stand, 
citing rules from other self-regulatory organizations (``SROs'') \22\ 
that permit SRO staff to adjust or bust clearly erroneous trades.\23\ 
The ISE also disputed the commenter's assertion that the proposal would 
allow the ISE to cancel trades on the basis of a formula that the 
public could not calculate or verify. The ISE stated that its proposal 
provides specific objective criteria that the Exchange will use to 
determine if a quotation is erroneous and notes that the ISE spread 
requirements are described in ISE Rule 803.\24\
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    \21\ ISE Response, supra note 19 at 3.
    \22\ Rule 11890 of the National Association of Securities 
Dealers, Inc. (``NASD''); Rule 75 of the New York Stock Exchange, 
Inc (``NYSE'').
    \23\ ISE Response, supra note 19 at 2.
    \24\ Id. at 3.
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    Responding to the commenter's arguments regarding the arbitrariness 
of the theoretical price determination and potential conflicts of 
interest for the Obvious Error Panel, the ISE states that the proposal 
specifies exactly the prices to be used in determining whether a trade 
is an ``obvious error,'' i.e., the quotation in the most liquid market 
for the option. Where there is no available quote, the ISE has proposed 
to amend its proposal to state that ISE Market Control, not an Obvious 
Error Panel comprised solely of market makers, will determine the 
theoretical price.\25\ In addition, the composition of the Obvious 
Error Panel has been proposed to be altered by Amendment No. 1 so that 
it would consist of both market maker members and EAMs and it will 
review ISE staff decisions made under the proposed rule.\26\ The ISE 
notes that this is a limited function in which pricing and trading 
expertise is needed and that the proposal explicitly prohibits market 
makers from ruling on any matter involving their own firms.\27\ 
Moreover, the Obvious Error Panel would have no involvement in the 
initial review of a trade and would only provide a forum for an 
appeal.\28\ The ISE also adds that in any trade involving a customer, 
the proposal explicitly provides that the ISE would bust any customer 
trade that is obviously in error unless the customer agrees to adjust 
the price.\29\
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    \25\ See Amendment No. 1, supra note 5.
    \26\ Id.
    \27\ ISE Response, supra note 19 at 5.
    \28\ See Amendment No. 1, supra note 5.
    \29\ ISE Response, supra note 19 at 4.
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    Responding to the commenter's concern of market maker manipulation 
under the proposal, the ISE commented that the Exchange is charged with 
the responsibility to engage in active surveillance of its markets and 
to discipline members who violate its rules or the federal securities 
laws.\30\ The ISE noted that ISE Market Control would easily detect the 
commenter's example of manipulation, since the market maker must seek 
ISE staff involvement to ``correct'' trades.\31\ The ISE also stated 
that the Exchange posts both its rules and its rule proposals on its 
Internet web site for anyone to review.\32\
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    \30\ ISE Response, supra note 19 at 6.
    \31\ Id.
    \32\ Id.
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    Finally, the ISE challenged the commenter's argument that the 
proposal would allow market makers to avoid losses and transfer risks 
to public customers. The ISE stated that the proposal would provide all 
market participants with notice that trades clearly out-of-line with 
the market--subject to clear, objective standards--would not stand.\33\ 
The proposal, instead of permitting arbitrageurs to exploit a clear 
mistake in the market, would reasonably allocate the risk in this type 
of situation in a manner that protects customers while not unfairly 
harming market makers who attempt to provide investors with deep and 
liquid markets.\34\
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    \33\ Id. at 7.
    \34\ Id.
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C. Amendment No. 1

    Amendment No. 1 would alter the proposal in several aspects. In 
Amendment No. 1, the ISE revised the composition of the Obvious Error 
Panel to comprise two Electronic Access Members and two members that 
are market makers on the Exchange.\35\ The ISE also amended the 
proposed rule change to state that the ISE Market Control, not the 
Obvious Error Panel, would determine the theoretical price of an option 
where there are no quotes for comparision purposes.\36\ Finally, the 
ISE clarified its procedures for appealing an ISE staff decision to the 
Obvious Error Panel.\37\ Proposed ISE Rule 720, as amended by Amendment 
No. 1, follows. Additions are italicized.
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    \35\ Amendment No. 1, supra note 5.
    \36\ Id.
    \37\ Id.
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* * * * *

Rule 720. Obvious Errors

* * * * *
    (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 designated personnel in the Exchange's market control 
center (``Market Control'').
* * * * *
    (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. Absent unusal circumstances, Market Control will not 
grant relief under this Rule 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 (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. Upon taking final action, Market Control shall promptly 
notify both parties to the trade.
    (e) Obvious Error Panel.
    (1) Composition. An Obvious Error Panel will be comprised of 
representatives from four (4) Members. Two (2) of the 
representatives must be directly engaged in market making activity 
and two (2) of the representatives must be employed by an Electronic 
Access Member.
    (2) Request for Review. If a party affected by a determination 
made under this Rule so requests within the time permitted below, 
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) and Market Control declined to grant an extension, 
but unusual circumstances must merit special consideration. A 
request for review must be made in writing within thirty (30) 
minutes after a party receives verbal notification of a final 
determination by Market Control under this Rule, except that if 
notification is made after 3:30 p.m. Eastern Time, either party has 
until 9:30 a.m. Eastern Time the next trading day to request review. 
The Obvious Error Panel shall review the facts and render a decision 
on the day of the transaction, or the next trade day in the case 
where a request

[[Page 30775]]

is properly made after 3:30 on the day of the transaction or where 
the request is properly made the next trade day.
    (3) Panel Decision. The Obvious Error Panel may overturn or 
modify an action taken by Market Control under this Rule upon 
agreement by a majority of the Panel representatives. All 
determinations by the Obvious Error Panel shall constitute final 
Exchange action on the matter at issue.

Supplementary Material to Rule 720

* * * * *
    .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 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 Market Control.
* * * * *
    .05  To qualify as a representative of an Electronic Access 
Member on an Obvious Error Panel, a person must (i) be employed by a 
Member whose revenues from options market making activity do not 
exceed ten percent (10%) of its total revenues; or (ii) have as his 
or her primary responsibility the handling of Public Customer orders 
or supervisory responsibility over persons with such responsibility, 
and not have any responsibilities with respect to market making 
activities.
    .06  The Exchange shall designate at least ten (10) market maker 
representatives and at least ten (10) Electronic Access 
representatives to be called upon to serve on Obvious Error Panels 
as needed. In no case shall an Obvious Error Panel include a person 
related to a party to the trade in question. To the extent 
reasonably possible, the Exchange shall call upon the designated 
representatives to participate on an Obvious Error Panel on an 
equally frequent basis.
    .07  All determinations made by the Exchange, Market Control or 
an obvious Error Panel under this Rule shall be rendered without 
prejudice as to the rights of the parties to the transaction to 
submit a dispute to arbitration.
* * * * *

IV. Discussion

    The Commission has reviewed the ISE's proposed rule change and 
finds, for the reasons set forth below, that the proposal is consistent 
with the requirements of section 6 of the Act \38\ and the rules and 
regulations thereunder applicable to a national securities exchange. 
Specifically, the Commission believes the proposal is consistent with 
section 6(b)(5) of the Act,\39\ because it promotes just and equitable 
principles of trade, removes impediments to and perfects the mechanism 
of a free and open market and a national market system, and protects 
investors and the public interest, by providing objective standards for 
the ISE to use in correcting executions made as a result of an obvious 
error and procedures by which ISE staff decisions may be appealed.\40\
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    \38\ 15 U.S.C. 78f.
    \39\ 15 U.S.C. 78f(b)(5).
    \40\ In approving the proposal, the Commission has considered 
the rule's impact on efficiency, competition, and capital formation. 
15 U.S.C. 78c(f).
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    The Commission believes that the proposal is a reasonable means by 
which the Exchange might allocate the costs of obvious error trades. 
The proposal reasonably balances the concern that one market 
participant may receive a wind-fall at the expense of another market 
participant who made an obvious error, with the expectation that market 
participants not be permitted to reconsider poor trading decisions.
    In addition, by providing objective standards for resolving 
disputes involving obvious errors, the proposal should enhance the 
proper functioning of the markets. When an obvious error has been made 
and publicly reported, it is important that the ISE correct these 
obvious errors as quickly as possible using procedures that are clearly 
outlined. Thus, for any trade involving a customer, the proposal 
explicitly provides that the ISE will bust any customer trade that is 
obviously in error unless the customer agrees to adjust the price. The 
proposal further delineates and appeals process to the Obvious Error 
Panel and provides a specified time period in which an appeal can be 
made. The composition of the Obvious Error Panel will provide for the 
equal representation of both EAMs and market makers. Moreover, if there 
is no majority consensus among the panel, the decision of ISE Market 
Control will stand. In addition, where a panel member is an EAM from a 
firm that engages in both public customer business and market making 
activity, the ISE expects that the firm will have information barriers 
in place to ensure against any inappropriate sharing of information 
between the public customer side and the market making side of the 
firm.\41\
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    \41\ Telephone conversation between Katherine Simmons, Vice 
President and Associate General Counsel, ISE, and Susie Cho, Special 
Counsel, Division, Commission, on May 25, 2001.
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    The Commission finds good cause for approving Amendment No. 1 to 
the proposed rule change prior to the thirtieth day after the date of 
publication of notice in the Federal Register. In Amendment No. 1, the 
ISE proposes to change the composition of the Obvious Error Panel to 
comprise two Electronic Access Members and two members that are market 
makers on the Exchange. The ISE also amended the proposed rule change 
to state that the ISE Market Control, not the Obvious Error Panel, 
would determine the theoretical price of an option where there are no 
quotes for comparison purposes. As the changes to the proposal set 
forth in Amendment No. 1 are directly responsive to the concerns raised 
by the commenter, the Commission finds that, consistent with section 
19(b)(2) of the Act,\42\ good cause exists for approving Amendment No. 
1 on an accelerated basis. Accelerated approval of Amendment No. 1 will 
allow the ISE to expeditiously implement the obvious error procedures 
set forth in the proposal.
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    \42\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether the proposed 
amendment 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 June 28, 2001.

VI. Conclusion

    It Is Therefore Ordered, pursuant to section 19(b)(2) of the 
Act,\43\ that the proposed rule change (SR-ISE-00-19), as amended, is 
approved.
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    \43\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\44\
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    \44\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-14332 Filed 6-6-01; 8:45 am]
BILLING CODE 8010-01-M