Document ID: SEC-2008-0539-0001
Agency: sec
Document Type: Notice
Title: Order Modifying Exemption for Qualified Contingent Trades From Rule 611(a), etc.
Posted Date: 2008-04-09T04:00Z

[Federal Register: April 9, 2008 (Volume 73, Number 69)]
[Notices]               
[Page 19271-19274]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09ap08-92]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-57620]

 
Order Modifying the Exemption for Qualified Contingent Trades 
from Rule 611(a) of Regulation NMS Under the Securities Exchange Act of 
1934

April 4, 2008.

I. Introduction

    Pursuant to Rule 611(d)\1\ of Regulation NMS \2\ under the 
Securities Exchange Act of 1934 (``Exchange Act''), the Securities and 
Exchange Commission (``Commission''), by order, may exempt from the 
provisions of Rule 611 of Regulation NMS (``Rule 611'' or ``Rule''), 
either unconditionally or on specified terms and conditions, any 
person, security, transaction, quotation, or order, or any class or 
classes of persons, securities, quotations, or orders, if the 
Commission determines that such exemption is necessary or appropriate 
in the public interest, and is consistent with the protection of 
investors.\3\ On August 31, 2006, the Commission granted an exemption 
for qualified contingent trades from Rule 611(a) (``QCT 
Exemption'').\4\ As discussed below, the Commission is modifying the 
QCT Exemption to remove the minimum size limitation that was included 
in the exemption as originally granted.
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    \1\ 17 CFR 242.611(d).
    \2\ 17 CFR 242.600 et seq.
    \3\ See also 15 U.S.C. 78mm(a)(1) (providing general authority 
for Commission to grant exemptions from provisions of Exchange Act 
and rules thereunder).
    \4\ Securities Exchange Act Release No. 54389 (August 31, 2006), 
71 FR 52829 (September 7, 2006) (``QCT Exemptive Order'').
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II. Background

    The Commission adopted Regulation NMS in June 2005.\5\ Rule 611 
addresses intermarket trade-throughs of quotations in NMS stocks.\6\ 
The Rule applies only to quotations that are immediately accessible 
through automatic execution. On August 31, 2006, the Commission granted 
the QCT Exemption for any trade-throughs caused by the execution of an 
order involving one or more NMS stocks (each an ``Exempted NMS Stock 
Transaction) that are components of a qualified contingent trade.\7\ In 
the QCT Exemptive Order, the Commission defined a ``qualified 
contingent trade'' as a transaction consisting of two or more component 
orders, executed as agent or principal, where:
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    \5\ Securities Exchange Act Release No. 51808 (June 9, 2005), 70 
FR 37496 (June 29, 2005) (``Regulation NMS Adopting Release'').
    \6\ An ``NMS stock'' means any security or class of securities, 
other than an option, for which transaction reports are collected, 
processed, and made available pursuant to an effective transaction 
reporting plan. See 17 CFR 242.600(b)(46) and (47).
    \7\ QCT Exemptive Order, 71 FR at 52831.
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    (1) At least one component order is in an NMS stock;
    (2) all components are effected with a product or price contingency 
that either has been agreed to by the respective counterparties or 
arranged for by a broker-dealer as principal or agent;
    (3) the execution of one component is contingent upon the execution 
of all other components at or near the same time;
    (4) the specific relationship between the component orders (e.g., 
the spread between the prices of the component orders) is determined at 
the time the contingent order is placed;

[[Page 19272]]

    (5) the component orders bear a derivative relationship to one 
another, represent different classes of shares of the same issuer, or 
involve the securities of participants in mergers or with intentions to 
merge that have been announced or since cancelled;\8\
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    \8\ Transactions involving securities of participants in mergers 
or with intentions to merge that have been announced would meet this 
aspect of the exemption. Transactions involving cancelled mergers, 
however, would constitute qualified contingent trades only to the 
extent they involve the unwinding of a pre-existing position in the 
merger participants' shares. Statistical arbitrage transactions, 
absent some other derivative or merger arbitrage relationship 
between component orders, would not satisfy this element of the 
definition of a qualified contingent trade.
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    (6) the Exempted NMS Stock Transaction is fully hedged (without 
regard to any prior existing position) as a result of the other 
components of the contingent trade;\9\ and
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    \9\ A trading center may demonstrate that an Exempted NMS Stock 
Transaction is fully hedged under the circumstances based on the use 
of reasonable risk-valuation methodologies.
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    (7) the Exempted NMS Stock Transaction that is part of a contingent 
trade involves at least 10,000 shares or has a market value of at least 
$200,000 (``Size Condition'').\10\
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    \10\ See 17 CFR 242.600(b)(9) (defining ``block size'' with 
respect to an order as at least 10,000 shares or $200,000 in market 
value).
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    The Chicago Board Options Exchange, Inc. (``CBOE'') has requested 
that the Commission modify the QCT Exemption by removing the Size 
Condition.\11\ According to the CBOE Exemption Request, market 
participants find contingent trades to be an efficient means to effect 
coupled executions in an option and the underlying stock based on the 
pricing spread between the two instruments. CBOE notes that a large 
percentage of these contingent trade orders end up unexecuted due to a 
variety of factors. CBOE states that one of the factors impeding the 
execution of contingent trades is the Size Condition. Contingent trades 
involving a stock size under 10,000 shares (or $200,000) cannot be 
executed if the stock leg would trade through an automated trading 
center's protected quote.\12\ CBOE notes that, due to the need to price 
the trade based on the spread between the option and stock leg more so 
than on current market quotations for the stock, a contingent trade of 
a modest size may still have the stock leg priced outside of a 
protected quotation. In CBOE's experience, the Size Condition is a 
factor that will continue to make it more difficult to complete 
smaller-sized contingent trades. CBOE believes that this impediment has 
a greater impact on individual investors who want to effect a buy-write 
transaction of modest size than on institutional investors, who tend to 
trade in much larger share amounts.\13\
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    \11\ Letter to Nancy M. Morris, Secretary, Commission, from 
Edward J. Joyce, President and Chief Operating Officer, CBOE, dated 
November 28, 2007 (``CBOE Exemption Request'').
    \12\ See CBOE Exemption Request at 3.
    \13\ Id. A buy-write transaction, for example, involves the 
execution of a stock transaction and a corresponding options 
transaction.
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    CBOE states that, if the Size Condition is removed, the other 
conditions--conditions (1) though (6) above--in the QCT Exemption would 
continue to ensure that eligible contingent trades are not used in an 
abusive manner to avoid compliance with Rule 611. CBOE believes that 
the Commission primarily focused on these conditions when it found that 
the exemption was narrowly drawn to encompass only those trades most in 
need of relief to remain part of a viable trading strategy and where 
execution of the NMS stock component at a trade-through price is 
reasonably necessary to effect the contingent trade. CBOE notes that 
the Commission believed that conditions (1) through (6) of the 
exemption require a close connection between any Exempted NMS Stock 
Transaction and the other components of a qualified contingent trade, 
and that this close connection should both significantly limit the 
number of Exempted NMS Stock Transactions and help assure that the 
exemption applies only to those trades most in need of flexibility to 
be executed efficiently. Finally, CBOE believes that a key rationale 
behind the Qualified Contingent Trade Exemption is that contingent 
trades are not priced based on current market quotations, but rather 
the pricing relationship between two related instruments. CBOE believes 
that the rationale holds as true for a small contingent trade that 
meets all the requirements of the exemption as it does for a large 
trade. In this regard, CBOE notes that the Commission recently approved 
a proposed rule change of the options exchanges to amend the definition 
in the Intermarket Linkage Plan of ``complex trade'', which is exempt 
from trade through liability, to include stock-option trades.\14\ CBOE 
states that the rule change does not set a size minimum for a stock-
option trade to be exempt from trade through liability.\15\
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    \14\ See Securities Exchange Act Release No. 56761 (November 7, 
2007), 72 FR 64094 (November 14, 2007).
    \15\ CBOE Exemption Request at 4.
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    CBOE therefore believes that the QCT Exemption, even without the 
Size Condition, would continue to be in the public interest and 
consistent with the protection of investors. In this regard, CBOE 
believes that the proposed modification to the exemption would not 
change the many benefits that contingent trades provide to the market. 
At the same time, CBOE states that the remaining conditions from the 
exemption will continue to ensure that the exemption is narrowly drawn 
to prevent evasion of Rule 611 and that the exemption is limited to a 
small number of transactions. CBOE believes that removing the Size 
Condition will not result in a large increase in the number of 
transactions being exempted from Rule 611 because smaller contingent 
trades represent a very small portion of the overall amount of stock 
executions in listed stocks.\16\
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    \16\ Id.
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III. Discussion

    After careful consideration and for the reasons discussed in this 
order, the Commission hereby modifies the QCT Exemption by removing the 
Size Condition. A ``qualified contingent trade'' now is defined as a 
transaction consisting of two or more component orders, executed as 
agent or principal, where:
    (1) At least one component order is in an NMS stock;
    (2) all components are effected with a product or price contingency 
that either has been agreed to by the respective counterparties or 
arranged for by a broker-dealer as principal or agent;
    (3) the execution of one component is contingent upon the execution 
of all other components at or near the same time;
    (4) the specific relationship between the component orders (e.g., 
the spread between the prices of the component orders) is determined at 
the time the contingent order is placed;
    (5) the component orders bear a derivative relationship to one 
another, represent different classes of shares of the same issuer, or 
involve the securities of participants in mergers or with intentions to 
merge that have been announced or since cancelled;\17\ and
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    \17\ Transactions involving securities of participants in 
mergers or with intentions to merge that have been announced would 
meet this aspect of the exemption. Transactions involving cancelled 
mergers, however, would constitute qualified contingent trades only 
to the extent they involve the unwinding of a pre-existing position 
in the merger participants' shares. Statistical arbitrage 
transactions, absent some other derivative or merger arbitrage 
relationship between component orders, would not satisfy this 
element of the definition of a qualified contingent trade.
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    (6) the Exempted NMS Stock Transaction is fully hedged (without 
regard to any prior existing position) as

[[Page 19273]]

a result of the other components of the contingent trade.\18\
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    \18\ A trading center may demonstrate that an Exempted NMS Stock 
Transaction is fully hedged under the circumstances based on the use 
of reasonable risk-valuation methodologies.
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    The Commission notes that a trading center must meet all of the 
foregoing elements of a qualified contingent trade to qualify for the 
exemption. The exemption is not restricted to dealers or the over-the-
counter market. It can be used by any trading center that meets the 
terms of the exemption.
    The Commission recognizes that contingent trades can be useful 
trading tools for investors and other market participants, particularly 
those who trade the securities of issuers involved in mergers, 
different classes of shares of the same issuer, convertible securities, 
and equity derivatives such as options. Those who engage in contingent 
trades can benefit the market as a whole by studying the relationships 
between the prices of such securities and executing contingent trades 
when they believe such relationships are out of line with what they 
believe to be fair value. Contingent trades therefore are one example 
of a wide variety of trades that contribute to the efficient 
functioning of the securities markets and the price discovery process.
    As discussed in the QCT Exemptive Order,\19\ the Commission 
believes that qualified contingent trades potentially could become too 
risky and costly to be employed successfully if they were required to 
meet the trade-through provisions of Rule 611. Absent an exemption, 
participants in contingent trades often would need to use the Rule's 
intermarket sweep order exception and route orders to execute against 
protected quotations with better prices than an NMS stock component of 
the contingent trade. Any executions of these routed orders could throw 
the participants ``out of hedge'' and necessitate additional 
transactions in an attempt to correct the imbalance. As a practical 
matter, the difficulty of maintaining a hedge, and the risk of falling 
out of hedge, could dissuade participants from engaging in contingent 
trades, or at least raise the cost of such trades. The elimination or 
reduction of this trading strategy potentially could remove liquidity 
from the market. The Commission therefore determined to exempt 
qualified exempted trades from Rule 611.\20\
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    \19\ 71 FR at 52831.
    \20\ Id.
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    To minimize the effect of the QCT Exemption on the objectives of 
Rule 611, it was narrowly drawn to encompass only those trades most in 
need of relief to remain part of a viable trading strategy and where 
execution of the NMS stock component at a trade-through price is 
reasonably necessary to effect the contingent trade. In particular, 
elements (1) through (6) of the exemption, as set forth above, require 
a close connection between any Exempted NMS Stock Transaction and the 
other components of a qualified contingent trade. This close connection 
both significantly limits the number of Exempted NMS Stock Transactions 
and helps assure that the exemption applies only to those trades most 
in need of flexibility to be executed efficiently. For example, the 
execution of one component of the transaction must be contingent upon 
the execution of all other components at or near the same time, and the 
Exempted NMS Stock Transaction must be fully hedged (without regard to 
any prior existing position) as a result of the other components of the 
contingent trade.\21\ In addition, there must be a specified 
relationship between the instruments involved in the component orders. 
The component orders must bear a derivative relationship to one 
another, represent different classes of shares of the same issuer, or 
involve the securities of participants in mergers or with intentions to 
merge that have been announced or since cancelled.\22\ The QCT 
Exemption does not apply to contingent trades, such as statistical 
arbitrage transactions, if their components do not involve instruments 
with a specified relationship.
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    \21\ The requirement that an Exempted NMS Stock Transaction be 
fully hedged should significantly limit the scope of the exemption. 
For example, a contingent trade would not qualify for the exemption 
if an NMS stock transaction was the purchase or sale of 50,000 
shares, and the only other component was the purchase or sale of a 
small quantity of options on the NMS stock. A trading center may 
demonstrate that an Exempted NMS Stock Transaction is fully hedged 
under the circumstances based on the use of reasonable risk-
valuation methodologies.
    \22\ Transactions involving cancelled mergers would be qualified 
contingent trades only to the extent that they involve the unwinding 
of a pre-existing position in the merger participants' shares.
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    In the QCT Exemptive Order,\23\ the Commission noted that the Size 
Condition further limited the QCT Exemption to those transactions where 
an exemption is likely to be most needed to facilitate the trading 
strategies of informed customers. As a national securities exchange 
with extensive experience in executing contingent options and stock 
transactions, CBOE notes that the Size Condition in practice has served 
to inhibit retail investors from engaging in buy-write transactions of 
modest size.\24\ This type of options strategy can be suitable for a 
broad range of investors, and the Commission does not wish 
unnecessarily to inhibit retail investors from engaging in useful 
investment strategies that are available to those who trade in larger 
size. In addition, there are existing duties that brokers owe their 
customers, such as suitability and best execution of contingent stock 
and options transactions. The Commission therefore has decided to 
remove the Size Condition from the QCT Exemption to enable the use of a 
wider range of options strategies for retail investors. In this way, 
buy-write strategies, as well as other contingent trade strategies, 
will not be hampered by the terms of the QCT Exemption and will be more 
readily available to those for whom such strategies are useful and 
appropriate. In addition, removing the Size Condition, by expanding the 
range of investors who can take advantage of the QCT Exemption, 
potentially could promote competition among trading centers.
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    \23\ 71 FR at 52831.
    \24\ CBOE Exemption Request at 3.
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    The Commission does not believe that removing the Size Condition 
will result in the use of contingent trades to evade the requirements 
of Rule 611. Elements (1) through (6) of the exemption, as set forth 
above, are sufficient to encompass only those trades most in need of 
relief to remain part of a viable trading strategy and where execution 
of the NMS stock component at a trade-through price is reasonably 
necessary to effect the contingent trade.
    Accordingly, the QCT Exemption, as modified, should provide 
appropriate relief in those circumstances where compliance with Rule 
611 could be most difficult as a practical matter, but also is limited 
to a small number of transactions that should not unduly undermine the 
objectives of Rule 611.\25\ In this regard, the Commission notes that 
the exemption, as discussed in the QCT Exemptive Order, is premised on 
an expectation that qualified contingent trades will continue to be 
used for essentially the same valid trading purposes as they are 
currently. A material change in the nature or frequency of such trades 
could cause the Commission to reconsider the terms of the exemption.
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    \25\ See CBOE Exemption Request at 4 (representing that removal 
of the Size Condition will not result in a large increase in the 
number of transactions being exempted from Rule 611 because smaller 
contingent trades represent a very small portion of the overall 
amount of stock executions in listed stocks).
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    For the foregoing reasons, the Commission finds that removing the 
Size Condition from the QCT Exemption

[[Page 19274]]

is necessary and appropriate in the public interest, and is consistent 
with the protection of investors.

IV. Conclusion

    It is hereby ordered, pursuant to Rule 611(d) of Regulation NMS, 
that the Size Condition is removed from the QCT Exemption.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\26\
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    \26\ 17 CFR 200.30-3(a)(82).
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Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E8-7446 Filed 4-8-08; 8:45 am]

BILLING CODE 8011-01-P