

[Federal Register: December 1, 2005 (Volume 70, Number 230)]
[Notices]               
[Page 72139-72141]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr01de05-62]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52827; File No. SR-PCX-2005-56]

 
Self-Regulatory Organizations; Pacific Exchange, Inc.; Order 
Approving Proposed Rule Change and Amendment No. 1 Thereto and Notice 
of Filing and Order Granting Accelerated Approval to Amendment No. 2 
Relating to the Directed Order Process and the Establishment of 
Designated Market Makers and Lead Market Makers

November 23, 2005.

I. Introduction

    On April 21, 2005, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange''), through its wholly-owned subsidiary PCX Equities, Inc. 
(``PCXE''), filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC''), 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 modify its rules governing the 
Directed Order Process on the Archipelago Exchange (``ArcaEx'').\3\ The 
PCX filed Amendment No. 1 to the proposed rule change on October 4, 
2005.\4\ The proposed rule change, as amended, was published for 
comment in the Federal Register on October 13, 2005.\5\ The Commission 
received no comments from the public in response to the proposed rule 
change. The PCX filed Amendment No. 2 to the proposed rule change on 
November 17, 2005.\6\ This order approves the proposed rule, as amended 
by Amendment No. 1; grants accelerated approval to Amendment No. 2; and 
solicits comments from interested persons on Amendment No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See PCXE Rules 7.31 and 7.37.
    \4\ Amendment No. 1 replaced and superseded the original filing 
in its entirety.
    \5\ See Securities Exchange Act Release No. 52566 (October 5, 
2005), 70 FR 59791.
    \6\ Amendment No. 1 clarified language in PCXE Rule 7.34(d).
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II. Description

    The PCX proposed to add two new classifications of Market Makers, 
Designated Market Makers (``DMMs'') and Lead Market Makers (``LMMs''), 
in connection with ArcaEx's Directed Order Process. Under the proposal, 
only DMMs and LMMs would be eligible to receive orders in ArcaEx's 
Directed Order Process. DMMs would be required to meet certain 
selection criteria and ongoing performance criteria, making them 
eligible to participate in the Directed Order Process. LMMs would be 
granted exclusive eligibility to receive Directed Orders and would be 
held to higher ongoing performance standards than DMMs in listings for 
which ArcaEx is the primary market. Such ongoing performance standards 
would include (i) percent of time the DMM is quoting at the NBBO; (ii) 
percent of executions better than the NBBO; (iii) average displayed 
size; (iv) average quoted spread; and (v) in the event the security is 
a derivative security, the ability of the DMM to transact in the 
underlying markets. LMMs would be held to higher ongoing performance 
standards than DMMs. Although the Exchange would have the ability to 
apply specific levels to be used in defining the performance standards, 
the Exchange would not modify the types of standards to be used without 
changing its rules. The Exchange also proposed to amend PCXE Rule 7.22 
to provide the Corporation with the ability to limit the number of DMMs 
with prior written notice to ETP Holders. Lastly, PCXE Rule 7.25 would 
be modified to require LMMs to register as Odd Lot Dealers in the 
securities in which they are registered as LMM.
    The PCX also sought to modify its Directed Order process in a 
number of ways. First, the Exchange proposed to add a provision that 
requires Users \7\ to be given permission by DMMs in order to send a 
Directed Order to that DMM. The Exchange also proposed to eliminate the 
provision limiting the Directed Order Process to the Core Trading 
Session and proposed to eliminate a provision that suspends the 
Directed Order Process when a locked or crossed market exists in a 
security. In addition, the amendment to the definition would also make 
clear that a Directed Fill specifies the size and price of the Directed 
Fill.
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    \7\ See PCXE Rule 1.1(yy).
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    The Exchange also proposed that marketable Directed Orders would 
first attempt to match against the DMM to which the order has been 
directed, but that, prior to execution, Directed Orders matched against 
DMMs pursuant to their Directed Fill instructions first would be 
executed against any displayed order in the Arca Book priced at or 
better than the terms of the Directed Fill before executing as a 
directed match.\8\ If such matched orders are broken up by orders on 
the Arca Book, the remaining portion of the Directed Order would be 
posted in the Arca Book. Lastly, the Exchange proposed to delete a 
reference in the Directed Order Process rules restricting the price at 
which executions can occur within the Directed Order Process.
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    \8\ Accordingly, a Directed Order would only execute against a 
Directed Fill at a price superior to the Arca best bid or offer.
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    In Amendment No. 2, the Exchange proposed to remove provisions in 
PCXE Rule 7.34(d) that limit the availability of the Directed Order 
Process during the Opening Session and Late Trading Session.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether Amendment No. 2 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

[[Page 72140]]

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-PCX-2005-56 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-9303.
    All submissions should refer to File Number SR-PCX-2005-56. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, 

all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Section, Station 
Place, 100 F Street, NE., Washington, DC 20549. Copies of such filing 
also will be available for inspection and copying at the principal 
office of the PCX. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-PCX-
2005-56 and should be submitted on or before December 22, 2005.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\9\ In particular, the Commission finds that the 
proposal, as amended, is consistent with the provisions of section 
6(b)(5) of the Act,\10\ which requires, among other things, that a 
national securities exchange's rules be designed to prevent fraud and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to remove impediments to and to perfect the 
mechanism of a free and open market and a national market system and; 
in general, to protect investors and the public interest.
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    \9\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \10\ 15 U.S.C. 78f(b)(5).
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    Under the proposal, the two new classifications of Market Makers, 
DMMs and LMMs, would be entitled to receive Directed Orders. In 
exchange for this benefit, the Exchange would subject DMMs and LMMs to 
certain selection criteria and ongoing performance standards. In 
addition, DMMs and LMMs must comply with obligations currently set 
forth in the Exchange's rules. In particular, DMMs and LMMs would be 
required to maintain continuous two-sided Q Orders in those securities 
in which they are eligible to receive Directed Orders and to engage in 
a course of dealings to assist in the maintenance of fair and orderly 
markets. The Commission believes that providing the benefit of 
receiving Directed Orders to DMMs and LMMs while in turn holding DMMs 
and LMMs to increased obligations to the market is consistent with the 
Act. The Commission notes that the Exchange would hold an LMM to higher 
standards than a DMM. The Commission believes that applying a higher 
standard to LLMs is appropriate because LMMs would have exclusive 
access to participate in the Directed Order Process as a Market Maker 
for primary listings.
    The Commission also believes that the amendments to the operation 
of the Directed Order Process are consistent with the Act. In this 
regard, the Commission notes that if there is an order displayed on the 
Arca Book at a price that is at or better than the price of a Directed 
Fill, the Directed Order would not execute against the Directed Fill. 
Further, the Commission notes that executions in the Directed Order 
process may not take place at prices inferior to the NBBO.\11\ 
Accordingly, in order for a DMM or LMM to receive a Directed Order 
execution, the DMM or LMM must improve the best displayed price on the 
Arca Book, and such price must be equal to or better than the NBBO.
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    \11\ See PCXE Rule 7.37.
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    The Commission emphasizes that approval of this proposal does not 
affect a broker-dealer's duty of best execution. A broker-dealer has a 
legal duty to seek to obtain best execution of customer orders, and any 
decision to preference a particular DMM or LMM must be consistent with 
this duty.\12\ A broker-dealer's duty of best execution derives from 
common law agency principles and fiduciary obligations, and is 
incorporated in Self-Regulatory Organization rules and, through 
judicial and Commission decisions, the antifraud provisions of the 
Federal securities laws.\13\
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    \12\ See, e.g, Newton v. Merrill, Lynch Pierce, Fenner & Smith, 
Inc., 135 F.3d 266, 269-70, 274 (3d Cir.), cert. denied, 525 U.S. 
811 (1998); Certain Market Making Activities on Nasdaq, Securities 
Exchange Act Release No. 40900 (January 11, 1999) (settled case) 
(citing Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Arleen Hughes, 
27 SEC 629, 636 (1948), aff'd sub nom. Hughes v. SEC. 174 F.2d 969 
(D.C. Cir. 1949)). See also Order Execution Obligations, Securities 
Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996) (``Order Handling Rules Release'').
    \13\ Order Handling Rules Release, 61 FR at 48322. See also 
Newton, 135 F3.d at 270. Failure to satisfy the duty of best 
execution can constitute fraud because a broker-dealer, in agreeing 
to execute a customer's order, makes an implied representation that 
it will execute it in a manner that maximizes the customer's 
economic gain in the transaction. See Newton, 135 F.3d at 273 
(``[T]he basis for the duty of best execution is the mutual 
understanding that the client is engaging in the trade--and 
retaining the services of the broker as his agent--solely for the 
purpose of maximizing his own economic benefit, and that the broker 
receives her compensation because she assists the client in reaching 
that goal.''); Marc N. Geman, Securities Exchange Act Release No. 
43963 (February 14, 2001) (citing Newton, but concluding that 
respondent fulfilled his duty of best execution). See also Payment 
for Order Flow, Securities Exchange Act Release No. 34902 (October 
27, 1994), 59 FR 55006, 55009 (Nov. 2, 1994) (``Payment for Order 
Flow Final Rules''). If the broker-dealer intends not to act in a 
manner that maximizes the customer's benefit when he accepts the 
order and does not disclose this to the customer, the broker-
dealer's implied representation is false. See Newton, 135 F.3d at 
273-274.
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    The duty of best execution requires broker-dealers to execute 
customers' trades at the most favorable terms reasonably available 
under the circumstances, i.e., at the best reasonably available 
price.\14\ The duty of best execution requires broker-dealers to 
periodically assess the quality of competing markets to assure that 
order flow is directed to the markets providing the most beneficial 
terms for their customer orders.\15\ Broker-dealers

[[Page 72141]]

must examine their procedures for seeking to obtain best execution in 
light of market and technology changes and modify those practices if 
necessary to enable their customers to obtain the best reasonably 
available prices.\16\ In doing so, broker-dealers must take into 
account price improvement opportunities, and whether different markets 
may be more suitable for different types of orders or particular 
securities.\17\
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    \14\ Newton, 135 F.3d at 270. Newton also noted certain factors 
relevant to best execution--order size, trading characteristics of 
the security, speed of execution, clearing costs, and the cost and 
difficulty of executing an order in a particular market. Id. at 270 
n. 2 (citing Payment for Order Flow, Securities Exchange Act Release 
No. 33026 (October 6, 1993), 58 FR 52934, 52937-38 (October 13, 
1993) (Proposed Rules)). See In re E.F. Hutton & Co. (``Manning''), 
Securities Exchange Act Release No. 25887 (July 6, 1988). See also 
Payment for Order Flow Final Rules, 59 FR at 55008-55009.
    \15\ Order Handling Rules Release, 61 FR at 48322-48333 (``In 
conducting the requisite evaluation of its internal order handling 
procedures, a broker-dealer must regularly and rigorously examine 
execution quality likely to be obtained from different markets or 
market makers trading a security.''). See also Newton, 135 F.3d at 
271; Market 2000: An Examination of Current Equity Market 
Developments V-4 (SEC Division of Market Regulation January 1994) 
(``Without specific instructions from a customer, however, a broker-
dealer should periodically assess the quality of competing markets 
to ensure that its order flow is directed to markets providing the 
most advantageous terms for the customer's order.''); Payment for 
Order Flow Final Rules, 59 FR at 55009.
    \16\ Order Handling Rules, 61 FR at 48323.
    \17\ Order Handling Rules, 61 FR at 48323. For example, in 
connection with orders that are to be executed at a market opening 
price. ``[b]roker-dealers are subject to a best execution duty in 
executing customer orders at the opening, and should take into 
account the alternative methods in determining how to obtain best 
execution for their customer orders.'' Disclosure of Order Execution 
and Routing Practices, Securities Exchange Act Release No. 43590 
(November 17, 2000), 65 FR 75414, 75422 (December 1, 2000) (adopting 
new Rules 11Ac1-5 and 11Ac1-6 under the Act and noting that 
alternative methods offered by some Nasdaq market centers for pre-
open orders included the mid-point of the spread or at the bid or 
offer).
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    Furthermore, the Commission finds good cause for approving 
Amendment No. 2 to the proposed rule change prior to the thirtieth day 
after the amendment is published for comment in the Federal Register 
pursuant to section 19(b)(2) of the Act.\18\ Amendment No. 2 clarified 
that the Exchange proposed to make the Directed Order Process available 
during the Opening Session and the Late Trading Session. The Commission 
does not believe that Amendment No. 2 materially affects the original 
proposed rule change, as amended, or that it presents any novel 
regulatory issues. Accordingly, the Commission finds good cause to 
accelerate approval of Amendment No. 2.
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    \18\ 15 U.S.C. 78s(b)(2).
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\19\ that the proposed rule change (SR-PCX-2005-56), as amended by 
Amendment No. 1, be, and it hereby is, approved, and that Amendment No. 
2 is approved on an accelerated basis.
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    \19\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. E5-6732 Filed 11-30-05; 8:45 am]

BILLING CODE 8010-01-P
